Money and Capital Markets - Example

MONEY AND CAPITAL MARKETS By: Code+ course name: Professor’s name: University name: City, State: Date: Executive Summary The money and capital market in a country can be volatile and is usually affected by several factors and events. In some countries the exchange rate, also known as the floating exchange rate, is of great significance. This is because it determines the balance of payments internationally; hence, it is considered a very important price in the economy and significantly affects the money and capital market index. There is no general theory used for determining the money and capital market index. However, the main determinants of the performance of the money and capital markets can be categorized into the following area; infrastructure, cross border foreign investment, speculation, parity conditions, portfolio investment and political risks. Even though, no forecast model has been very consistent in predicting the short-term trend of the money and capital market index, there exist several key factors which play a decisive role in the determination of the short and long-term trends and performance of the money and capital markets. An important tool that can be used as a good predictor of the future economic activity in a given country is the yield curve. The shape of the yield curve is subject to supply and demand forces of the short and long-term securities. However, the changes in the slope of the yield curve have its subsequent significant impact on the country’s economy. As the slope of the yield curve increases positively, appreciation of the GDP occurs, but the GDP and economic growth tends to decrease when the slope of the yield curve is flat or downward-sloping. Table of Contents Executive Summary 2 Table of Contents 3 Introduction 4 Factors that influence the shape of the yield curve 4 Default risk of a Security 4 Liquidity of the securities 4 Taxes Status 5 Maturity period 5 Impact of changes in the slope of the yield curve on future economic prospects 6 Effectiveness of monetary policy responses in the wake of economic and financial stress and their impact on the shape of the yield curve 10 Conclusions and Policy implications for investors and policy makers 11 References List 14 Introduction The yield curve can be used to determine the future expectations in the capital markets. Therefore, most investors usually study the yield curve of the securities in the capital markets when making investment decisions. There are several factors which affect the shape of the yield curve of a given security in the capital markets. These are mainly the demand and supply factors for the securities which include the exchange rates, default risk, liquidity, tax status, maturity, expectations of interest rates and other special provisions such as the call feature related to a security. Factors that influence the shape of the yield curve Default risk of a Security In general, the higher the default risk, the higher the yield of a security. This is mainly because the securities with higher risks are expected to have higher risk premiums than the securities with less default risks. Consequently, the higher risk premiums lead to higher yields for the securities. Thus, securities with high risk and interest rates have a higher yield relative to the securities with low default risk. Liquidity of the securities Typically, the securities with lesser yield tend to have greater liquidity. Therefore, the greater the liquidity of a given security the lesser it’s yield. The securities with larger maturity are usually less liquid but are relatively high yielding than the securities with shorter maturity, which are usually more liquid. Expectations of interest rates Interest rates, inflation rates and exchange rates of currencies are all economic measures which are highly correlated. Changes in interest rates usually influence both the inflation rates and currency value, thus, impacting the money and capital market index. Higher interest rates offer the lenders in a country’s economy a higher return for their money relative to the lenders in other countries with lower interest rates (Hallerbach, 2003). However, money becomes expensive to borrow as a result of the high interest rates. Therefore, the higher interest rates reduce borrowing. Consequently, the yields of the securities in the money and capital market are adversely affected by the interest rates charged on the securities. In contrast, decreasing interest rates in a country encourage investors to borrow money and invest in business organizations, which subsequently tend to cause an increase in the yield of the securities. Taxes Status The tax status of a given security influences its yield. This is mainly because the taxes related to the various securities influence the demand and supply of the respective securities. For instance, investors who belong to the high-tax bracket category would benefit more from securities which are exempted from tax. Consequently, the demand for tax exempted securities by such investors would tend to increase. This would subsequently lead to increased yield of the