The Need for Regulations in the Financial Markets, Money and Capital Markets - Assignment Example

Question 1(a): Asymmetric Information and Moral Hazard

Asymmetric information refers to a problem in the financial markets involving borrowing and lending. The borrower has more information about his or her financial state than the lender (Welfens and Ryan, 2011, p.408). Lenders, for example, banks, experience problems determining whether the borrower will default in paying loans or credit. Some lenders assess past credit record and salary evidence, but the sources contain limited information. Limited information presents a risk, which compels lenders to compensate the perils by charging high rates. For example, banks and investors lacked sufficient public disclosure before the financial crisis of 2008 (Cowling, Liu, and Ledger, 2012). The asymmetric information compelled banks in UK and U.S to undertake risky lending.

Moral hazard involves individuals or financial institutions engaging in risk-taking behaviors hoping to achieve favorable outcomes (Cukierman, 2013).The person or entity expects another institution to bear the costs when they experience unfavorable outcome. Moral hazard is a subset of asymmetric information where a person or entity takes advantage of the inadequate information. For example, banks in England engaged in excessive risk taking because they believed that the Bank of Bank of England would bail them out (Acharya and Richardson, 2009). The behavior led to the 2008 financial and credit crisis. A similar risk-lending occurrence happened in the U.S within the same period.

Question 1(b): The Need for Regulations in the Financial Markets

Financial markets require regulation to prevent an imbalance between the interest of the consumers of financial products and the sophisticated sellers (Welfens and Ryan, 2011). Imbalance creates asymmetric information, which may compel institutions such as banks to engage in risky lending behavior, which exploits borrowers. Consumer protection extends to the investors and consumers in the retail exchange-traded markets.

The presence of social externalities in the financial markets necessitates regulation. The consequences of certain activities in the market should reflect the interests of the individuals or entities involved. The failure in the financial and credit systems in 2008 in U.S and U.K created the need for regulation (Acharya and Richardson, 2009). Shareholders and the lenders of the last resorts bore the costs of the failed financial system.

Financial regulation sustains efficient investments. The process reduces cases of moral hazard behaviors through limited liability arrangements (Welfens and Ryan, 2011). The excessive risk lending increases the benefits for the bank owner, but they do not bear the losses when the risky ventures fail. The risky lending prevents investors from considering efficient investments due to the negative values of financial disclosures.

Regulation maintains the operations and stability of the financial markets. Investors are essential players in the markers, and they work when the market does not experience cases of fraud or manipulation (Acharya et al., 2009). Information asymmetry inhibits the breakdown of control in the entities, but regulation from the government eliminates the impediments in create stability. Financial intermediaries and markets work well under supervision or regulation. For example, Bank of England introduced a levy in the form of annual tax on balance sheets to regain stability in 2010 (Bank of England, 2016).

Question 2: Money and Capital Markets

Similarities

Both money and capital markets sustain the financial markets in the globe (Choudhry and Beehler, 2011). The markets facilitate the trading of financial instruments that have a high liquidity level. The financial market further provides a platform the buying and selling of securities. Sovereign governments and individual entities use capital and money markets to raise long-term funds, for example, bonds (Welfens and Ryan, 2011). The financial market provides facilitates of money between parties where the money and capital markets assist in taking surplus money from lenders to borrowers.

The markets engage in the improvement of the world economy. The short-term and long-term capital requirements from governments, individual entities, and corporations come from the markets through regulated transactions. According to Thiessenhusen (2015, p.5), the high level of returns from the capital and money markets encourages investment. For example, Eurobond has been a key source of capital for corporations within and beyond the Eurozone. The two markets have noteworthy differences despite having identifiable similarities in their key activities.

Differences

Money markets provide diverse financial instruments to the government and corporations across the globe (Thiessenhusen, 2015).The financial instruments offered in the money markets include federal funds, deposit certificates, and Treasury bill. The platform provides the investment tools on short term and long term based alongside low-risk securities. The provision of the financial instruments becomes the temporary source of investment and highly attractive returns for private and public entities. However, the instruments have low investment rates due to low yields.

