When most people talk about "financial markets" they are, in common use, referencing the stock market. This is true even among people who should know better. Often financial reporters will write about how "the market" performed or reference "financial markets" when they talk about domestic or global stock prices.
Financial markets are bigger than that, though.
Technically, a financial market is any discrete, well defined marketplace in which people trade purely financial assets. (This is as opposed, for example, to a real estate market or a commodities market, in which traders would swap those assets.) In practice, the most active financial markets in the U.S. break down into two categories: money markets and capital markets. Together they make up what we generally think of as "the financial markets."
Here's what you need to know.
What Is a Money Market?
Say you own a company with $1 million in the bank. You don't want to sink that money into a serious investment because you might need it for payroll or other expenses in the relatively near future. On the other hand, having it just sit in the bank is something of a waste.
Instead, you might invest it in the money market.
On a money market, parties trade short-term financial assets such as commercial paper, certificates of deposit, Treasury bills, trade credits and bills of exchange. The assets traded on a money market are highly liquid, being near-equivalent to cash, and generally have a redemption period of less than one year. That said, investors may participate in the money market as briefly as overnight, making investments designed to last only a few hours at most.
For investors, the money market serves as a place to put money for a short time until they need it again. These are generally very secure investments that offer a safe, temporary investment. Although this reliability also comes with a reduced interest rate, it allows investors to accrue some value with their money.
Parties that sell assets on the money market use it to secure short-term liquidity. This isn't a market for parties that want to fund capital or long-term expenses. Instead, as with investors, this is a market for parties who need liquidity that they will pay back within one year. This typically includes paying operating expenses, making purchases or covering other near-term needs.
Retail investors rarely access the money market directly, although individuals can participate through the use of money market funds. Instead, typical parties in this market are banks, companies, brokers, governments and other financial institutions. In part this is because of the specialized nature of the market, and in part it's because this is a decentralized investment space. Most money market trades are conducted over the counter, which means that the two parties make the trade directly as opposed to through a central institution.
What Is a Capital Market?
In a capital market traders swap long-term financial assets, most notably:
• Debt and other securities with a maturity period greater than a year (such as a multi-year bond);
• Securities backed by equity (such as a stock).
The stock market and the bonds market are the two largest capital markets.
The assets traded on a capital market range in liquidity. Some may be highly liquid, like a stock which traders can ordinarily convert to cash rapidly and with little effort. Others may have very low liquidity, such as a mutual fund with trading rules.
For investors, the capital market is a way to develop value with their money over time. Most traders in this market look for long-term holdings that will accrue value typically over a period of years. Even traders who do sell assets quickly tend to reinvest in a new asset rather than take their money out altogether. This is as opposed to a money market account, in which investors have a short-term need for their cash beyond investment opportunities.
For companies selling assets, the capital market is a way to raise long-term financing for major (or "capital") expenses. Common examples of this include companies and governments selling bonds, through which they fund their operations by selling long term, structured debt. This also includes companies that sell shares of equity in the form of stocks in order to raise capital for operation, expansion or startup costs.
There are two types of capital markets:
• The Primary Market - This is a market where securities are initially offered by the company that issued the debt or equity behind the asset. The purchasers buy the financial assets directly from the issuer, and the purchase price goes to the capital funds that the issuer is trying to raise.
• The Secondary Market - This is a market where traders swap existing securities among themselves. The purchase price, in this case, goes to enrich the seller and does not directly contribute to the capital funds of the issuing party.
Individuals and institutions alike participate in the capital market. This is a more risky market than the money market, with both larger gains and losses. As a result, and because of the long-term nature of investing in the capital market, institutions tend not to use operational funds in it.
Capital markets are generally formal and centralized, with trading taking place through institutions such as the New York Stock Exchange and NASDAQ.
Money Market vs. Capital Market: Key Differences
There are a few key differences to remember about these two markets:
• Purpose: The money market secures short term liquidity for both investors and sellers. The capital market secures long term financing and investment opportunities.
• Time Horizon: Typically less than a year on the money market. Typically multiple years on the capital market.
• Assets Traded: The money market trades instruments such as Treasury bills, certificates of deposit, promissory notes, commercial papers and bonds redeemable in less than a year. The capital market trades in most bonds, stocks and other instruments either backed by equity or redeemable in more than one year.
• Risk Factor: Money markets are considered low risk. Capital markets are potentially high risk depending on the asset.
• Profitability: Money markets have low returns. Capital markets can have considerably higher returns.
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