An Introduction To Financial Markets

In this brief introduction to the global financial markets, we take a look at some of the key markets that are available to trade, along with an outline of factors that you should consider before making your decision.

So, what is the financial market? Online financial markets are broad and can vary from world currencies to virtual currencies, shares to bonds and raw materials to stock market indices, where traders can invest into securities and derivatives at a low transaction cost. Read further to discover the world of financial markets and their wide range of assets.

Currency market trading

The currency market is the world's largest and most active trading market, as well as being the most liquid. While foreign exchange trading has long been dominated by large global banks and institutions, it has become increasingly popular and accessible to individual investors.

Trading currencies is done slightly differently to other asset classes. Trading in other assets involves trading in one market with profit and loss based on absolute returns. For example, if you buy and the market goes up, you make money. If you buy and it goes down, you lose money.

Currency trading is done using currency pairs, with one currency being traded against another. Returns in currency markets are relative, with profit and loss being measured by how one currency performs relative to another. For example, on a given day, the US dollar (USD) could appreciate relative to the euro (EUR), Swiss franc (CHF) and British pound (GBP), but decline relative to the Japanese yen (JPY), Canadian dollar (CAD) and Australian dollar (AUD).

As the world's reserve currency, trading in US dollar-related currency pairs is the foundation of currency trading around the world. The most active pairs (also known as the major currency pairs) include EUR/USD, GBP/USD, USD/CHF and USD/JPY. Currency pairs that don't involve USD are known as cross pairs. Popular cross pairs include GBP/EUR, EUR/JPY and AUD/CAD.

Pricing in currencies is based on the first currency in the pair, also known as the base currency. In the case of EUR/USD, this means how much USD it would take to buy one EUR. When EUR/USD goes up it means that EUR is gaining in value and when it goes down, it means EUR is losing value against the USD.

Trading in resource currencies such as AUD/USD and USD/CAD is also popular, as the valuation of these currencies with those of other resource-producing nations such as the New Zealand dollar (ZND), Norwegian krona (NOK) and South African rand (ZAR) tend to be influenced by commodity prices. These represent a significant part of the goods traded by these countries. Note that CAD and NOK tend to be more sensitive to energy prices, AUD and NZD to metal and grain prices and ZAR to precious metal prices.

How does a carry trade work?

USD and JPY tend to be seen as more defensive currencies. Because of their low interest rates, investors tend to borrow money at lower rates in these countries and try to earn higher returns elsewhere, in what is widely known as a carry trade. In times when investors are interested in taking on risk, the carry trade increases and capital flows out of USD and JPY into other currencies. When fear increases and investors become more risk averse, they tend to sell off their riskier assets and pay back their USD and JPY based loans.

Similar to other financial markets, currency values tend to be based on supply and demand. Generally speaking, traders favour countries and currencies with a higher interest rate, political and financial stability and higher economic growth (higher potential for profit from investments) over countries with lower interest rates or a slower growth. Because inflation erodes the value of paper currencies over time, currencies with the potential for current or future high inflation rates tend to be shunned. Currencies with higher political or financial risks (high deficits, high national debt levels or banking system problems) also tend to be marked down in order to reflect these issues.

Commodity market trading

There are two main types of participants within the commodity market; hedgers and speculators. Hedgers are those who want to lock in a price for a product that they intend to deliver or use at a future point in time. For example, a farmer about to plant wheat may want to lock in a price for when they deliver it in September, while a baker needing wheat for June may want to lock in their price before that for planning and budgeting purposes. This financial market tends to be dominated by industry participants.

Commodity prices are mainly impacted by changes in supply and demand of the particular goods being traded. Speculators are those interested in attempting to profit from changes in prices as supply and demand conditions change and have no intention of delivering or taking delivery of physical goods. Most investors fall into this category.

Commodities tend to fall into a number of groups that share similar influences:

Precious metals and base metals

While most people may consider precious metals as jewellery, gold and silver have been used as currencies for centuries. Because of this, precious metals tend to be viewed as a store of value and tend to attract interest during times when investors are concerned that the value of paper money, particularly the US dollar, may fall. This is known as a hedging strategy.

Base metals with industrial applications, such as copper, also tend to be sensitive to global economic activity, with demand generally increasing as economies grow. Supply can be increased by the development of new mines and limited by strikes or other operational difficulties. In recent years, demand for base metals has been driven by demand from emerging economies such as China, India and Brazil that are building out infrastructure.

Energy commodities

Similar to the weather, energy prices often tend to be a hot topic of conversation because they have such an impact on many people's day to day lives.

Energy prices and demand tends to be linked to global economic growth as people tend to use more energy during good times and cut back during lean times. For example, businesses may operate more shifts or consumers may travel more in good times. Weather can have an influence on the pricing of energy commodities that are used in home heating systems, such as natural gas and heating oil.

