Introduction to the Financial Markets and Institutions
Financial Markets and Institutions is a big term. There is a lot of components inside financial markets and a lot of things to cover.
This is why we have prepared a complete guide for you where you going to learn about the basics but also a more advanced stuff.
Table of Content
- Introduction to the Financial Markets and Institutions
- What are the Financial markets and Institutions?
- What is an OTC (over-the-counter) market?
- Comparison for the retail trader
- Instruments traded in Financial Markets and Institutons
- Trading terminology
- Contract For Difference
- How to make money in trading?
- Market Participants
What are the Financial markets and Institutions?
A financial market is a place which provides the ability to exchange different financial assets.
Through this exchange, you can buy and sell assets such as foreign currencies, stocks, bonds, commodities etc., in exchange for money.
A financial market is one of the main parts of the capital market.
Investors and issuers meet at the exchange every day.
Issuers gain funds at the exchange of their own business, while investors can gain ROI (Return of investment).
The exchange takes the form of double-sided auction, where the final price of the traded instrument decides the state of supply and demand.
The price thus obtained is called a course.
The world's biggest centralized exchanges
- NYSE – New York Stock Exchange (USA) - Largest exchange in the world measured by the market value of securities traded
- NASDAQ – National Association of Securities Dealers Automated Quotations (USA)
- Euronext – European New Exchange Technology (Europe)
- FWB – Frankfurt Stock Exchange (Germany)
- LSE – London Stock Exchange (United Kingdom)
- TSE – Tokyo Stock Exchange (Japan)
All the above-mentioned institutions are so-called centralized exchanges - being characterized by the settlement of a transaction between the buyer and the seller. It is the central place where the price is determined, settlement of trades is called the clearing.
Contrary, a decentralized exchange is not physically or logically linked to one particular place. The market therefore operates on the basis of a link between the participants, without a central authority.
Structure of Decentralized Exchange
Decentralization is the very process of distributing the decision-making powers of central authorities.
Decentralization is one of the most attractive attributes of cryptocurrencies, which cannot be controlled by any central entity.
For example, in peer-to-peer systems, it is Bitcoin which requires no central authorities for its transactions.
Unlike centralized exchanges and exchange bureaus, their decentralized "sisters" are just a kind of interface that connects two people who want to make a shift and the rest is on these participant.
Main characteristics of decentralized exchange
- Allow its clients to have control over their own resources
- Does not have a central server that could become the target of a hacker attacks
- Not controlled by an individual or a narrow group of people
- Respects the privacy of its clients and does not require lengthy forms of registration or fulfilment of KYC (know your customer) standards
The decentralized exchanges also include the foreign exchange market. Talking about Forex, we use the term OTC.
What is an OTC (over-the-counter) market?
A decentralized market without a central physical position, where market participants trade between each other through various means of communication, such as telephone, email and proprietary e-commerce systems.
In the OTC market, traders act as market makers by stating the prices at which they buy and sell securities, currencies or other financial products.
A trade can be made between two participants in the OTC market without others being aware of the price at which the transaction was completed.
In general, the OTC market is usually less transparent than stock exchanges and is also subject to less regulation.
The OTC market is primarily used to trade bonds, currencies, derivatives and structured products.
The currency market is the largest and most liquid financial market in the world.
Trading is allowed 24 hours a day, 5 days a week through repeating Asian, London and New York sessions.
Thanks to the boom in online trading, it is available to almost everyone.
The average daily trading volume of around $5 trillion, which is about 10 – 15 times more than the daily volume of trades on the world's stock markets.
The currency market is decentralized, there is no specific market floor such as NYSE for trading stocks.
Forex, therefore, has the character of OTC (over-the-counter) market. It works on the basis of the connection between dealers and traders.
Comparison for the retail trader
The centralized market is characterized by high standardization in terms of the size of traded contracts, trading hours, and a uniform price for all participating brokers.
The market is heavily regulated and completely transparent.
It offers a wide range of products but is highly capital demanding.
Different trading conditions, different contract sizes and trading hours among brokers.
Even the prices of the same instruments may vary between brokers.
However, the great competition of brokers means lower costs for traders.
Lower entry cost trades with the so-called leverage effect.
