While the money market and the capital market are both aspects of the larger global financial system, they serve different goals for investors. In a nutshell, the money market is where short-term debt and lending takes place; the capital market is designed for long-term assets, such as stocks and bonds. The former is considered a safer place to park one's money; the latter is seen as riskier but potentially more rewarding.
Understanding the difference between money market and capital market matters plays a role in understanding the market as a whole. Whether you hold assets that are part of the money market vs. capital market can influence your investment outcomes and degree of risk exposure.
Learn more here, including:
• What is the money market and how does it work?
• What is the capital market and how does it work?
• How do capital markets and money markets differ?
• How to decide whether to invest in the money market or capital market.
• Alternatives to the capital and money markets.
What Is the Money Market?
The money market is where short-term financial instruments, i.e. securities with a holding period of one year or less, are traded. Examples of money market instruments include:
• Bankers acceptances. Bankers acceptances are a form of payment that's guaranteed by the bank and is commonly used to finance international transactions involving goods and services.
• Certificates of deposit (CDs). Certificate of deposit accounts are time deposits that pay interest over a set maturity term.
• Commercial paper. Commercial paper includes short-term, unsecured promissory notes issued by financial and non-financial corporations.
• Treasury bills (T-bills). Treasury bills are a type of short-term debt that's issued by the federal government. Investors who purchase T-bills can earn interest on their money over a set maturity term.
These types of money market instruments can be traded among banks, financial institutions, and brokers. Trades can take place over the counter, meaning the underlying securities are not listed on a trading exchange like the New York Stock Exchange (NYSE) or the Nasdaq.
You may be familiar with the term “money market” if you've ever had a money market account. These are separate from the larger money market that is part of the global economy. As far as how a money market account works goes, these bank accounts allow you to deposit money and earn interest. You may be able to write checks from the account or use a debit card to make purchases or withdrawals.
Features of Money Market
The money market has the following characteristics:
1. Liquidity: Money market instruments are highly liquid assets that provide investors with a steady stream of income. The instruments' short maturity makes them a highly liquid asset. As a result, they're a close match for carrying cash.
2. Security: Money market instrument issuers have a good credit rating, and the returns are guaranteed. Furthermore, there is essentially no chance of losing the money. As a result, these instruments are among the safest and most secure solutions on the market.
3. Returns: Money market instruments are sold at a discount to their face value and have a predetermined maturity date. These investments, unlike the capital market, have fixed returns that are heavily tied to market performance. As a result, the investor can readily predict how much money they will make from the investment. As a consequence, individuals can pick the optimal alternative for their financial goals and time horizon.
Types of Money Market Instruments
The various forms of money market instruments are as follows:
1. Treasury Bills (T-Bills): To raise finances, the Reserve Bank of India issues Treasury Bills (T-Bills) on behalf of the government. T-bills are short-term financial instruments with a one-year maximum maturity. T-bills are available for 14 days, 91 days, and 364 days. They are sold at a discount and are reimbursed at face value when they mature.
2. Commercial Bills or Bills of Exchange: Businesses use bills of exchange to meet their short-term cash needs. A broker or a bank can discount the creditor's bill of exchange. Because they may be passed from one person to another, they are very liquid instruments.
3. Commercial Papers (CP): Commercial Papers (CPs) are issued by large enterprises and corporations to raise finance for short-term commercial needs. These businesses have excellent credit ratings, which act as collateral for unsecured commercial papers. The maturity of CPs is predetermined and ranges from 7 to 270 days. Investors can also trade CPs on the secondary market.
4. Certificates of Deposits (CD): CDs are negotiable term deposits issued by corporations, scheduled commercial banks, trusts, and individuals. They are accepted by commercial banks and function similarly to a promissory note. A CD might last anywhere from three months to a year. CDs issued by financial institutions, on the other hand, have a longer term, ranging from one to three years.
5. Repurchase Agreements: A repurchase agreement, also known as a repossession agreement, is a legal contract between two parties. A security is sold to a third party with the promise of repurchasing it from the buyer at a later date. The seller returns the security at a predetermined date and price. The repo rate is the interest rate charged by the buyer. Repos are a quick solution to meet short-term capital needs while simultaneously providing a good return to the buyer.
6. Banker's Acceptance: A banker's acceptance is a financial instrument created in the name of a bank by an individual or a corporation. On a given date, the issuer must pay the instrument bearer a specific amount. It normally takes between 30 and 180 days after the issue has occurred. It is a safe financial instrument because a commercial bank guarantees the payment.
