The financial markets are viewed with intrigue, confusion, and sometimes hatred – mostly as a result of the confusion – by those not in the know or on Wall Street. This is partly because the average person does not understand the fluctuations in price of the financial markets and their effect on one’s life and the world.
Firstly, what is a financial market? As defined by Investopedia, “the financial market is a broad term describing any marketplace where trading of securities including equities, bonds, currencies and derivatives occurs.” Equities are tokens of ownership in a company, bonds are packaged debt, currencies are generally accepted forms of exchange that differ county to country, and derivatives are packages of contracts between two or more parties involving an underlying asset. To put it simply, financial markets are places where people buy and sell financial products like those listed above. So, what drives the prices of these products?
Well, to answer this question, we must ask another: what is something worth? The common answer to this seemingly simple question is that something is worth what someone is willing to pay for it. To understand why someone is willing to pay a certain price for something, it is important to understand why that person wants to buy or sell that item. There are many types of organizations involved in buying and selling assets. Central banks, institutional investors, non-financial corporations, and household retail investors are the major players in financial markets. These players use a variety of investment strategies, which determine how they value certain assets and when to buy and sell.
Central banks buy and sell financial products (usually sovereign debt or treasury bills) as part of their monetary policy. They have the biggest effect on financial markets, being in control of the money supply by either issuing currency or setting interest rates on loans and bonds. In addition, central banks can regulate member banks by imposing reserve requirements, which dictate how much money a bank can loan out compared to how much cash they have on hand; this also has further implications on interest rates.
According to Investopedia, “an institutional investor is an organization that invests on behalf of its members,” and there are six major types of institutional investors: “endowment funds, commercial banks, mutual funds, hedge funds, pension funds and insurance companies.” These funds are the largest holders of assets, and therefore, the largest force behind the supply and demand in financial markets. Each of these funds has a different type of investment strategy behind them, but the main purpose of their buying and selling is to increase their capital. According to Bloomberg, “50 to 60 percent of trade volume on public US equity markets [is done by a type of hedge fund that practices high frequency trading]”; these trades are carried out by computers following preprogramed algorithms. The trades and underlying assets are exchanged very quickly, and most of the algorithms follow a style of investing called technical or trend analysis. This type of analysis is purely concerned with what direction the market seems to be heading for these assets. Aside from technical analysis, there are many techniques of gauging value that institutional investors employ, ranging from fundamental analysis to pure speculation. Fundamental analysis is a broad concept, but for the most part, it focuses on the financial aspects of a company to gain insight on its future performance. Most institutional investors will employ an individualized take on fundamental analysis to assess whether to buy or sell equities and bonds. Another largely utilized strategy is called top-down analysis, where an institutional investor makes predictions on economic factors and then makes investments based off them. Also, there are specific economic environments created by central banks that entice institutional investors to buy or sell certain assets. To learn more about this topic, look out for an upcoming article titled “Cycles.”
Non-financial companies can sell equity of their own businesses to the public markets and also buy back their equities, usually to regain control of their company from the public or to protect themselves from hostile takeovers. International non-financial companies also purchase and sell currencies for operation of their business in other countries. Additionally, these companies can buy and sell derivatives in order to hedge or mitigate the risk of their business operations.
Household retail investors are small-time investors who manage their own money; these investors usually have very little effect on financial markets. They have had even less effect after the Financial Crisis of 2009 because many suffered from financial PTSD and are no longer comfortable with returning their capital to the financial markets.
All of the ups and downs of the assets in the financial markets can have a major effect on people even if they do not participate in them actively. Most people have their entire retirement savings with an employer-assigned pension fund, which as mentioned previously, is a relatively safe institutional investor but has large exposure to changes in financial markets. Furthermore, many people who hold contracts with an insurance company do not realize that the ability of an insurance company to pay its share of your coverage is heavily reliant on how their capital is managed in the financial markets. Thankfully, because of the Dodd-Frank Act, people who keep their savings in a bank no longer have to worry that those savings will be subjected to these fluctuations. However, the desire for short-term gains by the current U.S. administration may provoke the original policy to return. In addition, the interest rate on mortgage and car loans are also extremely dependent on the changes on Wall Street.
Ever since America’s entrance into World War II, the world has been covered by long trade routes that span continents and oceans. Those routes were followed by international corporations and global finance. With the creation of the internet, this international connection has been able to flourish and intensify, allowing information to reach all seven continents within seconds. In search of greater returns, capital criss-crosses the globe, being invested in all types of assets. It is this global interconnectedness that forms a greedy idea upon one big street in America to send horrible ripples all throughout the world’s financial markets, defining what it believes to be value.