ACCA Applied Skills · Financial Management

The nature and role of money markets: formula sheet

Full chapter guide

Key formulas

Money market vs capital market: Money market = short-term (usually up to 1 year); Capital market = long-term (over 1 year, including equity); State the maturity dividing line when you answer a comparison question.
Main intermediary functions: Aggregation + maturity transformation + risk reduction + lower transaction costs; Use these four as a checklist for any 'role of intermediaries' question.
Bank margin: Interest margin = interest charged to borrowers − interest paid to savers; This is the price of the intermediary service.
Primary vs secondary market: Primary = new issues raise cash for the issuer; Secondary = trading of existing securities, no cash to the issuer; Secondary markets provide liquidity and price information.
Money market definition: Money market = wholesale market for short-term funds, usually up to 1 year; Use this to separate it from the capital market, which deals in long-term finance.
Money market vs capital market: Short-term, low risk, high liquidity (money) vs long-term, higher risk, higher return (capital); Use as a comparison frame when asked to contrast the two.
Simple interest on a short deposit: Interest = Principal × Annual rate × (Days ÷ 365); Use the day-count basis given in the question. Some markets use 360 days.
Discount instrument return (not annualised): Return = (Face value − Price paid) ÷ Price paid; Use for treasury bills, commercial paper and discounted bills. The return is for the holding period, not a year.
Annualised simple return: Annual return = Return for the period × (365 ÷ days to maturity); Simple scaling. Use 360 only if the question says so.
Effective annual rate (compounded): EAR = (1 + period return)^(365 ÷ days) − 1; Use when the question asks for the effective or compound annual rate.
Instrument comparison: Higher risk and lower liquidity → higher yield; Rule of thumb for ranking: treasury bills lowest yield, then bank CDs, then commercial paper.
Fisher equation (exact): (1 + money rate) = (1 + real rate) × (1 + inflation rate); Money (nominal) rate includes inflation. Real rate removes it. Rearrange to find the real rate.
Real rate: Real rate = (1 + money rate) ÷ (1 + inflation) − 1; Use this when asked for the exact real rate. The approximation money rate − inflation is only rough.
Build-up of a required yield: Required yield = real rate + expected inflation + default risk premium + liquidity premium + maturity premium; A conceptual build-up, not a precise calculation. Use it to explain why two securities have different yields.
Credit spread: Credit spread = corporate yield − risk-free yield (same maturity); Wider spread means the market sees more default risk.
Implied forward rate (expectations theory): (1 + r2)² = (1 + r1) × (1 + f); r1 and r2 are one-year and two-year spot yields. f is the implied one-year rate starting in a year.
Bank quote convention: Quote = Base currency 1 = Variable currency: Bid (bank buys base) / Offer (bank sells base); The bank always gets the better of the spread. Customer sells base currency at the lower rate and buys it at the higher rate.
Converting from base to variable currency: Variable amount = Base amount × rate; Multiply when moving from the base currency to the variable one.
Converting from variable to base currency: Base amount = Variable amount ÷ rate; Divide when moving from the variable currency back to the base.
Spread: Spread = Offer rate − Bid rate; Often expressed as a percentage of the rate. It is the dealing cost.
Eurocurrency definition: Eurocurrency = deposit or loan in a currency held outside its home country; Short to medium term, wholesale, lightly regulated. Eurobonds are the long-term bond equivalent.

Quick revision

Money markets deal in short-term funds, generally up to one year.
They are wholesale markets, so transactions are large and between institutions.
Main functions: liquidity, short-term funding, cash investment and a guide to interest rates.
Intermediaries pool savings, spread risk and match different maturities.
Maturity transformation means borrowing short and lending longer, which creates liquidity risk.
Treasury bills are short-term government securities sold at a discount and repaid at face value.
Commercial paper is unsecured short-term borrowing by creditworthy companies.
Certificates of deposit are issued by banks and can be traded before maturity.
Higher risk, longer term and lower liquidity normally mean a higher required yield.
Eurocurrency markets hold deposits and loans in a currency outside its home country.
The foreign exchange market sets exchange rates and enables currency conversion and hedging.

Common mistakes

Saying equity shares are traded in the money market. Fix: Money market instruments are short-term debt-type instruments. Shares are long-term and belong to the capital market.
Confusing maturity transformation with risk reduction. Fix: Maturity transformation means short-term deposits fund long-term loans. Risk reduction means spreading lending across many borrowers and checking credit quality.
Saying the money market provides long-term finance for capital projects. Fix: Anchor on time: money market is up to about one year. Long-term projects need capital market funds.
Treating the money market as only a place for banks. Fix: Always list banks, companies and governments, and give one use for each.
Dividing the discount by face value instead of the price paid. Fix: Your investment is the price paid. Divide the gain by that amount.
Forgetting to annualise the return. Fix: Check the days to maturity. Multiply by 365 ÷ days, or compound if EAR is asked.
Using nominal minus inflation when the question asks for the exact real rate. Fix: Use (1 + nominal) ÷ (1 + inflation) − 1 unless the question says to approximate.
Saying liquidity preference theory explains an upward curve only because rates are expected to rise. Fix: Liquidity preference adds a premium for longer terms. The curve slopes up even with flat expected rates.
Thinking Eurocurrency only means euros or only European banks. Fix: Remember it means any currency held outside its home country. Eurodollars can be held in London, Singapore or elsewhere.
Using the wrong side of the bid-offer spread. Fix: Decide what the bank does with the base currency. Bank buys at the lower rate, sells at the higher rate.

Exam tips

In Section A and B objective tests, the maturity test (up to one year or longer) answers many money market versus capital market questions quickly.
For written answers, name each intermediary function (pooling, maturity transformation, risk reduction, lower costs) and tie it to the scenario in the same sentence.
Show balance: after benefits, mention the margin charged, liquidity risk or disintermediation.
Use correct instrument names: Treasury bills, commercial paper and certificates of deposit for money markets; shares and bonds for capital markets.
Read whether the question is about the issuer raising cash (primary) or investors trading (secondary) before you answer.
In Section A, check the time horizon first. Over one year is almost never a money market answer.
In Section C, name the user, the function and the reason. Three short linked points score better than a long list.
Use the scenario facts, such as seasonal cash flow or a known future payment, to justify your recommendation.