Financial markets are markets where financial instruments or securities are traded. Financial markets can be classified based on various parameters. In order to understand the types of financial markets, we need to first understand the broad categories in which it is subdivided.
The broadest classification divides financial markets into two types’ viz. money markets and capital markets. In this article, we will understand what money markets and capital markets are and the difference between the two.
Money Markets vs. Capital Markets
The difference between money markets and capital markets is actually quite simple. Money markets transact in financial securities that have a maturity of less than one year. Commercial paper, short term treasury notes, promissory notes, and bills of exchange are commonly traded on the money market. Therefore, it can be said that money markets are used by firms who are looking to borrow money for a very short period of time.
On the other hand, securities sold on the capital markets have maturities that are at least longer than a year. Most financial instruments sold on these markets have extremely long term maturities i.e., a decade or more. Also, a lot of equity stock is sold in the capital market, and equities do not have any definite maturity! Preferred stock, common stock, bonds, gilts, and debentures are the financial instruments that are commonly transacted in the capital market. All stocks and bonds which retail investors commonly buy are said to be a part of the capital markets. Therefore, it would be fair to say that companies use the capital market when they want to raise money for the long term.
Differences between Money Market and Capital Markets
- Funds raised from the money market are used to meet the working capital needs of the firm. As a result, each firm only borrows a small amount of money relative to its total asset base. On the other hand, funds raised from the capital market form the entire asset base of the company.
- The primary function of the money markets is to provide short term liquidity to the economy. On the other hand, the primary function of the capital markets is to channelize the savings of the economy in a meaningful way to aid growth and development.
- Most transactions that happen on the capital market are routed via exchanges. There are dealers who specialize in making markets in every security which is sold on the exchange. On the other hand, most securities sold in the money market are sold over the counter. There are no market makers, but there are brokers who help parties find counterparties.
- Money markets are more liquid as compared to capital markets. This may be counterintuitive given the fact that money markets don’t have market makers and capital markets do. However, since the maturity of money markets is smaller, a lot more investors are willing to deploy their funds in these short term funds.
- Money market instruments have a short term maturity. Hence, the funds raised from these securities are not deployed in risky projects. As a result, money market instruments are known for having a lower risk. On the other hand, capital markets deploy money in complex projects because of the long term nature of these funds. As a result, capital market instruments are believed to be riskier. Once again, this is counterintuitive given the fact that in capital markets, the exchange acts as a counterparty to all transactions. Hence, the risk should ideally be low. In most circumstances, money markets are considered to be absolutely safe. However, in some cases, they end up giving negative returns as well. Therefore, investors need to be careful while selecting money market funds, as well.
- The returns obtained from the money market are equivalent to the cost of capital i.e., the interest rate in the economy. It is unusual for investors to earn significantly more than the interest rate. On the other hand, the potential returns in capital markets are almost unlimited. This can be attributed to the higher duration as well as a higher risk, which is undertaken by the investors.
- The most active participants in money markets are banks and other financial institutions. Banks frequently want to raise short term funds since they have to show that they have the reserves necessary to make the loans. Also, other financial institutions like mutual funds and pension funds are required to keep some amount of liquid cash on hand. This is because they need to pay back investors who want to redeem their investments. However, cash does not provide any return. Money markets are the next best alternative. They are so liquid and risk-free that they can almost be considered equivalent to cash. Most investors know that they can easily redeem their money market funds to cash without any loss of value.
The bottom line is that capital markets and money markets both serve different but complementary needs. Hence, both thee markets complete the financial system of any country.
