1.2 Money and Capital Markets
As shown in Figure 1.1, the financial markets are the place in which suppliers and users of capital interact. They not only encompass a multitude of securities, including stocksA security that represents ownership in an incorporated company., bondsA debt instrument issued by governments and corporations with a maturity of more than one year. Coupon bonds pay periodic (annual or semi-annual) interest payments to the holder (called coupons) and pay a final lump sum (called the face value) at maturity., and other securities, but also span national borders. They exist physically (e.g., the New York Stock Exchange), and they exist virtually like the bond and foreign exchange markets.
To help classify financial markets, the first distinction we make is between money markets and capital markets. The money marketThe market for bonds with a maturity of less than one year. These bonds are all zero-coupon bonds and include bankers’ acceptances, commercial paper, and government T-bills. is for securities that have an original maturity of one year or less. The capital marketThe market for long-term securities with original maturity greater than one year. The main securities are bonds and stocks issued by companies and governments. is for securities that have an original maturity of more than one year.
The U.S. financial markets are very large—the largest in the world. Figure 1.4 shows the value outstanding at the end of the year of the following classes of securities: equities, corporate bonds, mortgage- (and asset-) backed securities, government bonds, and money market securities. In 2022 there was over $115 trillion in assets (primarily stocks and bonds). Notice how corporate equities constitute about half of that total and the value of corporate securities (both equities and debt) is substantially larger than the value of government securities.
Figure 1.4 Financial Markets: Values Outstanding
Sources: Data from Bloomberg, Federal Agencies, Refinitiv, SIFMA, The Federal Reserve, US Department of Treasury; FlatWorld
Money Markets
The term money market is a misnomer. Money is not traded in money markets. However, in a money market, the securities
are fixed income securities (i.e., bonds),
are short term,
are highly liquid (easy to sell), and
mature in less than one year from their issue date.
Investors use the money market as an interim investment that provides a higher return than cash. Most investment funds and financial intermediaries (such as banks) hold money market securities to meet withdrawals. Money market securities have large face values (i.e., $1 million), which precludes most individual investors from buying them. As a result, individuals participate in the money market when they buy units in money market mutual funds (MMMFs)A pooling of investor money that is professionally managed. The investors own shares (or units) in the pooled fund and are entitled to a proportionate share of earnings..
The sellers of money market securities find that the money market provides a low-cost source of temporary funds. Banks borrow in the money market to meet short-term reserve requirement shortages. The government funds a large portion of the national debt by issuing Treasury bills (T-bills)A bond issued by the U.S. government that has a maturity of 91 days, 182 days, or 52 weeks. T-bills are zero coupon bonds.. Money markets permit finance companies to raise the funds uses to make car and other smaller loans. Figure 1.5 shows a diagram of the money market.
Figure 1.5 The Money Market
Source: FlatWorld
Table 1.2 Definitions of Terms in Figure 1.5
| U.S. Treasury | The U.S. Treasury is the largest of all money market borrowers. It issues T-bills and other securities to finance the national debt. Short-term issues enable the government to raise funds until tax revenues are received. |
| Companies | Corporations use commercial paper to finance the loans they extend to their customers. For example, GMAC Financial Services borrows money by issuing commercial paper and uses the money to make loans, for example, to consumers buying General Motors cars, with repayment to come from customers making their monthly payments. |
| Banks (Issuers) | Banks are the major issuer of negotiable certificates of deposit (NCDs) and the only issuer of federal funds. |
| T-Bills | The most widely held money market security is the Treasury bill, or T-bill. Sold at a discount to par value. They have the lowest possibility of default of all money market securities. T-bills have 4-week, 13-week, 26-week, and 52-week maturities. |
| Commercial Paper | Commercial paper securities are unsecured promissory notes issued by corporations. Because these securities are unsecured, only the largest and most creditworthy corporations issue commercial paper. Commercial paper always has an original maturity less than 270 days, so as to avoid the need to register the security issue with the Securities and Exchange Commission (SEC). Most commercial paper actually matures in 20 to 45 days. Commercial paper is issued at a discount to its face value. |
