Whenever someone mentions something even finance related to me, my mind does this wondrous thing where it blurs my vision and lowers the volume of that person's voice in relation to other objects in the environment. I literally DO NOT GET one out of every three words coming out of their mouths. I couldn't seem to visualise what they saying.
Now, I have stumbled upon a couple of books (and a lot of links). Hopefully, they will make it easier for me to understand finance speak.
First, what are Banks?
Finance starts with banks. They are places where people deposit their money in the hopes of earning a stable interest. They are also places where people loan money from and pay interest in exchange for those loans (for instance, a loan to buy a house, build a business, your credit card, etc...) They usually earn when the interest they collect from people is higher than the interest they give to depositors (people who deposit their money in the bank).
Ok, that sounds simple enough. Why is finance so complicated?
Imagine - what if one day everyone were to take all their deposits out? The bank would not have money to finance the loans and they can't make money. This would also be an issue as banks don't keep all their deposits on hand. They are using them to give out loans so as to earn money. They do stuff, like issue fixed deposits, where people can deposit money and guarantee they won't take it out for a period of time so that the people can earn a higher interest and so that the banks would lessen the risk of running out of money. Sometimes they give short term loans, other times they give long term loans. These different types of loans issued out are different ways the bank earns money now and in the future. As things become more complex, the banks become more creative with what they issue out as loans or money-making opportunities, like derivatives (scary word alert).
What else do banks do to manage risk?
Most banks are commercial banks. Their sole purpose is to make money and issue profits to their shareholders. Shareholders are people who own part of the company in the form of shares. In order to get these shares, the shareholders will have to pay for them. This money becomes the capital that the bank can look to when they are suffering losses. Sometimes, they borrow money from central banks.
What are Central Banks?
There are also central banks. These central banks are sponsored by the government (and your taxes). They conduct transactions with commercial banks and with central banks in other countries. They also lend money to commercial banks. They don't deal directly with people (us peons) but with banks and the government. They help to make sure that things don't become too expensive too quickly (by moderating inflation) and help to balance the economy(we will talk about that later). As they deal with central banks in other countries, they also have a hand in our currency. So next time you lose (or 'win') money when you exchange your cash for another currency before your travelling and change it back after you come back from another country, you have your central bank to thank.
What is inflation?
It is when stuff around you become more expensive. It could be due to the fact that the thing you want, maybe chocolates, is becoming more rare due to overconsumption and global warming, so every gram becomes more expensive.
It could also be due to this: Long ago, after barter trading, people used to use stuff, like beaver skin (YUCK) as money to exchange for goods and services. However, these things are sometimes really heavy to carry around and there might not be enough of supply of it, when the government, needs to let's say raise a lot of it to pay people to go to war (yep, that's A LOT of beaver skin). So one day, they decided to use paper money. In some countries, the paper money used to be an IOU that is backed by a commodity, like gold. So people go to the government and place their gold there in exchange for the paper money. With that money, they could get that gold back. Nowadays, a lot of currency is backed by fiat (not the car) money. Meaning, it is money because the government said it is. So when the government doesn't have enough of it and need to raise money to pay for stuff, like bailing banks out of trouble so that everyone doesn't lose their life savings (without incurring the wrath of the populace through added taxes), they could just ask the central bank to print more money. However, even though there is more cash, the amount of stuff to buy is still the same. Therefore, the amount of stuff that you could buy with the money you currently have becomes less. So, your money becomes less valuable.
Why does my currency not have the same value as other countries?
There are three ways your country's money's value can be determined.
There are three ways your country's money's value can be determined.
- It is fixed and depends how much gold reserves your country has. The value of your currency would depend on how valuable gold is at that time. Some countries don't have a lot of gold. So, some countries go to option number 2.
- The value of how much your money is worth to people in other countries depends on how high a demand for your money there is. Meaning, if someone overseas wants to buy goods from your country, they have to pay you in your currency, because it is useless paying you in their currency unless you want to go to their country on holiday. Therefore, there will be higher demand for your country's money. The higher demand there is for something, the more valuable it is. However, there is a risk to this. The value of your currency could fluctuate like mad depending on the times and how stable your country's economy is. So perhaps one day, the pair of shoes from France you have your eye on costs $30, but due to a newspaper article announcing uncertain times, less people are willing to invest in the businesses in your country, the demand for your currency drops, and all the sudden it would cost you $300 to get that pair of shoes. This reminds me, if buying goods from other countries, it would be good to time it according to when your country's currency is in your favour.
- Do take note: Some countries like having a currency that is a little weaker compared to another currency - so that their goods will seem cheaper and others would want to buy goods from them.
- Your country's currency is pegged to a strong, stable currency. For instance, your country decided to follow the currency of America. When America's currency price falls so does yours. When it increases, so does yours. To make your currency stay within a certain range and make it go according to plan, your country buys a lot of foreign cash. They buy and sell the foreign cash to manipulate their demand in relation to yours so as to manipulate the price. Why? Let's say that country exports a lot of goods to the US. They get paid in dollars and places the USD in their banks. The bank then exchanges this USD for their local dollar. Their central bank places the USD in their foreign reserves. With less USD out and about in the market, the USD becomes more expensive and valuable. People from other countries are less likely to buy their goods. In addition, the USD is usually used for international trade and countries that rely heavily on international trade for income would peg their currency to the USD.
What is Forex?
It stands for foreign exchange. Let's say a huge company wants to exchange their country's cash for Baht. A lot of cash. This increases the demand for the Baht as well as its value. The value of a currency is determined by supply and demand. The more a currency is being demanded, the more valuable its currency is and the stronger its currency is. All this exchange of currency and purchase of goods in foreign currency is what makes up forex. Some people thought about how they could profit from this exchange and profit the demand and supply of certain currencies.
One way to profit is by simply exchanging money. Let's say one Singapore Dollar is now worth 0.73 Swiss francs. I exchange $100 SGD for 73.01 Swiss francs. Then tomorrow, a Singapore dollar becomes worth 0.6 Swiss francs. That means that 1 Swiss franc is worth 1.66 Singapore dollars. I can exchange 73.01 Swiss francs for around $121 and make some money from this. What if a company were to invest a few thousand dollars? They would earn even more. A lot of forex exchange can be done online through brokers.
It stands for foreign exchange. Let's say a huge company wants to exchange their country's cash for Baht. A lot of cash. This increases the demand for the Baht as well as its value. The value of a currency is determined by supply and demand. The more a currency is being demanded, the more valuable its currency is and the stronger its currency is. All this exchange of currency and purchase of goods in foreign currency is what makes up forex. Some people thought about how they could profit from this exchange and profit the demand and supply of certain currencies.
One way to profit is by simply exchanging money. Let's say one Singapore Dollar is now worth 0.73 Swiss francs. I exchange $100 SGD for 73.01 Swiss francs. Then tomorrow, a Singapore dollar becomes worth 0.6 Swiss francs. That means that 1 Swiss franc is worth 1.66 Singapore dollars. I can exchange 73.01 Swiss francs for around $121 and make some money from this. What if a company were to invest a few thousand dollars? They would earn even more. A lot of forex exchange can be done online through brokers.
What is Equity?
Well, you are thinking of buying a company's stocks. The company has decided to give you ownership to a part of its money. In return, you give it some money so that it can conduct its business (because business things are expensive). If you decide not to sell the stock, you get to earn dividends (aka money). The total equity of a company is calculated when you take the total value of a company's assets (things with potential to earn the company money) and deduct the total value of its liabilities (debt it owes). Stockholders' equity is the total amount of assets that the stockholders will own once the company pays off all its debts.
What are Dividends?
Every quarterly, when a company reviews its financials, it will determine how much of the money they earn will be used to build the company in future (retained earnings) and how much to pay back the investors - the dividends. They will indicate the dividends-per-share, investors can calculate how much they will get by multiplying this number with the number of shares they own. If they wish to get a cash dividend, the company will send them a cheque. They could also reinvest the dividend - they could exchange their dividend for more stock in the company without incurring a broker's fee and even at a discount. To some people, the dividends are not incentive enough to stay invested with a company. Therefore, they might decide to sell their stock when the price is higher.
How are stock prices determined?
Let's say you own some stocks of a company. One day, the news announces that the company has just invented something revolutionary that many people are excited about. They are also excited about the fact that they think this stock is going to be worth a lot. So they call their stock brokers. They want to buy this company's stocks. People who do have the stocks hold on to it to see if the price can go higher. There is a lot of demand for this stock and very little supply. It becomes more valuable and the price goes up. You decide to sell your stocks. You call your stockbroker who sells it for you. You are also being charged a fee by the stockbroker who sells it for you. Then you decide to buy another stock. You can either ask your stockbroker to buy it at the current market price (market order), buy it when it reaches a certain price (limit price) or buy unless the stock hits a price that is too high (ceiling order).
What is Fundamental Analysis?
Fundamental analysis is used when you buy a stock based on how well you think the company is performing and is going to perform. You use fundamental analysis to find out the underlying health and performance of the company. There are many companies on the stock exchange. Whose stock should you pick? They all publish information about their financial health in a prospectus. You can use this data to filter out which companies you could be keeping an eye on. Fundamental analysis helps you to decide which company stocks to buy. Unlike technical analysis, where charts on stock prices are updated in real time, fundamental analysis relies on data that is published monthly or even quarterly. Fundamental analysis could help you to identify which companies are flourishing in their industry or sector. To carry out fundamental analysis, you will have to look at some ratios, like P/E ratio, dividend yield, market capitalisation, gross margin, operating margin, return on equity and debt-to-equity ratio among others. A lot of investors who rely on fundamental analysis tend to follow a buy and hold strategy. They buy a stock when the company is young. They wait for the company to grow and flourish before cashing out after a few years (and earning dividends along the way). Think about the big companies - they all started small at some time. A $1 stock today could be worth $50 a few years down the road. However, the big companies that we see nowadays are the successful few. There are way more companies that don't success in the long run.
What is a P/E ratio?
Whenever you want to go buy a stock, experts always suggest that you look at the company's price/earnings ratio. First, price is how much the stock is selling for. The next part is earnings per share. This earnings per share is calculated when you take away dividends from the net profit and divide it by the number of shares there are out there. If the PE ratio is high, it could mean that the stock's price is too high. A lot of people are willing to pay a high price for it, and because this is not really substantiated by current earnings, the price could crash. If the PE ratio is low, it might mean that it is a good bargain.
What is the Gross Profit Margin?
It is an indicator of how profitable a company is. It is calculated by taking the gross profit and dividing it by revenue. For those who don't know gross profit is, it is what is left after you take cost of goods sold away from revenue. Cost of goods sold means how much it costs to create a product. It includes things like materials and direct labour involved. It is often used to compare a company's profitability with its competitors. There might be two companies that make computers. However, one company is able to make it at a way cheaper price and yet earn the same amount of profits. This tells you that this company has an edge over the other company. Take note that there could be sudden increases in cost-of-goods-sold, especially if new technology or machinery has just been installed to increase productivity. However, this might only be a short term increase in expenses.
What is the Net Profit Margin?
Apart from the cost of goods sold, which is used in the calculation of gross profits, net profits also take into consideration other expenses (like marketing, rental, indirect labour, electricity, etc), and taxes. To find the net profit margin, you take the net profits of the company and divide it by its revenue. It tells you how effectively a company is turning its revenues into profits. It tells you whether a company's management is making the right decision.
