Differences between Liquidity and Solvency Problems - Assignment Example

?Assignments A) Differences between liquidity and Solvency problems: When economic bodies borrow they have contractual obligations to repay in the future period. But if the borrower has liquidity constraint to meet the contractual obligations the debt problem occurs. In an organization the ability to repay the contractual obligations can be accessed through the Balance sheet, which is a statement of Assets and Liabilities of the firm as on a particular date. The Balance Sheet clearly shows the liquidity of the intermediary firm to meet its obligations. A firm with more contractual obligations i.e debt but insufficient cash or marketable securities to repay the debt definitely faces liquidity problems. The circumstances turn grimmer with more and more liquidity crisis in the organization when the firm becomes completely unable to repay its obligations, thus the firm in such situations become insolvent or faces solvency problems. Thus with more amount of liquidity crisis with not much fresh cash or marketable securities in the system, the firm tends to borrow more from the banks and financial institutions thereby increasing its obligations of repayment more. But with high debt to equity ratio sometimes it becomes difficult for organizations to obtain debt from the financial institutions. This definitely hampers the operational activities of the organization. In such a situation with deep crisis of liquid cash to carry out business and with difficulty in getting loans from the banks, the sustainability of the firm in the long run gets hampered. In certain cases the firm becomes insolvent and may go out of business. (Burnside, 2005, pp.87-90; Course material, pp.112-118) Different approaches to Financial Asset Valuation: One of the major approaches designed in the financial valuation process includes valuation of Equity. The major forms of equity valuation include- 1) Dividend discount modeling- Under this method of valuation, the valuation of the firm is determined by the dividends paid out by the firm. Using the projected growth rate in dividends in the next 5 years with an estimated growth rate and then using a constant growth rate for the rest of the years, discounted by the required rate of return by the shareholders’ the valuation of the firm is determined. 2) 2) The free cash flow modeling approach- The valuation method is performed using the free cash flow. The free cash flow is the cash flow available to the firm after meeting the necessary capital expenditures and necessary short-term working capital requirements. In this method also, the valuation is performed using the projected free cash flow in the next 5 years using a projected growth rate and then a constant rate for the rest of years after the 5-year period, discounted by the required return for the shareholders. 3) 3) Price earning model- This equity valuation method is a market based method which calls for the market price an investor wants to pay for 1 rupee earning by the company. Higher Price-Earnings ratio designates that the company is overvalued in terms of its market compared to its earnings. Besides equity valuation, we have valuation for fixed income securities like bonds. Bonds, which have fixed coupon rate attached to them, pay fixed interest every year. The fair value of the bond is calculated by the annuity approach which is calculated by the summation of the net present value of the fixed coupon interest over the maturity of the bond with a discount rate as required by the bond holders. (Pinto, Henry, Robinson & Stowe, 2010, p.1) 1B)  On the Capital and Liability side of the Balance sheet of different organizations, the different types of capital and liabilities have different features. These are categorized under the major head ‘Financial capital’. The different classifications include the following: 1) Senior debt, 2) Mezzanine debt, 3) Subordinate debt, 4) Preferred Stock and 5) Common Stock. In case a company goes bankrupt, the company has to first pay back its obligations to the debt holders and finally to the equity holders. During the time of the recent financial crisis a vast number of organizations suffered deep and severe liquidity crunch, which led to the closure of many organizations as a result. Thus as the organization goes bankrupt, the court would oversee the appointment of a liquidator who takes part in selling all the assets of the company for the best negotiated price converting the illiquid assets into cash (liquid). Whatever the amount is generated from the selling, it is being allocated to the liability holder according to the seniority in the capital structure. So as per the seniority, cash would first be paid to the senior debt, which includes any interest due and the principle. After making the payment cash would then be paid to mezzanine debt, which also includes the interest and the principle and accordingly paid to each in the subordination level. After paying all obligations, if cash is left it is paid to the equity shareholders receiving as the residual holders in the company. Obviously the company officials don’t prefer more liabilities at the highest level and more equity shareholders reflect less risk in times of company winding up as there is no obligation to pay to the common stock holders. (Course material, p. 127) 1C) The shadow banking system is