Текст книги "101 Things Everyone Should Know about Economics: From Securities and Derivatives to Interest Rates and Hedge Funds, the Basics of Economics and What They Mean for You"

Автор книги: Peter Sander

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Why You Should Care

Money market funds are a good place to park reserve cash—reserved either to invest or to handle unexpected emergencies in your personal finances. They offer stability and liquidity, and did offer somewhat better yields in the past.

77. CREDIT RATING AGENCY

Credit rating agencies are specialized companies that evaluate the financial strength of other companies and of the debt instruments they issue. These ratings are used by banks, lenders, and others interested in corporate strength to judge the safety and quality of debt. While credit rating agencies are important to the proper function of the financial system, they might not have been mentioned in this book, except for the large role they played in the 2008–2009 financial crisis and the Great Recession that resulted.

What You Should Know

Credit rating agencies evaluate the overall strength of credit and credit risk of a company, similar to the so-called “credit rating” you might receive as a consumer, and they also evaluate the strength and quality of specific debt issues, like bonds or commercial paper. The “big three” ratings agencies evaluating U.S. companies are Standard & Poor’s, Moody’s, and Fitch Ratings. They each have their own set of rating criteria, and each issues ratings more or less analogous to school letter grades, although the exact grading scale used by all three is different. Companies will usually get a credit risk rating as a whole, and most large corporations are rated by all three agencies. Individual securities will also get ratings, but typically from only one agency. Special securities issued by companies, like asset-backed securities (see #67), also get ratings, and it was these ratings that brought credit rating agencies into the spotlight after the financial crisis.

Credit ratings are, in theory at least, convenient and independently calculated tools to help others make fast decisions about whether to lend to or invest in companies. For the most part they work, and have been the standard for years. But ratings agencies and their ratings came into question in the wake of the 2008–2009 crisis for two primary reasons. First, they tend not to change fast enough to reflect current economic or corporate conditions. Second, and perhaps more damaging, is the apparent conflict of interest in their creation: the firm issuing securities hires the rating agencies to provide the rating. Naturally, the agencies try to please their customer for the sake of future business and the business relationship. But those attempts to please have been called into question, particularly with the number of highly rated mortgage-backed securities that blew up in the crisis.

To be fair, it isn’t just the conflict of interest at fault—most likely, these securities were just too complex, and backed by assets too difficult to value, for any such rating to be accurate. Legislative reform of the ratings agencies has been slow in coming, but since reputation is the chief asset these companies have to sell, there has been a fair amount of self-reform, and their public image and effectiveness has returned to a large extent since the crisis.

Why You Should Care

Agencies rate debt securities that ultimately may include loans or mortgages you take out, and the ability of a rating agency to rate them fairly will determine how easily they can be sold to investors, ultimately affecting your ability to get financing. So there’s no direct impact on you or your household, but ratings agencies are part of the machinery that makes financing—money—available to you at an appropriate price.

78. STOCKS, STOCK MARKETS, AND STOCK EXCHANGES

As recently as 1960, only about 10 percent of all households owned shares of stock in corporations. Today, due in part to individual retirement savings needs, that figure has grown to exceed 50 percent; that is, one in two households across the United States own shares of corporations.

The discussion of stocks and stock markets cannot be possibly completed in this small of a space; it’s the subject for an entire book. What’s important to know is that stock represents the owners’ interest in a corporation, that interest is divided into shares, and that those shares are traded on one or more stock exchanges that comprise the stock market.

What You Should Know

Stocks can be listed on stock exchanges if they meet certain criteria in terms of size, volume, and share price given by the exchange. The exchange is a corporation or organization set up to bring buyers and sellers together, either in person or electronically. The exchange handles all incoming orders, executes them by matching a buyer to a seller, and routes the proceeds as funds to the appropriate parties.