Why don't they use actual net profits instead?
When you use a margin, like the net profit margin, you get to see how efficient a company is, without factoring in whether the company is a huge company. Some large corporations might have a lot of net profits, but are losing market share to newcomers who are taking over the market with new technology. On paper, with just the net profit, it might seem that the large corporation is more profitable. However, if you look at the net profit margin, you might see a different story.
What is Operating Margin?
To calculate operating margin, you take revenue, subtract cost of goods sold and operating expenses (like rent and labour, marketing, etc), and then you will get the operating income. Take the operating income and divide it by the total revenue and you will get the operating margin. The operating margin tells you how efficient a company is. A number of things affect operating margin - including pricing strategy and prices of raw materials. A higher operating margin tells you how competent the company's managers are, especially during rough times. If the operating margin changes a lot, it might tell you that the business is taking on a lot of risk.
What is Return on Equity?
It is calculated by taking net income (or profit) and dividing it by the average shareholder's equity. Shareholder's equity is calculated by taking liabilities (how much a company owes) away from the company's assets (the amount owed to the company and the things that it has that can bring it income, like machines). To calculate average shareholder's equity, take the shareholder's equity at the beginning of the period and the shareholder's equity at the end of the period, add them together and divide it by two. It tells you how good a company is at reinvesting its earnings so as to generate earnings in future. It will tell you how sustainable the company's growth is. If the return on equity is lower than industry average, it might tell you that the company is investing in unproductive assets.
What are Dividend Yields?
The dividend yield is the total dividends issued divided by the share price. It tells you how much dividend is being given out. If a company gives out a lot of dividend (has a high dividend yield), it means that a lot of its income is not being invested in expanding the company. A high dividend yield is what investors look for when investing in a mature company that isn't growing very quickly.
What is Market Capitalisation?
It is the total value of a company as traded on the stock exchange. You can find it by taking the total number of shares that it issued and multiply it with its share price. It tells you how big a company is and helps you to compare how big one company is in relation to another. It also helps the investor to manage risk. For instance, buying the stock of a company of a market capitalisation that is more than $10 billion (large-cap company) is often considered a less risky investment than buying the stock of a company that is worth less than $2 billion (a small-cap company). A small-cap company is more vulnerable to an economic downturn than a big-cap company. There also might be more volatile changes to the stock prices of the small-cap company if it is growing at a fast rate.
There are many more ratios other than the ones above that are used to measure a company's health and potential for growth in fundamental analysis. You might want to consider doing some research on them if interested.
What is Technical Analysis?
Technical analysis helps you to decide when to buy the stocks and when to sell them. You don't want to buy them when the price is high and at its peak and then sell them when the stock prices are low. You would want to buy the stocks when prices are low and sell them when prices are high so that you can earn. People doing technical analysis will analyse the trend of a company's stock to find out how the prices can fluctuate, what a peak price looks like (ceiling) and what a low point in the stock looks like (floor). The underlying assumption is that past performance of a stock can be used to predict future performance of a stock. Technical analysis is used by the investor to find out if the stock price is fluctuating within a certain range (meaning that the company's stock price is stagnating), if the price is on an upward trend, or if it is in a downward trend. If it is in an upward trend, if the investor spots it early, they can buy it while the price is low. If the investor can identify once the price goes on a downward trend, they can sell off their shares before the price goes any lower. Alternatively, if an investor thinks that the downward trend is temporary, they could wait till the price is really low and buy the stocks while the price is low.
What are Blue Chip Stocks?
A blue-chip stock is the stock of a company that is well-established, large, and financially sound. Their market capitalisation is usually in the billions and they are usually household names, and are the market leader or within the top 3 in terms of market capitalisation in its sector. It would usually cost a lot to buy 1 blue chip stock and its growth might not be huge, but blue chip stocks are generally safer to invest in. Other stocks are common stocks.
What are Penny Stocks?
It is a common stock whose stock price is less than USD 5 (in Wallstreet, at least). They are usually more risky as the companies issuing penny stocks are usually companies that have small market capitalisation. In the past, a penny stock was one whose stock price was less than a dollar. The prices of penny stocks are usually more volatile and will change more often. Companies issuing penny stocks are sometimes not required to file with the SEC. There is usually less regulation involved with penny stocks. Because of this, some penny stocks might be owned by companies on the verge of bankruptcy, or have very poor track records. If it is newly formed, there is very little data given for technical analysis to be done. In a worst case scenario, some of the penny stocks might even be a scam - meaning that there are only shell companies behind them and no actual companies generating profits. A lot of penny stocks are from legitimate companies that you could still invest in ( I mean, you might see this company all over your neighbourhood, like this bread company in my country that has many branches nationwide) - just make sure you do your homework before investing and only invest what you can afford to.
What are IPOs?
When a company decides to list its stocks on the stock exchange for the first time, a lot of processes go into reviewing its financials. Most companies will announce that they will be having an IPO (or initial public offering). The initial price of the stock is determined by an underwriting bank. Some savvy people who know that the IPO is coming soon may get the investor's relations number from the company website and ask if they have a private offering and are willing to sell shares before it is listed. After it is released in the market, the demand and supply of that share in the market will determine its price.
What are Preferred Stocks?
If you do get them when they are issued, take note that they could have fixed dividends which means that the amount of money you get are fixed. The dividends from these payouts are usually issued before the common stockholders get their dividends. If the company goes bankrupt, preferred stockholders are usually paid (with the proceeds from the sale of the company's assets) before the common stockholders are paid.
What are Bonds?If you do get them when they are issued, take note that they could have fixed dividends which means that the amount of money you get are fixed. The dividends from these payouts are usually issued before the common stockholders get their dividends. If the company goes bankrupt, preferred stockholders are usually paid (with the proceeds from the sale of the company's assets) before the common stockholders are paid.
Sometimes the government needs money for huge projects. Sometimes companies need money and would rather borrow it than give out stock (ownership) of the company. These companies might not want to borrow from banks as they might feel the interest rate is too high or the banks don't want to issue out the loan to them from the first place. Therefore, the government or the company issue bonds to people. These bonds are loans. So, you lend the money to the government or company and in return you receive interest payments every year, which is known as the coupon rate.
There are some risks attached to this. For instance, the company you borrow from might go broke and not be able to pay you back your money at the end of the loan period. The government might go bankrupt and have the same problem. However, there is a higher chance that a company would go bankrupt than a government would, so the government issued bond is usually safer. Do not take this for granted, however; there are governments that have gone bankrupt in the recent past. Safer bonds usually give out less interest payment. More risky bonds give out higher interest payments. Next, the company might decide to call back the loan early and return you your bond, so you won't be getting that interest payment for the rest of the loan period. There is also the issue of whether you need that money to be available to you as cash. If all the sudden, you need to sell the bond to get back the money so that you could, let's say, buy a house or fund your wedding, you will be at the mercy of the bond market. The bond market is the place where people buy and sell bonds before the bond reaches the end of its loan period. If you are selling it at a time where people could get a higher interest payment for it if they get it directly from the issuer, so let's say the ones buying your bond would get $50, but if they were to get it directly from the issuer at that time, they could get interest payments at $70, they would less likely want to buy your bond, reducing the price that you could sell your bond for. However, if the situation were reversed, you could sell your bonds at a higher price.
Therefore, when interest rates are high, bond prices are low and vice versa. When the stock market is volatile and there is more risk in owning shares, people might also decide to switch to bonds, especially safe bonds, like government bonds.
What is a bond yield?
Let's say you paid $1000 for a bond. Every year, the company will pay you $100 extra interest for this loan. The yield is therefore $100/$1000 * 100% = 10%. If someone buys it from you at a price of $900 (though I can't think about why you would sell it at that price unless it were for an emergency and you need the cash), that person's yield would be $100/$900 * 100% = 11.1%. If the yield is less than inflation, you would think that buying this bond is a very bad deal; therefore, bond prices are affected by people's expectations of what future inflation would be like.
What are Interest Rates?
They are the added interest that banks will charge when they lend money out. They are also the interest earnings accompanying bonds. They could also be the interest rates accompanying housing loans.
These interest rates could be affected by a few factors. For instance, if there is a huge expansion project and companies or governments need to borrow lots of money from the banks, they could fund these projects by charging a higher interest rate to those who owe the bank money, like other companies and people with floating housing loans (which are housing loans who interest payments depend on interest rates and would change over time, unlike the fixed housing loans).
Sometimes the government needs to implement cooling measures or they need to manipulate the economy in order to prevent a catastrophe or to encourage growth and spending (I am assuming the government is one that you can trust). They would then ask the Central Banks the change the interest rates that they are charging the commercial banks which are borrowing money from them.
These interest rates could be affected by a few factors. For instance, if there is a huge expansion project and companies or governments need to borrow lots of money from the banks, they could fund these projects by charging a higher interest rate to those who owe the bank money, like other companies and people with floating housing loans (which are housing loans who interest payments depend on interest rates and would change over time, unlike the fixed housing loans).
Sometimes the government needs to implement cooling measures or they need to manipulate the economy in order to prevent a catastrophe or to encourage growth and spending (I am assuming the government is one that you can trust). They would then ask the Central Banks the change the interest rates that they are charging the commercial banks which are borrowing money from them.
How do interest rates affect the stock market?
High interest rates would mean high borrowing costs for business and therefore lower profits. It would also mean higher liabilities. Where a higher interest rate is announced, people will tend to spend less money too and this will affect a business' profits. It would mean lower dividends for shareholders. Less people are also likely to want to buy the stocks. As a result, stock prices will fall. Lower interest rates could help increase profits and demand for stocks, increasing stock prices.
However, even if interest rates rise, stock prices might still rise if there is an upturn in the economy, where people expect that businesses will still profit. Even if interest rates fall, stock prices might still fall if there is a downturn in the economy.
Why should I get Stocks instead of Bonds which are safer?
Stocks are more able to keep up with inflation. When things get more expensive, it could mean that there is more demand for a company's goods and services and their profits are higher, which means that share prices would increase. In the long run, they might outperform safer investments. They could also act as a tax shelter. Depending on your country's tax rules, sometimes when you invest in stocks, the amount you invest is deducted from the total amount of income used to calculate income tax, which is tax that you have to pay every year based on how much you own. Hopefully, your taxes are used to fund nation building projects, like government services (schools, police, hospitals), infrastructure, etc and not corrupt officials.
What are Junk Bonds?
Junk bonds are bonds that have high yields but are riskier. They could be bonds issued by companies that do not have a good credit rating by rating bureaus like Standard & Poors'. A company with a good credit rating are more likely to pay off their debts.
What are Convertible Bonds?
These bonds are attached with an option for you to exchange them for shares, especially during good times when earnings from shares are higher than earnings from bonds. You could hold onto the bonds during tough times where you could still earn your interest.
These bonds are attached with an option for you to exchange them for shares, especially during good times when earnings from shares are higher than earnings from bonds. You could hold onto the bonds during tough times where you could still earn your interest.
What are Zero-Coupon Bonds?
