Both the money market and capital market are spaces where financial assets are traded. Both serve as an efficient tool to exchange products. Their differences are primarily found in the specific assets they are based on. The money market facilitates the exchange of short-term instruments, whereas the capital market is founded on both long-term and short-term assets.
Money Market Examples
Company Y needs money to pay a series of salaries. To pay the salaries, it sells a piece of machinery to the bank in exchange for the money it needs. The company and bank agree that the company would repurchase the machine later on at an interest rate to own its machine again. The bank receives the interest payment as a reward for helping the company with its liquidity. The process represents a more complex exchange in the money market.
Capital Market Examples
It can be considered that capital markets operate with less complexity than money markets. The New York Stock Exchange is the ideal example of a capital market. Millions of assets are traded daily on this exchange. The latest data suggests that over 74 billion dollars worth of financial assets are traded monthly on the New York Stock Exchange.
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Capital market instruments are predominantly traded on financial exchanges such as the New York Stock Exchange, the NASDAQ, the London Stock Exchange, and the Shanghai Stock Exchange. There are several different types of capital market products, namely stocks, bonds, and real estate investment trusts. Each product has its own set of advantages, limitations, and objectives.
Stocks
Stocks are fractional shares that a company issues to investors, representing partial ownership in the company itself. Stocks are broadly divided into common stock and preferred stock. Common stockholders have voting rights, while preferred stockholders typically do not. Apple and Tesla have some of the most famous stocks on the capital market.
Bonds
Bonds are debt-based assets that derive their value from guaranteed interest payments rather than mere value appreciation like stocks do. An example of a bond is the event where an investor lends money to the government in exchange for an interest payment once the bond matures on a predetermined date. This instrument is called a government bond, and it is a very safe investment.
Real Estate Investment Trusts
Real estate investment trusts (REITs) invest in real estate and/or mortgages. An example of a well-known REIT is Regency Centers. It invests in real estate such as shopping centers that prioritize grocery stores as a primary form of rent income. This trust can be bought on the NASDAQ and provides an annual return of 3.37%.
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There are several different money market products, including Treasury Bills, commercial paper, repurchase agreements, and certificates of deposit. These instruments are solely based on monetary agreements, which are extremely liquid. The money market is based on short-term assets with quick maturity dates. Money markets provide practical solutions to entities with immediate cash needs.
Treasury Bills
Treasury bills are issued with maturities of three months, six months, and one year. They draw a lot of similarities to bonds since they are also debt-based assets that the government commonly issues. An investor purchases a $1 million Treasury bill with a competitive bid of $700,000. As a result, they will receive a $300,000 interest payment when the bill matures.
Commercial Paper
Established corporations typically issue commercial paper. Where the government secures the Treasury bill, commercial paper is unsecured debt issued by a company. For example, a business needs to pay its factory workers but does not have the needed money at hand. It issues commercial paper to acquire the needed funding to an investor who immediately supplies the business with its needed money. The commercial paper serves as a debt asset that the investor holds as an income tool.
Repurchase Agreements
Repurchasing agreements relate to how an entity sells security as a form of fundraising. The entity agrees to buy back the security at a later date at a higher price. For example, a transport company needs money to pay for repairs. To acquire the necessary funding, it sells one of its trucks to the bank, giving it the needed money in return for the repairs. The company agrees to buy back the truck at a later date at a higher price, allowing the bank to profit off the exchange.
Certificates of Deposit (CDs)
CDs can be described by way of an example. A citizen looks to deposit excess income into a bank account. The citizen decides to earn interest on the extra money they have made and purchases a CD. This certificate stipulates that the depositor will lock in a certain amount of money with the bank for a specified time. As a reward for not withdrawing the money, the citizen receives an interest payment when the certificate expires.
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Money markets are spaces where securities with less than one year to maturity are traded, while capital markets are where securities with more than one year are traded. The attractive element of money markets is that they are highly liquid. Investors favor capital markets for the tremendous opportunity found in trading financial assets.
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Money markets are where securities with less than one year to maturity are traded, while capital markets are where securities with more than one year are traded. Commercial paper and Treasury bills are some of the most common money market instruments. Commercial paper is typically issued by established corporations, whereas Treasury bills are issued by the government and can have maturities of three months, six months, or one year. Other money market instruments include repurchase agreements, and certificates of deposit. Stocks and real estate investment trusts are well-known capital market assets.
Stocks represent fractional shares in the issuing company and can be divided into common stocks and preferred stocks. Common stockholders have voting rights, while preferred stockholders typically do not. On the other hand, real estate investment trusts invest in real estate or mortgages. Bonds are debt-based assets that are also traded on the capital market.
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Video Transcript
Capital Markets vs. Money Markets
Capital markets are the markets in which securities with maturities of greater than one year are traded. The most common capital market securities include stocks, bonds, and real estate investment trusts (REITs). Money markets are the markets for financial products with maturities of less than one year. The most common money market instruments include U.S. Treasury bills, commercial paper, certificates of deposit (CDs), and repurchase agreements. While this maturity distinction is important to business and government entities with different funding needs, it's also useful to investors with varying investment horizons and risk tolerances.
