Capital Market Assessment - Example

Capital Market xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecturer xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Executive summary The federal government of Australia has put in place regulatory framework, procedures and policies for governing the financial market players. It exercises control through the reserve bank of Australia. Financial market assists in the exchange of goods and services from one sector to another and from industry to another. The financial market is composed of the foreign exchange, the stock exchange and the trading of short term and long term bonds among other aspects. Specifically this report discuss in details the markets mentioned. To help in understanding of the markets, a game was played and this report analysis the game in a bid to help in decision making and understanding of the financial markets. These markets have two main aspects in the price of instruments and yields. These attract the investors. This report discus the factors that affect these markets, the prices and yields in these markets. Table of Contents 1.0 Introduction 1 2.0 A Reflection on the Trading Activities 1 Question 1.1 1 Question 1.2 4 Question 1.3 6 Question 1.4 6 Question 1.5 9 3.0 Part 2 - A Statement of What I Learnt From both Playing the Game and Completing the Assignment 12 Question 2.1 12 Question 2.2 12 Question 2.3 13 Question 2.4 13 Question 2.5 13 Question 2.6 14 Question 2.7 14 4.0 Conclusions 14 5.0 References 1 1.0 Introduction The financial markets are one of the most efficient sectors and industry in Australian economy, Edison et al, (2003, page 67). Financial markets are also one of the most important ones in terms of necessity. The foreign exchange provides and determines the exchange rate of the local currencies in respect to foreign currencies, this indicates if it is losing or gaining value. There are four financial markets presented in this report. Each market plays its role in necessitating trading of financial instruments in a bid to create wealth and increase economic growth. To understand how markets operate, a game is played in each of the markets and results (yields) are hence drawn. This report analyses the game for a purpose of helping develop an understanding of the financial markets and how they operate. 2.0 A Reflection on the Trading Activities Question 1.1 Main Factors that Determine the Price (or Yield) in the Market Foreign Exchange Market The yields and price in the foreign exchange markets are affected by inflation differentials. Lower inflation rate makes the currencies to rise in their value. This results to increasing the purchasing power relative to the other currencies. Depreciation of currency is observed where there is high inflation rate. A currency with high value is expensive while a weak currency is cheap. In most cases this is accompanied by higher interest rates. Inflation rate, exchange rates and interest rates are highly correlated, they affect each other, Humpage (2003, page 27). The manipulation of the interest rates exerts influence on the exchange rates and inflation. In addition higher interest rates impacts on the value of currencies. It reduces or increases the investor’s yields, higher interest rates increase yield while lower interest rates lower the yields. Foreign exchanges price and yield are also determined by the consumption level and consumer spending especially for the essential commodities, Melvin & Taylor (2009, page 32-36). Demand for a currency, mostly influenced by the confidence level, determines the yields in that declining demand supply increases leading to depreciation of the currencies and hence low yields. Rising demand makes the currency to be expensive and thereby high price and high yields. S&P/ASX200 Market This market is highly volatile; it is highly determined by the rate of growth experienced by firms and the valuation of their stocks. Hedging, arbitrage and trading play a big part in determining the prices of stocks in this market, demand for firms stocks makes the prices to rise while low demand makes the prices to fall down below the real value of the stocks. Demand for the stocks is influenced by the growth prospects and the level of profitability of the respective firms, Chiu (2003 page 26-29). Sustained growth makes investors to buy the firms stocks in anticipation of getting the distribution of the profits; this makes the prices of the company stocks to rise. Market expectations also determine the prices of stocks in this market. High expectations from the investors increase the prices due to buying of the stocks while low expectations means that investors have no confidence with the stocks and therefore the prices fall. Obstfeld & Taylor (2004, page 15-17) explain that, the equity market trading levels and certain investor sentiments makes the volatility of the market to be low; this implies high levels of investor confidence. This raises stock prices as well. Prices in this market also determined by the size of firms, the larger the firm the more influence it has on the index prices while small company has little influence of the index prices. 90 Day Bank Bill Market The expected future inflation is closely related to yields in this market. The projections of future inflation in the 90 day bank bills provides insight on the yields to be made, however, lack of information on the real rates of the bills makes the yields to be unpredictable, Milne & Wood (2008). Compensation for inflation helps in preventing further effects on the yields though this is not enough; this is because of the persistence of inflation. Another factor that determines the yields and or prices in this market is lack of relation of the bills to economic activities. The fluctuations of the real interest rates are short lived hence this is a latent factor in the dynamism of the yields in this market. Bills in this market have small level of interest rate risks component and small risks of default, this is a positive aspect for investors to exploit, Frank & Goyal (2009, page 31-35). This market is as well regulated by the monetary policies that are put in place by the reserve bank. The actions of this bank affect the rate of federal funds and likely they influence the interest rates for other close replacements which included the 90 day bank bills in this market. The supply of the bills by the government in this market determines the yields. If the government has a surplus federal budget it reduces the supply of these securities in this market, it issues less bills, this affects the yields. The major factors that determine the prices and yields of bonds in this market are the interest rates, the inflation rates and demand. 