Relationship Between Money Market & Capital Market
The relationship between the money market and capital market helps explain the basic framework of the financial system. Under this framework, businesses and government agencies access sources of short-term and long-term funds to generate immediate cash flow or finance long-term projects. Both markets have a particular role in how money flows from savers to businesses and government to finance operations and investment. As a result, both markets provide investors with opportunities to generate earnings and premiums from risky ventures.
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Capital Market
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Broadly, the capital market is a marketplace for trading investments with maturities of more than a year. Capital market investments are typically debt, equity or derivative securities used to raise money for long-term purposes. For example, large corporations issue equity securities called stocks to raise money. This money is invested back into the company in the form of machinery, real estate or equipment to improve and build long-term profitability, and increase the value of the company.
Money Market
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The money market is the marketplace used to trade short-term securities which have maturity dates of less than one year. Money market securities are commonly short-term bonds issued by corporations or governments to fund immediate needs. For instance, the federal government finances its budget deficits by issuing Treasury bills to investors in the U.S. and around the world. Similarly, large corporations issue commercial paper to raise money from investors which is then used to fund ongoing operations.
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Capital Market Purpose
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Capital markets provide a source of funds from which corporations and governments borrow based on potential future cash flows. For example, a large manufacturing company borrows money by selling bonds to investors to finance an upgrade in machinery. The upgrade is calculated to increase production and profits beyond current levels. The increase in profit makes it possible to pay back bond holders and increase the value of the company for stock holders. Therefore, the company bet that the increase in future income from the upgrade financed with bonds would be sufficient to cover the bond issue and make money for the company.
Money Market Applications
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Alternately, the money market is used to finance current operations and is not necessarily used to fund investment spending. For instance, a large company that does not have enough money to cover payroll might issue commercial paper to raise money to pay employees. In turn, investors use the money market as a safe holding place where money still earns even a minimal return but more than in a traditional savings or checking account.
Risk
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Short-term securities correlate with lower levels of risk while long-term securities are exposed to greater amounts of risk. This occurs from long-term securities being exposed to the volatility in the securities market for a much longer period of time. Generally, short-term securities are less risky because there is less market volatility in the short term. This difference in risk also corresponds to returns. Returns are generally higher with riskier investments and than in safer investments.
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