Financial Markets Primer
Asking what the market did today is a common question, but in this case the market is really referencing a single equity index, which is usually the S&P 500. While the S&P 500 is a significant index it is only a single index within an economy that has multiple markets, and each market operates in different ways. A market, by definition, is a trading place where a buyer and seller exchange goods and services, and it could be a physical market or an online market. Because the definition is so broad, the balance of this article addresses financial markets: equity markets, debt markets, derivative markets and money markets.
Equity Markets
Raising Capital
There are two basic ways for a corporation to raise money, equity or debt financing. A major difference between these two forms of financing is that bondholders do not have an ownership interest in the corporation and no influence on its management. In contrast, equity securities represent an ownership interest in the corporation, and the main financial benefit of equity is that shareholders can benefit, if a company prospers, by receiving cash or stock dividends and increase in the value of their shares.
However, if a corporation must liquidate, it must pay creditors and owners in a priority order, where owners are last. The order of liquidation is: Secured creditors, administrative expenses like taxes, Unsecured creditors, Subordinated creditors, Preferred shareholders, and Common shareholders.
Common and Preferred Shares
Common shares are the basic unit of ownership and the most widely issued form of stock. Common shares are usually issued with a par value which is a nominal amount used on the firm’s financial statement. At the time of incorporation, a firm is authorized to issue a certain number of shares and this number can only be changed by a majority vote of the shareholders and by revising the corporate charter. Most firms issue fewer shares then authorized. Treasury stock refers to when stock is issued but then repurchased by the company, and lastly (Issued Stock less Treasury Stock equals Outstanding Stock). It's Outstanding stock that receives dividends and has voting rights.
Preferred shares, unlike common shares, usually have no voting rights. Preferred shares are typically sold to investors who are more concerned with income then capital appreciation. Cumulative preferred shares are those shares where if a company chooses not to pay dividends, the preferred shares dividends in arrears must be paid before the corporation can pay the common shares dividends. Non-cumulative preferred do not have the right to payment in arrears, and convertible preferred shares have the right, at their discretion, to convert at par value of the preferred into a predetermined number of common shares at a specific price, which is the conversion price.
Exchange and Non-Exchange Securities
Securities that trade on either the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automation Quotation (NASDAQ) are referred to as listed securities. NYSE assigns every security one designated market maker to be responsible for the security’s fair and orderly trading. In contrast, NASDAQ securities can have multiple market makers. An Over the Counter (OTC) is generally considered any security that is not listed on either the NYSE or NASDAQ. The SEC has adopted several rules pertaining to the solicitation and sale of low-priced OTC securities.
Types of Orders
Market orders are the most basic type of order. A market order will be executed at the best available price when the order is entered. Market orders are typically used for very liquid securities that have narrow spreads since securities at a specific e they are not assured of a specific execution price. In contrast, limit orders are used when investors want to buy or sell securities at a specific price. A limit order can only be executed at the specified price or better. A buy limit can be executed at the limit price or lower, whereas a sell limit order can only be executed at the limit price or higher.
Stop orders (also referred to as Stop Loss Orders) are usually entered when an investor is trying to prevent a large loss or trying to protect a profit on an underlying stock position. A stop order is a contingent order in that it won’t be executed unless the market rises or falls to a certain price. A sell stop order is placed below the current market price of the security and is used to limit a loss or protect a profit on a long stock position. A buy stop order is placed above the current market price of the security and is used to limit a loss or protect a profit on a short sale.
A stop-limit order is like a stop order in that if the market trades at or through the preset stop price, the order will be activated. But once activated a stop-limit order becomes a limit order and may only be executed at a specific price or better.
Debt Markets
Raising Capital
The other way for a corporation to raise money is debt financing. When a corporation sells bonds (debt), it’s borrowing money from the investors who buy the bonds. These funds are borrowed for a preset period at an interest rate paid over the life of the line. Bondholders have no ownership interest, and their returns are limited to the interest the corporation pays to borrow the money, and the holders of the bonds assume credit risk.
Bond Characteristics
The amount of money an issuer agrees to pay a bondholder when the bond matures is call the par value, principal or face amount. Most bonds are issued with a par value of $1,000, and a bond’s price is typically stated as a percentage of its par value.
A bond is trading at a discount if it’s priced below par value. In contrast, a bond is trading at a premium if it’s priced above par. The maturity date of a bond is simply the date upon which principal is returned to the bondholder. Lastly, the coupon rate is the interest a bondholder will receive from the issuer.
In comparison to stocks, bonds have two primary advantages. Bonds are usually considered safer than stocks because bonds are paid before common shareholders in the case of bankruptcy. Second, bonds provide investors a more predictable stream of income. On the flip side, when choosing bonds over stocks investors should be aware that bonds don’t offer the same potential for capital appreciation, and bonds don’t provide significant protection from inflation.
Bond Yields
A bond has several yields:
Nominal yield is the same as its coupon rate.
Current yield, unlike nominal, is based on the current market price (Current Yield = Annual Interest / Current Market Price).
Yield to maturity considers the bond’s regular interest payment plus the difference between what the bondholder paid for the bond and what the bondholder receives when the bond matures (par value). A bondholder who purchases a bond at a discount will have a profit since the holder paid less than the face value for the bond. Conversely, a bond purchased at a premium would result in a loss since the holder paid more than face value.
