Financial Markets and Institutions - Essay Example

Financial Markets and s Financial Markets are markets where financial securities such as stocks, bonds and merchandises e.g. precious metals are traded at competent market prices. Financial Markets can be national, local or international. They do not have to be physical spaces because the term ‘financial markets’ indicate their mechanisms. Types of Financial Markets: Capital markets bring together borrowers and savers together. In the economy at one time there are institutions who’s cash inflows and outflows do not coincide and they need money for either short term expenses or long term investments, at the same time there are individuals and institutions who are saving money and want to invest it. Primary markets are those capital markets where stocks and bonds are issued to the public for the first time. These include e.g. Initial Public Offers. Secondary markets on the other hand, are markets where existing bonds and stocks are traded between investors. These transactions do not include direct investor dealings with a company. Money markets are another type of financial markets and provide short term financing for debt. Another type of financial market is foreign exchange market, which enables the conversion between different currencies. Commodity markets or physical asset markets are markets where consumer goods are sold. Similarly, insurance markets provide support from future risks. Additionally spot markets and future markets signify whether assets bought will be delivered on the spot (in a couple of days) or at some time in the future (e.g. six months later)-(Anonymous, 2010) Importance of Financial Markets: Financial markets are essential because they reallocate capital from one sector, organization, person or industry to another. They help businesses raise finance, lenders find borrowers and therefore earn interest, help governments borrow money when government expenditure is greater than taxes and aid business expansion and growth. Factors that affect interest rates: Inflation is a key influencer of interest rates since it reduces the a) strengthof the currencyand b) the value of interest or dividends received from savings. Lenders therefore attach an inflation premium, which is a payment for anticipated future inflation. The risk of default, or the risk that borrowers will not pay back the interest amount or basic investment, also affects interest rates. The more the risk of default the higher the investors will add to the interest expense. In the U.S treasury bonds have no default risk because they are government securities. For companies bonds the bonds overall credit rating affects the amount of default risk premium added to its interest rate. (Litterman& Weiss, 1983) Liquidity premium is another addition to a securities interest rate. Liquidity is the ability to covert assets into cash and to be able to soundly capture the initial investment. Financial assets are usually more liquid than physical assets and short-term securities are more liquid than long terms securities. Liquidity premium is added to securities when they cannot be easily and quckly converted to cash, and drive up interest rates. When interest rates rise, the prices of bonds tend to fall. Therefore, bonds are secured against capital losses (the reduction in the market worth of a bond) by adding a cost called maturity risk premium. This is done because usually all interest rates fluctuate in the long run and the longer the maturity on a bond the more the interest maturity risk premium it carries. (Friedman &Shwartz, 1983) Lastly, the US interest rates are most affected by the foreign trade balance, more than any of the above-mentioned elements. Businesses and individuals in the US sell to other businesses and individuals abroad. When trade deficits occur due to this trading then they are usually financed through debt. This excessive borrowing increases interest rates. Moreover, foreign investors hold US bonds if US interest rates are competitive with those of the global market therefore, if the government tries to reduce interest rates in the economy through the Federal Reserve then foreign investors will sell their bonds which would reduce bond prices and increase interest rates further. The US has been experiencing a trade deficit since the 1970’s and the aggregate affect of this is that the US is the greatest debtor of all time. Therefore, the interest rates in the US are influenced by the global interest rates. (Bruce, undated) Ease or difficulty of forecasting Interest Rates: The article “Business Cycles in emerging economies: the role of interest rates” surveyed business cycles experienced by developing countries with developed ones. One of the findings suggested that economic cycles of boom, recession, slump and growth are unstable in developing countries than in their developed counterparts. In such economies the real rate of interest moves in the opposite direction of the business cycle. The study also revealed that demand is relatively more unpredictable than production whereas net export trends also move in opposite directions of the business cycle. In the methodology the article uses the prototype of a compact economy, which engages in trading, in this country the rate of interest is high due to the rates prevailing abroad and country risk component. Country risk is agitated by basic shocks however of working capita also intensifies the effects of shocks. The standard produces business cycles even with Argentinian statistics. Abolishing country risk cuts Argentina’s output instability by 27% as steadying international rates depresses it by less than 3%. However, future economic cycles cannot be estimated accurately, as can be seen by the US mortgage bubble that unexpectedly burst in 2007. Therefore, it is impossible to accurately estimate what course interest rates will take. Additionally, Liquidity premiums, default risk premiums, maturity premiums are mere approximations based on the analysis of economic cycles. Why was the Federal Reserve created? And what is its importance: The main reason for the creation of the Federal Reserve was the Bank Crisis of 1907 when the banking sector tried to bring ruin to the F. Augustus Heinzes Knickerbocker Trust by jointly refusing it financial support. The resulting failure of the trust to gain finances resulting in public panic directed at trust companies and banks, which led to a bank run. Wall street then took the help of J.P Morgan-a private banker- who summoned the major financial market players who then jointly flooded the capital market with their reserves, whichliquidated the banks and eased the US off the impending depression. In 1913 national officials went to look at the model of Europe’s central banks and passed the legislation for the US Federal Reserve. Consequently, this created the Federal Reserve that has the right to control money supply and was not under the control of the government. (Litterman& Weiss, 1983) The financial crisis of 1907 put pressure on the government