PART II: MARKETABLE SECURITIES AND FINANCIAL MARKETS

Chapter I: Financial Markets

Financial markets refer broadly to any marketplace where the trading of securities occurs,
including the stock market, bond market, forex market, and derivatives market, among others.
Financial markets are vital to the smooth operation of capitalist economies.

Understanding the Financial Markets

Financial markets play a vital role in facilitating the smooth operation of capitalist economies by
allocating resources and creating liquidity for businesses and entrepreneurs. The markets make
it easy for buyers and sellers to trade their financial holdings. Financial markets create securities
products that provide a return for those who have excess funds (Investors/lenders) and make
these funds available to those who need additional money (borrowers). 

The stock market is just one type of financial market. Financial markets are made by buying and
selling numerous types of financial instruments including equities, bonds, currencies, and
derivatives. Financial markets rely heavily on informational transparency to ensure that the
markets set prices that are efficient and appropriate. The market prices of securities may not be
indicative of their intrinsic value because of macroeconomic forces like taxes.

Some financial markets are small with little activity, and others, like the New York Stock
Exchange (NYSE), trade trillions of dollars of securities daily. The equities (stock) market is a
financial market that enables investors to buy and sell shares of publicly traded companies. The
primary stock market is where new issues of stocks, called initial public offerings (IPOs), are
sold. Any subsequent trading of stocks occurs in the secondary market, where investors buy
and sell securities that they already own.

 
Prices of securities traded in the financial markets may not necessarily reflect their true intrinsic
value.

Types of Markets and Regulation

A primary market issues new securities on an exchange for companies, governments, and
other groups to obtain financing through debt-based or equity-based securities. Primary markets
are facilitated by underwriting groups consisting of investment banks that set a beginning price
range for a given security and oversee its sale to investors.

Once the initial sale is complete, further trading is conducted on the secondary market, where
the bulk of exchange trading occurs each day.

The primary market is where securities are created. It's in this market that firms sell (float) new
stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example
of a primary market. These trades provide an opportunity for investors to buy securities from the
bank that did the initial underwriting for a particular stock. An IPO occurs when a private
company issues stock to the public for the first time.
 
The important thing to understand about the primary market is that securities are purchased
directly from an issuer.

Companies and government entities sell new issues of common and preferred stock, corporate
bonds and government bonds, notes, and bills on the primary market to fund business
improvements or expand operations. Although an investment bank may set the securities' initial
price and receive a fee for facilitating sales, most of the funding goes to the issuer. Investors
typically pay less for securities on the primary market than on the secondary market.

For example, company ABCWXYZ Inc. hires five underwriting firms to determine the

financial details of its IPO. The underwriters detail that the issue price of the stock will
be $15. Investors can then buy the IPO at this price directly from the issuing
company. This is the first opportunity that investors have to contribute capital to
a company through the purchase of its stock. A company's equity capital is comprised of
the funds generated by the sale of stock on the primary market.

All issues on the primary market are subject to strict regulation. Companies must file statements
with the Securities and Exchange Commission (SEC) and other securities agencies and must
wait until their filings are approved before they can go public.

A rights offering (issue) permits companies to raise additional equity through the primary
market after already having securities enter the secondary market. Current investors are offered
prorated rights based on the shares they currently own, and others can invest anew in newly
minted shares.

Other types of primary market offerings for stocks include private placement and preferential
allotment. Private placement allows companies to sell directly to more significant investors
such as hedge funds and banks without making shares publicly available. While preferential
allotment offers shares to select investors (usually hedge funds, banks, and mutual funds) at a
special price not available to the general public.

Similarly, businesses and governments that want to generate debt capital can choose to issue
new short- and long-term bonds on the primary market. New bonds are issued with coupon
rates that correspond to the current interest rates at the time of issuance, which may be higher
or lower than pre-existing bonds.

Examples of Primary Market Selling

In June 2016, the Republic of Argentina announced it was selling $2.75 billion worth of
debt in a two-part U.S. dollar bond sale. Funding was going toward liability management
purposes. Joint underwriters included Morgan Stanley, Bank of America, Merrill Lynch,
Deutsche Bank, and Credit Suisse.

YPF, an Argentine oil company, announced it was offering peso-linked, U.S. dollar-
denominated 2020 bonds worth $750 million. The senior unsecured notes were being
marketed with no registration rights, listed in Luxembourg and governed by New York
law.
 Costera, a Colombian road concessionaire, announced a dual-currency bond sale.
Funding would cover construction expenses and related costs for the Concesión
Cartegena Barranquilla Project. The bonds were listed in Luxembourg and governed by
New York law. The main underwriter was Goldman Sachs and co-manager was
Scotiabank.

Facebook’s Initial Public Offering

Facebook Inc.'s initial public offering (IPO) in 2012 was the largest IPO of an online
company and one of the largest IPOs in the technology sector. Many investors believed
the stock's value would very quickly increase on the secondary market due to the
company's popularity. Because of high demand in the primary market, underwriters
priced the stock at $38 per share, at the top of the targeted range, and raised the stock
offering level by 25% to 421 million shares. The stock valuation became $104 billion, the
largest of any newly public company.

Although Facebook raised $16 billion through the primary market, the stock did not
greatly increase in value the day of the IPO. After 460 million shares were sold and
turnover exceeded 100%, the stock closed at $38.23. However, Facebook still raised
funding and investors purchased stock at a discount through the primary market.

TYPES OF FINANCIAL MARKETS

Over-the-Counter Markets
An over-the-counter (OTC) market is a decentralized market—meaning it does not have
physical locations, and trading is conducted electronically—in which market participants trade
securities directly between two parties without a broker. An OTC market handles the exchange
of publicly traded stocks that are not listed on the NYSE, Nasdaq, or the American Stock
Exchange. In general, companies that trade on OTC markets are smaller than those that trade
on primary markets, as OTC markets require less regulation and cost less to use.

Bond Markets
A bond is a security in which an investor loans money for a defined period at a pre-established
interest rate. You may think of a bond as an agreement between the lender and borrower that
contains the details of the loan and its payments. Bonds are issued by corporations as well as
by municipalities, states, and sovereign governments to finance projects and operations. The
bond market sells securities such as notes and bills issued by the United States Treasury, for
example. The bond market also is called the debt, credit, or fixed-income market.

