Financial Market : Money Market and Capital Market
A financial market is a marketplace which facilitates buyers and sellers to participate in the trading of financial assets such as bonds, currencies, equities, derivatives and other financial instruments. It provides a mechanism between the investors/lenders and the borrowers/users for the transfer of funds.
In the financial markets, the individual investors, Financial Institutions and other financial intermediaries are linked by trading rules and communication networks for the trading of various financial instruments and financial assets. The characteristics of financial markets include transparent pricing, trading regulations on costs and fees, and determination of prices of securities by the market forces.
Major functions of financial markets
- To provide a platform for the interaction between the investors/ lenders and the borrowers/ users.
- To provide security in the dealings and operations in the financial instruments and assets.
- To provide the pricing information which results from the interaction between investors and the borrowers in the financial market place during the trading operations.
- Financial markets provide liquidity to various financial assets and financial instruments.
- Financial Market ensures lower transaction costs and also saves effort and time.
- It helps in the mobilisation of savings and ensures their utilisation in more productive financial assets.
Classification of financial markets
Financial markets are categorised as organised market and unorganised market.
The financial markets which work according to the laws, rules, and regulations made by the government and supervised by the central bank of the country (RBI) or any other regulatory body are known as organised financial markets.
Organised financial markets are further classified as
- Money market which mainly deals with short term credit transactions.
- Capital market which deals with the medium term and long term credit and financial transactions.
Unorganised market are those which are not governed and controlled by the central bank, and it mainly consists of money lenders, indigenous bankers etc who provide credit facilities to the public.
Money market mainly deals with borrowing and lending of short term credit/loan generally with a time period of less than or equal to 1 year. It helps in meeting the short term credit requirements of borrowers. In money markets, short term investment funds are bid by the borrowers which can comprise of individuals, Financial Institutions and even the government etc.
- Money market is not any specific Marketplace, but it is a network of different Financial Institutions which deals with the trading of short term funds.
- Money market does not deal in cash or money rather it provides a Marketplace for the different credit and financial instruments which includes treasury bills, promissory notes, bill of exchange etc, which are the close substitute of money.
- In India, the money market consists of Reserve Bank of India (RBI), scheduled commercial banks, microfinance institutions, regional cooperative banks, some non-banking Financial Institutions like LIC, UTI etc.
Functions of money market
- Money markets ensure an equilibrium between the demand and supply of money and short term funds through financial transactions.
- It promotes economic growth by ensuring availability of funds to different sectors of the economy such as Industry, agriculture service sector etc.
- Money market makes available sufficient finance to the trade and industry and provides a platform for discounting bills of exchange for them.
- Money market provides a mechanism for Reserve Bank of India (RBI) to implement monetary policy.
- It helps the government to meet its deficits through non inflationary financial sources. Government issues treasury bills to raise short term loans.
- It provides facilities for allocation of short term funds through money market instruments and interbank transactions.
Different instruments of money market
Call money/ Term money market/ Notice money
- Call money or notice money is generally used to meet the temporary cash requirements. Call money market deals with very short term funds, and is demanded extremely short durations from a few hours to 1 day. Notice money is demanded for borrowing and lending operations of 2 to 14 days. Lending and borrowing of funds beyond 14 days are referred to as term money.
- These transactions are mainly used by stock brokers and dealers for fulfilling their financial needs. The rate charged for these funds is known as call rate, and it is determined by the market forces.
Treasury bills are the government securities issued by RBI on behalf of the central government to meet its fiscal deficits. The maturity period of these securities varies from 14 days to 364 days.
- Treasury bills are further classified into two types viz. ordinary/regular treasury bills and ad hoc treasury bills.
- It refers to the bill of exchange which is used to finance the short term working capital requirements of any business.
- These are negotiable and self liquidating financial instruments used to finance the sales of Corporate firms, in which the seller is the drawer while the buyer is the drawee.
Cash management bills(CMBs)
- Cash management bills have been issued by the government of India in consultation with the Reserve Bank of India (RBI) to meet its short term cash requirements. The maturity period of these bills is less than 91 days, and they have a generic character of treasury bills.
Certificates of Deposits (CDs)
- Certificate of deposit (CD) is a money market instrument issued in a dematerialised form against the funds which have been deposited in any bank for a fixed period of time. These are negotiable money market instrument and are equivalent to a promissory note. The guidelines for Certificate of Deposit are issued by RBI from time to time.
- These are issued to the individuals, corporations and companies etc by scheduled commercial banks, excluding local area banks and regional rural banks.
- The minimum amount issued through the certificate of deposit is rupees 1 lakh by a single user, and larger amounts are in the multiples of rupees 1 lakh.
- For banks, the minimum maturity period of the certificate of deposit should not be less than 7 days and maximum maturity period should not be more than 1 year. For Financial Institutions, the minimum maturity period should not be less than 1 year and the maximum maturity period should not be more than 3 years.
Commercial papers (CPs)
- Commercial paper is a money market instrument introduced in India in 1990 to allow high rated Corporates companies to diversify their resources and meet their short term requirements of funds. Commercial paper is issued by a listed company having a minimum net worth of rupees 4 crores.
