FINANCIAL MARKETS AND INSTITUTIONS 8
FinancialMarkets and Institutions
Financialmarkets present the platform where investors trade in financialsecurities, commodities as well as other fungible and valuable itemsat a low cost of transaction. The prices in this market areinfluenced by demand and supply of the tradable items. The financialmarket varies from capital market ranging from the definition anditems traded. As Miller (2012) expounds, financial markets play asignificant role in the economy hence, regulations are necessary toensure control.
Financialmarkets engage in the creation of financial resources for bothshort-term and long-term investments through facilitating financialintermediation. Financial markets are classified into the money andcapital markets (Miller, 2012). The money market is distinct from thecapital market in that it only facilitates short-term financing. Someexamples of instruments traded in the financial markets includecommercial company bills, treasury bills and related securities. Thecapital markets facilitate mobilization of long-term investmentresources for government projects and other large-scale businessenterprises. Financial markets contribute to the economic growth ofthe US in different ways as discussed in the paragraphs that follow.
Well-functioningfinancial markets facilitate the use of resources and diffusion oftechnology through the creation of robust investment incentives. Theyalso stimulate investments in human resources and physical capital bymarshaling useful investment savings as well as capital inflows.Furthermore, financial markets redirect savings towards moremeaningful ventures by gathering and analyzing investment data.Eicher & García-Peñalosa (2006) add that financial marketsystem enhances efficiency within the corporate segment throughmanagement monitoring as well as exerting controls.
Thevarious trading instruments in the financial markets can be utilizedto raise short-term funds that can easily become liquidated to meetshort-range needs. Also, the federal government can borrow funds fromthe general public to meet long-standing investments through theissue of bonds or treasury bills (Miller, 2012). The money raisedthrough such avenues are used to construct hospitals, schoolstransport networks or other social amenities. This action bringsabout the creation of national wealth.
Corporationsalso contribute to economic growth through the issuance of corporatebonds and equities. The returns from these securities are used toconstruct new plants or expand existing ones thereby, creating morejob opportunities for the US citizens. In addition, investorscontribute to economic growth by reinvesting the income generated inthe financial markets. These investors make money by receivinginterests when they sell securities such as government bonds (Eicher& García-Peñalosa, 2006).
Financialsecurity is defined by Rini (2003) as a fungible and negotiableinstrument that represents a monetary value. The securities arecategorized as debt, equity, and derivative contracts. Debtsecurities, also known as the fixed-income securities, refer to anydebt instrument that is tradable between two parties with definedinitial terms. The buyer lends the issuer money in exchange for thesecurity, and the holder is then entitled to receive interest andprincipal in addition to any rights described under issuance terms.Debt securities are usually offered under fixed terms and areredeemable at the expiration of the period by the issuer, and theycan be secured or unsecured. Debt securities include treasury bills,bonds and notes as well as corporate bonds (Rini, 2003). After 2009,the US debt held by the public was $3.6 billion in 2000 and aprojection of $413 in the fiscal year 2009. Equity earning forGeneral Motors Company for 2015 were $ 2,194,000 while for 2014 were$2,094,000.
Equitysecurities are shares of the equity interest in items such as capitalstock, trust or partnership in a firm (Bjørnland & Jacobsen,2013). This form of security is not subject to any regular paymentsas in the case of debt securities. Equity security holders receivesettlement after all other creditors to a firm have been paid in caseof bankruptcy. Equity signifies ownership of a firm by its holder andrepresents a claim on the profits and assets of the corporation. Anypartner with equity security is entitled to vote during annualmeetings of companies. The stock of a company is classified ascommon stock and preferred stock. Common stock refers to the basicequity an investor holds in a company and has a potential ofproviding huge gains. On the other hand, preferred stock does notoffer great potential for large gains as common stock, but isguaranteed of dividends. The level of interest rate largelyinfluences the price of preferred stock as prices are tied to therates. This relationship between the rates and prices is inverse suchthat the price increases as the rate falls and vice versa. The stockprices for General Motors were at 30.51 in May 2016 and an average of35.55 for the same period in 2015.
