Financial Markets and Institutions - Essay Example

The derivative market can be further sub-divided into the OTC (over the counter) market and the exchange traded derivatives market. While the former is more customized and offers tailor made innovative instruments in the later all transactions take place via exchange. The OTC market transactions are done mainly by the investment banks that heir traders or agents to market derivative instruments to clients. Some instruments of OTC market include forward contract, swaps (interest rates and currency), credit derivatives, and hedge funds.

The derivative market transactions in US are mostly dominated by large multinational financial institutions. The global economic importance of derivatives market is that they are important instrument for determining current and future prices of underlying asset. In addition, a derivatives market also helps to reduce the risk of transaction by bringing certainty in to expected cash flows. The derivatives market encourages speculative trading and arbitrage. A derivatives instrument reduces transaction costs and also offers liquidity of the instrument in market (Parsons, 2013, pp.2-6). Factors Affecting Interest Rates Interest rates are amount payable by the borrower to the lender for using capital for certain amount of time.

They are also referred to as financial cost of borrowings. Generally the federal bank or the central bank of a country determines the rate of interest on borrowing. Interest rates are determined primarily from the forces of supply and demand. Inflation plays a very important role for determining the interest rates since almost every lender expects to be compensated after considering the purchasing power of money. Thus, the rate of interest is also driven by the market trends and corresponds to changes in inflation levels.

The credit of the borrower is also taken into consideration while determining the interest rates. For instance, entities with good credit ratings are able to enjoy debt at cheaper rates compared to entities with bad credit ratings. This is mainly because the entities with poor credit rating have more chances of defaulting both in terms of regular fixed interest payments as well as the principal. Another important factor that determines the rate of interest is the duration of debt. Generally, the short term rates are less costly since predicting risk factors and inflation levels are more accurate for shorter time frame.

However, the same is not true for long term rates since the future is uncertain and only expected or probabilistic returns are possible. Forecasting of Interest Rates Changes Forecasting the changes in interest rates is an important factor for determining the bond prices. When the interest rates are expected to appreciate in future, the objective of the investor should be to hold bonds with shorter maturity and not to hold long term bonds so as to minimize losses. Conversely, when the interest rates are expected to decline in future, it is an opportunity for the investors to invest in good credit bonds.

Hence, interest rates directly influence the market value of debt instruments including bonds, money market securities, mortgages, and so on. By determining the key factors that have significant influence on interest rates, the interest rates for future can be forecasted. Some of the important factors that influence interest rates are economic growth rates, inflation rates, monetary policy, and budget deficit