Explain it to me like I am a 5 year old: Financial Market
I am a graduate student pursuing Masters in Computer Science from NYU wanting to understand finance and many of the underlying concepts. This post is meant for people who are completely new to Finance but want to have a basic understanding of the stock market. My aim here is to make the concepts easier and more understandable.
Imagine going to a Whole Food store, where you can get anything and everything ranging from seafood to organic food. There are different sections within the store to suit each and every customer need. Here, the Whole Food store is what you call as the Financial Market and the different sections are the different types of financial securities that customers (we call them investors) can buy depending on whatever fits their pocket. Each nation has its own financial market where you can buy different types of financial securities like bonds, equities, derivatives, commodities and currencies. Financial markets are comprised of different markets like Capital Markets, Money Markets, Derivatives Markets, Spot Markets etc. In this post we will have a look at two major markets (Capital and Money Markets):
Consider an auditorium where people from different institutions gather along with the people who want to help the institutions. Here the auditorium can be called as Capital Market where institutions can ask other people to help them raise money. So the process of asking or giving money (which people usually refer to as financial securities) between institutions and individual investors is called trading which happens in Capital Markets. There are two major types of Capital Markets:
1. Stock Markets:
It’s a market where investors can buy or sell shares of publicly traded companies. This helps investors to be a part of profits gained by the company in which they trust and put their money into, on the other hand, it helps institutions raise capital to fund their projects. There are two main sections: Primary and Secondary markets.
When a company plans to go from private to public, they are first traded in Primary Market. It’s a market where investors give money directly to the company and in turn get a slice of ownership in that company. After all the shares have been sold to investors, the company is then listed in Secondary Market (Stock Exchange). I know it’s confusing so let’s have a look at an example: Let’s say Company ABC wants to raise $10,000 and its underwriting bank (bank who helps the company decide what should be the opening stock price) wants to price each stock of ABC at $10. This means there are in total of 1000 shares (10,000/10) that company ABC wants to sell to investors. After investors in the primary market exhaust all the 1000 shares available, that means now the company has got the money that they needed. It now goes from Primary to Secondary market where investors buy or sell stocks with another investor and not directly with the company.
Hence in Primary Market, prices are usually set beforehand while in Secondary Market, forces like supply and demand determine the price of the stock.
2. Bond Markets:
Let’s have a look at what are bonds. Consider you are the head of your county’s municipal and you want to build roads in your county. After checking the treasury, you realise you don’t have enough money to build it. You foresee that once the road is built, there will be revenue by tolls but at the current moment, you don’t have the money to build one. So you go out to people asking them to trust your plan for building new roads and give you money. In return, you give them a note saying “Thank you for giving me your money. I will return you the money after X months and also as an incentive I will give you some amount of money every year”. This note is called a bond, which you issue to the people who financially help you build the road.
Money Market is the best place for institution and governments to manage their short-term cash needs. Maturity period can range from overnight to a year. Money Market instruments include Treasury Bills, Certificate of Deposits, Commercial Papers, Repurchase Agreements(repos) etc. These instruments are liquid(can be converted to cash very quickly) and extremely safe which makes them instruments offering low returns (remember in most of the cases, if its low risk it will have a low return). The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money for short term.
That’s it for this post. Do check out my other posts to gain more knowledge about finance.
Please do let me know if there is any other concept in finance you want me to write an article on, I will try my best to explain it in simpler terms.
Also, feel free to ask questions in the comment section. Will be happy to help you out :)
PS: The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy. I read related articles from different sources like Investopedia and try to explain it in a simpler manner.