A financial market is a market that brings buyers and sellers together to trade in financial assets such as stocks, bonds, commodities, derivatives and currencies. The purpose of a financial market is to set prices for global trade, raise capital, and transfer liquidity and risk. Although there are many components to a financial market, two of the most commonly used are money markets and capital markets.
Money markets are used for a short-term basis, usually for assets up to one year. Conversely, capital markets are used for long-term assets, which are those with maturities of greater than one year. Capital markets include the equity (stock) market and debt (bond) market. Together, money markets and capital markets comprise a large portion of the financial market and are often used together to manage liquidity and risks for companies, governments and individuals.
Capital markets are perhaps the most widely followed markets. Both the stock and bond markets are closely followed, and their daily movements are analyzed as proxies for the general economic condition of the world markets. As a result, the institutions operating in capital markets – stock exchanges, commercial banks and all types of corporations, including nonbank institutions such as insurance companies and mortgage banks – are carefully scrutinized.
The institutions operating in the capital markets access them to raise capital for long-term purposes, such as for a merger or acquisition, to expand a line of business or enter into a new business, or for other capital projects. Entities that are raising money for these long-term purposes come to one or more capital markets. In the bond market, companies may issue debt in the form of corporate bonds, while both local and federal governments may issue debt in the form of government bonds. Similarly, companies may decide to raise money by issuing equity on the stock market. Government entities are typically not publicly held and, therefore, do not usually issue equity. Companies and government entities that issue equity or debt are considered the sellers in these markets.
The buyers, or the investors, buy the stocks or bonds of the sellers and trade them. If the seller, or issuer, is placing the securities on the market for the first time, then the market is known as the primary market. Conversely, if the securities have already been issued and are now being traded among buyers, this is done on the secondary market. Sellers make money off the sale in the primary market, not in the secondary market, although they do have a stake in the outcome (pricing) of their securities in the secondary market.
The buyers of securities in the capital market tend to use funds that are targeted for longer-term investment. Capital markets are risky markets and are not usually used to invest short-term funds. Many investors access the capital markets to save for retirement or education, as long as the investors have long time horizons, which usually means that they are young and are risk takers.
The money market is often accessed alongside the capital markets. While investors are willing to take on more risk and have patience to invest in capital markets, money markets are a good place to “park” funds that are needed in a shorter time period – usually one year or less. The financial instruments used in capital markets include stocks and bonds, but the instruments used in the money markets include deposits, collateral loans, acceptances and bills of exchange. Institutions operating in money markets are central banks, commercial banks and acceptance houses, among others.
Money markets provide a variety of functions for either individual, corporate or government entities. Liquidity is often the main purpose for accessing money markets. When short-term debt is issued, it is often for the purpose of covering operating expenses or working capital for a company or government and not for capital improvements or large-scale projects. Companies may want to invest funds overnight and look to the money market to accomplish this, or they may need to cover payroll and look to the money market to help. The money market plays a key role in ensuring companies and governments maintain the appropriate level of liquidity on a daily basis, without falling short and needing a more expensive loan or without holding excess funds and missing the opportunity of gaining interest on funds.
Investors, on the other hand, use the money markets to invest funds in a safe manner. Unlike capital markets, money markets are considered low risk; risk-adverse investors are willing to access them with the anticipation that liquidity is readily available. Older individuals living on a fixed income often use the money markets because of the safety associated with these types of investments.
The Bottom Line
There are both differences and similarities between capital and money markets. From the issuer or seller’s standpoint, both markets provide a necessary business function: maintaining adequate levels of funding. The goal for which sellers access each market varies depending on their liquidity needs and time horizon. Similarly, investors or buyers have unique reasons for going to each market: Capital markets offer higher-risk investments, while money markets offer safer assets; money market returns are often low but steady, while capital markets offer higher returns. The magnitude of capital market returns often has a direct correlation to the level of risk, but that is not always the case.
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Although markets are deemed efficient in the long run, short-term inefficiencies allow investors to capitalize on anomalies and reap higher rewards that may be out of proportion to the level of risk. Those anomalies are exactly what investors in capital markets try to uncover. Although money markets are considered safe, they have occasionally experienced negative returns. Inadvertent risk, although unusual, highlights the risks inherent in investing – whether putting money to work for the short term or long term in money markets or capital markets.
Courtesy: Kristina Zucchi
Sam Bediako-Asante is the CEO of Sambed Consult, a Business/Investment Advisory firm. He is also a former Banker, a Professional Administrator, and also presently, a certified and an accredited SA Specialist of the South African Tourism in Ghana.
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