How are financial instruments created?

So, you know stocks and bonds exist, right? They have to come from somewhere—and that’s what financial markets are all about.

The reason for their existence comes down to an age-old and not-uncommon problem: somebody needs to access money somebody else has. This isn’t just a matter of simple greed, though – the idea behind both bonds and stocks is that the first person plans to do something with that money so that both parties make a profit.

Let’s say a million-dollar company has a billion-dollar idea, but they need $10 million to put that idea into practice. Instead of borrowing all that cash, they sell $10 million worth of stock, i.e. ownership, in their company, which is thereby converted into a publicly traded enterprise. After some time has passed and the wheels of commerce have been given a chance to churn a little, those shares’ value has risen from $10 million to (perhaps) $15 million, so the people who each bought a small piece of the growing pie are satisfied.

Primary vs secondary markets

This method of pooling capital from multiple sources to make a business viable dates back at least to Ancient Greece, where a number of wealthy people would club together to buy and equip a trading ship. The above example also brings us neatly to an important distinction, namely that between primary and secondary markets. When a company offers shares in itself for the first time, it is done on the primary market. Once these have been issued and are sold on by the original buyers, this is done on the secondary market, for example, a stock exchange. Most small investors are only concerned with secondary markets.

Alternatively, a company worth $10 million might require $2 million to expand their facilities or, perhaps, weather a temporary rough patch. One of the options open to it is to “sell” debt instead of partial ownership of the business. This is called a bond. By carving the borrowed $2 million into smaller chunks, the company raises the needed cash from numerous sources. Each of these assumes a portion of the risk, and the magnitude of that risk determines how much of a premium, over and above the amount borrowed, the company promises to repay to bondholders.

Other financial instruments

At a fundamental level, financial markets exist to facilitate trade – the exhange of things that have value for money. With some more arcane securities, like complex derivatives, the link between the thing of value and the pieces of paper that financial traders buy and sell may seem tenuous, but it is never absent.

One example of a market that, at first, makes little sense is that for foreign currencies, or forex. Why would you use money to buy different money? Practically speaking, a British company will need yen to pay its Japanese supplier, so it turns to the foreign exchange market. The relative value of the currencies fluctuates over time, though, so it’s not only importers and exporters who trade on the forex markets but also speculators who hope to profit from these price shifts. Partly as a result, the foreign exchange market is the largest and most liquid in the world and is open for trading 24 hours per day, 5 days per week.

Derivatives and futures contracts

Aside from stocks, bonds, and forex, the most commonly traded kinds of securities are called derivatives. The most common financial instruments in this class are called futures contracts. These amount to agreements or obligations to buy or sell something of value (called the underlying asset) on a later date at a specific price. Initially, futures contracts were a way for both parties to reduce their risk, a concept the CME Group explains well, when trading in commodities like petroleum…, agricultural products, industrial or precious metals: a farmer has peace of mind knowing what price his soybean crop will fetch, while a refinery can plan ahead more effectively if they know what they’ll be paying for oil in three months.

Over time, though, these derivatives have taken on a life of their own. In addition to futures, which are relatively simple, traders can now invest in call and put options, Contracts For Difference (CFDs), and even more exotic instruments. These can apply to commodities and therefore use something physical as their underlying assets, but are often based on forex prices, share values, stock indices, and a number of other things not normally thought of as assets.

How financial markets determine securities’ prices

For a company issuing bonds or shares, the main purpose of selling these instruments is to raise capital. The people buying securities, meanwhile, hope that the prices of these will rise and thus enable them to make a profit. As it turns out, the market is quite good at figuring out a fair price for any asset: if there are more sellers than buyers, the price drops, or vice versa. Investors vote with their money. Those who gauge the market correctly make a profit, those who guess wrong take a loss.

Aside from the simple demand for and supply of a stock or other security, a few other important elements you need to understand in order to grasp how financial markets determine prices are market structure, market participants, liquidity, and the spread. 

Market structure in financial markets

Some of these markets, like stock exchanges, are highly transparent and tightly regulated. The current price is simply the meeting point of the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. In other cases, like where securities are sold over-the-counter, it may be more difficult for retail (i.e. part-time) traders to get an accurate view of supply and demand levels. When information does not flow freely, the result is a fragmented market in which different prices can be quoted depending on the specific channel used to buy.

Financial markets are typically categorised based on the kind of instrument that is being traded. Futures markets, quite reasonably, comprise all futures contract trading, while company shares are typically traded on the stock exchange.

For the most part, a flawed market structure is not a major concern for someone using a trading app or website. At the same time, they and the retail investment products they carry allow private investors to put money into instruments that normally have a very high minimum investment. In forex, for instance, a standard order quantity or lot typically means 100,000 units of some currency.

Market participants

When referring to “the financial markets”, we’re not just talking about the nuts and bolts of how securities are exchanged but also the various entities involved. These include governments and central banks, major global banks, hedge funds, institutional investors, and retail traders, each of whom has a different motive for trading. These goals can range from speculation on the markets to hedging business risk. For example, the corporate treasurer at a global company might be hedging currency exposure on foreign transactions, like the acquisition of equipment or a sale to an overseas customer. A central bank, meanwhile, may be purchasing a currency to top up its reserves.

Professional market participants are typically split into the “buy side” and “sell side”. The buy side is made up primarily of hedge funds and pension funds. Their goal is to make a return for their investors and partners by investing cash in the market. The supply side is dominated by the major global banks, whose job is to facilitate investors’ trading.

Retail traders are typically not finance professionals and put up their own capital in the hopes of growing it through careful investment. They gain access to the market through online brokers and may trade full-time or part-time to supplement their main income.

Liquidity

If every seller can find a buyer and every buyer can be paired with a seller willing to pay a fair price, we have a perfectly liquid market. Market liquidity is directly correlated to the volume of trades taking place at any given time. High liquidity means that an investor can easily place their trade at the desired price; it indicates there is a high number of matching buy and sell trades. Low liquidity, meanwhile, means that trading volume is low and it will be difficult to match an investor’s transaction with that of another.

The market price is not so much an abstract concept as the last price, or a recent average, of what a financial instrument has been traded for. In liquid markets, like that in blue-chip stocks, major ETFs (Exchange-Traded Funds), and important currencies, the sheer volume of trades help to establish an accurate consensus about what constitutes a fair value. Illiquid markets, like that in emerging-market forex and small-cap stocks, make it more difficult to establish a security’s true value.

Spread

Even in very liquid markets, there is always a difference between the price buyers pay (the “bid”) and that which sellers receive (the “ask”). In practice, the difference, along with commissions and other transaction costs, go to intermediaries that place retail investors’ orders on their behalf. The spread is typically wide when an asset is experiencing volatility (i.e. its price is fluctuating rapidly) and narrow in stable, liquid markets.

Higher spreads imply that traders need to see larger price swings before they can take profits exceeding their transaction costs. In other words, large spreads not only indicate an unstable price or low liquidity, but can actually amplify these conditions.

In conclusion

Even after devouring whole economics textbooks on the nature of financial markets and the mechanisms that drive them, you may still feel that you’ve barely scratched the surface. That’s generally not a problem: most retail traders are more concerned with whether a particular security is going up or down. Still, it is worthwhile thinking about what goes on behind the scenes. A little knowledge of how financial markets work can sometimes help you to understand events beyond what can be seen in a price chart.