securities. Maturity period In general, securities with longer maturity period tend to have higher yields. This is mainly because of the less liquidity associated with the securities with the longer maturity period. Consequently, investors expect to get higher premiums from securities with longer maturity period compared to the securities which have shorter maturity period. Therefore, the longer the maturity period of a given security the greater it’s yield. Impact of changes in the slope of the yield curve on future economic prospects The changes in the slope of the yield curve have several impacts on the future economic prospects of a particular country. The slope of the yield curve is normally derived by calculating the difference in yields between the long and short term maturity funds. Typically, a negative slope (inverted yield curve) indicates that there could be an economic recession within a period of a year. A generally flat curve is an indication of a weak growth, while a steep curve indicates a strong economic growth. Table 1: Yield of the respective short and long term Australian Treasury Bonds Time to maturity (years) Yield (%) 2 5.11 3 5.24 5 5.37 10 5.51 Figure 1 Table 2: Yield of the respective short and long term Greece Treasury Bonds Time to maturity (years) Yield (%) 3 13.75 5 12.89 7 13.66 10 12.01 15 10.75 30 9.15 Figure 2 Typically, a negative (downward-sloping) yield curve indicates a weakening economy (Cwik, 2005). This suggests a higher demand for short-term funds compared to the supply of the short-term funds which causes increased interest rates and subsequently high yield for the short term securities. Subsequently, the demand for long-term funds decreases and becomes relatively lower than the supply of the long-term funds, causing low interests rates and yield for the long-term securities. The demand for loan also decreases leading to reduced interest rates of the loans offered by the financial institutions. Therefore, most investors would opt to invest in short term securities, when the yield curve has an inverted (negative) slope. This is because of the uncertainty of the future prospective economic condition of a given country brought about by the weakening economy. As indicated in figure 2, the yield curve for Greece during the year 2010 has a downward-sloping curve. This indicates an economic recession of Greece which occurred during the recent euro currency crisis which heightened in the year 2011. However, a flat slope of the yield curve indicates a weak growth in the economy. When the liquidity premium is not factored in, the occurrence of a flat slope of the yield curve would imply that the interest rates are not expected to change. However, when liquidity premium is put into consideration, yield curve would actually have a slightly down-sloping curve, when the liquidity premium is removed. This suggests future expectations of slight declines in interest rates. A highly positively-sloped curve indicates a strong economic growth. This suggests a higher demand for long-term funds compared to the supply of the long-term funds which causes increased interest rates and subsequently high yield for the long term securities. Subsequently, the demand for short-term funds decreases and becomes relatively lower than the supply of the short-term funds, causing low interests rates and yield for the short-term securities (Jessica & Webber, 2001). Therefore, most investors would tend to invest in long term securities, when the yield curve has an upward (positive) slope. This is because of the prospective future economic condition as a result of the strong economic growth. In addition, the demand for loans would increase due to the strong economic growth as indicated by the upward sloping yield curve. Consequently, there would be a rise in interest rates over the next few years. Figure 1 above illustrates the yield curve for Australian treasury bonds during the year 2010. The yield curve has an upward-sloping curve. This indicates a prospective growth of the Australian economy in the subsequent few months follow December 2010. Effectiveness of monetary policy responses in the wake of economic and financial stress and their impact on the shape of the yield curve During economic and financial crisis a government and business institutions usually respond by formulating and implementing monetary policies that would facilitate and assist in improving the economic conditions. Such responses include the adjustment of the supply of money by the central bank and the adjustment of the interest rates by the central bank, commercial banks and other financial institutions. As already established a flat or downward-sloping curve indicates a weakening of the economy and possibility of an economic recession within the next few months. Consequently, the demand for long-term funds and securities decreases, leading to reduced yields of the long term funds and securities. To attract more investors to invest in the long term securities, the government through its financial institutions can decide to exempt tax on some of these long term securities. This would lead to increased