Money Markets
Typically the money markets trade in products with highly liquid short-term maturities (of less
than one year) and are characterized by a high degree of safety and a relatively low return in
interest. At the wholesale level, the money markets involve large-volume trades between
institutions and traders. At the retail level, they include money market mutual funds bought by
individual investors and money market accounts opened by bank customers. Individuals may
also invest in the money markets by buying short-term certificates of deposit (CDs), municipal
notes, or U.S. Treasury bills, among other examples.
Derivatives Market
A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset (like a security) or set of assets (like an index). Derivatives are
secondary securities whose value is solely derived from the value of the primary security that
they are linked to. In and of itself a derivative is worthless. Rather than trading stocks directly, a
derivatives market trades in futures and options contracts, and other advanced financial
products, that derive their value from underlying instruments like bonds, commodities,
currencies, interest rates, market indexes, and stocks. 

Forex Market
The forex (foreign exchange) market is the market in which participants can buy, sell,
exchange, and speculate on currencies. As such, the forex market is the most liquid market in
the world, as cash is the most liquid of assets. The currency market handles more than $5
trillion in daily transactions, which is more than the futures and equity markets combined. As
with the OTC markets, the forex market is also decentralized and consists of a global network of
computers and brokers from around the world. The forex market is made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and
retail forex brokers and investors. 

Bond Market
The bond market—often called the debt market, fixed-income market, or credit market—is the
collective name given to all trades and issues of debt securities. Governments typically issue
bonds in order to raise capital to pay down debts or fund infrastructural improvements. Publicly-
traded companies issue bonds when they need to finance business expansion projects or
maintain ongoing operations.

Understanding Bond Markets

The bond market is broadly segmented into two different silos: the primary market and the
secondary market. The primary market is frequently referred to as the "new issues" market in
which transactions strictly occur directly between the bond issuers and the bond buyers. In
essence, the primary market yields the creation of brand new debt securities that have not
previously been offered to the public.

In the secondary market, securities that have already been sold in the primary market are then
bought and sold at later dates. Investors can purchase these bonds from a broker, who acts as
an intermediary between the buying and selling parties. These secondary market issues may be
packaged in the form of pension funds, mutual funds, and life insurance polices—among many
other product structures.

Bond investors should be mindful of the fact that junk bonds, while offering the highest returns,
present the greatest risks of default.

Types of Bond Markets

The general bond market can be segmented into the following bond classifications, each with its
own set of attributes.

Corporate Bonds
Companies issue corporate bonds to raise money for a sundry of reasons, such as financing
current operations, expanding product lines, or opening up new manufacturing facilities.
Corporate bonds usually describe longer-term debt instruments that provide a maturity of at
least one year.

Government Bonds
National-issued government bonds (or Treasuries) entice buyers by paying out the face
value listed on the bond certificate, on the agreed maturity date, while also issuing periodic
interest payments along the way. This characteristic makes government bonds attractive to
conservative investors.

Municipal Bonds
Municipal bonds—commonly abbreviated as "muni" bonds—are locally issued by states,
cities, special-purpose districts, public utility districts, school districts, publicly-owned airports
and seaports, and other government-owned entities who seek to raise cash to fund various
projects.

Mortgage-Backed Bonds
These issues, which consist of pooled mortgages on real estate properties, are locked in by the
pledge of particular collateralized assets. They pay monthly, quarterly, or semi-annual interest.

Emerging Market Bonds

Issued by governments and companies located in emerging market economies, these bonds
provide much greater growth opportunities, but also greater risk, than domestic or developed
bond markets.

Bond Indices
Just as the S&P 500 and the Russell indices track equities, big-name bond indices like Barclays
Capital Aggregate Bond Index, the Merrill Lynch Domestic Master and the Citigroup U.S. Broad
Investment-Grade Bond Index, manage and measure bond portfolio performance. Many bond
indices are members of broader indices that measure the performances of global bond
portfolios.

The Barclays (formerly Lehman Brothers) Government/Corporate Bond Index, also known
as the 'Agg', is an unmanaged market-weighted benchmark index. Like other benchmark
indexes, it provides investors with a standard against which they can evaluate the performance
of a fund or security. As the name implies, this index includes both government and corporate
bonds. The index consists of investment grade corporate debt instruments with issues higher
than $100 million and maturities of one year or more. The Lehman Brothers
Government/Corporate Bond Index is a total return benchmark index for many bond funds.

The Inverse Relationship Between Interest Rates and Bond Prices

Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises,
bond prices usually fall, and vice-versa.

At first glance, the negative correlation between interest rates and bond prices seems
somewhat illogical. However, upon closer examination, it actually begins to make good sense.

Bond investors, like all investors, typically try to get the best return possible. To achieve this
goal, they generally need to keep tabs on the fluctuating costs of borrowing.
An easy way to grasp why bond prices move in the opposite direction of interest rates is to
consider zero-coupon bonds, which don't pay regular interest and instead derive all of their
value from the difference between the purchase price and the par value paid at maturity.

Zero-coupon bonds are issued at a discount to par value, with their yields a function of the
purchase price, the par value, and the time remaining until maturity. However, zero-coupon
bonds also lock in the bond’s yield, which may be attractive to some investors.

Zero-Coupon Bond Examples

If a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid
at maturity in one year), the bond's rate of return at the present time is 5.26%: 1,000
- 950 ÷ 950 x 100 = 5.26. In other words, for an individual to pay $950 for this bond, they
must be happy with receiving a 5.26% return.

This satisfaction, of course, depends on what else is happening in the bond market. If

current interest rates were to rise, where newly issued bonds were offering a yield of
10%, then the zero-coupon bond yielding 5.26% would be much less attractive. Who
wants a 5.26% yield when they can get 10%?

To attract demand, the price of the pre-existing zero-coupon bond would have to
decrease enough to match the same return yielded by prevailing interest rates. In this
instance, the bond's price would drop from $950 (which gives a 5.26% yield) to
approximately $909.09 (which gives a 10% yield).

Now that we have an idea of how a bond's price moves in relation to interest rate
changes, it's easy to see why a bond's price would increase if prevailing interest rates
were to drop. If rates dropped to 3%, our zero-coupon bond, with its yield of 5.26%,
would suddenly look very attractive. More people would buy the bond, which would push
the price up until the bond's yield matched the prevailing 3% rate. In this instance, the
price of the bond would increase to approximately $970.87.

Given this increase in price, you can see why bondholders, the investors selling their
bonds, benefit from a decrease in prevailing interest rates. These examples also
show how a bond's coupon rate and, consequently, its market price is directly affected
by national interest rates. To have a shot at attracting investors, newly issued bonds
tend to have coupon rates that match or exceed the current national interest rate.

