2.
Chapter 2: The Money Market and the Capital
Market
Lecture Notes
● Classification of Financial Markets (By Maturity):
○ Money Market: Trades in debt instruments with original maturities
of one year or less.
■ Characterized by high liquidity and low default risk. Used
by governments and corporations for managing short-term
cash flow needs.
○ Capital Market: Trades in equity (stock) and debt instruments with
original maturities greater than one year.
■ Characterized by lower liquidity and higher risk (price risk
and default risk). Used for long-term financing and
investing.
● Money Market Instruments (Key Examples):
○ Treasury Bills (T-Bills): Short-term debt of the U.S. government;
virtually default-risk free; issued at a discount to face value.
○ Federal Funds (Fed Funds): Short-term interbank loans, usually
overnight, used by banks to meet reserve requirements. The
Federal Funds Rate is the central bank's key target rate.
○ Commercial Paper: Unsecured, short-term debt instrument issued
by corporations to raise cash; typically issued in denominations of
$100,000 or more.
○ Certificates of Deposit (CDs): Time deposits with fixed maturities;
Negotiable CDs can be traded in the secondary market.
○ Repurchase Agreements (Repos): An agreement to sell securities
and repurchase them later at a slightly higher price; essentially a
short-term collateralized loan.
● Capital Market Instruments (Key Examples):
○ Bonds: Long-term debt instruments promising periodic interest
(coupon) payments and principal repayment at maturity.
■ Includes Treasury Bonds (US government), Municipal Bonds
(state/local government, tax-exempt interest), and
Corporate Bonds.
○ Equity (Stock): Represents ownership in a corporation.
■ Common Stock: Voting rights, residual claim on
income/assets.
■ Preferred Stock: Fixed dividend, no voting rights, priority
claim over common stock.
○ Mortgages: Loans to individuals or businesses to purchase real
property; backed by the property itself.
● Classification of Financial Markets (By Trading Process):
○ Primary Markets: Where new issues of securities are first sold to
the public (e.g., Initial Public Offerings - IPOs). Funds go to the
issuing entity.
○ Secondary Markets: Where existing securities are traded among
investors (e.g., NYSE, NASDAQ). Funds do not go to the issuing
entity.
■ Secondary markets are critical as they provide liquidity and
facilitate price discovery.
● Stock Market Operations:
○ Exchanges: Organized marketplaces (like the NYSE) where brokers
and dealers meet to trade.
○ Over-the-Counter (OTC): Decentralized network where trading
takes place via computer and telephone (e.g., NASDAQ).
Summary (Chapter 2)
Financial markets are classified by the maturity of the instruments they trade:
the Money Market (short-term, high liquidity, low risk) and the Capital Market
(long-term, higher risk, used for permanent financing). Key money market
instruments include T-Bills and Commercial Paper. Key capital market
instruments include bonds, stocks, and mortgages. Markets are also segmented
into Primary Markets (new issues) and Secondary Markets (trading existing
securities), with secondary markets providing essential liquidity and price
discovery for the entire financial system.