10 Year Treasury Bond market This is a store of wealth over time. Interest rates affected almost every market; this market was not an exemption. The sum of the real interest rates and the expected inflation over the life of the bonds affect their yields in this market. Interest rates vary in the long run over the real returns. The rise or fall of investment opportunities in this market affect and determine the real yields on the stocks in this market. Rapid run up of the stock markets increases the yields, like it happened from year 1998 to year 2000 where the yields rose from four per cent to 6.5 per cent. Bonds in this market therefore pay a higher rate of return as a result of competition from the stock markets, Easley & O'hara (2004, page 76-81). The spread and demand for these bonds in the market determines price. High demand for the bonds raises the price while low demand makes prices to be decreased in a bid to attract more investors. The availability of alternative debt instruments dictate the price and yields that the bonds will priced at and the return thereafter. It these alternatives are not readily available or does not exists; they make the bonds in this market to be very attractive, expensive but having high yields. These alternatives are such as euro bonds. As conditions may change, depending on the market forces (demand and supply), and the terms in which investors are willing to finance saving rate change, the real returns on this bond instrument rises, Khoo (1994). Question 1.2 (a) For AUD/USD market, the main factor that had a significant impact on the exchange rates during the course of the game is inflation differentials. It depreciated and appreciated the value f the currencies. This is as provided by the Australian stock exchange (ASX) and also backed by Brealey et al, (2006; page 56 - 61) during the game. (b) For S&P/ASX200 market, demand for stocks was the main factor that had a significant impact on the index during the course of the game. This demand was brought about by the performance of the respective companies in terms of their profitability. High profitability raised the investors’ confidence making them to buy more stocks of a given firm; this raised the index in this market considerably. (c) For the 90 Day Bank Bill market, the fluctuations of the interest rates were the main factor that had a significant influence on the bank bills yields during the course of the game. The interest rates kept on changing thereby increasing or decreasing the bank bills yields. The reserve bank of Australia provided this information as well, Sarno & Taylor (2001, page 841). (d) For the 10 Year Treasury Bond market, the differentials in the inflation rates over the course of the game had significant impact on the yields of this bond. The changes in the expected inflation rates influenced the returns since they were directly related. High inflation rate decreased the yields while during low inflation rates the yields were stable. The changes the level of the government borrowings had also considerable influence on the Treasury bond. During deficits the government issued more bonds for financing the shortfall. Increase in the quantity of the bond supplied decreased the yields, Foerster & Karolyi (1999, page 983). Treasury buy back during budget surplus decreased the bonds supply and this yielded more. This information was also provided by the treasury in Sydney. Question 1.3 There are two factors which simultaneously and significantly impacted on all four markets during the course of the game. These factors are the rate of inflation and the rate of interest rate. The prevailing interest rates and inflation rates increase or decrease the yields from these markets. According to Laubach (2009; page 858-885), inflation affects the affect yields in that when it increases it reduces the purchasing power and therefore the yields are low, the opposite is that, when the inflation rate, in this market, were stable (low), the yields were high (the value of the currency was strong and hence increased the purchasing power). The long term markets, such as the 10 year Treasury bond market, experienced mixed yields in that the level of inflation was increasing and increasing irregularly, the yields were therefore unpredictable as such. On the other hand, Dewachter & Lyrio (2008; page 98-100) suggest that, interest rate differentials influences the yields. In these four markets, the offering of the instruments yields was determined by the interest rates present and or determined by the reserve bank. The interest rates are set by the reserve bank as the regulatory authority over the market to ensure it is systematic, this affected all the markets. Question 1.4 I was making my weekly decisions based on the all information collected for the whole of the week. This information helped a lot in forecasting and predicting how the next trend would be in the market. The markets gave different results and data collected was unique to the market, the market which required daily information is the foreign exchange, the value of the currencies were changing rapidly and decision were made as according to the prevailing occurrences. This was being compiled and used to predict how the forex would be the following week. It helped in determining the amount of yields from the markets. The easiest market that I found easiest to make decisions in was the 10 Year Treasury bond market, the only factors that were affecting this market are the interest rates and the inflation rates unlike the other markets which were determined and influenced by many factors. The interest rates were determined by the