Friday, March 28, 2008

Money Market Thoughts

Optimization of returns via money markets calls for the pursuit of high yielding liquid instruments while minimizing associated risks. A variety of investment vehicles remain available to the retail investors, but finding and exploiting high yield of limited risk takes a bit of research.

Debt Securities Primer

The US government issues treasury bills, notes, and bonds regularly. Treasury bills do not hold coupon payments and mature within a year, the notes range from two to ten years, and bonds up to thirty years. Their rates vary with respect to their shifts in supply and demand and the Federal Reserve’s sentiment toward the general economy.

Banks issue notes and bonds as well. As they clearly hold higher default risk than the US government, these instruments generally offer higher interest rate returns for compensation. It takes more work to manage said risks, but it could result in higher returns.

Risks Involved

Counterparty Risk- it runs with all debt based instruments, where the debtor may become unable to repay the promised amount due to insolvency. While low, this risk exists for American banks and requires active management to mitigate.

Interest Rate Risk- If the US Federal Reserve decides to raise interest rates and the holder needs to sell the debt instrument before maturity date, a net loss would likely occur.

Opportunity Cost- money market investment vehicles have historically provided lower returns than equity or commodity alternatives. Depending on economic conditions, investors experienced higher returns off the stock or commodity markets than debt securities (of course with higher risks, too). Timing is critical.

The Strategy

Noted above, the most efficient manners of money market investment rely on strategic planning. For preservation and low risk growth of capital, money markets do well under negative economic conditions. One of few indications of an oncoming bear market lies in the inverted yield curve, i.e. where short term rates are higher than long term counterparts.

Interest rates tend to move in a semi-mean reversion manner, i.e. debt security returns do not normally drift in either direction. The strategy is simple. With most capital in a savings account, one could invest added portions in the short term debt instruments only when they carry higher rates than the long term rates, and simply hold on to them until maturity. A if the rates increase higher, add on to the investments.

Risk Management

The aforementioned strategy helps to maximize short term returns via US treasury and bank backed debt securities. At the same time, by applying the inverted yield analysis, the investor would more often than not mitigate opportunity cost associated with equity or commodity returns.

Holding until maturity remains the only sure-fire way to avoid interest rate risk. Despite that, due to the quasi-mean reverting nature of interest rates, the above strategy of “buying high” would result favorably for the investor frequently. The return from the savings account would also cushion the unlikely losses.

As for default risks regarding bank solvency, it requires the investors to stay informed of financial industry matters. Stock prices, insider transactions, and institutional equity holdings of said banks provide important indications of their financial outlooks.

Final Wrap Up

The money market allows for lower risks; and at the same time lower returns as well. To optimize returns over in the long term, it pays to become informed in debt, commodity, and equity markets. In the world of finance, relevant knowledge is power.

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