Marketing of Reserve Bank of Australia - Case Study Example

Running header: Banking and finance Student’s name: Instructor’s name: Subject code: Date of submission: 1. The RBA is independent of the federal government in that it makes decisions regarding interest rates independently of the country’s political process. This means it does not get instructions from the government of the day on the interest rates. This is important in ensuring that interest rates are not manipulated for political ends while keeping the monetary policy focused on its long-term goals (Reserve bank of Australia, 2013). While RBA may be independent from political influence in theory, it would be prudent to ensure that its six non-executive directors do not come from for profit making organisations. This would ensure total independence and eliminate bias that would arise for economic reasons. 2. If the supply of money is increased, the level of interest rates lower. It should be noted that money also follows the law of demand and supply. The interest rate is the price for borrowing money. This price is influenced by the laws of demand and supply implying that when the supply of money increases, more money will be available for borrowing hence forcing the lending institutions to reduce the price of borrowing money (Johannes, 2010). The vice versa will happen when the supply is reduced until an equilibrium rate is achieved where the demand for money equals supply of money. 3. Historically, the yield curve has been typically upward sloping. I would expect this to be the case due to the market’s anticipation of a rise in risk free rate. If investments are held now, better rates are expected in future to compensate for the invested money. In addition, investments with longer maturity dates imply greater risk for the investor. As such, a risk premium will be needed for the associated risk. Furthermore economic recessions have always been much shorter than economic expansions. This means that long-term investors would anticipate higher interests to arise from expansion periods. 4. The following are the characteristics of money market instruments i) Liquidity –this is how fast investors are able access their money and hence a money market instrument should be relatively liquid. ii) Return –money market interests earn interest to the lender iii) Safety- Money market instruments are safe due to their liquidity and do not have long-term uncertainties iv) Risk- Money market instruments always possess some level of risk such as the risk of default A financial claim must possess these characteristics to function as a money market instrument otherwise it can not be termed as financial market instrument. 5. Systematic risk or market risk refers to uncertainty that is inherent to the entire market or market segment and consists of the day to day fluctuations in a stock price. Unsystematic risk on the other hand refers to specific risk or uncertainty arising from the company or industry one invests in and can be reduced through diversification. Beta is a measure of systematic risk of a portfolio in comparison to the entire market. It measures systematic risk based on how returns co-move with the overall market. It compares a stock’s market risk to that of other stocks. 6. Hybrid securities are securities sharing the characteristics of equity financing and debt financing. They include; a) Convertible preferred stocks – the stock gives the investor the ability to convert it into common stock in future. In addition, the investor receives regular dividends from the company. b) Convertible bonds –this is a bond that can be converted into common stock in future. This is in addition to receiving regular interest as long as it remains a bond. c) Mezzanine financing –the type of financing allows the lender to take a certain ownership of the company if the debt is not repaid. 7. Equilibrium exchange rate is the exchange rate at which supply of a certain currency equals the supply of the same currency. It indicates the price at which exchange of two currencies remain stable. Appreciation of the local currency (Australian dollar) means that its value will increase relative to foreign currencies making the exchange rate to fall. As such, it will take fewer Australian dollars to purchase a unit of foreign currency which will make the local currency less competitive leading to larger imports than export of goods and services. Exchange rate $ $1 Q1 Q Quantity 8. Off-balance sheet activities are the business activities of a savings association which generally do not entail booking assets and taking deposits. They normally generate fees and produce assets or liabilities that are contingent and hence do not appear on the organization’s balance sheet until they become actual liabilities or assets with a value that is ascertainable. Off balance sheet activities include standby letters of credit, foreign exchange forward options, interest rates swaps, loan commitments, and repurchase agreements. Off balance sheet activities are important since they generate income for institutions in terms of fees or gains in value of the contracts. 1. Prudential supervision refers to regulation of institution including banks, friendly societies and building societies with the supervising authority seeking to ensue the depositors get protected through the financial institution in question being sound financially. Prudential supervision is important in ensuring the financial soundness of financial institutions hence contributing to the stability of the financial sector. The Australian Prudential Regulatory Authority (APRA) is responsible financial institutions including ADIs, life and general insurance companies as well as superannuation funds. 