Understanding Financial Markets

This is my attempt to organize everything I’ve learned about the U.S. financial markets into a single document. Like my computer memory post, it’s intentionally broad with links throughout for further reading.

The inspiration was Perry Kaufman’s Trading Systems and Methods book and the first lecture of MIT’s Financial Mathematics course.

Financial Instruments

Financial instruments are contracts between parties that can be traded. They can be categorized into four main types: equities, fixed income, forex, and derivatives.

Equities and Fixed Income

Equities are shares of ownership in a company also known as stocks. Equities offer the potential for capital appreciation and sometimes dividend income.

Fixed income refers to bonds and other debt instruments. They provide regular interest payments and return of principal at maturity. An important market indicator is the inverted yield curve. When short-term (3-month or 2-year) yields are higher than long-term (10-year), it historically has signaled a recession. This time, it didn’t.

Forex and Derivatives

Forex or currency is traded 24/5 and is the largest financial market by volume.

Options are contracts that give the holder the right (but not the obligation) to buy or sell an underlying asset at a specified price on or before a specified date. They are used for speculation, hedging, and income generation.

Futures are standardized agreements to buy or sell an asset or financial instrument at a predetermined price on a future date. They are commonly associated with commodities like crude oil and equity indices like the S&P 500. Important aspects of futures are contango and backwardation. Futures are popular with day traders because they are taxed at 60/40 long/short term capital gains rates and not subject to the pattern day trader rule.

Investment Funds

Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. They are managed by professional portfolio managers who either actively select investments to beat a benchmark index or passively track an index’s performance. Mutual funds are regulated by the Investment Company Act of 1940 (updated in Dodd-Frank). Two of the best-known funds are Fidelity’s Magellan and Contra.

Exchange-traded funds (ETFs) are similar to mutual funds but trade on exchanges like stocks. They are usually passively managed and track an index like the S&P 500 (SPY) or Nasdaq 100 (QQQ). You can now trade Bitcoin with ETFs like IBIT. ETFs are structured as limited partnerships to keep the assets held by the fund separate from the issuer. This means if the bank issuing the fund goes bankrupt (like Lehman Brothers), the assets are safe.

Exchange-traded notes (ETNs) are unsecured debt securities that track an index. They are subject to the credit risk of the issuer, so if the issuer goes bankrupt, the ETN could lose all its value. Unlike ETFs, ETNs are taxed as debt instruments, so they don’t qualify for the lower, long-term capital gains tax rate. For example, Barclay’s VXX ETN compared to ProShare’s VIXY ETF.

Market Participants

Investment banks like Goldman Sachs, JP Morgan, and Morgan Stanley serve as intermediaries between companies and investors. They underwrite new securities and offer prime brokerage services to hedge funds. Their research divisions employ analysts who provide detailed industry insights and company ratings that are followed by investors.

Asset managers like BlackRock, Fidelity, and Vanguard oversee vast sums of money through mutual funds, ETFs, and pensions, with their assets under management (AUM) reaching into the trillions. The necessary trades just to balance their portfolios would move the market against them, so they rely heavily on algorithmic trading to break up massive orders into smaller chunks.

Hedge funds like Citadel LLC, Renaissance, and Two Sigma, represent a more specialized category of market participants. These funds pool capital from accredited investors - individuals meeting high net worth or income requirements - and operate under specific securities law exemptions that afford them greater flexibility in their investing strategies.

Market makers like Citadel Securities, Optiver, and Virtu provide liquidity to the market by simultaneously quoting the bid and ask prices. They profit from the spread using high-frequency trading (HFT) strategies and rely on low-latency direct market access.

Proprietary trading firms like Hudson River, Jane Street, and Jump use their own capital to trade financial instruments for profit. They seek market inefficiencies using quantitative analysis and techniques like statistical arbitrage. Many prop firms also act as market makers.

Exchanges like the New York Stock Exchange (NYSE), Nasdaq, CME, and CBOE facilitate the buying and selling of securities, while clearing houses like the Depository Trust & Clearing Corporation (DTCC) and the Options Clearing Corporation (OCC) ensure that trades are settled.

Dark pools are private exchanges where institutional investors can trade large blocks of shares without revealing their intentions to the public market.

