Core Path · L1.6.03

Money markets

10 minMoney marketsRates

By the end you will be able to

  1. 1Describe Treasury bills, commercial paper, certificates of deposit and interbank deposits, and who issues and buys each.
  2. 2Price a Treasury bill from a discount rate (ACT/360) or a yield (ACT/365).
  3. 3Work out the interest on a deposit or CD with the right day count.
  4. 4Explain the difference between a discount rate and a yield, and why money markets matter for funding.

Why it matters

A company with spare cash for three months, a bank short of cash until tomorrow, a government that collects its taxes in April but pays salaries every month. All three turn to the same place: the money market, where large sums are lent and borrowed for days, weeks or months.

Core explanation

Borrowing and lending for less than a year

The money market covers borrowing and lending for up to one year. Its instruments are short, usually safe, and traded in large amounts, so they behave almost like cash that earns interest. Think of it as the financial system's current account. Bonds (Module 1.4) are where borrowers raise money for years; the money market is where they manage the next few months.

Four instruments make up most of it.

Treasury bills

Issued by: Governments

Short-term government IOUs. In the US they run from a few weeks up to 52 weeks and are sold at regular auctions; the UK, euro-area countries and Japan issue their own. No coupon: you buy below face value and get face value back. Seen as the safest money-market asset in their currency.

Commercial paper (CP)

Issued by: Large companies, banks

Unsecured IOUs, also sold below face value. Only well-known borrowers with strong credit can issue it. In the US, CP usually runs for 270 days or less, and often much shorter.

Certificates of deposit (CDs)

Issued by: Banks

A fixed-term deposit with a certificate. Negotiable CDs can be sold to someone else before maturity. They usually pay interest at maturity, worked out with simple interest.

Interbank deposits

Issued by: Banks lend to banks

Unsecured loans between banks, from overnight to a few months. A bank with spare cash at the end of the day lends it to one that is short.

Who lends? Companies with spare cash, banks, central banks, and above all money market funds, which pool savers' money and buy these instruments. Repo, the secured way to borrow short-term against bonds, is so important that it gets its own lesson (L1.6.04).

Sold at a discount. Bills and CP are sold on a discount basis. A $10,000 bill might cost about $9,894 today and repay $10,000 in 91 days. The $106 difference is your interest. There are no coupons to track.

Two ways to quote. US Treasury bills are quoted on a discount rate: the interest as a share of face value, on a 360-day year (ACT/360, as in L1.3.06). UK Treasury bills are quoted on a yield: the interest as a share of the price you pay, on a 365-day year (ACT/365). Euro-area money markets, like the US, count ACT/360. Always check which convention a quote uses before comparing two numbers.

Unsecured means a credit risk

CP, CDs and interbank deposits are unsecured: if the borrower fails, the lender has no collateral to fall back on. That is why their rates sit above Treasury bill rates for the same term, and why these markets can freeze in a crisis, when lenders stop trusting borrowers.

Which instrument is it?

  1. Sold at a discount by a national government, and backed by its power to tax.

  2. An unsecured IOU sold by a large company to pay suppliers until its customers pay it.

  3. A bank takes a 90-day deposit and gives the depositor a certificate that can be sold on.

  4. At 5 pm a bank has spare cash and lends it to another bank until tomorrow, with no collateral.

  5. In the US, usually issued for 270 days or less.

The formal version

Let FF be the face value, PP the price, tt the actual days to maturity and dd the discount rate. Start from the definition of the discount rate and solve for the price, one line at a time:

d=F−PF×360td = \frac{F - P}{F} \times \frac{360}{t}
F−P=F×d×t360F - P = F \times d \times \frac{t}{360}
P=F(1−d×t360)P = F \left(1 - d \times \frac{t}{360}\right)

The yield on the money you actually invest uses the price on the bottom instead. On a 365-day basis it is the UK quoting convention, which turns into a price by dividing:

y=F−PP×365t⟺P=F1+y×t/365y = \frac{F - P}{P} \times \frac{365}{t} \quad\Longleftrightarrow\quad P = \frac{F}{1 + y \times t/365}

Because PP is smaller than FF, the yield is always above the discount rate. Interest on a CD or deposit is simple interest: principal × rate × days ÷ basis.

Try it

Start with a 91-day US bill at a 4.20% discount rate. Push the days towards 364 and watch the gap between the discount rate and the yields widen. Then switch to the UK convention: the rate you set is now a yield, so the price changes even at the same number.

Try itTreasury bill calculator

Open the yield toolkit →

Market and quoting convention

You pay today

9,893.83

USD, and receive 10,000.00 in 91 days

Interest earned106.17
Discount rate4.2000%
Yield, ACT/3604.2451%
Yield, ACT/3654.3040%

What you pay, and what the bill adds

price 9,893.83 interest 106.17

The discount rate divides the interest by the face value; the yields divide it by the price you actually pay, so they are always a little higher. Simple interest, no compounding.

