Friday, September 25, 2009

The money market versus the capital market

The pool of funds represented by the financial markets may be divided into different segments, depending upon the characteristics of financial claims being traded and the needs of different groups. One of the most important divisions in the financial system is between the money market and the capital market.
The money market is designed for the making short-term loans where individuals and institutions with temporary surpluses of funds meet borrowers who have temporary cash shortages. By convention, a security evidencing a loan which matures within one year or less is considered to be a money market instrument. One of the principal functions of the money market is to finance the working-capital needs of corporations and to provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities.
In contrast, the capital market is designed to finance long-term investments. Trading of funds in the capital market makes possible the construction of factories, office buildings, highways, bridges, schools, homes, and apartments. Financial instruments traded in the capital market have original maturities of more than one year.
Who are principal suppliers and demanders funds in the money market and the capital market? In the money market commercial banks are the most important institutional lender to both business firms and governments.
Nonfinancial business corporations with temporary cash surpluses also provide substantial short-term funds to commercial banks, securities dealers, and other corporations in the money market. Finance companies supply large amounts of working capital to major corporate borrowers, as do money market mutual funds which specialize in short-term, high-grade government and corporate securities.
On the demand-for-funds side the largest borrower in the American money market is the U.S Treasury, which borrowers several billion dollars weekly. The largest and best-known U.S. corporations are also active borrowers in the money market through their offerings of short-term notes. Major securities dealers require huge amounts of borrowed funds daily to carry billions of dollars in securities held in their trading portfolio to meet customer demand. Finally, the Federal Reserve System, which is charged by Congress with responsibility for regulating the flow of money and credit in U.S. financial system, operates on both sides of the money market. Through its open market operations the Fed both buys and sells securities to maintain credit conditions at levels deemed satisfactory to meet the nation's economic goals. Due to the large size and strong financial standing of these well-known money market borrowers and lenders, money market credit instrument are considered to be highly-quality, "near money" IOUs.
The principal suppliers and demanders of funds in the capital market are more varied than in the money market. An institution must be large and well known with an excellent credit rating to gain access to the money market. The capital market for long-term funds, in contrast, encompasses both well-established and lesser-known individuals and institutions. Families and individuals, for example, tap the capital market when they borrow to finance a new home or new automobile. State and local governments rely upon the capital market for funds to build schools, highways, and public buildings and to provide essential services to the public. The U.S. Treasury draws upon the capital market in issuing new notes and bonds to pay for federal government programs. The most important borrowers in the nation's capital market are businesses of all sizes, which issue bonds, notes, and other long-term IOUs to cover the purchase of equipment and the construction of new plants and other facilities.
Ranged against these many borrowers in the capital market are financial institutions which supply the bulk of long-term funds. Prominent here are life and property-casualty insurance companies, pension funds, savings and loan associations, mutual savings banks, finance companies, and commercial banks. Each of these institutions tends to specialize in a few different kinds of loans consistent with it own cash-flow needs and regulatory restrictions.
For example, life insurance companies are major buyers of corporate bonds and commercial mortgages. Property-casualty insurers stay heavily invested in state and local government (municipal) bonds, corporate stock, and corporate bonds. Pension funds are major buyers of both corporate equities and bonds, while savings and loan associations are principally home mortgage lenders. Mutual savings banks emphasize investments in mortgages and corporate bonds. Finance companies and commercial banks provide large amounts of capital funds to both individuals and businesses through direct loans and financing. Commercial banks are probably the most diversified of all lenders in the capital market since they provide long-term funds to all major groups in the economy.

1 comment:

Krish said...

Thank you. It helped me.