Brokerages like Interactive Brokers, Robinhood and Schwab act as intermediaries between traders/investors and the exchanges. They provide the necessary infrastructure for trading to take place, but they don’t hold trades on their own books. Instead, they route orders to exchanges or market makers for execution, using order routing algorithms to ensure clients get the best possible price.

Wealth managers like Merrill Lynch, Northern Trust and UBS cater to high-net-worth individuals, offering comprehensive financial services. These firms offer personalized investment advice, estate planning, tax services, and portfolio management through dedicated financial advisors. While they can execute trades on behalf of clients, their main focus is managing wealth holistically.

Robo-advisors like Betterment and Wealthfront provide automated portfolio management and sit between completely self-directed investing at a brokerage and full-service wealth management. They use algorithms to create and manage diversified portfolios based on client risk tolerance and investment goals. Robo-advisors emerged as part of the broader trend towards passive investing.

Regulatory bodies maintain oversight of market participants and trading activities. The SEC serves as the primary regulator for securities markets, while the CFTC oversees commodities and derivatives markets. FINRA acts as a self-regulatory organization (SRO) for firms that trade securities, like brokerages, more broadly known as broker-dealers.

Retail trading transformed in the early 1990s with the emergence of online trading platforms like E*TRADE (now Morgan Stanley). As more brokerages adopted online trading, the commission fees slowly dropped. By the 2010s, commission-free trading was mainstream with the rise of Robinhood, made possible by payment for order flow, where brokerages route orders to market makers in exchange for a small payment. Per CBOE, retail trading is a contributing factor to a steady increase in average daily trading volume since 2018.

Market Structure

The U.S. equity market structure evolved from a system of regional exchanges like the old Boston Stock Exchange and Philadelphia Stock Exchange. Reg NMS was implemented in 2005 to address this fragmentation by requiring trades to be executed at the best price available across all exchanges, creating a more unified national market system.

Today’s market structure consists of multiple exchanges and alternative trading systems (ATS) connected through the Securities Information Processor (SIP). While the NYSE and Nasdaq remain the primary listing exchanges, significant volume occurs on smaller exchanges like the NYSE Arca (formerly Archipelago) and BATS (“Better ATS”, now owned by CBOE).

The National Best Bid and Offer (NBBO) represents the highest bid and lowest ask prices available across all exchanges, where the bid is the price buyers are willing to pay, and the ask is the price sellers are willing to accept.

Market data is typically categorized into different levels:

• Level I: Basic NBBO quotes (bid and ask) and last trade price; what most retail traders see on their trading platforms.
• Level II: Multiple bid/ask levels with their associated quantities on each exchange. It allows traders to see the depth of market (DOM), essentially the queue of orders waiting to be executed at each price level.

The bid-ask spread represents the basic transaction cost of trading and is tighter for highly-liquid stocks. Market makers profit by buying at the bid and selling at the ask, capturing the spread and providing liquidity to the market.

Traders can use various order types including:

• Market: Execute immediately at the best available price.
• Limit: Only execute at a specific price or better.
• Stop: Trigger a market order when a price threshold is reached. Also known as stop-loss.
• Stop-limit: Trigger a limit order when a price threshold is reached. Requires entering the stop price and limit price.
• Fill-or-kill: Execute the entire order in full or cancel it.
• Immediate-or-cancel: Execute as much of the order as possible immediately, cancel the rest.

The Federal Reserve

The Federal Reserve (“the Fed”), established by the Federal Reserve Act, is the central banking system of the United States, operating independently within the government to conduct monetary policy.

It is not a single entity, but a system of 12 regional banks, coordinated by the Board of Governors. The 7 members of the Board are appointed by the President and confirmed by the Senate to serve 14-year terms. The Chair and Vice Chair are appointed from among the Board members and serve 4-year terms.

Dual Mandate

The two key objectives for monetary policy are:

• Maximum employment: Foster labor market conditions conducive to employment.
• Price stability: Target 2% long-term inflation, as measured by the PCE.

This is known as the Fed’s dual mandate. The Humphrey-Hawkins Act of 1978 requires the Fed Chair to report to Congress twice a year to give an update on the state of the economy and explain any recent monetary policy decisions.

The Fed tracks different measures of money supply, from the monetary base (M0) of physical currency and bank reserves, to broader measures like M1 and M2 that include increasingly less liquid assets like checking accounts, savings accounts, and money market funds.