Capital Market Instruments
Let's look at some common capital market products.
Stocks represent ownership of a company. Common stock is the most basic form of ownership and comes with the right to vote for members of the board of directors and the possibility, but not guarantee, of sharing in company earnings through dividends. Common stockholders typically purchase shares in hopes of the value of the shares appreciating over time. Common stockholders may also have the right to vote in major decisions (e.g., mergers) involving the company. Preferred stock also represents ownership in a company. Unlike common stock, preferred stock generally does not come with voting rights.
However, as the name suggests, preferred stock does offer some advantages over common stock. Preferred stock comes with a stated dividend that must be paid before common stockholders can receive a dividend. Moreover, in the case of bankruptcy, the preferred stockholders are paid any residual value before common stockholders. Both common and preferred stock are perpetuities, meaning that they do not mature. To redeem stock, the owner must generally sell to a new buyer on the open, or secondary market. While stocks offer high upside potential gains, they also run the risk of losing all value.
Bonds, unlike stock, don't represent ownership. Instead, bondholders (or creditors) have essentially extended a loan to the company. Bonds have a maturity date, a face value (the amount to be repaid at maturity), and a stated annual interest rate usually paid semiannually. While bondholders do not generally share in company windfalls, they are safer than stocks in that they must be paid interest before stockholders can be paid dividends. Also, in the case of bankruptcy, bondholders are paid before stockholders. Bonds held to maturity are redeemed at face value. If redeemed before maturity, they must be sold on the secondary market for the current market price, which can be above or below face value.
Real estate investment trusts are securities that invest in real estate properties, mortgages, or both (hybrid). These provide vital liquidity to the real estate market, as well as providing investors with a lower cost opportunity to real estate investment exposure with lower minimum investments. REITs are issued by investment companies and trade in the secondary market on stock exchanges.
Money Market Instruments
Now, let's look at some money market products.
Treasury bills are debt instruments issued by the U.S. Treasury Department to fund the ongoing operations of the federal government. They're issued with three-month, six-month, and one-year maturities in minimum denominations of $1,000. Since they are short term and backed by the full faith and credit of the U.S. government, they are considered to have no risk of default. In return for this safety, they pay relatively low interest rates. They're considered very liquid in that they can be readily sold on the secondary market. The interest earned on Treasury bills is taxed at the federal level but exempt from state and local taxes. Treasury bills are a common investment by commercial banks in order to manage liquidity.
Commercial paper represents short-term (generally less than 270 days) borrowing by corporations. It differs from Treasury bills in a few key ways. While typically issued by established corporations, since it is not backed by any specific assets, it does have some default risk. Because of this, and the fact that it's fully taxable, commercial paper typically pays a rate slightly higher than Treasury bills. Commercial paper is traded on the secondary market, but due to its specialized nature (specific maturity and level of risk), it's not as liquid as Treasury bills. Commercial paper typically trades in large denominations (over $100,000), and thus is more commonly held by institutional than individual investors.
Repurchase agreements are short-term investment contracts that involve the sale of a security (typically a Treasury security) with a simultaneous agreement to repurchase the security at a predetermined price at a predetermined date. These are often used by banks to manage short-term liquidity needs and by the Federal Reserve to conduct open-market operations in order to manage the nation's money supply.
Certificates of Deposit (CDs) are bank time deposits with typical minimum denominations of $100,000. These fully taxable CDs are issued by banks. They're often traded in the secondary market and are frequently referred to as negotiable CDs. These accounts are issued in a variety of short-term maturities, and thus allow banks to manage their asset and liability mix. From an investor's standpoint, CDs are much like bank savings accounts. The latter, however, aren't traded in the secondary market. Savings accounts typically pay slightly lower interest rates, but offer the depositor immediate access to their funds, while CD holders are penalized if they redeem their CD prior to maturity. This penalty can be avoided by selling the CD in the secondary market.
Lesson Summary
All right, let's take a moment to review what we've learned. In this lesson, we learned about the differences between the two main types of markets:
- Capital markets, which are the markets in which securities with maturities of greater than one year are traded
- Money markets, which are the markets for financial products with maturities of less than one year
We also looked at the different instruments used in both of these types of markets. The instruments used in capital markets include the following:
- Stocks, which represent ownership of a company
- Bonds, in which bond holders (or creditors) have essentially extended a loan to the company
- Real estate investment trusts are securities that invest in real estate properties, mortgages, or both (hybrid)
And, conversely, we learned that the instruments used in money markets include the following:
- Treasury bills, which are debt instruments issued by the U.S. Treasury Department to fund the ongoing operations of the federal government
- Commercial paper, which represents short-term (generally less than 270 days) borrowing by corporations
- Repurchase agreements, which are short-term investment contracts that involve the sale of a security (typically a Treasury security) with a simultaneous agreement to repurchase the security at a predetermined price, at a predetermined date
- Certificates of Deposit (CDs), which are bank time deposits with typical minimum denominations of $100,000
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