MONEY MARKETS AND CAPITAL MARKETS
Money Market
- refers to the network of corporations, financial institutions, investors, and governments which deal with
the flow of short-term capital
- where short-term liquidity transactions occur
- expanded significantly in recent years as a result of the general outflow of money from the banking
industry, a process referred to as disintermediation
How does money market work?
Money market exists to provide the loans that financial institutions and governments need to
carry out their day-to-day operations. For instance, banks may sometimes need to borrow in the short
term to fulfill their obligations to their customers, and they use the money market to do so.
Example:
Most deposit accounts have a relatively short notice period and allow customers access to
their money either immediately, or within a few days or weeks. Because of this short notice
period, banks cannot make long-term commitments with all of the money they hold on deposit.
They need to ensure that a proportion of it is liquid (easily accessible) in market terms.
Otherwise, if a large number of customers wish to withdraw their money at the same time, there
may be a shortfall between the money the bank has lent and the cash deposits it needs to return to
savers.
The money markets are the mechanisms that bring these borrowers and investors together without
the comparatively costly intermediation of banks. They make it possible for borrowers to meet short-run
liquidity needs and deal with irregular cash flows without resorting to more costly means of raising
money.
The Users of Money Market
1. COMPANIES
- when companies needs to raise money to cover their payroll or running costs.
- commercial paper - short term, unsecured loans for P100,000 or more that will mature within 1-9
months.
2. BANKS
- if demand for long-term loans and mortgages is not covered by deposits from savings accounts
- certificate of deposit with a set of interest rate and fixed maturity of up to five years.
3. INVESTORS
- individuals seeking to invest large sums of money at relatively low risk
- financial instruments- whose sum is less than P50,000
What do money markets do?
A well-functioning money market facilitates the development of a market for longer-term
securities. Money markets attach to a price to liquidity, the availability of money for immediate
investment. The interest rates for extremely short-term use of money serve as benchmarks for longer-term
financial instruments. If the money markets are active, or “liquid”, borrowers and investors always have
the option of engaging in a series of short-term transactions rather than in longer-term transactions, and
this usually holds down longer term rates.
In the absence of active money markets to set short-term rates, issuers and investors may have
less confidence that longer-term rates are reasonable and greater concern about being able to sell their
securities should they so choose. For this reason, countries, with less active money markets, on balance,
also tend to have less active bond markets.
Features of Money Market Instruments
Money Market Securities
- short-term instruments with an original maturity of less than one year
- used to “warehouse” funds until needed
- the returns earned on these investments are low due to their low risk and high liquidity
- usually more widely traded than longer-term securities and tend to be more liquid
Types of Money Market Instruments
Commercial Paper
- short-term debt obligation of a private-sector firm or a government-sponsored corporation
- used for obtaining short-term funding and is usually in the form of a promissory note
- it has a lifetime, or maturity, greater than 90 days but less than nine months.
Bankers’ acceptances
- before the 1980s, these were the main way for firms to raise short-term funds in the money
markets
- a promissory note issued by a non-financial firm to a bank in return for a loan
- bank resells the note in the money market at a discount and guarantees payment
- have a maturity of less than six months
Treasury bills (T-bills)
- maturity of one year or less, issued by national governments
- safest of all possible investments in that currency
- account for a larger share of money-market trading than any other type of instrument
Government agency notes
- notes, bonds, and discount notes issued or guaranteed by government agencies or
instrumentalities and backed by the full faith and credit of the country’s Treasury
- issued by national government agencies and government-sponsored corporations
Local government notes
- notes issued by provincial or local government, and by agencies of these governments such as
school authorities and transport commissions.
Interbank loans
- loans extended from one bank to another with which it has no affiliation
- used by borrowing institutions to re-lend to its own customers
Time deposits (Certificate of Deposit/CDs)
- interest-bearing bank deposits that cannot be withdrawn without penalty before a specified date
that may be as brief as 30 days or last for as long as five years
- often used to invest cash for brief periods
- interest rates depend on the length of maturity, with longer terms getting a better rate
- main risks include: (a) being locked into low-interest rates if rates rise and (b) early withdrawal
penalties
Repos (Repurchase agreements)
- serve to keep the market highly liquid and ensures that there will be a constant supply of buyers
for new money-market instruments
- combination of two transactions: (1) A securities dealer (bank) sells securities to an investor and
agrees to repurchase it at a higher price at a future date; (2) Dealer buys back securities from the
investor
- applies haircut or spread, meaning the amount the investor lends is less than the market value of
the securities - this is to ensure that it still has sufficient collateral
Capital Market
– a financial market in which longer-term debt (original maturity of one year or greater) and equity
instruments are traded
– capital market securities include bonds, stocks, and mortgages
– are also often held by financial intermediaries such as insurance companies and pension funds, which
have little uncertainty about the amount of funds they will have available in the future
Capital Market Participants
1. National and local government
2. Corporations
Capital Market Trading
- occurs in either the primary market or the secondary market
- (primary market - new equity stock and bond issues are introduced and sold to investors)
- (secondary market - sale of previously issued securities takes place; trade existing securities)
BONDS
- any long-term promissory note issued by the firm
- bond certificate being the tangible evidence of debt issued by a corporation or governmental
body
- represents a loan made by investors to the issuer -most prevalent example of the interest only
loan
Trading Process for Corporate Bonds
- occurs either through a public offering or private placement to a small group of investors -investment
banks are interested in underwriting bonds when a firm issues the bonds to the public
- most often offered publicly through investment banking firms as underwriters
- "firm commitment underwriting"