Worked example

A 13-week US Treasury bill

A treasurer buys a 13-week (91-day) US Treasury bill with face value $10,000 at a discount rate of 4.20%, ACT/360.

Price and yield of the bill

Step 1 of 4
  1. 1

    Discount for the period

    d×t/360=0.042×91/360=0.010617d \times t/360 = 0.042 \times 91/360 = 0.010617

The same toolkit prices the other instruments:

InstrumentTermsConventionResult
UK Treasury bill91 days, yield 4.00%Yield, ACT/365Price 99.0126 per 100
Euro CDEUR 5,000,000, 90 days, 3.10%Simple, ACT/360Interest EUR 38,750.00

Regulatory lens

Money market funds are tightly regulated because savers treat them like bank accounts. In the US, the Securities and Exchange Commission tightened its rules for these funds several times after 2008. In the EU, the Money Market Funds Regulation of 2017 sets limits on what they may buy, how long their holdings may run, and how much must mature within a day or a week.

Looking ahead: under the Basel III Liquidity Coverage Ratio, banks must hold a buffer of high-quality liquid assets, and government bills sit at the top of that list (L4.5).

Sparks

SparkThe fund that broke the buck
Money market funds aim to keep each share worth exactly $1. On 16 September 2008, the day after Lehman Brothers filed for bankruptcy, the Reserve Primary Fund announced that its shares were worth 97 cents, because it held Lehman commercial paper. Investors rushed to pull money from similar funds, and the commercial paper market seized up until the US government stepped in.
SparkPaying to lend to a government
For much of the period from the mid-2010s to 2022, German and Swiss government bills traded at negative yields: buyers paid more than they would get back. Investors accepted a small, certain loss as the price of a very safe place for large sums, when central bank rates were themselves below zero.

Key takeaways

  • The money market covers borrowing and lending for up to a year: Treasury bills, commercial paper, CDs, interbank deposits and repo.
  • Bills and CP are sold at a discount to face value; CDs and deposits pay simple interest at maturity.
  • US bills are quoted on a discount rate (ACT/360); UK bills on a yield (ACT/365). Euro money markets use ACT/360.
  • A discount rate divides interest by face value, a yield by price, so the yield is always higher.
  • CP, CDs and interbank deposits are unsecured, so they pay more than bills and can freeze in a crisis.

Reaction

Check what stuck

Question 1 · objective 1

A large retailer needs cash for 45 days to stock up before the holidays. Which instrument fits best?

Question 2 · objective 2

A US Treasury bill has face value $1,000,000, 182 days to maturity and a discount rate of 5.00% (ACT/360). What is its price, in dollars, to the cent?

USD

Question 3 · objective 2

A UK Treasury bill has 182 days to maturity and a yield of 4.50% (ACT/365). What is its price per £100 of face value, to four decimals?

Question 4 · objective 3

A company places $2,000,000 in a 61-day CD at 4.00% (ACT/360). How much interest does it receive at maturity, in dollars?

USD

Question 5 · objective 4

Why is a bill's discount rate always a little below its yield on price?

Glossary

Money market
The market for borrowing and lending for up to one year.
Treasury bill
A short-term government IOU sold below its face value and repaid at face value on maturity.
Discount basis
Sold for less than face value, with no coupon. The gap between price and face value is the interest.
Discount rate
Interest as a share of face value, scaled to a 360-day year. The way US bills are quoted.
Commercial paper
Short-term, unsecured IOUs sold by large companies and banks to borrow from investors.
Certificate of deposit
A bank deposit for a fixed term, evidenced by a certificate. Negotiable CDs can be sold on before maturity.
Interbank deposit
A loan from one bank to another, usually unsecured, from overnight to a few months.
Unsecured
Backed only by the borrower's promise, with no collateral the lender can take if it fails to pay.
Money market fund
A fund that invests in money market instruments and aims to keep investors' money safe and easy to withdraw.

Deep Dives & Origins

Deep Dives

  • Mishkin, The Economics of Money, Banking and Financial Markets (Pearson), the chapter on the money markets. Beginner.
  • Stigum and Crescenzi, Stigum's Money Market, 4th edition (McGraw-Hill, 2007). Advanced.

Origins

  • Saunders and Cornett, Financial Markets and Institutions (McGraw-Hill), the chapter on money markets.
  • US Department of the Treasury, TreasuryDirect, “Treasury Bills” (product terms and auction pricing).
  • UK Debt Management Office, Treasury bill information memorandum.
  • Regulation (EU) 2017/1131 on money market funds.
  • President's Working Group on Financial Markets, Overview of Recent Events and Potential Reform Options for Money Market Funds (2020).

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FX forwards and covered interest parity

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Repo and securities financing