Bond Prices and the Fed

When people refer to "the national interest rate" or "the Fed," they're most often referring to
the federal funds rate set by the Federal Open Market Committee (FOMC). This is the rate of
interest charged on the inter-bank transfer of funds held by the Federal Reserve (Fed) and is
widely used as a benchmark for interest rates on all kinds of investments and debt securities.1

Fed policy initiatives have a huge effect on the price of bonds. For example, when the Fed
increased interest rates in March 2017 by a quarter percentage point, the bond market fell. The
yield on 30-year Treasury bonds (T-bonds) dropped to 3.02% from 3.14%, the yield on 10-year
Treasury notes (T-notes) fell to 2.4% from 2.53%, and the two-year T-notes' yield fell from
1.35% to 1.27%.1  2
The Fed raised interest rates four times in 2018. After the last raise of the year announced on
Dec. 20, 2018, the yield on 10-year T-notes fell from 2.79% to 2.69%.1  3

The current COVID-19 pandemic has seen investors flee to the relative safety of government
bonds, especially U.S. Treasuries, which has resulted in yields plummeting to all-time lows. As
of May 24, 2020, the 10-year T-note was yielding 0.64% and the 30-year T-bond was at 1.27%.

The sensitivity of a bond's price to changes in interest rates is known as its duration.

Zero-Coupon Bond
Zero-coupon bonds tend to be more volatile, as they do not pay any periodic interest during
the life of the bond. Upon maturity, a zero-coupon bondholder receives the face value of the
bond. Thus, the value of these debt securities increases the closer they get to expiring.

Zero-coupon bonds have unique tax implications, too, that investors should understand before
investing in them. Even though no periodic interest payment is made on a zero-coupon bond,
the annual accumulated return is considered to be income, which is taxed as interest. The bond
is assumed to gain value as it approaches maturity, and this gain in value is not viewed as
capital gains, which would be taxed at the capital gains rate, but rather as income.

In other words, taxes must be paid on these bonds annually, even though the investor does not
receive any money until the bond maturity date. This may be burdensome for some investors.
However, there are some ways to limit these tax consequences.

BOND VALUATION

Bond valuation is a technique for determining the theoretical fair value of a particular bond.

Bond valuation includes calculating the present value of a bond's future interest payments,
also known as its cash flow, and the bond's value upon maturity, also known as its face value or
par value. Because a bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for a bond investment to be worthwhile.

Understanding Bond Valuation

A bond is a debt instrument that provides a steady income stream to the investor in the form
of coupon payments. At the maturity date, the full face value of the bond is repaid to the
bondholder. The characteristics of a regular bond include:

 Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which
is paid to bondholders semi-annually. The coupon rate is the fixed return that an investor
earns periodically until it matures.

 Maturity date: All bonds have maturity dates, some short-term, others long-term. When
a bond matures, the bond issuer repays the investor the full face value of the bond. For
corporate bonds, the face value of a bond is usually $1,000 and for government bonds,
the face value is $10,000. The face value is not necessarily the invested principal or
purchase price of the bond.
  Current price: Depending on the level of interest rate in the environment, the investor
may purchase a bond at par, below par, or above par. For example, if interest rates
increase, the value of a bond will decrease since the coupon rate will be lower than the
interest rate in the economy. When this occurs, the bond will trade at a discount, that is,
below par. However, the bondholder will be paid the full face value of the bond at
maturity even though he purchased it for less than the par value.

Bond Valuation in Practice

Since bonds are an essential part of the capital markets, investors and analysts seek to
understand how the different features of a bond interact in order to determine its intrinsic value.
Like a stock, the value of a bond determines whether it is a suitable investment for a portfolio
and hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon
payments. The theoretical fair value of a bond is calculated by discounting the future value of its
coupon payments by an appropriate discount rate. The discount rate used is the yield to
maturity, which is the rate of return that an investor will get if they reinvested every coupon
payment from the bond at a fixed interest rate until the bond matures. It takes into account the
price of a bond, par value, coupon rate, and time to maturity.

$42.8 trillion
The size of the U.S. bond market, or the total amount of debt outstanding, at the end of 2018,
according to the Securities Industry and Financial Markets Association (SIFMA), an industry
group
Coupon Bond Valuation
Calculating the value of a coupon bond factors in the annual or semi-annual coupon payment
and the par value of the bond.

The present value of expected cash flows is added to the present value of the face value of the
bond as seen in the following formula:
Zero-Coupon Bond Valuation

A zero-coupon bond makes no annual or semi-annual coupon payments for the duration of the
bond. Instead, it is sold at a deep discount to par when issued. The difference between the
purchase price and par value is the investor’s interest earned on the bond. To calculate the
value of a zero-coupon bond, we only need to find the present value of the face value.

Following our example above, if the bond paid no coupons to investors, its value will simply be:

$1000 / (1.03)4 = $888.49

Under both calculations, a coupon-paying bond is more valuable than a zero-coupon bond.

STOCK EXCHANGE
If the thought of investing in the stock market scares you, you are not alone. Individuals with
very limited experience in stock investing are either terrified by horror stories of the average
investor losing 50% of their portfolio value—for example, in the two bear markets that have
already occurred in this millennium1 —or are beguiled by "hot tips" that bear the promise of
huge rewards but seldom pay off. It is not surprising, then, that the pendulum of investment
sentiment is said to swing between fear and greed.

The reality is that investing in the stock market carries risk, but when approached in a
disciplined manner, it is one of the most efficient ways to build up one's net worth.2 While the
value of one's home typically accounts for most of the net worth of the average individual, most
of the affluent and very rich generally have the majority of their wealth invested in stocks.3 In
order to understand the mechanics of the stock market, let's begin by delving into the definition
of a stock and its different types.

Definition of 'Stock'
A stock or share (also known as a company's "equity") is a financial instrument that represents
ownership in a company or corporation and represents a proportionate claim on its assets (what
it owns) and earnings (what it generates in profits).4

Stock ownership implies that the shareholder owns a slice of the company equal to the number
of shares held as a proportion of the company's total outstanding shares. For instance, an
individual or entity that owns 100,000 shares of a company with one million outstanding shares
would have a 10% ownership stake in it. Most companies have outstanding shares that run into
the millions or billions.

