What essentially happens in the financial markets can be explained with three product categories.
Financial Market Overview
A market is a trading place for buying and selling products. The financial market is not different it’s simply the buying and selling of financial products. These products can be divided into three categories. One is the supply and amount of capital to the supply and demand of foreign currencies and then, the supply and the amount of risk, the supply and the amount of capital.
Supply and Demand of Capital
The products in this category connect parties that require capital, but those that have a surplus of capital. Let’s start with the demand for capital, a need for capital can be to pay operational liabilities such as wages, suppliers, or Taxes. Another source of demand is the need to repay debts or to make investments to produce goods or services. Also, consumers borrow to buy houses, or other consumer products, or to bridge a period in which they don’t have an adequate income, for example, to allow them to focus on their studies. But not only corporations and consumers are on the demand side of capital. Most governments also run large budget deficits that need to be financed. Now, who’s supplying this capital for these parties and why?
Suppliers of Capital
Capital is supplied by parties that need their capital for some time for future payment, direct investment, or consumption needs. Most corporations and consumers supply capital by accumulating savings while the main capital suppliers are, in fact, institutional investors, pension funds, and insurance companies.
Connecting Supply and Demand
Supply and demand complete our needs either via a direct transaction on the financial markets or indirectly by using financial intermediaries such as banks. There are two prototypes available to connect supply and demand for capital shares and loans.
Shares
First, we talk about the shares a company can issue shares to raise capital for its investment plans, the buyers of the shares then become part owners of the corporation. The reason to buy is that capital suppliers or investors expect the corporations to be successful and to benefit from the generated future profits from their investment plans. Profits can be paid to the owner as dividends or accrue via capital growth in the corporation’s share price.
As a result, the investor can then sell the shares for a higher price to realize the increase in accrued value. However, if the corporation does not meet the market’s expectations and is unsuccessful, the shares will drop in value. Since there is no right of repayment to the share buyer and future profits depend on many factors, the bank shares can be a risky proposition. Because of this risk, investors expect a higher return if they buy shares than if they deposit funds into a savings account.
Summary of Shares
Now, let’s summarize the expectation that the corporation’s future financial performance is key in attracting investors to supply capital by buying shares and that determines the issue price of new shares. Most of the trading of issued shares happens at exchanges to make it possible to buy and sell quickly. These exchanges publish price indicators that also can be used as a performance benchmark or for derivative products.
For example, the well-known Dow Jones index is published by the New York Stock Exchange.
This graph of the Dow shows that share prices can be very volatile. It shows the Dow Jones index from the year 2000 to January 2014 and indicates the volatility in the line and the share price changes. The Dow ranges from approximately seven thousand to fifteen thousand five hundred. This also shows the risk of buying shares, Share market prices and indices will go down. Economists are facing problems as soon as the economic outlook improves. Investors will start buying shares in expectation of increasing profits and returns.
Loans
So shares of high-risk financial products that connect capital to demand and supply. The other product tied to demand and supply of capital is Lance. Alone is also a deposit for the capital supplier, the lender. The main difference to shares is that in the case of borrowing and lending there alone are agreements entrance, which sets out the maturity of the loan, the interest rate, and the payment arrangements for interest and principal reductions. These agreements make loans less risky investments for a supplier of capital compared to shares, and thus it’s easier and generally cheaper to raise capital by borrowing compared to issuing shares. Loans can also be tradable, for example, as bonds and commercial paper. Commercial paper has a maturity of a maximum of two years, bonds are long-term tradable loans.
Because of the substantial issue expenses, tradable loans are only issued by big corporations, large financial institutions, and governments, most governments run high deficits that are funded by issuing tradable loans such as Treasury bonds, notes, bills, interest, or yield. It is agreed compensation for the lender for capital supply and risks. A main factor influencing the interest rates is default or credit risk. That is the risk of interest or if principal payments cannot be paid, the higher the default risk, the higher the interest rate charged to the borrower. If a loan is not tradable, the credit risk for the lender is higher as the loan will prove to be a less liquid form of investment.
Factors Influencing Interest Rates
If It’s default risk of a borrower is too high, it may not be possible for the borrower to cover its debt, capital needs to assess credit. Risk is a complex task that requires data mining analysis and expertise. Commercial rating agencies assess the default risk for the issuer of the securities by publishing ratings. Well-known rating agencies are Moody’s, Standard and Poor’s, and Fitch investors rely on these ratings for their lending decisions and interest compensation. Besides credit risk, other factors that can impact the interest rate level include maturity, inflation outlook, economic situation, politics, and central bank policy.
This graph is an overview of the three-month deposit rate. This interest rate is set in the money market, the market for short-term demand and supply of capital. Although central banks use monetary policy to steer short-term interest rates. As we can see It is far from stable. It is verified in a range of approximately 12 percent in 1993 to practically zero in 2014. Now let’s have a look at recent long-term interest rates history in this graph, the blue line is the youth for 10-year government bonds from 2009 to 2010. The huge range is between approximately three point eight percent and seven percent. The Green Line shows the interest rate for government loans with a maturity of only two years. The gray line expresses the difference or spread between two and 10-year Treasury loan interest.
This graph shows that also interest levels for long maturities are volatile and unpredictable. It also shows that long-term interest rates are generally higher compared to short-term interest rates. This is typical for normal market circumstances.
