Financial markets and their components

Financial markets are physical or virtual markets for trading any financial asset. The equity, money, capital, commodity, and currency markets are examples of financial markets. The critical components of the financial markets are the capital market, money market, derivatives market, equity market, mortgage market, debt market, and foreign exchange market.

What is the money market?

The money market is a part of the financial market and deals with short-term financial instruments. The market where liquid financial assets are traded is known as the money market. Money market instruments are purchased and invested in bulk quantity which can be liquidated easily and quickly within one year. It provides returns in the form of interest rates on the securities. A financial asset with high-interest rates is more profitable for an investor as he receives a higher return from such an asset than the other assets.

International money market instruments

The image shows the various money market instruments. These include promissory notes, commercial paper, treasury bills, certificate of deposit, money funds and municipal notes.
Money Market Instruments
  • A promissory note is a type of money market instrument that describes the promise of one party towards another party. The buyer, with the help of the promissory note, promises the seller to pay the specific amount within a specific period. It is a written promise which is to be fulfilled on-demand or at a future date.
  • Commercial paper is a short-term source of financing used by international business organizations and financial institutions. It helps the organization to meet its debt obligations and liabilities. The maturity period of commercial paper is 270 days. The principal amount along with the interest rate is paid after the maturity period. Drafts, checks, etc., are good examples of commercial paper used in the international market.
  • Treasury bills are money market securities provided by government corporations. It is provided to meet the regular and ongoing expenses and debts. The validity of such bills is 364 days. It does not bear any type of interest rate. It is sold based on discounted prices. In the international market, treasury bills are purchased with the help of the auction process organized by financial institutions and can be traded in the secondary market.
  • A certificate of deposit is an investment vehicle that is mostly provided by financial institutions such as central banks, commercial banks, etc. It has a low level of risk which results in low earnings and low returns to the investors. Banks do not provide loans against such types of deposits. In the international market, such types of instruments are purchased with the help of foreign exchange by converting domestic currency into foreign currency.
  • Money funds are low-risk money market instruments that also act as a saving account. It is provided by the financial institutions and financial markets. International investors who like to bear less risk always use money funds. It charges interest rates on money market funds.
  • A municipal note is a type of money market fund used to raise capital for various international business organizations. They are provided by government officials. It is a type of debt security.

International aspects of the money market

The image shows the international aspects of the money market. These are financing trade, safety of investments, fund management, helping the central bank, maintaining liquidity and flexibility and ensuring industrial development.
International Aspects of the Money Market
  • Financing trade: Money market instruments help to facilitate international trade by providing foreign exchange. It provides finance to conduct the import and export of trade. With the help of such types of instruments, it becomes easy for traders to conduct international financial trades. With the help of foreign exchange, trade can be conducted easily.
  • Safety of investments: Investment is a strategy that helps the investors to accept the risk and earn a return on it. Money market instruments facilitate the safety and security of the investments by investing in different instruments and securities of the money market. High safety of investments results in high growth and development and increases the possibility of high earnings. It provides less risky investment instruments.
  • Fund management: The money market helps in the collection, utilization, and management of funds with the help of different money market instruments. It helps to use the money market securities and finance international business activities and operations by utilizing foreign exchange. It helps to manage foreign exchange effectively.
  • Help central bank: Money market instruments help the central bank to bring stability in the banking services and systems. It provides liquidity to the bank and economy. It helps the central bank to provide short-term money market funds and instruments to the customers to fulfill their needs and requirements. It also helps the bank in easy and quick growth and the development of the banking system. It also allows the central bank to regulate and supervise the different short-term debt securities and instruments.
  • Liquidity and flexibility: The basic feature of the money market is liquidity and flexibility. As it is short-term security, it can be liquidated within one year, or whenever there is a requirement of cash, it can be sold in the market. At the same time, it provides flexibility in the international market. Some money market instruments do not have a fixed maturity period.
  • Industrial development: The money market also helps in industrial and economic development in the international market. It provides various short-term instruments to the small business and industry to undertake the activities and operations. It provides finance to the industrial sector and flourishes the growth and development in the market.

