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The Ocean of the World’s Capital

Viewed from the moon


Ocean-of-Money_art (1)Market products and their purposes

The vast majority of the world’s total capital is held in these three products.

  1. Stocks
  2. Bonds
  3. Derivatives

(Real estate, for instance, by comparison, represents only around 3 % of the world’s capital.)

Purpose of the products.

The goal in this section is to define the purpose, to the end user, of each type of financial product.  Of course, all these products are traded.  And to traders, their purpose is just to make money.

But here we want to define the actual intended purpose of each product.

(Similarly, the purpose of houses is to live in, and of course as a store of value too…an investment.  But there are people who “flip,” houses.  They are house traders. )

Stocks

When most people think of “the market,” they think of stocks.  But stocks are the smallest of the three main pools of capital.

The purpose of publicly traded stocks is to allow the public to take an ownership stake in corporations.  That way, when the corporations grow in value, their investment appreciates.  And some companies also offer dividends.

From the point of view of the corporation, the initial public offering is used to raise money, by selling a portion of the company to the public.  Companies typically use the money they raise to consolidate their market position, through acquisitions, and ramping up production, marketing, etc.

Bonds

The total amount of the world’s capital held in bonds is 2-3 times the amount held in stocks.

Bonds come in two main flavors, corporate, and government.  The government type are further broken down by federal, state and municipal.

The function of bonds is to allow the public to act as a bank, to governments and corporations.  When you “buy” a bond, you are actually loaning money to the corporation, country, state or city.  In a normal world, traditionally, you are rewarded by some interest paid on the debt.

Although, in the increasingly bizarre modern world, sometimes people and others buy bonds with zero interest, or very low interest, with the idea that their money will shrink less in that form, than by holding cash, or some other asset.

The purpose of bonds for the issuer, of course, is another way to raise money.

Derivatives

This is a more complex topic.  The size of the derivatives market is not normally included in the total world net worth, or all the money in the world.

The notional value of the derivatives market is hard to estimate precisely, but it’s somewhere around 4-5 times bigger than all the actual assets in the world.

Derivatives is an interesting topic, worth more exploration.  But for now, let’s just outline the main types of derivatives, and their supposed purpose.

Tradable derivatives

There are two main types of derivatives that the public can trade on open exchanges, through their broker.

  1. Options
  2. Futures

Options

The purpose of options is usually seen as a form of insurance policy, for other assets in a portfolio, like stocks, commodities, etc.

For instance, a fund that owns a lot of Apple stock, might buy puts, that will pay off, if the stock goes down.  This is known as a “hedge.”  They pay a small premium, which is just an expense, if they stock does not go down.  So it is very much like an insurance policy.

Of course, others trade options, as if they were a commodity themselves.  And that is true of all asset classes.  But the point of this section is to define the actual purpose of the product.

Futures

A futures contract represents some quantity of an underlying product, barrels of oil, quantities of soy beans or corn, quantities of bonds, etc.  They are “derived” from various underlying commodities or asset classes.

Futures, like options, have expiration dates.  Futures are sort of like options on commodities, and other things.  They are an option to buy a specified quantity of the product, at a certain price.

The purpose of futures to the end user is to lock in a quantity of a product, at a certain price, in order to stabilize their costs.

For instance, if an airline or refinery wants a specified amount of oil, at a certain price, they can use futures to buy it.  Or if Nestle wants a certain amount of corn, each month, they can lock in prices for future months, to help stabilize their cost structure.

Forex

Is similar to futures, except used for trading the relative flow of currencies against one and other.

Over the counter derivatives

This is a class of product that is even harder to estimate and talk about.  And it’s largely irrelevant, to ordinary investors and traders.

These are derivatives like the mortgaged backed securities and credit default swaps, which became famous due to the 2008 housing crash.

But unless you are a fund with $100 million or more, or an investment bank, or other large type entity, interest in these is mainly academic.  You can’t trade them through your broker, or on the open market.

To learn more about this type of derivate, Michael Lewis’s Big Short is a great book, which is also a move.

This is an incredibly murky pool, the size of which has been roughly estimated at 2-3 times the value of the total world’s capital.

This is a relatively new class of “product,” only developed an grown over recent decades.

The purpose of this type of derivative, is to commoditize (make a product out of) things like loans a bank issues.

Loans, debt, to a bank, is an “asset,” a product.  Before this type of derivative, the bank was the end user of that product.

But this type of derivative added a new tier of end user.  It allowed banks, and large entities, to “trade” or invest in debt, like a commodity.


