Chapter 2, Lesson 1: Financial Vehicles (Yes, hedge fund managers drive Porsches, but that’s not what we’re talking about)

This is the first lesson that pertains to how you can make money from the financial system, so I’m going to save the cute, little introductory paragraph and get right into it because I’m excited.

Financial vehicles are the basis of the whole financial market. They are the assets and liabilities traded between two entities. Without them, there would be nothing to trade and no market. And that’s right, you read correctly, liabilities. Since the Venetians, and possibly even earlier, people have been trading debt, especially government debt. Now, there are a multitude of financial vehicles. Some are quite evident, like real estate, gold, and company ownership, while others are obscure and fairly new, such as the weather. Below I’ll make a list of the most important, and a few of the obscure, just for fun.

Commodities

Commodities are physical resources. Some of the most traded commodities are:

  • Metals & Minerals (e.g. gold, aluminum, silver, copper, platinum)
  • Agricultural products (e.g. coffee, soybean, wheat, rice, corn, oranges)
  • Fuel (e.g. crude oil, natural gas, biofuels)
  • Animal products (e.g. cattle, beef, eggs, pork bellies)
  • Food products (e.g. sugar, butter, orange juice)
  • Plastics

Now, I’m sure you’re wondering what people do with these commodities when they buy them, and how they acquire them, and where they put them, etc. In fact, most don’t. Commodities trading is facilitated primarily by contracts, which vary in price themselves as the price of the underlying commodity changes. This way, in order to trade gold, one doesn’t need a bunker with 12 inch thick steel doors and round-the-clock security; or, orange speculators don’t have to worry about the fruit going bad and not being able to sell it. Instead, they simply trade contracts with the commodity, whose price they are speculating, as the underlying asset. Therefore, technically, commodity traders are actually just contract traders with commodities as the underlying assets, and the prices of these contracts are based on the price of the underlying commodity which the contract is for. We’ll discuss these contracts in the next lesson.

Companies

As described in the previous chapter, companies issue shares of ownership in the company in order to finance their operations and for other matters. Because companies have value, so do their shares. This allows people to trade ownership of companies.

Economies

Every country has an economy, and many countries have their own currency which reflects the performance of their economy, as well as the supply and demand of the currency. Some countries, such as Eurozone members, share a currency. This occurs for many reasons, from having closely related economies to joining forces to have a stronger currency with greater purchasing power. Other countries, such as China, keep the purchasing power of their currency lower. In China’s case, this is done in order to maintain the low costs of its exports, which have made China the industrial and economic powerhouse it is today, in such a short amount of time.

Debt

Organizations, such as companies and governments, who do not wish to give up ownership in turn for cash, can take on debt to finance their operations. Almost all organizations use debt to make things they can’t afford happen in the present, and pay for it later. This allows them to increase their value much faster. These organizations issue debt contracts, wherein investors give them cash in turn for a contract promising repayment and interest. This interest is paid for by inflation and the revenue generated by operations the loan financed. Alternatively, organizations can borrow money from lending agencies such as banks, and then issue bonds or notes (debt certificates as described above) in order to repay the loan. It is to note that many lending institutions are heavily leveraged (meaning they have debt) themselves, and this makes the entire financial system much more complicated and has made many people unsure of its stability. This was one of the reasons for the Great Recession, which you can find a brief explanation of in Chapter 1, Lesson 1.

Real estate

Real estate has long been touted as a stable investment, mainly because you can see it and the real estate market can be analyzed fairly easily. Though it is a physical asset, it is not classified as a commodity because all real estate assets are not of the same quality and are much harder to trade. They are thus seen, in physical asset form, as an individual investment and part of personal finance.

Weather

Thanks to the same types of contracts used to trade commodities, traders with a high risk-tolerance and probably a gambling problem can bet on the weather. While there is sufficient data to make accurate predictions, the weather itself has no value. Therefore, while it is a financial vehicle because there are contracts that can be traded with it as the underlying asset, it has no physical value and in the event of a major recession, the market for these products would become highly illiquid and the contracts would become worthless. Don’t invest in them, and only trade them as a last resort.

Now you know the most important vehicles which drive the financial markets. Next, you can learn about the instruments that facilitate their trading.

Next up: Financial Instruments (No, hedge fund managers don’t all play the cello) – Part 1: Debt Obligations


Sources:

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