The two major U.S. stock exchanges continue to be household names: the New York Stock Exchange (NYSE EuroNext) and the NASDAQ, which originally stood for the National Association of Securities Dealers Automated Quotations. In addition, the over-the-counter (OTC) and Pink Sheets markets and a series of regional exchanges handle specialized trading situations in the United States, and a network of online-only electronic exchanges has emerged, such as BATS Global Markets and Direct Edge, which have recently announced plans to combine to become the second-largest exchange in the U.S. by trading volume, ahead of NASDAQ. Most countries also have at least one major stock exchange.

How stock trades are actually executed varies by exchange. The original approach begun in the early 1790s on the corner of Wall and Broad Streets in Lower Manhattan eventually became the mainstay of the NYSE. That approach uses a specialist—an individual with assistants who manually matches buy and sell orders with each other and with a personal inventory when such external orders don’t exist or are too few. Each stock has one specialist and one only; that specialist is assigned the task of maintaining orderly markets.

The specialist system obviously predates computers; the advent of computers naturally brought new, faster, and more transparent technologies to stock trading practice. The first change came in 1971 with the advent of the NASDAQ. Prior to the NASDAQ, the only alternative to the specialist system was a network of securities dealers hooked to each other by telephone; these dealers traded the stock, mostly of small or emerging companies “over the counter.” The NASDAQ created a virtual marketplace accessed by computers where buyers and sellers, mostly dealers, posted quotes and executed trades against those quotes. Dealers could trade with the big brokerage houses to fill end-customer orders, and the late 1990s advent of personal computer and networking technology enabled individual traders to also access these markets. The day-trading craze of the late 1990s was the end result, and such high-powered direct access trading still goes on today.

Gradually and not surprisingly the specialist system is quickly becoming outmoded and replaced by faster, cheaper, and more transparent electronic tools; even the NYSE has evolved to electronic trading for a significant share of its volume. The specialist system still survives mostly to handle larger institutional trades.

Why You Should Care

The stock market and its effective operation are vital to a capitalist society. It is how capital is allocated between individuals, their representatives, and the corporations that need that capital. Without a fair or efficient market, that allocation wouldn’t work well, and people would be fearful of investing in companies.

79. BONDS AND BOND MARKETS

Bonds are securities bought and sold by investors promising repayment by a certain date (maturity) with a certain yield, or interest amount, paid usually semiannually. Not surprisingly, bonds and other debt securities are sold in the bond market.

What You Should Know

Trading in the bond market sets the price of the bond, which in turn sets the effective yield on the bond. Suppose a bond pays 7 percent at par—that is, at $100 in price, the typical original sale amount and ultimate value paid back at maturity. That means that the bond pays $70 per year in interest on a $1,000 bond (the normal trading increment). If the market thinks that bonds are worth less, and drives the price down to $95 ($950 face value), the effective yield rises to 7.37 percent—interest rates go up. Remember, when bond prices go down, interest rates go up, and vice versa.

Carrying the discussion one step further, even if the bond falls to $95 ($950), eventually $1,000 will be repaid to the bondholder. So the yield to maturity captures not just the interest paid, but also the additional $50 recovered at maturity. Suppose the 7 percent bond matures in ten years. The yield to maturity would be 7.72 percent—a fairly complex calculation best done on a financial calculator.

Most bonds are traded “over the counter” between individual securities dealers, rather than on a transparent, electronic-driven market like the NYSE or the NASDAQ. Today’s bond market looks more like the stock market of the 1960s and 1970s. Bonds are traded this way because each is unique—different issuer, different interest rate, maturity, and other terms and conditions. And most bonds are held longer and traded less frequently than stocks. The bond markets are less consumer-friendly—in part because consumers participate less in the bond markets; it is more of an institutional investor playground (see #75 Institutional Investors).

There are four categories of bonds and bond markets—corporate, government and agency, municipal, and asset-backed securities (see #67). The U.S. Treasury sells a lot of bonds, and has made the purchase of Treasury bonds among the most friendly of bond markets for the average consumer with its bond purchase website www.treasurydirect.gov.