Instruments traded in Financial Markets and Institutons
A stock is a security that the owner becomes a shareholder of the company.
A shareholder has different rights. E.g. he/she is entitled to participate in the profit of the company in the form of dividends, but also to participate in the management of the company, inter alia, by being entitled to vote at the general meeting or to participate in the liquidation balance of the company in the event of a liquidation.
Why are stocks traded?
Firstly, there is an incentive for companies to raise capital by selling shares on the stock exchange.
Investor motivation is to evaluate their resources.
The company's liabilities are guaranteed by shareholders only by their stake, which is the share price multiplied by the quantity purchased.
Types of stocks
We distinguish stocks in terms of form on:
Paper shares - physical documents
Dematerialized shares - shares entered in electronic records. The dematerialized shares are no longer used today.
Then the shares in the name of the natural or legal person, or shares of the owner/bearer, which are anonymous and are no longer used today.
How to trade stocks
Stocks can be traded on stock exchanges but also through CFDs.
The stocks are traded entirely online.
Examples of significant shares: Microsoft (NASDAQ: MSFT), Apple etc.
For certain shares, we use the term Blue chip.
These are the shares of the largest and most profitable companies, being traded on the stock market exchange, having stable growth and paying dividends on a regular basis.
A currency pair consists of two currencies, where one currency is called the base currency and the other is the quote currency.
We trade currencies in such a way that we speculate on strengthening of one currency against the other currency.
We can explain the relationship of currencies to the EUR/USD currency pair, which is the most popular and most frequently traded pair.
In this case, the base currency is the euro and the quote currency is the US dollar.
What does the EUR/USD rate at 1.12 level mean?
This indicates that 1.12 USD is required to buy 1 Euro.
The rate is always the unit of the base currency.
Currency pairs are divided into 3 categories – Majors, Crosses, Exotics
Other examples of currency pairs: USD/JPY, AUD/USD, EUR/CHF.
Currency pairs are characterized by high liquidity and often volatility too, depending on the fundamentals. Price usually moves up to 1-2% daily.
The stock index is the sum of many different instruments traded on one exchange.
The stock index is an indicator of the development of a given segment or economy of the country as a whole.
Most often, we have stock indices that reflect the value of shares traded on a given stock exchange.
For example, the most famous stock index of the Frankfurt Stock Exchange - DAX, which is composed of a share price by 30 most important selected German companies. (DAX: BMW, Adidas, BASF, Bayer, Lufthansa, Siemens)
Examples of stock indices: DowJones, S&P 500, FTSE 100
The value of stock indices varies based on the movement of all shares that are contained in the index.
In general, indices are a stable investment instrument.
As a rule, they are not volatile just as any individual stock titles can be.
Therefore, investment in the indices is gaining increasing popularity among investors.
Goods traded in the markets without quality differences.
Deliveries from different suppliers are mutually substitutable.
For example, a commodity cannot be a car which is produced by many different means and at different prices.
The most well-known traded commodities are Crude Oil, Gold, Natural Gas, but also Coffee, Corn, Orange juice etc.
There are two types of traders on the market - the first (also being a minority), only speculates on price development, while others are really buying that particular commodity.
E.g. Starbucks arranges Coffee deliveries in advance for the year 2020 through the stock exchange.
For commodities, we need to take greater risks – their price depends on climate change, global resource outages, trade wars, etc..).
It is important to understand that some commodities are correlated to the certain currency of a particular economy. Correlation of price developments between currency pairs and commodities:
- Crude Oil - Canada
- Gold, Iron Ore - Australia
- Dairy products - New Zealand
- Natural Gas - Qatar
There is also a need to monitor world affairs, macroeconomic data, population growth demands etc.
Cryptocurrencies are a type of digital currency or, in other words, electronic money.
The biggest problem or for someone else the advantage is that electronic money is not regulated.
The most famous is Bitcoin - others are Dash, EOS, Ethereum, Ripple, Litecoin etc.
The price changes of cryptos are very steep – eg. Bitcoin in 2018 ranged from $3000 to $19 000.
Forex stands for Foreign Exchange. Forex is also known as Forex Trading, Currency Trading, Foreign Exchange Market or FX.
