Session 1 Introduction to financial markets: Stocks, bonds, commodities, derivatives
What is a financial market?
-A physical or digital marketplace where buyers and sellers trade assets like stocks, bonds, currencies, and derivatives. These platforms connect those needing capital (borrowers/issuers) with those having excess capital (investors), facilitating economic growth, liquidity, and risk management.
Key roles of financial market:
1. Facilitate saving by households and businesses
Financial markets give people and businesses a safe place to put their money and earn something extra over time instead of keeping cash at home.
Real-world example:
A household puts savings into a bank account or bonds and earns interest, while a company invests surplus cash in money market funds.
2. Enable lending to businesses and individuals
Financial markets connect people who have extra money with people who need money to spend, invest, or grow.
Real-world example:
Banks use customer deposits to provide loans to individuals buying homes or businesses expanding their operations.
3. Allocate funds to productive uses
Money flows to businesses and projects that are expected to perform well compared to the risks involved.
Real-world example:
Investors buy shares in a fast-growing technology company rather than a struggling firm because the potential return is higher for the risk taken.
4. Facilitate the exchange of goods and services
Financial markets make everyday payments fast, safe, and convenient.
Real-world example:
Using a contactless card, mobile payment app, or exchanging currencies when traveling abroad.
5. Provide forward markets for currencies and commodities
Forward markets allow businesses and investors to lock in prices today for transactions that will happen in the future, reducing uncertainty.
Real-world example:
An airline locks in future fuel prices to protect itself from sudden increases in oil prices.
6. Provide a market for equities
Stock markets allow companies to raise money by selling ownership shares to investors.
Real-world example:
A company lists on the stock exchange and issues shares to fund new factories, product development, or international expansion.
Types of Financial Markets:
1. Stock (Equity) Market
Stock markets are among the most well-known financial markets. They are venues where companies list their shares, which are then bought and sold by traders and investors. Stock markets—also called equity markets—allow companies to raise capital while giving investors opportunities to earn returns through capital appreciation (rising share prices) and dividends.
Stocks are traded on regulated exchanges such as the New York Stock Exchange (NYSE) and Nasdaq, as well as on over-the-counter (OTC) markets. Most stock trading takes place on regulated exchanges, which play a vital role in the economy by enabling money to flow efficiently between investors and businesses.
Typical participants in stock markets include:
1. Retail Investors
- Buy and sell stocks for personal investment.
- Example: John buys Apple stock for retirement.
2. Institutional Investors
- Manage large sums of money for clients or shareholders.
- Example: Vanguard & BlackRock manage mutual funds.
3. Traders
- Actively buy/sell stocks for short-term gains.
- Example: Sarah trades Tesla stock based on price movements.
4. Market Makers
- Provide liquidity by offering continuous buy/sell prices.
- Example: Citadel Securities ensures stock availability.
5. Specialists
- Oversee trading of specific stocks for liquidity.
- Example: A NYSE specialist manages IBM stock.
6. Brokers
- Facilitate trades between buyers and sellers.
- Example: Charles Schwab or Robinhood execute trades.
2. Over-the-Counter (OTC) Markets
Imagine there’s a new tech company called TechO, which has been doing really well. The company started small, but now it has a great product and is starting to get a lot of attention. TechO wants to raise more money to keep growing and let people invest in it. So, it decides to go public.
Step 1: TechO Goes Public (Becomes a Publicly Traded Company)
What Does "Publicly Traded" Mean?
TechO decides to issue shares (pieces of ownership in the company) to the public. This allows people like you and me to buy shares of the company and become part-owners.
This is called an Initial Public Offering (IPO), which is when a company sells shares to the public for the first time.
How It’s Different from Private Companies:
Before going public, TechO was a private company—meaning only a small group of people (like the founders, early investors, and employees) owned shares. After going public, anyone can buy shares of TechO on the open market.
Step 2: But TechO Is Too Small to Be Listed on the NYSE or Nasdaq
What Are NYSE and Nasdaq?
These are the big stock exchanges where large, established companies like Apple and Microsoft trade their shares. These exchanges have strict rules for companies to be listed, like having a big market value and meeting certain financial requirements.
TechO Is Not Big Enough Yet:
TechO’s market value (the total value of all its shares) is growing, but it’s still a small company—let’s say it has a market value of $30 million. For a company to be listed on the Nasdaq, it typically needs to be worth at least $50 million.
TechO isn’t big enough yet, so it can’t be listed on the major exchanges (like the NYSE or Nasdaq). But it’s still public because it issued shares, and people can trade them.
Step 3: TechO Trades on the OTC Market
What Is the OTC Market?
Since TechO is too small for the big exchanges, its shares trade on a smaller, less regulated market called the Over-the-Counter (OTC) market.
The OTC market is decentralized, meaning there’s no central exchange like the NYSE. Instead, buyers and sellers trade shares directly through brokers or dealers.
OTC vs. Stock Exchange:
On the NYSE or Nasdaq, there are lots of buyers and sellers, and prices are transparent. But on the OTC market, there may be fewer buyers, so it might be harder to sell shares quickly or at a good price.
Step 4: TechO Continues to Grow and Get Bigger
Over time, TechO grows in size and becomes more successful. Its market value rises as it continues to make profits, gain customers, and expand its product line.
Eventually, TechO reaches the point where it’s big enough to meet the requirements to be listed on the Nasdaq or NYSE. Now, it can move from the OTC market to a major stock exchange!
Key Points to Remember:
Publicly Traded: When a company goes public, it means they sell shares to the public, and those shares can be bought and sold. TechO is publicly traded even though it's not on a major exchange yet.
OTC Market: Since TechO is still growing and not big enough for a major exchange, its shares trade on the OTC market. The OTC market is a place where shares of smaller companies or companies that don’t meet the big exchange rules can still trade.
