Financial Markets and Institutions - Article Example

FINANCIAL MARKETS AND S Application of Information to the Industry and Nation: “Prices in an organized derivatives market reflect the perception of the market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivatives contract.” (Khan, Ch.23 P.1). Investors’ behavior keeps evolving depending on market fluctuations being experienced and or predicted by financial institutions and various other agencies including media. Thus the article under analysis purports to inform the industry as well as a certain kind of readers who are basically interested in investing in the capital market. Innovations in the credit market also influence corporate bond spreads. As a result of growing liquidity in the credit default swaps (CDS) market, corporate bond collateralized debt obligations (CDOs) are increasingly being replaced by synthetic CDOs, which are funded with CDS contracts as opposed to cash bonds. Recently there has been exponential growth in the synthetic debt obligations market as investors, rating agencies etc have embraced this new asset class. In fact, structured credit demand increasingly acts as the marginal price determinant of credit risk today. Since the default rates have lowered investors are now comfortable taking on more structured credit risk. However, the predicted economic slump is certainly a cause of worry as it may run the risk of future increase in the defaults as perceived by most of the predictors. It must be considered that in order for the investors to obtain ideas and take appropriate decisions about investment, they need to receive relevant information apart from what a particular company or financial institution can offer. This is where the relevance of articles like this becomes most apparent. A nation’s development basically depends on its economic growth, and in order for the economy to flourish, capital investment is necessary. Free and accurate information educates the investors and enables them to make the right choices in investment which in turn empowers the nation’s ability to build a sound economy. Application of Financial Concepts: In the present day, corporations have easy access to capital as a result of large number of investors, financial market innovation, and the introduction of new products in the credit market. As the global economy continues to grow default rates are decreasing and investors readily provide capital. However, risk is inevitable when new innovations are tried. It is also relevant that the present appetite for risk taking will become unhealthy if the economy registers sharp decline. Such a deceleration will mean reduced capital availability, which in turn will increase volatility entail in downward pressure on asset prices. The most practical solution lies in managing the situation by proactively seeking new ways to add value and to exercise effective check against the risks in today’s credit market. “Derivatives due to the inherent nature are linked to the underlying cash market. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.” (Khan, Ch.23 P.1). Thus the availability of predictions based on facts will provide a good platform for transmission of information that investors can use to determine the extent of risk they can safely take. This will help curb the tendency of indiscriminate risk taking and will facilitate control over investing habits as well as illogical speculations in the capital market. Positive and Negative Points of Information: The article takes into consideration the maximum risk factors in its analysis of the current capital market environment. It has also discussed the relevant factors that can influence a possible slump in the market in the immediate future. At this point of time, when capital market has reached a stage of high boom and with predictions of further prospect for development of the market, public has a general tendency to invest heavily on bonds and other derivatives. The article could, therefore, act as a timely forewarning to an overtly speculative public who are eager to embark upon heavy investment. With the availability of reliable information, “speculative trades shift to a more controlled environment of derivatives market.” (Khan, Ch.23 P.1). The article feels a bit on the arbitrary side, and could be misleading to laymen investors who are not well-versed with the industry or the working of the financial concepts. While it tries to project several opinions, most of them are not backed with corroborative evidence, and it is not exhaustive enough to include any empirical data or supporting figures. Some of the issues dealt in the article may sound unrealistic alarms to at least a particular segment on the public which may prevent from investing in the capital market. Though the article indicates to a possible slump in the economy it doesn’t amply clarify the source of information or support it with a reasonable argument. On some levels it sounds like opinionating without having been thoroughly apprehensive. Recommendation of Course of Action: Rising defaults and restricted credit availability will negatively affect the housing market, foreshadowing what is also in store for the credit market. The purported economic downturn will test the new synthetic players and products in the corporate bond market. The growth of CDS, synthetic CDOs, and leveraged structured credit products, such as the recent constant proportion debt obligations (CPDO) vehicles, has been swift. These products and markets are relatively new and are yet to pass the tests of time; also, more importantly, these are yet to be tested in a bear market. Leverage has been pushed to the point that corporate bonds, and particularly CDS securities, may have limited upside potential going forward. In fact, the explosive growth in leveraged structured credit products globally is likely a main catalyst behind the dramatic tightening in the major U.S. and European credit default indices (CDX and iTraxx) where credit spreads have now reached new tights. There is a need to check the tendency of over investment and reckless risk taking behavior of investors so that the economy of the nation can exercise appropriate control over adverse fluctuations. Works Cited Khan, M. Y, Financial Management: Text, Problems and Cases, Fifth Ed. Tata McGraw-Hill Publishing Company Ltd, New Delhi. Read More