Categorizing the Financial Markets

So far in pervious articles we’ve covered

What happens in the financial markets? - Buying and selling of financial instruments.

How does this buying and selling happen? - Primarily through brokers and exchanges.

Who are the major participants? - Retail investors, hedge funds, investment banks and central banks.

Now its time to answer the question: What are they buying and selling?

There are several different instruments available for the average investor to invest in and it can be a little overwhelming for someone outside the industry. The goal here is not to explain every single type of instrument (the most popular ones will be covered in individual articles), but to provide you with a lens through which you can view how the popular instruments are categorized.

Note: You will commonly see the word “securities” being used when talking about financial instruments. Securities generally refer to financial instruments that can be traded on an exchange. Not all financial instruments can be bought and sold on an exchange. Every security is a financial instrument, but not every financial instrument is a security.

These are several different ways investors categorize the markets, lets briefly look at some of the most common ones.

Classification 1: Cash Instruments and Derivative Instruments.

Cash instruments are instruments whose value is determined directly by the markets. Purchasing a cash instrument gives you a direct ownership position or lender/borrower position.

Derivative instruments are contracts whose value is derived from the underlying assets that they represent. The underlying assets can be stocks, bonds, indices etc. Futures and options are the most common derivatives you will come across. Derivatives will be covered in depth later, but let me give you a quick example to understand the difference. When you buy an options contract for a stock, you are not buying the stock itself, you are buying a contract that gives you the RIGHT to buy the stock at the predetermined price anytime within the predetermined period of time. This means you’re not paying the full price of the stock itself, but paying a premium to have the OPTION to buy if the stock moves in your preferred direction.

Classification 2: Equity Instruments and Debt Instruments

Equity instruments represents an ownership position in an entity such as stocks. When you buy shares of a company, you own piece of the company and may be entitled to a portion of the profits.

Debt instruments represents a creditor relationship with an entity such as a government or company. This is usually in the form of Bonds. Bonds are issued by companies and governments in order to raise money for a specific purpose such as a new project or acquisition. The investor makes money from the interest rate on the bond, like any other loan. Unlike stocks, you don’t own a piece of the company and are not entitled to a portion of the earnings

Classification 3: Asset classes

Financial instruments that behave in similar ways in similar conditions are usually categorized as one asset class. A popular way to categorize this is Money Markets and Capital Markets.

Money markets consist of short-term (1 year or less) debt-based instruments. Capital Markets consists of stocks and longer term debt securities.

Some investors even consider the commodities market and the foreign exchange markets in addition to these two asset classes, while choosing investments.

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