Financial Markets and Instruments - Case Study Example

Financial Markets and Instruments Table of Contents Topic 5 Central Banks/Monetary Policy 5 Open Market Operations (QE) 5 Response Other than QE toCurrent Problems 5 High Debt Levels 5 Slow Growth 5 Lack of Demand 6 Topic 2 6 Efficient Markets Hypothesis 6 CAPM Theory 6 Benefits and Problems with CAPM 7 Topic 3 7 Financial Institutions 7 Topic 4 8 Equities 8 Topic 5 10 Fixed Income 10 Interest Rate Theory 10 Term Structure of Interest Rates 10 Yield Curve Slopes 10 Empirical Evaluation of Yield Curve Spreads 10 Bond Types and Pricing 11 Topic 6 11 Derivatives 11 Topic 7 13 Securitization 13 Swaps 13 Asset Backed Securities 13 Credit Derivatives 14 CDS 14 Influence of ABS securities on the Credit Crisis 14 Topic 8 14 Financial Crisis 14 Specific Causes 15 References 17 Topic 1 Central Banks/Monetary Policy Central bank is the public institution which manages the money supply, interest rates, and state’s currency. Central bank also monitors the commercial banking framework of the different countries. It is also responsible for managing the money supply of the nation. The Central Bank also has the responsibility to print the national currency, and also serve as the national tender. Open Market Operations (QE) Quantitative Easing signifies alternative monetary policy that is often used by Central Banks for stimulating the economy of the nation. This is usually followed when the standard monetary policy becomes inactive or ineffective. The QE is implemented by the Central Bank by purchasing financial assets from the Commercial banks and various other private financial institutions for increasing the monetary base. The Open Market Operation is the activity by Central Bank sell or buys government bonds on open market. The Central Bank utilises Open Market Operations to achieve interest rate target (Bandenhorst-Weiss, 2010). Response Other than QE to Current Problems High Debt Levels High debt level is minimized by the Central Bank by purchasing and selling second hand debt of the government. Apart from this, the reserve requirements are also altered in order to control the high debt. Slow Growth Contractionary monetary policy assists in slowing down the rising inflation that is followed by a boom economic condition. Governments of different countries slow down their spending, and raise their interest rates in order to make money borrowing expensive. This slows the inflation rate and efficient economic growth increases market sustainability. Lack of Demand During recession, the purchasing power of the consumers’ decreased leading to a decrease in the demand. The government uses countercyclical tool in such situation, which directly increases the employment rates. However this would also affect the money supply and increase the price (Baker, and Powell, 2009). Topic 2 Efficient Markets Hypothesis Efficient Market Hypothesis is an investment assumption, which states that the financial markets cannot be challenged as they are well-equipped with information and are regularly updated. Due to this reason no one can achieve excess returns consistently. Under this assumption, the stock are always traded at their fair value on the stock exchange, so the investors can never purchase undervalued stocks or sell overvalued stock. This also proves that it is not possible for any stock to out-perform. In order words, Efficient Market Hypothesis is assumptions taken to control the market operations. CAPM Theory Capital Asset Pricing Model (CAPM) assist in determining rate of return of the asset, if the asset is added to well-diversified portfolio, considering the non-diversifiable risk of the asset. This model considers assets sensitivity in comparison to the non-diversifiable risk, which is represented by Beta (β). This is a model used for pricing the securities or portfolio of individuals. For pricing individual’s portfolios, security market line and its relativity with the systematic risk and expected return is represented through the CAPM Model (Barrow, 2001). Benefits and Problems with CAPM The benefits of CAPM model are stated below: The problems of CAPM model are stated below: Topic 3 Financial Institutions Financial institutions are those institutions that provide financial services to the clients either directly or by acting as intermediaries. The financial institutions are either directly or indirectly regulated by the government of the different countries. Insurance Companies Insurance means transferring the risk of loss to another entity of payment. The insurance companies assist individuals to hedge their risk against contingencies and uncertain losses. These companies offer insurance policies to the customers by either selling them directly to the individuals or through various employee benefit plans (Bernstein, and Wild, 2004). Pension Funds The pension plans are for the benefit of the employees after their retirement. Pension plans such as Defined Benefit (DB) plan is an employer sponsored plan, which is based on the salary history, and the employment duration. There are various DB plan, for example tax-benefit plan, etc in pension plan. Investment Companies The investment companies are those who hold securities