It is an international trading system for the exchange of major and minor currencies, i.e. the foreign exchange market, whose mid-range courses are considered as official world courses.
The amount of funds needed to participate in the market.
Trading on margin with leverage is a process in which a broker allows a trader to borrow money (either from a broker or from an investment bank) and to make a purchase of a particular instrument.
Margin is the difference between the amount provided to the trader and the real value of the investment.
Let's take a look at a practical example on the platform – when we open 1 lot of EURUSD pair, the margin is what we have to hold on the trading account. For this example, it is $1000.
In finance, the notion of hedging means creating a position in a particular market to minimize risk from another position.
There are many different tools through which you can hedge. Such as insurance contracts, forwards, swaps, options, many different Over-the-counter derivatives and arguably the most popular are futures contracts.
Futures exchanges arose in the 18th century to allow transparent, standardized and effective hedging against the movement of prices of agricultural commodities.
The principle of leverage is the use of a small amount of equity, supplemented by substantially larger amounts of foreign capital to finance the investment.
This practice can magnify profits, but also losses.
Leverage is, therefore, a tool that increases the size of the maximum position that you can open as a trader.
For a better understanding, let's give an example:
Suppose the trader has a balance of $1.000 in his account and his broker provides a leverage of 1:500.
In this case, the trader can open a position that equals 5 lots if the account is in USD currency.
In other words, 1.000 USD * 500 would be equal to a maximum size of 500.000 USD per position. In this case, the trader can trade orders 500 times greater than the deposit. And this is the basic pillar of understanding leverage.
In this case, if leverage 1:500 is utilized, the trader would earn 500 USD instead of $1 for the same investment. Of course, it is important to emphasize that losses can be equally rapid.
Currency pairs are increasing or decreasing by the value traditionally measured in the so-called PIPs (Points in Percentage). PIP is defined as a "percentage of one percent", or 0.01%.
Traditionally, forex prices have been quoted in a certain number of decimal places - more often to four decimal places - and initially, the PIP was moving by one point in the last decimal place. Most brokers now dimension Forex instruments in one extra decimal place, which means that PIP is no longer the last decimal place.
The exceptions you'll notice include currency pairs with a Japanese Yen - for these pairs, one pip value is the second decimal place, while mostly the price has three decimals.
We'll give you an example:
Let's say you buy a currency pair EURUSD for 1.11510 and later you close your position at 1.11520.
The difference between the two prices is:
1.11510-1.11520 = 0.00010-in other words, the difference is just one PIP, or in other words - 10 points.
The price of the financial instrument is always stated in two values:
Bid represents the price of demand - i.e. the price, for which the contract can be sold at a given moment
Ask represents the price of the offer - i.e. the best price at which the contract can be purchased at the moment. Retail Trader therefore always gets a less advantageous price.
The difference between supply and demand is called a Spread. It is therefore the difference between the price claimed by the seller of the instrument and the price at which the buyer is willing to buy.
The spread is the expense that a trader must take into account while trading.
The absolute necessity for every trader is the so-called Trading strategy.
Each trader has own financial objectives and acceptable level of risk, which influences the choice of the financial instrument that he/she buys or sells, as well as the settings of input and output limits, profit with stop loss and analysis of a possible market direction.
All these factors combined set a specific trading strategy and give a trader the edge.
This edge is an important part of any trading strategy.
If a trader does not have the edge, then he/she hardly achieves favourable results in his/her trading.
Volatility indicates the fluctuations in the value of an asset or its rate of return over a given period of time and expresses the risk of investing in an asset.
Volatility is an essential heartbeat for a trader because it moves the price of the instrument up and down. When the volatility is zero, the trader cannot make any profit or loss.
During Intraday trading, traders buy and sell financial instruments in a short scope of time, generally within the same day.
Most often, transactions are closed within a few hours or minutes.
Day traders are often called active traders who usually trade one or two sessions and do not hold trades overnight.
A brokerage firm is a legal entity that provides its customers with access to the capital market, thus acting as a necessary third party for buying and selling securities.
It facilitates secure transactions on behalf of its customer who executes own trades on his/her trading account.
Forex broker is a company registered in the commercial register dealing with the mediation of access to trading on financial markets, especially in Forex.
