The money market and capital market are two major components of the Indian financial system. The money market caters to short term liquidity needs, while the capital market provides a platform for long term investing. The instruments of the money market have a maturity of less than one year. In contrast, capital market instruments have a maturity of more than one year. This article covers money market vs capital market, their features and types in detail.
What is a Money Market?
A market for securities that have a maturity of less than one year is a money market. The securities in the money market are short term in nature, highly liquid. A few of the money market instruments are treasury bills, repos, certificates of deposits, and banker’s acceptances.
The primary function of the money market is to cater to the immediate cash needs of the economy. This is usually done by adjusting the cash positions of different players in the market. In other words, the money market caters to the liquidity needs of the economy.
The money market also helps in mobilising funds across different sectors of the market. When investors have excess funds in the short term, they invest in the money market. Other players in the market use these funds to fulfil their short-term cash needs. Due to the high liquidity of money market instruments, channelising savings to investments is easier.
The interest rates of money market instruments serve as a benchmark for all other debt securities. Moreover, RBI and the government use money market interest rates to frame future monetary policy.
The major players in the money market are RBI, banks, Non-Banking Financial Companies (NBFCs), and acceptance houses. Moreover, All India Financial Institutions and Mutual Fund houses can access call and notice money. Individuals, companies, firms and other institutions can invest in treasury bills and other money market instruments.
Features of Money Market
Following are the features of the money market:
- Liquidity: Money market instruments are highly liquid assets that generate fixed income for investors. The short term maturity of the instruments makes them a highly liquid asset. Hence, they are a quite close substitute to holding cash.
- Safety: The issuers of the money market instruments have a high credit rating, and the returns are fixed. Also, the risk of losing the investment is almost zero. Therefore, these instruments are one of the safest and secure options available in the market.
- Returns: Money market instruments are issued at a discount to their face value, and the maturity amount is decided in advance. Unlike the capital market, the returns are fixed from these investments, which is highly correlated to market performance. Therefore, the investor can easily anticipate how much they can earn through the investment. As a result, they can choose an option that best suits their investment needs and horizon.
Types of Money Market Instruments
Following are the different types of money market instruments:
Treasury Bills (T-Bills)
The Reserve Bank of India issues the Treasury Bills (T-Bills) on behalf of the central government to raise funds. T-bills are short term financial instruments with a maximum maturity period of one year. There are 14 days, 91 days and 364 days T-bills. They are issued at a discount and repaid at par on maturity.
Bills of Exchange or Commercial Bills
Businesses issue bills of exchange to meet their short term money requirements. The creditor can discount their bill of exchange with a broker or a bank. They are highly liquid instruments as they are transferable from one person to the other.
Commercial Papers (CP)
Large businesses and corporations issue Commercial Papers (CPs) to raise capital to meet their short-term business requirements. These corporations have high credit ratings, which acts as a security to the unsecured commercial papers. CPs have a fixed maturity that ranges from 7 days to 270 days. Furthermore, investors can trade CPs in the secondary market.
Certificate of Deposits (CD)
Corporates, scheduled commercial banks, trusts, individuals issue Certificate of Deposits (CDs) that are negotiable term deposits. Commercial banks accept them and they work similarly to a promissory note. The duration of a CD varies from 3 months to one year. While CDs issued by financial institutions have a longer duration that varies between one year to three years.
Repurchase Agreements, also known as repos, is a legal agreement between two parties. One party sells a security to another with the promise of purchasing it back from the buyer at a later date. The seller buys back the security at a prefixed date and amount. The interest rate that the buyer charges is the repo rate. Repos are a quick way to raise short term capital requirements that also earn good returns for the buyer.
Banker’s Acceptance is a financial instrument that an individual or a business creates in the name of a bank. The issuer has to pay the instrument bearer a specific sum on a specific date. It is usually anywhere between 30 and 180 days after the issue. As a commercial bank guarantees the payment, it is a safe financial instrument.
Call and Notice Money
In a Call Money scenario, the funds are borrowed for a period of one day. On the other hand, in a Notice Money market, the funds are lent up to a duration of 14 days. Both the options do not have any collateral security. Cooperative banks and commercial banks borrow and lend funds in call and notice money markets. Mutual funds and financial institutions are only lenders of funds.
What is a Capital Market?
A market for long term investments is the capital market. In other words, when the players in the industry need funds for a long term horizon, they approach the capital market. The capital market instruments have a maturity of more than one year. The players in the capital market industry deal in capital market instruments like shares, bonds, ETFs, debentures, derivatives like futures, options, and swaps.
The capital market mobilises savings to investments. They also assist in funding long term projects of the companies. These markets use competitive price mechanisms and hence help inefficient capital allocation. Moreover, they also enable the faster valuation of financial securities listed on the stock exchange.
Capital markets in India are highly regulated and organised. Though they are risker than money markets, capital markets have the potential to give good returns in the long run.