Implementing Monetary Policy

The federal funds rate is the Fed’s primary monetary policy tool. This is the interest rate banks charge each other for overnight loans to meet reserve requirements. The FOMC sets a target range for this rate, and changes to it impact borrowing costs throughout the economy. The discount rate is the interest rate the Fed charges banks for short-term loans directly, typically higher than the federal funds rate.

Before 2008, the Fed primarily used open market operations to maintain the federal funds rate by adjusting banks’ reserve balances. However, after the financial crisis, the framework changed to an “ample reserves” system where interest rates are managed more directly through:

• Interest on Reserve Balances: Interest paid on excess reserves held at the Fed.
• Overnight Reverse Repurchase Agreements: Short-term loans where the Fed borrows cash from banks, collateralized by Treasury securities.

Open market operations, including QE and QT, are now used to maintain an ample supply of reserves, rather than for day-to-day interest rate management.

Prior to 2021, many debt instruments were priced based on LIBOR. Due to manipulation by banks, the Fed developed SOFR based on actual U.S. Treasury transactions.

Market participants closely monitor Fed policy because it significantly impacts asset prices. Interest rate changes affect bond yields directly, while also influencing stock valuations through the cost of borrowed capital.

Economic Indicators

Economic indicators are periodic data releases that provide insights into the health and direction of the economy. Traders closely monitor these as they can significantly impact financial markets.

Gross Domestic Product (GDP), released quarterly by the Bureau of Economic Analysis, measures the total value of goods and services produced. It’s a broad indicator of economic activity and is broken down into personal consumption expenditure, business investment, government spending, and net exports.

The Employment Situation Report (ESR) is released on the first friday of every month by the Bureau of Labor Statistics and includes the nonfarm payroll report, providing insights into the labor market, including the unemployment rate, job creation, and wage growth. It is often considered the most important economic release as it can influence monetary policy decisions.

Initial jobless claims are released every Thursday by the Department of Labor and provide a real-time snapshot of the labor market.

The Consumer Price Index (CPI) and Producer Price Index (PPI) track changes in the prices of goods and services. The CPI measures the cost of a basket of consumer goods, while the PPI tracks wholesale prices. The Bureau of Labor Statistics releases these monthly.

Retail sales are reported monthly by the Census Bureau and track consumer spending. The Conference Board releases the Consumer Confidence Index (CCI) and Leading Economic Index, which provide insights into consumer sentiment and future economic activity. The latter is a composite of ten indicators that predict economic turning points, like a recession.

Housing starts are released monthly by the Census Bureau. The National Assocation of Realtors also releases the monthly Existing-Home Sales report. These provide insights into the health of the housing market.

Market Theories

Dow Theory

Charles Dow, co-founder of Dow Jones and the first editor of the WSJ, developed what became known was Dow Theory through a series of editorials in the late 1800s. While Dow never wrote a comprehensive text on his theory, his ideas were compiled years later by William Hamilton and Robert Rhea.

From Time Magazine in 1938:

It presumes three simultaneous movements of stock prices, which may be compared to tides, waves, and ripples. Speculators try to ride the tides, sometimes duck in & out of the big waves; only the reckless try to profit by the day-to-day ripples.

All modern technical analysis is based on Dow Theory, that is, using historical data to predict future price movements and looking for signals to confirm trading hypotheses.

I should point out that unlike the other theories here, Dow Theory has no mathematical basis. It’s more of a philosophy or a way of thinking about the markets.

The Theory of Speculation

In 1900 at the Sorbonne, Louis Bachelier defended his thesis, The Theory of Speculation (to Poincaré). In it, he proposed that stock market prices follow what we now call a random walk, suggesting they are unpredictable.

Bachelier’s mathematical model of price movement turned out to be the same as Einstein’s model of Brownian motion, published 5 years later in Investigations on the Theory of the Brownian Movement.

Despite all that, the importance of Bachelier’s thesis wasn’t recognized for over 50 years until Paul Samuelson rediscovered it in a library at MIT.

Foundations of Economic Analysis

Paul Samuelson’s Foundations of Economic Analysis, published in 1947, is based on his doctoral dissertation at Harvard (which won the Wells Prize for best thesis in economics). The book unifies various economic theories under a single mathematical framework and builds on Alfred Marshall’s Principles of Economics.

His 1974 article, Challenge to Judgment, was the inspiration for John Bogle’s creation of Vanguard and the index fund.

