I remember when I was first starting to learn about finance, the word "capital market" kept coming up and I had no idea what it meant. You see the word everywhere in companies - BMO Capital Markets, CIBC Capital Markets, RBC Capital Markets, you get the idea.
Capital markets provide a medium for investors to generate returns off of their hard-earned money.
It's an important concept to understand, so I thought I would write a post about what exactly is meant by the capital markets and why it's important to understand them.
Probably the best place to start with this is to define what exactly is a capital market.
Google gives the following definition for capital market: "The part of a financial system concerned with raising capital by dealing in shares, bonds, and other long-term investments." This is very high level, and full of ambiguity if you don't know what some of those terms mean.
The Financial Canadian definition of capital market is as follows: a capital market is a marketplace formed by buyers and sellers through which you can move money (i.e. capital) in exchange for investments (think stocks, bonds, etc.). Technically, your grocery store could be considered a capital market if you're interesting in making investments in grapefruit.
Broadly speaking, Canada has five main capital markets and they each behave in different ways. Each has their own advantages and disadvantages, so it's important to have a fundamental understanding of each one so that you know where to invest your money. Without further ado, I'll take us right into our first capital market - the stock market.
The Stock Market
This is what most people imagine when they think about the world of investing. This includes myself - for example, in my post Ten GuidingPrinciples of Personal Finance, I gave you a snapshot of my portfolio at the time. It was entirely stocks, as you can see:
The simplest definition of a "stock" would be to say that a stock is a share in the ownership of a company. This part ownership has value, which comes primarily from two sources - the company's assets (real estate, inventory, etc.) and the company's earnings (both present and future).
Stocks are often called shares, because they are a share in the ownership of a company.
There are two main ways to make money by investing in stocks. The first is through capital appreciation. Basically, this is the belief that sometime in the future you will be able to sell the stock for more than you bought it for. The second way to make money in the stock market is through dividends and share buybacks.
When companies have excess profits that cannot be usefully reinvested in their business, they often declare a dividend. These are essentially cash payments to shareholders that typically occur periodically. For example, the big 5 Canadian banks pay dividends periodically. Share buybacks are another technique used by companies to benefit their investors. By repurchasing outstanding shares for cancellation, they reduce the number of shares outstanding which logically increasing the partial ownership of each share. In a rational market (which doesn't always occur) this will increase the value of the company's stock.
The Bond Market
Ah, the bond market. This is the capital market that is most near and dear to my heart. This is partially because this is the industry where I am currently employed, but there are also many factors that drew me to this industry in the first place.
Before I gush any further about the benefits of investing in bonds, it's best that I start with a definition.
Bonds are essentially a contract between an investor and a borrower.
A bond is a contract where an investor loans money (called the principal) to an entity (typically a government or a corporation) in return for a fixed semiannual payment and the repayment of principal at maturity. Bonds are typically issued in denominations of $1,000 or $10,000, and are used by companies, cities, provinces and countries to raise money for investment.
There are two types of bond markets. The first is called the "primary market" - this is where investors purchase bonds directly from the issuing corporations. The other bond market is the "secondary market," which is where investors trade bonds among themselves. Typically there is no guarantee of liquidity in the secondary market, so if you're purchasing a bond it's best to have the intention to hold it until maturity.
The bond market appeals to me because it is (in my humble opinion) the most predictable capital market. Bonds typically have much lower volatility (measured by the standard deviation of their returns) than stocks, which make them suitable for the more risk-averse investors. As well, they have a variety of characteristics that are easy to be modeled with math. These include duration, yield to maturity, and credit ratings. These characteristics are all outline in my post Bonds for the Beginner.
The Options Market
Options trading should be a whole post on it's own (and it actually is - see my post on strategies for trading stock options), so I won't go into extreme detail here.
Stock options are often used by active traders to speculate on short-term movements in other capital markets.
Essentially, options are contracts, and these contracts come with tremendous variety. Options are split into two broad categories: call options and put options. Their generally accepted definitions are as follows:
Call option: an agreement that gives an investor the right (but not the obligation) to buy a stock at a specified price, on or before a given date.
Put Option: an agreement that gives an investor the right (but not the obligation) to sell a stock at a specified price, on or before a given date.
Options allow investors to perform a variety of exotic investment strategies. One that immediately comes to mind is the covered call income strategy, which I recently wrote a blog post about. This strategy is best suited for stocks whose price you believe will remain relatively constant moving forward. To execute the covered call income strategy, you need to hold a 100-multiple of a given stock, which will be the underlying security for stock options you will be selling.
