Glossary of terms
Illiquidity describes when a trader is unable to trade an [instrument] in the market in a straightforward manner. The primary cause of illiquidity is a lack of demand for the instrument, this could mean that there is a lack of traders, and thus the selling trader has nobody to sell to; or it could mean that there is not enough volume demand and thus the selling trader cannot have their order [filled].
An instrument may have opened trading with [liquidity], but news events throughout the trading day can drive demand away from the market, leaving it in an illiquid status by the end of the day. If a trader is in possession of an illiquid instrument, they might have to suffer a loss in order to rid themselves of the instrument if they are uncertain when or if it will be able to recover from that status.
In an illiquid market born of a lack of buying and selling traders, there will often be a large discrepancy in the [asking] and [bid] prices of the instrument. This will lead to a much larger bid-ask spread than is normally found in liquid markets. Due to this lack of [market depth], holders of illiquid instruments will often suffer losses, especially if they are seeking to sell the instruments quickly.
In the case of illiquid stocks, they will often have a liquidity premium reflected in their price due to the fact that they may be harder to offload in the future. This is especially true in times of market uncertainty when the ratio of traders desiring to enter the market will usually be far outweighed by traders seeking to exit, and therefore, holders of illiquid assets will find it very hard to dispose of these at a good price, if at all.Key Takeaways
- An illiquid asset is a financial instrument that cannot easily be traded.
- Illiquidity is commonly caused by a lack of traders or a lack of volume demand for an instrument.
- Instruments may originally trade with liquidity but due to market and news events, may in the future become illiquid.
- Holders of illiquid stocks may have to dispose of these at a loss if they wish to dispose of them quickly.
The term “indices” is the plural of the word “index”, and in trading terms, an index is a way of tracking the performance of a group of [assets] by a standardised method.
Indices usually track and measure a basket of stocks and can either be a broad mix to capture the whole market or more specialised to track a specific market industry or segment.
Examples such as the S&P500, FTSE100, or Dax 50 track a broad selection of stocks traded on specific [stock exchanges]. Whereas, indices such as the Philadelphia Gold & Silver Index, NASDAQ Biotechnology Index, and PSE Mining & Oil Index, as their names suggest, follow and track baskets of stocks from specific industry sectors (or countries) and allow investors to be more selective in their investment strategy.
Indices are often used by investors as a benchmark to measure the performance of investment portfolios and often the returns from a portfolio will be measured against, as an example, the FTSE100’s performance(return) over a specific time period.
Each global index has its own specific method of calculating the hypothetical value, and this will be based on the weight that each stock, or bond, has in the index; and the relative price movements of each.
Investors cannot actually invest directly into an index and therefore various funds have been created that try to mimic the performance of these indices for investors, while traders can bet on fluctuations in the hypothetical value using instruments such as [CFDs], [ETFs] and [futures].Key Takeaways
- Indices are a way of tracking a basket of stocks, bonds, or various other financial instruments.
- There are thousands of indices listed around globally.
- Investors may use indices to measure the performance of investment portfolios against.
- Indices may track a wide range of stocks or be more market/sector specific and track a select number of stocks in a specific industry sector.
- Trades cannot trade indices directly, but can bet on price fluctuations using CFDs, ETFs, and futures.
Inflation is generally quoted in percentages and is the measure of the average price at which a select basket of goods and services in a country rises over a specific time period.
Inflation demonstrates the rise in prices in a country and therefore the reduced purchasing power of the country’s currency over that time period. The opposite of inflation is known as deflation, which is where prices are decreasing over the specified time period.Types of Inflation
The three major types of inflation are:Built-in Inflation
Built-in inflation is when future expectations become factored into pricing, for example, a workforce will demand higher wages to compensate for an increased cost of living, and therefore of the cost of goods or services provided by the workers’ employers increase so that the employer’s profit margins are protected.Demand-Pull Inflation
Demand-pull inflation occurs when the market demand for goods and services is greater than the ability to produce them, resulting in a demand-supply gap that is capitalised on by either the original supplier to the market or third-parties seeking to profiteer by re-introducing the volume they have procured back into the market at inflated prices.Cost-Push Inflation
Cost-push inflation is often exhibited when the cost of production increases. Good forecasting and financial planning would expect, and allow for, certain occurrences, and therefore many factors in cost-push inflation become built-in inflation.
However, in the food industry for example, an unexpected drought in a country key to the production of the world’s wheat supply, resulting in an unexpected shortage in supply to the market would likely lead to demand-pull inflation in the price of wheat. This price rise increases the cost of production of any product containing wheat and would likely result in a rise in the price of the final product to consumers.Controlling Inflation
Central Banks monitor their country’s inflation rate closely and try to control the inflation rate by utilising various monetary policies. These policies will aim to control the money supply within the country’s economy and therefore control the rate of inflation in an attempt to hit the Central Bank’s long-term inflation rate target.
Central Banks will aim to have a stable inflation rate as it will allow businesses in the economy to better prepare for the future as they will know what to expect in regards to many economic factors such as labour and production costs and likely future selling prices received for their products or services.Key Takeaways
- Inflation, in general terms, is the rate at which a basket of goods and services increases over time.
- There are three major types of inflation: built-in inflation, demand-supply inflation, and cost-push inflation.
