Concept
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In our previous video, we discussed how certain qualities of money-market instruments ensure that they have a high probability of fulfilling their intended functions for both the lender and borrower and are thus relatively low in risk for both parties. Since the maturities of money market
loans are over the short term, there is only a small probability that an entity will become unable to meet their promised loan obligations; a problem that may arise when longer-term instruments mature.
While it is possible for an entity’s financial standing to deteriorate suddenly, it is typically a gradual and discernible process. As you may recall from previous modules, financial markets tend to be efficient; as any information about an entity’s standing becomes available, it is incorporated
into market prices for everyone to see. It is important to note that it is also extremely unlikely for an entity to choose to not meet their obligations because they have in fact every incentive to meet their obligations if at all possible. Wherever this is not the case, the market will be reluctant to purchase the entity’s instruments in the future, causing the cost of borrowing for the entity to increase drastically, and in extreme cases make borrowing impossible.
While the default risk in money-market instruments is relatively low, as we have already seen supply and demand and market efficiency will causes prices to reflect any default risk that market participants perceive.
For instance, consider a treasury bill that promises to pay the holder 100 units of currency in 3 months’ time. The money market will determine the current price of this bill, and if, for example, its market value seems lower than it should be, investors will rush to enter what they view as a good investment opportunity, and demand will drive the price up. Now let’s suppose the market settles on a price of 98 for the treasury bill, and therefore you purchase a bill for 98, and after 3 months, the government will repay your 98 units of currency, plus 2 units as interest. This should be seen
as compensation for the fact that you (as the investor) had to forgo the use of your money for the 3-month period.
Now, after you’ve been reimbursed, you consider investing in commercial paper issued by a small company, in particular, one that is not directly comparable to the treasury bill. The commercial paper promises a repayment of 100 units of currency in 3 months’ time. As before, the market forces will determine the current price of the instrument, and because there is some probability that the company will run into financial distress in the next while, the price will be less than 98.
This is because the note is a less desirable investment than the treasury bill, and therefore its market-going price settles at a lower price of 97. Now you decide to purchase the note for 97 and then, assuming the entity does not default, you will receive your 97 units of currency back in 3 months, along with 3 additional units. These 3 units again should be seen as the usual interest- rate compensation, in addition to compensation for bearing the minor degree of default risk. Therefore, in this second case, you are also compensated for the possibility that the issuing entity does in fact default and will not meet their obligation to repay you the obligatory 100 units.