Money markets are the types of financial markets with financial instruments that have short maturities and high liquidity. Trade in money markets involves borrowing and lending for short term, that is, within one year. There is a wide range of participants in money markets including companies, banks, and investors among others. This section uses examples to discuss the nature of money markets and money market instruments.
One quality of money markets is short term of maturity that range from one day to one year. In addition, the assets traded can easily be converted to cash. Through money markets, significant amounts of money can quickly be transferred from an economic unit to another at a low cost for short periods (Fabozzi, Mann, & Choudhry, 2002). Some instruments traded for short term include bank accounts, interbank loans, commercial papers, treasury bills, securities lending and repurchase agreements or repos, and money market mutual funds (MMMFs). The participants in money markets include financial institutions and money or credit dealers with the need to lend or borrow. Examples of participants include the government, banks, money managers, broker-dealers, retail investors, nonfinancial corporations, and hedge funds (Madura, 2006).
Money markets are relatively safe or have minimal risks although some risks exist such as default on securities including commercial papers. Safety or risk depends on the type of asset and how it is treated. For instance, there is usually no collateral for interbank loans and a lender assesses the creditworthiness of a borrower before lending to them to determine the probability of repayment (Fabozzi et al., 2002. In England, interbank trading is closely monitored through London interbank offered rate (LIBOR), which is determined on a daily basis. LIBOR represents the average price set by major banks for lending to each other. However, the integrity of LIBOR’s pricing process has been questioned by regulatory authorities. For certificates of deposit issued as securities, the lender or depositor considers the creditworthiness of the bank or government insurance of bank deposits (Fabozzi et al., 2002).
The financial instruments in money markets are commonly referred to as paper. Interbank lending forms the core of the money markets and involves bank to bank borrowing and lending using repurchase agreements, and commercial paper among other instruments. Money market instruments differ on the manner in which they are traded. For instance, some securities rely on a borrower’s collateral instead of assessing the borrower’s capability to pay. According to Madura (2006), the safest money market instruments are the treasury bills that are issued by the government and their selling price is discounted from the face value. They are the safest short term instruments to invest in. These instruments are controlled by security laws and can be used in transactions. Treasury bills can be transferred through electronic payment systems as readily as money.
Another form money market instrument is the repos, which are traded at competitive interest rates on short-term. Maturity is usually from overnight to two weeks. The borrower sells a security for cash with an agreement to repurchase it from the lender at an agreed upon date. The borrower repurchases the securities at a price that includes the interest over the period of borrowing. The security is the collateral in the agreement. Repos and other securities entail short-selling, which means a trader is selling a security that they do not own (Fabozzi et al., 2002). In that case, the seller buys or borrows the security temporarily via repo. At the maturity time, they must buy or borrow the same security. The short-seller can make money in such a transaction if the price falls at the time of returning the security.
Money markets provide retailers, institutional investors, and corporations with low-risk returns on investments that have short-term maturity. For example, MMMFs are securities offered by institutions that invest in other instruments such as certificates of deposits, repos, treasury bills, and commercial papers (Fabozzi et al., 2002). The US and EU regulate the MMMFs as investment companies. MMMFs trade in liquid instruments that are short-term and highly rated. The price of MMMFs is usually constant or maintained at a stable net asset value.
Money markets are important to businesses due to the fact that receipts of economic units often fail to coincide with expenditures. The units can hold money balances to ensure planned expenditures are met independent of cash receipts (Madura, 2006). However, holding the balances costs the trader foregone interest and it would be more profitable to hold minimum balances and supplement them with money market instruments because the instruments can be converted to cash quickly and at low cost. The instruments are also low risk because they have short maturities. Therefore, companies with temporary surplus in cash can invest in these short-term instruments and when they have temporary want of cash, they can sell their securities or borrow short-term funds. For example, they can trade in repos, which are the most liquid money market investments and the company can arrange for automatic transfer of surplus cash to the funds by their banks (Fabozzi et al., 2002). Cash deposits (CDs) are another example of such instruments that companies can rely on to transfer excess cash or get cash when in need.
In conclusion, the money market and money market instruments provide a relatively safe or low risk means of short-term lending and borrowing. It involves instruments that a trader who needs to save money on short-term can buy and sell when they need cash. The instruments have maturity period of between one day and one year. In most cases, the security or instrument acts as the collateral for amount borrowed.
