Many finance novices confuse the currency market with the money market. These two, are in fact, very different concepts with different functions. This article will demystify the differences between the currency market and the money market. First, let’s understand the definition of these terms.
What is the money market?
The money market is simply trading in short-term debt instruments. It entails a continual flow of cash between corporations, governments, banks, and financial institutions that engage in borrowing and lending for terms ranging from a single night to up to a year.
A money market is an adequate place for individuals, banks, companies, and governments to park their cash for short periods. Money markets intend to enable businesses and governments to get their hands on liquid money quickly and reasonably. When an organization issues short-term debt, it is typically to cover working capital, not for capital improvements or large-scale projects.
The returns on money markets are modest but at the same time, the risks are low. Instruments used in the money markets include deposits, collateral loans, acceptances, and bills of exchange.
What is the currency market?
The currency market, also known as the foreign exchange market, is a marketplace where different currencies are bought and sold by different participants from different parts of the globe. This market plays an eminent role in the conduct of international trade.
Currency market serve companies and individuals by permitting them to purchase and sell goods or services in foreign currencies as well as enable a smooth flow of capital. Currency markets operate 24*7 and involve major participants such as large international banks, corporations, government entities, and retail participants.
Members enter the currency market with different objectives in mind and together they make the market more liquid and efficient. Largely, these markets are the drivers of the dynamic global economies.
It is noteworthy that the currency market is not a single market exchange but instead, a network of global markets. These global markets do not work simultaneously but work as per their time zones – starting with Japanese markets followed by Hongkong, Singapore, India, Bahrain, Europe, United Kingdom, USA, Canada, and ending with Australia.
Difference between the currency and money market
The essential difference between the currency market and the money market is that the currency market is a trading network for foreign exchange trading, whereas the money market is a short-term capital lending market with a deadline of one year or less, which is an integral part of the international capital market.
The foreign exchange market and the money market have different compositions of business. The currency market consists of a spot trading market, a forward trading market, and an adjustment trading market. The money market is composed of three parts – short-term credit market, short-term securities market, and discount market.
The types of money used in the foreign exchange market and the money market are different. In the currency market, a foreign exchange transaction invariably deals with two kinds of money. Whereas in the money market, typically a loan business, only involves one kind of money.
Another difference between the currency market and the money market lies in the function of the respective markets. The function of the currency market is to realize the exchange of different types of currencies and prevent the risk of exchange rate fluctuations. The function of the money market is plain to finance the surplus and deficit of short-term funds.
In the currency market, the profits of banks in the foreign exchange business come from the differences in the exchange rates while buying and selling foreign exchange. The part of the selling price that exceeds the buying price is the bank's profit. In the money market, the profit of a bank's short-term capital deposit and loan business comes from the difference between the deposit and the loan interest rate. The part of the loan interest rate higher than the deposit interest rate is the bank's profit.
What is currency conversion?
It is the process of converting from one currency to another. Currency conversion requires only two steps. The first is identifying the exchange rate.
Exchange rates tell you how much one currency is worth in another. For example, if you have INR 2000 and you plan to go to the USA, then the exchange rate will tell you how much your INR 2000 is worth in US Dollars. Sometimes, you may end up with more money, and otherwise, you may find yourself with less money. This is purely dependent on the exchange rates prevailing at the time. This conversion is usually governed by commercial banks.
What are the different types of money market instruments?
There are several different types of money market instruments that are traded in the money market. These are:
Certificate of deposit If an organization requires substantial lending of financial resources, it can be done using or against a certificate of deposit. It works the same way as a fixed deposit, except with a higher negotiating capacity, and lower liquidity terms.
paper This money market instrument serves as a promissory note generated by an organization or a company to raise short-term funds. It is an unsecured instrument, which means that it has no collateral attached. As a result, it is usually used by large-cap companies that have a renowned market reputation. The maturity period for commercial papers ranges from anywhere between 7 days to one year, therefore attracting lower interest rates than equivalent securities traded in the capital market.
Treasury bills can only be issued by the central government of a country when it warrants requirement funds to meet its short-term obligations. These do not generate interest but permit an investor to make capital gains as they are sold at a discounted rate while at maturity, the entire face value is paid. Treasury bills are backed by the government, and consequently, the risk involved is negligible. They serve as an optimal investment tool for risk-averse or novice investors.
Repurchase Agreements Also known as Repo, are short-term borrowing tools, wherein the issuer availing of the funds guarantees to repay or repurchase it in the future. Repurchase agreements generally involve the trading of government securities.
Banker’s Acceptance This is a common money market instrument traded in the financial sector. A banker’s acceptance marks a loan that is extended to the stipulated bank, with a signed guarantee of repayment in the future.
Final word
The money market offers a high degree of security and relatively lower rates of return. And the foreign exchange market is a massive global market that offers opportunities but is equally risky. You can choose to invest or trade in either market based on your financial requirements and goals.