Common and Preferred Stock

While there are two main types of stock—common and preferred—the term "equities" is
synonymous with common shares, as their combined market value and trading volumes are
many magnitudes larger than that of preferred shares.5

The main distinction between the two is that common shares usually carry voting rights that
enable the common shareholder to have a say in corporate meetings (like the annual general
meeting or AGM)—where matters such as election to the board of directors or appointment
of auditors are voted upon—while preferred shares generally do not have voting rights.
Preferred shares are so named because they have preference over the common shares in a
company to receive dividends as well as assets in the event of a liquidation.5

Common stock can be further classified in terms of their voting rights. While the basic premise
of common shares is that they should have equal voting rights—one vote per share held—some
companies have dual or multiple classes of stock with different voting rights attached to each
class. In such a dual-class structure, Class A shares, for example, may have 10 votes per
share, while the Class B "subordinate voting" shares may only have one vote per share. Dual-
or multiple-class share structures are designed to enable the founders of a company to control
its fortunes, strategic direction and ability to innovate.6

Why a Company Issues Shares

Today's corporate giant likely had its start as a small private entity launched by a
visionary founder a few decades ago. Think of Jack Ma incubating Alibaba Group
Holding Limited (BABA) from his apartment in Hangzhou, China, in 1999, or Mark
Zuckerberg founding the earliest version of Facebook, Inc. (FB) from his Harvard
University dorm room in 2004. Technology giants like these have become among the
biggest companies in the world within a couple of decades.7

However, growing at such a frenetic pace requires access to a massive amount

of capital. In order to make the transition from an idea germinating in an entrepreneur's
brain to an operating company, they need to lease an office or factory, hire employees,
buy equipment and raw materials, and put in place a sales and distribution network,
among other things. These resources require significant amounts of capital, depending
on the scale and scope of the business startup.

Raising Capital
A startup can raise such capital either by selling shares (equity financing) or borrowing money
(debt financing). Debt financing can be a problem for a startup because it may have few assets
to pledge for a loan—especially in sectors such as technology or biotechnology, where a firm
has few tangible assets—plus the interest on the loan would impose a financial burden in the
early days, when the company may have no revenues or earnings.

Equity financing, therefore, is the preferred route for most startups that need capital. The
entrepreneur may initially source funds from personal savings, as well as friends and family, to
get the business off the ground. As the business expands and capital requirements become
more substantial, the entrepreneur may turn to angel investors and venture capital firms.

Listing Shares
When a company establishes itself, it may need access to much larger amounts of capital than
it can get from ongoing operations or a traditional bank loan. It can do so by selling shares to
the public through an initial public offering (IPO). This changes the status of the company from a
private firm whose shares are held by a few shareholders to a publicly traded company whose
shares will be held by numerous members of the general public. The IPO also offers early
investors in the company an opportunity to cash out part of their stake, often reaping very
handsome rewards in the process.

Once the company's shares are listed on a stock exchange and trading in it commences, the
price of these shares will fluctuate as investors and traders assess and reassess their intrinsic
value. There are many different ratios and metrics that can be used to value stocks, of which the
single-most popular measure is probably the Price/Earnings (or PE) ratio. The stock analysis
also tends to fall into one of two camps—fundamental analysis, or technical analysis.

What is a Stock Exchange?

Stock exchanges are secondary markets, where existing owners of shares can transact with
potential buyers. It is important to understand that the corporations listed on stock markets do
not buy and sell their own shares on a regular basis (companies may engage in stock
buybacks8 or issue new shares,9 but these are not day-to-day operations and often occur
outside of the framework of an exchange). So when you buy a share of stock on the stock
market, you are not buying it from the company, you are buying it from some other existing
shareholder. Likewise, when you sell your shares, you do not sell them back to the company—
rather you sell them to some other investor.

The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities
or trading hubs such as Antwerp, Amsterdam, and London.1 0 These early stock exchanges,
however, were more akin to bond exchanges as the small number of companies did not issue
equity. In fact, most early corporations were considered semi-public organizations since they
had to be chartered by their government in order to conduct business.

In the late 18th century, stock markets began appearing in America, notably the New York Stock
Exchange (NYSE), which allowed for equity shares to trade. The honor of the first stock
exchange in America goes to the Philadelphia Stock Exchange (PHLX), which still exists
today.1 1 The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24
New York City stockbrokers and merchants. Prior to this official incorporation, traders and
brokers would meet unofficially under a buttonwood tree on Wall Street to buy and sell shares.1 2

The advent of modern stock markets ushered in an age of regulation and professionalization
that now ensures buyers and sellers of shares can trust that their transactions will go through at
fair prices and within a reasonable period of time. Today, there are many stock exchanges in
the U.S. and throughout the world, many of which are linked together electronically. This in turn
means markets are more efficient and more liquid.

There also exists a number of loosely regulated over-the-counter exchanges, sometimes known

as bulletin boards, that go by the acronym OTCBB. OTCBB shares tend to be more risky since
they list companies that fail to meet the more strict listing criteria of bigger exchanges.1 3 For
example, larger exchanges may require that a company has been in operation for a certain
amount of time before being listed, and that it meets certain conditions regarding company
value and profitability.1 4 In most developed countries, stock exchanges are self-regulatory
organizations (SROs), non-governmental organizations that have the power to create and
enforce industry regulations and standards.1 5 The priority for stock exchanges is to protect
investors through the establishment of rules that promote ethics and equality. Examples of such
SRO’s in the U.S. include individual stock exchanges, as well as the National Association of
Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).

How Share Prices Are Set

The prices of shares on a stock market can be set in a number of ways, but most the most
common way is through an auction process where buyers and sellers place bids and offers to
buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the
price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.

The overall market is made up of millions of investors and traders, who may have differing ideas
about the value of a specific stock and thus the price at which they are willing to buy or sell it.
The thousands of transactions that occur as these investors and traders convert their intentions
to actions by buying and/or selling a stock cause minute-by-minute gyrations in it over the
course of a trading day. A stock exchange provides a platform where such trading can be easily
conducted by matching buyers and sellers of stocks. For the average person to get access to
these exchanges, they would need a stockbroker. This stockbroker acts as the middleman
between the buyer and the seller. Getting a stockbroker is most commonly accomplished by
creating an account with a well established retail broker.

Stock Market Supply and Demand

The stock market also offers a fascinating example of the laws of supply and demand at work in
real time. For every stock transaction, there must be a buyer and a seller. Because of the
immutable laws of supply and demand, if there are more buyers for a specific stock than there
are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock
than buyers, the price will trend down.