| NCDs | A negotiable certificate of deposit (NCD) is a security issued by a bank that documents a deposit and specifies the interest rate and maturity date. Because a maturity date is specified, an NCD is a term security as opposed to a demand security. An NCD is also a bearer instrument, which means that whoever holds the instrument at maturity receives the principal and interest. The denominations of NCDs range from $100,000 to $10 million. Few NCDs are denominated less than $1 million. NCDs typically have a maturity of 1 to 4 months. |
| Fed Funds | Federal funds are funds that are used for borrowing or lending between financial institutions. The term of the loans is usually less than one day. The name “federal funds” (“fed funds”) derives from the fact that the loan rates are close to the rate charged by the Federal Reserve. Fed funds are an alternative to borrowing from the Federal Reserve. Banks borrow from other banks so that they do not alert the Fed to liquidity problems. Banks lend in the fed funds market because money held at the Federal Reserve does not earn any interest. On a typical day, over $250 billion in fed funds are purchased. You are unlikely to ever buy or sell fed funds; however, their interest rates are the most closely watched and reported of all money market instruments. The Federal Reserve often announces its intention to raise or lower the fed fund rates. The Federal Reserve influences the fed funds market by buying (selling) government securities from (to) banks. |
| Funds | Because many money market instruments are too large for the average investor to afford, investors instead buy units in money market mutual funds (MMMFs). The funds purchases money market securities. |
| Federal Reserve | The Federal Reserve (the Fed) is the Treasury’s agent for the distribution of all government securities. The Fed holds a large inventory of Treasury securities that it sells (buys) if it believes that the money supply should be reduced (expanded). The Fed’s responsibility for the money supply makes it the single most influential participant in the U.S. money market. By flooding the economy with money, the Fed can push down short-term borrowing rates. |
| Insurance Companies | Property and casualty insurance companies must maintain liquidity because of their unpredictable need for funds. For example, when Hurricane Katrina hit the Gulf Coast in 2005, insurance companies paid out billions of dollars in benefits to policy holders to help cover the $81 billion loss Katrina caused. To meet this demand for funds, the insurance companies had to sell a portion of their money market holdings. |
| Pensions | Pension funds maintain a portion of their funds in the money market so that they will be liquid enough to take advantage of investment opportunities. Additionally, pension funds must have sufficient liquidity to meet their obligations to beneficiaries. |
| Banks (Buyers) | Commercial banks hold a larger percentage of U.S. government securities than any other group of financial institutions (approximately 12%). This is partly because of regulations that limit the investment opportunities available to banks. |
Figure 1.6 compares the interest rates on selected money market instruments. On this graph, you will notice that all of the money market instruments appear to move together over time. This is because all are very low risk and have short-term maturities, so they are close substitutes. Figure 1.6 also demonstrates the large drop in interest rates after the financial crises of 2008. Before 2008, rates ranged between 3% and 5%. After the crises they were below 1% for a number of years. In early 2020, the COVID-19 pandemic led to an economic lockdown of the economy. In response, the Federal Reserve lowered rates and the Federal Funds rate fell to about 0.10%. In 2022, the Federal Reserve began raising rates to combat the high inflation that followed COVID-19. These high rates continued through 2023.
Figure 1.6 Rates on Money Market Securities
Sources: Data from Federal Reserve Bank of St. Louis; FlatWorld
Capital Markets
Unlike money markets, capital markets are markets in which the securities have an original maturity greater than one year. The principal securities traded in the capital market are bonds and stocks.
Capital market participants have different motives from those of money market participants. The money markets are primarily for warehousing funds until a more important need arises. The securities traded on the capital markets fund long-term investments by companies and governments in projects like factories and highways.
