Default risk of money-market fund portfolios

Abstract

We address the problem of quantifying the risk associated with money-market fund (MMF) portfolios. As MMFs are intended to be perpetual investment vehicles but hold short-maturity instruments, this problem presents some unique modeling challenges. By focusing on default risk, the most material driver of portfolio losses, and by using a constant level of risk assumption, we show how this problem is similar to that of pricing a collateralized debt obligation. Drawing upon this insight, we present a novel semianalytic approach to compute the default risk of MMF portfolios. Upon using this model to evaluate the portfolios of three of the largest prime MMFs, we find that they vary considerably in their default risk, which in our stylized model increases with the risk horizon. This suggests that to be effective and yet not punitive, any regulatory proposal (eg, establishing capital buffers, imposing liquidity fees, etc) to address the systemic risk posed by MMFs should be based on the riskiness of the MMF portfolios as well as their liquidation strategy.