Financial Markets and Risk - Essay Example

Topic:  Financial Markets and Risk XXXXXXXXXXX XXXXXXXXX XXXXXXXX XXXXXXXXXX XXXXXXXXXXX Introduction The current state of economy is greatly influenced by business performance. Financial institutions facilitate financial transactions and events in any economy. They act as intermediaries between the borrowers and the lenders of finance. They consist of both banking and non-banking institutions. The various types of financial institutions include clearing banks, investment banks, saving banks, building societies, insurance companies and pension funds. These operate in a competitive financial market where the objectives of firms are met. The objectives of the firm include: profit maximization, wealth maximization, employee welfare, customer interest, society welfare, and duty to the government. The current rate of economic development, characterized by fluctuations in price, increased poverty levels. Increase in population growth rate, among other factors, has led to a crisis in the financial institution. These have also impacted on the performance of the financial market sector, savings and investment sector, as well as the general performance of the economy. This report brings out clearly the main long-term saving and investment products provided by the financial institutions, as well as the effects of increases in the rates of interest to the people and the commercial banks. Main long-term investment products for consumer provided by financial institutions The major sources of long term finance in the capital markets are actually the products provided to the consumer for long term investment. The consumers are assumed to be rational in their choices among the various alternatives presented. The choice of the product to use will depend on: time element, cost of finance, flexibility and the mode of payment. Long-term investment products provide funds that may be used usually for more than five years (Bollerslev and Mikkelsen, 1999, p. 75). They include: Share capital - this consists of both ordinary share capital which is contributed by the real owners of a limited company and it is not redeemable and the preference share capital. This is contributed by the preference shareholders. Retained earnings provisions - these are part of the profits which belong to the ordinary shareholders and are not paid to them in the period they are earned. Debentures or long-term loans - a debenture is the written acknowledgement of a debt incurred by a limited company. Mortgages - the consumers and companies can get loans for long periods by mortgaging their assets with any mortgage brokers or any other financial institution. Sale and lease back - a company which owns its own premises or fixed assets can obtain finance by selling the property to an insurance company for immediate cash and renting it back. The cost of finance or the product depends on the terms of finance, nature and size of the business, availability of the product, the nature of security, growth stage of the company and government influences through the central bank (Bollerslev and Mikkelsen, 1999, p. 80). Implications of increases in the levels of interest rates to savings by consumers and investors The central bank in any state through the action by the state is responsible for regulation of the interest rates (Benito, Waldron and Zampolli, 2007, p. 48). This means that, if the central bank’s rate of charge to the commercial banks increases, there is a corresponding increase in the rates of interest charged to the consumers and vice versa. The central banks are also responsible for the licensing and the supervision of the commercial banks on depositors interests rates. This is part of the monetary policies undertaken by the government to curb inflation. An increase in the general level of interest rates has several implications to the consumer including: Low savings and investments - the consumers’ rate of saving is affected due to the high rates of interest. The rates of returns to the customers are low and many tend to withdraw and thus save less. Consequently, the banks have low floats and the available funds for long-term investment are reduced leading to low capital formation. To individual consumers, the savings are reduced due to low incomes and extravagance. Inflation - an increase in the general price level may arise due to increases in interest rates. The income of individual consumers is hardly enough to satisfy their needs, thus, there is little left to save and invest (Brandt, Santa-Clara and Valkanov, 2004, p. 96). Capital formation is hindered in banks and the investment rate is low. There is impact on the business cycle as money earned is continually used faster, hence, little is generated as profits and little is left to save. Risks to commercial banks of a significant rise in the interests rates Low savings and investment - an increase in the rates of interest leads to lows saving and reduced credit creation in the commercial banks sector. Low savings translate to low fund available for investments due to the unwillingness by the consumers to have bank deposits and savings. There is less money available to create credit by the bank and thus an eventual reduction in profits and income generated in the financial institutions (Christoffersen, 2003, p. 104). Increase in the bank deposits by the commercial banks to the central bank - the increase in the interest rate relates to a consecutive increase in the money deposited to the central banks by the commercial banks. This is due to a money factor that corresponds to the ratio of the increase in the rates. This means that the central bank have a reduced float of money which they try to compensate by charging the consumers. Reduced flexibility and more rigidity - the consumer will take long to adjust to the changes that arise from time to time. This does not only accrue to the customers, but also to the staff of the banks. A readjustment is also required in the statements and the ratio calculation. This translates to more work in the institutions and thus more time is required to achieve this objective (Christoffersen, 2003, p. 115). The banks lose money trying to cope up with change through the hiring of staff and new workers to achieve this. It leads to an increase in the management cost. Conclusion An increase in the interest rates has an impact on the general economic levels of various states compounded by the inflation. The financial institutions bear the brunt of it, especially where the rate of investments is low. The individual consumers are affected with reduced incomes and low savings leading to lack of capital. Low capital influences the demand in the market, and the size of the market is reduced causing low incomes and hence low investments. In this case, many states continue to be economically unstable with generation of low investments due to the crisis experienced in the financial institutions. If such items are not looked at, the states may succumb to dependency and foreign aids. References Benito, A., Waldron, M., Young, G. and Zampolli, F., 2007. The role of household debt and balance sheet in the monetary transmission mechanism. Bank of England: Quarterly Bulletin. Brandt, M., Santa-Clara, P. and Valkanov R., 2004. Optimal Portfolios with Parametric Weights, Manuscript, Duke University and UCLA. Christoffersen, P., 2003. Elements of Financial Risk Management. San Diego: Academic Press. Bollerslev, T. and Mikkelsen, H.O., 1999. Long-Term Equity Anticipation Securities and Stock Market Volatility Dynamics. Journal of Econometrics, 92, 75-99. Read More