Options also allow you the hedge out much of the risk that come with investing in stocks. Typically this comes in the form of reducing your maximum return in exchange for reducing your maximum loss. You can read more about these types of risk-reducing techniques in my post on option trading strategies.
The Currency Market
Currencies are everywhere - the Canadian and US Dollars, the Great British Pound, the Euro, the Mexican Peso. But there are tons of people who don't realize that they can actually invest (or more commonly, speculate) in the foreign exchange markets to make a profit. Since it's called "foreign exchange" trading, most people abbreviate it to forex, and that's the convention I will use for the rest of this post.
Because of the long/short pairs that are inherent in the forex markets, your money is constantly being pulled in two directions by the forces effecting each underlying economy.
One of the things that is unique about investing in the currency market is that since you're always exchanging one currency for another, you're creating both a short position and a long position. It's rather complicated and will be the subject of a future blog post.
There are tons of advantages to forex trading when compared to the other capital markets. Most importantly, the forex market is by far the largest financial market, and by extension the most liquid. You never really need to worry about exiting a position when trading forex - the liquidity is always there.
Additionally, the forex market is open longer than any of the other markets. Generally speaking, forex is liquid 24 hours a day, 5 days a week. This is because there are forex "exchanges" at countries all over the world. The greatest liquidity occurs when many of operating hours at many of these exchanges overlap, due to time zone differences.
Forex brokers also typically allow for extreme amounts of leverage. For example, one of my colleagues at work has an account with Vantage FX that allows for 500x leverages and you are capable of funding your account with a credit card. So even if you have a net worth of $0 but have access to a credit card, you can make extreme investments in the currency markets.
Let's say you have a $10,000 credit limit on your card - fund the account with $10,000 and you're capable of making a $5,000,000 investment in the currency markets. There's no real money here, which is crazy, and I've been hounding her for ages to write a guest post about this (with no luck).
The Commodities Market
When people think about the Canadian economy, they often think of it being strongly linked to two things. Canadian banks and energy. Oil is one of the most recognizable commodities to the Canadian investor because of it's role in our overall financial picture, but there are lots of other commodities out there.
Gold is a prime example. With all of the uncertainty in the stock market lately due to high levels of volatility in both February and August, people are going risk-off (meaning they are shedding risky assets in exchange for more conservative plays) and many people are moving into gold as a safe haven. This demand has driven the price up:
This is a 1-year price chart of XAUUSD:CUR courtesy of Bloomberg. Note that this was taken before Brexit, and the price is even higher at the time of this post.
But how to we actually trade commodities, or at least benefit from anticipating their price movements? Think back to oil for a second. If someone wants to invest in oil because they anticipate a price increase, they could obviously buy some land, and park a few thousand barrels of oil on it waiting for the right moment to sell. For obvious reasons, this is impractical, and investors have devised clever alternatives so entrance into the commodities market is easier than ever.
The main way that investors can participate in the commodities market is through futures contracts. In a nutshell, a futures contract is a binding agreement to buy or sell a particular quantity of a commodity at a specific price on a specific date.
So an oil future could be a contract enforcing the purchase of 100 barrels of oil at $25.00/barrel on June 30, 2016. Since oil is currently trading much higher than $25.00/barrel (as I write this we are about 48 USD/bbl), this contract obviously holds a lot of value because of the savings involved.
At the maturity of the futures contract, it actually has to be exercised (this is unlike stock options, which simply give you the option to exercise them). This means that at the end of the day, someone is actually going to be buying the 100 barrels of oil and there will be a seller on the other end.
My point here is that you really don't want to be stuck with the futures contract at maturity, unless you have recreational use for 100 barrels of oil. But obviously someone has got to be the end buyer, right?
Because of this the commodities market is generally composed of two types of participants. There are the traders, who can be individual or institutional, and who are doing exactly what I've written about here - speculating on future movements in commodity prices to make money. Then there are the commercial participants. These are people who will be the actual end users of the commodities, and are buying these contracts for the eventual claim to wheat, oil, gold, or whatever other commodity. These guys are the people who want the contracts on the maturity date.
And that's about all I have on the commodity market. Since I've never actually traded commodities myself, I have to keep my advice pretty generic to avoid writing outside my circle of competence. However, one word of caution - the commodity market can be extremely volatile, and your account can be crushed in minutes if you end up on the wrong side of a trade. This is not a market I would suggest that you enter unless you have extreme confidence in your trading abilities!
Hopefully this has given you an understanding of the variety of different capital markets that we have here in Canada. My goal in writing this post was to show you that there are many different ways to invest outside of the stock and bond markets. Hopefully I've achieved that goal!
Readers, were there any surprises for you in this post about capital markets? Which markets do you regularly participate in? Let me know in the comments section!