Financial Markets & Securities

Every investment reduces to the same trade: money changes hands now in exchange for a promise of more money later. The document that records the promise (in practice, a row in a database) is a financial asset.

Valuing that promise means answering three questions: how much money comes back, when it arrives, and how likely it is to arrive at all.

Amount, timing, risk. That’s it. Every topic in this series works on some combination of those three inputs.

Real Assets vs. Financial Assets

Those three questions describe a promise, not the thing that keeps it. Real assets are the things that produce output: factories, land, equipment, people with skills. They are what make an economy go. Financial assets produce nothing on their own and are instead claims on the output that real assets generate.

A share of Apple stock is not a fractional iPhone factory. It is a legal right to a slice of whatever cash Apple’s operations generate. The distinction is subtle and it matters, because valuing a financial asset means valuing a claim rather than a machine.

In aggregate, financial assets are a zero-sum game. Every dollar a buyer spends is a dollar a seller receives. The wealth in an economy comes from real assets, and financial markets are the mechanism for deciding who holds the claims on it.

The Functions of a Market

Though financial assets do not produce output themselves, the markets that trade them do four kinds of real work.

Price discovery comes first. Millions of participants put money behind their opinions, and the prices that result are how the market registers what they collectively think things are worth. A stock that drops 10% after an earnings call is not noise but a real-time referendum on the company’s prospects.

Capital allocation follows from those prices. Good ideas attract funding and bad ones, in theory, do not, which makes a market act like a sorting machine that directs savings toward their most productive uses.

Liquidity is the ability to convert an asset to cash without moving its price much. Ten thousand dollars of S&P 500 stock can be sold in about two seconds, and ten thousand dollars of a house cannot. The value of liquidity is easiest to see when it is missing.

Risk transfer lets people offload risks they cannot stomach onto people willing to bear them. A farmer worried about wheat prices collapsing before harvest sells a futures contract to a counterparty willing to take that exposure instead.

The Big Three Asset Classes

Those four functions operate on claims that mostly sort into three groups.

Fixed Income (Bonds)

A bond is a loan with a schedule attached. Money goes to an issuer (a government, a corporation, a local municipality) and the issuer promises interest on fixed dates plus return of principal at the end. The main flavors:

• Treasuries are U.S. federal government debt: bills maturing in under a year, notes at one to ten years, and bonds beyond ten years. They are the closest thing to “risk-free” that exists, on the assumption that the federal government keeps paying.
• Corporate bonds are the same structure issued by companies. They pay more interest than Treasuries because a company can go bankrupt and a government can print money.
• Munis are state and local government debt. The interest is often tax-exempt, which matters most to investors in high tax brackets.
• Money market instruments are the short-maturity end: T-bills, commercial paper, certificates of deposit. These are safe, dull, and liquid.

Equity (Stocks)

A share of stock is a piece of ownership in a company. Unlike a bond, it promises nothing, and its return depends entirely on how the company performs.

Shareholders are “residual claimants,” which means everyone else (employees, suppliers, lenders, tax authorities) is paid first and shareholders receive what is left. The claim has no ceiling. It also stands last in line when things go badly. Every shareholder is implicitly an optimist.

Derivatives

A derivative is a contract whose value comes from the price of something else. Two forms do most of the work.

An option is the right, but not the obligation, to buy or sell at a set price, closer to paying for a reservation the buyer may never use than to buying the thing outright. Futures and forwards take that choice away: both sides are bound to trade at a specific price on a specific date, with no way to back out.

Derivatives get a bad reputation, most of it earned in 2008, but they are useful for managing risk. Used carelessly, they are equally efficient at destroying a portfolio.

Market Structure

Knowing what a claim is says nothing about where it trades. Markets are not built alike, and the venue determines both trading costs and the kind of counterparty on the other side.

The diagram below separates the primary market, where new securities are created and sold for the first time, from the secondary market, where existing securities change hands between investors. Click through to the secondary market to see its three venues, ordered from the most liquid (exchanges) to the least (brokered markets).

