Money market derivatives are financial products based on the value of short-term instruments such as US Treasury bills and Eurodollar CDs. They are traded through futures, forwards, options, swaps, caps, and floors, and can be used to limit risk or enhance returns. Money market funds and institutional investors can invest in these derivatives.
Traditionally, money market instruments are financial products that mature in one year or less. Therefore, money market derivatives are financial products whose values are derived from the price of certain money market instruments, which are called underlying instruments. The underlying instruments on which the most common money market derivatives are based include US Treasury bills, Eurodollar Certificates of Deposit (CDs), federal funds, and interest rates. The vehicles through which money market derivatives are commonly traded are futures, forwards, options and swaps, as well as caps and floors. Additionally, money market participants use money market derivatives to help limit risk and/or enhance returns.
Futures are standardized legal contracts between a buyer or seller and an exchange or its clearing house. Contracts oblige the buyer or seller to accept or deliver money market instruments on a specific date at a particular price. Those who trade money market derivatives through futures do not need to take or deliver the underlying instruments. This can be ideal for those who just want to profit from price fluctuations in the market. They typically accomplish this by exiting the contract before the delivery date.
Forwards are somewhat similar to futures, except that they are traded over-the-counter (OTC), which means that they do not trade on an exchange, but instead contracts are typically traded between two parties. In a forward transaction, one party will agree to deliver a money market instrument on a particular date in the future, within 12 months, at a specified price. These transactions are normally designed for the delivery of the underlying instruments.
Options give the buyer and seller the right to buy or sell money market instruments on or before a specified date at a specified price. Using money market options helps to minimize the risk of loss or simply to make a profit. However, in some cases, like other types of derivatives, options can increase risk. Like futures, options are traded on an exchange.
Swaps are primarily types of OTC derivatives, although there are specific exchange-traded swaps. One type of transaction involving swaps, called interest rate swaps, allows people to swap the types of interest rate payments from variable to fixed, and vice versa. Such derivatives are used by those who lend or borrow money and prefer to receive or make payments at a different type of interest rate than that attached to the original money borrowed or lent.
Caps and floors are used primarily to manage interest rate risk. In a basic sense, limits allow you to protect people if interest rates rise above a certain level. Floors do much the same thing, except they protect people if interest rates fall below a certain level. In particular, those who lend money at a variable rate use caps so that they can protect themselves from rising interest rates, while those who lend money use floors as a hedge against falling interest rates.
Investing in the money market can be done through a money market fund, which is a type of mutual fund that invests primarily in the money market. Both individuals and institutions can buy shares of money market funds. These shares stay at the same price, but the returns change, that is, interest rates fluctuate, not the shares. Investment in money market derivatives can be made through the futures and options markets by institutional and private persons. Institutional investors can also make use of the OTC type of deals, which are generally not viable for private private investors.
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