Wednesday, October 12, 2016

Likely internal mathematical working mechanism of liquid funds

How can money market funds give returns as good as bank fixed deposits, without the duration commitments and the premature withdrawal penalty charges? Seems to me like if the entire corpus of a liquid fund is thought of as a pool of water [with fixed length and width], and the pool is growing in height/volume over time, and any withdrawals are more than compensated for by deposits [resulting in net deposits], then, say, ~90-95% of the pool can be safely invested into higher duration instruments by the fund manager [which have higher returns than shorter term instruments], with only ~5-10% kept in really liquid form to meet day-to-day withdrawal requests [which'll anyway be met even otherwise by incoming deposits]. The result? Practically, almost the entire pool is invested into long-duration, high-interest instruments, while giving each customer of the liquid fund the impression of full liquidity [with the critical assumption that not all of these customers are going to withdraw all of their money together]. Based on randomness, some withdraw, some deposit, and the overall effect is sort of zero, and ~90-95% of the corpus doesn't need to be touched. This mechanism will work even if the pool size isn't growing on a net basis, but is sort of stable.

This magic of liquid funds is possible only because the individual deposits of the customers are clubbed together.

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