Financial Instruments
& Markets

Overview

Financial instruments are generally divided into four main categories: equities, debt, derivatives, and currencies. Each serves a distinct role in finance and investing.

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Stocks (Equities)

Stocks represent ownership in a company. Purchasing a stock makes an individual or institution a shareholder, owning part of the company’s assets and earnings. Companies issue stocks to raise capital for projects, operations, or expansion.

Key features:

• Represent ownership and a claim on company profits

• Provide voting rights depending on the class of shares

• May pay dividends, which are periodic payments from profits

• Traded on exchanges such as the New York Stock Exchange, London Stock Exchange, and Tokyo Stock Exchange

Advantages:

• Potential for long-term growth as companies expand

• Opportunity to receive income through dividends

• Highly liquid in established markets

Risks:

• Prices can fluctuate due to company performance, economic conditions, and market sentiment

• Investors may lose part or all of their investment if the company underperforms

Global examples of widely traded stocks include Apple, Toyota, Nestlé, and Unilever.

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Bonds (Debt Securities)

Bonds are loans made by investors to entities such as governments, municipalities, or corporations. Investors receive interest payments and the return of principal at maturity.

Key features:

• Provide predictable income through interest payments

• Include a maturity date for repayment of the principal

• Are assigned credit ratings reflecting the issuer’s ability to meet obligations

• Can be traded in secondary markets before maturity

Types of bonds:

• Government bonds like U.S. Treasuries, German Bunds, and Japanese Government Bonds

• Corporate bonds issued by companies for financing operations or projects

• Municipal bonds issued by local governments, often offering tax advantages

Advantages:

• Stable income and lower risk compared to stocks

• Useful for portfolio diversification

Risks:

• Inflation can reduce the real value of payments

• Rising interest rates may lower bond prices

• Credit risk exists if the issuer cannot fulfill obligations

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Derivatives

Derivatives are contracts whose value depends on an underlying asset or index. Common derivatives include futures, options, swaps, and forwards.

Uses:

• Hedging against risks such as price, interest rate, or currency fluctuations

• Speculation for potential profit

• Enhancing portfolio efficiency by managing exposure

Risks:

• High complexity and leverage can lead to large losses

• Counterparty risk is present in over-the-counter contracts

Derivatives are crucial in global finance for risk management and trading strategies, but they require careful use due to complexity.

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Currencies

Currencies are money issued by governments or monetary unions. The foreign exchange market is where currencies are traded globally. It is highly liquid and operates around the clock during weekdays.

Major currencies include:

• U.S. Dollar (USD)

• Euro (EUR)

• Japanese Yen (JPY)

• British Pound (GBP)

• Swiss Franc (CHF)

Uses:

• Facilitating international trade and investment

• Hedging against currency risk for companies and investors

• Speculation on currency price movements

Trends:

• Forex trading is affected by interest rate changes, economic reports, and geopolitical events

• Central banks may intervene to stabilize currencies

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Money Market Instruments

Money market instruments are short-term debt securities with maturities under one year. They provide liquidity and are low-risk.

Examples include:

• Treasury bills

• Commercial paper

• Certificates of deposit

Uses:

• Short-term financing for governments, corporations, and financial institutions

• Preserving capital while earning small returns

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Commodities

Commodities are physical goods such as oil, gold, or wheat. They can be traded directly in spot markets or through futures contracts.

Examples include:

• Energy commodities such as crude oil and natural gas

• Metals like gold, silver, and copper

• Agricultural products such as wheat, corn, and coffee

Uses:

• Hedging against price changes for producers and consumers

• Diversifying investment portfolios

• Trading for profit in futures markets

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Types of Financial Markets

Financial markets provide the infrastructure to buy and sell instruments efficiently.

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Primary Markets

Primary markets involve the initial issuance of securities. Funds raised go directly to the issuer.

Examples:

• Initial public offerings for stocks

• New bond issues by governments or corporations

• Private placements for selected institutional investors

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Secondary Markets

Secondary markets involve trading existing securities between investors.

Examples:

• Stock exchanges for equities

• Bond markets for trading government and corporate debt

• Over-the-counter markets for non-standardized instruments

Functions:

• Provide liquidity to investors

• Enable price discovery for financial instruments

• Allow investors to buy or sell holdings easily

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Capital Markets versus Money Markets

• Capital markets handle long-term financing such as stocks and long-term bonds

• Money markets deal with short-term instruments with low risk and high liquidity

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Derivatives Markets

Derivatives markets include exchange-traded and over-the-counter instruments.

Exchange-traded derivatives:

• Standardized contracts such as futures and options

• Cleared through centralized exchanges

Over-the-counter derivatives:

• Customized contracts like forwards and swaps

• Negotiated privately between parties

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Foreign Exchange Markets

The forex market is a decentralized global market for trading currencies. Participants include banks, corporations, governments, and individual traders.

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Commodity Markets

Commodity markets trade raw goods and related derivatives. Exchanges include the Chicago Board of Trade and the Intercontinental Exchange.

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Global Interactions and Trends

• Financial markets are interconnected worldwide. Changes in one market can affect others globally

• Cross-border investments allow diversification across countries and currencies

• Interest rates set by central banks influence stock, bond, and currency markets

• Technology enables electronic trading and faster information flow, increasing market efficiency

• Emerging trends include green bonds, ESG funds, digital currencies, and central bank digital currencies

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Risks and Strategies

Market risk: Prices fluctuate due to economic and geopolitical events

Credit risk: The possibility that issuers cannot meet their obligations

Liquidity risk: Difficulty selling an instrument without impacting its price

Currency and interest rate risk: Changes in rates and currency values affect returns

Strategies:

• Hedging using derivatives to manage risk

• Diversification across asset types and geographies

• Active monitoring of economic indicators and central bank policies