Overview
Money Market vs Capital Market
These are two significant elements of the global financial system.
Short-term debt is traded on the money market. Governments, businesses, banks, and other financial entities constantly borrow and lend money for terms as short as overnight and as long as a year.
The trading of both stocks and bonds is included in the capital market. Financial institutions, licensed brokers, and ordinary investors purchase these long-term investments.
The financial market, also referred to as the money market, is largely made up of the capital market and money market combined.
Money Market
Money market is a financial market where for a limited period of time, typically one year or less, the financial assets are traded on stock exchange. Money market is a good area for individuals, banks, other businesses, and governments to store cash.
It exists so that organizations and governments that require money to function can do so promptly and affordably, and so that organizations with extra cash can spend it.
The risks are low, but the returns are limited.
Deposits, collateral loans, acceptances, and bills of exchange are some of the instruments utilized in the money markets.
The Federal Reserve, commercial banks, and acceptance houses are some of the organizations that participate in the money markets.
Short-term debt is typically issued by businesses or governments to fund working capital needs or regular operating expenses.
Individual investors can invest their resources in a secure and convenient location by using the money markets.
There are other options, including mutual funds that concentrate on municipal, U.S. Treasury, and state money market funds. Many government funds are exempt from taxes. Most banks also allow you to open a money-market fund.
Main Functions
1) Financing industry
Money market aid businesses in obtaining quick loans to cover their working capital needs.
2) Central Bank assistance
Although a money market is not necessary for the central bank to function and affect the banking sector, the presence of a developed money market makes the central bank more effective.
3) Financing trade
The funding of both local and foreign trade depends heavily on the money market. Through bills of exchange, which are discounted by the bill market, commercial money is made available to the traders.
4) Successful and profitable investments
The money market helps commercial banks make profitable investments using their excess reserves. Commercial banks’ primary goals are to generate income from their reserves and to keep enough liquidity on hand to satisfy their depositors’ erratic cash needs.
The excess reserves of commercial banks are invested in easily convertible near-money assets (such as short-term bills of exchange) on the money market. As a result, commercial banks profit without jeopardizing liquidity.Â
5) The independence of commercial banks
Commercial banks can become self-sufficient thanks to developed money markets. Commercial banks do not need to go to the central bank in a time of financial crisis to borrow money at a higher interest rate. Instead, they can fulfill their needs by requesting their previous short-term money market loans.
Advantages and Disadvantages of Money Markets
Due to the protection of FDIC insurance, backing by a government or bank, or the high creditworthiness of the borrowers, the majority of money market assets are regarded as having an exceptionally low risk.
Additionally, they are relatively liquid, making quick exchanges for cash possible.
These investments’ poor returns are a trade-off for their minimal risk. Money markets not only perform worse than other asset types, but frequently even lag behind inflation. Additionally, any account fees could significantly reduce those meagre earnings.
Furthermore, not all money market securities have these benefits. Even the most reliable borrowers could default because some of them are not FDIC insured. Some money market accounts have minimum balance standards or withdrawal limitations.
Pros
- Very little danger.
- Be FDIC-insured is possible.
- Extremely liquid
- Greater yields than the majority of bank accounts.
Cons
- Low returns that might not match inflation
- Money market securities are not always Insured.
- May impose steep withdrawal thresholds or large minimum investments.
Types of Money Market Instruments
Money Market Accounts
Money market accounts are a type of savings account. They pay interest, but some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank promptly converts it to a checking account.)
Banks typically calculate interest on a money market account on a daily basis and make a monthly credit to the account.
In general, money market accounts offer slightly higher interest rates than standard savings accounts. But the difference in rates between savings and money market accounts has narrowed considerably since the 2008 financial crisis.
Average interest rates for money market accounts vary based on the amount deposited.
[Funds in money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC) at banks and the National Credit Union Administration (NCUA) in credit unions.]
Certificates of Deposit (CDs)
Most certificates of deposit (CDs) are not strictly money market funds because they are sold with terms of up to 10 years. However, CDs with terms as short as three months to six months are available.
As with money market accounts, bigger deposits and longer terms yield better interest rates. Unlike a money market account, the rates offered with a CD remain constant for the deposit period. There is usually a penalty associated with an early withdrawal of funds deposited in a CD.
Money Market Funds
The wholesale money market is limited to companies and financial institutions that lend and borrow in amounts ranging from $5 million to well over $1 billion per transaction. Mutual funds offer baskets of these products to individual investors.
The net asset value (NAV) of such funds is intended to stay at $1. During the 2008 financial crisis, one fund fell below that level. That triggered market panic and a mass exodus from the funds, which ultimately led to additional restrictions on their access to riskier investments.