Samuelson’s work made him the first American to win the Nobel Prize in Economics in 1970.

Modern Portfolio Theory

In 1952, Harry Markowitz published Portfolio Selection, which introduced the concept of modern portfolio theory (MPT).

MPT assumes investors are only willing to take on extra risk if they can expect higher returns. Individual assets are subject to specific or idiosyncratic risk, which can be diversified away by holding a portfolio of assets with imperfect correlations. The remaining risk is systematic.

By combining assets in different proportions, investors can construct portfolios with varying levels of risk and expected return. The set of portfolios that offer the highest expected return for each level of risk form the efficient frontier.

Nassim Taleb has criticized MPT for its assumptions that don’t accurately model reality, like returns following a Gaussian (normal) distribution, in The Black Swan.

CAPM

Building on Markowitz’s work, Jack Treynor, William Sharpe, John Lintner, and Jan Mossin developed the Capital Asset Pricing Model (CAPM) independently from 1961 to 1966.

CAPM describes the relationship between risk and expected return. It proposes that an asset’s expected return is determined by its relationship with the market’s systematic risk, beta.

Markowitz and Sharpe were awarded the Nobel Prize in Economics in 1990 for their work on MPT and CAPM, respectively.

The Efficient Market Hypothesis

The efficient market hypothesis (EMH) states that asset prices reflect all available information. The EMH was popularized by Eugene Fama in his 1970 paper, Efficient Capital Markets.

While Fama’s work supported market efficiency, Robert Shiller’s Do Stock Prices Move Too Much to be Justified demonstrated that stock market volatility was higher than could be explained by fundamental factors. 2000’s Irrational Exuberance warned of the dot-com bubble in the first edition, and the housing crisis in the second. 2009’s Animal Spirits (with George Akerlof) argues that animal spirits (a term used by Keynes) drive economic behavior.

Both Fama and Shiller were awarded the Nobel Prize in Economics in 2013.

A Random Walk Down Wall Street

A few years after Eugene Fama published his work on the EMH, Burton Malkiel wrote A Random Walk Down Wall Street. The book popularized the random walk hypothesis, suggesting stock prices are unpredictable. Malkiel reviews approaches like fundamental and technical analysis and concludes that individuals are better off with a passive investing strategy. As for professionally-managed funds, he argues that most will eventually underperform the market after experiencing brief periods of success.

Black-Scholes-Merton

In 1973, Fischer Black and Myron Scholes published The Pricing of Options and Corporate Liabilities, which introduced the Black-Scholes model. The model includes a formula to determine the fair price of European-style options. They showed that you could theoretically create a risk-free portfolio by continuously adjusting the proportion of stock and options based on the option’s delta, or rate of change of the option price with respect to the underlying price.

At the time, Robert Merton was also working on derivative pricing at MIT and published Theory of Rational Option Pricing. Merton improved the mathematical framework of the model using stochastic calculus and Itō’s lemma. He literally wrote the book on continuous-time finance.

In 1997, Scholes and Merton were awarded the Nobel Prize in Economics for their work on the model. Sadly, Fischer Black had passed away in 1995 from cancer.

Prospect Theory

Daniel Kahneman and Amos Tversky published Prospect Theory: An Analysis of Decision under Risk in 1979. Their research demonstrated that people are risk-averse for gains, but risk-seeking for losses.

Kahneman and Tversky’s work was foundational in the field of behavioral economics and the study of heuristics. Kahneman won the Nobel Prize in Economics in 2002 for his contributions. Sadly, Amos Tversky had passed away in 1996 from cancer.

Fama-French

Research began revealing patterns in stock returns that CAPM couldn’t explain. In 1992, Eugene Fama and Kenneth French published The Cross-Section of Expected Stock Returns, which introduced the Fama-French three-factor model. The model adds size and value factors to CAPM’s market risk factor. Their research showed that small-caps outperformed large-caps, and value stocks outperformed growth stocks over the long term. In 2015, they expanded the model to include profitability and investment factors. These models helped explain market behavior that seemed to contradict the EMH.

Conclusion

I hope this overview serves as a solid foundation for anyone interested in understanding the financial markets. I’ll try to keep it updated.

Be sure to follow me on GitHub and Hugging Face if you’d like to keep up with my work. Thanks for reading!