2. The following are the characteristics of money market instruments v) Liquidity –this is how fast investors are able access their money and hence a money market instrument should be relatively liquid. vi) Return –money market interests earn interest to the lender vii) Safety- Money market instruments are safe due to their liquidity and do not have long-term uncertainties viii) Risk- Money market instruments always possess some level of risk such as the risk of default A financial claim must possess these characteristics to function as a money market instrument otherwise it can not be termed as financial market instrument (Peter, 2011). 3. Default risk refers to the variability of realized yields owing to delays or failure to collect the contracted amount of interest or principal the lender has promised. The default risk premium varies over the business cycle. During periods of economic recessions, he economy has contracted implying less money supply and hence the default risk premium would be expected to be larger while it would be expected to be smaller during periods of economic expansion owing to increased money supply and hence less risk of defaulting. 4. Futures and forwards markets differ in that futures are traded on exchanges while forwards trade over the counter. While the terms of a futures market are standardized for each contract, those of forwards are privately negotiated by the parties concerned. Forwards involve both credit and market risks while returns on a forward contract is only realised at the time of settlement implying increasing credit exposure risk (Keith, 2006). Futures require credit risk mitigation measures which in not a requirement for forwards. While futures are settled at the settlement price fixed on the last trading date of the contract, forwards are settled at the price agreed on at the trade date/start. While futures are subject to a single regulatory regime in a jurisdiction, forwards are transacted across jurisdictions and are governed by contractual relations between the parties. While forwards specify to whom a physical delivery should be made, the counter party for futures is chosen randomly by the exchange. 5. Interest rate risk is the risk that an investment’s value will vary owing to variation in absolute interest rate levels in the spread between two rates in the shape of a yield curve or in any other interest rate relationship (Webber, 2001). Such variations adversely affect securities and are reduced through diversification or hedging. Interest rates risks include price risk which is variability in the realized yield as a result of changing interest rates when the bond is sold before maturity and investment risk which is the variability of the realised yield arising from varying interest rates when coupons are reinvestment. An investor can select an investment with duration equal to investor’s holding period to lock in the yield to maturity hence eliminating interest rate risk. 6. By selling the Australian dollar, the government will be decreasing the supply of the local currency while increasing the supply of the US dollar. This will lower the value of the US dollar relative to the Australian dollar. This has the effect of increasing imports from the US while reducing the exports due to the increased value of the local currency. However, the effect is short as the market will react to forces of supply and demand to bring the exchange rate to equilibrium. 7. Systematic risk or market risk refers to uncertainty that is inherent to the entire market or market segment and consists of the day to day fluctuations in a stock price. Unsystematic risk on the other hand refers to specific risk or uncertainty arising from the company or industry one invests in and can be reduced through diversification. Beta is a measure of systematic risk of a portfolio in comparison to the entire market. It measures systematic risk based on how returns co-move with the overall market Shiller, 2007). It compares a stock’s market risk to that of other stocks. 8. Government‘s intervention may affect the exchange value of a currency. This can be achieved through a number of means; i) Reserves and borrowings – when the exchange rate falls the government uses foreign exchange reserves to purchase the currency hence increasing the value ii) Borrowing – the government may borrow foreign currency hence affecting the exchange value iii) Reduction of inflation using fiscal and monetary policies to affect aggregate demand of the currency If a government sells assets to foreigners, the foreigners will pay the government using the currency which will increase the money supply for the government. The result of this is lowering the exchange rate for the currency due to its increased availability and hence its value/rate of exchange will decrease. 1. When organisations engage in international trade they take risks that include foreign exchange risk and political risk which may make it difficult for them to maintain reliable and constant revenue. Foreign exchange risk arises due to changes in currency exchange rates while political risks occur due to unexpected changes in government policies that negatively affect international trade (Economy watch.com, 2010). There are a number of ways for overcoming some of these risks. For instance, a firm may attempt hedging some of the foreign exchange risk through buying futures, options or forwards. 