EUROPEAN FINANCIAL CRISIS AND FINANCIAL MARKETS - Essay Example

? Introduction Acharya observes that a combination of factors led to the emergence of the European Union Financial Crises of 2010-2013. These factors include availability of easy credit conditions which occurred during the periods 2002-2008, and they led to high risk borrowing and lending practices. Patomaki (2013) believes that other factors include globalization of finance, imbalances in international trade, poor governmental fiscal policies, the economic recession of 2008-2012, and ineffective methods used by these nations to bail out troubled financial institutions. Acharya (2013) observes that the European financial crises had began unfolding late in 2009, when the government of Greece gave a revelation that previous governments did not give accurate reports of their budget deficits. In fact, they were under-reporting the financial position of the country. The revelation of this under-reporting occurred during the first quarter of the year 2010. During this year, the government of Greece gave a revelation that the 2009 budget deficit was 12.7%, and not 5%, as reported by the previous government (Patoma?ki, 2013). Roth (2013) denote that the Maastricht treaty made a provision which required parties to the treaty to maintain a budget deficit which is lower than 3% of the country’s GDP. Greece had a debt of around 400 billion pounds, and the French government owned 10% of this debt (Roth, 2013). This debt crisis spread to other smaller countries such as Portugal, Ireland, and Spain. Tyrie and London (2012) denotes that this crisis led to economic imbalances within Euro zone countries. In 2010, the European Union bailed out Greece by giving them a loan of 110 billion Euros, and another 130 billion Euros after two years (Tyrie and London, 2012). This paper analyzes the impact of the Euro zone debt crises on the financial markets. This paper analyzes the impact of this crisis on the equity market, and the bond market. This paper seeks to answer the question; What was the impact of the European Financial Crises on the bond and the equity market? In seeking an answer to this question, this paper borrows heavily from the elements of the portfolio theory and the asset pricing. Matousek (2012) observes that the portfolio theory is a theory of finance that aims at maximizing the expected return of a particular portfolio risk, or effectively minimizing the risks associated with a particular portfolio. It aims to achieve this objective by careful consideration of various investments options or portfolios. The portfolio theory is an aspect of diversification in investments, and it aims at selecting a variety of investments options which presents a lower risk, as opposed to other investments options (Matousek, 2012). This theory was developed on the basis that different investments assets, normally constantly change in value. Diversification therefore lowers the risk an investor might face. The asset pricing theory on the other hand concerns itself with explaining the relationship between expected returns, and the risk undertaken (Marco, 2013). It was developed on the premise that diversification alone cannot reduce the risks associated with investing in a volatile stock market. Marco (2013) further denotes that an investor has to be compensated in two ways, namely; the risk undertaken, and the value of his money, which is also considered in terms of time. This theory identifies a formula to use in calculating the expected returns of an investment (Marco, 2013). Equity Markets and the Euro zone Financial Crises: Farlow (2013) denotes that another term used to refer to the equity market is the stock market. This refers to a market where there is an issue of shares, and subsequent trading of those shares. These shares can either be traded over the counter, or through various exchanges. Equity markets are a very volatile segment of an economy, and companies can use this type of a market to raise capital for their expansion and growth. The European Financial Crises had a great negative impact on the various equity markets in Europe, and also in the world (Hieronymi, 2012). It created a very volatile stock market, where share prices of various companies went on a downward trend. Because of the contagious nature of the financial crises, its impact was also felt on the New York stock exchange. Investors were very reluctant to buy share prices of companies with operations in Europe, causing their fall in prices. For example, in 2012, United States companies that had operations in Europe cited the reductions in their European operations as a factor that led to a fall in their share prices. Hieronymi (2012) identifies companies such as General Motors, First Solar Incl and Cisco Systems Incl. Farlow (2013) observes that General Motors a leading auto maker in United States of America made a profit of 899 million dollars, in its December Quarter of 2012. However, the company made a loss of 699 million dollars in its European markets, and this made it to lose on their market targets. The annunciation of these losses had a negative impact on the stock prices of General Motors (Farlow, 2013). Currently, the share prices of General motors’ are trading at 37 dollars per share, against their expected value of 53 dollars a share. First Solar on the other hand has experienced a loss in revenue, fallowing a drop in the demand of solar panels in Europe. It is important to denote that Europe has the world’s biggest market for solar panels. This has seen a fall in its share prices. Other solar companies whose share prices are affected are, SunPower tumbling, and Solyndra. Currently, the share prices of first solar are selling at $53.40 per share (Corcoran, 2013). This is an increase of 60%, since January, in which the company’s shares were selling at $33.3. The reasons advanced for this factor is that the company managed to increase its revenues, by reducing its operational costs in Europe (Corcoran, 2013). The problems were not only experienced by American companies, but also by