These are bonds that do not pay an interest to you over time. Instead, they are sold to you at a cheap price (for instance, $800). At the end of the bond, you could get back the full price for the bond (for instance, $1000). The longer the period of the loan, the lower the price it is usually sold to you compared to its full redemption price.
What are Investment (Mutual) Funds?
A finance company (one that is regulated) might decide to create a fund. These experts buy and sell a whole bunch of shares, bonds, and other assets and bundle them inside a package (a fund) so as to make a profit. Some of these funds have a theme. For instance, there could be a fund with a fund manager who specialises in the medical market and have special knowledge of all financial things related to the medical market. Another example would be a mutual fund that specialises in all things China. In order to make a substantial profit, they will need money. They get the money from many investors (some of whom are companies and many are peons like you and me) who decide to invest in their funds. Most of the times, they would charge investors a fee (perhaps even an on-going one) in exchange for their expertise. The idea behind this is diversification - mutual funds have a mixture of bonds and shares. When they are not earning from the bonds, they could be earning from the shares. When they are not earning from one type of share, they could be earning from a share in a competing company or industry. Different mutual funds come with different types of risk, depending on the market they are invested in.
There are many types of mutual funds. One would be the money market fund, another would be bond funds. You also have balanced funds (mixed of several types of bonds and shares).
What are bond funds?
They are funds that mainly deal with bonds. Most (or all) of the portfolio is invested in bonds. You will have to look out for whether they are invested in government bonds, corporate bonds, or even junk bonds and what the percentage is like. This determines how risky the fund is.
What are Exchange-Traded Funds (ETFs)/ Index Funds?
The price at which at ETF is traded on the exchange daily depends on demand and supply of the ETF and is different from its net asset value.
Let's say a financial institution wants to create an ETF. They submit a plan to the commission of a country (like the SEC), and once it is approved, they gather stocks from the different companies that make up the index. Then, they deliver all these stocks to a custodial bank, who then issues the shares to the financial institution for the ETF. Next, the financial institution will sell these ETF shares on the stock exchange. The ETFs are traded at the same value of the index.
What are Unit Trusts?
They are like mutual funds. However, unlike mutual funds which reinvest the profits earned from stocks and shares (therefore adding to the net asset value of the fund), the profits are directly sent to the unit trust owner's account.
What are Securities?
A security is a broad term that could be a stock, a bond, or an option.
What are stock splits?
Let's say you have 100 shares at $1 each. Now the company sends you a letter telling you that you have 200 shares at $0.50 each. Basically it is all worth the same amount of money. You throw the letter away thinking that they wasted your time and wonder why they would even bother. To an outsider, it would look that the shares are now cheaper and therefore they are more willing to buy it.
What are stock dividends?
This happens when a company decides to give their shareholders more shares instead of cash when they are supposed to be paying dividends. Basically, the company will announce that ALL their shareholders will get an additional certain percentage of stock. Let's say everyone gets an additional 3% of stock. The total value of your stock is still the same, just that you don't get paid cash now for your dividends. This might happen when the company is a little cash strapped as they need it to expand or they are headed for trouble.
What are dividend reinvestment plans?
You get cash dividends and you are given the option to use that cash to buy new shares in the company without having to pay brokerage commission and even at a discount. It is not the same as stock dividends.
What does it mean to sell short?
It means to sell a stock that you don't own. First, you ask your broker to borrow the stock when the price is high. Next, you sell the stock at a high price even when it doesn't belong to you. Because you borrowed the shares, you have to return then. Hopefully, you can buy it back when the price is low so that you can return the shares to the owner. When you return the shares to the owner of the stock, you are covering your position. Since you are selling high first, then buying low later, you might make money.
Let's say you want to short sell a stock going at $150. You short sell 10 shares and receive $1500 in your account. However, you are short of 10 shares, which you need to return. If the share price goes to $100, you buy the 10 shares at $1000 and return 10 shares to the original owner. $500 will be left in your trading account. If the price goes up to $200, you need to pay $2000 for the 10 shares. The risk here is that the lender has the right to ask you to return the shares at any point of time. Let's say before the share price goes to $100, it goes to $200 and the lender asks you to return the shares when the price is high, you will lose $500. Most of the time, the lender of the stock is the brokerage firm. They rarely ask short sellers to return the shares unexpectedly (unless the losses are really too heavy, depending on firm policy and the margin call contracts signed with clients) as it will give them a bad reputation and less people will want to buy shares through them.
Remember that you have the pay the broker commission for helping to find stock for you to borrow. If the price climbs, you might need to hold onto the stock longer than you like or if it doesn't drop at some time, you might need to buy it at a high price, especially if the owner of the shares wants it back. The problem with holding the stock is because you borrow the stock, instead of the company paying dividends to the person owning the stock, you have to pay dividends. You are also going against the efforts of the company's management who are doing their best to help the company thrive and have the price go up, and it would make you very nervous once the stock starts climbing.
What are Over-The-Counter stocks?
They are tiny, obscure stocks. You have to pay commission to buy and sell them.
What is Beta?
Beta tells you how volatile a stock is to the market. If a fall in 10% in the market (or average of selected 30 stocks that tell you about the market) causes it to fall 20%, the beta is 2. Most stocks have beta of around 1. These stocks have the potential to rise a lot or fall a lot.
What is the Dow Jones Average?
There is this thing called the S&P Dow Jones Indices, which is a joint venture between 3 big corporations. This joint venture has a panel of experts who will select 30 companies whose weighted-average price represents the US economy. If its price is going up, it means that the economy is doing well. The 30 companies chosen are huge performing companies that are symbolic of how well the economy is. These companies can change over time. If an expert says that the 'market' is up, it would mean that these huge corporations are making money and that people are being employed by them. If an expert says that the market crashed, it means that this companies are not doing well, and employees and businesses that depend on these big companies would have hard times ahead.
What is Leverage?
Leverage is an investment strategy. For instance, you buy something at $100,000 but only put $10,000 as down payment. If you sell it at $140,000, your profit is at 400% (40,000/10,000). It is when you put less money down, hoping to repay it once you have earned your profit. However, if you sell it at less than $100,000, your percentage loss will be multiplied as well as you are required to return that $100,000.
What is Margin?
It is when the brokerage firm lend you money to buy more stock than you can afford to buy. This happens when people are really confident that the price of the stock will increase. They hope to pay back the brokerage firm once they make a tidy profit from the stock that they have borrowed. The brokerage firm will then hold on to the stock as security. If stock prices fall too much and below a minimum, the stockholder either puts more money in it to buy more stock or the brokerage firm would sell off the stock to reduce their losses. This is known as a margin call. This strategy is highly risky and a person could get into a lot of debt following this strategy.
What are Derivatives?
Well, they are things that make stocks and bonds way more complicated that it already is. They also present additional creative opportunities for investors to profit from their speculations on the price of stocks and other things. They are additional stuff that you can buy whose price and value depends on stocks, bonds or commodities (goods like oranges, wheat, coffee, steel, etc) that they are attached to. For instance, an option is a derivative. You buy an option so that you will be able to buy a stock at a specific price at a specific date. However, you pay extra for that option. It is not a share. You pay an additional price for the option to buy that share. After you pay for the option, if you decide to exercise it, you still need to pay for the share. The value of the option will depend on the share. Sometimes, derivatives are bought so that there are additional opportunities to earn money, apart from just buying and selling the shares. This is known as derivative speculating. Sometimes, the derivatives help to decrease risk. For instance, you buy an option to purchase a house at a specific price because you are not sure how much the market price will increase for a foreseeable future. You don't want to be given a shock and asked to pay through your nose on the day you need to buy the house. Buying derivatives to decrease risk is known as derivative hedging.
What are Call Options?
Let's say you want to buy a house. You have a discussion with the owner and he or she agrees to sell it to you by or on 31 December this year (a specific date - the expiration date) at $200,000 (a specific price - the strike price), no matter what the market says the price of the house is at that time. You pay the owner an additional $1000 (the premium option) to ensure that that you will get to buy the house at that time at that price. 31 December comes and you decide to buy the house as you have the funds to do so. You have decided to exercise your option. However, you can decide not to buy the house there and then. This means that you have decided not to exercise the option. You cannot get a refund for that $1000 as it is the money you have paid to give you the option. You can get an option for stocks and shares too, where you pay in order to buy that stock at a specific price on a specific date instead of the listed price on the stock exchange. For instance, you speculate that the price of a share is going to rise. You buy an option early to pay for it at a lower price. When the price of the stock go up, you exercise your option, buy it at a low price and sell it for the higher market price and earn money as a result. You can purchase options from a brokerage firm.
If you can only exercise the option on the expiration date, you have gotten a European Style option. If you can exercise the option before or on the expiration date, you have gotten an American Style option.
What are Put Options?
Let's say you want to insure your car. You pay an option premium of $1500 per year (the year indicates the expiration date) so that it gets insured for $50,000 (the strike price). If your car gets stolen and damaged, you exercise your option and get up to $50,000 to cover your loss. Whether or not something happens to your car, you have paid $1500 a year for the put option to get it insured. In stock terms: You buy a put option at $0.20 to sell a stock at $45 before an expiry date. The stock price falls to $40, but you exercise your option and sell it for $45. You make a profit of $4.80. The person who sold you the put option would make a loss of $4.80 because they have to buy the stock back from you. If the price never drops below $45, that person would have kept your $0.20 and you would make a loss of $0.20.
What are Warrants?
Warrants are like options but are issued by companies, unlike options which are listed on an exchange, like the Singapore Exchange. Companies sometimes issue warrants together with their stocks, so as to entice stockholders to purchase shares. Like options, there are call warrants and put warrants. Let's say you have a share at a company. You can choose to exercise your put warrant, where you would sell your share at a specific price before the expiration date when the price drops below a certain threshold. You could also exercise your call warrant to buy a certain share by the expiration date, at a certain price. If the price listed on the exchange is higher than the price your warrant allows you to buy the share at, you would have made money.
Some warrants are issued by investment banks. These are known as structured warrants.
Warrants come with conversion rates. Meaning, if the conversion rate for a warrant is 3:1, you need to buy 3 warrants in order to purchase a share.
Warrants tend to have a wider range of expiry dates and exercise prices as they are issued by the company. Options, which are listed by the exchange, usually have standardised and limited prices and expiry periods.
Options and warrants, when to buy? When?
If you have a bullish view (where you think prices are going to rise), you would want to get a call warrant so you can buy the share below the market price. Likewise, you would want to get a call option or sell a put option (to minimise loss, I guess). If you have a bearish view (where you think prices are going to fall), you would want to get a put warrant or a put option or sell your call warrant, as it allows you to sell your shares above the market price.
What does it mean to be cash settled?
This means that when you wish to exercise your option or warrant, instead of having to buy the stock and then sell it at the market price, and therefore incur transaction costs for buying and then selling, when you exercise your option, the buying and selling is done automatically and you will just get the price difference between the market price and your option exercise price in cash. Most options and warrants are cash settled. This is why sometimes people want to get options. It is a lot cheaper to buy 100 warrants than it is to buy 100 shares, however, the earning potential will still be the same.
Instead of having to have enough money to buy the shares, a person might decide to purchase the option. If they are confident they can make money through the transaction, they don't have to pay to buy the shares in order to make money. However, this makes it risky, as if things don't go as plan, they might end up not exercising that option and will lose money on the option. This is why options and warrants are considered leveraged.