Order Books and Order Types

Exchanges are the most transparent of the three, and their transparency comes from one data structure. On a modern exchange, trading runs through the order book: a ranked queue of every posted intention to buy and every posted intention to sell.

Limit orders are patient. A limit order names a price and a quantity (100 shares at 99.50 or less) and rests on the book until someone is willing to take the other side.

Market orders are impatient. A market order names only a quantity and accepts whatever the book offers, eating immediately into the resting orders on the other side.

The bid is the highest price any buyer is offering and the ask is the lowest price any seller will accept. The gap between them is the bid-ask spread, and the midpoint of the two is what gets reported as the price of a stock. A quote of 200 dollars for Apple is shorthand for the middle of what buyers are offering and what sellers are asking.

The Bid-Ask Spread

Of those four quantities, the spread is the one that costs money. It is a toll booth: the price of right now, paid for trading immediately instead of waiting for someone to meet a specific price.

Market makers collect the toll. These firms post both a bid and an ask continuously, standing ready to buy or sell at a moment’s notice, and they earn the difference between the two prices. The spread compensates them for three costs:

• Inventory risk comes from holding securities that can fall in value before they are offloaded.
• Adverse selection is the risk that the party on the other side of a trade knows something the market maker does not. Trading against better-informed counterparties is an occupational hazard.
• Operating costs cover the rest: servers, compliance, and the unglamorous plumbing of running a trading operation.

Drag the bid and ask apart in the simulator below and watch the spread widen. The readouts give the spread in dollars, the spread as a percentage of the midpoint, and the midpoint itself.

When spreads are tight (fractions of a penny on large-cap stocks), the market is working well and trading is cheap. When spreads widen past 1%, as they sometimes do on small-cap stocks and corporate bonds, that gap is a real tax on participating.

Walking the Book

A tight spread describes the cost of a small trade. So far we have assumed orders small enough to fill at one price level. But what happens when we want more shares than the best ask has posted?

The order walks the book—namely, it takes every share at the best price, then moves to the next level, and the next, filling at progressively worse prices until it is complete. The gap that opens between the best quote and our average fill is price impact, or slippage. Every share we buy pushes the price up a little and every share we sell pushes it down, because each fill removes liquidity from the book. The larger the order relative to available liquidity, the wider the gap.

This price impact is why institutional investors do not send a market order for a million shares. They split large orders into pieces, spread them out over time, and use execution algorithms to keep their footprint small.

Go back to the simulator above and raise the order quantity. It reports slippage per share directly, as the difference between the best available price and the average fill, and pushing the quantity up drives the fill through more price levels. Toggling between buy and sell walks the ask side or the bid side, respectively. For a small order the slippage stays near zero. For a large one it adds up fast.

The Trust Problem

Order books explain the mechanical cost of trading. Two further frictions are not mechanical at all. They arise when the parties to an arrangement want different things, or know different things.

Agency problems arise when someone making decisions on another party’s behalf has different priorities. A fund manager may prefer collecting fees to earning clients the best return, and a chief executive may prefer an office renovation to a share buyback. Markets try to fix this with incentive alignment (performance bonuses, stock compensation) and monitoring (boards, analysts, regulators), but the conflict never fully goes away.

Information asymmetry is the formal term for something simpler: one side knows more than the other. A chief executive knows things about a company that outside investors do not. The problem shows up in two forms, separated by timing.

Adverse selection is the before problem. Recall that a market maker faces it on every quote, and an ordinary buyer faces it whenever insiders who know a stock is overpriced sell into that price. Buyers who anticipate the pattern demand a discount, which is partly why IPOs are typically priced below their first-day trading value.

Moral hazard is the after problem. Once money has changed hands, incentives shift, and a company may take on riskier projects than its lenders would prefer. Lenders answer with covenants, ongoing monitoring, and a good deal of informal pressure that never reaches the paperwork.

Regulation, disclosure requirements, audits, and credit ratings all exist to manage these frictions. They help. They do not solve them.

What’s Next

We have covered the lay of the land: what financial assets are, the three groups they sort into, how markets are organized, and the frictions that keep them from being perfectly efficient. In the next post we start doing math. The time value of money is the pricing machinery that everything else in this series runs on.