Introduction to the Financial Markets

6 Lessons
6 Hours

Introduction to the Financial Markets

Welcome to Introduction to the Financial Markets! In this video, you will learn the following: trading, the Forex market, the equity market, the commodities market, and the derivatives market.

The Origins of Trading

The origins of trading date back to prehistoric times. It’s been there ever since man started painting symbols on cave walls and realized that in exchange for an arrowhead, he could get paint. Some 10,000 years B.C., exchanging cacao leaves for shiny stones was as common as selling cars for money today.

Since goods were first exchanged between people thousands of years ago, trading has been a great way of making profits. People started trading everything - real estate, cattle, sugar, cotton, gold, oil, food, clothes, weapons, technology, even art. Today, even trading money for money is possible! Anyone can do it online, at any time, and from anywhere. So basically, the financial market is the place where financial assets such as stocks, bonds, currencies and commodities are traded.

What is Trading?

Some people are motivated to trade because they expect to gain a profit on their investment – we call them speculators. Speculators try to anticipate price movements and trade to make a profit by buying low and selling high. Other people are motivated to trade in order to manage their risk - we call them hedgers. Hedgers trade in order to protect an asset they already have, like a farmer who sells his crop before harvest season. Besides trading to save, manage risk, and speculate, some people trade simply because they find it challenging.

Financial trading takes place either through a regulated centralized exchange or over the counter. “Exchange-traded” markets operate via a centralized exchange, such as a stock exchange or futures exchange like the New York stock exchange NYSE, the London stock exchange LSE, the Tokyo stock exchange TSE and many more around the world. Over the counter (OTC) markets are decentralized markets made up of networks of different dealers who compete to link buyers to sellers. In an over the counter market, dealers act as market makers by quoting prices at which they will buy and sell a security or currency.

In addition to being exchange traded or OTC, financial markets are also categorized based on the type of security traded such as (1) the foreign exchange (Forex) market, (2) the equity or stock market (3) the commodities market, (4) the bond or fixed income market, or (5) the derivatives market.

The foreign exchange (Forex) market is where you can buy and sell currencies like the Euro and the US Dollar. The equity or stock market is where you can buy and sell shares of companies such as Apple, Facebook, and Alibaba. The commodities market is where you can buy and sell commodities such as gold, oil, grains, sugar, and even frozen concentrated orange juice. The bonds or fixed income market is where you can lend money to governments or corporations. Lastly, the derivatives market is where you can trade financial contracts that obtain their value from an underlying asset like the above four.

The Forex Market

The foreign exchange (Forex) market is the financial market where currencies are traded or exchanged for the other. It is the biggest market in the world with an average volume exceeding 5 trillion dollars per day; and is open 24 hours a day, 5 days a week, from Monday to Friday. The foreign exchange market is an over the counter market used by Individuals, financial institutions, businesses, governments and other agencies.

Foreign exchange transactions occur because of international trade, tourism, borrowing and lending, and speculation. Today, most currencies are freely floating; and their price is determined based on the demand and supply of each currency

The Equity Market

The equity or shares market is where shares or stocks are traded. As its name implies, shares are financial assets that provide evidence of ownership in a company and hence, a share in its profits.

Shares of publicly listed companies like Apple and IBM are traded in a stock exchange like the New York Stock Exchange. If a company is currently profitable and is expected to make more profits in the future, the share price of that company will increase, as more people will want to own part of it. If a company is not currently profitable and is not expected to make profits in the future, its share price will decrease, as people will not want to own a part of it.

The Commodities Market

The commodities market is where raw materials, as opposed to manufactured goods, are traded. It is divided into 3 main sectors (1) agricultural commodities, (2) energy commodities, and (3) metal commodities.

Agricultural commodities include grains, food, and fiber like corn, soybeans and cotton. It also includes livestock and meat (like cattle). Energy commodities include crude oil, brent oil, ethanol, natural gas, and propane. Metal commodities include industrial metals like copper, lead, zinc, and of course, precious metals like gold and silver.

The Bond Market

The bond market or fixed income market is where investors and traders trade debt securities. It is the market where borrowers that have shortage of cash meet with investors that have surplus of cash. The main issuers of bonds are governments, semi-government institutions like municipalities, and corporations like IBM. Debt securities can be as simple as a bank loan, a government bond, a corporate bond, and other securities. When you buy a bond, you are lending the issuer money and they promise to pay you back in full with interest in the future. A city may sell bonds to raise money in order to build a bridge; while a company like American Airlines may issue bonds to buy new aircrafts.

Derivatives

A derivative is an instrument whose value depends on (or is derived from) the value of some other instrument called the underlying asset. For example, oil derivatives derive their value from the value of oil in the oil market. Derivatives are divided into two categories based on the asset they derive their value from including (1) commodity derivatives and (2) financial derivatives.

Commodity Derivatives
Commodity derivatives are based on commodities. For example, energy contracts derive their value from energy commodities like oil and gas. Financial derivatives are based on financial instruments. For example, stock and index contracts derive their value from the underlying stock or index.

There are several types of derivatives with the most common being (1) futures contracts, (2) options contracts, and (3) contracts for differences (CFDs).

Futures is a standardized contract to buy or sell an asset at a pre-determined price, at a specified date in the future. Options is a contract that gives the holder the right to buy (call option) or sell (put option) a security at a specified price. A CFD is a derivative contract used as a speculative tool against changes in the value of an underlying asset.

Financial Derivatives
Financial derivatives have many benefits such as margin trading, going long and short, with some being tax-exempt. Margin trading, however, as in all cases, can increase both profit potential and risk; so traders must use them wisely and always remember the most fundamental rule of investing – the higher the risk, the higher the return.

Recap!

Speculators

People who trade expecting profit off their investments

Hedgers

People who trade to protect their assets or manage their risk

Exchange traded markets

Centralized markets like stock markets such as the New York Stock Exchange (NYSE) (e.g. for shares/stocks, futures)

Over the counter (OTC) markets

Decentralized markets made up of networks of different dealers who compete to link buyers to seller (e.g. for securities, foreign currencies)

Foreign exchange (Forex) markets

Where currencies are traded or exchanged for the other (e.g. USD-EUR)

Equity (stock/share) markets

Where shares or stocks or publicly listed companies are traded (e.g. AAPL, IBM)

Commodities markets

Where raw materials are traded (e.g. agricultural commodities like corn, grains)

Bond (fixed income) markets

Where investors and traders trade debt securities (e.g. bank loan, corporate bond, government bond)

Derivatives

Instruments whose value depends on (or is derived from) the value of some other instrument (e.g. futures, options, CFDs, margin trading)

In our next video, we will talk about Forex. Thank you for watching!