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A New Model for Assessing Risks and Opportunities in the Money Markets Justin Brimfield, ICD, and Anthony Carfang, The Carfang Group, explain how ICD and the Carfang Group's new quantitative model works and outline how it can be used to health check short-term investment portfolios and sense check investment policies.

A New Model for Assessing Risks and Opportunities in the Money Markets

By Eleanor Hill, Editor


In the wake of Covid-19, corporates are reassessing their liquidity management strategies. To assist treasury managers in this endeavour, ICD and The Carfang Group have created a new quantitative model for assessing the risk/return relationships among money market instruments. Justin Brimfield, Chief Marketing Officer, ICD, and Anthony J. Carfang, Managing Director, The Carfang Group, explain how the model works and outline how it can be used to health check short-term investment portfolios and sense check investment policies.

March 2020 was the most profound stress test that money markets have seen since the post crisis regulations. As Covid-19 spread across the globe, and economic turmoil took hold, corporates shifted assets, drew down on credit lines and issued debt as a means to increase the liquidity and safety of their cash.

Carfang says: “There was an immediate emotional response to the coronavirus crisis. Investors were uncertain, so the majority sought a safe harbour. As a result, we saw trillion-dollar inflows into money market funds (MMFs).” Even since the ‘March madness’, assets in money market instruments have remained at historic levels.

Justin Brimfield

Justin Brimfield
Chief Marketing Officer, ICD

Brimfield adds: “We expected to see some of the cash corporates are sitting on being reinvested into the business – to help make organisations more resilient post-pandemic and to bolster growth. Nevertheless, most of the over 400 corporates on ICD Portal have held on to their large cash balances. We are still very near record highs in assets on ICD Portal, well over $200bn.”

Moreover, investors want to make more informed decisions going forward, Brimfield believes. “In March, we saw emotion overtake disciplined investment philosophies. Now that the initial turmoil is behind us, it’s time for corporate treasurers to review what they’ve learnt and re-examine their liquidity management practices, based on concrete data. To help this process, ICD has teamed up with The Carfang Group to develop a methodology to evaluate the risk, return and liquidity trade-offs in the money markets, with the aim of identifying opportunities for building a more optimised short-term investment portfolio.”


Model behaviour

This collaboration has led to the creation of a new quantitative model, called Beta(m)™, based on Modern Portfolio Theory (MPT), but adapted to the money markets. Carfang explains: “MPT evaluates the overall securities market, most often using the S&P 500 as a proxy, and computes a beta for each portfolio to measure relative risks. This is much more difficult in the money markets, since different securities have different characteristics. Some are discounted, others pay interest or dividends, some fluctuate in value, and others trade at par or mature at par.”

In order to be consistent across all these instruments, a ‘variance of total return’ methodology was used to construct Beta(m)™. And after testing 14 money market instruments (the most commonly used by corporate investors) over a five-year period, the one-month T-bill emerged as the most robust representative of overall short-term money market volatility. As such, the model measures the volatility of 13 other money market instruments against the one-month T-bill, which has a Beta(m)™ of 1.00.

 

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