The Basics of Financial Markets

The term “market” refers to a place or group of places where people can exchange certain goods or services for money. There is, of course, the basic “market” drawn from medieval exchanges wherein buyers and sellers would gather to exchange money for goods. Today, there are all sorts of markets, ranging from the supermarket that sells our everyday food and household products, to the art market, the real estate market and even the drug market. Our current financial markets are generally based on the types of goods or “assets” that are traded on them.  The most well known and most commonly traded are the equity market, the bond market, the foreign exchange market and the currency market. Each of these markets have a vast assortment of instruments that are “traded” on them.

The equity market is the financial market that is most commonly known among the public.  The term comes from the fact that a company’s value is known as its equity, or its equity stock, and it can sell parts of that equity to investors. These parts of its equity are known as “equity shares” or “stock shares” and hence we have the expressions “buying shares on the stock market”, or “owning shares of a stock”. These shares do not pay any interest; the value of shares in the equity market go up an down constantly, so those who buy them are counting on the value going up, so they can sell them at a higher rate. Remember Will Rogers advice on the stock market: “Buy when the price is low and sell when the price goes up. If the price doesn’t go up, don’t buy.”  Since the rest of us don’t have that kind of hindsight, we just hope the price goes up. Shares on the stock market do not pay any interest, so anyone investing in them is only hoping to make money by the increase in the value (price) of the shares. The stock market is divided by company size (measured by capitalization), industry or type of growth pattern. Investors and their advisors therefore talk about large-cap vs. small-cap stocks, energy vs. technology stocks, or growth vs. value stocks, for example.

The fixed income market is comprised of bonds, notes, bills, and certificates of deposit. The fixed income market is called just that because, unlike stocks, the securities on it pay interest (income) to the holder. Each bond, note, bill or certificate of deposit is issued at an interest rate that will be paid the holder, either over time or at maturity.  Companies or governments issue bonds to fund their day-to-day operations or to finance specific projects. The owner of a bond, note, bill or CD does not own a piece of the company, as the owner of a share does. A bond holder, in essence, is lending money for a certain period of time (until the maturity date) to the issuer of the bond. That issuer may be Ford Motor, the U.S. Government, the City of Los Angeles, or the Government of Brazil. The bond holder will get back the “loan” amount plus interest payments at the maturity date of the bond.  The underlying value of the bond may change during the course of holding the bond. If the bond was issued with an interest rate (coupon) of 8%, and interest rates on other, similar bonds are being issued at 10%, this bond will become less attractive to other buyers and will become less valuable. This is not an issue if an investor intends to hold onto the bond until maturity, but if he wants to sell it at some point before it matures, the face value may be less. It may also be more, if interest rates on similar bonds went down to 6%, a bond paying 8% would be more valuable.

The commodities market is comprised of promises to buy or sell goods such as wheat, oil or gold at a certain price on a certain day. This market evolved from the nineteenth century Midwest market where farmers (sellers) and dealers (buyers) committed to future exchanges of grain for cash. Farmers gave up any increase in the price of their crop for the security of knowing their crop was sold for a set price, even if the bottom fell out of the market.  In time, these contracts became a market of their own, as they changed hands before the delivery date. Before long, traders who had no intention of ever buying or selling a crop, but who thought they could outguess how the price of the commodity would perform, were trading commodities for the potential profit.

The currency market, also known as the foreign exchange market, or the Forex market, is where companies or governments that need to settle their debts in another currency, can obtain that currency.   If the owner of a shoe store in the United States wants to buy leather shoes from Brazil, he will have to obtain Brazilian Reals in order to pay for them. (Or, the manufacturer in Brazil may accept the dollars, but have to sell them for Reals when he receives the dollars.) Banks and brokerages perform this exchange service and, in addition to charging a fee for it, will try to make money off the fluctuations of the various currencies that they exchange.  Just as with the commodities markets, the allure of buying a currency at a low rate and selling it higher appealed to speculative types, and today the currency market is dominated by  speculative traders who never actually use the currencies they buy and sell.

The derivatives market  is comprised forwards, futures, options and swaps on all of the underlying products in the above markets. Both companies and governments, when faced with the increasing risks of issuing stocks and bonds, or covering commodity or foreign exchange positions, have decided to manage or reduce these risks and to hopefully increase returns. The derivative market is an intensely complex market wherein almost any aspect of debt or risk can be broken away into a separate trading instrument and bought or sold.  These sales are made on the basis of a guaranteed future sale at a current price, which is known as the underlying price. For example, the company that issued the 8% bond in our above example, may want to manage the risk of that 8% bond if the interest rates go down by selling off the coupon on the bond and financing it at a lower rate through the use of a derivative.

Categories Investing and Financial Planning

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