Concept
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In conclusion, money-market instruments provide relatively low risk investments, although there can be some degree of default risk dependent on the issuing entity’s financial standing. Nonetheless the short-term maturity of money-market instruments make the potential default risk less significant than it could be. Liquidity risk may also be associated with certain instruments traded in money markets, whereby it may be difficult or impossible to convert the instrument to cash immediately. This can be minimized in some cases, but not completely eliminated in all, as one can avoid instruments that are not allowed to be traded secondarily, but not instruments that are tradeable but do not have any interested buyers. However, this is a minor factor relative to instruments from other markets, which have a greater degree of liquidity risk associated with them.
Despite the apparent lack of or, more factually, the minor degree of risk associated with money- market instruments, it is of critical importance to always compare money-market instruments with alternatives from other markets. In other words, one must assess the relative performance
risk that can be present, particularly in the context of long-term horizons, because other instruments might be preferable. Despite these alternatives typically being regarded as carrying more risk, they may nevertheless be more suitable to particular contexts.
It is important to recall the idea of risk premiums here, which we discussed in Module 1; riskier investments tend to perform better on average in terms of compensation for investors, who bear the risk of the larger variation of potential outcomes.
Sometimes, this risky variation is not problematic for particular investment contexts; for example, the daily fluctuations of stock prices is not problematic when investing over a thirty-year horizon. In such long-term cases, earning the corresponding risk premium can be attractive as it amounts to more profit, and therefore forgoing it by investing exclusively in money-market instruments might be a sub-optimal strategy. In other words, relative performance risk might be present. We will begin developing a formal framework that will allow us to express the interest rate earned from investing in a particular investment (or, equivalently, the interest rate paid by the issuing entity).