The broker company generates profits by charging spreads and trading commissions. Forex Broker provides its customers with the trading platform (software for access to financial markets), monitors current market events, issues, opinions, communicates ideas for trading in the form of comments, fundamental or technical analysis etc. When choosing a Forex broker, it is recommended to pay attention to market capitalization, company history, number of active clients, registration, license and security of finances.
Contract For Difference
It is a so-called derivative that covers a wide variety of financial instruments traded on both stock exchanges and OTC markets around the world.
The term "financial derivative" is based on the meaning of the English word "derive". It is, therefore, a kind of derivative of a particular asset. In our case, it is a derivative of the selected financial instrument traded on one of the world exchanges.
We also call this financial instrument an underlying asset and this can be a stock, index, commodity, currency pair, etc.
The price of derivatives is fully dependent on the price of the underlying asset (shares, index, currency pair...).
Contract For Difference - Beginnings, Pros and Cons
For CFDs, it is 1990 when a first derivative was created by the famous London broker 'Smith New Court'. It was a financial product that bore all the benefits of trading stocks without the need for their physical possession while minimizing their disadvantages.
Compared to shares, it was several times cheaper and allowed to take "short" positions without the need for the previous borrowing of shares.
At the end of 1990, a company called GNI was allowed to trade CFD contracts directly on the London LSE Exchange by forwarding instructions over the Internet.
Nowadays, CFD trading is very popular and is offered by many brokerage companies.
CFDs are traded to profit from price differences between sales and purchases.
CFDs are therefore among the financial derivatives that are always linked to its subject underlying financial asset.
The specific type of the underlying financial instrument (underlying asset) is levied by each intermediary company (brokers, banks, etc.) according to its capabilities.
Most often this is the currency pair, stocks, equity indices (cash and futures), commodities, bonds (futures), interest rates (futures), etc. traded on a world exchange.
There are no standard contract terms for CFDs, each provider can use its own, but the substantial part is common.
CFD thus constitutes a contractual arrangement between the seller's party and the buyer's party, when the buyer is obliged to pay the seller a positive difference in the price generated between the current value of the underlying asset and its price at the time of closure this agreement.
If there is a situation where this difference is negative, the obligation arises for the seller to pay the resulting difference to the buyer.
Long Term Holding of CFDs
Holding open CFDs is possible, but it should be remembered that even though CFDs do not expire, the trader can be charged for overnight holding.
This means that profits and losses (in favour of the client's account, respectively) were realised and any fees would be recovered.
The position is then transferred to the next day. The norm is that this process takes place at 10 PM of British time, but this differs from broker to broker and it is always necessary to verify the specific terms of your account.
The main reason to trade CFDs
CFDs are available with many brokers who also provide classic investment products.
The first execution method is the so-called Direct Market Access (DMA). Some providers offer DMA and allow you to directly enter the world markets, plus you can see the Depth Of the Market (DOM).
Access can be given to a wide range of financial markets, mainly to stocks, forex options, CFDs on commodities or bonds.
Since you have never owned an underlying asset for CFD contracts, you can trade markets that are otherwise non-negotiable for a retail trader, such as indexes.
With CFD contracts, you can benefit not only from a rising price but also from the price declines.
Most stock CFDs can also be shorted and you don't need to borrow stocks as you normally would for traditional investments.
On stock CFDs, you pay expenses in the form of spreads, swaps and sometimes also the commissions.
CFD trading can be unlimited.
This means that you have access to financial markets 24 hours 5 days a week through various brokers.
Such trading is called continuous, as you can open and close a position even when the market for the underlying asset is closed.
CFD Trading has no fixed trading hours.
Some brokers have an expiration date of the futures CFDs already built into the platform, corresponding with its underlying asset.
You can hold the position for an arbitrary length of time and close the trade when you really want.
CFD trading can be made extremely fast, in this case it depends on the broker's execution time.
You should know that the good trading platform has live market data feed and various automated trading systems can work its logic on these data changes immediately.
CFD contracts are traded with leverage, so you don't need high initial capital to speculate on short-term volatility fluctuations.