- Central Banks aim to keep their country’s inflation rate stable and on target as this helps businesses to plan, contributing to a stronger economy.
- Central Banks use monetary policy in attempt to control the inflation rate.
Financial instruments are anything that can be used to complete a trade. These include, but are far from limited to, cash, [forex], commodities, [equities], [indices], and [ETFs].
The reason for the existence of such a vast range of financial instruments is that traders and brokers wish to have a variety of trading options at their disposal, with each one serving a unique purpose that can be utilised to render different outcomes.Types of Instruments
Financial instruments are largely categorised under one of two types: cash instruments and derivative instruments.Cash Instruments
Cash instruments refer to securities that are easily transferable and where the holder will often take possession of the underlying asset, for example, bonds, stocks, and shares are cash instruments.
Cash instruments can also be subcategorised into equity based and debt-based instruments. They can also be divided into either long term or short term.< b>Derivative Instruments
Derivative instruments are linked to stocks and shares, and commodities, but what is in fact being traded is their underlying valueand the holder will not actually take physical possession of the asset.Forex
As financial instruments, forex cannot easily be classified under the above categories. This is because depending on how you trade forex, it could fit into either category.
Spot forex trading does involve an actual transfer of the asset and would therefore make it a cash instrument. However, it is most commonly traded through CFDs, options and futures which only trade on the value of the asset derived from the spot market. Subsequently, trading forex through any of these instruments would be classified as derivatives.Key Takeaways
- There are a wide range of instruments available to be traded, each with their own specific utilities and considerations.
- Most instruments fit into two main categories: cash instruments and derivative instruments.
- Forex could be either a cash or derivative instrument, depending on how it is traded.
Interest rates are the rate at which a lender is prepared to charge for the use of a financial service. The interest rate charged is normally expressed as a yearly percentage amount and known as the Annual Percentage Rate or APR.
While interest rates are most commonly associated with cash related services such as loans, credit cards and overdrafts, they can also be applied to a variety of different asset classes, not solely cash. These may include goods, commodities, and large assets such as buildings.Types of Interest Rates
The three main interest rates are regulated by the central banks of a country, these are the nominal interest rate, the real interest rate, and the effective rate.Nominal Interest
The nominal interest rate is the rate at which interest on repayments are calculated.Real Interest Rate
The real interest rate subtracts the rate of inflation from the nominal interest rate, resulting in a more accurate view of the purchasing power of the interest being earned. This rate tends to be the rate of most interest to investors and lending parties.Effective Rate
The effective interest rate compares the annual interest rate with different compounding terms. For example, if two lenders both charged interest of 10% APR on their loan provision, but one compounded monthly, while the other compounded quarterly, this would result in different amounts of interest being paid in monetary terms. Monthly compounding results in higher values of interest than quarterly, quarterly more than semi-annually and so on.Who Decides Interest Rates?
Central banks set their country’s main interest rate as part of their monetary policy to help control other economic factors such as the country’s inflation rate, this is often referred to as the base rate.
Reference rates such as WIBOR, EURIBOR, and LIBOR are used as a standard to set other interest rates. LIBOR or The London Interbank Offered Rate is the most commonly used reference rate.
Lenders consider a wide range of factors to calculate their interest rates, these commonly include the level of interest in the market for a particular asset or facility, along with market competition, the debt to security ratio offered by the borrowing party, and the perceived risk of default on the part of the borrowing party, this is usually measured by a credit rating.Key Takeaways
- Interest rates are the rate at which a lender will charge for lending to the borrowing party.
- There are three main interest rate types, the nominal interest, the real interest rate, and the effective interest rate.
- Major base interest rates are set by the central bank of a country and are used as part of monetary policy to help shape the country’s economy.
- Reference rates are used as a benchmark to set other interest rates.
The worth of a [financial instrument]or asset is referred to as its intrinsic value. Intrinsic value is also sometimes referred to as the equilibrium price.
It is in the best interests of a trader to know the intrinsic value of an instrument so that they can assess whether it is currently being overvalued or undervalued by the market. This helps the trader to decide upon their possible [entry] and [exit] points and strategies.
There is no set recognised formula for calculating the intrinsic value of an asset. Analysts and traders will use a mix of qualitative, quantitative, and perceptual factors on which to build a model to arrive at the intrinsic value. This process is commonly referred to as [fundamental analysis]. Some analysts or traders may apply more weight to qualitative measures whilst others may favour a more quantitative approach.
Three key techniques that are used to determine intrinsic value are asset-based valuation, discounted cash flow analysis and analysis based on a financial metric. Discounted cash flow analysis, or DCF, is the most commonly used measurement method. While these are most commonly used for stock valuations, they can also be applied for calculating the values of stocks that make up indices.Key Takeaways
- Intrinsic value reflects the worth or value of a financial instrument or asset.
- Intrinsic value can help traders buy or sell instruments that may currently be undervalued or overvalued in the marketplace.
- There is no set formula used to arrive at the intrinsic value of an asset and analysts and traders will use various differently weighted methods to arrive at their own specific value.
- Qualitative, quantitative, and perceptual factors that will be taken into account when determining an asset’s intrinsic value in a process commonly referred to as fundamental analysis.