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Introduction to the Financial Markets
A financial market refers to any marketplace where you can trade financial instruments, such as the stock market, foreign exchange market, bond market, derivatives market, commodities market and so on. Financial markets provide financing for companies looking to hire, produce and grow. They provide money for the government to build new public amenities such as schools, hospitals, and roads, and they offer the opportunity for individuals to trade and make a living.
Financial trading is the process of buying and selling in the financial markets with the core aim of turning a profit. To break this down simply, as a trader you are trying to predict whether the price of the instrument will go up or go down and if you get it right then you could be heavily rewarded. Get it wrong and you could stand to lose sums of money.
Supply & Demand
Let's break it down and look at what a market is. First, we ask ourselves what drives a market, we call this supply and demand. For example, I have goods or services I would like to sell (supplying) and there is a counterparty that would like to buy my goods or services (demanding). So how do we find a fair price to trade at?
Let’s say I have 3 apples that I wish to sell for £8 per apple, 3 customers wish to buy apples but only one is interested in buying an apple at this price.
This is a problem because the demand (1) is lower than the supply (3), so to solve this I will lower the price to £6 per apple so more customers will be interested in buying apples. The other two customers buy my remaining apples at £6 per apple, so I have found a fair price for the apples where demand equals supply.
The financial markets are the same in that, like goods or items, they allow investors to discover the fair price for their financial assets. In many cases, the fair price of a financial asset is constantly changing due to macro and micro factors.
When there is high demand and little supply, the price of the financial instrument will rise and when there is little demand and lots of supply, the price will fall. As a trader, you can capitalise on this volatility in price!
Inflation
Another reason why the financial markets are useful is that some asset classes provide inflation protection. Being able to access these assets means we can protect our money from losing value.
What is inflation? Well, year-on-year the cost-of-living rises, this is because prices of goods and services 'inflate' year-on-year. Now say you took all your money and stored it in a safe as cash 20 years ago, you would still have the same amount of cash in that safe 20 years later, however now everything is more expensive due to inflation. So has your money decreased in value, increased in value, or stayed the same?
The money you stored away cannot purchase as many goods and services as it could 20 years ago, so that cash has lost value relative to the cost of living. Have a look at the chart below which shows how the value of cash versus investing in the financial markets has changed over time. Remember there is always the risk of a financial asset losing its value rather than gaining value, so we must measure our risk tolerance. We go into this in further detail in the Risk Management course.
Investing vs Trading
What is the difference between investing and trading? Investors tend to focus on the long-term value of an asset, so if you place capital into an asset for a prolonged period you would be an investor. Traders tend to focus on the short-term value of an asset, some traders will only hold an asset for a few seconds and others will hold them for a few weeks. We will learn about the different types of traders in later modules.
Participants in the Financial Markets
- Institutions: these are the big participants who hold most of the money circulating in the market – they are the ‘whales’ with large sums of capital to push around. They are pension funds, insurance companies, investment banks, mutual funds, hedge funds, commercial trusts and so on.
- Retail: these are individuals, usually non-professionals who trade through a broker, bank, or mutual fund. They execute their trades through traditional full-service or discount brokers and trade for their benefit, not on the behalf of others.
How do the Financial Markets Work?
Learn about the financial markets, including the role of key players such as banks and brokers, the mechanics of buying and selling financial assets, and industry terminology such as bears and bulls.