2. The RBA is responsible for implementation of monetary policy with the following objectives; i) Ensuring the stability of Australian currency ii) Maintenance of full employment in Australia iii) Ensuring the economic prosperity and welfare of the people of Australia RBA uses a number of tools to manage monetary policy. Through open market operations, RBA buys and sells government bonds thus altering the money supply in the market hence affecting interest rates. To manage money demand, RBA sets interbank lending rates. In addition, RBA uses reserve banking to encourage economic activity and investment. 3. Corporations wishing to make an underwritten security must make decisions regarding the value of investment that is to be underwritten. They also have to ensure compliance with all legal requirements that relate to the underwriting process. In addition, they have to make decisions regarding their ability to absorb the related risk incase the underwritten security fails to be taken up. The decision on how much risk they are willing to assume as well as the amount of fees they are willing to take for the entire process are some of the major decisions that corporations willing to make underwritten securities make. 4. Insurance companies make money through a number of ways. Part of their money comes from charging slightly higher premiums than they pay out. Investment income is the major source of money for insurance companies. They invest their capital and the money arising from the time lag between when a premium is made and when a claim is paid (Sarah, 2007). When a premium is paid, it is invested to generate money for the company. The importance of insurance to the society can broadly be said to be two fold. Insurance takes risks on behalf of the clients. In addition, it allows sharing of risks across the society hence reducing the impact of risks on persons and stress resultant from occurrence of risk. For life insurance policies, it encourages a saving culture while providing profitable investment. 5. Regulation of the financial institutions by government is necessary due to their vulnerability to crisis and failures as seen in the past. In addition, financial institutions are important tools of economic growth and hence the need to regulate them (Joel, 2010). This will ensure investors are protected since they may never be able to judge the soundness of financial institutions. Consumers must be protected from monopolies in provision of financial services. In addition, regulation is important in ensuring the stability of the financial system. Lack of proper regulations in the past has led to major financial crisis such as the collapse of the gold standard, the global financial crisis and the Euro zone crisis. 6. A yield curve is a line which plots interest rates at a set point in time of bonds that have equal credit quality though with different maturity dates. It is a way of looking at interest rates in that it represents the yields// rates offered by bonds of different maturities. Yield curves mainly take three shapes including sloping upwards (normal), inverted or flat yield curves. The shapes are explained by three theories including; a) The expectation theory which postulates that expectations of rising shot term interest rates create a positive yield curve (Investing answers.com 2013) b) Liquidity preference theory which postulate that investors will prefer highe3r liquidity of short-term and hence deviance from a positive curve is a temporary phenomenal c) The segment market hypothesis which state that different investors confine to different maturity segments which makes the yield curve a reflection of prevailing investment policies. 7. Forward and futures markets differ in that futures markets are exchanges while the forwards markets are over the counter markets. In addition, terms of futures markets are standardized while those of forwards markets are private agreements between the parties involved. There are many risks involved in futures markets including; a) Futures markets expose investors to unlimited liabilities and losses could accumulate beyond their committed capital as long as their prices move against one’s futures position. b) Daily settlement – profit and losses in futures markets are settled daily which can lead to a profitable futures position being closed out prematurely owing to losses on short term whipsaw. 8. It is important to note that money markets provide a platform for short-term borrowing and investing. On the other hand, the capital markets are a platform for long-term borrowing and investment. The duration of using capital raised through the two means is the main incentives for firms to use capital markets securities rather than money market instruments. This is because using the capital market securities, firms are able to access and use the capital for a longer time and even undertake long-term projects as opposed to the short terms of money markets. References: Reserve bank of Australia, 2013, About monetary policy, Retrieved on 9th January 2014, From; http://www.rba.gov.au/monetary-policy/about.html Johannes, B2010, Effects of a price level increase on interest rates, International Financial Journal, vol. 102, no.3, pp.19-25. Webber, N2001, Interest rates modeling, New York, John Willey & Sons. Peter, G2011, Getting to understand the money market, London, Rutledge. Shiller, B2007, Macro shocks and aggregate risk, Quarterly Journal of Economics and Finance, vol. 43, pp. 668-696. Keith, B2006, Financial derivatives, London, Prentice Hall. Economy watch.com, 2010, Risks in international trade, Retrieved on 9th January 2014, From; http://www.economywatch.com/international-trade/risks.html Sarah, p2007, Risk management, New York, John Willey & Sons. Investing answers.com, 2013, Yield curve, Retrieved on 9th January 2014, From; http://www.investinganswers.com/financial-dictionary/bonds/yield-curve-810 Joel, M2010, Financial regulation, Oxford, Oxford University Press. Read More