Market players

  1. End Users. This is the part discussed above, the actual users of the products.
  2. Traders are like merchants, or stores.  They buy and sell products, and try to make money on the transactions.

Traders

Traders provide “liquidity to the market.”  So that if the end user comes to the market, wanting to buy stocks, bonds, options, or whatever, there is some of that product available for sale.

Traders come in various sizes, and time frames.  Smaller traders try to make money from smaller price movements in products.  They try to buy low and sell high, and they might be buying and selling from and to bigger sized traders than them.

Traders can also be seen analogously to stores, and their suppliers.  A big trader is like Safeway or Wallmart.  A smaller trader might buy  products from local people, and sell them for a profit to a bigger trader, like Safeway.


2013-08-07_Geldwelle_Dollar_1500pxTotal size of the ocean of capital

World net worth

These #s are hard to gauge precisely, and are a moving target.  But it’s good to get an Applo type view of the size of the world’s capital, how it is distributed, and how it tends to flow.

Some links to estimates:
$241 trillion in one estimate, which is arguable, as of 2015

Total world of stocks $69 trillion

The total world of bonds  is about 3x the size of stocks, so approximately $180 trillion.

To give an idea of the fuzziness of money on this scale:

This article recites 2011 figures and has the ratio of stocks to bond at 1 to 2 instead of 1 to 3.

The main takeaway is that the bond market is much bigger than the stock market, and almost all of the world’s money is tied up between the two, stocks and bonds.

What is left over is a small pool of hard assets, owned without debt, such as precious metals, real estate, actual physical currency, and knick knacks (art, cars, jewels, etc.)

All the money in the world

So how much money is there in the world?  Those pesky diapers.  Depends. Somewhere between $80 trillion and $quadrillions.

http://www.marketwatch.com/story/this-is-how-much-money-exists-in-the-entire-world-in-one-chart-2015-12-18

A useful figure for stock and bond traders is: the total value of all stocks, bonds, is probably about $250-300 trillion as of mid 2016.

Derivatives as “dark matter”

As a derivatives trader myself (futures) and financial hobbyist, the nature of the derivatives market is interesting to me, both academically and practically.

Derivatives are sort of like “dark matter,” in the financial universe.  In some sense derivatives may represent $1 quadrillion, 4 times the size of all the stocks and bonds in the world.

But derivatives are not something one actually buys, or owns.  They are positions taken relative to one and other.

So as the underlying goes up or down, the leveraged derivative position gets more or less valuable, very quickly.

You need a certain amount of money in your account to hold a position in a derivative contract.  But you don’t really “own” anything.  (Unless of course you hold the product until it expires.  Then, in the case of 1 contract of oil, you take delivery of 1000 barrels of oil.  Or one options contract of Apple delivers 100 shares of Apple.)

So like dark matter, it’s bigger than all the regular matter (actual money, or stocks and bonds.)  And in some theoretical sense, it’s known to be there.  But in another way, it’s quite hard to measure, or put a finger on it.

Currents in the ocean

The main point of getting an overview of the ocean of the world’s capital, as a trader, or investor, is

  1. To get a general sense of the scale of the ocean (traders and investors are like financial mariners setting out on journeys on this sea)
  2. To get a feel for the weather and currents of the ocean, by knowing the general purpose and behavior of the main financial products.

For instance, bonds are seen as less risky than stocks (equities.)  Roughly speaking, traditionally, bonds and stocks are thought to move inversely to each other.  This is a current in the ocean of the world’s capital.

When the financial world is worried, it becomes risk averse, and theoretically, capital flows in to bonds, out of stocks, and therefore stock markets “should” go down, while bonds go up.

This is only the broadest way to talk about the currents in the ocean of the world’s capital.

Active traders and investors can learn about many, many smaller currents.  For instance, a strengthening dollar tends to correlate to weakening commodities.  Small cap companies tend to lead bigger companies in an uptrend, when appetite for risk is growing.

There are probably unlimited combinations and permutations among the world’s financial products, which create weather and currents in the ocean of world capital.

Learning to read these relationships and the currents they create is a useful, important, part of trading and investing.

But like the actual weather, the components are so complex and dynamic, that true “mastery” of the subject is probably like Zeno’s arrow.  We can get closer and closer to the target, but never quite reach it.

But from a functional perspective, with practice, we can probably get close enough, to help us make decisions, which, while not always right, over time, should be right often enough to become profitable.

 

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