If you take a look at financial markets, you can divide them into two main categories. They include the short term market and long term markets. Before investing, you need to have a strong understanding of the differences between these two types of markets.
Short term markets deal with funds required for less than a year. On the other hand, long term markets offer funds for longer tenures that exceed a year. There are some significant differences between them. Read on and let’s explore those differences in detail.
Participants
The participants in short term and long-term markets are quite different. The short-term market comprises of commercial banks, non-banking finance companies, money market mutual funds and corporates having temporary surplus funds. They lend for very short periods ranging from overnight to one year to borrowers needing funds to finance their working capital needs.
The long term market, on the other hand, includes insurance companies, pension funds, mutual funds, FIIs, commercial banks and development finance institutions. They invest for longer tenure exceeding one year. The borrowers are governments, institutions and companies raising funds for investment in developmental projects and capacity expansion. While short term markets serve the fund requirements for operational purposes, long term market caters to investment-related funding needs.
Instruments Traded
Some key money market instruments traded in the short term market are treasury bills, commercial paper, certificate of deposits, repurchase agreements, call money, bill rediscounting and bankers’ acceptances. These instruments have maximum maturity up to one year and are highly liquid.
In comparison, the long term market deals in instruments like government and corporate bonds, debentures, loans, equity and preference shares which have a maturity period of over one year. The secondary market for long term debt instruments and equities also comes under the purview of the long term market. While short term instruments are discounted securities, long term debt instruments usually carry a fixed coupon rate of interest over their tenure.
Liquidity Risk
Short term instruments have very high liquidity as they have a large investor base and mature within one year. Funds can be easily raised or instruments sold in the market at short notice. In contrast, long term instruments like bonds may sometimes suffer from lower liquidity, especially in developing markets. Selling them prior to maturity can be difficult in the absence of an active secondary market for such securities. The investor may have to give significant price discounts or sell at a loss due to this illiquidity.
Return versus Risk
Return is inversely proportional to liquidity. Due to higher liquidity and shorter maturity, short term debt instruments are relatively less risky than long term securities. They offer modest returns to investors. For instance, treasury bills and certificate of deposits in India currently yield around 5-6% per annum.
Long term debt instruments, on the other hand, carry higher market risk due to interest rate fluctuations over their investment horizon. So, they offer higher returns as a risk premium over short term instruments. Government and corporate bonds in India currently yield 6 to 8% based on the tenure and issuer credit profile. Within long term instruments, bonds are relatively less risky than equity which has the potential to provide higher inflation-adjusted returns of 10-15% over years but with higher volatility.
Market Efficiency
Both short term and long-term segment differ substantially when it comes to market efficiency. The short term money market and instruments traded therein are more organized and transparent. Short term interest rates react swiftly to changes in liquidity conditions and RBI policy rates due to higher participation of banks and institutional investors. Price discovery and dissemination of information is quick.
In comparison, the long term debt and equity market lacks breadth and depth in India. Secondary market activity for long term corporate bonds is muted leading to intermittent price updates. Even government bonds do not trade frequently after initial issuance, leading to opaque or stale pricing at times. The equity market is dominated by retail investors prone to overreact to news and events. This results in higher volatility not fully explained by fundamentals. Long term markets thus demonstrate relatively lower efficiency than short term markets.
Regulations
RBI governs the Indian money market setting rules for participants and instruments. It enforces strict guidelines on liquidity, transparency and risk management to be adhered by banks and NBFCs. SEBI regulates the equity market including rules for disclosure, corporate governance and investor protection mechanisms. The long term corporate bond market follows guidelines issued by SEBI and RBI though still lacks depth. Short term money market regulations have led to robust risk controls and orderly functioning. The long term market remains loosely regulated in comparison, especially for bonds.
Investor Base
The short-term money market serves the investment and funding needs of large participants like banks, mutual funds and corporates. The investor base is smaller but cash rich to take on short term exposures. In the long term market, there is high participation from retail individual investors in equity. But the corporate bond investor base remains narrow despite latent demand from insurers and pension funds. Efforts are ongoing to broaden the investor profile for long term instruments to enhance demand and liquidity.
Final Words
To conclude, short term money market serves immediate funding needs of borrowers and provides liquidity to lenders. Instruments carry modest yields with low volatility and high safety. In contrast, the long term market provides committed resources for developmental needs at higher yields, volatility and illiquidity risks. Greater efficiency, transparency and regulations make short term markets more robust. Expanding the investor base through financial inclusion and literacy is vital for developing the long term market.
