A Basic Understanding of Financial Instruments

This introduction is by no means a quantitative one. It has been designed as an introductory and intuitive primer to understand the financial markets with specific focus on the traded financial instruments. I will begin by shedding light on this topic as a whole using the socratic method. Enjoy!

A Series of Preliminary Questions

What is trade? It is an exchange of goods and services. In our case, It is an exchange of assets.

Trade involves two actions that must occur: Buying and selling. They can occur together at the same time or one can precede the other. Nevertheless they ultimately must both occur to be called a trade.

Buying is the act of obtaining x in exchange for payment y. Whilst selling is the act of obtaining y in exchange for payment x.

Each party sits at the opposite side of a trade requires what the other party has.

What is a market? It is the gathering of individuals/entities to exchange goods and services; assets.

Now we can begin to ask:

What is financial trading? It is the buying and selling of financial instruments.

What are financial instruments?

Financial instruments fall into these six main categories:

Shares
Bonds
Indices
Forex
Commodities
Derivatives

What are financial markets? Where buyers and sellers gather to trade specific financial instruments.

How do financial traders differ from regular traders? They trade to profit from fluctuations in price and generally do not hold the assets in trade.

Why are markets regulated? To reduce fraud, keep transaction costs low and improve efficiency.

Investors focus on the long-term value of assets while active traders (speculation) focus on short-term market movements.

Now fundamentally, what is money?

It is a means for exchanging goods and services. (Refer back to- Can be a payment x or y)

For example: USD, Gold, KWD, etc.

Money has four important properties:

Divisible: can be broken down into smaller amounts
Durable: stands the test of time
Fungible: commoditization
Verifiable: check if it’s real

1) Shares

What is a share? It is a unit of ownership in a company. As the share price fluctuates, so does the value of the company. Investors who buy shares in a company, hope that their shares will grow in value, enabling them to sell their shares at a higher price than the one they bought at.

The company and shareholders are extremely reliant on each other. Company requires shareholders for funding whilst the shareholders hope the company will use their investments to grow and add value to their shares.

Volatility is the amount a share fluctuates. It is fundamentally governed by supply and demand. If demand for the share is greater than the supply of shares then the price increases (scarcity). If the supply of the share is greater than the demand for the share then the price decreases.

Supply and demand are influenced by:

1) Earnings

These are the profits a business makes.
If actual earnings are better than expected, price rises
If actual earnings are less than expected, price falls
Companies release earnings either in quarter, half or full year.
Share price are sensitive and volatile immediately before and after the announcement of earnings
Use economic calendar to follow your company’s earnings results

2) Sentiment

Share prices react strongly to expectations of the company’s future performance.
Sentiment comes from: upcoming industry legislation, public faith in management, or health of the economy.

Prices of shares/equities fluctuate based on public opinion. However company statistics will influence the perceived value of the stock.

A stock market is a global network of specific exchanges where shares are bought and sold. Eg. LSE, NYSE, NASDAQ — — — Highly regulated, where buyers and sellers gather to negotiate transaction of shares. Only qualified individuals can physically trade on the exchange, so investors/traders require a stockbroker to act as a middleman.

Most brokers are online now.

Brokers make money from three primary ways:

Commission and fees
Take the opposite position of many amateur investors
Services (including snd not limited to advisory services)

There are three main types of brokers:

Full-service: create and execute a strategy based on client goals and trade on their behalf. HIGH COMMISSION
Advisory: Provide investment advice and recommendations, the final decision is the clients. MEDIUM COMMISSION
Execution-only: Client does all the work via online platform. No advice given. LOW COMMISSION

Trading times:

Shares are only traded during the opening hours of their designated stock exchanges.

What is a dividend? It is an amount of money paid to shareholders, representing a portion of the company’s profits.

Dividends compensate for lack of movement in share price and help motivate shareholders to hold their shares.

Companies that are expanding rapidly usually don’t give out dividends, choosing to reinvest profits back into the business.

How does a company end up on an exchange?

Initially it is a private company looking for funding. One of the ways is to be a publicly traded company on an exchange. To do so, a company must first issue out a decided number of shares in return for capital, this is called an Initial Public Offering (IPO). Once the shares hit the secondary market where constant buying and selling occurs, none of the actually transactions affect the company. After that if the company needs to re-issue shares to gain more capital it’s called Follow-on Public Offer (FPO).

2) Bonds

This image depicts a yield curve for bonds of various coupon rates

What is a bond? It is a debt security. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. Bonds and the methodology of pricing them is very mathematical, hence they are a very important topic of interest in quantiative finance.