The bid-ask or bid-offer spread—the difference between the bid price for a stock and its ask or
offer price—represents the difference between the highest price that a buyer is willing to pay or
bid for a stock and the lowest price at which a seller is offering the stock. A trade transaction
occurs either when a buyer accepts the ask price or a seller takes the bid price. If buyers
outnumber sellers, they may be willing to raise their bids in order to acquire the stock; sellers
will, therefore, ask higher prices for it, ratcheting the price up. If sellers outnumber buyers, they
may be willing to accept lower offers for the stock, while buyers will also lower their bids,
effectively forcing the price down.

Matching Buyers to Sellers

Some stock markets rely on professional traders to maintain continuous bids and offers since a
motivated buyer or seller may not find each other at any given moment. These are known
as specialists or market makers. A two-sided market consists of the bid and the offer, and
the spread is the difference in price between the bid and the offer. The more narrow the price
spread and the larger size of the bids and offers (the amount of shares on each side), the
greater the liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially
higher and lower prices, the market is said to have good depth. Stock markets of high quality
generally tend to have small bid-ask spreads, high liquidity, and good depth. Likewise, individual
stocks of high quality, large companies tend to have the same characteristics.

Matching buyers and sellers of stocks on an exchange was initially done manually, but it is now
increasingly carried out through computerized trading systems. The manual method of trading
was based on a system known as "open outcry," in which traders used verbal and hand signal
communications to buy and sell large blocks of stocks in the "trading pit" or the floor of an
exchange.

However, the open outcry system has been superseded by electronic trading systems at
most exchanges.1 6 These systems can match buyers and sellers far more efficiently and rapidly
than humans can, resulting in significant benefits such as lower trading costs and faster
trade execution.

Benefits of Stock Exchange Listing

Until recently, the ultimate goal for an entrepreneur was to get his or her company listed on a
reputed stock exchange such as the New York Stock Exchange (NYSE) or Nasdaq, because of
the obvious benefits, which include:

 An exchange listing means ready liquidity for shares held by the company's

shareholders.
 It enables the company to raise additional funds by issuing more shares.
 Having publicly traded shares makes it easier to set up stock options plans that are
necessary to attract talented employees.
 Listed companies have greater visibility in the marketplace; analyst coverage and
demand from institutional investors can drive up the share price.
 Listed shares can be used as currency by the company to make acquisitions in which
part or all of the consideration is paid in stock.

These benefits mean that most large companies are public rather than private; very large
private companies such as food and agriculture giant Cargill, industrial conglomerate Koch
Industries, and DIY furniture retailer Ikea are among the world's most valuable private
companies, and they are the exception rather than the norm.

Problems of Stock Exchange Listing

But there are some drawbacks to being listed on a stock exchange, such as:

 Significant costs associated with listing on an exchange, such as listing fees and higher
costs associated with compliance and reporting.
 Burdensome regulations, which may constrict a company's ability to do business.
 The short-term focus of most investors, which forces companies to try and beat their
quarterly earnings estimates rather than taking a long-term approach to their corporate
strategy.
Many giant startups (also known as "unicorns" because startups valued at greater than $1
billion used to be exceedingly rare) are choosing to get listed on an exchange at a much later
stage than startups from a decade or two ago.1 7 While this delayed listing may partly be
attributable to the drawbacks listed above, the main reason could be that well-managed startups
with a compelling business proposition have access to unprecedented amounts of capital
from sovereign wealth funds, private equity, and venture capitalists. Such access to seemingly
unlimited amounts of capital would make an IPO and exchange listing much less of a pressing
issue for a startup.

The number of publicly traded companies in the U.S. is also shrinking—from more than 8,000 in
1996 to around to between 4,100 and 4,400 in 2017.1 8

In the local setting, the publicly listed firms in the Philippine Stock Exchange is more than 270
from 2020.

Market Cap and Sector

While stocks can be classified in a number of ways, two of the most common are by market
capitalization and by sector.

Market capitalization refers to the total market value of a company's outstanding shares and is
calculated by multiplying these shares by the current market price of one share. While the exact
definition may vary depending on the market, large-cap companies are generally regarded as
those with a market capitalization of $10 billion or more, while mid-cap companies are those
with a market capitalization of between $2 billion and $10 billion, and small-cap companies fall
between $300 million and $2 billion.

The industry standard for stock classification by sector is the Global Industry Classification
Standard (GICS), which was developed by MSCI and S&P Dow Jones Indices in 1999 as an
efficient tool to capture the breadth, depth, and evolution of industry sectors.2 0 GICS is a four-
tiered industry classification system that consists of 11 sectors and 24 industry groups. The 11
sectors are:

 Energy
 Materials
 Industrials
 Consumer Discretionary
 Consumer Staples
 Health Care
 Financials
 Information Technology
 Communication Services
 Utilities
 Real Estate2 0

This sector classification makes it easy for investors to tailor their portfolios according to their
risk tolerance and investment preference. For example, conservative investors with income
needs may weight their portfolios toward sectors whose constituent stocks have better price
stability and offer attractive dividends – so-called "defensive" sectors such as consumer staples,
health care, and utilities. Aggressive investors may prefer more volatile sectors such as
information technology, financials, and energy.
Stock Market Indices
In addition to individual stocks, many investors are concerned with stock indices (also called
indexes). Indices represent aggregated prices of a number of different stocks, and the
movement of an index is the net effect of the movements of each individual component. When
people talk about the stock market, they often are actually referring to one of the major indices
such as the Dow Jones Industrial Average (DJIA) or the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting
scheme and that it only consists of 30 stocks—when there are many thousand to choose from—
it is not really a good indicator of how the stock market is doing. The S&P 500 is a market cap-
weighted index of the 500 largest companies in the U.S., and is a much more valid indicator.2 1
Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain
industry or market sector. Investors can trade indices indirectly via futures markets, or via
exchange traded funds (ETFs), which trade like stocks on stock exchanges.

A market index is a popular measure of stock market performance. Most market indices
are market-cap weighted—which means that the weight of each index constituent is proportional
to its market capitalization—although a few like the Dow Jones Industrial Average (DJIA)
are price-weighted.2 1 In addition to the DJIA, other widely watched indices in the U.S. and
internationally include:

 S&P 500
 Nasdaq Composite
 Russell Indices (Russell 1000, Russell 2000)
 TSX Composite (Canada)
 FTSE Index (UK)
 Nikkei 225 (Japan)
 Dax Index (Germany)
 CAC 40 Index (France)
 CSI 300 Index (China)
 Sensex (India)

Largest Stock Exchanges

Stock exchanges have been around for more than two centuries. The venerable NYSE traces
its roots back to 1792 when two dozen brokers met in Lower Manhattan and signed an
agreement to trade securities on commission;1 2 in 1817, New York stockbrokers operating
under the agreement made some key changes and reorganized as the New York Stock and
Exchange Board.2 2

The NYSE and Nasdaq are the two largest exchanges in the world, based on the total market
capitalization of all the companies listed on the exchange. The number of U.S. stock exchanges
registered with the Securities and Exchange Commission has reached nearly two dozen, though
most of these are owned by either CBOE, Nasdaq or NYSE.2 3  The table below displays the 20
biggest exchanges globally, ranked by total market capitalization of their listed companies.

