Chapter 1

Financial Markets

Equities, bonds, derivatives, and market structure.

Introduction to Financial Markets

Financial markets are the backbone of modern economies, serving as the infrastructure where capital flows between those who have it (savers and investors) and those who need it (corporations, governments, and individuals). Understanding these markets is essential for anyone working in quantitative finance or developing financial software.

Market Classification

Primary vs. Secondary Markets

Primary markets are where securities are first issued. When a company conducts an Initial Public Offering (IPO), it sells shares directly to investors in the primary market. The proceeds go to the issuing company.

Secondary markets are where previously issued securities are traded among investors. The New York Stock Exchange (NYSE) and NASDAQ are examples. Here, the issuing company receives no direct benefit from trades; instead, investors buy and sell from each other.

Asset Classes

Equities (Stocks): Represent ownership in a corporation. Shareholders have residual claims on assets and earnings. The return on equity comes from:

  • Dividends: Periodic cash distributions
  • Capital gains: Appreciation in stock price

The total return can be expressed as: R=P1−P0+DP0R = \frac{P_1 - P_0 + D}{P_0}

where P0P_0 is the initial price, P1P_1 is the final price, and DD represents dividends.

Fixed Income (Bonds): Debt instruments where the issuer promises to pay periodic interest (coupons) and return the principal at maturity. Key concepts include:

  • Face value (par): The amount repaid at maturity
  • Coupon rate: The annual interest rate paid
  • Yield to maturity (YTM): The total return anticipated if held to maturity

Derivatives: Financial instruments whose value is derived from an underlying asset. Common types include:

  • Futures: Standardized contracts to buy/sell an asset at a predetermined price on a specific date
  • Options: Contracts giving the right (not obligation) to buy (call) or sell (put) an asset
  • Swaps: Agreements to exchange cash flows between parties

Foreign Exchange (FX): The largest and most liquid market globally, trading over $6 trillion daily. Currency pairs are quoted as exchange rates.

Market Microstructure

Order Types

Market orders execute immediately at the best available price. They guarantee execution but not price.

Limit orders specify the maximum buy price or minimum sell price. They guarantee price but not execution.

Stop orders become market orders when a specified price is reached, used for risk management.

The Order Book

The order book displays all outstanding limit orders. Key concepts:

  • Bid: Highest price a buyer is willing to pay
  • Ask (Offer): Lowest price a seller is willing to accept
  • Spread: The difference between bid and ask: Spread=Pask−Pbid\text{Spread} = P_{ask} - P_{bid}
  • Depth: The quantity available at each price level

Market Participants

  • Market Makers: Provide liquidity by continuously quoting bid and ask prices
  • Institutional Investors: Pension funds, mutual funds, hedge funds
  • Retail Investors: Individual traders
  • High-Frequency Traders (HFT): Use algorithms to trade at microsecond speeds

Market Efficiency

The Efficient Market Hypothesis (EMH) states that asset prices fully reflect all available information. Three forms exist:

  1. Weak form: Prices reflect all historical price information
  2. Semi-strong form: Prices reflect all publicly available information
  3. Strong form: Prices reflect all information, including insider knowledge

If markets are efficient, consistently beating the market through analysis is impossible. The implication for quantitative finance is that any alpha (excess return) must come from:

  • Processing information faster
  • Finding market inefficiencies
  • Taking compensated risks

Regulatory Framework

Financial markets are heavily regulated to ensure fairness and stability:

  • SEC (Securities and Exchange Commission): Regulates US securities markets
  • CFTC (Commodity Futures Trading Commission): Oversees derivatives markets
  • FINRA: Self-regulatory organization for broker-dealers

Key regulations include insider trading prohibitions, disclosure requirements, and capital adequacy rules for financial institutions.

Programming Applications

Understanding market structure is crucial for:

  • Building trading systems that interact with exchanges
  • Analyzing market data feeds
  • Implementing backtesting frameworks
  • Developing risk management systems

APIs from exchanges provide real-time and historical data in formats like FIX protocol, which programmers must parse and process efficiently.

ELI10 Explanation

Simple analogy for better understanding

Think of financial markets like a giant marketplace, similar to a farmer's market but for money and investments. Instead of buying apples or vegetables, people buy tiny pieces of companies (stocks) or lend money to governments and businesses (bonds). Just like how prices at a farmer's market change based on how many tomatoes are available and how many people want them, prices in financial markets change based on how many people want to buy or sell. Some people come to the market every day to help others trade (market makers), while others visit occasionally to buy things for the long term (investors).

Self-Examination

Q1.

What is the fundamental difference between primary and secondary markets, and why does this distinction matter for capital formation?

Q2.

Explain how the bid-ask spread compensates market makers for providing liquidity. What factors cause spreads to widen or narrow?

Q3.

If the Efficient Market Hypothesis holds in its semi-strong form, what types of analysis would be unable to generate excess returns?

Q4.

How do limit orders and market orders differ in terms of execution certainty and price risk?

Q5.

Describe the relationship between derivatives and their underlying assets. Why are derivatives useful for both hedging and speculation?