Importance of money and capital market to entrepreneurs in financing their business

Definition of money market

A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities, but there are risks in the market that any investor needs to be aware of including the risk of default on securities such as commercial paper.

What constitute money market

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods, typically up to thirteen months. Money market trades in short-term financial instruments commonly called “paper”. This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of interbank lending—banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. Finance companies typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Some large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the U.S. Treasury issues Treasury bills to fund the U.S. public debt:

  • Trading companies often purchase bankers’ acceptances to be tendered for payment to overseas suppliers.
  • Retail and institutional money market funds
  • Banks
  • Central banks
  • Cash management programs
  • Merchant banks

Definition of capital market

Capital markets are financial markets for the buying and selling of long-term debt or equity-backed securities. These markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments. Capital markets are defined as markets in which money is provided for periods longer than a year. Financial regulators, such as Securities and Exchange Commission (SEC), oversee the capital markets in their jurisdictions to protect investors against fraud, among other duties.

Modern capital markets are almost invariably hosted on computer-based electronic trading systems; most can be accessed only by entities within the financial sector or the treasury departments of governments and corporations, but some can be accessed directly by the public. There are many thousands of such systems, most serving only small parts of the overall capital markets. Entities hosting the systems include stock exchanges, investment banks, and government departments.

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A key division within the capital markets is between the primary markets and secondary markets. In primary markets, new stock or bond issues are sold to investors, often via a mechanism known as underwriting. The main entities seeking to raise long-term funds on the primary capital markets are governments (which may be municipal, local or national) and business enterprises (companies). Governments tend to issue only bonds, whereas companies often issue either equity or bonds.

The main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign wealth funds, and less commonly wealthy individuals and investment banks trading on their own behalf. In the secondary markets, existing securities are sold and bought among investors or traders, usually on an exchange, over-the-counter, or elsewhere. The existence of secondary markets increases the willingness of investors in primary markets, as they know they are likely to be able to swiftly cash out their investments if the need arises. A second important division falls between the stock markets (for equity securities, also known as shares, where investors acquire ownership of companies) and the bond markets (where investors become creditors).

Types of capital markets

There are two types of capital market

  1. Primary market

The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus.

Features of primary markets are:

This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM). In a primary issue, the securities are issued by the company directly to investors. The company receives the money and issues new security certificates to the investors. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business. The primary market performs the crucial function of facilitating capital formation in the economy. The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as “going public.”

  1. Secondary market

The secondary market, also known as the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold. The term “secondary market” is also used to refer to the market for any used goods or assets, or an alternative use for an existing product or asset where the customer base is the second market (for example, corn has been traditionally used primarily for food production and feedstock, but a second- or third- market has developed for use in ethanol production).

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With primary issuances of securities or financial instruments, or the primary market, investors purchase these securities directly from issuers such as corporations issuing shares in an IPO or private placement, or directly from the federal government in the case of treasuries. After the initial issuance, investors can purchase from other investors in the secondary market. The secondary market for a variety of assets can vary from loans to stocks, from fragmented to centralized, and from illiquid to very liquid. The major stock exchanges are the most visible example of liquid secondary markets – in this case, for stocks of publicly traded companies.

Constituents of capital market

  • Stock exchange:A stock exchange is a body which facilitates trading of securities (shares, derivatives, currencies etc).
  • Merchant bankers: A merchant banker is responsible for offering consultation services for mergers and acquisition, capital raising via equity or debt, giving advice to businesses that plan to enter the international market and helping small businesses expand for a bigger target market.
  • Investors: Investors are the most important part of the capital market as they are the ones who spend capital in the subscribing to the issue issued by issuers like IPOs, FPOs, Right Issues etc.
  • Stock brokers: A stock broker is responsible for buying and selling securities for both retail and individual clients through a stock exchange. One cannot directly trade securities on stock exchanges and instead have to do it though the registered member of the stock exchange popularly known as stock brokers.
  • Depositories: A securities depository is like a bank which maintains investor’s accounts having securities such as shares, mutual fund units, bonds etc. The primary function of a depository is to facilitates the exchange of securities and maintain the book entry. In simple words a depository helps in transferring the ownership of securities from one account to another when trade takes place between the buyer and the seller of the security.
  • Depository participants: As an investor you never deal with a depository directly but indirectly through a depository participant (DP) which is a member of the depository. All major banks and stock brokers are members of country’s security depository.
  • Market regulators: Like any major industry all mature capital markets have respective regulators.
  • Issuers: Issuers are the issuers of securities like shares, bonds etc. They raise capital from investors and usually employ merchant bankers who advise them on the timing, pricing, market etc.

Difference between money markets and capital markets

The money markets are used for the raising of short term finance, sometimes for loans that are expected to be paid back as early as overnight whereas the capital markets are used for the raising of long term finance, such as the purchase of shares, or for loans that are not expected to be fully paid back for at least a year.

Funds borrowed from the money markets are typically used for general operating expenses, to cover brief periods of illiquidity. For example a company may have inbound payments from customers that have not yet cleared, but may wish to immediately pay out cash for its payroll. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long term.

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Together, money markets and capital markets form the financial markets as the term is narrowly understood. The capital market is concerned with long term finance. In the widest sense, it consists of a series of channels through which the savings of the community are made available for industrial and commercial enterprises and public authorities.

How money and capital market assists the entrepreneurs in financing their business

The money market and capital market plays an important role mobilising saving and channel is in them into productive investments for the development of commerce and industry. As such, the capital market helps in capital formation and economic growth of the country.

The capital market acts as an important link between savers, investors and entrepreneurs. The savers and investors are lenders of funds while the entrepreneurs are borrowers of funds. The savers and investors who do not spend all their income are called. “Surplus units” and the borrowers are known as “deficit units”. The capital market is the transmission mechanism between surplus units and deficit units. It is a conduit through which surplus units lend their surplus funds to deficit units.

Funds flow into the capital market from individuals and financial intermediaries which are absorbed by commerce, industry and government. It thus facilitates the movement of stream of capital to be used more productively and profitability to increases the national income.

Surplus units buy securities with their surplus funds and deficit units sells securities to raise the funds they need. Funds flow from lenders to borrowers either directly or indirectly through financial institutions such as banks, unit trusts, mutual funds, etc. The borrowers issue primary securities which are purchased by lenders either directly or indirectly through financial institutions.

The capital market prides incentives to savers in the form of interest or dividend and transfers funds to investors. Thus it leads to capital formation. In fact, the capital market provides a market mechanism for those who have savings and to those who need funds for productive investments. It diverts resources from wasteful and unproductive channels such as gold, jewellery, real estate, conspicuous consumption, etc. to productive investments.

The capital market encourages economic growth. The various institutions which operate in the capital market give quantities and qualitative direction to the flow of funds and bring rational allocation of resources. They do so by converting financial assets into productive physical assets. This leads to the development of commerce and industry through the private and public sector, thereby inducing economic growth.

References

Andrew, M. (2009), An Introduction to International Capital Markets: Products, Strategies, Participants , New York: John Wiley

Boyle, D. (2006). The Little Money Book. London: The Disinformation Company. p. 37.

Carmen, R. & Kenneth, R. (2010). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.

Mankiw, N.  (2007). “2”. Macroeconomics (6th ed.). New York: Worth Publishers. pp. 22–32.

Mishkin, S. (2007). The Economics of Money, Banking, and Financial Markets (Alternate Edition). Boston: Addison Wesley.

Sullivan, A. & Steven, M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River,: Pearson Prentice Hall. p. 283.