Domestic Market Capitalization (USD millions)

     
Exchange Location Market Cap.*
Domestic Market Capitalization (USD millions)
NYSE U.S. 22,987,587
Nasdaq U.S. 13,286,825
Japan Exchange Group Japan 6,000,171
Shanghai Stock Exchange China 5,037,349
Euronext France 4,821,103
Hong Kong Exchanges and Clearing Hong Kong 4,595,366
LSE Group U.K. 4,024,164
Shenzhen Stock Exchange China 3,454,965
TMX Group Canada 2,386,066
Saudi Stock Exchange (Tadawul) Saudi Arabia 2,333,838
BSE India Limited India 2,181,351
National Stock Exchange of India Limited India 2,162,693
Deutsche Boerse AG Germany 2,020,041
SIX Swiss Exchange Switzerland 1,775,268
Nasdaq Nordic and Baltics Sweden 1,594,481
Australian Securities Exchange Australia 1,497,599
Korea Exchange South Korea 1,402,716
Taiwan Stock Exchange Taiwan 1,143,210
B3 - Brasil Bolsa Balcão Brazil 1,118,281
Moscow Exchange Moscow 772,189
 
   
* as of January 2020
Source: World Federation of Exchanges2 4

FOREIGN EXCHANGE MARKET

The foreign exchange market (also known as forex, FX, or the currency market) is an over-
the-counter (OTC) global marketplace that determines the exchange rate for currencies around
the world. Participants are able to buy, sell, exchange, and speculate on currencies.

Foreign exchange markets are made up of banks, forex dealers, commercial companies, central

banks, investment management firms, hedge funds, retail forex dealers, and investors.

Forex Market Basics

Understanding the Foreign Exchange Market
The foreign exchange market—also called forex, FX, or currency market—was one of the
original financial markets formed to bring structure to the burgeoning global economy. In terms
of trading volume, it is, by far, the largest financial market in the world. Aside from providing a
venue for the buying, selling, exchanging, and speculation of currencies, the forex market also
enables currency conversion for international trade settlements and investments.

According to the Bank for International Settlements (BIS), which is owned by central banks,
trading in foreign exchange markets averaged $6.6 trillion per day in April 2019.1
Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is
relative to the value of the other. This determines how much of country A's currency country B
can buy, and vice versa. Establishing this relationship (price) for the global markets is the main
function of the foreign exchange market. This also greatly enhances liquidity in all other financial
markets, which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or "fixed float". Free-
floating currencies are those whose relative value is determined by free market forces, such
as supply-demand relationships. A fixed float is where a country's governing body sets its
currency's relative value to other currencies, often by pegging it to some standard. Free-floating
currencies include the U.S. dollar, Japanese yen, and British pound, while examples of fixed
floating currencies include the Chinese Yuan and the Indian Rupee.

One of the most unique features of the forex market is that it is comprised of a global network of
financial centers that transact 24 hours a day, closing only on the weekends. As one major forex
hub closes, another hub in a different part of the world remains open for business. This
increases the liquidity available in currency markets, which adds to its appeal as the
largest asset class available to investors.

The most liquid trading pairs are, in descending order of liquidity:1

1. EUR/USD
2. USD/JPY
3. GBP/USD

Forex Leverage
The leverage available in FX markets is one of the highest that traders and investors can find
anywhere. Leverage is a loan given to an investor by their broker. With this loan, investors are
able to increase their trade size, which could translate to greater profitability. A word of caution,
though: losses are also amplified.

For example, investors who have a $1,000 forex market account can trade $100,000 worth of
currency with a margin of 1%. This is referred to as having a 100:1 leverage. Their profit or loss
will be based on the $100,000 notional amount.

Benefits of Using the Forex Market

There are some key factors that differentiate the forex market from others, like the stock market.

 There are fewer rules, which means investors aren't held to the strict standards or
regulations found in other markets.
 There are no clearing houses and no central bodies that oversee the forex market.
 Most investors won't have to pay the traditional fees or commissions that you would on
another market.
 Because the market is open 24 hours a day, you can trade at any time of day, which
means there's no cut-off time to be able to participate in the market.
 Finally, if you're worried about risk and reward, you can get in and out whenever you
want, and you can buy as much currency as you can afford based on your account
balance and your broker's rules for leverage.
DERIVATIVE

A derivative is a financial security with a value that is reliant upon or derived from, an

underlying asset or group of assets—a benchmark. The derivative itself is a contract between
two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities,
currencies, interest rates, and market indexes. These assets are commonly purchased through
brokerages.

Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a

greater proportion of the derivatives market. OTC-traded derivatives, generally have a greater
possibility of counterparty risk. Counterparty risk is the danger that one of the parties involved in
the transaction might default. These parties trade between two private parties and are
unregulated.

Conversely, derivatives that are exchange-traded are standardized and more heavily regulated.

The Basics of a Derivative

Derivatives can be used to hedge a position, speculate on the directional movement of an
underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the
values of the underlying asset.

Originally, derivatives were used to ensure balanced exchange rates for goods traded
internationally. With the differing values of national currencies, international traders needed a
system to account for differences. Today, derivatives are based upon a wide variety of
transactions and have many more uses. There are even derivatives based on weather data,
such as the amount of rain or the number of sunny days in a region.

For example, imagine a European investor, whose investment accounts are all
denominated in euros (EUR). This investor purchases shares of a U.S. company through
a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-
rate risk while holding that stock. Exchange-rate risk the threat that the value of the euro
will increase in relation to the USD. If the value of the euro rises, any profits the investor
realizes upon selling the stock become less valuable when they are converted into
euros.

To hedge this risk, the investor could purchase a currency derivative to lock in a specific
exchange rate. Derivatives that could be used to hedge this kind of risk include currency
futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could profit by using a
derivative that rises in value with the euro. When using derivatives to speculate on the price
movement of an underlying asset, the investor does not need to have a holding or portfolio
presence in the underlying asset.