What are Naked Options?
Let's use the analogy of selling a house. You sell people the option to purchase a house. However, you don't own the house. Let's say the option costs $1000, the price at which the house is sold at expiration date (market price) is $400,000 and the buyer would pay you $500,000 according to the option. You have already earned $1000. When the expiration date hits, you get $500,000 from the buyer and return $400,000 to the original owner of the house. However, let's say the price of the house at expiration date is $800,000. Yes, you would have gotten $500,000, but you will need to come up with another $300,000 to pay the original owner.
Naked options are when you sell options on shares which you do not own. Like the housing example above, there is potential for you to earn a bundle. However, there is also a likelihood that you will owe an astronomical amount. This means that naked options have unlimited liability.
Let's say you want to sell a new option. You write the option, which is to draw up the contract to sell the shares at the specific price. In the first scenario, you write the option to for someone to buy 100 shares from you. You have the shares as you have paid for them. If the person who bought the options from you decide to exercise the option as they will make money, you have the shares to issue to them. These options are covered. However, there are some people who think that they can make money from the options as they are confident whoever buys the options from them will not exercise it and they will end up earning. They are so confident that they don't even feel the need to buy the shares. However, if their speculation goes wrong and the buyer wants to exercise the option, the person who wrote the option without buying the shares will have to buy the shares now, even if the share prices are really high. When you sell shares or other financial instruments you don't own, you have a short position. When you sell warrants whose shares you own, you have a long position.
Structured warrants, on the other hand, have limited liability. The amount of money that you stand to lose would be the amount that you have purchased for the warrants or the amount of money that you have paid for the shares.
What is an Option Margin?
Let's say you are thinking of selling options, especially naked options. You will need to deposit a minimum amount of money in your trading account before you can start selling options. This minimum amount of money that you have to have in your trading account is the option margin. The amount required depends on the type of option you are buying. The riskier it is, the more money you need to have in your trading account.
What is in-the-money, at-the-money, and out-of-the-money?
In-the-money means that you are able to make money from your options at the current price. At-the-money means that you won't make a loss as your strike price from the option and current market price is the same. The only loss is the amount you paid for the option. Out-of-the-money means that you will definitely make a loss if you exercise your option.
What is the intrinsic value of a warrant?
It is simply the difference in price between the current price of the share and the strike price of your warrant.
What is the time-value of a warrant?
It is the difference between how much you pay for the warrant and the intrinsic value of the warrant. Usually, the warrant or option is more expensive when the expiry date is longer. If you think about it, you would have to pay more to 'reserve' to buy a house using an option for one year than for a month.
What else determines the price of a warrant?
The price of a warrant will vary over time and depending on a number of factors. You will definitely want to buy a warrant at a low price (the cheaper, the better, right?). If the share that you want to buy seems to be increasing in price, a call warrant would be more valuable and in demand as there is a higher chance of earning money from it (where you can buy the share at a lower price than market). It will make a put warrant less valuable. If there are greater fluctuations in price, the risk is higher, but so are the potential gains. A warrant for a share that is volatile will be at a higher price. When it is nearing the time to expire, especially when it seems that it very unlikely the buyer can exercise the option without making a loss, the warrant becomes less valuable.
Other things that affect the price are the dividend yield of the stock or share linked to the warrant, the exercise price and interest rates. Some people borrow money from banks to buy shares. If the interest rate increases, it becomes more attractive to buy warrants than to buy the shares, as the shares are way more expensive but the earning potential is still there. The person will have to borrow less money to buy shares which will incur less expenses from interests. They could put that money inside interest-earning fixed deposits whose earnings are more when interest rates are higher. Higher interest rates could also be indicative that stock prices will rise, so call warrants become more attractive and the price of the call warrant will increase.
What are other risks with regards to Options or Warrants?
There is issuer risk. For instance, you decide to exercise your warrant and earn money from the current price of the warrant. However, the bank that issued the warrant to you goes bankrupt. As only an warrant holder and not a stockholder, you don't have any claims on the assets.
There is market risk where your option or warrant's price will increase or decrease over time.
Liquidity risk: Where you know that you are going to make a loss if you exercise a warrant, so you decide to sell it, but no one wants to buy it from you. OR, when you want to buy a warrant for a stock, but no one wants to issue or sell it to you at a price that you are comfortable with.
Foreign exchange risk - when you decide to buy an option or warrant from another country using another country's currency and the exchange rate ends up costing you.
What are Swaps?
These are usually contracts between business and financial institutions. It is an agreement for 2 institutions to exchange sequences of cash flow over a period of time (that is the official explanation, so I understand if your eyes glazed over it). An example is that of a credit default swap. So let's say a company wants to expand and so it issues bonds. It will pay interest to those who buy its bonds over time and at the end of the day, pay back the principal. However, there is a chance that the company will go bankrupt and not be able to pay back the principal. So, it can pair its bonds with a credit default swap, where part of the interest paid to the bond holders is paid to the seller of the credit default swap (usually a financial institution) who in turns will pay the full principal back to the bondholder should the company issuing the bond not be able to pay.
Retail investors can't buy a credit default swap. A credit default swap usually trades in $10 million notational units. They will also need to have an ISDA agreement with the other party.
There is usually an element of uncertainty in swaps. It could be based on an interest rate. One example of a swap is an interest rate swap. Let's say you have a company that borrowed money from a financial institution to expand. There is a chance that the interest rate that you pay in future might increase, especially if you are paying a variable rate (where the rate you pay will change over time, depending on market conditions or bank policies, etc...). You don't want to be caught off-guard and have to pay a really high interest one day when you are not prepared to pay for it. Therefore, you decide to exchange your variable rate for a fixed rate. You go to the bank and agree to pay them a fixed rate interest payment. In return, the bank hands you the money for the variable rate which you pay to the financial institution.
Another example of a swap is a currency swap. Let's say there is this Thai company that wants to expand in Malaysia and this Malaysian company that wants to expand in Thailand. If the Thai company gets a loan from the bank in Malaysia, they will be charged a higher rate than if they get the loan in Thailand. Likewise, if the Malaysian company gets a loan from the bank in Thailand, they will be charged a higher rate than if they get the loan in Malaysia. However, the Thai company needs Malaysian Ringgit to expand in Malaysia and the Malaysian company needs Thai baht to expand in Thailand. So, these two companies decided to have an agreement with one another. The Malaysian company will borrow from the Malaysian bank and the Thai company will borrow from the Thai bank. They then come to an agreement to swap the cash and interest payments. Both parties will then be able to get the money in the foreign currency at a cheaper interest rate.
What are the different types of ETFs (Exchange Traded Funds)?
An ETF is created by an ETF manager, perhaps someone working in a brokerage firm or a financial institution. To create the EFT, the ETF manager will have to find ways to create a fund that copies the index. Different exchange traded funds copy the index in different ways. There are cash-based (or physical) ETFs and synthetic ETFs. Synthetic ETFs are based on derivatives (mainly swap agreements).
Cash-based ETFs or Physical ETFs copy the index. They buy stocks from the companies listed in the index. If it is a direct replication, even the percentage allocation is copied. For instance, let's say that 2% of an index's price is calculated from its stock in company A. 2% of the physical ETF would also be based on stocks from company A.
Sometimes, direct replication is downright near impossible, especially if the index has many companies - for instance, the S&P 500. It might be difficult for the ETF manager to do this on a daily basis. Therefore, the ETF manager creates an ETF that buys and sells shares based on some of the companies listed in the index. They might decide to focus on the top 10 performing companies in the index, instead of buying shares from all 500 companies.
A synthetic ETF is created when the ETF manager decides that instead of buying and holding onto the stocks that are listed in the index, they will enter into a swap agreement with a bank. In exchange for a perhaps a fixed fee, foreign currency or something else, the bank will give the ETF manager the earnings that replicate that of the index who will then distribute the earnings to the investors.
What are Long ETFs? What are Short ETFs?
Long ETFs are your normal ETFs. Short ETFs (also known as bear ETFs or Inverse ETFs) are ETFs whose shares you buy when you think that the economy of a country is not going to be good. The ETF manager would form the short ETF using derivatives that would earn if the prices of the stocks in the companies listed in a particular index are falling.
What are leveraged ETFs?
Instead of matching the index (for instance, when the index rise by 5%, its price will rise by 5%), some magnify the effects (it rises by 15% instead of 5%). If it were a short ETF, it would fall by 15% instead of 5%. There are leveraged ETFs that are both long and short ETFs. These ETFs are created using derivatives instead of just shares.
What are the risks of Short ETFs?
Unlike ETFs which do not need to be managed too much, there is a lot of management of funds for short ETFs by fund managers. Therefore, their fees will be higher.
If it is a leveraged ETF, the risks are even higher.
Both short ETFs and leveraged ETFs are rebalanced daily. This means at the end of every trading day, they adjust their derivatives so that they will get what their financial goal is. For instance, if a leveraged short ETF aims to rise $2 every time an index drops by $1, the fund manager will do to the derivatives in the ETF to ensure that it does that.
Long ETFs are passively managed. This means that you just buy the shares and hold onto them. You collect dividends over time but you are not affected by price adjustments until you cash out and sell your shares, like mutual funds. Short ETFs and leveraged ETFs are actively managed. They are bought and sold only a daily basis. Shares which are actively managed are those which you buy and sell many times of the day as you track the price of the share.
Due to daily rebalancing, if you hold onto the short ETF for more than a day, the performance from the second day onwards might not what you expect.
For instance, if you buy $100 worth of short ETFs. The index falls by 10% (from 10,000 to 9000). You will earn $10 plus your $100 and your ETF is now $110 at the end of the first day. In the second day, the index rises from 9000 to 10,000, which is an 11% rise ((10000-9000)/9000 = 11%). Therefore, your ETF's value will also fall by 11% (89% of 110 is now $97.78) when they rebalance at the end of the second day. Even though the index went from 10,000 to 9,000 and went back to 10,000, you have effectively made a loss. You started off with $100 but ended up with $97.79. This is compounding risk.
However, with long ETFs, let's say, you invest $100. As long as you don't cash out in between, if the index goes from 9000 to 10000 and then back to 10000, the value of your shares are the same. If you cash out, you still get your $100.
What are some advantages of long ETFs?
First, as most of them are passively managed, their management fees tend to be really low. It is usually at 0.25% to 0.5% for each trade. On the other hand, management fees for unit trusts can be as high as 3% to 5%. Moreover, there is transparency. ETF prices and index prices are usually published online on a daily basis. You can see how much your share is worth on any day. However, with unit trusts and mutual funds, most of the information is only published at the end of the month. They are only required to disclose their portfolios on a quarterly basis.
What are the risks associated with ETFs?
First there is market risk. Let's say you invest in an ETF which tracks the index of a certain country. Then, for the next seven years, the price only seems to be on a downward trend. You only end up losing money. There is also tracking error where the fund manager is unable to get the ETF to replicate the performance of the index it is tracking.
