Capital Markets and Money Markets
Compare and contrast the key role and functions of the capital markets with those of the money markets. Critically explain how quantitative easing (QE) operations in the money markets might influence bond prices and bond yields in the capital markets. Give examples to illustrate your answer.
The money markets differ with capital markets in that money markets include only the trade in short term debt while capital markets include the sale and purchase of bonds and stocks. Short term debts ensure that there is a flow of funds in the short run between different financial entities which include; banks, governments, banks, SACCOs and other financial institutions. Short term debts are debts which have terms which may be a short as one day and a maximum of one year. The bonds and stocks are assets whose value is mostly realized in the long term. The assets are mainly bought by individual professional brokers in the capital market, big financial institutions and individual investors.
In capital markets, the exchange of liquid cash is rare while in the money market there is a constant exchange of almost liquid money. Exchange in the money market is done virtually through a computer and money is not the tool of the trade. Instead, capital markets make use of credit instruments such as equity, shares, stocks, securities, debentured and bonds. Money market involves trade using bills and certificates of exchange among others.
The tools of the trade in money markets show better liquidity potential compared to those of capital markets. Disposing of items such as bonds and equities is a bureaucratic process which requires a lot of paperwork. This makes the liquidation of tools of the trade in the capital markets a process that takes long. The long process and bureaucracy are due to the high regulation of capital markets. Capital markets are commonly regulated by huge financial institutions such as the New York Stock Exchange (NYSE). Regulation in the money market is minimal. The tools in money markets have better liquidity and fewer restrictions are available in this market. The duration of liquefying these assets in the money markets is also relatively small.
The most common participants in the capital markets include the central bank, commercial banks and other non-financial institutions. The central bank some times acts as a regulator, buyer and seller in the stocks market. The main players in the money market non-banking institutions, commercial banks and stock markets.
Implementation of quantitative easing techniques by central banks leads to high prices of bonds and lower returns to bondholders. Quantitative easing is classified among the traditional approaches to boosting the performance of the economy. In a case where the central bank of any country decides to adopt quantitative easing, there is printing of new money to buy the bonds. This, in turn, leads to an increase in the amount of money in the financial markets. Increase in money in the financial markets subsequently leads to overall demand in bonds. The bonds mainly purchased by the new money are government bonds which ensure that no private entities profit from such policies. Owning and holding bonds in a time when quantitative easing is riskier. Normally, when bond prices are artificially high then both the actual default risks and opportunity cost risks increase exponentially. Bondholders due to quantitative easing are exposed to loss of yields in cases where they would have been better pursuing other more profitable investment opportunities.
During the 2008 great recession, the Federal government of the United States decided to adopt a quantitative easing policy. The period before 2008 had seen the economy decreasing in the rate of growth by almost 50% and more people are losing jobs day by day. As a result of adopting the policy, the federal government bought millions of government bonds. This, in turn, resulted in rocketing of the size of assets belonging to the federal government. Despite the dangers posed by adopting the policy, high inflation levels were averted. Research before the adoption of the policy indicated that the policy was highly efficient in lowering long term interest rates making it possible for the government to borrow cheaply to reinvest into the economy. The effectiveness of the policy was highly felt with the growth rate being sustained at about 2%.
ADD another example of QE