On the other hand, capital markets offer trade investments, which come in the form of equity, credit, insurance, and foreign exchange (Choudhry and Beehler, 2011). The markets derive the instruments from existing financial portfolios that facilitate the operations of the bond markets through debt securities, and stock markets where companies sell their shares among other securities exchange tools. Capital markets have a high level of returns when compared to the money markets due to high yields. However, the provision of securities involves high risks due to the susceptibility of stocks and bonds to market fluctuations. Moreover, national monetary policies regulate the activities of the capital markets, which limit the prices, and interests of the bonds. For example, Mink and de Haan (2013) noted that the reconstitution of monetary policies during Greece crisis led to a reduction in the prices of sovereign bonds.

Furthermore, while capital markets engage in the mobilization of savings in the economy, money markets increase the liquidity of funds in developing and developed economies (Thiessenhusen, 2015). Money markets have a promising high rate of investment because the lending and borrowing occurs in the short-term, which gives corporations ability to meet cash or collateral obligations. Contrastingly, capital markets encourage savings because they generate high investment returns in the long term through traded securities (Welfens and Ryan, 2011). Despite the differences, advanced economies need both markets for diverse or universal reasons.

The Need for Both Markets in the Advanced Economies

Advanced economies need money and capital markets to fund financial institutions (Dell'Ariccia, 2008). While the 2008 financial crisis affected the money markets in the U.S and Eurozone, the reconstitution of the regulations after the credit, as well as financial crunch, gave banks a new source of funding (Cornwall, Vang, and Hartman, 2015). The financial institutions require a reliable source of funding to maintain liquidity in secured and unsecured markets. The introduction of fixed-rate allotment regime in the Eurosystem has sustained the capacity of the capital and financial markets to fund institutions.

The economies require financial markets to facilitate capital formation (Welfens and Ryan, 2011). The mobilization of savings through capital markets in the long term and reinforcement of the liquidity levels for corporations helps core stakeholders to sustain the generation of resources in various segments such as manufacturing and agriculture. The net addition of capital in the economy prevents countries against financial shocks. According to Bank of England (2016), the UK government requires significant capital to fund its projects to avoid overreliance on tax income.

Additionally, the markets accelerate economic growth and development by enhancing production and productivity in private and government institutions. The national economies of UK, China, and the USA require long-term sources of funds, which are readily available in the capital markets (Cornwall, Vang, and Hartman, 2015). The companies sustain employment and lead to the development of relevant infrastructure. On the other hand, Dell'Ariccia (2008) found that the financial markets become the investment avenues for the same corporations and the investors who target bonds, equities, bills, as well as mutual funds.

Question 3(a): Different Levels of Market Efficiency

The Efficient Market Hypothesis (EMH) assumes that financial markets are efficient and categorizes them into three levels namely weak form, semi-strong, and strong-form.

Weak-form level denotes efficiency of the market where all relevant information is available. The level implies that the rate of returns in the market is independent (Frino, Chen, and Hill, 2015, p.308). Subsequently, the past returns do not have any significant effect on the future rates. For example, the prevailing stock prices in the financial markets do not feature any past data. The inexistent of past data prices does not require investors or individuals corporations to conduct a technical analysis to facilitate making trading decisions.

On the other hand, semi-strong efficiency suggests that all information is available to the public, which investors can use to determine stock prices (Chandra, 2011, p.414). The utilization of technical analysis is unnecessary under semi-strong EMH just like in weak-form level. Investors cannot generate returns through fundamental analysis of the publicly available information. For example, investors cannot use IPOs alone to determine the viability of the announced share prices. The investors must consult with relevant players to make trading decisions.

Conversely, strong form efficiency assumes that the stock prices account for the information that available or unavailable to the public (Frino, Chen, and Hill, 2015, p.308). Therefore, investors cannot gain advantage using other sources of information within the financial markets. The high market efficiency limits the trading decisions of the investors. For example, an investor cannot make returns that exceed the prices announced in the stock markets even through research. In a real world, investors focus on diversifying numerous stocks or by investing in index funds to increase turns beyond the normal level.

Question 3 (b): Efficiency of London Stock Exchange Market (LSE)

Philip and Isiaq (2011) tested the weak form of EMH in the Nigerian Stock market. The study analyzed data between 1986-2010 using regression and autocorrelation methods. The mainstay of the research was using augmented Dickey-Fuller and Philip Perron tests. Philip and Isiaq (2011) found that the Nigerian stock market exhibited information efficient, where the stock prices do not demonstrate random walk behavior. The findings come after the end of the global financial crisis, where economies have focused on creating robust supervision and regulatory framework, which implies that Nigerian stock market, could move towards a strong form efficiency.

