Foundations · F1 · 7 min
The map of markets
Say what kind of risk a trade carries, who is on each side, where it trades, and how borrowed money magnifies losses.
In the news: Every story on the front page sits somewhere on this map: a government bond sale, an oil price move, a fund forced to sell.
The essentials
- Asset classes
- Families of similar risk: rates (government bonds), credit (company debt), equities (shares), FX (currencies) and commodities. What you buy decides which risk you carry.
- Primary and secondary markets
- In the an issuer sells new bonds or shares and receives the cash. After that, investors trade them with each other in the , where most trading happens.
- Buy side and sell side
- The (pension funds, insurers, fund managers, hedge funds) invests. The (banks) quotes prices, takes the other side of client trades and holds the risk until it can pass it on.
- Cash and derivatives
- A cash trade buys the asset itself. A is a contract whose value comes from something else, such as an agreement today on the price of oil delivered in three months. Futures, swaps and options are derivatives.
- Exchange and over the counter
- Standard contracts that many people trade, such as shares and futures, are listed on an exchange with public prices. Tailored deals, including most bonds, swaps and currency trades, are agreed directly with a bank: .
- Leverage
- Holding more assets than your own money pays for, by borrowing. At 20× , every 1% move in the assets is 20% of your capital, and a 5% fall wipes it out.
Leverage and the wipe-out move
L = E ÷ C; wipe-out move = C ÷ E = 1 ÷ L
- L
- leverage, as a multiple
- E
- exposure: the value of all positions held
- C
- capital: the investor’s own money at risk
How it works
1. Markets connect savers and borrowers
A financial market connects savers who have money to spare with borrowers who need it now. A saver with £100 they won’t need for a few years can lend it to a company building a factory, or buy a small slice of the business. The saver gets a return; the company gets cash today. Everything in this track builds on that swap.
2. Asset classes
What you buy decides the risk you carry. A government bond depends mainly on interest rates; a company’s bond also on whether the company pays; a share on the company’s profits; a currency on exchange rates; oil on supply and demand. Each family of similar risks is an asset class: rates, credit, equities (shares), FX (currencies) and commodities.
3. New securities and second-hand ones
When a company sells new bonds or shares, the buyers’ money goes to the company. That first sale happens in the . After that, investors trade the same securities with each other and the company receives nothing: that is the . Most trading on any day is secondary.
4. Who is on each side
Pension funds, insurers and fund managers invest money for the long term: they are the . Banks stand in the middle, quoting prices at which they will buy and sell, and holding the risk for a while until another client comes along: they are the .
5. Why clients trade
Clients come with one of four needs. An airline fixing the price of next winter’s fuel removes a risk it already has: it is hedging. A pension fund buying bonds for 20 years is investing. A company selling new bonds is raising money. A fund betting that interest rates will fall is speculating.
6. Cash or derivative
You can buy a barrel of oil today, or agree today a price for a barrel delivered in three months. The first is a cash trade: you own the thing itself. The second is a : a contract whose value comes from something else. Futures, swaps and options are all derivatives.
7. Exchange or over the counter
Standard contracts that many people trade, such as shares and futures, trade on an exchange, where prices are public. Everything else is agreed directly with a bank, by phone or on screen: that is . Most bonds, swaps and currency trades are dealt this way, because each one is a little different.
8. Leverage: bigger positions, bigger swings
Put up £10 of your own, borrow £90, and you control £100 of assets: that is 10× . A 1% rise earns £1, which is 10% of your money. A 10% fall loses all of it. The move that wipes you out is 1 ÷ leverage.
Worked example
A hedge fund has £20m of its own money and holds £400m of UK government bonds (gilts), paid for mostly with borrowed money. Their prices fall 3% in a week.
- Leverage = £400m ÷ £20m = 20×.
- Loss = 3% × £400m = £12m.
- As a share of the fund’s own money: £12m ÷ £20m = 60%.
- Wipe-out move = 1 ÷ 20 = 5%: a 5% fall would lose all £20m.
A £12m loss, 60% of the fund’s money, from a 3% move: at 20×, every 1% move in the assets is 20% of the fund.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Walk me through how a company’s new bond ends up in a pension fund.
Buy side or sell side to start a career, and why?
Why do some products trade on exchanges and others over the counter?
Remember
Wipe-out move = 1 ÷ leverage
At 20× leverage a 5% fall loses all the capital, which is why levered investors are forced to sell into falling markets.