SOS finance: basic concepts to understand the market

Let us begin with some data. It has been reported by Italian newspaper “La Repubblica” (https://goo.gl/X2ApKJ) that Italians, when compared to other Europeans, are amongst those who know the least about the financial sector.

Even though we are in Europe and our world is all about finance, although TV news report on money, markets and taxes on a daily basis, we are still some of those who most of all struggle understanding such matters. We have recently treated the Stock Exchange, outlining their main characteristics. We will now try and enlarge our financial discussion, including Law of Supply and Demand, Monopoly, Oligopoly and, finally, Shares and Bonds.

 

Supply and Demand

This is the basic principle of the free market system and it enables the definition of prices. However, it is important to highlight the difference between price and value, first. If I had 10 apples, 10 customers and if I sold each apple at 1€, each customer would have their own apple, I would have 10€ and the apple’s value would correspond to its price.

Instead, what if I had only one apple and the number of customers remained unchanged? In this case, the apple’s price (not its value) would raise because there would be many people wanting something that is hardly available. If I had 50 apples and only 10 customers, the apple’s price would decrease (then again, its value being unchanged). If this is yet not clear, think of how much someone would dispose to pay for a sandwich, after fasting for three days and, on the other hand, after a satisfying dinner. In the first case, one would be willing to spend much more.

Monopoly and Oligopoly

Monopoly is a particular form of market, in which there is only one seller to offer a product or a service. Some examples are the alcohol and tobacco businesses. Oligopoly is another form of market, where only a few companies are the suppliers. A particular kind of oligopoly is the duopoly, where only two companies have the market’s control.

Shares and Bonds

Before getting into the meaning of these two words, it is important to introduce the concept of risk. In a really basic way, we can associate risk to rating (e.g. AAA). Shares and bonds represent a typology of investments, and as such, who decides to invest their own capital, expects a remuneration, even if there is always a risk associated to it.

There are no investments without risk, hence it is important to be aware of it. For example, shares that issue high interests can usually represent a warning bell: my condition is not wealthy, I am thus appealing to investors who expect higher interests due to the risk investing on me represents, though my chances of refunding are limited. Vice versa, lower interest rates are usually a good indicator for those who issue shares. With that on the way, shares correspond to a fraction of the whole company, and represent the value of an investment and its evolution in time.

Small shareholders can either keep their shares, waiting for an eventual distribution of profits, or they can sell them at a higher price than the one they paid for them (if the market allows for it). Typically, shares represent more risk than bonds, but this is not a rule. A bond is an actual promise of payment and it is normally used to “make money”, that is, to immediately receive a certain amount of money and to promise a reimbursement with interests after a pre-determined period of time. Shareholders need to review their shares or to wait for profits in order to have their capital paid back, whereas bonds ensure the capital is refunded within a certain deadline (it is also possible to sell them).

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Alessio Colella

Born in Turin in 1994. Student of management engineering, I love writing about everything around me.