Assessing Credit Risk in Money Market Funds During the Eurozone Crisis

Abstract

This paper measures credit risk in prime money market funds (MMFs) and studies how such credit risk evolved during the eurozone crisis of 2011-2012. To accomplish this, we estimate the annualized expected loss on each fund’s portfolio. We also calculate by Monte Carlo the cost of insuring a fund against losses amounting to over 50 basis points. We find that credit risk of prime MMFs, though small, doubled from 12 basis points in June 2011 to 23 basis points in December 2011 before receding in 2012. Contrary to common perceptions, this did not primarily reflect funds’ credit exposure to eurozone banks because funds took measures to reduce this exposure. Instead, credit risk in prime MMFs rose because of the deteriorating credit outlook of banks in the Asia/Pacific region. We conclude that the increase in the credit risk of prime MMFs in the second half of 2011 reflected contagion in the worldwide banking system coupled with slowing global economic growth, not actions taken by MMFs.

Keywords: Money market mutual funds; credit risk; copula; default probability; break the buck

JEL Classification: G01, G18, G23, G28