With bonds, individuals can offer loans to either corporate or government entities (the issuer) for relatively safe and secure returns.

In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it “matures” or comes due after a set period of time.

Reasons governments and corporations seek bonds over bank loans:

Bank loans have higher interest rates
Bank loans are conditional whilst bonds have no strings attached.
Bonds don’t require the initial investment to be returned.
Are a safe, reliable, and predictable income stream
Bonds can be used to hedge risk

The payback date for a bond is called the maturity date. The interest rate for a bond is called the coupon rate.

Types of bonds:

Corporate bonds: issued by companies
US Treasury bonds: issued by the US government
Municipal bonds: issued by local municipalities, states, etc.
Investment-grade: have a higher credit rating, implying less credit risk than high-yield corporate bonds
High-yield: have a lower credit rating, implying a higher credit risk than investment-grade bonds, and do offer a higher interest rate for the increased risk.

Risks of bonds:

Credit risk: issued may default on making interest or principal payments
Interest rate risk: changes in interest rate can cause changes in bond value
Inflation risk: inflation reduces the purchasing power which is a risk for investors receiving fixed-rate of interest
Liquidity risk: investors might not find a market for the bond, making it difficult to buy or sell
Call risk: the possibility that the issuer retires a bond before it matures, something an issuer might do if the interest rate declines.

3) Indices

A stock index is a measurement of value of a certain section of the stock market.

This “certain section of the stock market” can be:

An exchange (eg NASDAQ, Tokyo Stock Exchange)
A region (such as Europe or Asia)
Or a sector (energy, electronics, property etc.)

E.g. FTSE100 is a number representing the largest 100 companies traded in the LSE.

US Markets: Dow Jones, NASDAQ, S&P

Euro Markets: DAX (Germany), CAC (France)

Asia-Pacific Markets: Hang Seng (Hong Kong), Nikkei (Japan), ASX (Australia)

Stock indices give traders and investors an indication of how an exchange, region, or sector is performing.

How are Indices calculated?

There are two ways:

A) Capitalization-weighted system

Takes each company’s size into account
How? We can tell how each company is worth by multiplying its share price by the number of shares issued. This is called Market Capitalization.
Eg of indices using this method: FTSE 100, S&P 500, NASDAQ 100, Hang Seng

B) Price weighted system

Based on actual share price
The higher the share price the higher the influence it has on the value of the index.
Eg of indices using this method: Dow Jones Industrial Average, Nikkei 225

How are indices traded?

You can’t. Because they are effectively just numbers- averages. So in order to trade on the value of indices we must choose a product that mirrors its performance.

Main products that mirror indices performance:

Index fund: is a specialized investment fund that attempts to replicate the movements of a particular stock index.
Exchange-Traded fund (ETF): is a distinct type of index fund that can be traded like a stock on an exchange. Like stocks, their prices can move during the day. Biggest ETF is SPDR S&P 500 which tracks the S&P 500
Derivatives: are financial Products that derive their price from the performance of an underlying instrument/asset. Eg. Futures, Options, digital 100s, or Contracts For Difference (CFDs)

4) Forex

Forex is how individuals and businesses convert one currency to another.

It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.

Who trades forex? Everyone! Eg. Individual speculators trying to make a small profit from fluctuations, central banks trying to control the amount of currency in circulation, or mainly: major international banks.

Major international banks control over 50% of globe forex trade. And they are:

The two major reasons people trade forex:

1) Speculation:

Trade with no intent on taking delivery of currency
Looking to turn a profit on movements in the market
Consistently the most volatile markets in the world
So provides more opportunities to make money

2) Purchasing goods or services in another currency:

Transaction between two entities in different regions
Currency traded is small compared to speculation trading
So not much influence in short-term market rates

How do you trade forex? OTC. Over-The-Counter, which means currencies are exchanged directly between two parties rather than in an exchange.

The forex market is run by a global network of banks- has no central location- which means one can trade it anywhere and it is traded 24/7.

When trading forex you are simultaneously buying one currency and selling another. So they are traded in “pairs”.

Each currency is known by short names (a three letter code where the first two indicate the country and the last letter indicates the currency).

For example:

USD: United States Dollar
KWD: Kuwaiti Dinar
JPY: Japanese Yen
AUD: Australian Dollar

Currency pairs are interesting structures that show the currency you are buying vs the currency you are selling.

You are buying Currency1 and selling Currency2. Isn’t that the definition of trade? Buying x for payment y?

An example of a currency pair is: EUR/USD = 1.1334

It means one unit of euro ie. One euro is worth 1.13340 US dollars

You buy it if you think the euro will strengthen against the dollar, going long. You sell it if you think the euro will weaken against the dollar, going short.