Why You Should Care

Aside from being a place to buy and sell bonds by matching supply and demand for bonds, the bond market effectively determines interest rates. A rising bond market means falling interest rates; a falling bond market signals that interest rates are on the rise. If you’re in the market yourself to “sell a bond of your own”—that is, to get a mortgage or some other large loan—watching the bond markets to see the direction of interest rates can be especially helpful.

80. COMMODITIES, FUTURES, AND FUTURES MARKETS

Commodities are physical materials and assets used in production of goods and services (like oil or corn or platinum) or as a store of value (like gold) or both (like silver). Many businesses buy commodities in large quantities to support their production, while other businesses, like mining companies or farms or agricultural producers, sell commodities in large quantities; that’s their business.

Commodity futures are derivatives (see #66), securities products designed to provide a convenient way to buy and sell commodities, while commodity futures markets provide a way for buyers and sellers to trade those commodity futures.

What You Should Know

Futures contracts are standardized contracts to buy or sell a specified item, usually but not always a commodity, in a standardized quantity on a specific date. Commodity futures include agricultural products, shown in some listings as grains; “softs,” like cotton, sugar, and coffee; meats; and mineral and mining products like metals and energy products. Futures contracts also go beyond commodities into financial futures, which include interest rates, currencies (see #81 Currency Markets/FOREX), and stock index futures. In fact, many more exotic futures products are coming to market for things like the weather, pollution credits, and so forth.

Futures contracts are typically set up for larger quantities of a commodity than any individual consumer would normally need. For instance, the standard contract size for gasoline futures is 42,000 gallons, quite a bit more than you’ll need, even if you own the largest SUV. At $3 a gallon or so, on paper this is a $126,000 investment that few individuals would be able to make. So doesn’t this discourage participation in the market? Not really, because commodities traders can borrow on margin (see #86) to finance most of the purchase. In the case of gasoline futures, a $6,000 upfront cash payment gets you in. As you can see, the leverage is high—a 10 percent increase in the price of gas ($12,600 on the contract) would almost triple the initial investment. However, if the price goes down, your $6,000 disappears quickly; when gone, your position is liquidated. That affords some downside protection.

Futures contracts are bought and sold by producers and consumers of the commodities involved. Producers like farmers or energy companies are looking to hedge, or protect, against future price decreases, while consumers like manufacturing companies are hedging against price increases. But there aren’t that many producing or consuming businesses in the market at any given time for, say, copper. The markets are made complete by speculators, short-term investors trying to make a profit by guessing the future direction of the price of a commodity. While many speculators rarely see the actual cotton, they do play an important role in the determination of the price of cotton.

In many cases, the underlying assets to a futures contract may not be traditional commodities at all. For financial futures, the underlying assets or items can be currencies, securities, or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The “future” is the future price of the instrument, not the physical commodity.

Futures are traded on special markets set up to trade them, the most important of which are the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX).

Why You Should Care

Commodities markets serve the economy as an important way to set prices on key materials that the economy depends on, both now and in the future. Ultimately, the price of the coffee you drink or the gas you buy is determined by what happens in the commodities markets. Commodity futures also provide a way—albeit not the only way—to invest in the perceived future scarcity of materials like oil, and in the performance of the economy in general.

Commodity traders like to point out that there is less “headline risk” in commodities—that is, there’s no CEO or CFO to be caught fudging the books, for instance. Many of the human factors that add risk to stocks, bonds, and other investments are not present in commodities; investors consider commodities to be more of a “pure” investment.

81. CURRENCY MARKETS/FOREX

The exchange of national currency is vital in the course of national trade, and thus in the course of international economics. We cannot buy Japanese cars (produced in Japan, anyway) without first buying Japanese yen, and the Japanese can’t buy U.S. rice without first buying U.S. dollars. So that need to support trade has given rise to foreign currency exchange markets to allow market participants to exchange currency, and in many cases to set the price, or rate, of that currency exchange.