of other companies purely for further investment. In case of close-ended investment companies, the fund has a fixed number of outstanding shares, which are not redeeming shares like mutual funds. Open-ended investment companies create shares when shares are redeemed and money is invested by the shareholders. ETF The exchange traded investment fund are like stocks and hold assets like commodities, bonds, or stocks to its net asset value during the trading day. They track the index, such as bond index or stock index (Brigham, and Ehrhardt, 2010). Topic 4 Equities Equities are stock or securities which represent the ownership interest. It is the amount mentioned in the balance sheet that is procured through investors or shareholders from the market. Different types of Exchanges The different types of stock exchanges are stated below: Equities trading The securities are floated for the first time as Initial Public Offering (IPO) in the primary market, and then they are re-traded sold or purchased in the secondary market, with the help of legitimate brokers. Equity Valuation (Tobin Q ratio) According to Tobin Q model the replacement cost would be equal to the combined market value of all companies in the stock market. In order to calculate the Q ratio, the market value of the company, which is also called market capitalization, is divided by the total value of the asset. Interaction between ROE and PE during Stock Market Cycle The stock market cycles signifies long-term price outline in the stock market. Return on Equity (ROE) will assist in estimating the return that the equity will yield for the investors. Profit Earning (PE) is the equity valuation multiple. All these can be considered as the ingredient in stock market cycle (Chandra, 2005). Topic 5 Fixed Income It is a type of budgeting and investing style due to which period income or real return rates can be received through regular interval at predictable levels. Interest Rate Theory The no-arbitrage situation that represents a state of equilibrium in which the investors would be indifferent to the interest rates that is available in the bank on deposits in the two countries in known as Interest rate theory or Interest rate parity theory (Chadwick, and Kirkby, 1995). Term Structure of Interest Rates The term structure of interest rates is also called yield curve that plays the primary role in the economy. It reflects the expectation of the participants in the market regarding the future changes, in relation to interest rate and monetary policy. Yield Curve Slopes It is a benchmark that signifies the other debts in the market, for example bank lending rates, or mortgage rates. Empirical Evaluation of Yield Curve Spreads In a yield curve, the line that is used to plot the rate of interest at a point of time for those bonds having same credit quality, but diverse maturity dates, as can be seen in Figure below. Bond Types and Pricing The different types of bonds are stated below: 1. The value of the bond is determined at the fair price of the bond, just like for any capital investment the fair value of the bond is determined by the present value of the cash flow is expected to generate (Conrade, and Fourie, 2002). Topic 6 Derivatives Derivatives are the financial instruments that assist in deriving value from the underlying assets by hedging the risks associated with it, to an extent. The underlying assets may be securities, debts, currencies, or even indices. The different types of derivative instruments are future, forward, and options. They are explained below in details (Edward, and Pointor, 1994). Options In an option, the derivative contract is made between the buyer and seller, where the buyer has the right and not the obligation to buy from the seller at the specific price and on the specified date. Options are traded on stock exchange and over the counter. Futures Futures are contracts between two parties, where the buyers give consent of buying the underlying asset at a predetermined date, and price. However, futures are traded through stock exchange, and both the parties in this case are protected from counter-party risk. Pricing of Options and Futures The future prices are determined through supply and demand. It is usually determined by using the formula started below: F= Sert Here, F is the future price, S is the spot price of underlying assets, r is the cost of financing, t is time in years, and the value of e is 2.71. This model is also known as the cost of carrying for estimating price of futures. There are several models for pricing options that use different parameters to determine fair market value. The Black Scholes model is the one which is most widely used for pricing options. The elements required to prices options are the intrinsic value, interest rates, cash dividends, etc (Gallagher, and Andrew, 2007). Forwards A forward is just a contract between the two parties to sell or buy certain assets at a future date and at a pre-decided price. It is not traded in stock market, but only traded over the counter. Derivatives Regulation Derivative regulations are policies or norms formed by the stock exchanges for monitoring and preventing the probability of derivative being used as a speculation