A Beginner's Guide to Financial Markets
What is a Financial Market and what do they do?
A financial market is a marketplace where buyers and sellers trade financial assets like stocks, bonds and currencies.
The basic functions of financial markets are:
Price Setting - markets provide price discovery, which is the ability to determine the relative values of different items, based upon the price at which individuals are willing to buy and sell them.
Asset Valuation - market prices represents the value of a firm or the firm’s assets or property
Showcasing Arbitrage Opportunities - financial products such as currencies or commodities may trade at very different prices in different locations & markets, allowing traders to profit from these discrepancies.
Providing a Platform for Investing - stock, bond and money markets provide an opportunity to earn a return on funds that are not needed immediately and to also accumulate assets that can provide income in the future
Risk Management - futures, options and other derivative contracts can provide protection against many types of risk, such as the value of a currency going down. They also enable the markets to attach a price to risk, allowing firms and individuals to trade risks, reducing exposure to some while retaining exposure to others.
Who are the players in Financial Markets?
There are two main players in the financial markets - individual investors and institutional investors.
Individual Investors are everyday people entering the market in hopes of earning a return. They make up a small portion of financial assets owned in the markets, often in the form of retirement savings or shares.
Institutional Investors are companies or organisations that invest money on behalf of clients or members. They are considered to have more expertise and resources than the average individual investor.
Examples of Institutional Investors are:
Mutual Funds - investment companies that typically accept an unlimited number of individual investments. The fund declares a strategy that it will undertake, and as additional money is invested into the fund, fund managers purchase financial instruments appropriate to that strategy.
Investors wishing to enter or leave the mutual fund must buy or sell the fund’s shares, which are typically found on exchanges.
Hedge Funds - investment companies that only accepts investments from only a small number of wealthy individuals or big institutions. The nature of only accepting from a small number of people gives the fund freedom from most types of regulations designed to protect the average consumer.
Because hedge funds have a decent amount of regulatory freedom, they are able to employ aggressive investment strategies, such as using borrowed money to increase the amount invested or focusing investment on one type of asset rather than diversifying. If successful, such strategies can lead to very large returns, but can also lead to catastrophic losses
Pension Funds - aggregates the retirement savings of a large number of workers. Unlike individual pension accounts, pension funds do not give individuals control over how they savings are invested.
Most pension funds typically offer a guaranteed benefit once the individual reaches retirement age.
Algorithmic Traders - also known as high-frequency trading, involves investors using computers to enter buy and sell orders automatically in an effort to exploit tiny price differences in securities and currency markets. HFT companies normally own the asset for a very brief period of time before selling it.
HFT companies only control a very tiny proportion of the world’s financial assets, but they account for a large proportion of trading activity in some markets.
What Causes Activity in Financial Markets?
The driving force behind financial markets is the desire of investors to earn a return on their assets. This return has two distinct components - Yield and Capital Gains.
- Yield - the income the investor receives while owning the investment
- Capital Gains - increases in the value of the investment itself, but are often not available to the owner until the investment is sold.
Investor preferences vary as which type of return they prefer, in which these preference influence their investment decisions. Some financial products are designed to only offer yield and no capital gains, vice versa, or somewhere in between.
There are also other factors which can increase activity in financial markets such as:
Lower Inflation - inflation erodes the value of financial assets and increases the value of physical assets, such as houses and machines. When inflation is high, firms typically avoid raising long-term capital because investors require a high return on investment, simply because price increases can render much of the return insignificant.
In a low inflation environment, financial market investors don’t require as high of an inflation premium, as they don’t expect general increase in prices to dampen their returns.
Stock and Bond Market Performance - increases in wealth can cascade on itself - investors whose portfolios have appreciate are willing and biased to reinvest some of their profits back into the financial markets. The appreciation of financial assets gives investors collateral to borrow additional money, which can also be reinvested.
Risk Management - there are financial products such as derivatives and asset-backed securities, whose basic purpose is to redistribute risks. There will always be products readily available in the market that will protect investors against events that can lower returns.
What are the key differences between Financial Markets?
Investors gravitate towards certain markets over others because of:
Liquidity - In an illiquid market, an investor may have difficulty finding another party willing to make the desired trade and the spread or difference between the price of which a security can be bought and the price it can be sold may be high. Trading is easier and spreads are narrower in more liquid markets.
Liquidity is the ease of which trading can be conducted
- Transparency - the availability of prompt and complete information about trades and prices. The less transparent the market, the less willing people are to trade there.
- Low Transaction Costs - participants will always gravitate towards places where trading costs, regulatory costs and taxes are reasonable.
This post is based on concepts from
Guide to Financial Markets: Why They Exist and How They Work by Marc Levinson, 7th Edition.