Because currency movements are small, and so occur in the fourth decimal place.

Back to our example EUR/USD = 1.13340 yesterday, moved to 1.13350 today. It moved 0.0001. An easier way to convey this information is by calling the fourth decimal place a pip. So the value change was 0.0001 which is 1 pip.

For most major currency pairs, a pip represents a one digit move in the fourth decimal place.

DISCLAIMER: an exception to this definition of a pip is when the JPY is the quote (counter). Here a pip is defined as the second decimal place.

Each one-pip movement in a forex price is only worth a small amount. So to take advantage of these small changes in value, forex is traditionally traded in large batches called lots.

Because small investors do not have access to such large amounts of money, many brokers allow their clients to trade on leverage.

Leverage means you can open a large market position with a relatively small deposit- called a margin. We will later cover more on Leverage.

Examples of Major, Minor, and Exotic currency pairs.

What are the factors affecting forex prices?

In general terms, the stronger the economy of a country, the stronger its currency will be compared to other currencies.

So the factors affecting forex prices are mainly the same factors affecting a country’s economy.

Factors affecting a country’s economy include:

Interest rates
Inflation rates
Government policy
Demand for imports and exports
Economic statistics such as a country’s growth figures, unemployment levels, and manufacturing data.

Economic announcements include:

GDP
Employment
Retail sales
Consumer price index
Quantitative easing
Non-farm payrolls
Federal reserves meetings

You can track economic announcements by following an economic calendar. An economic calendar shows you when each indicator/report will be announced by an official entity. Trading times during economic announcements are very volatile.

5) Commodities

What are commodities? They are physical assets. They are raw materials mined, farmed or extracted from the earth. Some examples include:

Gold
Oil
Wheat
Cattle

To be officially tradable, a commodity must be entirely interchangeable with another commodity of the same type, no matter where it was produced, mined, or farmed.

This is called Fungible (recall this term from the first part). Which ensures that a trader can be confident that they are buying/selling equivalent assets without needing to inspect them or find out where or how they were produced.

There are two categories of commodities:

A) Soft commodities

Are agricultural commodities; they are farmed.
Very volatile in the short term
Susceptible to seasonal growing cycles, weather, and spoilage — can suddenly dramatically affect prices.

B) Hard commodities

Are mined from the ground or taken from other natural resources
Easier to handle and transport
Easily interpreted into the industrial process

They can also be classified according to ecological sector:

Energy (oil and gas)
Metal (gold, silver, copper, lead, etc.)
Agriculture (wheat, coffee, livestock, etc)

How can we trade commodities?

There are two main ways:

1) The spot market

Financial assets are sold for cash and exchanged right there and then
Used if immediate delivery is needed

2) The futures market

Where buyers and sellers agree to exchange a specific quantity of an asset at a fixed date in the future, at a price agreed today.
The assets are not the things being traded, it is the futures contracts for the assets that are being traded.
It enables traders to speculate on the price of commodities without having to own them at any point, because the contracts can be sold or closed before the actual delivery date.
Predominantly used for speculation and hedging
Prices for futures contracts differ from the price of the commodity on the spot market because the seller needs to take into account the future risks and costs, such as the cost of holding the commodity and transporting it to the buyer. Hence futures prices are valued using forward prices, rather than spot prices.

Who trades commodity futures?

A) Producers

Companies/individuals that produce or extract commodities
Enter into future contracts to offset the risk of future price movements

B) Speculators

Traders looking to solely profit on commodity price movements
Have no intention nor interest of owning the commodity

C) Hedgers

Mid to long term investors who hold commodities in their portfolio to provide protection against downward movements in other securities.
Commodities tend to move in an unconnected direction to certain stocks and bonds.
Gold for example is a safe haven and receives significant investments when equities are unstable.

D) Brokers

Firms/Individuals who buy and sell commodity contracts on behalf of their clients

Example of exchanges specializing in a particular type of commodity:

Contract size?

Commodity futures are traded in contracts. Contract size tends to be large as commodities are generally traded in large quantities.

Small investors tend to use leverage to trade large amounts of commodity futures contract.

Exchanges or brokers may offer mini contract sizes.

What are the factors affecting commodity prices?

1) The weather:

Agricultural commodities are extremely dependent on weather as it affects harvest. Poor harvest will result in poor supply causing prices to rise.

2) Economic and political factors

Events such as war and conflict can have a big effect on prices.

3) The US dollar

Commodities are normally priced in USD so any fluctuations in USD means inverse fluctuations in commodity prices
For example if the dollar increase then one can buy more of the same amount of commodity.

