Financials Markets For Dummies
The basic understanding of financial markets are a must for everyone irrespective of whether they are active participants in it or not. This primer is designed to address the basics of financial markets before anyone plans to climb Mount Financial Everest!
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Financial markets, or jargons associated with them, can render even the smartest management graduates paralysed. While financial markets tend to be complex, their underlying principles are fairly simple and are standardised across geographies. The basic understanding of financial markets are a must for everyone irrespective of whether they are active participants in it or not. This primer is designed to address the basics of financial markets before anyone plans to climb Mount Financial Everest!
In simple English, financial markets are meant to provide a platform where providers of money (also termed capital to sound cool) and consumers of money interact. Governments or corporations need capital to run their operations and are primary consumers of money. They are provided money by retail investors (like you and me) or by large institutional investors (e.g. pension funds, mutual funds, foreign investors). The most common types of financial markets include equity markets, bond markets and money markets. Banks are conceptually not considered as part of financial markets as their underlying assets (fixed deposits) are not traded. Globally, financial markets are concentrated around London, New York, Hong Kong and Singapore while in India they are concentrated around Mumbai.
The equity markets are often the most glamorous markets among business school graduates. Equity markets, interchangeably called share or stock markets, occupy disproportionate mind space among television analysts and channels. If a company wants to sell a portion of itself to investors to raise money, it can choose to offer equity to investors. Investors, like you and me, can agree to buy a portion of that company and become small owners of that company by holding their shares. These shares of companies are actively traded on the stock markets, in electronic form, where the prices of these shares are decided upon by supply and demand. If a company is doing well, it will have a high demand for its shares and hence its share price will go up and vice versa. The major stock exchanges in India are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Financial newspapers regularly report headline numbers for stock exchanges (e.g. BSE crosses 40,000). For the BSE, this number is an index of the market capitalisation, calculated as the number of shares available to be purchased multiplied by the price of each share, of the top 30 companies divided by the market capitalisation of the top 30 companies in the year 1978 (taken as 100 to calculate the index). Even within the BSE, there are other index numbers reported; BSE mid cap, BSE small cap, BSE banking index etc. Stock exchanges the world over use the index method to represent their headline numbers. Given there are millions of transactions everyday, these exchanges are heavily regulated across the world (e.g. the Securities and Exchange Board of India (SEBI) in India). In general, equity markets are considered the riskiest class of assets but have the potential to generate the highest return. They are termed risky as the underlying company whose share you own is exposed to numerous risks - political risk, country risk, currency risk, industry risk and company specific risk. Equity markets tend to offer the highest return as they typically provide the GDP of the economy and the inflation as a return over a period of time. Hence, they are termed the best vehicles to beat inflation over a period of time. There are more complex financial instruments like derivatives which are not suited for retail investors but for financial corporations like hedge funds.
The bond markets, also termed as credit or debt markets, are not as glamorous as the equity markets but are an integral part of providing a platform between suppliers and consumers of money. A bond is a loan that is given by a consumer of money and in return, the provider of money is promised the principal and a designated interest (termed coupon rate) after a certain period of time (termed maturity). A bond is typically issued by the government (central or state) or a company (e.g. Mahindra & Mahindra) and the money is provided for by institutions like mutual funds, pension funds, etc. Once a bond has been issued (termed primary market), it can be traded actively where investors like you and me can buy it and see its price move up and down on an everyday basis (termed as secondary market). Traded bond prices are extremely susceptible to interest rates decided by the central bank. Bond prices and interest rates are inversely correlated. This is because if interest rates fall, suppliers rush to save their money in bonds as they offer a higher rate driving their prices higher due to higher demand and hence reducing their yields. Yields reduce when bond prices rise because bond prices are calculated as a discounted cash flow of the future coupon rates discounted by the yield to maturity (In case this sentence sounded like Greek to you, you can choose to ignore it). When a bond or a loan is issued, the ability of the entity borrowing to repay the loan is extremely critical. This is termed creditworthiness and is deterred by a credit rating agency (e.g. Fitch, Moody’s or CRISIL). The bond markets are regulated by the Securities and Exchange Board of India along with the Reserve Bank of India (RBI). Bond markets are considered safer than equity markets although they can crash when the credit worthiness of the borrower is suspect. The higher the perceived risk of the borrower, the greater the interest rate the borrower has to offer. In the past, people have made tons of money as well as burnt their hands while dealing with high risk, high yield bonds (junk grade bonds). These exciting times have often been captured in financial books like Liar’s Poker and When Genius Failed.
Money market instruments are short term bonds, typically less than a year in maturity with a focus on driving short term liquidity. Key entities in the money markets include institutions like the Reserve Bank of India (RBI), commercial banks and large corporates. Money market instruments are regulated by the RBI. Individual retail investors like you and me cannot directly participate in these markets but have to operate through a larger entity (e.g. a mutual fund that operates in money market instruments). Returns from money market instruments are considered extremely safe and their returns are typically benchmarked to the RBI determined repo rate, the rate at which commercial banks can borrow from the RBI for their liquidity requirements. The RBI typically uses the money market operations to manage money supply in the economy thereby controlling inflation, as inflation is decided by the quantity of money chasing goods and services.
Banks also play an important role in bringing providers and consumers of money together. Providers of capital, you and me, invest in fixed deposits in a bank whereby a return is promised. Banks use the fixed deposits to loan it to consumers of capital (e.g. corporates, individuals for buying home, car) at a lending rate (basis the marginal cost based lending rate - MCLR). The difference in the rate at which the bank lends money and the rate that it pays on fixed deposits is termed net interest margin which is the primary earning of a bank.
In summary, it is an old adage that a fool and his money are soon parted. The adage for contemporary times is that a financially illiterate person and his hard earned money are soon parted. Knowledge of the financial markets is an absolutely necessity irrespective of whether you and me are active participants in it or not. The easiest way to build upon this primer is to read the markets section in any business newspaper regularly.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.