Big Exchanges (like NYSE or Nasdaq): For larger and more established companies, these exchanges are the main platforms for trading. However, a company needs to meet specific criteria like market cap, revenue, and number of shareholders to be listed on them.
Advantages of OTC: Trading on the OTC market can make it easier for a company to go public without meeting the big exchange requirements, but it also means less liquidity and more risk because there might be fewer buyers and sellers, and prices may not be as transparent.
Growth Path: As TechO grows, it may graduate from the OTC market to a major exchange, which can help increase its visibility and attract more investors.
Simple Visual Recap:
Private Company → Issues Shares (Goes Public) → Publicly Traded
Publicly Traded but OTC → Not Big Enough for Major Exchange → Trades on OTC Markets
Growth → TechO Grows → Moves to Nasdaq/NYSE when Ready
3. Bond (Debt/ Credit market/ Fixed-income) Market
A bond is a debt security issued by an entity to raise funds. When an investor buys a bond, they are effectively lending money to the issuer in exchange for regular interest payments and the repayment of the original amount (principal) at maturity.
Bonds are issued by corporations, municipalities, states, and sovereign governments to finance projects and day-to-day operations. For example, the U.S. government issues Treasury bills, notes, and bonds to fund public spending.
The bond market is also known as the debt market, credit market, or fixed-income market, reflecting the predictable income bonds typically provide.
4. Commodities Market
Commodities markets bring together producers and consumers to trade physical goods. Most people imagine commodities trading as buying physical goods like oil or wheat. In reality, most traders never touch the physical commodity. Instead, they trade financial instruments that track commodity prices. There are five main ways to trade commodities, and they are arranged from the simper ones to the more complex ones down below:
1. Commodity Exchange-Traded Funds (ETFs)
An Exchange-Traded Fund (ETF) is a financial product that tracks the price of a commodity or a group of commodities and trades on a stock exchange like a regular share. Instead of trading contracts, you simply buy and sell the ETF.
Example:
You buy a gold Exchange-Traded Fund that tracks gold prices.
If gold prices rise, the value of the ETF increases.
You sell the ETF at a higher price and make a profit.
Commodity ETFs are widely considered the most beginner-friendly way to gain exposure to commodities.
2. Commodity Contracts for Difference (CFDs)
A Contract for Difference (CFD) is a financial instrument that allows traders to speculate on the price movement of a commodity without owning it. With CFDs, you profit if the price moves in your favor, whether it goes up or down.
Example
Oil is priced at $80 per barrel.
You expect oil prices to rise.
You buy an oil CFD.
Oil rises to $85.
You close the trade and profit from the $5 price move.
Commodity CFDs are popular with retail traders because they are simple to use and require less capital. However, they often involve leverage, which increases both gains and losses.
3. Commodity Futures Trading
A futures contract is a legal agreement to buy or sell a commodity at a fixed price on a future date.When traders use futures, they are trading the contract, not the physical commodity itself. Most futures trades are closed before the delivery date, so no physical delivery takes place.
Example
Gold is trading at $2,000 per ounce.
You believe gold prices will rise.
You buy a gold futures contract.
Gold rises to $2,050.
You sell the contract and make a profit from the price increase.
Commodity futures are traded on regulated exchanges such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) through specialized futures brokers.
4. Commodity Options Trading
A commodity option is a contract that gives the buyer the right, but not the obligation, to buy or sell a commodity at a specific price before a certain date. Options are often used for hedging risk or for advanced trading strategies.
Example
Gold is trading at $2,000 per ounce.
You buy a gold call option that gives you the right to buy gold at $2,000.
If gold rises to $2,100, the option increases in value.
You sell the option for a profit without buying physical gold.
Options can also expire worthless if the price does not move as expected, limiting losses to the cost of the option.
5. Trading Physical Commodities
Trading physical commodities involves buying and selling the actual goods, such as oil, wheat, or metals. This is mainly done by producers and businesses, not retail traders.
Example
A farmer sells wheat to a food manufacturer.
An airline buys fuel from an energy supplier.
This method is not practical for most traders
What Moves Commodity Prices?
Commodity prices are driven mainly by supply and demand, rather than company performance.
Common price drivers include:
Weather conditions (agriculture)
Geopolitical events (oil and gas)
Inflation
Strength of the U.S. dollar
Economic data and global growth
Example
A drought reduces wheat supply → wheat prices rise.
Conflict in an oil-producing region → oil prices spike.
5. Derivatives Market
Financial markets are interconnected, and derivatives markets play a critical role in linking them. Derivatives markets are built on top of other markets, such as stocks, bonds, commodities, and currencies, and their value depends on the performance of these underlying assets. Derivatives are contracts whose value is derived from an underlying asset, such as a stock, bond, commodity, currency, interest rate, or market index. Instead of trading the underlying asset directly, participants trade instruments such as futures, options, and forwards, which reflect expectations about future price movements in the underlying markets.
Derivatives markets react quickly to changes in underlying markets, often moving before the actual asset prices, which makes them an early signal system. This happens because derivatives allow traders to control large positions with relatively little capital, enabling faster and bigger trades. They are also forward-looking, reflecting expectations of future price changes rather than just current market conditions.
Derivatives also enable risk transfer. Market participants exposed to price fluctuations can hedge their positions, transferring risk to others willing to take it on. This interconnection ensures that risk, capital, and information flow efficiently across financial markets.
Some derivatives are traded on organized exchanges, where contracts are standardized and prices are transparent. Others are traded over the counter (OTC) through private agreements, allowing for customization but less transparency. Together, exchange-traded and OTC derivatives strengthen the interconnectivity of global markets.