6) Derivatives

What is a derivative? It is a financial instrument whose value depends on (derives its value from) the value of (other more basic) its underlying asset. Derivatives are a very important topic of interest in quantiative finance.

There are three main types (some other types can be made by mixing them together):

Swaps
Options
Futures

Generally, the variables underlying derivatives are the prices of traded assets.

Derivatives can be dependent on almost any variables.

Use of derivative instruments:

1) Risk management

Hedging (eg farmer with corn forward)

2) Speculation

Essentially making bets on the price of something

3) Reduced transaction costs

Sometimes cheaper than manipulating cash portfolio

4) Regulatory arbitrage

Tax loopholes, etc

The three main players in the derivative market:

1) Hedgers

Hedgers use derivative markets to manage or reduce risk
They are typically businesses that use derivatives to offset exposure resulting from their activities

2) Arbitrageurs

Arbitrage is a process of trying to take advantage of price differentials between markets
Arbitrageurs closely follow quoted price of the same asset/instruments in different market looking for price divergence
Should the market be divergent enough to make a profit, they would buy on the market with a lower price and sell on the market when the quoted price is higher
Most financial markets are integrated by computer networks, arbitrage opportunities can quickly disappear, hence quick action is needed

3 )Speculators

Take position in assets or markets without taking offsetting position
Eg. If they expect a certain asset to fall in value, they would short the asset. Should their expectation come true they would make a profit from having shorted the asset.
Hope profit from taking risk.

Types of derivatives (based on where and how they are traded):

A) Exchange-Traded (ETD)

Contracts that are traded on derivative exchanges
Contracts traded are standardized as defined by the exchange
Derivative exchange acts as a counter-party to all contracts.

B) Over-The-Counter (OTC)

Contracts that are privately negotiated and traded directly between two parties
OTC market is the largest market for derivatives

The Successive evolutionary chain of derivative markets/instruments (how derivatives formed):

Derivatives are a result of financial innovation. Innovation that responded to the existing need to help manage risk.

Forward contracts were originally innovated for risk-management of agro-based products (protecting crop prices by entering into forward contracts), the later instruments were needed as risk environments changed (businesses with business abroad use them to protect themselves against the volatility of the forex marke as they convert the currency of foreign currency to their local currency).

Each step down the successive evolutionary chain added value:

A) Forward contracts to Future contacts:

Reduced liquidity risk
Reduced counterparty risk
Avoid price squeeze etc.

B) Future contracts to options:

Managing contingent claims/liabilities
Increased flexibility
Ability to take advantage of favorable price movements (unlike lock-in)

The objective of all these innovations is risk management.

What is risk?

Risk is the uncertainties associated with returns from an investment.

Such as:

Volatility or fluctuations of returns from an investment, measured by standard deviation.

There are two kinds of risk management:

Forward contracts:

Is a contract between two parties for one party to buy from the other at a later date at a price agreed upon today.
It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today.
Usually traded in the OTC market, usually between two financial institutions or between a financial institution and one of its clients.
Function in financial operation is to hedge risks as a means of speculation, or allow a party to take advantage of the quality of the underlying instrument/asset which is time sensitive. (Eg. Afro-Products which can spoil).
Both parties (buyer & seller) eliminate the price risk by “locking-in” the price at which they would carry out the transaction at the future date.

Future contracts:

Is an agreement between two parties to buy or sell an asset at a certain time in the future for a specified price.
Unlike forward contracts, futures contracts are normally traded on an exchange.
To make trading possible, the exchange specifies certain standardized features of the contract.

Options:

Is a financial instrument that conveys the right, but not an obligation, to engage in a future transaction on some underlying securities, or in futures contracts.
Options are traded both on exchanges and in the OTC market

There are two types of options:

Call option: gives the holder the right to buy the underlying asset by a certain date for a certain price.
Put option: gives the holder the right to sell the underlying asset by a certain date for a certain price.

The price in the contract is known as the exercise price or strike price.
The date in the contract is known as the expiration date or maturity.

Swaps & Other Derivatives:

Is a bilateral contract where the parties agree to exchange a series of cash flows at fixed periodic intervals based on the underlying asset.

Features of Swap:

Exclusively OTC
Other types of derivatives include swaptions and hybrids
Their creation is a process called financial engineering

The underlying asset:

Is called the underlying
A derivative derived its value from the underlying

Five generic types of swaps:

Interest rates swaps
Currency swaps
Credit swaps
Commodity swaps
Equity swaps

With this we conclude our basic introduction to financial instruments. I hope you found it useful. My goal was to make it as insightful as possible without over complicating with unnecessary jargon.