If your ETF is a synthetic ETF which relies on swaps and other derivatives, a third party could be involved and is necessary in order to ensure that your ETF tracks the performance of the index. If the third party is not able to fulfil the obligation, your ETF could suffer losses. This is counter-party risk. There is also shutdown. There are at least 100 ETFs that are shut down each year as they aren't popular. There are costs associated that shareholders have to pay before the capital (or total earnings) of the shares can shared amongst them. There are transaction costs. Once, a firm even tried to stick its legal fees with shareholders. There is also foreign exchange risks. Let's say you live in Singapore. When you bought your ETF, you were able to exchange 3 Singapore Dollars for 1 Euro. You bought 90 Singapore dollars worth of shares. That is 30 Euros worth of shares. Your ETF grows 10%. You decide to cash out when it is 33 Euros. However, now, you can only exchange 2 Singapore Dollars for 1 Euro. So your 33 Euros becomes 66 Singapore Dollars. You had put in 90 Singapore Dollars. Even though the ETF rose by 10%, you only earned 66 Singapore Dollars back due to currency exchange risk. You made a loss even though there were gains in the market due to change in currency.
There is liquidity risk. Let's say the ETF share prices are high. You decide to cash out your ETF. So did a whole bunch of people. The fund company does not have enough cash to pay out the ETFs to everyone. They don't have enough in their funds. They are also not able to find buyers for these shares as the price is high. You are not able to sell without buyers and are stuck with it.
What are Exchange Traded Notes (ETNs)?
They are debt instruments, like bonds. It is basically money that you lend to the bank you are buying the ETNs from. It is unsecured, meaning that if the bank goes bankrupt (like the Lehman Brothers in the 2008 financial crash), you might end up even losing the money you invested inside. If you were to get a huge loan, some times a bank would want you to secure it with a collateral, like a house. If you don't pay the bank back, they can sue you and take your house from you. That is what a secured loan means. With ETFs, if the financial institution selling you the ETF goes bankrupt, you still own the shares that make up the ETF. ETNs, like ETFs, track the index.
They have a maturity date, meaning that on (or sometimes before) the maturity date, you can/have to cash out your ETN. You can hold onto your ETN until its maturity date. Before that, you can sell it on the market. That is the date the bank returns your money to you. Depending on how well the index performed, you might get more money you invested or might make a loss. Unlike an ETF, you don't own any of the stocks and shares of companies listed in the index, making ETNs riskier than ETFs. Like ETFs, you have to pay a fee for an ETN.
Unlike bonds, ETNs don't have a guaranteed fixed rate of interest payment.
ETNs are issued by large financial institutions. As they are issued 50000 units at a time, financial firms, like brokerage firms buy them, then sell them to regular investors. There are far less ETNs than there are ETFs.
What are some benefits of ETNs?
First, there are no minimum purchase requirements. If a unit or share costs $25, you can purchase as little as 1 unit. This is unlike bonds that have this minimum purchase requirement, where you have to loan at least a certain amount of money. You can also buy or sell them at any time of the day.
You only get taxed based on the earnings you have made in the end of the day with the ETN. With bonds, you get paid every year, so that money you are paid every year gets taxed. With ETFs, because you own shares, you might also get dividends. When you get the dividends, you might end up being taxed for those earnings.
There are some markets that are very hard to invest in. ETF managers that create an ETF based on these markets will have a hard time getting shares in these markets at times. As with ETNs, you don't own shares, there is no need to buy the shares of the companies in these markets.
What are some risks of ETNs?
There is less risk of tracking error, where the ETN is not able to track the index it seeks to replicate, than an ETF. The ETN does not own any of the shares, so it does not need to buy the shares to replicate the index. If the issuer (like Lehman Brothers) goes bankrupt, you could stand to lose your entire principal invested, even though the index is doing well.
What are Brokerage Firms?
They are companies that help clients buy and sell financial securities (shares, bonds, options, warrants, futures, etc, whatever they decide to offer). Some earn mainly through client commission. Some have their own trading accounts, apart from their clients. They would also trade using their own money to earn profits. The firms are known as broker-dealer.
What are Discount Brokers?
They are brokerage firms that earn very little commission from individual clients. Most of their transactions are automated using computers. They earn mainly from having many clients.
What are Distributors?
Distributors are broker-dealers who help to distribute mutual fund shares. They recommend shares on behalf of the fund manager or bank and are paid by the clients with upfront fees and annual fees.
What is a Financial Exchange or Stock Exchange?
It is a marketplace that is created by either companies or by governments. For instance, the New York Stock Exchange is owned by Intercontinental Exchange. The Shanghai Stock Exchange, on the other hand, is owned and governed by the Chinese government. This marketplace can be a physical place or an online marketplace. What people do here is that they buy and sell shares or other financial instruments. People who manage the exchange, ensure that those who want to sell their shares in this exchange meet certain criteria and abide by certain regulations. Those who wish to buy shares will go to the exchange to find out the latest price of the shares as well.
What are Market Makers?
Market-makers are broker-dealers. They help clients buy and sell shares and they have a trading account of their own. Let's say you want to buy a stock. Who do you approach to buy the stock? If you approach just one person, that person might not have enough stock to sell to you and you might need to approach another person. With market-makers, you can just buy your stock from this broker-dealer who will buy it from you at a firm ask price (how much they are selling it for), even they don't have sellers currently selling the stock. Likewise, if you wish to sell stock, the market-makers will buy it from you at a firm bid price (depending on demand and supply) even if they don't have any buyers lined up.
This is how market-makers earn money - they could buy a share from you at $100 and sell it to someone else for $100.10. They only earn 10 cents but if they do it to millions of shares, they could earn quite a bit. This $0.10 of profits is known as the bid-ask spread.
What are Futures?
Futures are contracts that are mainly used to reduce risk. For instance, the price of coffee fluctuates all the time, due to demand and supply, yet the amount of money you pay for it at the supermarket remains the same. How is that so? Let's say you own a coffee company. You get your coffee beans from farmers before processing them and selling them to supermarkets. You don't want to be taken by surprise when the coffee bean prices increase a lot, especially if there is a drought somewhere. You cannot afford to increase the price of your coffee too often either - people will buy coffee from others. On the other hand, even when there is a lot of coffee supply (perhaps at certain times of the year where conditions are good for growing coffee beans) and price is really low, coffee farmers want to earn a minimum amount of money so that they could survive and buy the necessary things needed to sustain their plantations and grow coffee beans. The coffee company also does not want to pay for all that coffee at once as it will need to pay to store it. This is when the futures market comes into play. The coffee companies and the coffee bean farmers buy and sell contracts in the futures market.
Before even planting, the coffee bean farmer might be anticipating that he/she will have a certain supply of coffee beans in the future. He/she sells part of his/her stock as part of a contract in the futures market, promising to deliver and sell the coffee beans at a specific price and at a specific date to the coffee company. If the farmer realises over time, as prices increase, that the price quoted originally was too low, the farmer can sell another set of crops using another futures contract at a higher price.
The coffee company could also have contracts in the futures market, looking to buy coffee beans at a specific price at a specific time.
What has it got to do with me? I am not a producer or manufacturer.
When it comes to futures markets, there are two types of people - hedgers and speculators. Hedgers are the producers and buyers of actual commodities. Speculators take the opportunity to bet on the price of commodities to make money. They won’t actually buy or receive the actual commodity. They are gambling on the price.
How is this possible?
Imagine you are a producer. You want to sell 1000kg of steel for $3000, which is the current price of the market or what you will need to pay to get it, with profit. You set up a future contract with a futures commission merchant who works with the broker at the exchange dealing with futures. Then, they find a manufacturer or buyer at the exchange who is willing to purchase at that price. The contract will expire in 3 months - in 3 months, you will have to deliver 1000kg of steel and get paid $3000 for it, even though it might cost you $2000 or $4000 to get the steel then. The following month, the market price rises to $4000. You are worried it will cost more to get hold of the steel, even up to $5000 and that you will lose more money in the deal. You want out. One the other hand, the manufacturer thinks that this is a price spike and that the price will go to $2000 in future, so they also want out. However, the futures contract is a legally binding contract so you cannot just dissolve it, so you create another contract to offset it. You say you will pay $4000 to buy back the steel from the manufacturer in 2 months’ time, as futures contracts are set at current market price. The third month comes. The price is at $4000. Here is a whole bunch of things that might happen:
- You get the steel at $4000 (or cheaper) for it.
- You sell it to the manufacturer and the manufacturer gives you $3000 (Contract 1).
- You buy it back at $4000 (Contract 2).
- You sell it off at $4000 somewhere, perhaps to a third party buyer.
Ignoring the first and last step, in the end of the day, you would lose $1000 and the manufacturer would earn $1000. Imagine if you ignore the buying and selling of the actual steel, it would be a lot easier for you to just pay the manufacturer $1000 without handling the steel. This is known as cash settlement and is what most people do in the futures market as speculators. They don't actually hold onto the futures contract until it expires. Not only does the futures market provide a place for manufacturers and producers of commodities to hedge against price increase, it provides an opportunity for opportunists to gamble on the price of commodities.
How does it work for speculators?
Let's say you want to buy some commodities, like steel, at a price of $1000, which is the market price at that time, according to the exchange. To buy in this case would be to take the long position. You put in a deposit, called the initial margin, at $100. This is the amount of money you put into your brokerage account. You don't actually have to pay $1000 unless you are intending to take hold of the steel at the contract expiry date. The brokers (with a lot of buyers and sellers) help find a seller of the contract for you. You might have to pay a small brokerage fee. There is a seller who sells it to you at $1000. (The seller is taking the short position). At the end of the day, the price drops to $940. You make a loss of $60. As futures contracts are daily settled, the $60 loss is immediately deducted from your deposit. You now have $40 left in your deposit. However, since the maintenance margin is $50 and you have less than that in your account, you need to top up $60 to get the initial margin. When you are asked to top up, you are experiencing a margin call. The $60 that you need to top up is known as the variation margin. However, let's say the price only falls by $5. Your account has not gone below maintenance margin and you won't have to top up. The end of the next day, the price rises to $1050. You decide to close your position, meaning that you decide to sell off your futures contract. (When you buy, then sell, you are closing and when you sell, then buy, you are closing) Some other person buys the contract from you. You make a profit based only on your deposit. There is a risk to you - what if the price continues dropping until contract expiry? If you forget to close your position, you might end up having to pay $1000 and the steel might end up being delivered to you!
Do take note:
- Not all futures are based on commodities. Those that are based on commodities are commodities futures and those that are based on the price of financial instruments like currencies, equities and interest rates are financial futures.
What are Extended Settlement Contracts?
In Singapore, there is a special type of futures contract called the extended settlement contract (ES). They are listed on the Singapore Exchange and are financial commodities based on the price of shares. They do have a initial margin, variation margin, margin call, and maintenance margin like normal futures contracts. You will also need to close your position within 35 days or you will pay full price for the shares and will own the shares in the end. The special thing about this contract is that there is no daily settlement. The settlement is only done at the end of 35 days. You will be able to close your position earlier than 35 days if you wish to.
What are Certificates?
They are documents that are proof that you own some financial security, like stocks.
What are Discount Certificates?
Discount certificates are sold at a price lower than the market price. At expiration, the minimum you can get back is the market price and the maximum is the cap level. For instance, there is a certificate sold at at discount. The current price is $5. The discounted price is $4. The cap level is $6. The tenure of the certificate is 6 months. When the certificate expires in 6 months (or at maturity), if the price of the certificate is $3, you will still receive $5 for it. Even if the price is $7, you will receive $6 for it.
