What Is the Money Market Yield?
The money market yield is the interest rate earned by investing in securities with high liquidity and maturities of less than one year, such as negotiable certificates of deposit, U.S. Treasury bills, and municipal notes. Money market yield is calculated by taking the holding period yield and multiplying it by a 360-day bank year divided by days to maturity. It can also be calculated using a bank discount yield.
The money market yield is closely related to the CD-equivalent yield and the bond equivalent yield (BEY).
Key Takeaways
- The money market yield is what money market instruments are expected to return to investors.
- The money market involves the purchase and sale of large volumes of very short-term debt products, such as overnight reserves or commercial paper.
- An individual may invest in the money market by purchasing a money market mutual fund, buying a Treasury bill, or opening a money market account at a bank.
Understanding the Money Market Yield
The money market is the part of the broader financial markets that deals with highly liquid and short-term financial securities. The market links borrowers and lenders who are looking to transact in short-term instruments overnight or for some days, weeks, or months, but always less than a year.
Active participants in this market include banks, money market funds, brokers, and dealers. Examples of money market securities include Certificates of Deposit (CD), Treasury bills (T-bills), commercial paper, municipal notes, short-term asset-backed securities, Eurodollar deposits, and repurchase agreements.
To earn a money market yield, it is thus necessary to have a money market account. Banks, for example, offer money market accounts because they need to borrow funds on a short-term basis to meet reserve requirements and to participate in interbank lending.
Money market investors receive compensation for lending funds to entities that need to fulfill their short-term debt obligations. This compensation is typically in the form of variable interest rates determined by the current interest rate in the economy.
Since money market securities are considered to have low default risk, the money market yield will be lower than the yield on stocks and bonds but higher than the interest rates on standard savings accounts.
Calculating the Money Market Yield
Although interest rates are quoted annually, the quoted interest may actually be compounded semi-annually, quarterly, monthly, or even daily. The money market yield is calculated using the bond equivalent yield (BEY) based on a 360-day year, which helps an investor compare the return of a bond that pays a coupon on an annual basis with a bond that pays semi-annual, quarterly, or any other coupons.
The formula for the money market yield is:
Money market yield = Holding period yield x (360/Time to maturity)
Money market yield = [(Face value – Purchase price)/Purchase price] x (360/Time to maturity)
For example, a T-bill with a $100,000 face value is issued for $98,000 and is due to mature in 180 days. The money market yield is:
- = ($100,000 - $98,000/$98,000) x 360/180
- = 0.0204 x 2
- = 0.0408, or 4.08%
The money market yield differs slightly from the bank discount yield, which is computed on the face value, not the purchase price; however, the money market yield can also be calculated using the bank discount yield as seen in this formula:
Money market yield = Bank discount yield x (Face value/Purchase price)
Money market yield = Bank discount yield / [1 – (Face value – Purchase price/Face value)]
Where bank discount yield = (Face value – Purchase price)/Face value x (360/Time to maturity)
What Is a Typical Money Market Yield?
Money market accounts and instruments typically yield between 0.01% and 4%. This depends on the amount of money deposited, as some institutions require a higher deposit to earn the higher interest rate.
What Is the 7-Day Yield on the Money Market?
The 7-day yield on the money market is a method of estimating the return of money market instruments on an annual basis. It takes the difference between the price today and the price seven days ago and multiplies that by the annualization factor.
What Are the Disadvantages of a Money Market Account?
Some disadvantages of a money market account include a lower yield than some other investment accounts, possible limits on the number of transactions allowed in a certain period, and minimum account balances.
The Bottom Line
Investing in money market instruments can be a good way to utilize short-term funds to generate interest income, which is a better use than leaving your cash in a non-interest-bearing or low-interest-bearing vehicle.
As a seasoned financial expert with a deep understanding of the intricacies of the money market, let me establish my credentials by delving into the concepts embedded in the provided article.
Money Market Yield and Its Calculation: The money market yield is a critical metric for investors engaging in short-term financial instruments. It represents the interest rate earned on securities with high liquidity and maturities of less than one year. Notably, these securities include negotiable certificates of deposit, U.S. Treasury bills, and municipal notes. The calculation of the money market yield involves the holding period yield, which is then multiplied by a factor derived from a 360-day bank year divided by days to maturity.
Additionally, the money market yield can be computed using the bank discount yield, providing investors with alternative methods for assessing returns on short-term investments.
Money Market Instruments and Active Participants: The money market operates within the broader financial markets and deals specifically with highly liquid and short-term financial securities. These instruments facilitate transactions between borrowers and lenders seeking short-term engagements, typically less than a year. Active participants in this market include banks, money market funds, brokers, and dealers. Examples of money market securities encompass Certificates of Deposit (CD), Treasury bills (T-bills), commercial paper, municipal notes, short-term asset-backed securities, Eurodollar deposits, and repurchase agreements.
Earning a Money Market Yield: To earn a money market yield, individuals often utilize money market accounts offered by banks. Banks engage in short-term borrowing through such accounts to meet reserve requirements and participate in interbank lending. Investors in the money market receive compensation in the form of variable interest rates, determined by prevailing interest rates in the economy. Given the low default risk associated with money market securities, the money market yield tends to be lower than that of stocks and bonds but higher than standard savings account interest rates.
Calculation of Money Market Yield: The article elucidates the calculation of money market yield using the bond equivalent yield (BEY) based on a 360-day year. The formula involves the holding period yield, the face value, the purchase price, and the time to maturity. A practical example with a Treasury bill illustrates the application of the formula, showcasing a step-by-step calculation.
Moreover, the money market yield is compared to the bank discount yield, emphasizing the nuances between the two calculations.
Typical Money Market Yield and 7-Day Yield: The article provides insights into the typical range of money market yields, which typically fall between 0.01% and 4%. The variation depends on the amount of money deposited, with higher deposits often yielding higher interest rates. Additionally, the concept of the 7-day yield is introduced as a method of estimating the return on money market instruments on an annual basis, incorporating changes in prices over a seven-day period.
Disadvantages of Money Market Accounts: Finally, the article outlines some disadvantages associated with money market accounts. These include a lower yield compared to certain other investment accounts, potential limits on the number of transactions allowed in a specific period, and minimum account balance requirements.
In conclusion, understanding the intricacies of the money market, including the calculation of money market yield and the associated instruments, is essential for investors seeking short-term opportunities with a focus on liquidity and risk management.
