Prework Module 4: Markets
Overview
In this module, we will discuss markets for investment securities, going into some detail about equity markets, insurance markets, derivatives, currencies, and real estate.
Module Objectives
By the end of this module, you will be able to:
- Identify a few of the largest markets for investment securities (e.g., stocks, currencies, real estate)
- Understand what derivatives are, and how they are sometimes used in practice
- Understand the key risks and business concepts behind insurance and real estate markets
Reading: What is a Market?
Quite simply, a market is a place-physical or digital-that people gather in order to exchange goods or services. While there are many different types of markets, we will explore only a few of the most prominent ones here.
Reading: Investing in Companies
Securities are tradable financial assets that derive their value from one of three main sources: the equity of a company, the debt of a company, or a derivative of one of the previous two.
In a previous module, we learned that companies raise capital by selling equity or debt. In the case of selling equity, the financial instrument used to make a sale is referred to as stock. Generally, the owners of stocks have some say in how the company is run, because the stock represents partial ownership of the company. Stocks are often traded on the market, known as a stock exchange. In the US, this includes exchanges such as the NASDAQ or the NYSE, but there are many exchanges in the US as well as around the world. Stock prices tend to fluctuate throughout the day, as those who are exchanging stocks (traders) alter their beliefs about the future value of the company (or stock) in response to new information.
To avoid selling ownership stakes in the firm, some companies may instead issue corporate bonds, which are a financial instrument that sells the debt of the company. In effect, corporate bonds are loans, just as you might get a loan for a house or a car. Corporate bonds are rated by the three major rating agencies: Standard and Poor’s, Moody’s, and Fitch (other rating agencies exist, but almost all bonds will have a rating from one of the big three). Bond ratings help investors understand the credit risk associated with the investment, and the risk if the firm defaults, or fails to keep making payments on its bonds.
Finally, there is a class of securities that derive their value more on the perception of a company’s stocks or bonds, rather than the company’s stocks or bonds outright. These are referred to as derivatives. Despite their esoteric sounding nature, derivatives are heavily traded. Two common derivatives are options and futures. Options are a contract for which the holder has the right, but is not required, to buy a security at a pre-arranged price at a later date; it is truly an “option” to buy something. A future is similar, but loses the element of choice: the contract holder is instead obliged to make the purchase, at some point in the future.
Consider this scenario involving the purchase of either a stock or an option on a company: Say that I have a belief that Corning Incorporated (GLW) will be worth a higher value in three months than it is right now. I could simply buy the stock, wait for it to increase in value, then sell at a higher price. Or I could purchase an option, giving me the right to buy the stock within the next three months, without the obligation. If I had bought the stock, and Corning fell, I could potentially lose a lot of money. If I had instead bought the option, the most I would lose is the price I paid to buy the option, which is comparatively less. Conversely, if Corning rose and I bought the stock, I would gain-but I could gain just as much (less the option fee) if I had bought the option instead. If used carefully, an option can help manage risk. Or, it can be used to speculate. There are an endless variety of ways to invest in securities, and many strategies can be employed to manage risk and returns.
Lastly, derivative instruments represent a fascinating market in which prices are driven more by the potential for events, rather than real events themselves. Because of the complexity and enormous quantity of data involved in derivatives (you can only buy one type of stock for Google, yet on any given day there are more than 50,000 different varieties of Google stock options to buy), machine learning and statistics play a role in determining and forecasting prices in derivatives markets.
Reading: Investing in… Money?
Have you ever been in a foreign country and needed to exchange US dollars for another currency? How are those prices set? Overshadowing the securities market in terms of trading volume is the foreign exchange market, also called Forex, or FX. In this market, the money of one type is exchanged for another, which is usually fiat currencies or cryptocurrencies. The prices on these markets also dictate the exchange rates offered around the world. In some countries, governments attempt to keep the price of their currency in relation to another “fixed,” so that it does not fluctuate in relation to that currency (often the US dollar). However, from the 1980s onward, an increasing number of countries have allowed their exchange rate to “float,” where the value of that currency is largely determined by participants in the exchange rate market. As a result, forex markets have even more liquid, with transaction volume increasing dramatically.
Forex (FX) markets have three main instruments for exchanges. Spot markets are where two currencies are directly exchanged for one another. The second and third types of markets are considered derivatives. Namely, Forwards are contracts that swap two currencies at a future date, are typically custom-tailored for a specific client or purpose, and are negotiated individually in an “over-the-counter” (OTC) transaction with an investment bank. Futures differ in that they are traded on a central exchange, can be re-sold, and have standardized features such as order size and pricing.
Reading: Investing in Risk Management
When you make a large personal investment in something such as a car, how can you protect that investment against risks? If you get into a major accident, how will you pay back the loan? These are all questions of risk management that fall directly into the realm of insurance. Insurance is a contract that allows the holder to collect a financial sum when a particular event (usually a bad one) occurs. In exchange, the contract holder also agrees to pay the contract issuer a fee on a regular basis, known as a premium. Groups of individuals may come together in order to seek a larger policy, which simultaneously lowers the risk for the insurer and thus lowers the cost of premiums for the insured.
How do insurers determine the price of premiums and the dollar amount that they will cover? Insurance is a realm driven by statistics-determining the likelihood of certain types of events occurring, and their potential financial impact. These statistical analyses come from a wide variety of sources, and in the course, we will discuss how they have changed dramatically with the broader application of machine learning. Insurance has continued to evolve and is sometimes referred to as InsurTech within the context of modern technologies.
Reading: Investing in Real Estate
Finally, we have real estate markets, where tracts of land or buildings are purchased, sold, and rented out amongst market participants. States and countries have vastly differing rules and regulations regarding the ownership and transferal of real estate. Additionally, real estate investments have the tendency to be illiquid (if you had to sell your house tomorrow, do you think you’d get a good price?) and long term. These are some reasons why real estate markets have historically been more resistant to technological change. However, change most certainly has arrived in the form of PropTech (property technology), or technologies used to aid in the valuation, sale, management, and other informational purposes in the market.
If you were looking to make a real estate investment, how would you go about deciding which plot of land would be the best value for your money? How would you know what a property is actually worth? As discussed in the previous lesson, this is another great opportunity to utilize a time value of money equation! If we have a belief about what the future value of the property is worth, we can discount the value back to today’s dollars, in order to understand what a good price for the property could be.