What are Callable Bull Contracts and Callable Bear Contracts (CBBCs)?
Let's say I have this contract. It tracks the price of a stock (it could also track the price of an index). I get it from a third party (like an investment firm or a bank) that buys this stock. The usual share price of this stock is very expensive, but the callable contract that I buy is a fraction of the price of the share. I am not buying the share - just betting on whether its price will go up (bull) or go down (bear). It has an expiry date (usually 3 months to 5 years).
A callable bull contract will increase in value when the stock (or index) it tracks rises in price.
A callable bear contract will increase in value when the stock (or index) it tracks falls in price.
It is callable as once the stock or index it tracks reaches a call price that is a fixed price determined by the investment firm or bank (it is listed out before you buy the CBBC), the contract will immediately expire and the bank that issued the contract will take it back. This is known as a Mandatory Call Event (or MCE) or knock-out Event. For instance, let's say you will make a loss once the price of the stock reaches $50. If it isn't the call price, you can hold onto your contract until the expiry date, and might still earn depending on whether your stock price recovers. However, if it is the call price, even if you make a loss, the contract will expire and you will need to accept this loss.
(Take note that some people will prefer to sell the CBBC before the MCE can occur so as to reduce their loss)
If you have a bull contract, your contract will be (re)called once the price of the stock it is tracking goes below the call price. If you have a bear contract, your contract will be (re)called once the price of the stock it is tracking goes above the call price.
There are 2 categories of CBBCs - N category and R category. Once N category callable contracts are recalled, you won't get any money back. With R category callable contracts, there is a chance you will get some money back, also known as the residual value. However, do not take this for granted - you could still end up with nothing even with R category callable contracts.
One thing to take note of that even though your contract follows the price of the stock it is tracking, its price might be affected by demand and supply of the contract itself in the stock exchange. When you buy the CBBC, the price of the CBBC itself determined by demand and supply is the strike price. The price of the stock it is tracking then is the spot price.
How much do you pay for the CBBC?
Let's say you are buying a Callable Bull Contract. At the time you are buying, the price of the stock it is tracking is $50. The spot price is $50. Based on demand and supply, the strike price is $30.
This strike price might become unstable (changing a lot) if the price of the underlying stock goes close to the call price.
It has an entitlement of 10:1, meaning that you only pay 1/10 of the price. It also has a funding cost (or fee) of $2. How much do you pay per share? You take $50 - $30 first (spot price - strike price). You will get $20. Then, you add $2 funding cost to get $22. Why the funding cost? Because investment firms and banks don't work for free. Because of the contract entitlement, you only pay $22/10 = $2.20 per share. Let's say you want to get contracts for 1 lot of 1000 shares, you will have to invest $2.20 x 1000 = $2200.
Take note that the funding cost will become less when the time-to-maturity (or expiry) shortens.
How can you earn from the CBBC?
What if the share that your contract is tracking rises to $60 at maturity? How much will you make? First you deduct the strike price from the $60 (settlement price). $60 - $30 = $30. This $30 after deduction is known as the intrinsic value.
Then you take the amount and divide by the contract entitlement - in this example, which is 10:1. So you divide $30 by 10 to get $3.
Next, you multiply it with the number of shares your contract is tracking (1000). $3 x 1000 = $3000. Deduct how much you invested ($2200) from $3000 and you will take back $800 in profit.
What is the Residual Value?
Remember - with a category N CBBC, if your CBBC is (re)called, you will get $0 back.
Residual value is found in Category R CBBCs. It is potentially how much you can take back when your CBBC is called. For a bull contract, the strike price is lower than a call price. Let's take the above example. Let's say that instead of $30, the call price is now $40. Strike price is still $30. You still pay $2200 for the lot of 1000 shares. Here how it is settled:
Let's say now the price of the stock becomes $35. It is now below $40. It will be called. This $35 is known as the minimum trade price.
First, take minimum trade price - strike price : $35 - $30 = $5.
Divide it by the entitlement: $5/10 = $0.50.
With 1000 shares, you get: $0.50 x 1000 = $500
Even though you have invested $1860, you only got back $500, giving you a loss of $1360.
Where does this minimum trade price come from?
The investment firm will observe the prices from the time of the (re)call or MCE to the end of the next trading session. If yours is a bull contract, they will find the lowest price. If yours is a bear contract, they will find the highest price. Imagine if in the above example, the lowest price is $30. If the minimum trade price is $30 and your strike price is $30, you will not getaway money back. You will effectively not get any money back. According to a web source, if the minimum trade price falls even lower than the strike price, you don't have to worry about topping up or paying even more money - your total loss will be the investment amount. Take note that length of trading sessions can be different depending on the exchange they are in. In the Singapore Exchange, they have a morning trading session and an afternoon trading session.
How is it different with a Bear Contract?
With a bear contract, when buying, instead of deducting strike price from spot price, you will calculate by deducting spot price from strike price. In a bear contract, the spot price is lower than strike price. When calculating returns, instead of deducting strike price of settlement price, you will deduct settlement price from from strike price. Also take note that your CBBC will be recalled if the price goes above the call price, and not below it.
What is Issuer Risk?
One risk associated with CBBCs is issuer risk, where the investment firm issuing it goes bankrupt and you lose your entire investment. There is also liquidity risk, foreign exchange risk, leveraged risk (because you are not paying full price), and market risk.
What are REITs?
Reits (or Real Estate Investment Trusts) are companies. They own, operate, and finance real estate like condominiums, shopping centres, business hubs, etc... They will come up with portfolios that combine the profits earned from some or all of the real estate that they have. Then, you can buy a stake in the portfolio as part of a mutual fund. There are a list of conditions that companies have to fulfil to become a REIT. Some REITs specialise in earning from the property that they have - for instance, from rental from the shopping centres that they own. These are known as equity REITs. Mortgage REITs earn from interest earned from loans given out to people who need money to buy homes (mortgages), from different kinds of real estate loans (even to businesses, for instance), and from mortgage-backed securities. Some REITs specialise in both.
What are Mortgage-Backed Securities?
When you take out a loan from the bank to pay for your home, you have to repay the loan as well as interest to the bank. This loan is backed by mortgage as if you don’t pay back to a certain extent, the bank will confiscate your home. If the bank have to process a lot of these loans, they will need to come up with a lot of money (even billions) and they might have reservations about getting all this money from bank deposits. So, they sell this loan to investment banks or firms so that they could get the cash to process these loans. Let’s say the bank paid $1 billion for these loans. It would then sell the loans to the investment banks for $1 billion. Why do people still go to the bank? Well think about it, would you rather get a loan from a seemingly sturdy and well-known bank or an investment firm? Well, once the bank sells these loans to the firms, the firms collate these loans and sell them to investors (people who want to earn from reits). The bank will earn from fees (if you have ever paid for housing loan processing fees, you will know that this could be quite expensive). They might even get a cut of your interest payments.
The investment bank on the other hand, creates a corporation. The loans belong to this corporation. They then issue shares belonging to this corporation to investors. It has an IPO and manages to sell the shares for let’s say $1.1 billion. Funds and individual investors buy these shares. All payments and mortgages goes to this corporation. The thing is that some people default on their payments, some pay off their entire loans early (therefore saving on interest payments), some choose to transfer their loan to another bank when it comes time to refinance their loan, some sell off the home and therefore prepay it - they pay off the rest of the loan. All this, including how much the bank could sell the home off for if it were confiscated and unemployment rate which would affect how people are able to repay the loan, affects the price of the share as well as the risk associated with it. As these are shares, investors could also buy and sell them.
These mortgage backed securities are usually rated by a rating agency. The rating agency will tell you how risky the mortgage backed security is. If it is grade AA, it is less risky than something rated DD.
What are Collateralised Debt Obligations?
It is like mortgage backed securities (or MBS for short); however, it comes in different classes. Some investors, like pension funds, prefer something safer, even though the returns are lower. Some investors, prefer something with higher returns even if it is riskier. The investment bank divides the MBS into different classes, also known as tranches. One class has less risky mortgages but might have lower returns. This class would be given a higher rating. They will also get their returns first. On the other end of the spectrum is a tranche with the riskier mortgages, perhaps those that are larger or those that are less likely to be paid off on time. These might have a lower rating but higher returns. The returns for these will be given last.
What are Subprime Loans?
There are different types of borrowers of money (for housing or other things). Those with an A rating are rated as most likely able to pay off their loan on time. They have a steady or high-paying job, a huge bank account and plenty of assets. On the other end of the spectrum, you have F-rated borrowers. They have no money, no assets and no job. Then you have the people in the middle, grades C to D. They have a low paying job, are likely not to have a degree, have problems making ends meet and live in poorer neighbourhoods. Those in grades C to D qualify for subprime loans. As it is quite risky to lend to them as they stand a medium to high chance of defaulting on the loan, the interest rates on loans given to them are usually around 2% higher than the loans given to those with and A or B credit rating. Even with a risky credit risk, banks still lend money to those with C or D credit rating as there is an expectation that a number of them would get better paying jobs. A number of these people whose credit ratings are C to D are usually retirees or qualify for government assistance. It is unlikely that they will earn more in future without looking for a job. Some of them are not physically able to, like retirees who might have health issues at their age.
Subprime lending is not only given for home mortgages. Some of them are given for student loans for a university education which can be very high. The benefits of subprime loans is that it can give an opportunity for those with less fortunate backgrounds to get a decent education or a place to stay in. Some of these loans are given to those who suffered an emergency, illness, divorce, or sudden unemployment who need a loan to help get them back on their feet.
What causes a recession?
Before you know what a recession is, you need to know what real Gross Domestic Product (or GDP) is. GDP measures the growth of a country. It is tracked by governments through their national agencies. The GDP of a country is determined by how much the people spend in that country, how much they invest in houses and businesses, how much the government spends, how much the government invests and net exports (the cost of goods the country exports or sells to other countries minus the cost of goods the country imports or takes in from other countries). This is nominal GDP. Real GDP also considers inflation (or how fast price of goods rise). The country measures rate of growth of real GDP, which is how much the GDP increases from each quarter of a year. If a country experiences a negative growth rate (or a situation when GDP dips for more than 2 quarters), it is experiencing a recession.
How can a central bank influence the economy?
The central bank influences the economy through the interest rates in which it charges the banks when the banks want to borrow money from it (the central bank is the entity that prints money - that's why the banks borrow from it). This means that money becomes more difficult to obtain. When they increase the interest rate, banks will borrow less from them. They will encourage people to save in their savings accounts and deposit cash in the bank. The banks will also be less likely to lend money to companies which will then look to other means to get funds, like from bonds. Bonds will have more attractive rates and people will want to invest in bonds. Banks will also increase the interest rates on variable loans for homes. As businesses have less money, they will hire less workers. This means that unemployment rate will increase. At the same time, people will become more frugal and demand less goods. The price of goods will fall or at least not increase. This way, the interest rate will affect inflation. When companies are not doing that well or have less money, their stocks become less desirable and less valuable, so the price of stocks will decrease. Therefore, when interest rates increase, it is a good time to invest in bonds. People might invest in stocks if they see that the dip is only temporary and there is a reason why they think a particular company's stock prices will increase. Therefore, they will be buying the stock when the price of the stock is low, hoping to sell it at a higher price later.
