Understanding Financial Markets & Instruments

As a non-financial manager, you may not be responsible for directly investing in or trading financial instruments. However, it’s important to have a basic understanding of financial markets and instruments, as they can impact your business and your career.

This blog will provide an overview of financial markets and instruments, such as stocks, bonds, and derivatives, and explain how these concepts can be relevant to non-financial managers in their roles.

What are financial markets and instruments?

Financial markets are platforms where buyers and sellers of financial instruments, such as stocks and bonds, can come together to trade. There are various types of financial markets, including stock markets, bond markets, and foreign exchange markets.

Financial instruments, on the other hand, are financial products that can be traded in financial markets. They can take the form of physical assets, such as gold or oil, or they can be more abstract, such as stocks or bonds. Financial instruments can be used for a variety of purposes, including raising capital, managing risk, or speculating on future price movements.

Stocks:

Stocks, also known as equities or shares, represent ownership in a company. When you buy a stock, you are purchasing a small part of the company. There are two main types of stocks: common stock and preferred stock.

• Common stock is the most common type of stock, and it entitles the holder to a share of the company’s profits, as well as the right to vote at shareholder meetings.
• Preferred stock, on the other hand, doesn’t come with voting rights, but it usually pays a higher dividend and has a higher claim on the company’s assets in the event of bankruptcy.

To buy and sell stocks, you’ll need to open a brokerage account with a company like Charles Schwab or E*TRADE. You can then use this account to place orders to buy or sell stocks of publicly traded companies, such as Apple or Amazon. For example, let’s say you want to buy 100 shares of Apple at $200 per share. You would place a buy order for 100 shares at a price of $200 per share, and if the order is filled, you would pay a total of $20,000 (100 x $200). If you later decide to sell your Apple shares, you would place a sell order at the current market price. The difference between the price at which you bought the shares and the price at which you sold them is your profit or loss.

Bonds:

Bonds are debt securities that are issued by companies, municipalities, and governments to raise capital. When you buy a bond, you are essentially lending money to the issuer in exchange for periodic interest payments and the return of principal at maturity.

Bonds are generally considered to be safer investments than stocks, as they offer a fixed stream of income and the issuer is contractually obligated to make interest payments and return the principal at maturity. However, bonds also tend to offer lower returns compared to stocks, as the issuer is not taking on as much risk.

There are various types of bonds, including corporate bonds, municipal bonds, and government bonds. Corporate bonds are issued by companies and carry a higher level of risk, but they also tend to offer higher interest rates. Municipal bonds are issued by cities and other local governments and are generally considered to be safer investments because they are backed by the issuer’s ability to tax. Government bonds, such as U.S. Treasury bonds, are considered to be the safest investments because they are backed by the full faith and credit of the issuing government.

To buy and sell bonds, you can use a brokerage account in the same way that you would buy and sell stocks. For example, you might open a brokerage account with a company like Charles Schwab or E*TRADE and use this account to place orders to buy or sell bonds. You can also purchase bonds directly from the issuer or through a bond fund, which pools together money from multiple investors to buy a diversified portfolio of bonds.

It’s important to consider the creditworthiness of the bond issuer when investing in bonds. A bond issuer with a strong credit rating is more likely to be able to make timely interest payments and return the principal at maturity, while a bond issuer with a weak credit rating carries a higher risk of default. You can research the credit ratings of bond issuers through agencies like Moody’s and S&P Global Ratings.

Derivatives:

Derivatives are financial instruments that derive their value from an underlying asset, such as a stock or commodity. The most common types of derivatives are futures contracts and options. Futures contracts are agreements to buy or sell a certain asset at a predetermined price on a future date. They are commonly used to hedge against price fluctuations in the underlying asset.

For example, a company like Procter & Gamble might use futures contracts to hedge against fluctuations in the price of raw materials, such as oil or wheat. By locking in a fixed price for the future delivery of these materials, the company can better manage its cost of goods sold and reduce its overall business risk.

Options are contracts that give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price on a future date. There are two types of options: call options and put options. A call option gives the holder the right to buy the underlying asset, while a put option gives the holder the right to sell the underlying asset. Options can be used for speculation or risk management, depending on the strategy employed.