basically involved in maturity mismatching (transformation). In the mechanism short-term maturity fund is borrowed to lend to the long-term maturity. Thus there is a huge risk of liquidity and the credit supply. The Shadow banking system incorporates derivatives such as “futures, options, swaps, repurchase agreements, securitization of loans in mortgage, corporate and household sectors” (Green, 2011, p.241). This system has triggered collapse in the financial system in the 2008 crisis period. Actually, banks and other financial organizations in USA and also major parts of Switzerland and Ireland had issued bonds thereby raising funds from the public. This fund had been invested in several derivative instruments like Collateralized debt Obligations and in other complex derivative products and these are backed by collaterals. But with the fall in value of the collaterals due to the default by the subprime borrowers during the crisis of 2008, the value of the investments also fell causing a major liquidity crisis in the system. This caused huge liquidity problems in the banks and financial institutions and in several cases they were unable to redeem the bonds as these institutions went bankrupt. This triggered major collapse in 2008. (Green, 2011, pp.241-243; Course Material, pp.78-82) 1D) In many cases Conflicts arise due to banks allocating a huge amount of capital to provide for the risk of unexpected losses thereby covering the depositors. But this has another implication. Although a high capital adequacy ratio is desirable for banks to provide for any credit risk but this reduces the capital base the banks may use for the purpose of its operational activities. In normal cases banks invest the funds being deposited by the depositors in different money market instruments, equity funds, bonds, derivative instruments etc. Investment in these instruments appears to be very risky as there is a major risk of reduction in market value of the investments. This creates risk for the depositors’ fund. Hence banks should provide enough cover to protect the depositors. But sometimes providing enough capital as cover causes a major impediment for the banks to grow and generate more profit from its operations. (Course Material, pp.72-78) 2.A) The price discovery mechanism of a security in a market takes place basically though the trade-off between demand and supply of the security in the market. The intersection point of the demand, which is a downward sloping curve and the supply, which is upwardly sloping, gives the price of the security. If the demand increases without change in supply, there is a rightward shift in the demand line and the new intersection point of the new demand line with the supply gives the new price, which is above the previous price. This shows that price adjusts automatically with change in demand and supply. In order to explain the price discovery mechanism and the transparency of the flow of order among the market participants, the market clearing mechanism is divided into quote driven and order driven. In Quote driven mechanism, the dealers quote the price before submission of the orders. Such a system is found in NASDAQ. In the order driven mechanism the prices are set after the orders are submitted.  An order driven system is a continuous auction process where the traders give the orders such that the dealers immediately execute it on the floor. A difference that exists in various trading mechanisms is in the degree of transparency as traders in the quote driven system generally have more trade information than the other trading mechanisms. (Hara, 2007, pp.252-253; Course Material, pp.135-143) 2 B) Dark liquidity pools are trading mechanisms, which tally anonymously with big and small orders. In Europe, these are broadly divided into two categories: 1) Crossing Networks: It includes dark pools operated by broker-dealers or investment banks and 2) Dark pools which function as Multilateral trading Facilities (MTF). In Crossing Networks there is no compulsion on compliance with the protocols such as treating investors at par, fair access to trading platforms and market surveillance. But dark pools functioning as MTF follow proper protocols but some pre-trade transparency waivers permitted under MiFID Level 2 regulation benefit them. But investment firms executing the order for their clients need to analyze whether executing orders under dark pools comply with order-handling and best execution obligation of the subjective order. Thus compliance of the prescribed rules under the MiFID Level 2 regulation makes dark pool orders more investor friendly with lower risk in the trading system. (Boskovic, Cerruti & Noel, 2010, pp.8-9; Course material, p.157) 2.C  Dark pools are basically trading mechanisms where no prior information is available regarding the bids and offers and also regarding the volume of trade at these levels. This helps the market participants to provide them with a cushion against adverse market fluctuations like in major price upsurge, information about a previously executed buy order is not revealed in the market. This helps the intermediaries to make better trade execution. It is worthy that after the trade activities take place all trade related information like the volume, price etc is published. The dark pools operating under the MTF function with pre-trade transparency. Dark pools operating under MTF still