government though the reserve bank and so the only major factor considered was the inflation rate, making decisions was therefore easy. It only required monitoring the trend of inflation effects and making decisions accordingly. It was easy to make decision in this market because the market was stable only being adjusted by the inflation and interest rates, besides, this market had very few players. The market that I found most difficult to make decisions in is the S&P/ASX200 market. The magnitude and the volume of transactions in this market made decision making very difficult, Alfaro et al, (2004). Besides volume and magnitude of transitions, this market was determined by many other factors. As it is with the securities exchange market, there was little time to make decisions. The information was changing very fast and therefore I had to be very devoted. Analyzing all these information and making decisions in a very short period of time was difficult. In addition, this market has a lot of players (investors). It is the market with the highest number of market players. These markets were operating under different, though related, factors, in this light some markets required making decisions on a daily basis while others needed decisions on a weekly basis. For instance, the foreign exchange market and the S&P/ASX200 market required decisions daily. For the former, the exchange rates were changing regularly, that is, every day and therefore decisions were made daily. S&P/ASX200 market was trading on real time information, the yields and prices were changing fast and therefore I made decisions accordingly. On the other side, I was making decisions on the bank bill and treasury bond markets weekly based on the stored and documented information, though trading was taking place every day. These markets had predictable trends and thus the reason for making the decisions weekly. The information I typically used in making my decisions were the interest rates, inflation rates, firms performance, volume of stocks traded, the prevailing market conditions (the number of investors willing to buy certain stocks) and directives from the regulatory author (the reserve bank). This information was very useful as they were the main determinants of yields and prices of the instruments. The value of the currency as at a certain time of the day was very important in making decisions as well. The way that I made my decisions changed during the course of the game. Each and every day presented different information and variations for the markets, more specifically for the foreign exchange market and the S&P/ASX200 market. With hundreds of companies in the stock exchange market and a lot currencies being traded, decisions changed frequently depending on the conditions of the market. Decisions changed depending on the market prevailing. However, for the bonds and bills market decisions did not vary or change as much because they were stable and predictable. The offering of treasury bills with certain fixed interest income rate, was only affected by the inflation rates and therefore decisions were not changing as for this market. This was the case with the bond market, their yields were known in advance but they either increased or decreased depending on the inflation rate effects, Truong et al, (2007 page 18). There are several lessons I learned from the game in terms of how to make decisions when trading in the financial markets. One of the lessons I learnt is decision making capabilities, due to the demands of the markets in terms of making decisions in a very short period of time, my decision making ability improved a lot. I also learnt how to take in to consideration many things in making a binding decision. The financial markets taught me how to make forecasts and predictions given a range of data. Question 1.5 (a) The final trading report for 90 Day Bank Bills and 10 year Treasury Bonds (b) A yield curve for the first day of 90 Day Bank Bills This graph have changed shape because of the differentials in the rate of earnings, this is attributable to inflation rate fluctuations. As discussed above, the rate of inflation have profound effects on the amount of earnings from this market. The yields were affected by high inflation during the first year of trading. This was worsened by the lack of information about the market. I didn’t have information of how this market works and many times I the yields were reduced considerably by inflation, this is because I didn’t know how to take the necessary actions to avoid inflation effects on the yields during the first moments of playing the game. (c) Commonwealth Government Security (CGS) yield curve The CGS yield curve had an increasing rate. The curve increased as the game went. The more I played the game the more the yields continued to be good. This was attributed to the gathering of information and the quality of decisions that I was making. As the game went on, I gained more understanding and therefore was able to generate more yields and also to protect the yields from the adverse market conditions such as the harsh inflation rates. Another factor that contributed to the increasing yields is availability of deficit in the budget. This made the government to source for another funds to finance the deficit. i took this advantage and this increased the yields. There were also good market conditions towards the end of the game. The conditions favored the market and this resulted to the instruments yielding more. My trading of bank bills and treasury bonds were related to the CGS yield curve but not as much. There a lot of relation. The Commonwealth Government Security contributed to the yields in the market. They were one of the factors that determined the yields of the instruments in their respective markets. They had significant influence on the amount of yield. 