European and African countries. Investing in the various stocks of companies having presence in Europe was very risky, on this basis; investors had to diversify their investments for purposes of getting returns or minimizing risks (Cline, 2012). For example, if investors are aware of the financial position of General Motors in the European market, then they might buy those shares, but not many. This is because they will have to buy shares of other companies just to diversify their risks. On this basis, if the share prices of General Motors fall, they will not lose entirely their investments because of diversification. In the perspective of asset pricing, stock markets are long term sources of investments, and investors are compensated by basing on the time value of their cash, and the nature of risks they undertake (Farlow, 2013). Volatility in the stock markets created by the European financial crises is only a temporary process, and hence individuals should take advantage of this fall and invest in these companies (Donovan and Murphy, 2013). According to this theory, the main reason an investor should earn more is by investing in one stock. This is because investing in one stock is riskier, as compare to investing in different stocks, and over a period of time, the investor will manage to recover back his money, with premium interests. Euro zone Financial Crises and the Bond Market: Bond market refers to a market whereby the there is the trade of debt securities. Under this market, there is the corporate-debt security, and government issued securities. This market helps the government to raise capital for its various projects and operations (Donovan and Murphy, 2013). During the Euro zone crises, the governments of Spain, Greece, Ireland, Portugal and Italy were unable to pay bondholders back their money. These five countries did not experience an economic growth that would have made this aspect possible. Even though these countries experienced default in paying back their debts, the effects of this crises was felt all over Europe, Africa, Asia and America (Nayak, 2013). This is because investors lacked confidence in buying the bonds of countries that did not have a strong economy, as such; they sought to buy government bonds of countries which were economically stable. Because of this crisis, the interest rates that bond holders required went so high. This is because it was very risky to invest in the bonds of countries that were not financially stable. Donovan and Murphy (2013) believe that according to the asset pricing theory, investors are right when they demand higher yields for their investments in bonds of countries that are not financially stable. According to this theory, the value of the money, time factor and the nature of the risk are responsible for identifying the amounts of returns an individual should get in a financial market (Wolfson, 2013). Higher returns will always compensate investors who did invest in bonds of countries which could default on their payments. This aspect therefore begins a cycle whereby the country in crises will be faced with a higher borrowing rate, and this is because of the need by investors to make higher profits (Donovan and Murphy, 2013). This in turn will lead to the financial strain of the country under consideration. Donovan and Murphy (2013) further observe that the lack of confidence by investors in bonds of a given country, will lead to the lack of confidence to bonds of other similar countries. This results to the concept of contagion. Investors will look for the bonds of stable countries and big economies. For example, the demand for bonds of countries such as Germany and the US increased; however, investors were cautious in investing in buying these bonds at a higher price (Farlow, 2013). For example, during this period, the United States treasuries went down to a considerably low level. According to the portfolio theory, diversification of assets is an important step in mitigating risks. The steps by investors in buying bonds from other countries amounts to diversification, and on this basis, they will manage to protect themselves from losses (Wolfson, 2013). In solving this crisis, the German government pushed for a series of austerity measures. This included a reduction in the spending of the financial unstable governments, and an introduction of higher taxes. However, these measures were not effective in solving the crises in Greece, Portugal, Spain and Ireland (Farlow, 2013). This is because these measures could lead to a slower growth, and hence the governments concerned could not raise taxes to solve their problems. Due to these austerity measures, investors were very reluctant to purchase the bonds of the governments concerned, because of the high risk that they may default on their payments. These policies further accelerated the demands of high yields on bonds by investors. Conclusion: In conclusion, the portfolio management theory and asset pricing theory play an important role in explaining how an investor should invest in a volatile financial market. For instance, portfolio management theory advocates for diversification in investments. This is because there are different securities in the bond and equity market, and each with different risks, and prices. On this basis, an investor needs to invest in different securities for purposes of protecting their interests. The Euro zone crises created unstable financial market, not only in Europe, but the rest of the world. The crisis was contagious, and as such investors did not have to invest on the shares of companies with a presence in Europe. This crisis did affect the American stock market, because of the heavy presence of American companies in Europe, and an example is General Motors. The asset pricing theory on the other hand concerns itself with the nature of risks, the time period and the value of money. In as much as investing in the European financial markets was very risk, the asset pricing theory, denotes that it is not wise to diversify. 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