account for 10% of trading on these platforms, which is still pretty, less in proportion. However increasing the threshold to 40% will help boosting large orders to get executed without any adverse impact on them on account of market fluctuation. (Directorate- General For Internal Policies, 2010, p.11) 3A) The fiscal and monetary policy is controlled by the Government. The fiscal policy basically denotes the Government expenditures and subsidies thus helping to boost demand for the workers and reduction in the unemployment scenario. On the other hand the Government generates revenue through the tax collections mechanism. On the other hand in monetary policy, the Government engages in controlling the supply of money in the economy. When there is a need to boost the economy, the Government engages in Quantitative easing policy thereby enhancing the flow of money in the economy and to fight against tight inflationary conditions, the Government sucks money out of the system to reduce liquidity known as Quantitative tightening. The Asset bubble is observed in a highly developing economy. This is in adversity to the growing economy. Actually in a growing economy there is a huge flow of money in the system. With fall in real interest rate, the cost of capital also decreases. This drives the firms to obtain for more credit at a cheaper premium thus promoting growth. During the phase of growing economy, the Government also frames policies thus boosting huge foreign investment in the country and there is also increase in cross border trade activities across nations. With increase in FII inflows, the home currency appreciates resulting in high inflation and asset price bubble. This promotes the Government to buy foreign currency thus helping depreciation of the home currency controlling inflation and bubble. Moreover with high liquidity in the system, the consumer spending also increases, as there is more money in the hands of people. This boosts huge demand with increased consumer spending. Thus increased demand leads to increasing price of assets as the supply doesn’t increase much to negate the rising demand. This creates asset bubble in the system when the market price goes skyrocketing and it grows exponentially leading to a considerable difference with the fair value of the asset price. This boosts more investment and thus increases the aggregate demand and higher potential future output. But the bursting of bubble will result in reverse direction of financial accelerator. Thus when there is asset price bubble leading to high inflation, the Government should suck the surplus liquidity in the system but should do a trade-off by not compromising the growth. (Hunter, 2005, pp.428-429; Course Material, pp.241-242) 3  B)  The bursting of the bubble formed in the real estate sector affected the normal households sector as it caused a severe jolt for them to service their mortgages. Thus the banks and the financial institutions that provided mortgage loans to these households got affected severely and this severely affected the Balance Sheet of financial organizations, thus resulting in banking crisis. This caused the stock market to crash causing erosion of wealth thereby affecting the final demand and this caused deterioration in the asset side of the balance Sheet of the financial and non-financial sectors. This led the Government to intervene in the system injecting fresh capital to boost up the organizations thereby leading to enough cash erosion for the Government. This initiated the sovereign debt crisis. As a result there was erosion of value of the Government bonds, which were tagged, risky and thereby the financial organizations holding these bonds got a severe jolt in the asset side of the balance sheet and this initiated liquidity problems. Correspondingly this turmoil also weakened the balance sheet of the central bank thereby transmitting the concern to the currency market also causing depreciation in the currency rate under a flexible exchange rate system. Moreover, the Balance sheet of the non-financial sector also gets affected directly in the process of refinancing the public debt, by the erosion in the value of the Government bonds and by the measures initiated to restore a balanced budget mechanism. The adjustments will be in place until there is equilibrium in the system and until steps are initiated to repair the mismatches between the various balance sheets. (Kolb, 2011, pp. 386-388; Course material, pp.131-133)   Bibliography: Kolb, R W., 2011, Sovereign Debt, John Wiley and Sons. Hunter W C., 2005, Asset Price Bubbles: The implications for Monetary, Regulatory, and International Policies. MIT Press Directorate General For Internal Policies, 2010, Trading in Financial Instruments- Dark Pools, EUROPARL, Available at: http://www.europarl.europa.eu/document/activities/cont/201103/20110324ATT16424/20110324ATT16424EN.pdf. (Accessed on May 24, 2011) Boskovic, T., Cerruti, C. & M. Noel, 2010, Comparing European and U.S. securities regulations, World Bank Publications Hara, M O., 2007, Market microstructure theory, Wiley-Blackwell Green, C J., 2011, Financial Crisis and the Regulation of Finance. Edward Elgar Publishing. Pinto, J E., Henry, E., Robinson, T R. & J D. Stowe, 2010, Equity Asset Valuation, John Wiley and Sons Burnside, C., 2005, Fiscal sustainability in theory and practice, World Bank Publications Course Material Read More