instrument rather than a risk hedging tool (Gandreau, 2005). Topic 7 Securitization The mortgages are combined and issued to different individuals into small pieces based on the individual’s ability to bear risk. This was a process through which the risk of mortgage based loans were divided a shifted on others. The different elements of securitization have been discussed below: Swaps Swap is a derivative instrument in which the counterparties exchange the cash flows of the financial instrument of one party to the financial instrument of other party. Swaps are used to hedge certain kinds of risk such as interest rate risk or speculate on the changes in expected price of the underlying assets. Asset Backed Securities Asset backed securities are those financial securities which are backed by loans, receivables, or leases against various kinds of assets, except real estate, and mortgage backed securities. For the investors, it is an alternative for investment in corporate debt. Credit Derivatives The exchangeable bilateral contracts which are privately held, allow users to supervise their exposure to the credit risk. The credit derivatives are the financial assets like the options, forward contracts, and swaps, for which prices are driven by credit risk of the economic agents. CDS The Credit Default Swaps (CDS) allowed the investors to invest in certain corporations without feeling the heat of direct equity exposure. By 2008 it was found that the outstanding associated with CDS was around $40 trillion, and the over the counter derivative outstanding amount was around $683 trillion in June 2008 (Gibson, 2012). Influence of ABS securities on the Credit Crisis The structural flaw of the loan- securitization market resulted in bursting of housing bubble and financial crisis. The financial institution transferred their obligations to the investors through the process of securitization. However, as the housing bubble busted, the prices of property went down, and the house owners failed to pay their loans, which initiated the sub-prime crisis. Topic 8 Financial Crisis The financial crisis of 2007-2008 has been regarded as the worst financial crisis after the Great Depression of 1930s. The financial crisis of 2007-08, not only led to the collapse of several banks and financial institutions, but turned down the stock markets in most of the countries. Every business cycle goes through different stages, which affect the economic condition of the global market aggressively. The financial crisis of 2007-2010 was the result of the recession stage of the business cycle which usually comes after the peak stage. Specific Causes There are several specific reasons for the financial crisis which is discussed below in detail. Securitisation The securitization market in 2007 was supported by the parallel banking system, which started to collapse and shut down by 2008. In this situation, the private credit market was not available to sources such funds. Even the traditional institution did not have the strength to cover such huge financial gap. The market of securitization was totally damaged and investors started expecting further loan losses (Krugman, 2009). Regulation Financial crisis by caused by increasing rate of complex regulations that were designed to increase control over the financial market. The increasing rate of regulations, made the bankers, investors and even regulators ignorant of the regulations. The credit ratings were speculated, which led to a disastrous outcome bursting the housing bubble. Asymmetric Information Information asymmetry increases uncertainty, which increases the risk level in transactions or asset price. The complexity of the financial market increases when monitoring get difficult and investors do not have much information regarding the buyer or seller. The recent credit default swaps that were circulated in market transfer the risk of one on another, which has made the matter worse. Deregulation Deregulation by the government, mismanagement by board of directors, fraud practices by credit rating agencies, and speculative activities by other financial firms led the economy towards the next stage of business cycle that means from boom to crisis and recession. Derivatives were designed as a tool that hedged risk associated with investment in securities market. However, this soon turned into a weapon for speculation. Bankers Bonuses Spectacular Collapse of the banks, where executives were paid for their performance has raised questions that link risk and executive pay and bonuses. In a research report by Thomas Philippon and Ariell Reshef, they have mentioned that in the year 2000, the wages of the executives has increased by 40 percent, the qualification remaining the same. The question is that how is executive’s compensation related to risk. The executives in the banks were offered stock or equity options in order to eliminate short-termism (Gibson, 2012). References Baker, H. K., and Powell, G., 2009. Understanding Financial Management: A Practical Guide. New Jersey: John Wiley & Sons. Bandenhorst-Weiss, J., et al., 2010. Introduction to business management. Cape Town: Oxford. Barrow, C., 2001. 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