Finance 101

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This is not a finance 101 class. In fact, finance 101 is rather boring. However, if you have a chance to take a finance class. I would highly suggest “Behavior Finance”. This course I took at Berkeley was excellent.

Anyway, in this post, I plan to discuss the financial industry in general, and some of the things I have learned.

INDUSTRY BREAKDOWN

First of all, within the financial industry, here is my breakdown into 4 categories.

  • Sell side (i.e. investment banks)
  • Buy side (institutions, hedge funds, etc.)
  • Proprietary trading (aka prop shops)
  • Credit rating agency ( S&P, Moody, etc)

Within the financial industry, you might hear a lot of people talking about the “Sell side”. What it means is that this part of the financial industry works in the creation and promotion of financial securities, whether it’s stocks, derivatives, bonds, structured products or any other financial instruments.

An example you might be familiar with is IPO stocks, usually a “Startup” company picks an investment bank for its IPO, investment bank then works with the company to issue stock shares and promotes the company to other market participants.

Another example is structured product, such as “Range Accural” that an investment bank sells to its clients. There are many structured products that investment banks create that many clients have interested in.

Furthermore, the sell side also provide its own research to the clients, aka its own analysis and insight into the financial instruments they sell, and try to get the highest price for them. Whether or not the clients believe the sell side research is another different story.

To summarize, the business of sell side is to provide great service, it must be good at marketing.


All the “clients” of sell side are essentially the “buy-side”. They are consist of institutions, hedge funds, mutual funds, etc. The main purpose of the buy side is to generate profit from their financial instrument they trade.

See the “Players” section below for detailed information about the buy-side.


Proprietary trading firms differ from “buy-side” in that they use their own money to trade. This means they have no clients, aka no outside investors. Chicago is the largest hub for prop. trading firms.


Credit rating agency or Rating agency for short, are companies that assign credit ratings on debt instruments issued by debtors. The agencies rate the debtors’ ability to pay back debt.

The biggest 3 rating agencies in the U.S. are Standard & Poors (S&P), Moody’s and Fitch. S&P and Moody are the 2 leading agencies.

Ratings usually have a quantitative component and a qualitative component. More importantly, ratings are not meant to be 100% correct all the time. During the financial crisis of 2007 – 2008, these agencies gave high ratings for junk debts.

PLAYERS

Now we understand the financial industry breakdown, the more interesting part of the industry is on the “buy-side” for most people.

Anyone does stock investments, forex, etc. can consider themselves on the buy-side as well except they are not so-called “professional” money manger.

Let’s first consider the main differences between for the buy-side:

 Players  Can Trade Time Horizon
Hedge funds Long/Short Anything
Institutions Long Only  Rebalance every 3/6 months
Mutual funds Long Only  Rebalance every 1/3/ months
You Long/Short  Anything

Let’s consider the stock market.

1, Institutions and Mutual funds can only “buy” (aka long) stocks. Hedge funds can “buy” stocks as well as “short sell” stocks.

2, Institutions and Mutual funds usually rebalance their portfolio every now and then. Hedge funds can do whatever they want, i.e. buy stock A now at 10am, then sell the stock 1 second later.

3, It’s true that you can operate like a hedge fund. However, in reality, most likely you won’t be operated as a hedge fund. One, you likely won’t short stocks. Second, you likely won’t trade like a high-frequency firm where buy and sell can be in the units of microseconds.

Understanding the market participants/players is very important for you to be consistently be profitable as a stock trader. I discuss it in another post – How to Make $$.

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