A similar study by Nisar and Hanif (2012) focused on the weak-form EMH and presented substantial empirical evidence from South Asia. The study sought to compare South Asia and the developed western economies whose markets have registered low participants in the recent decade due to the growing preference for East markets. While the study did not dwell on the global attraction for the various markets, it determined that East markets are adopting high market efficiency hence the reason for investors shifting focus. Nisar and Hanif (2012) tested weak form of EMH using serial correlation, unit root, runs test, and variance ratio test which gave the study a good foundation because the study would present evidence from diverse test perspectives. A focus on India, Pakistan, Bangladesh, and Sri Lanka did not show random walk behavior, which affirmed that the markets are not a weak form of EMH.

Correspondingly, Borges (2008) conducted a timely study during the crisis that affected credit and financial markets particularly in Europe where the crunch emanated. The research focused on EMH in the European markets, which was a wide and extensive scope of study considering the unpredictability of the stock markets during the crisis. Empirical evidence focused on the weak form of efficient markets for France, Germany, UK, Greece, Portugal, and Spain for a period of 1993-2007. Borges (2008) used a variety of tests in the same way that Nisar and Hanif (2012) did though with different test results as well as markets. The analysis found that monthly prices and returns for six countries follow a random walk within the test period. However, daily returns show a normal distribution that refutes the random walk criteria. Additionally, Borges (2008) affirmed that Greece and Portugal do not demonstrate random walk behavior due to serial positive correlation established in the tests.

Conversely, studies on the semi-strong form of EMH shows contrasting results from weak forms of EMH. According to an empirical study on Indian Capital Market by Khan and Ikram (2010), have a significant impact on the markets, which implied that the markets were semi-strong. The researchers utilized Karl Pearson’s Simple Correlation and linear regression for the period of 2000-2010 to establish the nature of the relationship. The findings revealed the influence of the Security and Exchange Board of India, which regulates the Foreign Institutional Investors from exploiting the markets. Khan and Ikram (2010) presented a landmark revelation that demonstrates that semi-strong form markets require a regulatory body to prescribe the norms for the investors, who then make their investment or trading decisions based on the guidelines provided.

Similarly, Alexakis, Patra, and Poshakwale (2010) analyzed semi-strong, but the Athens Stock Exchange revealed contrasting results for the period of 1993-2006. The study utilized panel data analysis to establish the trend of stock returns in the market and the portfolios selected by investors based on financial ratios. Global markets view Greek, as an emerging market and the likelihood of showing semi-strong were low. Alexakis, Patra, and Poshakwale (2010) found that Greek does not integrate accounting information into stock prices, which affirms its semi-strong efficient market. Borges (2008) carried out analysis on the European stock markets and affirmed that Greece does not adopt a random walk trend, which further confirms its weak form of EMH. The likelihood of strict regulations was low so that the investors would operate without the norms of the regulatory body in Greece.

Indian Stock Market rejects the weak form of EMH guided by the comparison between Gupta and Basu (2007) and Nisar, and Hanif (2012). According to Gupta and Basu (2007), Indian Stock Market does not demonstrate signs of random walk hypothesis, which affirms that the Indian Stock Markets is a semi-strong market in accordance with the findings of Nisar and Hanif (2012). The period of 1991-2006 presents landmark findings because it preceded the 2008-financial crisis. Highlighting the case of India as a world emerging economy was critical because it showed the movement of investors who focus on globally diversified portfolios.