Commercial Paper
The commercial paper market is for buying and selling unsecured loans for corporations in need of a short-term cash infusion. Only highly creditworthy companies participate, so the risks are low.
Banker’s Acceptances
The banker’s acceptance is a short-term loan that is guaranteed by a bank. Used extensively in foreign trade, a banker’s acceptance is like a post-dated check and serves as a guarantee that an importer can pay for the goods. There is a secondary market for buying and selling banker’s acceptances at a discount.
Repos
The repo, or repurchase agreement (repo), is part of the overnight lending money market. Treasury bills or other government securities are sold to another party with an agreement to repurchase them at a set price on a set date.
Eurodollars
Eurodollars are dollar-denominated deposits held in foreign banks, and are thus, not subject to Federal Reserve regulations. Very large deposits of Eurodollars are held in banks in the Cayman Islands and the Bahamas.
Money market funds, foreign banks, and large corporations invest in them because they pay a slightly higher interest rate than U.S. government debt.
Conclusion
One of the safest methods to invest money is in money market accounts and money market funds. Additionally, they frequently yield returns that are even lower than inflation than other types of investments.Â
Many consumers and corporations utilize money markets as a short-term investment for their cash reserves because they are so low risk.
Capital Market
The phrase “capital market” is a general one that refers to both physical and virtual locations where diverse entities trade various kinds of financial products.
The stock market, bond market, currency and foreign exchange (forex) markets, among others, may be among these venues.
Major financial cities like New York, London, Singapore, and Hong Kong are where the majority of markets are concentrated.
Savings and investments are transferred between suppliers and those in need on capital markets. Long-term debt and equity securities are sold and bought exclusively on the capital market.Â
The stock market and the bond market are the two most popular capital markets. The entire stock and bond markets collectively are referred to as “capital markets.”
These days, anyone can instantly buy and sell a stock, but businesses that issue stock do so to raise money for their long-term operations. While a stock’s value may change, it has no expiration date.
Suppliers, who can lend money or make investments, often comprise banks and investors.
In this market, corporations, governments, and individuals are looking for capital.
Primary and secondary markets make up capital markets.
By connecting suppliers with people looking for money and providing a platform where they may trade securities, they aim to increase transactional efficiency.
Main functions of the Capital Market
The capital market serves as a conduit between savers and investors.
> It promotes economic expansion.
> It makes trading in securities easier.
> It lowers the cost of transactions and information.
> To increase the country’s income, it aids in the migration of capital to more fruitful regions.
> It facilitates the mobilization of savings for long-term investment finance.
> It facilitates rapid financial instrument appraisals.
> It facilitates the settling of transactions.
> It provides hedging against market risks through the trading of derivatives.
> It ensures that money is always available to the government and businesses.
> It increases capital allocation’s efficacy.
Types of Capital Market
These markets are divided into two different categories:
Primary markets where new equity stock and bond issues are sold to investors
Secondary markets, which trade existing securities
Primary Market
In the primary capital market, a corporation offers new stocks or bonds for the first time to the general public, as in an initial public offering (IPO).
The new issues market is another name for this marketplace.
The company that provides the securities employs an underwriting firm to review it and produce a prospectus explaining the pricing and other features of the securities to be issued when investors purchase securities on the primary capital market.
On the primary market, there are strict regulations that apply to all issues.
Companies are required to file reports with the Securities and Exchange Commission (SEC) and other securities organizations, and they must hold off on becoming public until their filings have been authorized.
Because the company and its investment bankers need to quickly sell all of the available securities to reach the required volume, they frequently restrict access to the primary market for small investors and instead concentrate on marketing the sale to institutional buyers who can purchase larger quantities of securities at once.Â
Secondary Market
It’s the place where investors buy and sell assets which is usually known as the stock market.
These previously issued securities are traded between investors in the secondary market, which consists of places governed by regulatory bodies like the SEC.
Companies that issue securities have no involvement in the secondary market.
Examples of Secondary Market: Nasdaq and the New York Stock Exchange.
Secondary Market Subcategories
Auction Market and Dealer Market
The auction market and the dealer market are the two distinct subcategories of the secondary market.
Auction Market: The open outcry system, where buyers and sellers gather in one place and declare the prices at which they are willing to purchase and sell their securities, is unique to the auction market.
Dealer Market: commerce occurs across electronic networks. The majority of small investors transact on dealer markets.
Types of Capital Market Instruments
Equities:
The portion of a company’s ownership held by shareholders is referred to as equity securities.
It implies to a financial commitment made in exchange for joining the company as a shareholder.
The primary distinction between equity holders and debt holders is that the former do not receive regular payments but can instead make money by selling their stocks at a profit.