- The minimum maturity period of commercial paper is for 7 days and a maximum of 1 year.
- Commercial papers are issued in the denomination of rupees 5 lakh and its multiples. These are mainly used by corporate companies to meet the funds for working capital requirements.
Repo / Reverse Repo Market
- Repo is a repurchase agreement under which the selling of securities takes place with an agreement to repurchase it at a predetermined interest rate and date. It was introduced in India in December 1992. Repo transactions take place between banks and Financial Institutions among themselves, and also with the Reserve Bank of India.
- The interest rate charged on through this mechanism is known as a repo rate.
- Reverse repo was introduced in 1996, in which buying of security takes place with the commitment to resell it and future.
Short term loan
- It is a market where commercial banks provide short term loans to corporate firms to meet their short term credit requirements. These short term loans are provided in the form of cash credit or overdraft.
Importance of money market
- Money market is significantly important for financing industry, financing trade, implementation of monetary policy and self sufficiency of banks and Financial Institutions etc.
- It promotes economic growth and helps in the proper allocation of resources in different sectors of the economy.
Capital market provides and institutional arrangement for borrowing and lending of medium and long term funds. The capital market provides a platform for marketing and trading of different securities. It includes all the long term borrowings from scheduled commercial banks, Financial Institutions, borrowings from foreign markets and capital raised by issuing various securities including shares, debentures, bond etc.
Classification of capital market
Capital market is classified into primary market and secondary market.
- The primary market deals with shares, debentures and other securities sold for the first time for raising long term capital. The corporate firms and companies follow the well defined rules during the auctioning of shares and debentures for the first time which is known as the initial public offer.
- The funds raised by firms is generally used for improving their business and for the establishment of new business units etc. The merchant bankers, Financial Institutions, mutual funds and individual investors etc are the main players in the primary market.
- The primary market does not indicate any specific marketplace but it refers to the activity of bringing in new issues of shares and debentures.
Benefits of primary market
- Primary markets are considered as safer for investment as there are lower chances of manipulation of prices.
- There is no requirement to time the market and all the investors get the shares at the same price.
- The primary market is considered secure as primary research data is collected by the organisation which deploys the research.
- The company which issues the initial public offer receives funds and issues new security certificates to its investors.
- Secondary market deals with the buying and selling of existing securities. Trading of securities in the secondary market are done through the stock market or stock exchanges.
- This stock exchange plays an important role in mobilizing medium and long term funds and provides liquidity to shares and debentures.
- The secondary market is an organised market which deals with the regular trading of shares and debentures with high degree of security and transparency.
- Secondary market creates liquidity in the existing securities and boosts new investments.
Benefits of the secondary market:
- Secondary market provides investors the platform to recover their initial investment to a certain extent when they need funds.
- Secondary market provides the opportunity for investors to get large interest by investing for a longer period of time.
Functions of capital market
- To mobilize idle savings from the economy and ensure their utilisation and proper Investments.
- Capital market promotes capital formation in the economy which adds to the existing stock of the capital of the economy.
- Capital market increases the overall production and productivity of the economy and expedites the economic growth and development
- Capital market ensures proper allocation of financial resources and helps in regulation over these resources so that funds can be directed in a qualitative manner.
- Capital market ensures continuous availability of funds for long term investments. It is a liquid market in which the buyers and sellers can easily trade in financial securities.
Structure of the capital market
Capital market can be categorised into Financial Institutions and security market.
The main role of Financial Institutions is to make available long term and medium term credit facilities. Financial Institutions are called classified as development Financial Institutions and financial intermediaries.
Development Financial Institutions are those which provide long term loan and credit facilities to industry, trade and Agriculture. It Includes IFCI, IDBI, LIC, ICICI, GIC etc.
Financial intermediaries: It includes mutual funds, Merchant Bank etc which ensures mobilisation of savings and their supply in the capital market.
It is a part of the wider financial market were selling and buying of securities take place on demand supply basis. It can further be classified into government securities market and the corporate or industrial securities market.
Government securities market - Gilt edged market: government securities do not have the risk of default and hence they are known as gilt edged (or of the best quality). The government securities are risk free and both principal and interest are guaranteed. RBI has the responsibility to issue new government securities as it manages the public debt operations of both the union and the state governments. These securities are considered as most liquid debt instruments, and the market for these securities is large.
Industrial securities market deals with the trading of securities issued by corporate firms viz. Shares, bonds, and debentures. It consists of primary market dealing with new issues and secondary markets dealing with old securities through stock exchanges.
Major differences between money market and capital market
- Money market deals with short term marketable securities whereas capital market deals with medium term and long term securities.
- The securities in the money market have lower risk and are considered as a safer investment, whereas capital market securities comparatively have higher risks.
- The liquidity of financial instruments is higher in the money market whereas liquidity is comparatively less in the capital market.
- The central bank, scheduled commercial banks, non banking Financial Institutions etc mainly deal with the financial instruments of the money market. Whereas stock exchange, commercial bank, non banking institutions operate in the capital market.
- The returns in the securities of the capital market are higher compared to the financial instruments of the money market.
- Overall, the capital market is comparatively more organised than the money market.