Principles of functioning of financial markets, how everything works

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An Introduction to the Financial Markets

Make Financial Markets Work for You

What are the financial markets? It can be confusing because they go by many terms. They include capital markets, Wall Street, and even simply “the markets.” Whatever you call them, financial markets are where traders buy and sell assets. These include stocks, bonds, derivatives, foreign exchange, and commodities. The markets are where businesses go to raise cash to grow. It’s where companies reduce risks and investors make money.

  • Financial markets create liquidity that allows businesses to grow and entrepreneurs to raise money for their ventures.
  • They reduce risk by having information publicly available to investors and traders.
  • These markets calm the economy by instilling confidence in investors.
  • Investor confidence stabilizes the economy.

Types of Financial Markets

Most people think about the stock market when talking about financial markets. They don’t realize there are many kinds that accomplish different goals. Markets exchange a variety of products to help raise liquidity. Each market relies on each other to create confidence in investors. The interconnectedness of these markets means when one suffers, other markets will react accordingly.

The Stock Market

This market is a series of exchanges where successful corporations go to raise large amounts of cash to expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker-dealers. The investors profit when companies increase their earnings. This keeps the U.S. economy growing. It’s easy to buy stocks, but it takes a lot of knowledge to buy stocks in the right company.

To a lot of people, the Dow is the stock market. The Dow is the nickname for the Dow Jones Industrial Average. The DJIA is just one way of tracking the performance of a group of stocks. There is also the Dow Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow and instead focus on the Standard & Poor’s 500 index or other indices to track the progress of the stock market. The stocks that make up these averages are traded on the world’s stock exchanges, two of which include the New York Stock Exchange (NYSE) and the Nasdaq.

The market depends on the perceptions, actions, and decisions of both buyers and sellers concerning the profitabilities of the companies being traded.

Mutual funds give you the ability to buy a lot of stocks at once. In a way, this makes them an easier tool to invest in than individual stocks. By reducing stock market volatility, they have also had a calming effect on the U.S. economy. Despite their benefits, you still need to learn how to select a good mutual fund.

The Bond Market

When organizations need to obtain very large loans, they go to the bond market. When stock prices go up, bond prices go down. There are many different types of bonds, including Treasury Bonds, corporate bonds, and municipal bonds. Bonds also provide some of the liquidity that keeps the U.S. economy functioning smoothly.  

It’s important to understand the relationship between Treasury bonds and Treasury bond yields. When Treasury bond values go down, the yields go up to compensate. When Treasury yields rise, so do mortgage interest rates. Even worse, when Treasury values decline, so does the value of the dollar. This makes import prices rise, which can trigger inflation.  

Treasury yields can also predict the future. For example, an inverted yield curve heralds a recession.

The Commodities Market

A commodity market is where companies offset their futures risks when buying or selling natural resources. Since the prices of things like oil, corn, and gold are so volatile, companies can lock in a known price today.   Since these exchanges are public, many investors also trade in commodities for profit only. For example, most investors have no intention of taking shipment of large quantities of pork bellies.

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Oil is the most important commodity in the U.S. economy. It is used for transportation, industrial products, plastics, heating, and electricity generation. When oil prices rise, you’ll see the effect in gas prices about a week later. If oil and gas prices stay high, you’ll see the impact on food prices in about six weeks.   The commodities futures market determines the price of oil.

Futures are a way to pay for something today that is delivered tomorrow. They increase a trader’s leverage by allowing him or her to borrow the money to purchase the commodity.

The futures market removes some of the volatility in the U.S. economy. It allows businesses to control the future costs of the critical commodities they use every day.

Leverage can create outsize gains if traders guess right. It also magnifies the losses if traders guess wrong. If enough traders guess wrong, it can have a huge impact on the U.S. economy, actually increasing overall volatility.

Another important commodity is gold. It’s bought as a hedge against inflation. Gold prices also go up when there is a lot of economic uncertainty in the world. In the past, every dollar could be traded in for its value in gold. When the U.S. went off the gold standard, it lost this relationship to money. Still, many people look at gold as a safer alternative to cash or currency.

Derivatives

Derivatives are complicated financial products that base their value on underlying assets.   Sophisticated investors and hedge funds use them to magnify their potential gains. In 2007, hedge funds increased in popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in futures, some argued they decreased the volatility of the stock market and, therefore, the U.S. economy. The hedge fund investments in subprime mortgages and other derivatives caused the 2008 global financial crisis.