If it is time to stimulate the economy, the central bank will decrease interest rates. Banks will be able to lend more money to companies which can then expand and hire more people. Demand for goods will increase and goods will become more expensive. Stock prices will start to increase and stocks become more desirable.
What is the Business Cycle?
In the 1800s, a few economists studied how countries become wealthy and how they lose their wealth. The realised that there is a pattern where the GDP of a country would increase, reach a peak, which is a time of high employment but high prices. Then, when there is a sudden crisis, like when 'bubbles burst', or when there is war or an outbreak of disease, people start to lose confidence that the good times will continue. They will start experiencing fear, and start saving instead of spending. This would mean less income for businesses that would start letting go of staff. The staff who are let go will also have to tighten their pockets, and they will spend less. Businesses will also make less risky investments and be more prudent with their expenses. This continues and the GDP of a country decreases to a certain extent. After some time, perhaps with a fiscal package to help people out or through technological advancement or through some other reason that could stimulate consumer confidence, people start spending again. Businesses start to invest more again, signalling an economic recovery. The economists discovered this trend of boom and bust. However, it is important to note that there is no fixed period of time for each period of recession or expansion. For instance, some recessions last for as little as 6 months, others, like the Great Depression, lasted almost 4 years. The recession in Greece after the 2008 world economic crisis lasted for almost 6 years! Periods of expansion could last for as long as 10 years or as little as 1 year before the next recession.
What does it mean when Bubbles Burst?
A price bubble happens when people keep expecting the price of something to keep on increasing. They invest in it and speculate in it and earn money in the short term, but make huge losses when the price for the good becomes unsustainable and the demand for it decreases.
For instance, during the 1630s, there was expectation in Dutch Republic (or the Netherlands as it is now called) that the prices of tulips will keep increasing. Why did the price keep increasing? Well, the tulips were originally from Central Asia. Over time, they made their way to Europe. A Dutch botanist got hold of some tulip bulbs and discovered a tulip virus (also known as the tulip breaking virus) that would cause the petals to break in more than one colour, showing a flame like effect. He also discovered that the tulip grows well in the Netherlands. The Dutch at the time were practising Calvinism, so they would reject opulence. However, things of natural beauty like flowers are acceptable. In addition to that, the Dutch were benefitting financially from the Thirty Years War and had recently achieve their independence from Spain. This kept the demand for the tulips high as people could afford them. However, it takes some time to grow the tulips, so supply could not keep up with demand, causing the prices to soar. Furthermore, French merchants started buying the tulips for their wives. Merchants started to stockpile the tulips. Tulips became a means of stable investment. People kept buying the tulip bulbs expecting that they could sell it for an even higher price. This became a craze amongst the people then, where they would buy tulips just to resell them. People started buying and selling futures contracts in taverns, instead of actual tulip bulbs. (This was an early version of the futures market). Between 1636 and 1637, the price of tulips shot through the roof.
In February 1637, an auction was held for the tulips. It had failed to attract any buyers. This was when the bubble burst. The flowers were then deemed worthless. Merchants who held onto the tulips heard about this, panicked and tried to sell off their flowers. This caused the price to drop significantly. People who had futures contracts that bet that the price of the flowers would increase would have lost a lot of money when the price dropped. A lot of florists had been selling flowers that they did not own to buyers who could not afford them. This period of time was called the Tulip Mania.
Bubbles are usually caused when people make reckless investments and too many people start betting on rising prices of things. In the housing crisis of 2008, people were betting on the rising prices of mortgage backed securities. In recent times, people are betting on the rising prices of cryptocurrency.
How did the 2008 Housing Crisis come about?
It all started when US congress introduced quotas for affordable housing for the poor. This led to deregulation of banks when it comes to giving loans to people when they are purchasing their homes. Usually, it would seem risky for a bank and if they were to use their deposits to issue out loans, they would become more stringent. However, since there are mortgage backed securities, banks could just get the money the investment firms that get this money by issuing shares to investors. It gave third party investment banks opportunities to earn fees from both the borrowers as well as investors. Therefore, in order to earn more fees, some of the firms started encouraging any person (who is legally able to) to take up loans to buy homes they could hardly afford. Some of these firms were backed by the US government, so investors blindly trusted them and bought the MBS stocks. It was so deregulated that there were situations where these borrowers did not even have to put a down payment on their homes.
Most of these people took up adjustable rate loans instead of fixed loans. On a fixed loan, you have to pay interest at a fixed rate for a few years before you have to refinance your loan (which means to look for another home loan, typically around 2 to 3 years after the first loan, depending on the terms of your initial loan). So imagine, you are made to pay a total of 2% of your loan in interest per year, which is deducted every month. Then, there are adjustable rate mortgages. They could be according to the banks' rates. On some months, it could be as low as 0.8% of your loan divided by 12 months. On other months, it could rise to 1.5% or higher. The adjustable rate loan seemed like a better deal as it seemed as if the monthly payments for interest would be lower. However, borrowers seemed to forget that since it is an adjustable rate, the rate could skyrocket to 3, 4, or even 5%. Imagine your entire month's salary being wiped out just to service the loan for your home. Furthermore, the initial loan offering might be attractive, but the rates could skyrocket when it comes time when the terms for the initial loan expire and it is time to refinance the loan.
There was also a building boom. Lots of real estate companies took advantage of deregulation to build homes. This meant that there was a huge supply of real estate. Some people started buying real estate so that they could resell it and earn a bundle when the prices increase. The prices of homes started to increase as well. The price soon became unsustainable. First, there was a lot of real estate around to choose from. Second, who would buy a home at a ridiculously high price?
Fast forward to a couple of years later when the variable rates start to increase. The bargain period is over. It is time to pay up. The owners of the MBS stocks need to make a profit too, else if prices plunge, they would end up selling their stocks and the investment banks could end up footing the bill. Those who bought housing even though they could not afford it, well, could not afford to pay up. Who ends up paying more? Others who could initially afford to pay the loan at a normal rate but now who had difficulty to when the interest rates skyrocket. What happens when people are not able to pay their housing loans after a period of time? Their homes end up getting foreclosed or confiscated by the bank and sold off in order for the investment banks to make some money. However, with more homes getting foreclosed on, and with more loans getting defaulted on, the price of the MBS start to plunge. Panic ensues and people start to sell their stocks, even at a loss. The investment banks ended up holding onto stocks that no one wanted, therefore, sustaining a huge loss, considering the amount of money paid out for the loans in the first place. They were not able to get funds from selling new stock. Another type of person who made a loss are those who bought homes for speculative purposes. The prices of the houses they bought (often at high prices) plunged, and therefore they were unable to profit from them and sustained a loss.
How does this affect others?
Foreclosures were happening on a large scale. When that happens, people stopped buying stuff, like cars. In addition, banks sell loans to investment banks that raise funds from investors. When people stop investing, investment firms stop paying the banks. The banks have paid the companies that build the homes. When they have paid out, but new funds are not coming in, they become short of cash. Furthermore, with negative press, people might have less faith in banks and deposits will be affected. Not to mention the fact that people who have lost their jobs are depending on the savings in their deposits with the banks. With this shortage of cash, banks are less able to give out loans to companies. In bad times, companies need to take out loans to tide things over - they still need to pay for their operating expenses, like rental of outlets, production of goods, and pay their employees. When they do not have enough money, they will start retrenching staff. Therefore, people will start losing their jobs and livelihoods are affected even if they do not have much to do with subprime loans.
What was the bailout for?
The government started buying over the mortgage backed securities that were in danger of defaulting. This way, banks, hedge funds, and pension funds that held them could have them off their books. (Before you think about how good that is - remember where the government gets the money to bailout these banks from - yes, the taxpayer). When the banks have these loans off their books, with the added money from the sale of these MBS, they could start lending money again and bring interest rates for home loans down. There was also a programme that was instituted to help homeowners facing foreclosure. The bailout also helped prevent a money market run - well, more on that later.
What are hedge funds?
A hedge fund is somewhat like a mutual fund. The fund manager and his or her investors form a partnership where the fund manager manages the funds and the investors invest (duh) the money in this fund. It might sound like a mutual fund, but the fund manager is able to do more aggressive things to maximise profits and reduce risk, like hedging if they see that the market is going to rise or shorting stocks. To hedge means to reduce risk. For instance, the fund manager decides to buy stocks in a peanuts company as they are releasing a new product (peanut butter and jelly flavoured peanuts). There are risks in this industry as people have been protesting online about the use of peanuts in airlines. The fund manager decide to buy shares in this company but hedge his or her risk by shorting the stocks of the competitor. If the company does well, the fund will earn. If the industry takes a hit, the fund earn from shorting the competitor's stocks. There are many ways that risk can be hedged, especially with futures. You don't have to have a hedge fund to hedge, by the way.
What is the money market?
To understand the money market, you have to understand what money is. Money is not wealth. Wealth includes all your assets, including stocks, bonds, your house, your car. Money is how much you have in your checking and savings account, the money you have on you and your traveler's cheques. It does not include the money you owe in your credit card, however. The money market is one that helps usually corporate entities invest excess cash they have for short periods of time. It also helps companies get a cash supply when they need it quickly. There is no formal market or exchange just for it. However, there are certain financial instruments that are classified under the money market.
What are the different instruments in the money market and how are they different?
They include treasury bills, commercial papers, bankers' acceptances, certificates of deposits, bills of exchange, repurchase agreements, and short-term mortgage/asset backed securities. I will touch on the first four.
What are treasury bills?
Treasury bills (or T-bills) are issued by the U.S. government. Other governments might have their own T-Bills. It is a way for the government to borrow money to fund their operations by borrowing money from people. They are issued at a discount and then investors can claim the full value on the maturity date. Different T-Bills have different discount rates and they usually mature very quickly (being short term investments, like other money market instruments). The longer the maturity rate, the higher the interest earned will be. They are usually sold at a discount and the person who buys it will be able to redeem it for its original (or face) value at maturity. They are auctioned off to US citizens through the TreasuryDirect website. Most who invest in it are banks and broker firms. Individuals usually get it through their brokerage firms by investing in mutual funds or ETFs. There are competitive and non-competitive bids during the auction. Non-competitive bids for T-bills means that the investors submit prices for that T-bill. At the end of the auction, the T-bills will be issued at the average price of all bidders for that auction (which begs the question - what if all the bidders collude to bid at a very low price?). Competitive bids have to be made through banks or brokers. The investor will specify the maximum discount they want. If the discount they want is higher than what is offered, their bid is rejected. Else, it is accepted.
What are commercial papers?
Commercial papers are a way for large corporations with good credit to get cash. First, these corporations have to meet a certain criteria like good credit standing to be able to issue them. These commercial papers are offered at a discount to investors and redeemed at full value during maturity. It is important to note that these commercial papers are unsecured, meaning that if they are unable to pay you back, you cannot go after their assets. They are also short term so they do not need SEC registration. These commercial papers are sold at large denominations of $100,000 or more.
What are bankers' acceptances?
