Financial Markets

The Euro is slightly higher against the yen. The Dow Jones Industrial Average is off 18 points in active trading. Regulators close a Hong Kong bank after it loses $500m on derivatives trading. Following the Bank of England's decision to lower its base rate, monthly mortgage payments are set to fall.

All of these commonplace events are examples of financial markets at work. That markets exercise enormous influence over modern life comes as no news. But although people around the world speak glibly of "Wall Street", "the bond market" and "the currency markets", the meanings they attach to these time worn phrases are often vague and usually out of date. This book explains the purposes different financial markets serve and clarifies the way they work. It cannot tell you whether your investment portfolio is likely to rise or to fall in value. But it may help you understand how its value is determined, and how the different securities in it are created and traded.

In the beginning

The word "market" usually conjures up an image of the bustling, paper strewn floor of the New York Stock Exchange or of traders motioning frantically in the futures pits of Chicago. But formal exchanges such as these are only one aspect of the financial markets, and far from the most important one. There were financial markets long before there were exchanges and, in fact, long before there was organized trading of any sort.

Financial markets have been around ever since mankind settled down to growing crops and trading them with others. After a bad harvest, those early farmers would have needed to obtain seed for the next season's planting, and perhaps to get food to see their families through. Both of these transactions would have required them to obtain credit from others with seed or food to spare. After a good harvest, the farmers would have had to decide whether to trade away their surplus immediately or to store it, a choice that any 2oth century commodities trader would find familiar. The amount of fish those early farmers could obtain for a basket of cassava would have varied day by day, depending upon the catch, the harvest and the weather; in short, their exchange rates were volatile. The independent decisions of all of those farmers constituted a basic financial market, and that market fulfilled many of the same purposes as financial markets do today.

What do markets do?

Financial markets take many different forms and operate in diverse ways. But all of them, whether highly organized, like the London Stock Exchange, or highly informal, like the money changers on the street corners of many African capitals, serve the same basic functions.

Price setting. The value of an ounce of gold or a share of stock is no more, and no less, than what someone is willing to pay to own it. Markets provide price discovery, a way to determine the relative values of different items, based upon the prices at which individuals are willing to buy and sell them.

Asset valuation. Market prices offer the best way to determine the value of a firm or of the firm's assets, or property. This is important not only to those buying and selling businesses, but also to regulators. An insurer, for example, may appear strong if it values the securities it owns at the prices it paid for them years ago, but the relevant question for judging its solvency is what prices those securities could be sold for if it needed cash to pay claims today.

Arbitrage. In countries with poorly developed financial markets, commodities and currencies may trade at very different prices in different locations. As traders in financial markets attempt to profit from these divergences, prices move towards a uniform level, making the entire economy more efficient.

Raising capital. Firms often require funds to build new facilities, replace machinery or expand their business in other ways. Shares, bonds and other types of financial instruments make this possible. Increasingly, the financial markets are also the source of capital for individuals who wish to buy homes or cars, or even to make credit card purchases.

Commercial transactions. As well as long term capital, the financial markets provide the grease that makes many commercial transactions possible. This includes such things as arranging payment for the sale of a product abroad, and providing working capital so that a firm can pay employees if payments from customers run late.

Investing. The stock, bond and money markets provide an opportunity to earn a return on funds that are not needed immediately, and to accumulate assets that will provide an income in future.

Risk management. Futures, options and other derivatives contracts can provide protection against many types of risk, such as the possibility that a foreign currency will lose value against the domestic currency before an export payment is received. They also enable the markets to attach a price to risk, allowing firms and individuals to trade risks until they hold only those that they wish to retain.