Apart from ensuring appropriate liquidity, investors should also consider the risks present in the money market investments. Investments in the money market are basically unsecure in nature. While the unsecured nature does indicate a higher risk, the risks associated with money market, however, are not necessarily due to the unsecured nature but more due to the fluctuations in the rates. The level and the type of risk exposure that can be associated with money market instruments/investments are-
Market Risk/Interest Rate Risk
These risks arise due to fluctuations in the rate of the instruments, and are of prime concern in money market investments. Due to the large quantum of funds involved in the money market deals, and the speed with which these transactions are executed, the values of the assets are exposed to fluctuations. Further, if these fluctuations are wide, it may lead to a capital loss/gain since the price of the instruments, including the government securities, declines. This risk can be minimized by enhancing liquidity since easy exit can help curb the capital loss.
Reinvestment risk arises in a declining interest rate scenario. Investors who park their funds in short-term instruments will, at the time of redemption, have to reinvest these funds at a lower rate of interest. And since the existing securities will be having higher coupons/YTMs, their value generally rises in such situations to bring down the Yields. All money market instruments are exposed to this risk.
Lending decisions primarily focus on assessing the possibility of repayment since the first risk that the lender will be exposed to is the default risk. Except for the sovereign securities, all other investment/lending activities have the probability of default by the borrower in the repayment of the principal and/or interest. It is due to the absence of the default risk, that the government securities are considered as risk-free securities.
Due to inflation, the average prices for all goods and services will rise thereby reducing the purchasing power of the lender. The risk that arises due to the inflationary effect is known as inflation risk/purchasing power risk. All money market instruments are exposed to this risk. Lenders will generally ensure that their contractual rate of interest offsets this risk exposure. Though the capital market has designed instruments to hedge against this risk, they are yet to be introduced into the money market.
The Capital Indexed Bonds (CIBs) issued by RBI is an instrument designed to minimize/eliminate the inflation risk. With a maturity of 5 years, these CIBS earn a 6 percent return on the investments. The principal amount is adjusted against inflation for each of the years and the interest is then calculated on this adjusted principal. Further, upon repayment, the principal amount is adjusted by the Index Ratio (lR) as announced by the RBI.
A risk of loss is inherent in the multi-currency dealings due to the exchange rate fluctuations. Currency risk refers to this type of risk exposure. The money market players operating in overseas money market instruments will be exposed to this risk. Also, when the institutional investors like banks sell foreign currencies to play in the money market, they may be exposed to currency risk.
Most of the measures adopted to bring economic stability will have a direct/indirect implication on the money market instruments and operations. This is due to the fact that the money market activity reflects the money supply position in the economy, the interest rate and the exchange rate structures, etc. Thus, any policy decisions adopted by the Central Government will have an impact on the money market. In the Indian context, it is the policy measure taken by the RBI, and sometimes the Ministry of Finance (MoF) that has an impact on the money market.
There is yet another important and rather interesting feature of the money market that explains the lower level of the default risk. Money market players have to honor obligations as a universally accepted code of conduct. However, as observed earlier, the money market players are mostly large institutional players, having a good standing in the market with a good rating. Of the risks that the money market instruments are exposed to, the volume and the quantum of transactions generally put the market/interest rate risk at a higher level.