The capital market intermediaries are stock exchanges like BSE, NSE, MCX (Commodity Exchange), banks, brokers, insurance companies, and other financial institutions. It is through these intermediaries that capital markets mobilise savings to investments.
Features of Capital Markets
Following are the features of capital markets:
- Safety: Government regulates the capital markets. They operate under a defined set of rules. Therefore, investors people consider it a safe place for trading.
- Channelizes savings: Capital markets act as a link between savers and investors. They mobilise the savings from savers to industry players and promote economic growth.
- Long term investment: Capital markets provide a platform for long term investments. Any investors looking for investing in long term investments can do so through capital markets.
- Wealth Creation: The capital market provides an opportunity to investors with surplus funds to invest in capital market instruments like shares and bonds and create wealth for themselves through the power of compounding.
- Helps intermediaries: The capital market mobilises savings from savers to borrowers with the help of intermediaries like stock exchanges, brokers, banks, etc. By doing so, the capital market is helping intermediaries conduct business and earn income.
Types of Capital Markets
There are two types of capital markets and they are the primary market and the secondary market.
- Primary market: It is the new issue market, where companies issue shares for the first time through an IPO. Once the IPO is successful, the shares of the company get listed on the stock exchange. Money in the primary market is raised through private placement, rights issues, and prospectus. The money is raised for the growth and expansion of the company.
- Secondary market: It is a market for trading listed shares and securities. A stock exchange is usually the marketplace for buying and selling securities. In India, the major stock exchanges are National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) and a majority of equity trading and investments take place on these two exchanges. NSE and BSE are the perfect examples of secondary markets.
Capital Market Instruments
There are two major types of capital market instruments, and they are bonds and stocks.
- Bonds: Bonds are debt securities that trade on the stock exchange. Companies and firms issue bonds to raise money for the growth and expansion of the company. Bonds are debt instruments, hence bondholders receive interest. At the end of the maturity period, the company pays back the principal amount along with interest.
- Stocks: Stocks represent ownership of a company. Each share is a part of the ownership of the company. Shares trade on the stock exchange, and the share price depends on market demand and supply. The person holding shares of a company is the shareholder. Shareholders receive dividends. Also, in the case of equity shares, they have voting powers and can vote for important decisions in the annual general meeting of the company. During liquidation, they get a share of the assets after the liabilities are paid off.
Difference Between Money Market and Capital Market
Following are the key differences between money market vs capital market:
The money market funds help a firm to meet its working capital requirements. As a result, each company only borrows a small percentage of its overall asset base. On the other hand, funds raised through capital markets form the asset base of the firm.
Money markets’ principal purpose is to offer short-term liquidity to the economy. The fundamental role of capital markets, on the other hand, is to channel the economy’s savings in a meaningful way to help growth and development.
Nature of the market
Money markets are informal markets, while capital markets are formal and regulated.
Money market instruments include Bills of Exchange or Commercial Bills, Treasury Bills (T-Bills), Commercial Papers (CP), Certificate of Deposits (CD), Repurchase Agreements, Banker’s Acceptance and Call & Notice Money.
Mode of transaction
Most money market instruments are sold over the counter through brokers who help parties find counterparties. On the other hand, most capital market transactions happen through exchanges. Dealers facilitate the transactions on the exchanges.
Money market instruments are more liquid in comparison to capital market instruments. Though capital markets have market makers, most money market instruments are highly liquid and generate good returns. Since the maturity of the money markets is lesser, many investors are willing to invest their funds in the short term.
The maturity period of the money market instruments ranges from one day to one year. While the capital market instrument’s maturity is long term, and there is no stipulated time period.
Money market instruments are short term investment options, and the funds raised from these instruments are not deployed in risky projects. As a result, money market instruments are popular low-risk investment options.
Capital markets, on the other hand, invest the raised capital in long term projects. As a result, these instruments are perceived as riskier options.
The money market returns are equal to the cost of capital or the current interest rate in the economy. It’s uncommon for investors to make a profit that exceeds the interest rate. The potential profits in stock markets, on the other hand, are nearly unlimited. This might be linked to the longer-term duration as well as the risk that the investors are willing to undertake.
Banks and other financial institutions are the most active players in the money market. Banks typically seek short-term funding in order to demonstrate that they have the required reserves to make the loans. Other financial institutions, such as mutual funds and pension funds, must have a certain amount of liquid cash on hand as well. This is due to the fact that they must repay investors who wish to redeem their investments. Cash, on the other hand, yields no profit. The next best option is to invest in money markets. They’re so liquid and risk-free that they’re practically interchangeable with cash. The majority of investors are aware that they may simply convert their money market funds to cash without losing any of their investment value.
On the other hand, participants of the capital market are stockbrokers, mutual funds, retail investors, underwriters, insurance companies, commercial banks and stock exchanges.