In order to understand the types of financial instruments and how they work itís important to first of all understand the different types of financial markets out there. Some financial instruments can be traded on certain markets while others can be traded on more markets provided they are adapted to the specific requests of each one.
Part I. Financial markets
Based on the type of instruments being traded, financial markets can be divided in:
Money market (or short term finance)
This is the market where different players who are looking for financing or looking to place their money for the short term meet. In the finance world, short term is any period of up to a year. With some exceptions, there are instruments that mature in a maximum of two years which are included on the money market.
Fixed income market
This is an extension of the money market, but is treated differently because the financial instruments have a maturity of more than two years and some go as high as 50 years. There are instruments without maturity who are traded on this market. This is the market where players are looking to borrow or lend money for the long term.
Players on the money market and fixed income market can be divided into two types: lenders and borrowers. The financial instruments traded on these markets pay interest on a regular basis and when they mature they also pay the initial sum that was invested.
By maturity we mean the exact date at which that particular instrument is withdrawn from the market and stops having any sort of legal impact.
This is the market where various economical entities issue financial instruments in order to attract capital. These instruments usually donít pay any interest and neither do they bind the issuer to redeem them at a future date. They offer a property right on the issuer and the right to collect dividends when the issuer decides to distribute part of the profit.
The players on this market are issuers and stockholders.
This is the market where commodities are sold and bought, such as: wheat, corn, soy bean, oil, natural gas, energy, copper, nickel, zinc, lead etc. It is a special financial market, because most of the transactions are done through derivative financial instruments Ė which we will talk about later.
The precious metal market is part of the commodities market. In general, precious metals are traded physically, not through derivative instruments.
Although money is considered a commodity, the FX market is treated differently. Itís the market where money is bought and sold, currencies are quoted against each other and the price of one currency is expressed in another currency. It is the most liquid market in the world with a daily transaction volume estimated at around 3000 billion dollars.
From a transactional point of view, financial markets can be divided in:
Regulated markets Ė organized as stock exchanges (stock exchanges, future exchanges etc.)
On these markets the details of the traded instruments are predetermined and canít be negotiated by buyers. The only detail that can be negotiated is the price. The predetermined information is:
- Trading schedule
The size of the contract or transaction Ė which represents the trading multiple
Minimum price fluctuation
The daily variation limit
Maturity (in the case of derivatives)
Requirements regarding margin (in the case of derivatives)
All these details can be found in the contract specifications which are public and posted on the website of that particular exchange. Basically, the contract specifications set the game rules.
Another specific aspect of this particular market is that transactions are facilitated by brokerage firms which are members of a certain exchange. Those who want to trade must open an account at a broker which will offer them electronic access to the market.
On these markets trades are public. Any player can see the volume of trading and price in real time. He canít see the name of the traders though.
Over the counter markets (OTC)
The interbank system is an over the counter market where banks are the main players. OTC transactions are not standardized. In other words, the parties involved in a transaction decide when to trade, the sum of the trade, the maturity (if it is required) and the price. We can say that the instruments traded on OTC are tailored according to their needs.
On this market the counterparties know each other, they know the details of the transaction, but they donít have access to the trading of other players on the market. For trading they use special electronic systems but they sometimes use recorded confirmations by phone.
Another way of dividing the financial markets is between spot markets and derivatives markets.
A spot market is a market where the buyer pays the asset in full and the seller delivers the asset in full. It is also referred to as payment-versus-delivery. The stock market, fixed income financial instruments market, precious metal market and FX market are all spot markets. For example when we buy stocks we pay their cost in full.
In order to trade on these markets we need an account where we can deposit the money before buying anything. The money in this account is used to pay the assets you bought.
The spot market is also called an immediate delivery market. In the financial world, immediate usually means two days after the date the trade was made. In other words, the final payment and delivery of the traded asset is done on the second working day from the trading date.
A derivative financial instrument is an asset whose price depends on the price of an asset traded on a spot market. This asset is called underlying. The derivatives market is also called the market with future delivery (at a date called maturity).
In order to trade derivatives we need a margin account. Usually you deposit money in this account but in certain situations you can deposit other financial assets as well. The money in this account isnít used for buying various assets but represent a collateral for settle the transaction on time. For example if we wish to enter a trade whereby at maturity we have the obligation to buy oil at a price we establish now, we need a certain amount to be deposited in the account prior to confirmation. This amount is called margin.
The exchanges can be organized as spot markets or derivative markets. Some exchanges can host both types of markets. In turn, the OTC markets can be spot or derivative. Some financial instruments can be traded only on stock exchanges, others can only be traded on OTC and some Ė on both OTC and exchanges.
In the next article we will talk about the various types of financial instruments.
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