The Economic Implications of Money Market Fund Capital Bu

This paper develops an affine term structure for the valuation of money market funds. This valuation framework is then used to consider the economic implications of funds that are supported by a capital buffer. The main findings are twofold. First, relatively small capital buffers are capable of absorbing daily fluctuations between a fund’s shadow price and its amortized cost. For example, a fund with a capital buffer of 60 basis points can absorb most day-to-day price risk. The ability to absorb large scale defaults, however, would require a significantly larger and more costly buffer. Second, because a buffer is designed to absorb credit risk, capital providers demand compensation for bearing this risk. The analysis shows that, after compensating capital buffer investors for absorbing credit risk, the returns available to money market fund shareholders are comparable to default free securities, which would significantly reduce the utility of the product to investors.