How financial markets work
Investing & Finance
You can deposit your money in a savings account in a bank. This provides you with a safe place to keep your money and earn interest on it while you are not using it. But your money does not sit in a giant vault: The bank loans it to other people to help them pay for homes, cars, and college. When the bank makes a loan, it draws on all the money you and other consumers have deposited. In this way, the bank acts as a financial market place for money. A bank loan can help fuel growth, but one day the loan holder will have pay back the loan with interest — a fee to cover the cost of borrowing.
You can also use money to make investments. If you buy a bond from a company, you are giving them a loan. If you buy stock, you are purchasing a part of the company. . When you invest, the company may use the money to grow, purchase equipment, advertise, hire workers, research new products, or conduct many other business activities.
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. However, a sole proprietorship may not have enough money (capital) to grow, or the owner may be concerned about carrying 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 owners' homes and their money outside the business will be safe.
A company that still wants to grow has several choices. It can:
- use its profits for capital by reinvesting
- get money by borrowing from a bank. As with a personal loan, a bank loan must be paid back with interest. The bank may limit how much it will lend according to the business's ability to pay it back. A small company will probably only be able to borrow a small amount of money.
- issue bonds for longer-term growth. A bond is an IOU from the company to investors. After a specified amount of time, from six months to 30 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 time the investor holds the bond.
- sell pieces of ownership in the corporation to the public. Selling stock in the company can generate large amounts of cash that can be used for many purposes. When a company begins to sell stock, it is said to "go public." The company will usually hire an investment banker who evaluates the company, determines a price for the stock, and serves 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 (IPO) and is sold in the primary market. When stockholders want to resell, the stock is sold on a secondary market, such as one of the major stock 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.
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 different kinds of financial markets, depending on what investors want to buy or sell. All employ professionals and are regulated. Some examples:
- bank or credit unions, for loans or savings accounts
- securities markets, such as the New York Stock Exchange or the American Stock Exchange, for businesses to acquire investment capital, mutual funds, or bonds. Another securities market is the over-the-counter market, where a computer network of dealers buy and sell shares
Stock markets grew out of small meetings of people who wanted to buy and sell their stocks. These investors 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.
Any new issues of stock must be registered with the U.S. Securities and Exchange Commission (SEC), and in some cases with New York. The issuer provides a prospectus, which is a document that gives details about a company's operation and the stock to be issued. The issuer distributes this prospectus 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 they wish to purchase. The broker 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. A purchaser, receives a stock certificate. The certificate can be transferred from one owner to another or held by the broker on the investor's behalf.
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.
Futures markets can help businesses to manage price risks. Futures contracts can help protect buyers against rising prices and sellers against declining prices through futures contracts. For instance, imagine the following:
- In the spring, Farmer Jones planted 100 acres of soybeans and anticipates harvesting 5,000 bushels in September.
- 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, 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, Jones 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."
Futures markets carry substantial risk and are 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 been in the news for losing all of their money on one kind of risky futures investment called a "derivative."
The stock-market crash that lead to the Great Depression is famous. Many remember recent stock-market drops 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. Investors who are aware of the factors that affect market price are more likely to make sound investment decisions.
Factors that affect markets
- Actions of investors: The actions of individual, institutional, and mutual-fund investors all affect the prices of stocks, bonds, and futures. 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 condition:. Both the condition of an individual business and the strength of its larger industry affects the price of its stock. Profits earned, volume of sales, and even the time of year will all affect how much an investor will pay for a stock.
- Government actions: The government makes decisions that affect both how much an individual stock may be worth, such as by issuing new regulations on a business, and what sort of instruments people want to be investing in. The government's interest rates, tax rates, trade policy, and budget deficits all have an impact on prices.
- Economic indicators: Investors closely watch general trends that signal changes in the economy to predict what is going to happen next. Indicators include the gross national product, or how much the country is producing; the inflation rate, or how quickly prices are rising; the budget deficit, or 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 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 affected.
Bull and bear markets
"Bull market" and "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, which adds 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 can change quickly.