Financial Markets and Trading Anaylsis

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Introduction: Interest, spending, inflation, shares and indexes

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Interest rates are the cost of borrowing, or “the price of money”.

High interest rates > encourage saving.
Low interest rates > encourage spending.

More people saving and fewer spending slows the economy.
More people spending and fewer saving speeds up the economy.

Inflation is the rate of increase in the general price level, so a 10% inflation rate means prices overall are 10% higher than a year ago.

High inflation > money worth less.
Low inflation > money worth more.

Relationship between interest rates and inflation
High interest rates > borrowing is reduced, money becomes more expensive, therefore people have less of it and spend less. With a reduced demand for services and products, prices decrease.

Low interest rates > borrowing is increased, money becomes cheaper, therefore people have more of it and spend more. With an increased demand for services and products, prices increase.

In conclusion
Increase interest rates > Decrease inflation.
Decrease interest rate > Increase inflation.

Excessive economic growth can lead to high inflation, because people spend more and there is high demand, prices increase and the general cost of goods is higher (inflation).

Increase in savings also causes “leakage” from the economy since money is not being put back into the economy.

Interest rates normally have to be equal to or greater than inflation, otherwise money sitting in a savings account would actually decrease in value!

Interest rates are used to keep growth broadly in line with its long-run trend of 2.5% or so each year.

A share is simply a divided-up unit of the value of a company. If a company is worth £100 million, and there are 50 million shares in issue, then each share is worth £2 (usually listed as 200p in the money pages.) As the overall value of the company fluctuates so does the share price.

Shares can, and do, go up and down in value for various reasons. However, such movements are not usually for the most obvious of reasons.
It would be very simple if a share were priced solely on what the company in question owned - its buildings, cars, computers, value of contracts in the pipeline etc.

The total value minus company borrowings would be divided by the number of shares in issue and there would be the value of each individual share. But there is a fly in the ointment called "sentiment".

Strictly speaking ‘stocks’ refer to ‘shares’ across multiple companies. However many people use ‘shares’ when referring to shares cross multiple companies.

Why market sentiment matters
In general, share prices rise on the expectation (rather than the publication) of increased future profits and fall on published facts.

If this sounds entirely mad, bear in mind that if an analyst predicts that ABC company will double its profits then the price will rise at the time of the prediction. When the results come through, revealing that profits have gone up "only" 75%, the price will probably fall because the current facts are less exciting than the earlier prediction.

Understanding this apparent nonsense is key to appreciating the behaviour of markets in general, and individual shares in particular.

Dividends & Why companies want to please shareholders
Professional investors buy shares in the hope of benefiting from a rising stream of income over the long term.

When profits are distributed to the shareholders the payments are known as "dividends". The capital value of a share - its quoted price - moves mostly in line with expectations of long term dividend payment.

There are myriad reasons why the expectation may become better or worse. A reduction in alcohol duty would guarantee a rise in distilling companies making whisky. An increase in VAT would hit retailers. More technically, a positive or negative assessment of a company's management ability could change investor sentiment enormously.

So why do companies go through all this daily public examination and give shareholders votes to - in extremis - remove directors from their positions of power?
The simple answer is that "floating" - selling shares in their companies to anonymous investors - raises millions of pounds to allow those same companies to expand into bigger and hopefully better businesses. Companies and shareholders alike have a responsibility to each other.

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders.[1] When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

Markets bring together buyers and sellers (traders). A typically there are 3 types of markets:
1. Product markets
2. Service markets
3. Financial markets

A market does not have to be a physical or geographical place and goods traded do not have to be physical. We focus on financial markets. There are 2 basic needs in a financial market:

1. Invest excess money (supply)
2. Borrow money (demand)

The cost of borrowing or the money made on lending is determined by the interest rate. But it is not as simple as this:

An institution wants to invest a certain sum of money, for a certain time, giving them a certain yield.
Another institution wants to borrow a certain amount of money for a period at the lowest cost possible.

Problem: The lender’s and the borrower’s demands might differ.
Solution: An intermediary would be used to match the different needs.

An example would be:
Eskom needs £100 million for a period of at least 10 years to erect new power lines
SCMB has £50 million it wants to invest for 7 years
Investec has £50 million it wants to invest for 12 years.

An intermediary would seek to manage these requirements so the lending and borrowing can take place. A certificate would be issued to the lender giving him the right to the interest payments and the redemption amount at expiry of the loan (this type of transaction is known as a security). The following pieces of information are always required for securities:
the amount of the loan or investment
the interest paid and received thereon
the term to redemption of the loan.

A certificate is issued stating the above terms. A certificate in this context is a financial instrument, this specific type of financial instrument is known as a security. These pieces of information are so common, they are incorporated into financial instruments.
Instruments (certificates) issued by the ultimate borrower are called primary securities.
Instruments issued by intermediaries on behalf of the ultimate borrower are called indirect securities.

In finance, a portfolio is a collection of investments held by an institution or an individual.

Stock market
A stock market is a place where shares in companies can be bought and sold (traded). Stock markets are not physical entities. Stock markets list both stocks (shares) and securities. Stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization which specialise in bringing buyers and sellers to a listing of stocks and securities together.

There are many stock markets including: New York Stock Exchange in America and the London Stock Exchange in the UK.

Market indexes
Taking the London Stock Exchange as an example: there are many companies listed from which to buy and sell shares in. An index represents how a predefined list of companies perform in the stock market. Have their shares gone up or down?

For example, there could be an index of 4 companies and the index called “Top-Four-Index”. If all 4 companies see the price of their shares rise by 2%, then the index value of Top-Four-Index will increase by 2%. The absolute value of the index is unimportant. It is more important to see the relative value from one day to the next.

A real index is the FTSE-100. It is a share index of the 100 most highly capitalised UK companies listed on the London Stock Exchange.

What are market indexes used for?
It an individual invests in stocks, perhaps trading shares in companies listed in the London Stock Exchange, then it is useful to compare the performance of the individuals shares with that of an index.

If the individual is always buying shares which subsequently drop in price, therefore losing them money, it is useful to see if the FTSE-100 is down or up.

If the FTSE is up, then one could assume an individual should be able to sell shares for a profit and make money. If the individual is losing money, then they should reconsider their chosen companies, since they are losing money while share price is going up (for comapnies listed in the index).

If the FTSE is down, then the individual may feel their loss is just market trend and they should not change their investments too quickly.


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