Introduction to Financial Markets - Terminology

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HEDGING - take a financial position in order to reduce risk. Start with a risky position of some type and take an equal, opposite position in a market in order to offset (reduce) your existing risk Example: you have an unrealized capital gain in the stock market and to hedge against an unexpected downturn in the market you establish an offsetting short hedge in the options market.

- take a risky position in order to profit from short-term price movements. Start with no position and no exposure to risk then take on an additional risky position in an attempt to earn speculative profits over the short term. Example: you have no existing business activities in the frozen orange juice industry but you believe the recent cold weather in Florida will hurt the citrus crop and frozen orange juice concentrate prices will rise so you buy orange juice futures i order to profit on the expected price rise.

INVESTMENT - take a position that will provide an appropriate return for a given level of risk exposure. Invest your money in an investment vehicle that will provide an appropriate risk adjusted return over the medium or long term. Example: open an account in a diversified stock mutual fund and make periodic contributions to the fund while planning on using the fund proceeds when you retire.

REAL ASSETS - tangible, physical assets. Real assets either have an intrinsic value or are physical assets that can be used to create wealth. Examples: factories, tractors, gold, research laboratory.

FINANCIAL ASSETS - intangible, paper or electronic claims to wealth or other assets. Financial assets are either paper assets such as stock certificates or bond certificates or electronic claims on future cash flows or real assets.

BROKERS - act as intermediary, bring buyers and sellers together, earn commissions.

DEALERS - maintain an inventory of assets and fill buy/sell orders.
BROKER/DEALERS - function in both capacities maintaining an inventory in some assets and brokering others.

MONEY MARKETS - markets for short term debt instruments where original maturity is equal to or less than 1 year. Examples: commercial paper, negotiable CDs, Fed Funds, T-Bills.

CAPITAL MARKETS - markets for medium and long-term debt equities. Examples: notes, bonds, common stock and preferred stock.

FORMAL MARKETS - markets with a centralized physical location. Examples include stock markets like the New York Stock Exchange (NYSE) and American Exchange (AMEX) and the Futures/Options markets like the Chicago Board of Trade (CBOT) and Kansas City Board of Trade (KCBT).

INFORMAL MARKETS - computer and telecommunications based markets with no centralized physical location. Examples include National Association of Securities Dealers Automated Quotation (NASDAQ) System, the Institutional Network (InstiNet), and the foreign exchange market (FOREX).

FOREX MARKETS - informal market for buying and selling foreign exchange for spot and forward delivery.

T - generic term for any market for immediate delivery of the asset being bought and sold. Delivery and settlement in 1-2 business days. Example: spot FOREX market, spot commodities market, spot heating oil market.

DERIVATIVES MARKETS - markets where derivatives such as options and futures contracts or Swaps are traded. The largest formal derivatives markets often trade both futures and options contracts. The Swaps market is an informal market where swap counter parties arrange swap contracts through telecommunications linkages.

FUTURES MARKET - a market where standardized futures contracts are traded. Examples of formal markets are the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME or the Merc). The CME is establishing an informal, global market called GLOBEX.

FORWARD MARKET - generic term for any market involving delivery of an asset at some time in the future. Typical forward delivery takes place in 30, 60, or 90 days but other arrangements are available.

OPTIONS MARKET - a market where standardized options contracts are traded. Examples of formal markets are the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME or the Merc).

- market where securities (and other assets) are sold for the first time. Examples: initial public offering (IPO) market, follow-on issue markets, new issue bonds. New issues transfer funds from investors to the issuers of the securities.

- market where securities can be bought/sold after original issue. Examples: New York Stock Exchange (NYSE) trades listed stocks and bonds in a formal market and the Institutional Network (InstiNet) trades large blocks of shares in the informal market. Security sales in the secondary market transfer securities and funds between investors; no additional funds are transferred to the original issuer of the securities.