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Traditionally, money market instruments are financial products that mature in one year or less. Therefore, money market derivatives are financial products whose values come from the price of particular money market instruments, which are referred to as the underlying instruments. The underlying instruments that most common money market derivatives are based on include US Treasury bills, Eurodollar certificates of deposits (CD), 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. Moreover, money market derivatives are used by money market participants to help limit risk and/or to enhance returns.
Futures are standardized legal contracts between a buyer or seller and an exchange or its clearinghouse. The contracts oblige the buyer or seller to take or make delivery of money market instruments on a specified date at a particular price. Those who trade money market derivatives through futures do not need to take or make delivery of the underlying instruments. This can be ideal for those who wish only to profit from price fluctuations in the market. They usually achieve this by getting out of 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 rather are contracts usually negotiated 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 normally are designed for delivery of the underlying instruments.
Options give the buyer and the seller the right to buy or sell money market instruments on or before a specific date at a certain price. The use of options in the money market helps to either minimize risk of loss or to simply make a profit. In some cases, however, just like other types of derivatives, options can increase risk. Just like futures, options are traded on an exchange.
Swaps are mainly OTC types of derivatives, although specific exchange-traded swaps do exist. One type of transaction that involves swaps, called interest rate swaps, allows people to exchange the types of payments of interest rates 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 with an interest rate type that is different from the one linked to the original loaned or borrowed money.
Caps and floors are used mainly to manage interest rate risk. In a basic sense, caps allow people to be protected if interest rates rise above a certain level. The floors do more or less the same, except that they protect people if interest rates drop below a certain level. Particularly, caps are used by those who borrow money at a variable rate so they can be protected from rising interest rates, whereas floors are used by the ones who lend money as a protection against a decline in interest rates.
Investing in the money market can be done through a money market fund, which is a type of mutual fund that mostly invests in the money market. Individuals and institutions alike can purchase money market funds' shares. These shares remain at the same price, but the returns change — that is, the interest rates fluctuate, not the shares. Investing in money market derivatives can be done through the futures and options markets by institutional and private individuals. Institutional investors also can make use of the OTC type of deals, which generally are not viable for private individual investors.