demand for the long-term securities and subsequently, increased interest rate of the long-term securities. This would shift the yield curve to an upward (positive) slope. In addition, the central bank and other commercial banks can choose to reduce their lending rates. This would tend to increase the demand for loans and long-term funds, whose demand usually reduces during economic and financial crisis. The reduced lending rates by banking and financial institutions would attract more investors to borrow funds, thus, increasing the demand for loans. Consequently, this would lead to future tax increases, increase in liquidity risk as well as increase in the credit risk from the loan portfolio (Van Deventer, Kenji & Mesler, 2004). As a result of increased demand for the long-term investment funds, there would be eventual increases in the interest rates of the long-term investment funds leading to increased yield for the long-term securities. Subsequently, the flat or downward-sloping yield curve would gradually change to a positive upward-sloping curve. Conclusions and Policy implications for investors and policy makers The policy changers, during the event of economic and financial crisis, can decide to lengthen the maturity of the investment portfolios and subsequently lock higher interest rates for the long-term securities. This would increase the yield of the long-term securities compared to that of the short term securities leading to a shift of the yield curve from a flat or downward sloping to a positive (upward) sloping yield curve. Nevertheless, it is essential that the policy changers put into consideration significantly important factors such as the current yields, interest-sensitivity gap and tax status of the respective short and long term securities before making decisions related to the investment portfolios (Weiss, 2008). The GDP and the supply of domestic bonds also influence the yields of the related investment portfolios. In general, the short and long term securities of countries with substantial GDP have higher demand compared to investment portfolios of countries endowed with lesser GDP (Nafziger, 2005). This is mainly because the substantial GDP typically attracts investors to such countries. As a result, the interest rates of the investment portfolios in these countries rise due to their high demand. Subsequently, the rise in interest rates increases the yields of the investment portfolios. Hence, GDP has a significant influence on the yield curve and the money and capital market index. Countries usually engage in large-scale budget deficit financing to fund the public sector expenditure and other development projects. This sourcing of funds to cover budget deficits usually stimulates the domestic economy since it facilitates the completion of development projects (Cafferky & Wentworth, 2010). However, significantly large public budget deficits and debts are less attractive to foreign investors. This is mainly because large public debt encourages inflation. A government may print money so as to pay its public debt. However, the increase of money in supply as a result of printing more money, consequently, causes inflation. In addition, large public debt discourages foreign investors from investing in a country they feel has a high risk of defaulting on its public debt payment obligations. Hence, investors will be less willing to own securities and assets dominated in the country’s currency, reducing the demand for the respective securities. Subsequently, the yield for the securities decreases. Thus, a country’s public debt rating significantly influences the yields of the securities and other investment portfolios. In general, the shape of the yield curve is subject to supply and demand forces of the short and long-term securities. However, the changes in the slope of the yield curve have its subsequent significant impact on the country’s economy. As the slope of the yield curve increases positively, appreciation of the GDP occurs, but the GDP and economic growth tends to decrease when the slope of the yield curve is flat or downward-sloping. Therefore, the yield curve is a very significant analytical tool in the economy of a country. References List Ball, M. K & Seidman, D., 2011. Supply and demand, The Rosen Publishing Group. Brigham, E. F & Ehrhardt, M. C., 2008. Financial Management: Theory and Practice, Cengage Learning. Cafferky, M & Wentworth, J., 2010. Break Even Analysis, Business Expert Press. Cwik, F. P., 2005. "The Inverted Yield Curve and the Economic Downturn" New Perspectives on Political Economy. Hallerbach, G.W., 2003. Holding Period Return-Risk Modeling: Ambiguity in Estimation. Hairault, J-O & Kempf, H., 2002. Market Imperfections and Macroeconomic Dynamics, Springer. Hausman, D. M., 2006. Economic Analysis and Moral Philosophy. Cambridge University Press. Hill, C. W., 2008. Global business today, 7ed. NYC: McGraw-Hill Jessica, J. & Webber, N., 2001. Interest Rate Modelling. John Wiley & Sons. Nafziger, W. E., 2005. Economic Development, Cambridge University Press, London. Nas, T. F., 2006. 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