What Is the Capital markets ?
Capital markets are markets for investments of a long-term nature. They are the markets for capital deployed for strategic, long-term investments as opposed to the short-term, tactical and operational investments made in money markets. Money in the capital markets is generally raised to achieve business expansion objectives like setting up a new manufacturing plant or establishing a new supply chain.
Investments in the capital markets carry more risk than those in the money markets. The tenures, too, are longer. Since the risk and tenures are larger and longer, higher are the potential returns.
Types of capital market instruments
1) Bonds with tenures of more than a year
When companies and governments issue bonds with tenures over a year, then these bonds form a part of the capital markets rather than the money markets.
2) Debentures
Debentures are also debt financial instruments like bonds. However, they are not secured by physical assets or any similar collateral. Hence they are riskier than bonds. Since they are riskier, they tend to carry higher interest rates than bonds. The Interest rates of debentures may be fixed or floating. Their tenures are generally lower than those of bonds. Debenture holders get preference over shareholders of a company regarding the payment of interest or dividends.
Key Differences: Money Market Vs. Capital Market
The money market and capital market operate differently and tend to appeal to different types of investors.
The risk-averse investor worries about losing money. This investor will feel more comfortable using the money market because they will preserve the money they have, even if they will only generate a modest return on their investment.
The short-term investor needs money in the near term – within a year. While this is often spoken about in terms of proximity to retirement age, there are other reasons you might need money soon, says Riley Adams, CPA, senior financial analyst for Google, and owner of personal finance blog the Young and the Invested. Perhaps you're saving up for a new car, house, or college. Whenever you need the money soon, your number-one priority is preserving it – preferring the security of the money market.
The risk-tolerant investor understands that risk is the price you pay for the potential of a big reward and seeks the potential for greater profit offered by the capital market.
The long-term investor has a long time horizon, so they can invest in the capital market. If stocks fall, these long-term investors will generally be able to recoup losses over time.
Comparing Money Market and Capital Market
From the investor point of view, “the primary difference is the money market is short term, very safe, and very liquid,” says Adams. Comparing the money market and the capital market point by point can help you understand why the money market can be the preferred choice for a short-term investment need and how it differs from a capital market investment like buying stocks.
This chart can help you conceptualize the formats, pros, and cons of these two financial markets.
| COMPARISON POINT | MONEY MARKET | CAPITAL MARKET |
|---|---|---|
| Examples | Certificates of Deposit (CD), Treasury Bills, Commercial Paper | Stock shares and Bonds |
| Duration | Short term (1 year or less) | Long term (greater than 1 year) |
| Investment objective | Maintain wealth | Generate wealth |
| Level of risk | Low | High |
| Level of volatility | Low | High |
| Liquidity | High | Low |
Which is a Better Investment?
The best place to invest “depends on your goal and your time horizon,” says Johnson. For investors with a long time horizon, such as a twenty-something saving for retirement, the capital market is the better pick. A large-cap index fund is a good start for these investors, recommends Johnson.
“If you need that money within a year or two, it's best to just put it in the money market because of that volatility,” Johnson recommends. The money market is a lower risk. “People who invest in the money market can sleep well. There's very little volatility but very little growth,” says Johnson.
Those that need the money soon will be motivated to preserve wealth rather than accumulating it. You wouldn't put money you were saving for a down payment in the stock market (capital market) because there's a chance it could fall into correction, and you'd no longer be able to afford your dream house. With a money market investment, your down payment wouldn't grow very much – but it wouldn't evaporate due to market volatility, so you can rely on it to be there when you get ready to make that offer.
Conversely, “those capital market investors may suffer some sleepless nights when the market falls into a correction,” says Johnson. Despite the risk, though, those who invest in the capital market can be rewarded better than the money market if they wait it out.
“If you're looking for long-term, like retirement, you want that to be in a capital investment,” Adams explains. However, the time will come when you need to transition that money from capital market investments to money market investments. “As you near any major purchase decision where you need the money you have, you want to plan a transition from the capital market to the money market because that guarantees your money will be there,” Adams says.
Since 1926, the S&P 500 – a capital market – has increased by 10.3% annually, Johnson says. Hiding within the average is the statistical fact that there are good years and bad years. Investors with long time horizons can generally take advantage of those banner years where stocks grow greater than 10% to offset the years its drops below that.
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