What You Should Know

The dynamics of currency exchange and exchange rates are complex and covered in more depth in Chapter 8. Here, we’ll talk about the foreign exchange markets themselves (known as “FOREX” or simply “FX”), and how they work.

Like commodity futures (see #80 Commodities, Futures, and Futures Markets), foreign exchange is a bigger market and plays a greater role than simply as a place for buyers and sellers of foreign goods to acquire the needed currency. Banks, large businesses, central banks, and governments use the FOREX markets to hedge positions, and even to implement policy, buying or selling currencies to achieve an exchange rate objective. And also like commodities, a considerable number of speculators and short-term traders “bet” on moves in currencies with relation to each other, adding market volume and liquidity to make exchange rates truly reflect the supply and demand of the moment.

Foreign exchange markets have grown enormously with the increase in international trade and the tendency since the early 1970s for countries to let their currencies “float”—that is, trade freely with a market-determined exchange rate. The average daily volume of FOREX transactions in 2013 was about $3 trillion, up from $2 trillion at the end of 2011 and $761 billion in 2008—phenomenal numbers. More than half of that volume is represented by dollar-euro and dollar-yen trades, according to the Foreign Exchange Committee’s Survey of North American Foreign Exchange Volume.

Foreign currencies can be traded outright as “spot” trades, or as futures, forwards, or swaps. FX markets are more like bond markets than stock markets—a loosely connected confederation of electronically connected, over-the-counter dealers, rather than a centralized market or exchange. By nature the markets work across borders, and thus aren’t subject to much regulation from any single country. There really isn’t any one single exchange rate; it is more a matter of the last trade that shows up “on the tape”—the electronic record from actual trades, and of the current dealer quotes being offered. Although these markets are set up more for large institutions and full-time players, most “retail” investors access these markets through specialized brokers set up for currency trading. Most retail investors play these markets through futures, which employ margin to expand the size of the transaction. More recently, regulators have moved toward allowing ordinary retail brokers to handle FX trading for their clients.

Why You Should Care

The exchange of currency is vital to the function of the growing global economy. While outright currency trading is complex and best left to specialists or dedicated individuals, the outcome of FOREX trading can have a big effect on what you pay for foreign goods, and on the greater health of the economy.

82. BROKERS, BROKER DEALERS, AND REGISTERED INVESTMENT ADVISERS

Your good friend John Smith, a registered investment adviser, wants your business. He wants to help you by investing your savings and managing those investments.

Your good friend Mary Jones, a broker working for YouNameIt Securities, a registered broker-dealer, also wants your business. She also wants to help you manage your investments.

What should you do? What do these people do, and what is their premise and promise in the management of your assets? Broker-dealers and registered investment advisers perform an important role in helping individuals (and corporations and institutions) manage their money, since perhaps they don’t have the time, expertise, and interest in doing so. It’s a service like any other service. But it’s good to know a few things about what these folks do, how they’re regulated, and what the pitfalls are before you pick one, if you decide that the “do it yourself” choice isn’t an option.

What You Should Know

A broker-dealer is a company set up and in business to trade securities—stocks, bonds, and commodities—for its customers (as “broker”) or on its own account (as “dealer”). Most broker-dealers participate in the markets to make money for their own benefit. A broker-dealer is a corporation or some other business form, not an individual. Many broker-dealers are actually subsidiaries of larger firms—banks or other financial services companies.

Broker-dealers are regulated under the Securities Exchange Act of 1934 by the SEC (see #43 and #44). They are also self-regulated to a degree through a familiar trade industry group known as the Financial Industry Regulatory Authority (FINRA), formerly known as the more familiar National Association of Securities Dealers (NASD).

Registered investment advisers (RIAs), on the other hand, can be individuals or firms registered with the SEC or a state regulatory body to manage the investments of others. RIAs can work independently, for RIA firms, for broker-dealers, or for other non-RIA firms.