Types of Bonds
Credit spread refers to the difference in yields between various types of bonds and US Treasury securities that have similar maturities. Since corporate bonds have higher default risk they require a risk premium of US Treasuries.
Callable Bonds allow an issuer to redeem (call) their bonds prior to maturity.
Deferred Interest Bonds are sold at a discount and interest is accrued to face value. Deferred interest bonds (also called zero-coupon) do not pay interim interest payments.
Convertible Bonds allows an investor to convert the par value of the bond into a predetermined number of shares of the company’s stock If bonds are converted the debt becomes equity and the firm’s capital structure is altered.
Secured Bonds provided holders with additional protection because they are secured by assets of the issuer.
Unsecured Bonds have no additional protection and no claim on a firm’s assets.
Collateralized Mortgage Obligations (CMOs) are bonds that are paid from the proceeds from an underlying pool of mortgages. CMOs are sold in various classes referred to as tranches, and each tranche has a different interest rate, repayment schedule, and payment priority level.
Asset Backed Securities are a type of security that’s collateralized by an underlying pool of assets, including home equity loans, car loans, student loans, and credit card receivables.
Structured Products are securities that are created to fit the specific needs of a customer. These products are bonds but can be structured to where returns are tied to equities or that their payout is more like an option or swap contract.
Bonds also include the various US Treasuries, states and municipalities.
Derivative Markets
A derivative is a financial instrument whose value is based on the value and characteristics of an underlying security or index. Derivatives are created instruments, unlike stock and bonds which are issued by a company. The list of derivatives is extensive and growing, this section will be limited to swaps, options, futures and forwards.
Swaps
A swap is a derivative in which two investors agree to exchange cash flows based on different financial instruments. For example, with an interest rate swap one party pays a fixed interest rate but receives a variable interest rate. The counterparty agrees the the exact opposite. Swaps are settled on a net basis, so payments are based on the difference between the fixed and floating interest rates. Swaps can be created for interest rates, foreign currencies, commodities, stock prices, and bond defaults.
Options
Options are contracts between two parties that gives the buyer of the contract the right, and the seller of the contract the obligation, to buy or sell a security at a specific price for a limited period. The buyer of an option contract pays the option’s premium to have the right to exercise the option under its stated terms. The other party, the seller of the option contract grants the owner the right to exercise the contract. The seller (also called the writer) is required to fulfill the obligation to buy or sell the underlying security of the owner decides to exercise the contract. Options can be over the counter or through one of the options exchanges.
There are two basic options:
Call options give the owner the right to exercise the contract and buy the underlying security at a specified price (the strike price), and the seller (writer) has the obligation to sell the security at the preset price.
Put options give the owner the right to exercise the contract and sell the underlying security at a specified price (the strike price), and the seller (writer) has the obligation to buy the security at the preset price.
All exchange listed options have the following components: the name of the underlying security, the expiration month, the exercise (strike) price, the type of option, and the premium.
The option premium is the amount the option buyer pays for the contract, and it is made up of two components: intrinsic value and time value. Intrinsic value is the amount by which the option is in-the-money, while time value is the portion of the option’s premium that exceeds the intrinsic value.
There is much more to options that goes beyond this primer, but the below summarizes the basic call and put strategies.
Call Buyer
Buyer thinks the share price will rise above the strike price
Wants the share to rise above the strike price and the amount of premium paid for the contract
Bullish
Call Seller
Seller thinks the share price will decline and stay below the strike price
Wants to pocket the premium without the contract being exercised
Bearish
Put Buyer
Buyer thinks the share price will fall below the strike price.
Wants the share to decline below the strike price and the amount of premium paid for the contract
Bearish
Put Seller
Seller thinks the share price will rise and stay above the strike prices
Wants to pocket the premium without the contract being exercised
Bullish
Futures and Forward Contracts
A futures contract is an agreement to buy or sell a specific amount of a commodity or financial instrument at an agreed upon price on a stipulated date in the future. The buyer of a futures contract must purchase the underlying commodity and the seller must sell it at the prearranged price – unless the contract is offset before the settlement date. Futures differ from options in that the buyer is obligated to take the delivery of the commodity, unless it is offset prior to expiration.
As with futures, a forward contract is an agreement between a buyer and seller for the future delivery of a commodity at a specified price, time and place. Forward contracts are not usually exchange traded and their features are customized. Also, with forwards both the buyer and seller must come to an agreement for either party to transfer the contract to a third party. In contrast, futures contracts are very liquid and are bought and sold on exchanges such as the Chicago Board of Trade.
Money Markets
Money Markets refers to short-term debt with one year or less to maturity. Money market transactions allow an avenue to both acquire money (borrow) and invest (lend) excess funds for short periods. Examples of money market instruments include:
Commercial paper
Bankers’ acceptances
Negotiable certificates of deposit
Federal funds
Money-market mutual funds
Repurchase agreements
Conclusion
Financial markets play an integral role in the economy. They allow buyers and sellers to come together to provide an avenue to invest for profit and to borrow to further grow a business. Markets help determine price levels and provide much needed liquidity into the economy. Financial markets play a key role that allows access to capital or to invest money for a return.