Crude oil trading (Brent or WTI) is a significant part of the global energy supply and tends to be produced in or travel through politically unstable regions. Because of this, political risks can impact the price of oil, particularly during times when supplies may be limited. Although crude oil is a global financial market, prices tend to be more sensitive to economic conditions in the United States and China, the world's largest energy consumers.

Global market indices

Another type of diversification is to invest in global stock indices across a wide variety of industry groups, in order to gain exposure to wider business opportunities and mitigate the risk that one sector may encounter difficult times.

For example, investors only looking at the energy sector could have problems when commodity prices fall, but this risk can be lessened by also having exposure to areas that benefit from falling energy prices, particularly transportation companies and anyone that consumes fuel.

Although sector trading has become more popular in recent years, trading broad market indices is the primary means that equity investors use to increase their diversification over individual shares. Most indices that are tradable are based on a basket of the largest and most actively traded companies on a particular exchange or in a particular country. Another advantage of index trading is that they are usually widely followed in the media, so there tends to be a lot of information available.

Indices around the world

Generally speaking, indices in the same region tend to perform similarly over time because the largest companies often have multi-national operations close to each other. Some of the best known global market indices include the following:

Europe

• UK 100
• ​Germany 30
• French 40
• Spain 35
• Sweden 30
• Italy 40

North America

• US30 (derived from the Dow Jones Industrial Average)
• US SPX500 (derived from the S&P 500)
• US NDAQ 100 (derived from the NASDAQ 100)
• US Small Cap 2000 (derived from the Russell 2000)
• Canada 60 (derived from the S&P/TSX 60)

Asia Pacific

• Hong Kong 43 (derived from the Hang Seng)
• Japan 225 (derived from the Nikkei)
• Australia 200 (derived from the S&P/ASX 200)

There can be some differences between indices, depending on what sectors make up the largest weightings in the basket. For example, the SPX500 is more heavily weighted in consumer products, financial services, technology and health care. Canadian and Australian indices carry a higher weighting in raw materials and energy products. The Hong Kong 43 is be more weighted in financials, including real estate. The UK 100, on the other hand, has a large weighting in banking, pharmaceuticals, metals and oil.

Treasuries and bonds

Government bonds, also known as gilts or treasuries, form part of another very active trading market, giving investors the opportunity to trade off grander macroeconomic trends in various countries.

Most large investors such as banks and institutions tend to purchase bonds with the intention of holding them to maturity and viewing the interest rate on the bond as the primary return on their investment. Over time, bond prices tend to fluctuate along with economic conditions, creating promising opportunities for investors.

The compensation through interest rates that investors demand in order to purchase a bond tends to be driven by two major factors, inflation and repayment risk. In order to earn income over time, investors need their bonds to return at least the rate of inflation in the issuing country. In addition, investors tend to demand a premium to cover the risk that the bond issuer may default on either the principal or interest payments, since you can't imprison debters in most countries.

Based on this, investors tend to demand higher interest rates from countries running high rates of inflation. As seen during the European sovereign debt crisis, issues such as high government deficits or high national debt levels can increase the risk of insolvency and lead investors to demand higher interest rates to compensate them, as part of their risk strategy.

While sometimes equity investors can fall in love with their stocks and be more forgiving of failure, bond investors tend to be extremely strict about the quality of their investments and are sometimes referred to as 'bond vigilantes'.

Due to the fact that interest rates on most bonds are fixed after issuance, bond prices change over time to reflect changing interest rates. Suppose a ten-year bond is issued at 5.0% interest and a year later, new nine-year bonds are being issued at 4.0%. Because the 5.0% bond carries a higher interest rate, all else being equal, investors would be willing to pay more for that bond. On the other hand, if investors could get 6.0% on new nine-year bonds, they would not be willing to pay as much for the 5.0% bond.

Bonds tend to be issued at a price of 100.0, known as par, and are expected to be redeemed for the same price at maturity. If interest rates on new bonds increase, the price of existing bonds tends to drop so that they trade below 100.0, or at a discount. The potential for capital appreciation offsets the lower interest rate. Similarly, if the interest rate on new bonds falls, the price of existing bonds tends to rise to trade at a premium to par with the capital loss over time offsetting the higher interest rate. Understanding this inverse relationship between interest rates and bond prices is key for bond traders.

The time to maturity is also an important factor. Central banks often use short-term rates to speed up or slow down economic growth. Because of this, the difference between short-term and long-term rates can fluctuate quite a bit. Most of the time, long-term rates are higher to reflect the risk of changing developments over time but sometimes short-term rates can rise above long-term rates, particularly when central banks are trying to slow economic growth or control inflation.

Stock market trading

Most people first become familiar with the world of investing through individual share trading on the stock markets. Companies around the world issue shares to the public for many reasons, primarily to raise capital for expanding their business. Additional benefits for corporations of being publicly traded include generating a higher profile with potential customers and the public at large, the sharing of risk among more investors, reducing the company's capital costs, succession planning for founders and many more purposes. The sale of shares from a company's treasury to shareholders is known as the primary market.