Common Forms of Derivatives

There are many different types of derivatives that can be used for risk management, for
speculation, and to leverage a position. Derivatives is a growing marketplace and offer products
to fit nearly any need or risk tolerance.
Futures
Futures contracts—also known simply as futures—are an agreement between two parties for
the purchase and delivery of an asset at an agreed upon price at a future date. Futures trade on
an exchange, and the contracts are standardized. Traders will use a futures contract to hedge
their risk or speculate on the price of an underlying asset. The parties involved in the futures
transaction are obligated to fulfill a commitment to buy or sell the underlying asset.

For example, say that Nov. 6, 2019, Company-A buys a futures contract for oil at a price
of $62.22 per barrel that expires Dec. 19, 2019. The company does this because it
needs oil in December and is concerned that the price will rise before the company
needs to buy. Buying an oil futures contract hedges the company's risk because the
seller on the other side of the contract is obligated to deliver oil to Company-A for $62.22
per barrel once the contract has expired. Assume oil prices rise to $80 per barrel by Dec.
19, 2019. Company-A can accept delivery of the oil from the seller of the futures
contract, but if it no longer needs the oil, it can also sell the contract before expiration
and keep the profits.

In this example, it is possible that both the futures buyer and seller were hedging risk.
Company-A needed oil in the future and wanted to offset the risk that the price may rise
in December with a long position in an oil futures contract. The seller could be an oil
company that was concerned about falling oil prices and wanted to eliminate that risk by
selling or "shorting" a futures contract that fixed the price it would get in December.

It is also possible that the seller or buyer—or both—of the oil futures parties were speculators
with the opposite opinion about the direction of December oil. If the parties involved in the
futures contract were speculators, it is unlikely that either of them would want to make
arrangements for delivery of several barrels of crude oil. Speculators can end their obligation to
purchase or deliver the underlying commodity by closing—unwinding—their contract before
expiration with an offsetting contract.

For example, the futures contract for West Texas Intermediate (WTI) oil trades on the
CME represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per barrel,
the trader with the long position—the buyer—in the futures contract would have profited
$17,780 [($80 - $62.22) X 1,000 = $17,780]. The trader with the short position—the
seller—in the contract would have a loss of $17,780.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many
derivatives are cash-settled, which means that the gain or loss in the trade is simply an
accounting cash flow to the trader's brokerage account. Futures contracts that are cash settled
include many interest rate futures, stock index futures, and more unusual instruments like
volatility futures or weather futures.

Forwards
Forward contracts—known simply as forwards—are similar to futures, but do not trade on an
exchange, only over-the-counter. When a forward contract is created, the buyer and seller may
have customized the terms, size and settlement process for the derivative. As OTC products,
forward contracts carry a greater degree of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up
to the obligations outlined in the contract. If one party of the contract becomes insolvent, the
other party may have no recourse and could lose the value of its position. Once created, the
parties in a forward contract can offset their position with other counterparties, which can
increase the potential for counterparty risks as more traders become involved in the same
contract.

Swaps
Swaps are another common type of derivative, often used to exchange one kind of cash flow
with another. For example, a trader might use an interest rate swap to switch from a variable
interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ has borrowed $1,000,000 and pays a variable rate of
interest on the loan that is currently 6%. XYZ may be concerned about rising interest
rates that will increase the costs of this loan or encounter a lender that is reluctant to
extend more credit while the company has this variable rate risk.

Assume that XYZ creates a swap with Company QRS, which is willing to exchange the
payments owed on the variable rate loan for the payments owed on a fixed rate loan of
7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will
pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just
pay QRS the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company
XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise
to 8%, then QRS would have to pay XYZ the 1% difference between the two swap rates.
Regardless of how interest rates change, the swap has achieved XYZ's original objective
of turning a variable rate loan into a fixed rate loan.

Swaps can also be constructed to exchange currency exchange rate risk or the risk of default
on a loan or cash flows from other business activities. Swaps related to the cash flows and
potential defaults of mortgage bonds are an extremely popular kind of derivative—a bit too
popular. In the past. It was the counterparty risk of swaps like this that eventually spiraled into
the credit crisis of 2008.

Options
An options contract is similar to a futures contract in that it is an agreement between two
parties to buy or sell an asset at a predetermined future date for a specific price. The key
difference between options and futures is that, with an option, the buyer is not obliged to
exercise their agreement to buy or sell. It is an opportunity only, not an obligation—futures are
obligations. As with futures, options may be used to hedge or speculate on the price of the
underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share they believe the
stock's value will rise in the future. However, this investor is concerned about potential
risks and decides to hedge their position with an option. The investor could buy a put
option that gives them the right to sell 100 shares of the underlying stock for $50 per
share—known as the strike price—until a specific day in the future—known as
the expiration date.

Assume that the stock falls in value to $40 per share by expiration and the put option
buyer decides to exercise their option and sell the stock for the original strike price of
 $50 per share. If the put option cost the investor $200 to purchase, then they have only
lost the cost of the option because the strike price was equal to the price of the stock
when they originally bought the put. A strategy like this is called a protective put because
it hedges the stock's downside risk.

Alternatively, assume an investor does not own the stock that is currently worth $50 per
share. However, they believe that the stock will rise in value over the next month. This
investor could buy a call option that gives them the right to buy the stock for $50 before
or at expiration. Assume that this call option cost $200 and the stock rose to $60 before
expiration. The call buyer can now exercise their option and buy a stock worth $60 per
share for the $50 strike price, which is an initial profit of $10 per share. A call option
represents 100 shares, so the real profit is $1,000 less the cost of the option—
the premium—and any brokerage commission fees.

In both examples, the put and call option sellers are obligated to fulfill their side of the contract if
the call or put option buyer chooses to exercise the contract. However, if a stock's price is above
the strike price at expiration, the put will be worthless and the seller—the option writer—gets to
keep the premium as the option expires. If the stock's price is below the strike price at
expiration, the call will be worthless and the call seller will keep the premium. Some options can
be exercised before expiration. These are known as American-style options, but their use and
early exercise are rare.

Advantages of Derivatives
As the above examples illustrate, derivatives can be a useful tool for businesses and investors
alike. They provide a way to lock in prices, hedge against unfavorable movements in rates, and
mitigate risks—often for a limited cost. In addition, derivatives can often be purchased on
margin—that is, with borrowed funds—which makes them even less expensive.

