Let’s begin with some definitions as always. Investopedia defines a market as:
A market is a place where two parties can gather to facilitate the exchange of goods and services. The parties involved are usually buyers and sellers. The market may be physical like a retail outlet, where people meet face-to-face, or virtual like an online market, where there is no direct physical contact between buyers and sellers.
In the financial industry, there are various types of markets that trade different types of financial instruments.
A stock exchange, for example, as the New York Stock Exchange (or NYSE), is a more strictly regulated type of market in which companies trade their stocks. The commodity exchanges are in the same area. An example of the latter is the Chicago Board of Trade (CME), also in the US. The advantages of an exchange market are that they can facilitate liquidity and provide transparency.
On the other side of the spectrum, a less regulated market is the Over the Counter (OTC) type of markets, where the transactions between the two parties are done without the supervision of an exchange. Unlike an exchange market, the OTC market doesn’t have a physical location. The transactions are happening simultaneously in every corner of the planet. Most transactions that facilitate in an OTC market are institutional in nature. The Forex market is also an example of an OTC market. Bonds are mainly traded in such markets.
Another classification between the different kinds of markets is the Primary Markets and the Secondary markets. In the primary markets, one can buy a financial instrument directly from the exchange, and in the secondary market, through someone else who owns it. Something to be noted here is that public traders cannot buy directly from the primary market. They need to route their orders through a broker who is a member of the exchange.
Inside the global financial markets, there are two main categories. The institutional and retail trader bodies.
The first category includes countries and states, a large primary financial institution like banks, insurance companies, etc., financial asset managers like hedge and mutual funds, Global corporations, and various private institutions.
In the second category are all of us private investors and speculators.
Note that the trading techniques, tools, and trading philosophies are totally different from each category to the other.
First of all lets make things dead-simple. Trading, as the “Merriam-Webster,” describes, is:
To give one thing in exchange for another.
In our case, trading means the exchange of financial products between the different market participants.
In a financial market, we trade the so-called financial products or financial assets for money. There are many types of them, and they have been as old as history itself. What exactly is a financial product, you may ask. The book “the handbook of financial instruments” contains the most complete definition. It describes them as:
A financial asset is a claim against the income or wealth of a business firm, a household, or a government agency, which is represented usually by a certificate, a receipt, a computer record file, or another legal document, and is usually created by or is related to the lending of money.
All the above financial instruments are summarized in 5 big categories. The equities and the equity-related products, the fixed-income or bond markets, the commodities, the currency markets, and the alternative investment markets such as real estate.
Lets those categories in detail one by one, starting from the more simple ones.
1. Equities / Stocks / Shares
The simplest form of a financial product is a “stock” (also known as “share” or “equity”). When a private company needs to take its business a step further, it needs to go from “private” to “public.” After its initial public offer or IPO, a company starts selling a proportion of its assets and earnings. The company can also decide if a proportion of its profits will be paid to its stockholders in form of dividends. Shares have no maturity date since they just represent a part of a particular company. The stocks cease to exist when the company that has produced them declares bankruptcy.
Subcategories of equity financial assets are index funds, mutual funds, hedge funds, and exchange-traded funds (ETFs).
Of course, we cannot hyper analyze this subject into this post, so let’s move on with the rest asset classes. But we will come back on this.
Preferred stocks are a hybrid of debt and equity.
2. Fixed Income / Bonds / CDs
As the name suggests, fixed income financial instruments provide a fixed return on the investment over time. In a certificate of deposit (also known as CD), we can go to a bank, buy a certification on deposit, let’s say with 2% income over a time period, and when this period is over the certification either expires, and we are able to collect our principle plus the 2% interest, or we can renew it.
Bonds issued by governments (also known as government bonds) are the most common subcategory in the fixed income category of financial assets. Bonds, after its issue, are then been rating by various organizations like Standard & Poor’s (S&P), Moody’s, and the Fitch Group, according to their riskiness. They can get an AAA, AA, A, BBB, BB, B, or CCC rating. Here is a good list of almost all the countries and their ratings.
An important key detail here is that all bonds have seniority. They expire after a time period.