Even before this, hedge funds had demonstrated their risky nature. In 1997, the world’s largest hedge fund at the time, Long Term Capital Management, practically brought down the U.S. economy.

Forex Trading

Forex trading is a decentralized global market in which currencies are bought and sold. About $6.6 trillion were traded per day in April 2020, and 88% involved the U.S. dollar. Almost one-fourth of the trades are done by banks for their customers to reduce the volatility of doing business overseas. Hedge funds are responsible for another 11%, and some of it is speculative.  

This market affects exchange rates and, thus, the value of the dollar and other currencies. Exchange rates work on the basis of demand and supply of a nation’s currency, as well as of that nation’s economic and financial stability.

Functions of Financial Markets

Financial markets create an open and regulated system for companies to acquire large amounts of capital.   This is done through the stock and bond markets. Markets also allow these businesses to offset risk. They do this with commodities, foreign exchange futures contracts, and other derivatives.

Since the markets are public, they provide an open and transparent way to set prices on everything traded. They reflect all available knowledge about everything traded. This reduces the cost of obtaining information because it’s already incorporated into the price.

The sheer size of the financial markets provides liquidity. In other words, sellers can unload assets whenever they need to raise cash. The size also reduces the cost of doing business. Companies don’t have to go far to find a buyer or someone willing to sell.

Financial System

What Is a Financial System?

A financial system is a set of institutions, such as banks, insurance companies, and stock exchanges, that permit the exchange of funds. Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and investors exchange current funds to finance projects, either for consumption or productive investments, and to pursue a return on their financial assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide which projects get financed, who finances projects, and terms of financial deals.

Key Takeaways

  • A financial system is the set of global, regional, or firm-specific institutions and practices used to facilitate the exchange of funds.
  • Financial systems can be organized using market principles, central planning, or a hybrid of both.
  • Institutions within a financial system include everything from banks to stock exchanges and government treasuries.

Understanding the Financial System

Like any other industry, the financial system can be organized using markets, central planning, or some mix of both.

Financial markets involve borrowers, lenders, and investors negotiating loans and other transactions. In these markets, the economic good traded on both sides is usually some form of money: current money (cash), claims on future money (credit), or claims on the future income potential or value of real assets (equity). These also include derivative instruments. Derivative instruments, such as commodity futures or stock options, are financial instruments that are dependent on an underlying real or financial asset’s performance. In financial markets, these are all traded among borrowers, lenders, and investors according to the normal laws of supply and demand.

In a centrally planned financial system (e.g., a single firm or a command economy), the financing of consumption and investment plans is not decided by counterparties in a transaction but directly by a manager or central planner. Which projects receive funds, whose projects receive funds, and who funds them is determined by the planner, whether that means a business manager or a party boss.

Most financial systems contain elements of both give-and-take markets and top-down central planning. For example, a business firm is a centrally planned financial system with respect to its internal financial decisions; however, it typically operates within a broader market interacting with external lenders and investors to carry out its long term plans.

At the same time, all modern financial markets operate within some kind of government regulatory framework that sets limits on what types of transactions are allowed. Financial systems are often strictly regulated because they directly influence decisions over real assets, economic performance, and consumer protection.

Financial Market Components

Multiple components make up the financial system at different levels. The firm’s financial system is the set of implemented procedures that track the financial activities of the company. Within a firm, the financial system encompasses all aspects of finances, including accounting measures, revenue and expense schedules, wages, and balance sheet verification.

On a regional scale, the financial system is the system that enables lenders and borrowers to exchange funds. Regional financial systems include banks and other institutions, such as securities exchanges and financial clearinghouses.

The global financial system is basically a broader regional system that encompasses all financial institutions, borrowers, and lenders within the global economy. In a global view, financial systems include the International Monetary Fund, central banks, government treasuries and monetary authorities, the World Bank, and major private international banks.

Top 10 Best Treasury Management Book

Top Best Treasury Management Book – Treasury management plays a central role in the smooth functioning of banks and financial institutions and involves several critical functions including working capital management, investment management, and risk management among others. Here we have presented a careful selection of titles on various aspects of treasury management, the broader framework in which treasury operations take place and the renewed role and responsibilities of a modern treasurer in the post-credit crunch era. These works should help students as well as finance professionals to grasp the fundamentals of treasury management and learn some of the key applications of principles along with available tools and techniques for the purpose.

