Frequently Asked Questions About Pricing of U.S. Money Market Funds

What is a stable net asset value (NAV) for a money market fund?
How does a fund maintain a stable NAV?
How do SEC rules help a money market fund maintain a stable $1.00 NAV?
Is the stable NAV guaranteed?
What is the “shadow price” of a money market fund?
Why are per-share market values called “shadow prices?”?
Do fund shadow prices fluctuate?
What has been the range of movement in money market funds’ per-share market value?
What causes shadow prices to fluctuate?
What kind of impact do interest rates have on per-share market values?
How much fluctuation can a fund have in its market value while maintaining a stable NAV?
What happens if a fund’s shadow price rises above $1.0050 or falls below $0.9950?
What financial events can cause a fund’s per-share market value to rise above $1.0050 or fall below $0.9950?
Are such financial events common?
Can the manager of a money market fund generally respond quickly to changing market conditions?
Can the manager of a money market fund usually respond to the changing credit situation of a particular issuer?
What happens to a money market fund’s per-share market value if a credit ratings agency downgrades securities held by the fund?
What happens to a shadow price if an issuer defaults on a securities held by the fund?
Do shadow prices provide early warning of severe financial shocks?

What is a stable net asset value (NAV) for a money market fund?

U.S. money market funds, unlike other mutual funds, seek to maintain a stable $1.00 per share net asset value (NAV). The NAV is the price at which investors purchase or redeem shares.

How does a fund maintain a stable NAV?

A money market fund provides investors a stable $1.00 NAV by using “amortized cost” to value its portfolio securities. Amortized cost is the book price of a security—the price a fund pays for a security, as adjusted over time for accounting changes in any discount or premium. Money market funds use amortized cost, rather than market value, to value their securities when calculating NAV. The Securities and Exchange Commission (SEC) allows a money market fund to use the amortized cost method only if the fund follows Rule 2a-7 under the Investment Company Act of 1940.

How do SEC rules help a money market fund maintain a stable $1.00 NAV?

By managing their funds to meet and exceed Rule 2a-7’s standards, advisers limit money market funds’ exposure to credit risk, interest rate or other market risk, and liquidity risk. Rule 2a-7’s standards help ensure money market funds maintain a stable $1.00 NAV.

Is the stable NAV guaranteed?

No. As money market funds disclose in their prospectuses, they are not insured by the Federal Deposit Insurance Corporation or any other government agency, and it is possible to lose money by investing in such funds.

What is the “shadow price” of a money market fund?

Money market funds are required to regularly calculate their portfolios’ per-share value at market prices, also known as their “shadow price.” While money market funds have routinely calculated shadow prices for decades, and disclosed them semi-annually,  the SEC’s 2010 amendments to Rule 2a-7 now require funds to disclose these shadow prices on a monthly basis (with a 60-day lag) to four decimal places (e.g., $1.0005 or $0.9995).

Why are per-share market values called “shadow prices”?

The term “shadow price” has been used for many years to reflect the fact that a money market fund’s per-share value, when calculated on a current market basis, must and typically does very closely “shadow” or track the fund’s per-share value calculated using the amortized cost method. The SEC introduced the term in its regulations in 1996, but per-share market values have been called shadow prices since the early 1980s.

Do fund shadow prices fluctuate?

Yes. Shadow prices can deviate from $1.0000, even when financial markets are largely stable. Such deviations are typically small and are not generally a cause for investor concern. Because money market funds hold short-term, high-quality securities, amortized cost usually provides a close approximation to a fund portfolio’s market value.

What has been the range of movement in money market funds’ per-share market value?

Historical evidence confirms that deviations between money market funds’ shadow prices and amortized costs are generally small. Data from a sample of taxable money market funds covering one-quarter of industry assets demonstrate that:

• Average per-share market values of all funds in the sample varied within a narrow range over the decade from 2000 to 2010—a period when financial markets experienced wide variations in interest rates and asset prices. Average shadow prices for funds in the sample ranged from $1.0020 in 2001–2002, when the Federal Reserve reduced interest rates sharply, to $0.9990 in the fall of 2008, at the peak of the financial crisis.
• Average per-share market values for prime money market funds in the sample—those taxable funds that invest in corporate as well as government securities—varied between $1.0020 and $0.9980 during the decade from 2000 to 2010.

These variations are well within the band ($1.0050 to $0.9950) in which a money market fund can price its shares at a stable $1.00 NAV.

What causes shadow prices to fluctuate?

Four factors are primarily responsible for changes in money market funds’ per-share market values.

• Changes in interest rates. Falling interest rates increase shadow prices, and rising rates reduce them.
• The maturity of a fund’s portfolio. The longer the portfolio’s dollar-weighted average maturity, the greater the impact of changing interest rates on the fund’s per-share market value.
• Flows of net new money into and out of funds. If a fund’s shadow price differs from $1.0000, net inflows, or investors’ purchases in excess of investors’ redemptions, will move the per-share market value toward $1.0000. Net outflows, or investors’ redemptions in excess of investors’ purchases, will increase the deviation from $1.0000.
• Credit events affecting securities held in a fund’s portfolio. Downgrades and defaults decrease shadow prices.

What kind of impact do interest rates have on per-share market values?

Usually small and temporary. Because the market value of fixed-income securities varies inversely with interest rates, an increase in interest rates can reduce (and a decline in interest rates can increase) the market values of the securities that a money market fund holds. However, such price effects are typically very small for the kinds of short-term, high-quality securities money market funds hold.