In addition, businesses frequently provide dividends to their shareholders as a portion of the earnings from their primary business operations.
Debt Securities:
Debt Securities can be classified into bonds and debentures:
i) Bonds:
Bonds are fixed-income instruments.
In order to finance infrastructure development or other types of projects, the federal, state, and local governments, as well as private corporations, issue bonds, which are fixed-income securities.
Bonds often have a predetermined lock-in duration. As a result, the bond issuers must give the bondholders their principal back on the bond’s maturity date.
ii) Debentures:
Unlike bonds, debentures are unsecured investment choices that are not supported by any kind of security.
Investors here serve as potential creditors of an issuing institution or corporation, and the lending is based on mutual confidence.
Derivatives:
The four most common types of derivative instruments:
i) Future: A future is a derivative transaction in which derivatives are exchanged at a predetermined price and on a predetermined future date.
ii) Options: An option is a contract between two parties that gives the buyer the right to buy or sell a specific quantity of derivatives at a specific price for a specific amount of time.
iii) Forward: A forward is a two-party contract in which the exchange takes place at the contract’s expiration at a specific price.
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iv) Interest Rate Swap: An interest rate swap is a pact between two parties wherein the interest rates are exchanged and both parties agree to pay the other party’s interest rates on loans in various currencies, options, and swaps.
Exchange-Traded Funds (ETFs):
Exchange-traded funds (ETFs) are a collection of financial assets from a number of investors that are used to buy various derivatives, debt securities, and shares on the capital markets.
ETFs are typically traded in the stock market as blocks of shares with characteristics of both shares and mutual funds.
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During the period of equities trading, ETF funds that are listed on stock exchanges can be bought and sold as needed.
Foreign Exchange Instruments
Financial instruments that are available on international markets are known as foreign exchange instruments. Derivatives and currency agreements make up the majority of it.
They can be divided into three groups based on currency agreements: spot, outright forwards, and currency swap.
How to Invest in these Instruments?
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Investors must create a trading account with a licensed broker in order to invest in or trade in these capital market financial instruments.
Advantages and Disadvantages of Capital Market
Advantages
Facilitates Transactions
The capital market’s primary benefit is that it enables transactions between savers, such as individuals, banks, and high net worth individuals, and spenders, such as businesses that constantly require capital.
This allows savers to earn income in the form of dividends, interest, and capital appreciation, while businesses can also use this capital to expand and become large.
In other words, when one side has a lot of money but no opportunities and the other side has a lot of opportunities but no money, the capital market functions as a great mediator between the two sides, bridging the gap and assisting both sides.
Liquidity
In contrast to other markets, such as the real estate market, where one cannot readily enter or exit the market, capital markets are relatively liquid in the sense that investors can invest and withdraw their money from the market whenever they need the money.
Simply put, the ability to purchase and sell securities on the capital market with the click of a mouse guarantees that you will never suffer from a lack of liquidity.
As a result, investors and businesses have more faith in the capital market than they do in other markets.
Diversification
The capital market offers a wide range of instruments, including mutual funds, debt instruments, derivatives, swaps, and more, all of which assist investors in diversifying their portfolios and generating higher returns.
The capital market is not a single flower-like fixed deposit of a bank, but rather a bouquet of flowers that offers many instruments in one location to meet the needs of all types of investors.
Disadvantages
Risky
The capital market’s largest flaw is that it is extremely dangerous because all of its instruments, including equity shares, derivatives, and swaps, come with inherent risks.
As a result, many innocent people lose their whole life savings due to the poor capital market decisions and investments.
Those who believe in safety of their funds and are used to regular returns should stay away from the stock market since it is not a place for the faint of heart.
Additional Costs
Capital market investing is more expensive than investing in bank fixed deposits because of costs like brokerage, exchange fees, taxes, and other expenses. As a result, it is more expensive for investors to trade on the capital market.
Complex
Different capital market instruments are not simple; rather, they contain several intricacies, which makes it much harder to trade them and profit from that trading. As a result, it need knowledge of finance to grasp a variety of securities like futures, options, swaps, and other trading techniques like straddles, strangles, covered calls, bond swapping, and others.
Conclusion
The financial sector’s capital markets are a crucial component. They connect those who have money to give with those who need it for their own needs.
This might apply to organizations that want to grow, governments that want to finance infrastructure projects, and even private citizens who want to purchase a home.
They are separated into two groups: the main market, where businesses list new issues for the first time, and the secondary market, where investors can buy securities that have already been issued.
The main advantage of these marketplaces is that they enable the transfer of wealth from those who possess it to others who require it for personal needs.
