Money market yield instrument

In debt capital markets the yield on a domestic government T-bill is usually considered to represent the risk-free interest rate, since it is a shortterm instrument guaranteed by the government. This makes the T-bill rate, in theory at least, the most secure investment in the market. It is common to see the 3-month T-bill rate used in corporate finance analysis and option pricing analysis, which often refer to a risk-free money market rate. 

The textbook definition of a money market instrument is of a debt product issued with between one day and one year to maturity, while debt instruments of greater than one year maturity are known as capital market instmments. In practice the money market desks of most banks will trade the yield curve to up to two years maturity, so it makes sense to view a money market instmment as being of up to two years maturity. 

That is, a money market product quoted as a yield instrument, similar to a bank deposit or a certificate of deposit. The other class of money market products are discount instruments such as a Treasury bill or commercial paper. 

This chapter considers some of the techniques used to fit the model-derived term structure to the observed one. The Vasicek, Brennan-Schwartz, Cox-Ingersoll-Ross, and other models discussed in chapter 4 made various assumptions about the nature of the stochastic process that drives interest rates in defining the term structure. The zero-coupon curves derived by those models differ from those constructed from observed market rates or the spot rates implied by market yields. In general, market yield curves have more-variable shapes than those derived by term-structure models. The interest rate models described in chapter 4 must thus be calibrated to market yield curves. This is done in two ways either the model is calibrated to market instruments, such as money market products and interest rate swaps, which are used to construct a yield curve, or it is calibrated to a curve constructed from market-instrument rates. The latter approach may be implemented through a number of non-parametric methods. 

Because the future values for the reference index are not known, it is not possible to calculate the redemption yield of an FRN. On the coupon-reset dates, the note will be priced precisely at par. Between these dates, it will trade very close to par, because of the way the coupon resets. If market rates rise between reset dates, the note will trade slightly below par if rates fall, it will trade slightly above par. This makes FRNs behavior very similar to that of money market instruments traded on a yield basis, although, of course, the notes have much longer maturities. FRNs can thus be viewed either as money market instruments or as alternatives to conventional bonds. Similarly, they can be analyzed using two approaches. 

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