Events in 2004 illustrate this: in July, the Federal Reserve began tightening monetary policy, causing short-term interest rates to rise. Consequently, the market prices of short-term Treasury securities fell. In particular, the price of a 3-month Treasury bill issued on July 6, 2004, fell below its amortized cost value for most of the security’s life. Nevertheless, the maximum deviation of the market value of the security from its amortized cost was small, only 3 basis points on August 2, 2004. The deviation shrank as the Treasury bill neared its final maturity, at which time its market price equaled its amortized cost. Thus, during this period, even a money market fund holding only 3-month Treasury bills would have seen its per-share market value drop a few basis points below $1.0000. If the fund held those Treasury securities to maturity, it would have suffered no loss because the fund would have received the full face value, including interest implicitly accrued from July 6, 2004.

How much fluctuation can a fund have in its market value while maintaining a stable NAV?

A money market fund can report a stable $1.00 NAV if its per-share market value remains within one-half cent ($0.0050) of $1.0000—in other words, from $0.9950 to $1.0050.

What happens if a fund’s shadow price rises above $1.0050 or falls below $0.9950?

If a fund’s shadow price rises above $1.0050 or falls below $0.9950, the fund’s board must promptly consider what action, if any, should be taken, including whether to discontinue the use of amortized cost valuation and reprice the fund’s NAV to be more or less than $1.00. Repricing the NAV is known as “breaking the dollar” or “breaking the buck.” The board may also consider whether to suspend redemptions and liquidate the fund.

What financial events can cause a fund’s per-share market value to rise above $1.0050 or fall below $0.9950?

Modeling based on reasonable assumptions about fund portfolio composition and maturity demonstrates that large, sudden changes in market conditions are necessary before a fund is at risk of breaking the buck.

• Short-term interest rates must rise by more than 300 basis points (3 percentage points) in one day to reduce a fund’s shadow price to $0.9950, absent any other changes in market conditions.
• Investor net redemptions must reach 80 percent of a fund’s assets to reduce a fund’s per-share market value to $0.9950, absent any other changes in market conditions and given an initial per-share market value of $0.9990.
• Interest rate changes and flows can have a combined effect on a fund’s shadow price. In the modeling, a 100 basis-point (1 percentage point) increase in interest rates combined with investor net redemptions of nearly 70 percent of a fund’s assets, all in one day, would be necessary to reduce a fund’s shadow price to $0.9950.

Are such financial events common?

No—they are rare. Historical data show that the large, sudden changes in interest rates or large investor net redemptions needed to change shadow prices significantly occur seldom, if ever.

• Over the 29-year period from January 1982 to December 2010, the yield on three-month Treasury bills increased by more than 100 basis points in a single day only once, on February 1, 1982. Instead, on 98 percent of all business days between 1982 and 2010, interest rates on the three-month Treasury bill changed (up or down) by 25 basis points or less. Over longer periods, changes in short-term interest rates also tend to be small; three-month Treasury interest rates changed by 25 basis points or less (up or down) in 63 percent of 30-day periods during those years.
• Between 1996 and 2010, investor net redemptions from taxable money market funds in a single week exceeded 20 percent of a fund’s assets in fewer than 1 percent of instances. Over four-week periods during those years, redemptions exceeded 20 percent of assets in fewer than 2.5 percent of instances.

Can the manager of a money market fund generally respond quickly to changing market conditions?

Yes. Money market funds hold securities that mature over a short period. This allows fund managers to adjust their portfolios relatively quickly to respond to changes in interest rates, net flows, and credit events.

Can the manager of a money market fund usually respond to the changing credit situation of a particular issuer?

Yes. Fund managers constantly monitor the credit quality of their portfolios to ensure that fund assets pose minimal credit risks. Should an issuer’s credit quality deteriorate, in most cases fund managers have time to react, such as by choosing not to reinvest in a firm’s commercial paper as it matures. It would be unusual for the credit quality of a security to change all in one day. Rather, investors would typically reassess the credit quality of an issuer over a period of time, causing interest rates on its securities to rise over the course of weeks or months.

What happens to a money market fund’s per-share market value if a credit ratings agency downgrades securities held by the fund?

A money market fund’s per-share market value can withstand large increases in the interest rate on a single security, such as the change that might be caused by a downgrade. For a security that comprises 5 percent of a fund’s portfolio, a 400 basis-point increase in its interest rate will reduce a fund’s shadow price by only 5 basis points, from $1.0000 to $0.9995. The impact on the shadow price is muted by Rule 2a-7’s diversification requirements, which allow a money market fund to invest no more than 5 percent of its assets with a single issuer.

What happens to a shadow price if an issuer defaults on a securities held by the fund?

The effect of a default on a fund's shadow price depends on the size of the fund's holding and the severity of the decline in the market values of the defaulted securities. For example, a default in a security that comprises 1.25 percent of a fund’s assets can reduce the fund’s per-share market value to $0.9950 or below if the default reduces the security’s value by 40 percent or more (to 60 cents or less on the dollar). To maintain minimal credit risk, money market fund managers work hard to diversify and monitor the credit quality of their portfolios in order to avoid holding securities that may end up defaulting.

Do shadow prices provide early warning of severe financial shocks?

No. For example, in the week ending September 10, 2008—two business days before the failure of Lehman Brothers Holdings Inc.—90 percent of prime money market funds in the sample had per-share market values within 5 basis points of $1.0000 (between $0.9996 and $1.0005). Even the following week, after Lehman Brothers had failed, 93 percent of prime funds in the sample had shadow prices greater than $0.9975, and none had a per-share market value within 10 basis points of $0.9950.

January 25, 2011