3.0 Part 2 - A Statement of What I Learnt From both Playing the Game and Completing the Assignment Question 2.1 The main thing I learned from playing the game and writing the assignment is the decision making in the financial markets. I understood how foreign exchange market operates, I got to know and understand how the government regulates the financial markets through the reserve bank. The stock exchange market is one that plays a very important role in trading of company stocks and creating wealth. It is through these markets that the federal government finances deficit in the budget whenever there is one. The government issues bonds and bills as a means of financing the deficit internally. These are things that I never understood before, but by playing the game and writing the assignment I understood them better. In addition, I know how these busy markets operate; in can know help an individual or investor who wants to invest in these markets. Question 2.2 I learnt much from completing the section in the assignment underlying what happens in these markets, it is good it was not left out because it is through completing the assignment I learnt how to connect the theory and the game. As I highlighted above, doing practically what I was learning in class helped me understand these terms. Putting in practice what we learnt in class helped me understand even better. It is through the assignment that I was able to connect the financial market terms and what was happening when I was playing the game. The writing of the assignment helped me understand the financial markets better. Question 2.3 Yes, I find it useful to submit to have to submit weekly journal. This is because from submitting the weekly journals, I am corrected on the mistakes I made during the game. I was advised on where I could improve so as to get the maximum yields from the markets. This was especially important during the first periods when the game was starting; I had little information about the markets. The advice and corrections helped me improve the yields as indicated in the curve above. Question 2.4 The most difficult aspect of the journal was the journals. Producing the journals was difficult, though as I proceeded, it became simpler and simpler especially towards the end. The assignment was not that much of a problem since I had more information on how to go about it from previous assignments. Since I had no experience of preparing the journals, it was difficult. However, I got support and advice on how to prepare the journals when I was delivering the weekly journals. Question 2.5 I had not used Endnote (or similar referencing software) before completing the journals and assignment. This method of referencing gave me some problems in the beginning since I had not used it again. It should be a requirement for another assignment that I use Endnote or its equivalent so that I understand it better. Question 2.6 Yes, I had used them before completing the assignment and journals. From the observations of the work, they should be made a requirement to use them in doing other assignment and journals. Question 2.7 I am so content from the game. The game gave me a very good understanding of the financial markets and how they operate; this is recommendable for the organizers. In the same case, the game can be improved by adding more instruments and the time of the game; this would make it more pleasant in terms of making players to understand. It would improve the decision making capabilities. 4.0 Conclusions The financial markets are one of the key drivers of economic growth. The demonstration of how some sectors of the financial industry operate gives an in-depth understanding. When this is combined with theory part of it, it gives broader understanding. This makes people to know and be aware of the investment opportunities that are available in the financial markets. The markets provide a good platform for getting capital and financing, here demonstrated by the government borrowings and the trading of stocks in the exchange market. This report has provided a reflection after playing game involving four markets, foreign exchange, stocks exchange, 90day bank treasury bills and 10 year treasury bonds. 5.0 References Alfaro, Laura, "FDI and economic growth: the role of local financial markets," Journal of international economics 64.1 (2004): 89-112. Brealey, Richard A, Stewart C, Myers, and Franklin Allen, Corporate finance, Boston et al.: McGraw-Hill/Irwin, 2006. Chiu, Priscilla, "Transparency versus constructive ambiguity in foreign exchange intervention," (2003). Dewachter, Hans, and Marco Lyrio, "Macro factors and the term structure of interest rates," (2008). Easley, David, and Maureen O'hara, "Information and the cost of capital," The journal of finance 59.4 (2004): 1553-1583. Edison, Hali J., Paul Cashin, and Hong Liang, Foreign exchange intervention and the Australian dollar: Has it mattered?, International Monetary Fund, 2003. Foerster, Stephen R., and G., Andrew Karolyi, "The effects of market segmentation and investor recognition on asset prices: Evidence from foreign stocks listing in the United States," The Journal of Finance 54.3 (1999): 981-1013. Frank, Murray Z., and Vidhan K, Goyal, "Capital structure decisions: which factors are reliably important?" Financial Management 38.1 (2009): 1-37. Humpage, Owen, "Government intervention in the foreign exchange market," (2003). Khoo, Andrew, "Estimation of foreign exchange exposure: an application to mining companies in Australia," Journal of International Money and Finance 13.3 (1994): 342-363. Laubach, Thomas, "New evidence on the interest rate effects of budget deficits and debt," Journal of the European Economic Association 7.4 (2009): 858-885. Melvin, Michael, and Mark P., Taylor, "The crisis in the foreign exchange market," Journal of International Money and Finance 28.8 (2009): 1317-1330. Milne, Alistair, and Geoffrey Wood, "Banking crisis solutions old and new," Federal Reserve Bank of St. Louis Review 90.5 (2008): 517-30. Obstfeld, Maurice, and Alan M. Taylor, Global capital markets: integration, crisis, and growth, Cambridge University Press, 2004. Sarno, Lucio, and Mark P., Taylor, "Official intervention in the foreign exchange market: is it effective and, if so, how does it work," Journal of Economic Literature 39.3 (2001): 839-868. Truong, Giang, Maurice Peat, and Graham Partington, "Cost of capital estimation and capital budgeting practice in Australia," Available at SSRN 1019962 (2007). Read More