As I read about cash, stocks, bonds, derivatives, etc., I can't help but wonder why there are so many diverse financial products out there. Any pointers to axiomatic treatment that explains fundamental reasons for these securities and their equivalence would be super useful!
For example, money is any thing that serves as a medium of exchange, a measure of value, and a storage of value.
Why are there so many types of transportation mechanisms (cars, bikes, trains, planes)? Why doesn't everyone just drive a car? Obviously, they each have their benefits in certain situations, and meet different needs.
Bonds are a way for companies to raise money to grow (or survive) by borrowing it from people or companies that are willing to lend it. In return, those investors expect to get paid interest in return.
Stocks are a way for companies to raise money by selling part of the ownership of the company (the "equity") to investors. Since there is no guarantee of return, there is greater risk, but potentially greater reward.
Some investors may like the relative safety of bonds, but would like returns that are slightly higher, without taking the full risk of stocks. So hybrid instruments like convertible bonds, preferred stock, and other instruments were developed to bridge the gap and meet specific investor needs.
For commodities, futures, options, and other derivatives were created because consumers and producers of commodities needed a way to buy and sell their commodities without all the risk of price spikes, counterparties not being willing to pay, etc. Futures allow two counterparties to enter in a contract to buy or sell a commodity at a specific point in the future at an agreed-upon price. So a corn farmer in Iowa can set a price to sell his harvest before planting, and not have to worry about a price drop. Options also reduce risks but allow for some profit if prices move in the other direction. An airline can buy call options on gasoline, so that it can lock in a certain maximum price to pay, but if the price of gasoline drops, it can still buy at the lower price.
For similar reasons, there are financial instruments on interest rates, currency exchange rates, and more and more creative and complex derivatives. They are all designed to mitigate a specific risk, to take advantage of systematic flaws in financial markets, etc.
Certainly many of these are not used in their traditional sense anymore, but are used for speculation, or to meet investment risk/reward goals, but they do all exist for a reason.
In general, investments can be divided into fixed-income and equities and each has its own safety, return, as well as pros and cons.
Equities are stocks that trade on exchanges. Equities have higher risk but offer a potentially higher return on your money. They may be pooled in mutual funds or ETFs which diversifies the assets and spreads the risk across a number of stocks. Equity investments symbolize interest of ownership in a corporation.
Fixed-income includes corporate or government bonds and may also be pooled in bond ETFs or mutual funds. Bonds are solely a financial interest-earning investment. CDs and savings accounts are also considered to be fixed-income investments.
The main advantage to of fixed income is certainty. You'll know exactly how much money you'll have at the end of the investment period.
Preferred stocks are a hybrid of both but lean much more toward the fixed income side.
Your allocation in these categories should be based on your risk tolerance.
Derivatives are a separate entity unto themselves. They are more complex and require a higher level of financial literacy to employ properly.
Financial instruments tend to exist if they meet a need for hedging/speculation on uncertain, economically significant events/outcomes. The profusion of instruments can be viewed as approaching the ideal of a complete market, in which bets can be placed on every possible outcome that might matter to anyone, thereby theoretically maximizing the efficiency of risk allocations.