Chung and Hrazdil (2010) argue that the movement of shares is as important as the announcement of dividends and earnings. The tools are essential signaling tools that convey information about the efficacy of the capital market. Participants base investment and trading decisions on the fundamental information available. Mînjină (2010) found that Romanian Stock showed significant improvement in efficiency when he carried the empirical analysis of returns and stocks for the period of 1996-2009. While the study showed mixed results, the positive development over the years shows a market that has improved to a semi-strong form of EMH. The following graph demonstrates the improvement:

Figure 1: Semi-Strong form of Romanian Stock Market in 1996-2009 (Mînjină, 2010)

Guided by the review of the empirical studies on diverse stock markets, an evaluation of London Stock Exchange (LSE) market for a three-month period between 14 February 2016 and 14 May 2016 shows a normal distribution behavior but a significant improvement from the first month. The distribution of All Share Index correlates with the semi-strong form of EMH as shown in the graph below:

Figure 2: All Share Index at LSE in February-May 2016 (Londonstockexchange.com, 2016)

The Financial Times Stock Exchange (FTSE) demonstrates the same trend as LSE within the same 3-month trading period:

Figure 3: FTSE All-Share Index for February-May 2016 (FTSE, 2016)

Conclusion

LSE exhibits all the signs of semi-strong where investors access publicly available information relating the share prices and movements as well as dividends. In Figure 2, LSE does not exhibit random walk trend for the share prices within the three-month period. The trend is attributable to the current Eurozone regulations where the markets admit shares for trading based on transparent and regulated base levels. The attractiveness of shares in the LSE markets under semi-strong form provides an efficient and regulation platform for investors with diversified investment portfolios.

Question 4: Spot and Forward Exchange Rates

Differences between Spot and Forward Exchange Rates

Spot and forward exchange rates define the currency exchange, but they have identifiable differences (MacDonald, 2007). Spot exchange rate features a simplified form because it entails the current exchange between currencies. For example, the UK Pound Sterling is exchanging at 1.43 U.S Dollar according to the current spot rate in the London Stock Exchange Market. On the other hand, the forward exchange rate is the exchange proportion quoted and traded in a market but for the purpose of future delivery as well as payment. For example, when a company from the UK makes an international sale of its good but expects payment a few months, it uses a forward exchange rate to determine the price of the products or the goods irrespective of the prevailing spot rate. However, some instances spot rates help to determine forward exchange rates.

The essence of exchange rates is to facilitate international trade, but companies use different types of contracts in accordance with spot and forward exchange rates (Apte, 2010). The utilization of a spot exchange contract necessitates constitution of a spot contract. A spot contract expedites the buying and selling of commodities, securities, and currency when an individual makes payment on a predetermined spot date. Conversely, forward contract features terms of agreement for delivery and payment at a future date. Individuals or companies use forward price as a settlement rate during the transaction.

The calculation of the spot rate is easy due to its simplified form when compared to the forward exchange rate. Institutions face difficulties in determining exchange rates due the challenge of predicting the future, which implies that current and future values are different (MacDonald, 2007). Large financial institutions engage in forward contracts because of the possibility of making small losses in the event of default on the forward date. The calculation of the forward rate depends on the securities traded in the market to avoid the implications of the fluctuations of spot rates (Apte, 2010, p.180). Admittedly, the determination of the two rates features significant variance, guided by the differences between spot and forward exchange rates.

Determination of Spot and Forward Exchange Rates

A simple framework of supply and demand in the market determines the spot exchange rate. Markets consider changing relative changes in inflation rates, currency tastes, and comparative advantage determinant among other current account factors. In addition, forex considers changes in interest rates, which are capital account factors. The incorporation of capital and current account factors gives rise to floating, pegged, and floating-pegged rates.

On the other hand, forward exchange market determines rates using outright rate, which is equal to the current spot rate (Alvarez, Atkenson, and Kehoe, 2009). Sometimes the markets develop a swap rate where they express forward rate as a discount or premium to the current spot rate. Alternatively, the market may express the forward rate based on annualized percentage rate above or below prevailing spot rate (Apte, 2010). Financial institutions such as banks expedite the process by agreeing to exchange a stated amount of currencies at a defined rate in future.

Therefore, predictor function defines nature of the relationship between the spot and forward exchange rates. A forward exchange rate predicts future spot rate when the risk of the premium is insignificant or when the information efficiency characterizes the foreign exchange markets (Bilson and Marston, 2007). The unbiased nature of forward rates enables investors to exploit due to the high economic value of the returns. According to MacDonald (2007, p.2), the predictability of the rates suggests that they are prone to controls, restrictions, adjustments or any changes in the national interests or inflation rates.

Reference List

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Appendices

Data used to develop Graph 1

Source: Mînjină (2010)