Capital markets represent the type of financial markets where debt and securities are sold for long term usually longer than one year. It provides savers with a means of channeling wealth for long term investments. The savers usually put their money in companies or governments, which put it in productive use for long-term (Sullivan, & Sheffrin, 2003). The capital markets are regulated by financial regulators to ensure that investors are not defrauded. For instance, the capital market in the U.S is regulated by the U.S Securities and Exchange Commission (SEC). Similarly, the UK’s capital market is regulated by Bank of England (BoE). This section uses examples to discuss the nature of capital markets and capital market instruments.
Capital markets operate through the stock exchange markets. Stock exchange markets facilitate trade in capital market instruments, which include shares, bonds, stocks, debentures, and securities (Liaw, 2004). There are two types of capital markets. These are the primary markets where new stock and bond issues are traded, and secondary markets where existing securities are traded. Examples of stocks exchange markets are New York Stock Exchange, London Stock Exchange Group, Japan Stock Exchange, and Shanghai Stock Exchange among others. Governments are the major entities that rely on primary capital markets to raise long-term funds (Sullivan, & Sheffrin, 2003). The other entities that raise money through primary capital markets are large companies.
The capital market is made up of institutions and mechanism that enable individuals, businesses, and governments to trade in medium-term and long-term funds. In addition, it includes the process of transferring already outstanding securities. Capital markets help to mobilize savings and put them into productive investments that help in developing commerce and industry (Sullivan, &Sheffrin, 2003). Therefore, capital markets help in the economic growth of countries through capital formation. Capital markets enable the corporate sector to raise capital and also protect the investors’ interests. The effectiveness of a capital market entails the ability to balance between raising capital and protecting the investors who trade in corporate securities (Liaw, 2004).
There are three main categories of capital market instruments based on the nature in which they are issued. First there are pure-instruments, which retain their basic features as their features are not mixed with those of others. Examples include equity shares, non-convertible debentures, and preference shares. Secondly, there are hybrid-instruments that are issued after features of some pure-instruments are combined. Investors get combined benefits when they invest in hybrid-instruments. Examples of hybrid-instruments include Convertible Preference Shares, Partly Convertible Debentures, and Fully Convertible Debentures (Liaw, 2004). Thirdly, there are derivatives, which are contracts whose value come from underlying assets. The underlying assets can mean bonds, gold, goods, and stock index. Traders in derivatives usually have no interest in the underlying assets. Instead, they use cash to settle the position of the underlying assets. The profit of a person trading in derivatives equals a loss incurred by another.
One example of capital market instruments is shares, which represent the proportions of capital that each member is entitled to in a company (Sullivan, & Sheffrin, 2003). It includes stock unless a distinction between shares and stock is well expressed. A share is the smallest unit of a company’s capital. Companies raise capital through the sale of shares, in which case the capital is called share capital. Share capital includes Equity share capital, equity share capital with differential rights, and preference share capital. An equity share gives its holder the right to be an owner in the company issuing the share (Liaw, 2004). The shareholder has voting rights since they are a member of the company.
The other example of capital market instruments are debentures. These are documents that evidence or acknowledge a debt. They include debenture stock, bonds, and other securities issued by a company. The nature of a debenture includes its use as a certificate of debt of the company, it shows the interest rate and redemption date, and imposes charges on company assets (Sullivan, & Sheffrin, 2003). The holder of a debenture is a secured creditor. Detachable warrants form another example of capital market instruments. These instruments entitle the holder of the debenture to have equity shares as per the warrants upon specified time of maturity at a price that does not exceed the price on the warrant. Warrants are negotiable and can be listed on stock exchange where they are easily traded.
Secured premium notes (SPN) are issued together with detachable warrants and can be redeemed after four to seven years. The holder can get equity shares upon full payment of SPN. The holder can resell the SPN to the company at its value or wait for it to earn interest or premium. Bonds, which are issued by companies, municipalities, and governments, form another example of capital market instruments. They are debt instruments that help the issuing party to raise funds for their expenditure. Bonds are not secured debt instruments. When an investor buys a bond, they lend money for a specific period at an interest rate. Interest earned on the bond is paid to the holder at regular intervals while the principal is paid after a set maturity date (Liaw, 2004).
One example of transactions in the capital markets is a government raising funds on the primary capital market. The government does this through sale of bonds mostly through computerized auction (Liaw, 2004). Another example is a company that wishes to raise money on the primary markets for long term investment. This could be through sale of shares, which helps the company avoid debt, or issuing of bonds. Bonds are safer especially for a poor performing company since they are not subject to serious price falls. The final example is a company trading on the secondary markets, where a security can be traded for unlimited number of times. The transactions in secondary markets are very quick and in theory, it is possible to trade a single security thousands of time in just an hour (Sullivan, & Sheffrin, 2003).
