How Financial Markets Work

How Financial Markets Work

What Money Does

Money can be used in a number of different ways. Your savings account provides you a safe place (a bank) to keep your money and gain interest on it while you are not using that money. But the money in your savings account does not sit in a giant vault in the bank, it is used to help other people buy homes and cars and go to college. When the bank makes a loan, it is drawing on all the money people have put into it. In this way the bank acts as a financial market place for money. A bank loan can help fuel growth but one day it will have to be paid back, with interest (a fee to cover the cost of borrowing).

Money is also used by people to make investments. When you invest in a company you are giving them a loan (when you buy bonds) or buying a part of that company (when you buy stock). When you invest in a company it may use the money to get bigger, purchase equipment, increase advertising, hire new people, research new products, or any number of other business activities.

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Investing In A Business

Businesses come in many different sizes and shapes. A business owned and operated by one person is called a sole proprietorship. A sole proprietorship is easy to form and all the profits go to the owner. But a sole proprietorship may not have enough money (called capital) to grow or the owner may be concerned that he or she carries all the risks of operating a business. A sole proprietor may join with other people to form a partnership, owned by two or more people. There may be more money to invest now, but the owners have to share decision making power and cash may still be limited. A partnership can also limit risk by making the business itself a legal entity. This way the business may be sued but the partners homes and money outside the business will be safe.

A company that still wants to grow has several choices. Its first option is to use its profits for capital -- called reinvestment. A company, like an individual, can also get money by borrowing from a bank. Like an individual though, the bank loan has to be paid back with interest, and the bank may limit how much it will lend a business according to the ability of the company to pay it back. A small company will probably only be able to borrow a small amount of money.

For longer term growth a company may try a different form of borrowing, by issuing bonds. A bond is an IOU from the company to the investors. After a specified amount of time, from six months to thirty years, a bond will mature. When this happens the company must pay each individual the amount they invested. The company also pays each investor interest at specific intervals during the years the investor holds the bond.

The fourth alternative for raising capital is to sell piece of ownership in the corporation to the public. Selling stock in the company can generate huge amounts of cash that can be used for a variety of purposes. When a company begins to sell stock it is said to "go public". The company will usually hire an investment banker to help it go public by evaluating the company, determining a price for the stock, and serving as an intermediary between the company and the investing public. When a company's stock is sold for the first time it is called an initial public offering or IPO and is sold in the primary market. Then when the stockholders want to resell the stock it is sold on a secondary market, like one of the exchanges. By selling stock the company is transformed from a private business owned by a few people to a public business owned collectively by a large pool of investors.

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How Investment Takes Place

A financial market is a place where firms and individuals enter into contracts to sell or buy a specific product such as a stock, bond, or futures contract. Buyers seek to buy at the lowest available price and sellers seek to sell at the highest available price. There are a number of different kinds of financial markets, depending on what you want to buy or sell, but all financial markets employ professional people and are regulated.

If you want a loan or a savings account you would go to the bank or credit union, if you want to buy stock, a mutual fund or a bond you go to a securities market. The purpose of a securities market is primarily for business to acquire investment capital. Examples of securities markets include the New York Stock Exchange and the American Stock Exchange. Another securities market is the Over-the-Counter market, where a computer network of dealers buy and sell shares.

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Stock Markets

Stock markets grew out of small meetings of people who wanted to buy and sell their stocks. These men realized it was much easier to make trades if they were all in the same place at the same time. Today people from all over the world use stock markets to buy and sell shares in thousands of different companies.

New issues of stock must be registered with the U.S. Securities and Exchange Commission (SEC) and in some cases with the State of New York. A prospectus, giving details about a company's operation and the stock to be issued is printed and distributed to interested parties. Investment bankers buy large quantities of the stock from the company and then resell the stock on an exchange.

A potential buyer places an order with a broker for the stock he or she wishes to purchase. The broker then puts in the order to buy on the appropriate exchange, the transaction takes place when someone wants to sell and someone wants to purchase the stock at the same price. When you purchase a stock, you receive a stock certificate, the certificate may be transferred from one owner to another or can be held by the broker on behalf of the investor.

Bonds also can be transferred from one owner to another. As with stocks, buyers go through brokers and dealers.

Stocks, bonds, and futures contracts can also be sold in groups as mutual funds. Mutual funds employ professional managers to make decisions about what to buy and sell.

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Futures Markets

Futures markets provide a way for business to manage price risks. Buyers can obtain protection against rising prices and sellers can obtain protection against declining prices through futures contracts.

Example: In the spring, Farmer Jones planted 100 acres of soybeans and he anticipates that in September he will harvest 5,000 bushels. He is concerned about what the prices of soybeans will be in September, if the price falls he will lose money.

To avoid this risk, Farmer Jones has his futures broker sell a contract for 5,000 bushels of soybeans for September at the current price. In this way the farmer locks in his September selling price. If the price is higher in September, the farmer will not make as much profit, but if the price has fallen, he will come out ahead. This process of obtaining price protection is called hedging.
in futures carries substantial risk and is complicated by complex kinds of trading options. To realize a profit, it is necessary to be right about both the direction and the timing of a price change. Even experienced investors rarely invest more than a small portion of a total investment portfolio in futures contracts. In fact, in the last few years a number of large and sophisticated investors have made the front pages of newspapers for losing all of their money on one kind of risky futures investment called a "derivative"

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Things That Effect Prices And Markets

Most everyone has heard of the stock market crash that lead to the depression. Many people remember recent stock market drops that occurred in 1989 and in 1997. What makes the markets rapidly fall, when hundreds of stock prices fall at once? What makes the market strong and causes stock prices to rise? Few investors can consistently predict the ups and downs of the market or of an individual investment. But investors who are aware of the factors that affect market price are more likely to make sound investment decisions.

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Factors Which Affect Markets

Actions of investors: Individual, institutional and mutual fund investors all affect the prices of stocks, bonds, and futures, by their actions. For example, if a large number of people want to buy a certain stock its price will go up, just as if many people were bidding on an item at an auction.

Business conditions: Both the condition of an individual business and the strength of the industry it is in will effect the price of its stock. Profits earned, volume of sales, and even the time of year will all affect how much an investor wants to own a stock.

Government actions: The government makes all kinds of decisions that affect both how much an individual stock may be worth (new regulations on a business) and what sort of instruments people want to be investing in. The governments interest rates, tax rates, trade policy and budget deficits all have an impact on prices.

Economic Indicators: General trends that signal changes in the economy are watched closely by investors to predict what is going to happen next. Indicators include the Gross National Product (how much production is going on in the country), the inflation rate (how quickly prices are rising), the budget deficit (how much the government is spending) and the unemployment rate. These indicators point to changes in the way ordinary people spend their money and how the economy is likely to perform.

International events: Events around the world, such as changes in currency values, trade barriers, wars, natural disasters, and changes in governments, all change how people think about the value of different investments and about how they should invest in the future.

Today, investments can be purchased around the clock. When the market opens in New York, the Tokyo market has just closed and the London market is half way through its trading day. When prices on one market change all other markets are effected.

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The Bull And The Bear

A bull market and a bear market are terms used to describe the general market trends. A bull market is a period during which stock prices are generally rising. A bear market is a period when stock prices are generally falling. Each of these markets is fueled by investors' perceptions of where the economy and the market are going. If investors feel that they are in a bull market, they will feel confident investing, adding to the growth of the market. However, if investors think that the market is falling they will sell stock at lower prices, continuing the bear market. These trends may quickly change.

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