International participants of the money market

The money market has several participants like government corporations, central banks, financial institutions, futures market, money market mutual fund and international brokers.
Money Market Participants
  • Government corporations are larger buyers and sellers of money market instruments and securities to international investors than others. It provides various instruments such as treasury bills to the public to fulfill their short-term goals and repay the short-term liabilities.
  • Central banks are the government bank of all the other banks in the market. It promotes economic growth and development, sets interest rates for various securities and instruments, provides money market instruments to the public for a short period.
  • Commercial banks are a major participant in the money market. It acts as an issuer of the money market instruments. It provides short-term funds in the form of money market securities to the public and customers.
  • Financial institutions act as a middleman in the money market. It is the provider and user of the money market securities. It provides funds in the form of money market instruments to the international business and public to meet their liabilities and financial burdens. It also assists in money market financial transactions.
  • Futures market exchange provides various financial products such as money market instruments and securities to the international public and sells them in the future on maturity or on-demand or on the date agreed between the parties.
  • Money market mutual funds provide various types of investments in the short-term securities of the money market. The fund manager allows the investments in commercial paper, treasury bills, certificate of deposits, etc.
  • An international broker is a person who helps financial investors to purchase and sell money market instruments in different financial markets with the help of regulations regarding foreign exchange. He or she makes a deal by providing information about foreign exchange and other money market securities.

International money markets and international capital markets

  • Money markets deal with short-term securities and capital markets deal with long-term securities.
  • The money market is not a formal market, but a capital market is a formal type of market that has rigid rules and regulations.
  • Commercial papers, certificates of deposits, promissory notes, etc., are money market instruments, whereas shares, bonds, debentures, etc., are capital market instruments.

Context and Applications

The above topic is significant in the professional exams for both undergraduate and graduate courses, especially for:

  • Bachelor of Business Administration (Banking and Finance)
  • Bachelor in Finance
  • Masters of Business Administration (Banking and Finance)
  • Masters in Finance
  • Masters in International Finance

Practice Problems

Question 1: Identify which word best describes the money market.

a. Liquid

b. Inflexible

c. Instability

d. Poor

Answer: (a)

Explanation: The money market is the market for short-term financial instruments. These instruments can be converted into cash quickly. So, the money market is very liquid.

Question 2: Identify which market has the money market as a component.

a. Primary market

b. Secondary market

c. Capital market

d. Financial market

Answer: (d)

Explanation: The primary market is where new stocks and bonds are issued in the form of IPO. The secondary market is where the stocks and bonds issued in the primary market are traded. The capital market is the place where debt and equity-based securities are traded. So, the money market is a part of the financial market.

Question 3: Identify which of the following is not an international money market feature.

a. Helps central bank

b. Lack of industrial development

c. Flexibility and stability

d. Financing trade

Answer: (b)

Explanation: The international money market helps in industrial development, helps finance trade, and helps the central bank. So, option (b) is the correct answer.

Question 4: Identify which of the following is not money market security.

a. Commercial papers

b. Promissory notes

c. Certificate of deposits

d. Bonds

Answer: (d)

Explanation: Money market instruments include certificates of deposit, commercial papers, and promissory notes. Bonds are primary market instruments.

Question 5: Identify which of the following is a feature of the capital market.

a. Informal

b. Formal

c. Short-term securities

d. Certificate of deposits

Answer: (b)

Explanation: A capital market is a formal market for trading debt and equity-backed securities. Short-term securities like certificates of deposit are traded in the money market.

Common Mistakes

Students get confused with the regulations regarding the domestic money market and international money market. It becomes difficult for them to understand the meaning and difference between capital and money markets. They should have a clear understanding of the financial markets and their components. Students should also learn about foreign exchange regulations.

While studying this topic, it is recommended to read the following topics to get a better knowledge:

  • Financial market
  • Capital market
  • Financial securities
  • Primary and secondary markets

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