An RIA must pass an exam (FINRA’s Series 65 Uniform Registered Investment Adviser Law Exam) or show equivalent professional competence, fill out forms, and pay filing fees, but there is no required curriculum or technical standard of performance. The standards are more centered on customer care, including the commitment to act in a “fiduciary capacity” by always placing the interest of a client in front of personal interest. There are also standards for disclosure and avoiding conflicts of interest. These legal responsibilities are well known but can be difficult to enforce in practice; RIAs must keep accurate records and file periodic reports. RIAs are usually paid on a fee-for-service basis, while broker-dealers are typically compensated by per-transaction commissions.

The key difference between broker-dealers and RIAs in practice is liability: RIAs can be liable for the advice they give, while broker-dealers as firms are not. Further, there is no clear regulation of the conflict of interest in a broker dealing in the same securities for its own account while advising you to buy or sell them; it’s a bit like doctors making money from the drugs they prescribe for you. Not that this conflict comes into play continually, but it happens, and it’s something to be aware of.

Why You Should Care

Obviously, not all broker-dealers are bad, and not all RIAs are good. Read the disclosure documents and discuss them carefully to know who or what you’re working with, and keep the fiduciary standard in mind as you observe your adviser’s behavior and actions.

83. FINANCIAL ADVISERS

Let’s suppose you need not only investment advice, but also advice on handling your overall finances. You need the right insurance. You need to plan for college and retirement. You need to figure out how much money you need now and in the future, and how to provide for yourself, your family, and the eventual financial legacy you leave to your loved ones.

Unless you’re the strong, silent, do-it-yourself type (and there are a lot of you out there), you need a financial adviser.

What You Should Know

Financial advisers are paid professionals who learn your financial situation, develop financial plans for you and your family, and help you find the tools—investments, savings plans, insurance, legal advice—to execute the plan. A good financial adviser looks at your personal and family goals, translates them to short– and long-term financial needs, and then develops, documents, and reviews a complete plan to meet the goals and needs.

Depending on the adviser, some may implement all or part of the plan—if they are registered investment advisers (see #82 Brokers, Broker Dealers, and Registered Investment Advisers) too, they may buy and sell securities on your behalf. If they are licensed insurance salespeople, they can sell insurance. If they are CPAs, they can do your taxes. If they are attorneys, they can execute trusts and estate plans. You get the idea.

There are two primary types of financial advisers, distinguished by the way they are paid. Fee-based advisers typically charge a mix of flat fees and per-transaction fees. The flat fees are tied to your asset base for general services; the per-transaction fees may be collected from you or from the providers of the securities they sell as commissions. Some criticize fee-based advisers for having an inherent conflict of interest, making money for selling XYZ family of mutual funds while supposedly also acting in your interest. Fee-only advisers don’t collect commissions, which reduces the risk of a conflict of interest between the adviser and the client if the adviser is beholden to another financial institution.

Financial advisers can come with a large assortment of credentials, some of which are more impressive than others. The Certified Financial Planner (CFP) is considered the highest in the food chain, with requirements for education, examination, and experience before practicing in the profession, and a strong fiduciary commitment to act in your interest besides. You’ll also see credentials like CLU (Chartered Life Underwriter) that point to a specialty in insurance, but many of these credentials also cover other elements of the financial planning process. For more on financial advisers and the financial planning process, the Financial Planning Association (www.fpanet.org) is a good resource.

Why You Should Care

As with most services, you should shop carefully for a financial adviser. Checking references, getting examples of what they’ve done for others, and checking credentials, experience, attitude, and personality all can play a part. They work for you, and their purpose, as well as their best interest, is to serve your needs.