They are short term debt instruments issued by a company that is guaranteed by a commercial bank. Like the above, it is sold at a discount and redeemed at face value at the maturity date. The money is drawn from a deposit in a bank, meaning that at maturity date, the bank will deduct the money from the the one borrowing the money to return to the one who has bought the bankers' acceptance. This bankers' acceptance is used for short term loans. It can be traded on a secondary market. For instance, a cereal company issues a bankers' acceptance to one of its wheat supplier, in exchange for wheat. It will pay the wheat supplier in full at the maturity date. The wheat supplier might not want to wait so long for the maturity date and decide to sell it in the secondary market. This is also useful if the wheat supplier and cereal company are located in two different parts of the world. For instance, the wheat supplier is located in China and the cereal company is located in US. Business transactions can be risky and the cereal company might not have much recourse if the wheat supplier did not ship the goods as intended or delays shipment for a very long time. The wheat supplier will also run the risk of the cereal company not paying on time or waiting very long before paying for the goods. The bank will act as a third party to ensure that both sides don't sabotage each other. The cereal company will deposit the face value into the account (like a cashier's order, where the bank makes you set aside the money in the cashier's order when you create one so that when it is redeemed, there are funds to be redeemed). When the supplier ships the goods and they are in order, on the maturity date, the bank will take the money and issue it to the supplier. Companies, like the cereal company, turn to the banker's agreement when it has issues getting funds or when it is cheaper to do so, as they can delay payment.
What are certificates of deposit?
It is similar to a savings account, there is a fixed interest that is pretty low, but higher than a savings account's interest. The only thing is that there are issues if you withdraw before the maturity date. You might have to pay a fee or the interest might be lower. The amount invested in a certificate of deposit is insured to a certain amount. Some certificates are negotiable, meaning that they can be sold on the secondary market (but you will have to sell at least $100,000 worth) but most are non-negotiable, meaning that they cannot be sold to a third party.
What are money market funds?
They are mutual funds that invest in money market instruments like treasury bills or commercial papers. They are mostly regarded as safe and before the housing crisis, have to maintain a net asset value of $1. The net asset value (NAV) is the calculated by taking the how much the funds have earned along with the cash amount in it, and the amount that it is owed and take away the payments, charges, fees, and amounts owed to banks and divide it by the number of shares in the funds. Each share should be stable at at least $1.
How were the money market funds affected during the housing crisis?
Most people invest in money market funds since they are seen as a stable source of earnings, even though the returns are not huge. During the housing crisis, the NAV of one of the funds went below $1. This got people panicking and they started to sell their shares in the money market mutual fund. The bailout helped to prevent mass sales of these funds.
What is cryptocurrency?
After the housing crisis, there have been a group of people who have lost faith in banks. They decided to create their own currency so that people will stop relying on banks or any third parties. Basically, like a barter, 2 people can exchange a bitcoin from anywhere in the world. For instance, I get a haircut. Both the hairdresser and myself feel that the haircut is worth 1 bitcoin so after the haircut, I will send the hairdresser 1 bitcoin. However, there is a problem with security. How can they ensure that the bitcoin is worth something? It is not worth anything if anyone can create their own bitcoin. It is also not worth anything if I can send my bitcoin to the hairdresser and then duplicate the bitcoin and send the same bitcoin to my manicurist. This is where blockchains play a part.
To understand what blockchains are, you need to know what hashing is. When you hash a message, you run the message through an algorithm and a new scrambled message appears. So I can hash the words 'Mesplain Finance' through an algorithm and the words '5-3r9sdgtlj49rq8-fivjdklbyn3w50 -9we0qrkfa24ya*(&^' appears. That long message above is known as the hash digest. The hash function used nowadays is SHA256. With this, I can has a short message like 'Hi' and get a hash digest that is 256 bits long. Hashing the same message will always produce the same hash digest and hashing 2 different messages will always produce a hash digest.
What the blockchain does is that it hashes transaction 1 to get a hash. The information in transaction 1 will contain the account numbers of the person sending the bitcoin, the person receiving the bitcoin, and the number of bitcoins sent. By hashing transaction 1, hash digest 1 is produced. Next, it will hash another transaction (transaction 2) and produce hash digest 2. Next, it will has both hash digest 1 and hash digest 2 to produce hash digest X. It will then hash transactions 3 and 4 to produce hash digest 3 and 4 and hash these 2 digests to produce hash digest Y. Next, it will hash both hash digests X and Y to produce the final hash digest for this block. Four things are stored in this block - the data, the hash for this block, the hash for the previous block and a random number known as a nounce. Because each block has the hash for the previous block, all these blocks are stored as a blockchain.
If one transaction gets hacked or duplicated, then the information in a block is incorrect and the information in the other blocks are incorrect as well. Moreover, copies of the entire updated blockchain is stored in multiple computers.
Not everyone who buys or transacts in bitcoin have the entire blockchain on their computers. Some only have basic wallets that enable them to carry out the transactions. Some of them have bought a lot of computers and have downloaded the entire software that will store the entire blockchain ledger in their computers as they will have to check and prove that each transaction is valid. Every time a new transaction is done, all of these computers with the entire software in it will have their ledger updated. If in even one of these computers is the transaction invalid, will the entire transaction be rejected. This makes blockchain very secure.
Who are these people who store the entire software in the computers?
They are called bitcoin miners. They need a lot of computers in order to help prove that each transaction is valid - imagine going through the entire blockchain for each transaction. Only after they can prove it using 'proof-of-work', can the block be added to the block chain. In return, they get 12.5 bitcoins (as of 2016). At that time, a bitcoin was worth more than $8500. This is why people are willing to spend so much money on equipment to become bitcoin miners. Moreover, after every 4 years, the number of bitcoins issued due to each successful transaction is halved. There is a fixed set of bitcoins that will circulate. This is also why people buy bitcoins. Imagine that a bitcoin that I paid my hairdresser that was worth $1 back in the day is now worth $8000. A lot of people are holding onto bitcoins as a form of speculation. If the price goes up, they can sell it and make a lot of money out of it in future.
What are benefits of cryptocurrency?
First, there are some social benefits to it. First, there will be a worldwide currency. Therefore, people living in developing countries whose economies are being controlled by oppressive dictators (or inept governments) have a way to do trade with people in other parts of the world without having to worry about their currency being devalued all of the sudden and don't have to worry about hyperinflation (which is what countries like Venezuela is going through now where money all the sudden becomes worthless and everything suddenly becomes very expensive for the locals). Now, one in three Kenyans own a bitcoin wallet. This provides a way for people without bank accounts to get loans and to get money. A coffee farmer in Kenya without a merchant account with a bank decides to sell his wares online. He has a cryptocurrency wallet that accepts payment for his wares. The potato farmer living on his street whom he buys potatoes also receives cryptocurrency as payment. Another Kenyan working in Singapore as a soccer coach wants to send money to his family in Kenya. He sends it through MPesa, which as minimal fees as opposed to remittance.
With regards to Venezuela, people are actually carrying out bitcoin mining in order to generate bitcoins and buy goods from overseas. However, there have been crackdowns from its government who have started to arrest bitcoin miners. Before you start mining or dealing in bitcoin, you might want to check up on how legal it is to do so in your country.
There is some argument about whether or not cryptocurrency help people become independent of oppressive regimes or if it helps dictators instead. Those who say that it helps people free themselves from oppressive regimes state that since the ledgers are public, there is greater transparency and corruption can be rooted out. Furthermore, if people want to flee their country, they don't have to forfeit their entire life savings that have been saved in their local currency. If they have cryptocurrency, they can uproot themselves more easily. On the other hand, oppressive regimes are creating their own cryptocurrency to bypass or circumvent sanctions made against them from other countries that disagree with their practices.
There are also a lot of opportunities associated with cryptocurrency. Imagine if I were able to buy foreign stocks and shares using the currency without being worried about how the exchange rate will affect the amount of money I could get back. There are now even derivatives on bitcoin. People could make money by speculating whether the price of bitcoin will go up or down, depending on what they have bought, like futures or options. Ethereum is actually a cryptocurrency or programme that creates other cryptocurrencies. You can create your own cryptocurrency using Ethereum.
What are the risks associated with cryptocurrency?
Cryptocurrency, as it is not regulated by a bank or third party, has been used on the dark web for criminals to carry out illegal transactions, like drug dealing. It could be used in the wrong hands and might make it even more difficult to track the transactions of criminal organisations and terrorist organisations. This is one social risk associated with cryptocurrency.
When cryptocurrency becomes more widely used, it makes you wonder about the effects it has on the value of your own money that is held in the bank.
Cryptocurrency like bitcoin is validated only once every 10 minutes. Therefore, I can take my bitcoin and spend it in 1 shop, go to another shop and spend the same coin again. Only 1 transaction will be validated and the other shop owner will be at the losing end.
Another thing to consider about buying cryptocurrency is that there are many different types of cryptocurrencies being offered. Bitcoin is only one of them. There are many springing up. Examples are Litecoin, Ethereum, and even Dogecoin (which is a meme-based cryptocurrency named after an Inu Shiba). Some of these cryptocurrencies are very shady and even linked illegal industries. It makes you wonder if these currencies are legitimately using blockchain or if there is something else going on in the background. Would you want to put your money in those hands? A lot of people are holding onto their investments as they are expecting the value of the currencies to go up. They are investing in the new cryptocurrencies when the old ones become too expensive to buy. However, you never know whether it is worth it until you cash out or try to purchase something using your cryptocurrency. Right now, a bitcoin is worth more than 5000 Singapore Dollars. Another currency, like Dogecoin is only worth 0.0032 Singapore Dollars.
Like Tulip Mania, you never know if the bubble for cryptocurrency will burst and how it will affect the people who have bought into it. Bitcoin was once at its peak at USD20000. Now, it is no longer at that value. Imagine if you were the schmuck who bought it when it was trading at that price.
There have been interesting ways on how people have lost money in bitcoin. One miner who had $150 million worth of bitcoin accidentally threw away his laptop's hard drive and lost it all that day. Ouch.
You will also need to consider the effects on the environment. The carbon footprint (or electricity consumption) of validating each transaction can be quite astronomical. It actually uses more electricity than the entire country of Ecuador.
Government intervention and new laws could also affect your earnings on cryptocurrency. Why would governments intervene? Well, governments usually tax people for spending money and for earning money. A part of all these expenses and earnings would go to the government. However, if they were not able to track how much you earn or how much you spend as it is all through cryptocurrency, they might not be able to tax you for it. Therefore, this could pose as a threat to governments.
When you think about it, even though it seems that the security behind cryptocurrency is foolproof, security is never fool-proof and if one takes enough time to look through the entire cryptocurrency processes or systems, they are bound to find flaws in the system.
What is some common sense financial advice?
The bottomline is - invest the amount that you can afford to invest. Don't invest your nest egg. Have a balanced portfolio. Make sure that you have set aside money for emergencies, to pay your bills and for retirement. Remember to budget for your living expenses as well. Invest part of your portfolio in safe investments. Be clear of the risks associated with what you invest in as well as its fees. Do some research and know what you are investing in before taking the plunge. In addition, do remember that what you invest in might be doing harm or good to society or to the environment.
How can I practise what I have learnt so far?
There are a lot of stock market simulators online that you could try your hand at. Some of these simulators include forex, futures, ETFs, mutual funds, options, REITs, and even warrants. Before playing, do take note if they charge fees and if any real money is involved.
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