Money market vs capital market: How do the two impact investors?

Summary

  • Investors and traders are expected to understand the difference between money and capital markets to make better investment decisions.
  • While money markets are used for trading in short-term debt, capital markets are used for long-term lending.
  • The two institutions together form a large part of the financial market.

Money and capital market are two widely used terms in the financial world. Investors and traders are expected to understand the two to make better investment decisions. While money markets are used for trading in short-term debt, capital markets are used for long-term lending.

A capital market comprises equity and debt markets. The two institutions together form a large part of the financial market.

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Understanding the money market

As already discussed, money market involves trading in short-term debt, with its duration not longer than a year. It includes a constant flow of cash between governments, corporations, banks, and financial institutions, borrowing and lending for a term.  The short-term debt instruments include trade credit, commercial paper, certificate of deposit, T bills, etc. These financial instruments are highly liquid and can be redeemed in a period of less than one year.

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The money market is used by money dealers, brokers, financial institutions, banks, companies, and governments to park their cash for brief duration.  Businesses and governments use the market to get access to cash at a reasonable cost to meet their working capital.

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Similarly, the businesses with surplus cash can park their cash in the market and earn interest. The short-term credit plays a critical role in infusing liquidity into the economy over the short-term.

What is a capital market?

Capital markets serve the purpose of long-term financing via products such as stocks, bonds, debentures, which are traded for a long duration. It is a dealer and auction market.  Analysts track and analyse the hour-to-hour movements of the capital market to gain cues about the economy’s health. It also gives an idea about the status of every industry in it and the expectations in the short-term.

The institutions in the capital market use it to raise money to meet their long-term goals. They either issue stocks or sell corporate bonds to do so.

There are two types of capital markets:

Primary market: It is a financial market where fresh issue of securities is offered to the public.

Secondary market: it is where issued securities are traded among investors.

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Three key differences between money and capital markets:

  • The money market is considered low risk due to high liquidity and short duration of maturity of financial instruments. However, capital markets are at relatively higher risk.
  • The major operators in the money market are central banks, commercial banks, and non-financial institutions. The stock exchanges, commercial banks, and non-banking institutions work in capital markets.
  • While money markets have lower returns, capital markets deliver higher returns to investors.

What should investors do?

Investors can choose between money market and capital market based on their investment targets and time horizon. For those who can afford to invest for a long period, the capital market is a good option.

In case an investor needs money within a year or two, he/she is better placed to park the money in the money market due to its low volatility attribute. Money market investors invest their money at low risk, however mostly they witness very little growth.

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