This means that you only need a fraction of the position value to open the order, and you can use some of your capital for other purposes, such as scalping other CFDs.
However, you should remember that even if you do not physically buy the underlying asset, you are exposed to the underlying markets and there are different risks involved.
In the case of leverage, it should also be remembered that while it reduces the margin needed to open a trade, profits, if any, may be significantly higher than when trading without leverage. Obviously, the same applies to losses too.
How to make money in trading?
As you already know, Forex is a big internet currency exchange, where you can buy any currency in any amount.
You can also trade stocks, commodities, precious metals and so on.
Forex traders hope that the value of the instrument they buy will increase.
If this happens, they can sell the purchased instrument back and collect the profit. It's the same as if you would buy $1 for 1.12€ and wait until the rate rises, and then sell the dollar for 1.2€.
If you don't buy one dollar, but just a thousand dollars, you'll earn a thousand euros instead of one euro when you sell.
In a similar way, you can speculate on the price decrease of the instrument – in this case, you just sell the instrument and if its value drops, you will buy it back at a lower price. In the case of Forex, you always buy one currency while selling the other so the operation reverses when you close the trade.
In addition, leverage can be used to multiply profits when trading.
Traders do not have to invest millions to earn even on a slight price movement, they can just use a high leverage effect.
However, as mentioned, leverage works on both sides so that the ratio by which it multiplies profits, multiplies losses in the same fashion. Trading on leverage is nothing more than trading with borrowed money.
First, we perform a LONG/BUY transaction with a currency pair of EUR/USD.
This means that we buy a EUR/USD instrument for the price of 1.11645 and we expect the euro to increase in the US dollar and the odds will rise.
We want to risk about 1% of our account and therefore we choose a 1 lot transaction unit, which corresponds to a volume of 100.000 units.
So we buy 100.000 euros for US dollars using the BUY command.
At course 1. 11645 we would have to pay 116.450 USD (100,000 * 1.11645), but using the leverage of 1:100 we will pay only hundredth place - therefore 1164.5 dollars is used as a margin.
If the rate grows, we will profit.
If we terminate the transaction at course 1.12420, then our profit from selling this position is $775.
Again, using leverage 1:100 if the odds fall to 1.10870, the loss would be $775 when the position is closed instead of profit.
There is a number of entities in the markets who all have a different motivation.
Although this may seem odd, the market primarily serves to ensure the continuity of business activities of large corporations.
Let's take a look at each of the two main groups in terms of the volume of trades and their motivation in the markets.
The first two entities are trying to capitalize on market price changes. Therefore they seek to estimate further market directions.
Other market players provide their assets against market exposure, such as exchange rate movements.
A slim percentage of business activity falls under speculators who are trying to capitalize on price changes. The speculators are all retail traders and professional traders who operate on their own.
Another form of participants in the markets is private companies (Proprietary firms) who employ traders and in most cases provide them with capital for trading.
In these companies, it is customary for traders to trade their strategies under the supervision of a risk manager, as is the case with us in the Challenge.
These companies also make up negligible volumes.
Other subjects in the markets include banks, large corporations, governments and funds.
Let's take an example of how large corporations like BMW operate in the markets and why they use markets to hedge.
BMW manufactures part of its production in the UK but sells most of its production in Europe. It receives EUR for sold cars but pays their UK employees in GBP. BMW is therefore prone to changes in the currency exchange rate of EURGBP.
Let's say BMW needs 1M GBP per month for payouts and at the current rate of 0.86, EURGBP must sell cars for 1.16M Euros. If, for example, GBP has strengthened, the 0.7 on EURGBP, BMW must sell cars for 1.42 M in order to pay its employees the same payout of 1M Euros.
How will BMW be hedged?
If the value is 1 lot 100 000 GBP, it is enough for BMW to sell 10 lots at the current 0.86 course, which BMW feels advantageous. If the course fell to 0.7 on EURGBP, BMW needs to sell the cars still for 1.16 M Euro, because the rest of 0.26 M gets as profit achieved in this position.
BMW and other companies use the market to achieve the efficient functioning of their business. These transactions form the vast majority of all traded transactions.
We hope this guide helped you to understand Financial markets a little bit more.
If you have any more questions, feel free to contact us.