How Uncle Scrooge Taught Me the Basics of Finance
In this series of posts, we will explore the financial market simply and clearly, but without sacrificing depth.
Let me start with a childhood memory.
I remember reading an old Disney comic by the brilliant Rodolfo Cimino, where Uncle Scrooge finds himself on a remote island in the ocean, where money does not exist and bread is the only currency. He wants to become rich even there, so he targets the main assets of the island: the ovens.
In an economy where bread is both money and food, saving means starving.
He saves up the loaves that are rightfully his according to the law of the island and makes his nephews starve too, until they have enough to buy the first oven from the baker with a big pile of bread. But then he discovers a shocking truth: bread only keeps its value if it is fresh, so people only bake what they need for their basic needs. This prevents any corruption, but also any progress as we know it.
This comic taught me intuitively why the financial market exists.
To go beyond bartering, the economy needed not only a unit of account and a medium of exchange, but also a store of value.
The store of value enables productive specialization and the accumulation of skills and capital goods, which increase productivity both in quality and quantity.
In the modern economic system, we have intrinsic value stored in any kind of capital, and “potential” value stored in money; that is why inflation, whether it is too high or too low, can indicate by means of prices how much productive potential is used compared to the demand (of course, inflation is a more complex topic, but we can leave it at that for now).
So some have money, some need it to finance themselves, and some help them meet (banks and the like). Since these three actors have different and varied objectives, they need tools that go beyond the three basic functions of money (unit of account, medium of exchange, and store of value).
They need tools that suit the needs of each of them, and these tools are the financial instruments, defined as claims on someone else in the economy.
In 2018, an interesting article was published, often cited on the internet.
The Elements of Diversification
It is a kind of periodic table of investments, which summarizes the financial world in a single graphic.
CLICK TO ENLARGE IMAGE
The classification is based on the objectives of the investors, the type of investment, and its characteristics. For example, the symbol Cs represents consumer staples, which defines the type of investment based on the industry sector, the objective is growth, and the underlying asset is the stock of a specific company.
The symbol Mg represents mega-cap, and in this case, it defines the type of investment based on the market capitalization, while we have the same objective, and the same underlying asset.
Fx represents the currency carry trade, which is a type of alternative investment, and its underlying asset is the currency of certain countries.
The symbols are grouped into categories.
We have 8 main categories, each with its investment type and objectives:
Cash: money market investment (investment type) —> capital preservation (objective)1.
Fixed income: e.g. investment grade corporations —> fixed yield
Multi-asset strategies: e.g tactical asset allocation —> growth
Real assets: e.g. commodities —> diversification
Hybrid securities: e.g. convertible bonds —> growth
Equity: e.g. mega-cap —> growth
Alternative strategies: e.g. currency carry —> diversification
Illiquid strategies: e.g. farmland —> inflation protection/illiquidity premium
Each category has its own underlying assets, such as:
money market instruments, which are debt instruments with a maturity of less than one year, such as treasury bills or Italian BOTs.
bonds
stocks
currencies
commodities
real estate
and their combinations
In particular, bonds and stocks are traded on two different types of markets:
The primary market: a company issues new stocks, for example in an initial public offering (IPO). Similarly, companies and governments sell bonds for the first time by preparing a prospectus that specifies the price and other information of the securities.
The secondary market: it is essential because it allows to quickly convert the complex instrument into cash at any time. It allows risk diversification, as investors can buy and sell different types of securities according to their preferences and goals; it enables price discovery, as the market reflects the information and expectations of the investors about the value of the securities.2
The primary market can contribute to the dynamics that determine the price action on the secondary market by influencing the supply of financial instruments.
Just as the debt issuances by the central government affect the interest rates (higher supply of bonds -> lower price -> higher rates), similarly, for example, the number of IPOs and secondaries3 can play a role in the direction of the stock prices on the secondary markets.
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$2.6 trillion of supply vs. $21 trillion of demand, cumulative since 2009
Source: Fidelity
Worth noting in the image above how little are retail flows.
What we have talked about so far is the tip of the iceberg. The hidden part is the derivatives market, whose primary purpose is risk management.
Futures, options and swaps are created to hedge the risk derived from holding the underlying asset.
Derivatives can be defined by two different values:
market value: the cost to purchase one contract, corresponding to the margin required in a margin account
notional value: the overall value of the assets involved in the contract (obviously much much bigger than market value)
NV=C×U
where
NV
is the notional value,
C
is the contract size, and
U
is the underlying price.
In the chart below, updated to November 2022, we have the visualization of the market value of the assets we have discussed so far: stock, debt, commodities, derivatives compared to the world GDP and central banks balance sheets4.
CLICK TO ENLARGE IMAGE
All of the World’s Money and Markets in One Visualization (2022)
Source: visualcapitalist.com
In the next post, we will look at the market from the perspective of the professionals who use financial instruments (dealers/market makers, asset managers, speculators, and the like); a key factor in grasping the market dynamics and its ups and downs.
It’s the only category with just one objective and investment type.
Example of regulated secondary markets: New York Stock Exchange (NYSE), Nasdaq, Euronext. On the other hand as per imf.org:
“OTC (over the counter) markets have never been a “place.” They are less formal, although often well-organized, networks of trading relationships centered around one or more dealers.
More on this next times.
These are the sales of new shares by a company that has already made an IPO.
Now SBF is poorer than me.