The Economist Guide To Financial Markets: Why they exist and how they work

A review and Summary

I picked up the seventh edition of this book recently because it showed up on the new shelf at Mountain View Library, and I found the assertion on the back that “history is littered with disasters that occurred because firms and individual investors purchased financial instruments they didn’t properly grasp.” Having been looking for the best ways to invest my money over the past several months, I felt that this would be a good book to read.

Despite the cute cover, the book very much feels like a textbook. However, I have no problem asserting that this book taught me much more than both my micro and macroeconomics classes in school (all I remember from those is the annoying supply and demand curves and shifting them around. Really? Is this how people model economic changes?). It’s very dense. I averaged, based on my notes, about 15-20 pages per hour, for a 16 hour read!

Chapter 1: Why markets matter

Nothing too interesting here.

I read chapter 3 before chapter 2.

Chapter 3: Money markets

  • There is a lot of trust in this book put into clearing houses and exchanges to ensure that investors receive their money. The problem

  • There is a claim that real-time settlement reduces the risk of a financial institution not being able to service its clients (I believe this is “Ersatz Risk”). It is not immediately clear to me why this is true. Rather, it seems that real-time settlement makes your bank less likely to run out of necessary funds because you get funds more quickly. Some other bank, meanwhile, which did not take the time to speed up settlement times, meanwhile, may end up paying the penalty. So my impression is that this reduces risks locally, but not necessarily globally.

  • Discount rate == base rate == marginal lending == Bank of Canada rate, everyone!

  • Funnily enough, the equivalent of the US Federal Reserve in Canda is called the “Bank of Canada”. I feel like this is a bad name, especially when you consider that there is a financial instution named Royal Bank of Canada. Then again, we do have Bank of America in the USA.

  • A basis point is one hundredth of a percentage point. In case anyone was wondering (I was).

  • Call rate is the same thing as the rate of return on an overnight loan.

  • What company can successfully make use of an overnight loan? It seems like too little time to make that money into more money. What is comedic is that the author initially says that overnight loans are viewed as less risky by investors than 3-month loans, but then later says that corporations often pay off overnight loans with new overnight loans, essentially bootstrapping their own 3-month loans, presumably with the same amount of risk to investors :P

  • ECB is the European Central Bank, whatever that is.

Chapter 2: Foreign-exchange markets

The only useful exchange rate is the floating exchange rate, because

  • Apparently investors in currency markets “overshoot” when new financial news comes out. I wonder if this is because of biases in algorithmic trading (something like NLP bots not being able to estimate the importance of some news), or just human nature. You could presumably tell by looking at the trades of investors that are asleep when certain news hits, if individual investors’ trades are public.

  • All exchange rates are bad other than floating exchange rates, because they open you up to losing all of your foreign funds, or using your interest rates solely to maintain favorable trade conditions, at the expense of messing with your domestic business’s abilities to get loans.

  • Interestingly, government “interventions”, where large sums of a foreign currency are purchased are done in secret, but presumably you’d be able to see the results of this in the financial markets, somehow. Would be fun to do a time-series Bayesian model to ask the question: Assuming that a government intervened, based on the current exchange rate of that government’s currency, what is the most likely day that it happened?

Chapter 4: Bond markets

  • I appreciate how it takes until chapter 4 to discuss the difference between real and nominal interest rates.

  • Apparently, good proxies for inflation are employment rates, wages, industrial capacity utilization, and prices of commodities. I am curious if there is a realistic way to understand whether factories are being used at capacity.

  • The common assumption is that the price of bonds should reflect the risk that the debtor will not repay you and the discounted total value of the entity taking the loan.

  • Repurchase agreements are a popular way to do bond financing, but it is not explained why. Or maybe Ijust did not understand.

  • Something I’m not clear about: Can any bond be repaid before its due date?

  • Wall Street finance boys have interesting names. Bonds which have gone bad are “fallen angels”, and foreign bonds go under names like “yankee bonds”, “kiwi bonds”, and “dimsum bonds”. Wow.

Chapter 5: Securitisation

  • Mortagage-backed bonds! Yay! I learned about these back when I read The Big Short!

  • The distinction between home-equity loans and mortgage-backed bonds were not made clear to me.

  • Why would anyone bother to invest in a security where no one is going to guarantee tht funds are returned? Especially when it’s a security like student loans or credit card debt. Really???

  • What are thrift institutions?

Chapter 6: International fixed-income markets

  • Probably one of the most interesting chapters in this book! It highlights the historical perspective that this book takes regarding the various markets which it discusses.

  • The “D-mark” is the currency ofGermany before it adopted the euro, in case you were confused like me.

  • Eurodollars are United States Dollars held in Europe, not another name fo euros!

  • The Bretton Woods Fixed Rate Exchange (post-WW2) and the Interest Equalization Tax in the USA created an unnatural situation where companies sought investment from investors in countries outside of the USA. The unnaturalness of this situation is reflected by the fact that these investments are no longer popular in recent years.

  • A big assumption throughout this book is that companies are always seeking more funds, and investors are always seeking higher interest rates, even if there is more risk. Somehow, I question this. Isn’t there a point where companies saturate their market? Will the economy continue to grow at around 6% annually into the future? Big scary questions.

  • There is a section in this chapter which says “sold debt”. I found this hilarious for whatever reason.

  • Swap securities are introduced for the first time! More to come in the final chapter!

  • Bourse is a fancy word for “exchange”, I think.

Chapter 7: Equity Markets

  • Hooray, stocks!

  • EBITDA is the least game-able definition of profit.

  • Inclusion of a stock in an index makes it more valuable, which I find hilarious, given that it basically makes indexes biased estimators of whatever they are trying to track.

  • Beta is the volatility in a stock price. Despite (apparently) being a commonly discussed term, it has multiple ways of being measured! Isn’t that nice?

Chapter 8: Futures and options markets

  • Leverage is the ability to

  • I like how there are blog posts online that talk about leverage like it is a good thing for an individual investor.

  • Black-Scholes equation predicts the likelihood that an option will be exercised

  • Options may be useful for large investors, but because option contracts are sold in large quantities (e.g., for 100 stocks), they don’t seem useful to individual investors.

  • The claim is made that speculators are necessary for options exchanges to work effectively. Presumably, speculators do better than breaking even because non-speculators consider an unexercised option or future to be useful (because that instrument acted as insurance).

  • Silicon is a commodity too!

  • The Chicago Mercantile Exchange has temperature futures (P.218), whatever that means. Is this a way that scientists can make bets on what the temperature will be at a given time in the future?

  • In general, who services after-market traders?

  • Who issues carbon dioxide and sulfur dioxide futures? Governments? How do they decide how many too issue? Very cool!

Chapter 9: Derivatives Markets

  • Derivatives are hard to value.

  • If you don’t understand, don’t play.

  • If you do play with these, prefer linear terms in your equations, not quadratic terms. Don’t be one of the public companies which embarrassed themselves.

I wonder what accounting majors learn.