to take steps to try to decrease the possibility of a future repeat. The industry response and the passing of a bill led to the creation of the Federal Reserve System. The U.S assembly granted the Reserve the authority to form and command a national check-clearing system. The Federal Reserves job was to develop flexibility in the quantity of money-that money supply should contract or expand according to the requirements of the monetary policy. The U.S. Federal Reserve provides banking services to the country’s merchandising trade and wholesale industry together with offering an array of financial services to depository organizations. The Federal Reserve offers many facilities such ascollecting checks and automatically relocating funds through the computerized clearinghouse and supplying new currency. The Reserve transfers a large quantity of money into and out of the deposits of banks all over the nation as well as government accounts. Due to this reason the Reserve has to devise strategies to check for and account for the risk of default, fraud or human error. It is through these services that the Reserve aids trade. The reserve also ensures that enough money is in circulation to meet the publics demand. It distributes money through the depository institutions to the public. In 2003 there was a $36.5 billion increase in US demand so the Reserve Bank dispensed to depository institutions 36.6 billion notes with a value of $633.4 billion and received nearly 35.7 billion notes with a value of $596.9 billion. The excess was to cater to the increase in demand. The Federal Reserve is also crucial for check processing. In 2003 a study conducted by the Federal Reserve showed that check payments had increased since 2002 as the source of payment. (Labonte, 2012) As fiscal agents of the US government the Federal Reserve acts as the governments bank. Furthermore, the reserve invests treasury monies of the government until it is needed by the government, it also makes disbursements on behalf of the government (through the governments accounts) and pays through Fed wire, checks or ACH, it therefore keeps records of the governments accounts. The US federal bank is the lender of the last resort to the government when the government has incurred more expenses than the revenues collected through the tax system. For the last decade, the US central bank has provided services to the IMF and IBRD, making payments and receiving donations on their behalf. (Selgin&Lestrapes, 2012) US Monetary Policy till June 2012 and its impact: To endorse the federal open market committees’ objective of maximum employment and price stability the committee placed fund rate targets between 0 and 0.25% for the first half of 2012. The committee then decided that the reserve would provide greater monetary space to the economy to fasten economic recovery. The data of the FOMC’s march meeting showed that although unemployment was high, economic activity had increased relatively and so had payroll employment. While long run inflation was stable the housing market was strained due to strict mortgage requirements and distressed properties. By June 2012 economic activity was expanding at a slower pace than earlier in the year. Expansions in labor market conditions slowed later months, and the unemployment rate became stagnant. Household spending was rising at a slower rate and business investment was advancing. Price inflation declined, reflecting lower prices of crude oil and gasoline. The financial markets were volatile over the 6-month period and investor sentiment was strongly influenced by the advances in Europe and indications of slower economic progress in local and global markets.(Kronszer, 2009) In conclusion the Committee decided to retain the focus range for the federal funds rate at 0 to 1/4 percent and repeat its expectation that economic conditions were liable to permit extremely low levels for the federal funds rate through late 2014. (Kronszer, 2009) Strategy for the use of bonds- From the eyes of a financial manager: As a financial manager, my advice has to be tailored to the needs of the investor. If the aim of the investor is to preserve the principle and earn an interest on it then I would advice “buy and hold” strategy. Investing in a bond and holding it to maturity will get interest payments, generally twice a year and lead to receiving the face value of the bond at maturity. If the bond that the investor has chosen is selling at a premium as its coupon is superior to the prevailing interest rates then the amount received at maturity will be less than the amount paid for the bond. In buying and holding bonds there is no need to be concerned about the effect of interest rates on a bond’s price or market value. If interest rates rise and the price of bond falls it will not affect the interest payments, the investor will only be affected if he changed his strategy and sells the bond. I would advise against redeemable bonds becauseof the risk of having the principal returned before maturity. Bonds are typically redeemed early by their issuer during conditions of falling interest rates which causes interest rate risk and may mean that the investor has to invest in lower interest giving securities. I would also counsel the investor to look closely at the coupon interest rate of the bond (multiply this by the par value of the bond to decide the dollar amount of his/her annual interest payments) 1 I would also inform the client that higher yields could mean higher risks. And that a bond with a lower credit rating might offer a higher yield, but these carry greater risk of default. References: 1.Types of financial markets. 2010. Retrieved from http://www.economywatch.com/market/market-types/financial-market-types.html 2.How interest rates are determined. Laura Bruce. Retrieved from http://www.bankrate.com/finance/cd/how-interest-rates-are-determined.aspx 3.Milton Friedman, Anna J. Shwartz. 1983. Monetary Trends in the United States and the United Kingdom. Retrieved from http://books.google.com.pk/books?hl=en&lr=&id=KulnXxZbytoC&oi=fnd&pg=PR9&dq=calculation+of+interest+rates+in+US&ots=_vmxS2khzv&sig=3taWbTXvPeeFEK5q2jQ_SVxTFCI#v=onepage&q=calculation%20of%20interest%20rates%20in%20US&f=false 4.Robert B. Litterman, Laurence Weiss. Money, Real Interest Rates, and Output: A Reinterpretation of Postwar U.S.1983. Retrieved from http://www.nber.org/papers/w1077 5.Marc Labonte. Monetary Policy and the Federal Reserve: Current Policy and Conditions. 2012. Retrieved from http://www.fas.org/sgp/crs/misc/RL30354.pdf 6.The Federal Reserve in the US payments system. Retrieved from http://www.federalreserve.gov/pf/pdf/pf_7.pdf 7.George Selgin, William D. Lastrapes, Lawrence H. White. Has the fed been a failure? 2010. Retrieved from http://www.cato.org/pubs/researchnotes/WorkingPaper-2.pdf 9.Randall S. Kroszner. The Response of the Federal Reserve to the Recent Banking and Financial Crisis. 2009. Retrieved from http://faculty.chicagobooth.edu/randall.kroszner/research/pdf/KrosznerMelickFedCrisisResponse.pdf Read More