Derivativesare financial securities whose price depends on the value of theunderlying asset (Miller, 2012). The price of a derivative depends onthe changes in the value of the underlying asset or assets. Theassets that underlie derivatives include stocks, bonds, as well ascommodities and currencies (Miller, 2012). The trading of derivativesoccurs through the exchange or over-the-counter (OTC). Derivativestraded on an exchange are standardized whereas OTC derivatives makeup the greatest proportion of derivatives, and they are unregulated.Derivatives are used for hedging against risks or speculating andarbitraging. Hedging of risks means that derivatives allow thetransfer of risk of the underlying assets from one party to another.Speculating and arbitraging refer to the act by investors to cogitatethe value of the underlying assets. The common forms of derivativesinclude futures contracts, forward contracts, swaps, option contractsand credit derivatives (Eicher & García-Peñalosa, 2006). TheOption Chain for General Motors stood at $30.57 in May 2016 while thesame traded at an average price of $29.95 during the same period in2015.
Debtrisk returns relationship depends on the prevailing inflation orinterest rates. For instance, a one-month treasury bill may offernominal rates of returns that bear no risk, but uncertainty ininflation may make the returns in the subsequent months risky. On theother hand, returns from equity instruments such as stock depend onthe success of a company. This happens because success in thefinancial performance of firm translates to higher dividends (Miller,2012). Therefore, the risk embedded on stocks comes from the successof a firm. Common shares are considered risky as they are settledlast hence, carry no guarantee of payment. Derivatives have inherentrisks arising from changes in expectations of the value of theunderlying asset. Investors use derivatives to hedge against risks,but speculation raises the level of risk faced.
Accordingto Cross (2006), Global Macro strategy presents the most practicalapproach as well as offering high-risk returns on any financialinstrument. This strategy is applied in bonds, stocks, and currenciesas well as derivative instruments, including futures and options. Inthis methodology, directional bets are placed by investors on thevalue of underlying assets which are usually leveraged. Equityhedging strategy is also applicable in dealing with stocks.
TheFederal Reserve can utilize the monetary policy to influence thedebt, equity, and derivatives. The monetary policy affects theshort-term interest rates which affect the cost of debt. The Fed maypurchase or sell US government securities, which mainly influence thefederal funds rate. The Fed encourages long-term investments bypurchasing government securities through the Federal Reserve Bank(Griffiths et al., 2010).
Monetarypolicy affects equity by influencing stock prices. Contracting themonetary policy makes the stock riskier to invest in hence,investors demand higher returns to hold them. This rise can onlyhappen by lowering the existing stock prices. The Federal Reservemonetary policy affects derivatives in different ways, but the mostnotable is the influence on futures. When the monetary policy is setto affect short-term rates, investors hedge or speculate againstfuture effects of such moves. Hedging is done to cushion againstharmful impacts while speculation is used to tap on potentialpositive effects (Griffiths et al., 2010).
Equity,debt, and derivatives provide a good investment for the next twelvemonths, five years and ten years. Taking the General Motors example,the company can borrow approximately $20 billion against a five-yearrevolving credit facility. This places the firm in a better positionto meet all its debt obligations. On the other hand, the stockreturns show a negative trend as earnings per share shows a decliningtrend. The gains per share decreased from $ 3.10 to $1.75 between2012 and 2014. The derivatives of the company held by December 2014were fully collateralized and hence the related level of credit riskassociated was reduced. This indicates that investing in the companyin the future periods promises potential gains.
Inconclusion, it is evident that financial markets contribute to thegrowth and expansion of the economy in different ways. Also, themarkets deal with a number of financial securities which includedebt, equity, and derivatives. The risk returns analysis of thesesecurities is important when making investment decisions as itprovides information on the most risky portfolio. The FederalMonetary Policy is used to regulate financial markets as they presenta risk in case they fail in the economy.
Bjørnland,H. & Jacobsen, D. (2013). House Prices and Stock Prices:Different Roles in the US Monetary Transmission Mechanism. Scand.J. of Economics,115(4),1084-1106.
Cross,A. (2006). US regulators release joint‐ruleproposal regarding futures contracts on debt indexes and securities.Jof Fin Reg And Compliance,14(4),402-407.
Eicher,T. & García-Peñalosa, C. (2006). Institutions,development, and economic growth.Cambridge, Mass.: MIT Press.
Griffiths,M., Lindley, J., & Winters, D. (2010). Market-making costs inTreasury bills: A benchmark for the cost of liquidity. Journalof Banking & Finance,34(9),2146-2157.
Miller,M. (2012). Financial Markets and Economic Growth. Journalof Applied Corporate Finance,24(1),8-13.
Rini,W. (2003). Fundamentalsof the securities industry.New York: McGraw-Hill.