Chapter 2, Lesson 2: Financial Instruments – Part 2: Stocks, Funds and Currency

Equity shares (stock)

Shares, also referred to as stock, represent the ownership share in a company. Therefore, because the company has value, so does the share. Likewise, as the value of the company changes, the share changes in value as well. The market is not always efficient, and thus the price of the share does not always reflect its value. This is because the price also changes based on its supply and the demand, and different investors will have different valuations of the company. There are many different ways to appraise a company, which occurs with a general lack of consensus among value investors.

A company is called a “public” company when it has issued shares to the public. The first time this occurs is called an initial public offering. These shares are issued on what is called the primary market, as it is the first market they pass through. The primary market simply refers to exchanges made between the company and the buyer. Every share exchanged by a primary buyer is then traded on the secondary market, such as through a stock exchange, where trades occur either primary buyer to buyer, or buyer to buyer.

Companies with stock outstanding have the option to pay a “dividend”, which is a portion of the company’s profits paid out to its stockholders.

There are two types of stock, preferred and common. Preferred stock gives the holder a guaranteed dividend, and are issued before the dividends given to common stock. Common stock are, as the name suggested, more common. Typically, there are more of them for each company’s stock, and when you look at the ticker prices a stock are most often seeing the prices of the common stock. This category of stock is often less expensive, as the holder will not be assured a dividend, and if one is issued, will receive it after those holding preferred stock, and in lower priority.

Funds

Mutual funds

Mutual funds are groups of investments managed by a fund manager. They are comprised of stocks, bonds, ETFs, etc. from various sectors. An investor will buy shares in the mutual fund, much like buying the shares of a company, and then that cash will go into a pool of money which may then be used to pay for investments that the fund’s manager believes will make money, or to fund operations, such as transaction fees, management fees, etc. Each share represents a certain fraction of the net asset value of the fund – the value of the fund’s cash, investments, etc. As the fund gains or loses capital based on its investments, the value of the share will rise or fall accordingly. Unlike shares in a company, the price of a share in a mutual fund reflects exactly the net asset value of the fund.Mutual funds have many investors, and allow people to invest in professionally managed, diverse portfolios which they would not be able to do otherwise given the amount of capital they have to invest.

Hedge funds

Hedge funds are much more actively managed than mutual funds, and are significantly more expensive to invest in. The goal of a hedge fund is to generate high returns from trades made with its large pool of investor capital. Hedge funds will often use derivatives to trade and to insure their other trades, and to invest domestically and internationally. In addition, many hedge funds use leverage (borrowed capital from banks) to generate higher returns. Hedge funds are typically found in independent firms and often require investors to be accredited and make a large initial investment, which they often must maintain for a certain period of time. The name, ‘hedge fund’ comes from the historical practice of these types of funds attempting to reduce the risk of bearish (downward trending) markets, incur by short selling, which will be explained later. Today, hedge funds are mainly focused on generating high returns for their investors and do so using a number of strategies,  including going long (buying), and shorting (selling), stocks.

Index funds

Index funds function much like mutual funds, and track the performance of an index. An ‘index’ represents the current value of a portfolio of assets. Index funds own the same portfolio as the index it tracks, and thus can have high costs per share when the index they track is comprised of many companies. Index funds are passively managed, meaning the fund’s managers don’t trade the portfolio often to generate higher returns, instead opting for appreciation on a long-term basis. Many index funds track a certain group of stocks which represent the general market sentiment. For example, the S&P 500 is one of the most popular index funds and tracks the performance of the 500 largest stocks by market capitalization on the NYSE and NASDAQ exchange.

Exchange traded funds (ETFs)

Exchange traded funds are much like index funds in that their portfolio tracks the performance of an index or asset, or many assets, and their shares are traded on an exchange. Unlike mutual funds and index funds, ETFs engage in short positions and employ margins (borrowed capital). They are more liquid (more are bought and sold) than mutual funds, and they typically charge lower fees than mutual funds.

Currency

A currency is a country’s monetary unit. Each currency has an exchange rate with other currencies. For example, one Canadian dollar can currently be traded for approximately 0.77 United States Dollars (USD), and one United States Dollar can currently be traded for about 1.31 Canadian dollars. Traders profit from changes in the exchange rate of currencies. Their relative value is determined by a number of factors, including supply and demand, purchasing power parity, inflation, interest rates, unemployment, and various other economic indicators. A now antiquated way of valuing a currency was for a government to fix the value of its currency to a specific amount of gold. This was done by the government holding all gold in its reserves, and fixing the exchange rate for gold to non-gold money. This was done by the United States until October, 1976 when the gold standard was removed from the U.S. dollar.

Next upChapter 2, Lesson 2: Financial Instruments (No, hedge fund managers don’t all play the cello) – Part 3: Derivatives


Sources:

Image: By Rafael Matsunaga (Flickr) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)%5D, via Wikimedia Commons

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