How do financial markets function, including the factors influencing stock prices, bond yield, commodity prices, and currency movement?
As the backbone of capitalist economies, financial markets play a crucial role in resource allocation and liquidity creation for businesses and entrepreneurs. They are the platforms that enable us to efficiently trade our financial holdings, thereby contributing to the smooth operation of the economy we interact with every day.
Capitalism, the driving force behind most economies today, has significantly accelerated industrialization and the widespread availability of consumer goods. Its influence is profound and far-reaching, shaping the economic landscape and enhancing our daily lives with various products and services.
In a capitalist economy, profit is the engine that drives wealth accumulation, which is then transformed into capital allocation. Companies use the profits for research and development, buying corporate stock, or other corporate endeavors to further their growth. This mechanism is at the heart of the capitalist economy, enlightening us about its inner workings.
Now that we know how the financial market functions, let’s keep the supply and demand theme going. Once a company goes public and its shares start trading on a stock exchange, its share price is determined by what else supply and demand in the market. Buyers and sellers interact to set the price. The buyers “bid” how much they are willing to pay, and sellers “ask” what they will accept. When they agree on a price, it becomes the stock price.
Stock prices are also influenced by supply and demand dynamics. A company's thriving business can lead to an increase in demand for its shares. Similarly, launching a highly desirable product or service could trigger a surge in demand. Conversely, increasing the number of shares available for sale can lead to a surplus, potentially lowering the stock price.
Future growth potential, whether the product is unique to the market, and projected earnings could also influence the price of a stock. Many buyers also consider the company's book value. Book value is the difference between a company’s total assets and liabilities because, theoretically, this is the amount of money paid to stockholders if the company is liquidated and paid off all its liabilities.
Bonds also have a direct correlation to supply and demand. Governments and corporations issue bonds to raise money. By buying a bond, you are giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date and to pay you periodic interest payments along the way. Unlike stocks, bonds can vary significantly based on the terms of a legally binding agreement.
The most common bonds are corporate, municipal, and U.S. treasury bonds. A corporate bond is a debt obligation issued by a company to raise money to pay its expenses and raise capital. Corporate bonds are subject to several risks, including interest rate, credit or default, market, and inflation risks. The level of default risk depends on the issuer’s credit quality, with corporate bonds generally more credit-risky than government bonds.
Municipal bonds are called “Munis” and are issued by government entities to fund public projects and daily operations. These entities include states, cities, counties, and other public bodies. Municipal bonds are often used to finance capital projects that benefit the community, such as building schools, highways, bridges, and parks. Future project users may help pay for some of the costs through higher taxes, tolls, fares, and other charges. Municipal bonds are generally considered safer than other investments, but one more bond type is considered the safest.
The U.S. treasury bond is issued by the U.S. Department of the Treasury and is considered a low-risk investment because if held to maturity, it may be risk-free. When you buy a treasury bond, you lend money to the U.S. government.
The yield of a bond varies depending on its type. Corporate bonds fluctuate based on interest rates and the market’s perception of the issuer’s credit quality. Corporate bonds often yield higher than government bonds with similar maturities because they typically have more credit risk. Municipal bonds can yield less than taxable treasury bonds, but the tax exemption can increase the after-tax value of the yield. Treasury bond yields fall when interest rates rise, and vice versa.
I bet you can guess what drives commodity prices; you got it: supply and demand. Production levels, such as major producing nations increasing or decreasing output, can affect supply. For example, if the supply of oil increases, the price per barrel will decrease. Consumer and business demand can affect prices. For example, oil demand often increases in the summer. During global economic recessions, energy demand may decrease, which can lower prices.
To wrap up this discussion, the price of currency, or exchange rate, constantly changes based on supply and demand in the foreign exchange market. Were you expecting me to say something different? The perceived value of a currency, whether as an investment or to pay for goods and services, is a major factor in supply and demand. Other factors that can influence exchange rates include economic performance, interest rates, inflation, politics, speculation, and fiscal policy.
The story's moral is that supply and demand drive all financial markets. Changes in either of these factors will cause the market price to increase or decrease.