Downside of Derivatives
On the downside, derivatives are difficult to value because they are based on the price of
another asset. The risks for OTC derivatives include counter-party risks that are difficult to
predict or value as well. Most derivatives are also sensitive to changes in the amount of time to
expiration, the cost of holding the underlying asset, and interest rates. These variables make it
difficult to perfectly match the value of a derivative with the underlying asset.

Pros

 Lock in prices

 Hedge against risk

 Can be leveraged

 Diversify portfolio

Cons

 Hard to value

 Subject to counterparty default (if OTC)

  Complex to understand

 Sensitive to supply and demand factors

Also, since the derivative itself has no intrinsic value—its value comes only from the underlying
asset—it is vulnerable to market sentiment and market risk. It is possible for supply and demand
factors to cause a derivative's price and its liquidity to rise and fall, regardless of what is
happening with the price of the underlying asset.

Finally, derivatives are usually leveraged instruments, and using leverage cuts both ways. While
it can increase the rate of return it also makes losses mount more quickly.

Real World Example of Derivatives

Many derivative instruments are leveraged. That means a small amount of capital is required to
have an interest in a large amount of value in the underlying asset.

For example, an investor who expects the S&P 500 Index to rise in value could buy a
futures contract based on that venerable equity index of the largest U.S. publicly traded
companies. The notional value of a futures contract on the S&P 500 is $250,000.

Frequently Asked Questions

What are derivatives?
Derivatives are securities whose value is dependent on—or “derived from”—an underlying
asset. For example, an oil futures contract is a type of derivative whose value is based on the
market price of oil. Derivatives have become increasingly popular in recent decades, with
the total value of derivatives outstanding currently estimated at over $600 trillion.

What are some examples of derivatives?

Common examples of derivatives include futures contracts, options contracts, and credit default
swaps. Beyond these, there is a vast quantity of derivative contracts tailored to meet the needs
of a diverse range of counterparties. In fact, since many derivatives are traded over the counter
(OTC), they can in principle be infinitely customized.

What are the main benefits and risks of derivatives?

Derivatives can be a very convenient way to achieve financial goals. For example, a company
that wants to hedge against its exposure to commodities can do so by buying or selling energy
derivatives such as crude oil futures. Similarly, a company could hedge its currency risk by
purchasing currency forward contracts. Derivatives can also help investors leverage their
positions, such as by buying equities through stock options rather than shares. The main
drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact
that complicated webs of derivative contracts can lead to systemic risks.

HEDGING VS. SPECULATION: WHAT'S THE DIFFERENCE?

Hedging vs. Speculation: An Overview

Speculators and hedgers are different terms that
describe traders and investors. Speculation involves trying to make a profit from a security's
price change, whereas hedging attempts to reduce the amount of risk, or volatility, associated
with a security's price change.

Hedging involves taking an offsetting position in a derivative in order to balance any gains and
losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the
price of an asset by taking offsetting positions contrary to what the investor currently has. The
main purpose of speculation, on the other hand, is to profit from betting on the direction in which
an asset will be moving.

Hedging
Hedgers reduce their risk by taking an opposite position in the market to what they are trying to
hedge. The ideal situation in hedging would be to cause one effect to cancel out another. It is a
risk-neutralizing strategy.

For example, assume that a company specializes in producing jewelry and it has a
major contract due in six months, for which gold is one of the company's main inputs.
The company is worried about the volatility of the gold market and believes that gold
prices may increase substantially in the near future. In order to protect itself from this
uncertainty, the company could buy a six-month futures contract in gold. This way, if
gold experiences a 10 percent price increase, the futures contract will lock in a price that
will offset this gain.

As you can see, although hedgers are protected from any losses, they are also restricted from
any gains. The portfolio is diversified but still exposed to systematic risk. Depending on a
company's policies and the type of business it runs, it may choose to hedge against certain
business operations to reduce fluctuations in its profit and protect itself from any downside risk.

To mitigate this risk, the investor hedges their portfolio by shorting futures contracts on the
market and buying put options against the long positions in the portfolio. On the other hand, if a
speculator notices this situation, they may look to short an exchange-traded fund (ETF) and a
futures contract on the market to make a potential profit on a downside move.

Speculation
Speculators trade based on their educated guesses on where they believe the market is
headed. For example, if a speculator believes that a stock is overpriced, they may sell short the
stock and wait for the price to decline, at which point it can be bought back for a profit.

Speculators are vulnerable to both the downside and upside of the market; therefore,
speculation can be extremely risky.

Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the
movements of the market to try to profit from fluctuations in the price of securities.

Hedging vs. Speculation Example

It's important to note that hedging is not the same as portfolio diversification. Diversification is a
portfolio management strategy that investors use to smooth out specific risk in one investment,
while hedging helps to decrease one's losses by taking an offsetting position. If an investor
wants to reduce their overall risk, the they should not put all of their money into one investment.
Investors can spread out their money into multiple investments to reduce risk.

For example, suppose an investor has $500,000 to invest. The investor can diversify and
put money into multiple stocks in various sectors, real estate, and bonds. This technique
helps to diversify unsystematic risk; in other words, it protects the investor from being
affected by any individual event in an investment.

When an investor is worried about an adverse price decline in their investment, the
investor can hedge their investment with an offsetting position to be protected. For
example, suppose an investor is invested in 100 shares of stock in oil company XYZ
and feels that the recent drop in oil prices will have an adverse effect on its earnings.
The investor does not have enough capital to diversify their position; instead, the
investor decides to hedge their position by buying options for protection. The investor
can purchase one put option to protect against a drop in the stock price, and pays a
small premium for the option. If XYZ misses its earnings estimates and prices fall, the
investor will lose money on their long position but will make money on the put option,
which limits losses.

References:

Financial Markets, WILL KENTON,  Updated Mar 3, 2020

Primary Market, JAMES CHEN, Mar 16, 2020

Bond Market, JAMES CHEN, Mar 31, 2020

The Inverse Relationship Between Interest Rates and Bond Prices, NICK K. LIOUDIS, Oct 8,
2020

Bond Valuation, JAMES CHEN, Dec 23, 2020

How Does the Stock Market Work, ADAM HAYES, Jul 13, 2020

FOREIGN EXCHANGE MARKET, AKHILESH GANTI, Nov 8, 2020

Derivative, JASON FERNANDO, Feb 3, 2021

HEDGING VS. SPECULATION: WHAT'S THE DIFFERENCE?, BRIAN BEERS, Feb 15, 2021