Financial markets are markets where individuals, business organizations and government trade financial instruments or securities. The main objective of a financial market is to fix world trade prices, increase capital and transfer risk and liquidity.
Financial markets can be categorized according to various framework. To understand the types of financial markets, we must first understand the broad categories into which it is divided.
The broader classification divides financial markets into two types, namely money markets and capital markets. In this article, we are going to understand what money and capital markets are and the difference between the two.
Before we proceed with the difference between capital market and money market, we will first explain the meaning of the two important types of financial markets.
What Is Money Market?
Money market is the section of financial markets that deals with short-term debt instruments such as cash, commercial paper, certificates of deposit and banking agreements.
What Is Capital Market?
The capital market is the part of the financial markets that facilitates the trading of long-term debt securities such as stocks, stocks, bonds, and debentures.
Capital Market Vs Money Market
The difference between money markets and capital markets is really pretty 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. Hence, it is safe to say that money markets are used by firms who are looking to borrow money for a short-term.
In contrast, securities sold on the capital markets have maturities of at least one year. Most of the financial instruments sold on these markets have extremely long maturities, i.e. a decade or more. In addition, many stocks are sold on the capital market and the stocks do not have a defined maturity! Preferred stocks, common stocks, bonds, gilts and debentures are the financial instruments commonly traded in the capital market.
All the stocks and bonds that retail investors usually buy are part of the capital markets. Therefore, it would be safe to say that companies use the capital market whenever they want to raise long-term funds.
Differences Between Money Markets and Capital Markets
- Funds raised in the money market are used to meet the working capital needs of the business. As a result, each business borrows only a small amount of money relative to its total asset base. Whereas, funds raised on the capital market form the entire capital base of the company.
- The main function of money markets is to provide short-term liquidity to the economy while the main function of capital markets is to channel savings in the economy in a meaningful way to promote growth and development of a country.
- Most of the transactions that take place in the capital market go through stock exchanges. There are dealers who specialize in creating markets for every share sold on the stock exchange. In contrast, most securities sold on the money market are sold over-the-counter. There are no market makers in the money market, but there are brokers who help the parties find counterparties.
- Money markets are more liquid than capital markets. This can be unreasonable as money markets do not have a market maker and capital markets do. However, as the maturity of money markets is smaller, many more investors are willing to place their funds in these funds on a short-term basis.
- Money market instruments have a short-term maturity. Consequently, the funds raised by these securities are not used in risky projects. As a result, money market instruments are known to present lower risk. On the other hand, capital markets spend money on complex projects due to the long-term nature of these funds. Thus, capital market instruments are considered to be riskier. Again, this is counter-intuitive taking into account the fact that in capital markets, the stock exchange acts as the counterparty for all transactions. Therefore, the risk should magnificently be low. In most cases, money markets are deemed absolutely secure. However, in some cases they end up giving negative returns too. Therefore, investors should also be careful while selecting money market funds.
- The returns earned from the money market are comparable to the cost of capital i.e the interest rate in the economy. It is strange for investors to earn much more than the interest rate. Nevertheless, the prospective returns in the capital markets are almost limitless. This can be credited to the longer duration and higher risk taken by investors.
The most active stakeholders in the money markets are banks and other financial institutions. Banks often want to raise short-term funds because they have to prove that they have the necessary reserves to lend. In addition, other financial institutions such as mutual funds and pension funds are required to keep a certain amount of cash on hand.
Indeed, they must reimburse investors who wish to redeem their investments. However, the cash does not provide any return. The money markets are the second best alternative. They are so liquid and risk free that they can be considered almost equivalent to cash. investors know they can easily trade their money market funds for cash without any loss in value.
The heart of the matter is that capital and money markets both serve different but complementary purposes. Therefore, the two markets complement the financial system of any country. The main difference between the money market and the capital market is their maturity schedule. Money markets deal with short term debt instruments such as Cash, CD, CP and Bas while capital markets deal with long-term securities such as stocks, bonds and debentures.