1. Financial Markets and Financial Products
“Five Big” Financial Markets –
Stock Market
Bond Market
Money Market
Futures and Forward Markets
Options Market
Also these Markets –
Commercial Banking Market
Foreign Exchange Market
Real Estate Market
Insurance Market
Exotic Derivatives Markets (Swaps, FRAs, CDS, CMOs, Swaptions,…)

2. Each Market is Dominated by Three Big Questions
What is the function of the product being traded?
How is the product traded?
How is the product priced or valued?
Additional Questions
(4) Are there any fees?
(5) Are there any taxes?
(6) What are the risks? What is the liquidity? What factors affect the market?

3. Stock Market
(1) Function of Stock – Stock is merely ownership claims on a corporation. When you buy stock you can earn money in two ways – (i) dividends and (ii) capital gains
(2) How Does Stock Trade – When you buy stock today you can sell it tomorrow. To sell stock, you contact your broker who contacts the floor of the exchange (possibly computerized) and a sale order is made. The specialists on the floor will help you find a buyer. The deal is made and the stock is transferred from you to the new owner.
(3) How is the Stock Price Determined – Supply and demand determine the price, but one way of thinking of things is that the P = Div/(R-G), where P = price, DIV = the cash dividend, and R = long term interest rate, G = the expected growth of dividends.

5. Bond Market
(1) Function of Bonds – Bonds do not give ownership. Instead they are a way to borrow money. You can earn money owning bonds in two ways – (i) interest coupons and (ii) capital gains
(2) How Do Bonds Trade – Bonds may be sold by corporations or by the government. If you buy a bond today you can sell it tomorrow. Its price will fluctuate during the day. If you buy low and sell high you have a capital gain, otherwise you have a capital loss. Some bonds sell in the secondary market on an exchange. You buy initial offers in the primary market.
(3) How is the Bond Price Determined – Supply and demand determine the price, but one way of thinking of things is that with very long term bonds, the P = Coupon/R approximately, where P = bond price, Coupon = the interest coupon on the bond and R = long term interest rate or yield to maturity.

7. Money Market
(1) Function of MM Instruments– MM Instruments are really bonds that mature within 1 year, so there are no coupons. They are used to borrow money very short term. If you have a $1000 MM Instrument with a 1 year maturity, maybe you will pay $995 for it today and get $1000 in one year.
(2) How Do MM Instruments Trade – There are many types of MM Instruments. Banks and large investors engage in buying and selling these financial products. Corporations may issue these to finance their inventories. They also arise very naturally in international trade.
(3) How are MM Instruments Prices Determined – Supply and demand determine the price, but one way of thinking of things is that the discount rate (not interest rate) can be computed as
Where d= discount rate, FV = face value, P = price, Term = number of days left to maturity

9. The list of money market instruments is quite long and includes such things as Treasury Bills (T-Bills), negotiable certificates of deposit (NCD's), bankers acceptances (BA's), repurchase agreements (repos), commercial paper (CP's), Federal funds and central bank loans, and Eurodollar loans. Each of these instruments are created for a specific purpose. For example, the US Federal government issues T-Bills to fund its spending rather than use taxes. Bankers acceptances result from international trade, while commercial paper is often used to finance short term expenses of business.

10. Futures Market
(1) Function of Futures – Futures are used for hedging underlying products and for speculation purposes. Financial futures now make up the majority of the market. Commodity futures include gold, wheat, corn, metals, coffee, etc. Stock Index and currency futures are especially important.
(2) How Do Futures Trade – Futures trade on exchanges such as the Chicago Mercantile Exchange. For example, you either buy corn futures or sell corn futures. You create a contract to do this. When you sell corn futures you fix the price you will sell a fixed amount of corn at a fixed time in the future. There are some additional terms you must learn such as spot price, offset, initial margins, maintenance margins, marked to market, and daily settlement.
(3) How are Futures Prices Determined – Supply and demand for the spot price is important in determining the futures price of a product. Also interest rates affect futures prices in very natural ways.

11. The Chicago Board of Trade
(Note the pits for different commodities)

12. Here is a scene involving the CBOT in the comedy movie Trading Places with Eddie Murphy and Dan Aykroyd. They first wait for the futures price to rise to $142 and then they start selling frozen orange juice (FOJ) futures. Later when the price falls to $29 they begin to buy FOJ futures at the end of the day they sell and buy and so they offset their position making a tidy profit on each contract. They have inside information and give the wrong information to the two old greedy guys.

13. Options Market
(1) Function of Options – Options are used for hedging underlying stocks or products and for speculation purposes. There are call options and put options. A call option gives its holder the right, but not the obligation, to buy a share of stock at a fixed price anytime before the option expires, say three months. Stock Index and currency options are especially important.
(2) How Do Options Trade – Options are traded on exchanges. You can buy puts and calls or any combination. Both puts and call options are created by a person called the writer. Anyone can be a writer. The options price is called its premium. When the writer first sells the option he gets the premium. The fixed price on the option is called the strike price (or exercise price). You can make money buy first buying an option (put or call) and then selling it at a higher premium later on.
(3) How are Options Prices Determined – Options prices are determined by supply and demand for the option. Several variables will affect the supply and demand such as movements in the price of underlying product or stock, the time left on the option, interest rates, etc.