Once a company completes its initial public offering, its shares then usually trade on a traditional stock exchange such as the New York Stock Exchange (NYSE) or London Stock Exchange (LSE). It can also be listed on an over-the-counter exchange such as NASDAQ, where trades are executed directly between brokerages. Both of these are known as secondary markets.

There are two methods to help individuals looking to make money within the stock market. Capital gains from making a profit on a favourable price move either from the long side (buy low and sell higher) or short side (sell high and buy back lower). Income can also be earned from dividends that companies pay to their shareholders out of net profits.

Generally speaking, investors tend to bid up the prices of shares where positive things are expected to happen to a company, such as improved earnings in future from increased sales, new contracts, higher dividends, takeover bids or other developments. On the other hand, expectations of negative developments, such as a slowdown in the business, regulatory changes, losing contracts and political changes, can lead investors to want to sell and push down the share price.

With a buyer and seller involved in every transaction, at any given time, share prices tend to reflect the balance of the expectations of all market participants. Share prices may change as expectations change.

Factors that can impact market expectations can include macroeconomic factors that influence business environments. This includes industry factors such as changing commodity prices, and company-specific factors such as earnings, dividend changes, and other business developments.

One regular development that tends to influence trading is a company's earnings report. The timing of these reports tends to be publicised well in advance, and analysts who follow the company weigh in with their expectations. Many companies also publish their own expectations, known as guidance. How a company's results and future guidance fare relative to expectations can have a major impact on short-term and long-term trading trends.

List of industry sectors

Once people start trading shares, they often find that they become exposed to the risks of the particular business that they are trading. For example, someone who trades shares of oil and gas companies may find that, while energy producers in general tend to rise and fall with the price of crude oil and related commodities, their return can also be influenced by how well the individual company performs on the exploration and operation fronts. For example, one company may have significant exploration success, while another may have slow production due to equipment problems.​

The primary methods that investors use to mitigate company-specific risks is to trade a group of shares rather than one share, in what is known as having a diversed portfolio. One way to diversify involves trading more than one share within an industry group.

In the oil and gas sector, for example, trading a basket of shares would give you exposure to several company exploration programmes, while mitigating the risk of one company's problems. It would also capture more general exposure to underlying commodity price movements.

​There are ten major sectors in equity markets that fall into four major categories.

Interest sensitive: financial services, utilities and telecommunications

These companies tend to have higher debt loads and because of this, interest payments represent a significant part of their expense base. These companies tend to outperform in times of falling interest rates and underperform when rates are rising quickly.

Defensives: consumer staples and health care

Companies in these areas boast fairly stable and predictable revenue and earnings streams. They tend to produce or sell goods that people use on a daily basis, regardless of economic conditions, such as personal care products, groceries and pharmaceuticals. They tend to outperform the market during recessions and underperform in stronger economic times.

Economically sensitive: consumer discretionary and industrials

These areas tend to do very well in times of prosperity and poorly during recessions as they represent goods and services that can be sacrificed or substituted during unstable times. Some examples within these groups include: automobile manufacturers, clothing stores, business services and airlines.

Capital spending sensitive: energy, materials and technology

Growth for companies in these groups tends to come from large scale projects that can take time to implement. Because of this, they can run a little behind the economic cycle as companies usually wait for confirmation that the economy has turned higher before committing to large scale projects. After a top, they complete projects that are underway before cutting budgets.

Note that for technology, this mainly applies to companies that sell hardware, software and B2B services to business customers. There are an increasing number of technology companies that sell primarily to consumers and would potentially fall into the economically sensitive group.

Understanding trading the financial markets

Deciding which financial markets to trade can seem like a complicated process, but there are a number of factors that can simplify this decision.

1. Trading what is familiar. Most investors start out trading the shares of companies they are familiar with or are located in the same country, before branching out internationally or trading different asset classes.

2. Trading similar asset classes. Once you have gained some comfort trading in one area, you may want to expand into related areas. For example, expanding trading from shares to indices or from resource shares to related commodities.

3. Small picture vs big picture. Investors more interested in taking advantage of broad national or global trends may find currencies, treasuries or indices more appealing. On the other hand, those interested in doing some digging and finding unnoticed opportunities may find investing in shares more interesting.

4. Financial markets opening hours. Which markets are active during the time of day that you plan to trade may also influence your decision. If you plan to trade during your business day, markets in your region may offer the best opportunities. If you plan to trade in the morning or evening, there may be more opportunities in other regions. View the difference between the 24 hour market hours and the fixed daily opening and closing stock market hours.

5. Relationship between markets. Although the details of investing in different markets or asset classes may vary, the underlying drivers of movement tend to be the same across markets, such as interest rates, inflation expectations, GDP growth, risk factors and more. As you gain comfort with some markets, you may find other markets where you can apply what you have learned.

Source: CMC Markets UK