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#1 – Treasury Management: The Practitioner’s Guide

by Steven M. Bragg (Author)

Book Review

This work covers several aspects of treasury management in-depth and offers a thoroughly practical treatment of the subject. The author discusses issues of central significance to treasury management including methods of cash flow, working capital management, investment management, financing, and risk management among other areas. The role of a treasurer is elaborated including how he raises debt and equity for financing needs of the company and invests funds while managing a variety of risks. This work is intended to help develop an understanding of the responsibilities of a treasurer along with the tools and techniques for fulfilling these responsibilities for efficient cash management and able handling of treasury systems. There is greater stress on the practical application of concepts instead of focusing on the theory of cash flow management and financing. A definitive guide on treasury management for professionals and anyone else interested in acquiring a detailed practical understanding of the field.

Best Takeaway from this top treasury management book

A practical guide for treasury management professionals which details the responsibilities of a treasurer and describes the tools and techniques necessary for carrying out tasks efficiently. The author deals at length with practical aspects of working capital management, financing and risk management among other related concepts. In short, a highly commendable work of practical significance on treasury management for professionals, amateurs and students alike.

#2 – Treasury Risk Management

by S.K. Bagchi (Author)

Book Review

This is a rather specialized work dealing with the changing dynamics in the modern global financial industry and how it is shaping the broader framework within which treasury risk management comes to play a key role in helping banks and financial institutions function efficiently. Several international banking regulatory accords, including Basel-1 and Basel-2, have been discussed by the author as part of an effort to incorporate changes in the broader operational framework of banking and financial institutions. Some of the key concepts covered in this work include the principles of Asset Liability Management (ALM), RBI guidelines on market risk management and managing the element of risk in mutual fund investments. On the whole, excellent work for academically interested and professionals to develop a detailed understanding of the international banking regulatory norms and the context in which treasury risk management functions in the modern global industry.

Best Takeaway from this best Treasury Management book

A complete overview of treasury risk management for professionals which offers a detailed treatment of the changes being effected in international banking regulatory norms in recent times. These regulatory norms and several newly developed guidelines have a decided impact on the theory and practice of treasury risk management, some of which have been outlined by the author in this work. An excellent practical treatise on the regulatory framework for banking and emerging risk practices in the renewed global context.

#3 – The Bond Book:

Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More

by Annette Thau (Author)

Book Review

This best book on Treasury delves at length on the evolution of the fixed income market in the post-2008 era and how one can make use of advanced strategies and techniques to invest with fixed income securities with confidence. With a specific focus on bond markets, the author discusses methods for identifying suitable investment opportunities in individual bonds and bond funds which can yield some of the finest returns with a carefully implemented strategy. Some of the types of instruments covered include closed-end funds, open-ended funds and Exchange-Traded-Funds (ETFs). The work details on how the changes in rating scales have helped shape the market for municipal bonds along with the relevance of bond insurance and Build America Bonds (BABs) in the current market scenario. The author also elaborates on how equities investors can effectively diversify their portfolios by investing in fixed income securities not only for higher security but higher returns as well.

Best Takeaway from this Top Treasury Management book

A definitive guide on bond-investing and fixed income securities market in the post-2008 era which details a number of tools and techniques for assessing and evaluating an entire gamut of fixed income instruments. The author demonstrates how fixed income instruments can be utilized for greater strategic advantage by equities investors as well when it comes to diversifying their portfolios as well as enhancing returns on the same. Offering a wealth of information on an entire range of fixed income instruments, this work makes for essential reading for any bond investor, professionals or students to gain an in-depth understanding of how fixed income markets operate.

#4 – Treasury’s War:

The Unleashing of a New Era of Financial Warfare

by Juan Zarate (Author)

Book Review

This best treasury book is a unique work in its own right, presenting an insider’s account of unprecedented financial warfare waged by the United State against its enemies. The author outlines how in an effort to isolate and target terrorist groups, rogue regimes and criminal syndicates, a small group of dedicated individuals in the US utilized its financial prowess and the strategic financial position to undermine potential foes. He stresses that it is the treasury that utilized the central position of the US dollar and the financial markets as some of the critical tools in this wholly new form of warfare. He goes on to describe in as simple terms as possible, how this novel financial warfare has slowly been integrated into the foreign policy and how it is set to change the shape of future warfare like never before.

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