Relevance To Non-financial Managers:

As a non-financial manager, you may not be directly involved in buying and selling financial instruments. However, it’s important to understand how financial markets and instruments can impact your business and your career. For example, if you work in a publicly traded company, you might need to understand stock prices in order to make informed decisions about the company’s equity compensation plan.

You might also need to understand bond prices if the company is considering raising capital through a bond issuance. And if you work in a company that is exposed to commodity price fluctuations, you might need to understand derivatives as a risk management tool.

Types Of Financial Institutions:

Financial institutions are organizations that facilitate the buying and selling of financial instruments. There are various types of financial institutions, including banks, brokerage firms, and investment firms. Banks are financial institutions that offer a range of financial services, including checking and savings accounts, loans, and investment products. They can also act as intermediaries in the trading of financial instruments, such as stocks and bonds.

Brokerage firms, such as Charles Schwab and E*TRADE, are financial institutions that specialize in facilitating the buying and selling of financial instruments. They typically charge a commission for their services.

Investment firms, such as mutual fund companies and hedge funds, are financial institutions that manage pools of money on behalf of investors. They use this money to buy and sell financial instruments, with the goal of generating returns for their clients.

Risks And Returns:

In the financial world, risk and return are closely related. The potential return on an investment is generally proportional to the level of risk that an investor is willing to take on. For example, stocks are generally considered to be riskier investments than bonds because the value of a stock can fluctuate significantly.

However, stocks also have the potential to offer higher returns over the long term. On the other hand, bonds are generally considered to be safer investments because the issuer is contractually obligated to make periodic interest payments and return the principal at maturity. However, bonds also tend to offer lower returns compared to stocks.

Diversification:

Diversification is a risk management strategy that involves investing in a variety of different asset classes and financial instruments. By spreading your investments across multiple asset classes, you can potentially reduce the overall risk of your portfolio and increase the chances of achieving your financial goals. For example, rather than investing all of your money in a single stock, you might invest in a diverse portfolio of stocks, bonds, and cash equivalents. This way, if one of your investments performs poorly, the other investments in your portfolio may offset the loss.

It’s important to note that diversification does not guarantee a profit or protect against loss. However, it can help to reduce the impact of market volatility on your portfolio. In addition to diversifying across asset classes, you can also diversify within asset classes. For example, rather than investing all of your money in a single mutual fund, you might invest in a variety of mutual funds that invest in different sectors or geographies. This can further reduce the overall risk of your portfolio.

It’s generally recommended to consult with a financial professional before making investment decisions, as they can help you to assess your risk tolerance and develop a diversified investment strategy that is aligned with your financial goals.

Regulation:

Financial markets and instruments are regulated by various government and industry bodies to ensure the integrity and stability of these markets. These regulatory bodies can include central banks, such as the Federal Reserve in the United States, as well as specialized agencies, such as the Securities and Exchange Commission (SEC).

Regulatory bodies have a number of responsibilities, including setting rules for financial institutions, enforcing compliance with these rules, and overseeing the buying and selling of financial instruments. They also play a role in protecting consumers and investors from fraud and other financial crimes.

Ethics:

Ethical behavior is important in the financial world, as it can impact an individual’s investment decisions and the overall functioning of financial markets. For example, insider trading, which is the illegal act of buying or selling securities based on material non-public information, can undermine trust in financial markets and lead to unfair outcomes.

Financial professionals have a responsibility to act with integrity and to put the interests of their clients ahead of their own. They should also be transparent in their dealings and avoid conflicts of interest.

Conclusion:

In conclusion, understanding financial markets and instruments is important for non-financial managers, as these concepts can impact your business and your career. By gaining a basic understanding of stocks, bonds, and derivatives, you can make more informed decisions and better understand the financial environment in which you operate.

Financial markets and instruments are facilitated by financial institutions, such as banks and brokerage firms, and are regulated by government and industry bodies to ensure their integrity and stability. Ethical behavior is also important in the financial world, as it can impact individual investment decisions and the overall functioning of financial markets.