Figure 1.7 The Capital Market
Source: FlatWorld
Table 1.3 Definitions of Terms in Figure 1.7
| Government | The U.S. Treasury is the largest issuer of bonds and accounts for about 85% of the outstanding public debt. A number of federal agencies issue bonds, as do state and local governments. The federal government issues bonds to fund the national debt. State and local governments issue bonds to finance projects like schools and prisons. |
| Companies | Corporations issue bonds to raise funds for projects and acquisitions. Bonds are an alternative to bank borrowing. |
| Banks | Banks will initiate mortgages and then sell off bundles (say, one hundred mortgages) to an investment bank. The investment bank sells the bundle to an investor. The bundles are called asset-backed securities. |
| Government Bonds | A bond is a security that requires the issuer to make a series of annual (or semiannual) interest payments followed by a final maturity payment. A bond is like an IOU. Bondholders don’t have to wait for maturity to get their money back, they can sell their bonds to other investors in the bond market. The U.S. Treasury issues T-Notes and T-Bonds (T-Bonds have a maturity greater than ten years). The Federal Reserve auctions new T-Notes and T-Bonds on behalf of the Treasury. |
| Common Shares | Stock represents ownership in a corporation. A stockholder owns a percentage interest in a firm consistent with the percentage of outstanding stock held. Stockholders are residual claimants in the sense that they get whatever is leftover after all of the company’s liabilities are paid off. Common shareholders exercise their control of the corporation by voting for directors who sit on the board (typically one vote per share), Common shareholders receive a dividend at the discretion of the board. |
| Preferred Shares | The preferred stockholder receives a fixed dividend that does not change. Preferred stockholders have a more senior claim against assets than common shareholders and are entitled to their dividends before common shareholders. Preferred stockholders usually do not vote. |
| Corporate Bonds | Corporate bonds are similar to government bonds, but corporate bonds can be more exotic in the sense of having more features. For example, some corporate bonds give the bondholder the option to convert into being a stockholder. |
| Mortgage- and Asset-Backed Securities | Mortgage-backed securities are bundles of mortgages. The owner of a mortgage-backed security receives the stream of interest and principal payments from the original borrowers. Asset-backed securities are similar to mortgage-backed, but they are bundles of car loans or credit card receivables instead of mortgages. |
| Individuals | The largest purchasers of capital market claims are households. Individuals, often through their employee-sponsored programs, invest in stocks and bonds as a means of preparing for retirement. |
| Funds and Pensions | Mutual funds, hedge funds, and pensions are pools of money that are managed by professional portfolio managers. The funds can be invested in any type of security. Different funds have different investment objectives. Investors own units or shares in the fund. |
| Financial Institutions | Financial institutions are also large purchasers of capital market securities, because individuals and households often deposit funds in financial institutions that use the funds to purchase capital market instruments. For example, property and casualty insurance companies invest their premium income in capital market securities (mainly bonds) to earn income on the money before they must pay out on a claim. |
There are some interesting differences in international capital markets. The Anglosphere (United States, United Kingdom, Canada, and Australia) tends to rely relatively more on capital markets for financing, whereas European and Asian countries rely less on markets and more on bank borrowing. This difference is highlighted in Figure 1.8, which shows the proportionate breakdown of corporation financing by source of financing.
Figure 1.8 Global Comparison of Corporate Financing by Source
Sources: Data from Organization for Economic Co-operation and Development (OECD), European Central Bank (ECB), Bank of Japan, National Bureau of Statistics of China; FlatWorld
Long Description
The graph shows the following breakdowns: the U.S. receives around 12% from loans, 20% from other financing, 58% from equity, and 9% from bonds; Europe receives around 28% from loans, 13% from other financing, 55% from equity, and 4% from bonds; Japan receives around 24% from loans, 17% from other financing, 55% from equity, and 4% from bonds; and China receives around 59% from loans, 15% from other financing, 5% from equity, and 21% from bonds.
Note how the proportion of financing that U.S. corporations obtain from bank loans (the bottom part of the bar) is smaller than in Europe, Japan, and China. The other thing to notice is that the sum of financing from capital market sources (Equity plus Bonds) is larger in the United States (about 67%) than in Europe, Japan, and China.