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Basics and Risks of Money Market Funds

There are many cash management tools on the market that you can use, one of the most popular among them being money market funds. They provide various benefits to their investors, but before putting your money in them it is better to examine them thoroughly.

Money Market Funds Basics

As their name implies, money market funds represent mutual funds that target money markets. The money markets are the places where money is traded the same way as stocks are traded on the stock markets. The buying and selling of money can be explained as the lending and borrowing of money alternatively.

The money market fund tends to use the money you have deposited in your account for investment purposes. In return you receive dividends, which come from the earnings the fund has made.

The target investments of money market funds are short-term instruments. This means that their maturities should be less than 13 months and don't exceed this time period. Such instruments are targeted for risk reduction purposes. The logic behind this is that with the increase of the time frame over which you loan your money the risk of not getting it back is increased.

US Treasury issues, CD's and corporate paper are the investments most often found within a money market fund.

The money you have deposited in the money market fund is characterized with a relative liquidity. This means that within several business days you are able to withdraw the money.

Some money market funds come with check writing privileges. This means that you can write checks and the money for their coverage comes from the money market fund. However, such accounts usually come with some restrictions or fees.

Money Market Funds Risks

The following risks can be faced with money market funds:

  • The risk of the share price falling

    Money market funds are usually classified as securities. The price per share is usually set at $1 and attempted to be kept at this level. The risk of losing a part or the whole principal is faced in case the price falls below this level. There is no guarantee that the price will maintain this level. As you know the higher the risk is, the higher the potential return. There are not many reported cases of losses from money market funds, but they are not impossible.

  • Uncertainty about the next month's earnings

    This risk comes from the fact that the rates of money market funds are not fixed. This means that the value of the rate can change in both directions. As a result, you face the risk of falling rates, which may end you up with the need for additional cash, since you have started to earn less. However, you will be in a beneficial position if the rates increase.

  • Inflation

    Inflation is notoriously famous with its negative impact on returns, which may completely eat them up.

Money market funds are usually purchased by investors that look for a relatively safe investment and a decent return.

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