84. ELECTRONIC AND HIGH-FREQUENCY TRADING

Few industries have been revolutionized as much by technology as the trading of securities—stocks, bonds, futures, and the like. Electronic trading has speeded the function of the markets to the point where trades can be executed on a global basis almost instantaneously. That has in turn speeded up the pace of change and increased the need for quick decision making at all levels of business and government—and has spurred a whole new approach to securities trading, where algorithms and computer models can replace a considerable amount if not all human thinking and decision making. The effects are huge. We got a hint as we witnessed the 2008 market meltdown; there was scarcely any time to react as global markets swooned on even the slightest news. We got another big hint—really, a kick in the side of the head—during the so-called “flash crash” of May 2010, where computerized trading froze up due to a relatively simple set of triggering events, and the market plunged—for a few minutes. So while electronic trading only affects those traders in a given securities markets on the surface, the global impacts can be a lot larger.

What You Should Know

For most of history, stock and other securities markets were physical markets like the NYSE, where people actually met face-to-face and traded stocks and securities (see #78 Stocks, Stock Markets, and Stock Exchanges). Communications like telephones and teletype machines connected those humans with other humans at exchanges, at securities dealers around the country, and in a few cases, around the globe. Those communications were rapid, but were only point-to-point—that is, one sender to one receiver—and the entire process was only as fast as the interaction of the humans at the end of the communication chain.

Improvements in communications and technology, notably networked computers, made it less important for buyers and sellers to work face-to-face. The NASDAQ automated quote system allowed market participants—dealers—to come together by posting quotes electronically; the entire market was visible to market players with the right level of access. This advance greatly superseded point-to-point communications; the markets could handle the actions of many participants at once. Personal technology allowed individuals to work in markets once restricted to big trading firms with large computer installations. Beyond the actual execution of electronic markets, all market players also had real-time access to information, including quotes, news releases, and company information.

Today’s trading is becoming more electronic, with buyers and sellers coming together on electronic quote boards known as electronic communications networks (ECNs). Some ECNs like Arca have been absorbed as part of the major exchanges (the NYSE in Arca’s case), providing an electronic trading platform within the exchange. The rapidly growing (and combining) BATS, Direct Edge, and other electronic markets noted in #78 have provided another major trading venue. Sophisticated “client” algorithms and triggers automate the entry of orders when certain price conditions have been met, and have enabled one computer to trade with another computer through the electronic network; humans barely need to be involved, except to set the conditions of order entry.

So-called “high-frequency trading,” where orders are triggered by algorithms and executed in milliseconds, even nanoseconds, accounts for some 50 percent of all stock market volume. High-frequency traders are attempting to capture tiny gains, over and over, by getting information “first,” and by capturing small differences in prices among markets, often less than a penny per share. High-frequency trading, while providing “liquidity”—volume and execution speed—to the markets, has also been described as unfair, as direct connects to exchange computers and newswire services give large firms involved in the game an unfair advantage. A recent ruling denied the release of University of Michigan’s Index of Consumer Sentiment indicators to certain traders (who paid extra) two seconds before the broadcast release, on the grounds that it was “insider information” giving advantage to those traders (see #85 Insider Trading).

Why You Should Care

If you’re a stock or other securities trader, it’s important to understand how the different trading platforms and markets work. If you’re not an active trader, it’s still good to be familiar with the forces behind today’s markets, and to be aware of how fast things can change, and why.

85. INSIDER TRADING

Suppose you wanted to buy into the corner ice cream store. It looks like a great investment, and the “fringe benefits” of being an owner seem appealing too. So the founder and majority owner offers to let you buy shares. You’re happy about your investment, and ready to cash in (and eat) the proceeds. Everything goes well; your investment rises in value, and you get a nice discount on two-scoop helpings of chocolate peanut butter ice cream besides. Eventually you need the money for something else, and sell for a reasonable profit.

Shortly afterward, you find out that a major operator of ice cream parlors wants to add that store to its chain, and is willing to pay a handsome price for it. Then, in a casual conversation with your neighbor across the fence, you find out that she bought a boatload of stock at a ridiculously low price because the founder/owner gave her a tip that this might happen. She got a tip; you didn’t. She bought; you sold. Is that fair? Should you, also an owner—and other owners—have been privy to the same news before you sold?