Money Market Instruments: Types, Functions & Nepal’s Market

TAKEAWAYS:

• The money market is a short-term (≤1 year) borrowing/lending market for liquidity management, dominated by government securities, commercial papers, and interbank loans.
• Key instruments in Nepal include Treasury Bills (T-Bills), Commercial Papers (CPs), Repurchase Agreements (Repos), and Certificate of Deposits (CDs), each with distinct issuers, maturities, and yields.
• The Nepal Rastra Bank (NRB) regulates the money market to ensure liquidity, interest rate stability, and monetary policy transmission.
• Money market instruments are riskier than fixed deposits but offer higher returns, making them critical for banks, businesses, and the government.
• Liquidity risk and interest rate risk are the primary risks in the money market, managed through diversification and hedging.
• The money market cycle (issuance → trading → maturity → reinvestment) directly impacts Nepal’s inflation, exchange rates, and economic growth.

1. Definition and Characteristics of the Money Market

The money market is a segment of the financial market where short-term (≤1 year) funds are borrowed/lent at low risk. It facilitates liquidity management for governments, banks, and corporations.

Key Features

mindmap
  root((Money Market))
    Characteristics
      Short-term: ≤1 year
      High liquidity: Easily convertible to cash
      Low risk: Backed by high-quality assets
      High volume: Daily transactions in billions
    Participants
      Issuers: Government (NRB), Banks, Corporates
      Investors: Banks, Financial Institutions, NRB
    Instruments
      Treasury Bills
      Commercial Papers
      Repurchase Agreements
      Certificate of Deposits

Why it matters in Nepal?

• Helps NRB control inflation via open market operations (OMOs).
• Provides cheap funding for businesses (e.g., Daraz, Ncell) and the government.
• Acts as a safety valve during economic crises (e.g., COVID-19 liquidity crunch in 2020).

2. Major Money Market Instruments in Nepal

Visual: How T-Bills Work in Nepal

1. NRB issues T-Bills (e.g., Rs 100 million) at auction.
2. Banks bid (e.g., Bank A bids Rs 7%, Bank B bids Rs 6.5%).
3. NRB accepts lowest rate (Bank B wins at 6.5%).
4. Bank B earns (Rs 100M × 6.5% × 90/360 = Rs 1.69 million profit).

3. Functions of the Money Market

flowchart TD
  A["Money Market Functions"] --> B["Liquidity Management"]
  A --> C["Interest Rate Determination"]
  A --> D["Government Borrowing"]
  A --> E["Monetary Policy Transmission"]
  A --> F["Risk Mitigation"]

  B --> B1["Banks lend excess cash via Repos"]
  C --> C1["T-Bill yields set benchmark for loans"]
  D --> D1["NRB funds deficits via T-Bills"]
  E --> E1["NRB uses OMOs to control money supply"]
  F --> F1["Diversification reduces default risk"]

Real-World Example: Ncell’s Funding via Commercial Papers

• Problem: Ncell needs Rs 500 million for network expansion but doesn’t want a long-term loan.
• Solution: Issues 90-day Commercial Papers at 7.5% yield.
• Outcome:
  • Investors: Banks and mutual funds buy CPs for short-term returns.
  • Ncell: Gets funds at lower cost than a bank loan (9-12%).
  • Money Market Impact: Increases liquidity, pushes interbank rates down.

4. Money Market vs. Capital Market

5. Risks in the Money Market

pie
  title Risks in Money Market Instruments
  "Interest Rate Risk" : 35
  "Liquidity Risk" : 30
  "Credit Risk" : 20
  "Inflation Risk" : 15

Worked Example: Interest Rate Risk for a Bank

• Scenario: A bank buys a 6-month T-Bill at 6% when rates are low.
• Problem: NRB raises repo rate to 8% after 3 months.
• Impact:
  • Bank’s T-Bill yield (6%) is now below market rates.
  • To reinvest, the bank must accept lower returns or take higher risk.

Solution: Banks hedge by:

1. Using forward rate agreements (FRAs).
2. Diversifying into floating-rate instruments.

6. The Money Market Cycle in Nepal

flowchart LR
  A["NRB Issues T-Bills"] --> B["Banks Bid at Auction"]
  B --> C["Winning Banks Hold Securities"]
  C --> D["Maturity: Banks Get Principal + Interest"]
  D --> E["Reinvestment: Banks Lend Excess Cash"]
  E --> F["Interbank Rate Adjusts"]
  F --> A

Trace: Rs 20 Million T-Bill Injection (Exam-Style Question)

Given:

• NRB injects Rs 20 million via T-Bills.
• Required Reserve Ratio (RRR) = 8%.

Steps:

1. Initial Deposit: Rs 20M enters the banking system.
2. Bank’s Required Reserve: 8% of Rs 20M = Rs 1.6M (kept with NRB).
3. Excess Reserve: Rs 20M - Rs 1.6M = Rs 18.4M (lent out).
4. Money Multiplier: $$\text{Total Deposit Created}=\frac{\text{Initial Injection}}{RRR}=\frac{20M}{0.08}=\text{Rs 250 million}$$
5. Real-World Impact:
   • Banks lend Rs 250M to businesses (e.g., Daraz for inventory).
   • Economic Growth: More loans → higher GDP.
   • Inflation Risk: If excess liquidity persists, prices may rise.

In the Real World

1. eSewa & Khalti (Digital Payments)

   • Instrument Used: Repurchase Agreements (Repos)
   • How? eSewa partners with banks (e.g., NMB) to manage liquidity via overnight Repos, ensuring they can process transactions without cash shortages.

2. Nepal Rastra Bank (NRB) Open Market Operations (OMOs)

   • Instrument Used: Treasury Bills (T-Bills)
   • How? When inflation rises, NRB sells T-Bills to absorb excess money from banks, reducing liquidity and cooling prices.

3. Daraz’s Working Capital Needs

   • Instrument Used: Commercial Papers (CPs)
   • How? Daraz issues 90-day CPs at 7% to fund seasonal sales (e.g., Dashain/Tihar), avoiding costly bank loans.

Exam Tip

1. Memorize the 4 instruments (T-Bills, CPs, Repos, CDs) and their issuers/maturities.
2. Practice calculations:
   • T-Bill yield = $\frac{\text{Face Value}-\text{Purchase Price}}{\text{Purchase Price}\times \text{Days}/360}\times 100$.
   • Money multiplier = $\frac{1}{RRR}$.
3. Link to real examples:
   • Always relate T-Bills to NRB’s monetary policy.
   • Relate CPs to corporate funding (e.g., Ncell, NMB).
4. Diagrams score marks:
   • Draw the money market cycle (issuance → trading → maturity).
   • Show a T-account for a bank’s reserve changes after a T-Bill purchase.
5. Common mistakes to avoid:
   • Confusing money market (short-term) with capital market (long-term).
   • Forgetting that Repos are collateralized loans (not pure debt).
   • Ignoring liquidity risk in answers (always mention it).

Final Worked Example: Kathmandu Retail Shop’s Liquidity Plan

Scenario: A shop in Thapathali needs Rs 5 million for 6 months to buy inventory before Dashain.

Decision:

• Best for liquidity: Buy T-Bills (6% return, Rs 5M invested).
• Best for funding: Issue CPs (7.5% cost, Rs 5M raised).
• Shop’s Strategy:
  1. First 3 months: Hold T-Bills (safe, 6% return).
  2. Next 3 months: Issue CPs to fund remaining needs.

Impact on Money Market:

• Increased demand for T-Bills → higher yields for NRB.
• More CPs issued → lower interbank rates as banks lend excess cash.

Summary Table for Quick Revision