Example Of Essay On Financial Markets And Institutions, Part 2

Financial markets play a critical role in stable and efficient operation of economies of various countries by providing liquidity to various forms of securities. Owing to their nature of providing simple and instant marketability, these markets allow both sellers and potential buyers of a variety of securities to interact openly and freely. Through the existing regulations in financial markets, efficiencies in several aspects of its operations can be achieved. In addition, these markets help in the determination of the various risks and rewards of these securities thereby helping in effective and fair pricing of these securities (Burke & Litwin, 1992). In the United States, these markets have played key role in improving the operations of the economy owing to the ability of the markets to allow effective flow of information concerning vital aspects in relation to the securities to different stakeholders involved. Included among the different forms of securities traded in these markets are treasury bonds, stocks, treasury bills, municipal bonds, futures, and many other forms of derivatives. In line with the existing norms and practices, the paper will focus primarily on critical examination of a number of market facets of treasury bonds, swaps, and general bonds. The effects of these derivatives in the creation of wealth in various countries will be analyzed with close reference to the United States (Burke & Litwin, 1992).

Bonds

A bond is a form of long-term investment where investors lend money to organizations for a specific period. Owing to the diverse nature of bonds, their usage and adoption by institutions varies depending on the desired facets of that specific bond. Related to the usage of bonds, there are certain terms that are very common and frequent. Some of the terms include the coupon rate, the principal amount and the maturity date (Essential dental public health, 2013).
The coupon rate defines the interest that will be paid for the bond at the end of the specified period. Maturity rate, however, is the defined period at which both the interest and the principal amount should be paid. In terms of maturity, bonds can be either for short, medium, or long terms. The maturity rate will highly influence the selection of the type of bonds purchased by corporations. In addition, the element of the market price will also be integral to influencing the overall interest to be paid for the bonds. Market rates refer to the prices that are charged for bonds in the marketplace. In the event that the financial market bond prices exceed the intrinsic value of the bonds at maturity, the bonds are considered as premium. On the other hand, if the intrinsic value at maturity exceeds financial market bond prices, then it is said that the bond is sold at a discount. Therefore, market prices can highly influence the purchase of bonds.

Swaps

Swap is a form of derivative that involves the exchange of one form to another of various forms of securities. Swap is founded on the principle of resource endowment, as parties involved in the swap process will accept terms that best fit their needs. Parties will only accept to participate in swaps that allow them a comparative advantage. In swaps, parties will exchange all the terms in relation to the security exchanged (Essential dental public health, 2013).A swap involving bonds will entail parties exchange terms such as the interests to be paid for the bonds and the maturity periods. Various forms of swaps exist and they are adopted depending on the targeted comparative advantages. Interest rate swaps can involve the exchange of fixed exchange rate system for a floating system. Secondly, currency swaps will involve exchanges involving the form of currency to be used in the repayment process. Participating parties in this form of swaps analyze if the currencies to be used in the swap favor them. Finally, commodity swaps can also be assumed. In general, this involves the exchange for a floating interest rate for a specified period for a specified commodity.

Treasury bonds

Treasury bills are government’s security instruments that are used in order to source funds for the government in various sectors and create public debt. The use of treasury bills involves selling securities to the public at either a discount or par value. This is mainly in order to attract buyers. Notably, treasury bills are also issued for a short-term period that can be as short as one year or less. Owing to the short-term nature, treasury bills are issued at no-interest. As a result of these aspects, treasury bills are considered less risky instruments and hence they are widely adopted in most sectors. The equation shown below is used for calculation of the maturity yield for treasury bills.

Risk to Return

There are a number of risks that are related to the use of various securities that at times can seriously compromise the targeted interest return. Among the most common risks involved are those relating to the fluctuation of prices in the markets that will affect the returns and thus the profits attained. In connection to this, different forms of strategies can be adopted in order to mitigate the adverse risks (McDonald & Keegan, 2002).
Bonds
Among the risks that are associated with the use of bonds, include interest rate risk, inflation risk, and reinvestment risk. Interest rate risk relates to the fluctuations in the values of the interest that will compromise the prices of the bond. When the interest rates increase, the overall prices of bonds fall. On the other hand, a fall in interest rates will result in a rise in bond prices. These uncertainties can significantly affect the valuation process of bonds. Inflation risk involves the upward fluctuations in prices of most goods and services such that in the values of the currencies in the global markets decline. Inflationary tendencies tend to affect the value of the bonds negatively. This is because, as a result of inflation, high-interest rates may be induced resulting in a fall in the prices of bonds (Ireland, Hoskisson & Hitt, 2008). In attempts to prevent the effects of inflation on the valuation of bonds, the introduction of inflation- indexed securities have been manifested in a number of sectors. Hedging strategies can also be used in strive to prevent cases of risks from inflation. Hedging will allow for prior determination of the values to be remitted, which will remain constant despite the changes in the inflation levels within the economy.

Swaps

The use of swaps is also associated with a number of risks that can jeopardize the entire financial plan. Among the common risks associated with swaps, currency risks are primary. This relates to downward fluctuations in the value of various currencies. Currency risks can often result in huge loses in events where the fluctuations are unfavorable and huge. In order to curb these currency risks, among the possible strategies for adoption is the use denominating both the securities exchanged in the same or similar currencies (Ireland, Hoskisson & Hitt, 2008). This will prevent cases of huge losses in the event of highly volatile currency fluctuations.

Federal Reserve System

There are a numerous ways by which the operations of the Federal Reserve System can affect the process of issue and operation of financial derivatives. The influence is manifested in the monetary policies that are implemented by the Federal Reserve Bank (Tushman & O'Reilly, 1997). The aspect of money supply, solely controlled by the Federal Reserve System greatly affects the valuation of the securities. In terms of bonds, increase in the money supply will result in inflationary tendencies and higher interests rates charged. As a result, the value of the bonds will be reduced considerably, making them less desirable (Ireland, Hoskisson & Hitt, 2008). However, in the event that the money supply is limited and restricted through monetary policies like reduction in the Federal Reserve overall expenditure, there will improvements in the values of the bonds making them highly attractive. Treasury bills are also affected by various aspects of money supply in the economy. However, since the prices of Treasury bills are fully controlled by the government, their prices will not be affected though high supply of money to make them less attractive. The value of a currency is critical in swap derivatives, hence, any slight changes in the value of the currencies will witness considerable effects in swap agreements. The Federal Reserve System controls the value of the currencies through a number of measures like devaluation and evaluation of the currency (Tushman & O'Reilly, 1997).
The use of treasury bills is best suited for investment activities for a period of 12 months or less. This is mainly due to the short-term maturity period of the treasury bills. In addition, owing to the nature of not attracting any interest, they should not be used for long-term investment plans. The use of bonds, however, can involve considerably longer periods depending on the type of bonds adopted. Certain type of bonds like Treasury bonds can be issued for long periods like 50 years (Ireland, Hoskisson & Hitt, 2008).This long maturity period coupled with the availability of risk preventing techniques like hedging will help in cubing any form of price fluctuations realized. Municipal bonds issued by States and other municipal corporations, in most cases, can be for long periods exceeding twelve years (United States, 2010). On the other hand, swaps are used for long periods not exceeding five years. This is mainly because swaps are agreements that are prone to be affected by a number of factors such as changes in the existing regulations. In light of this, individuals and corporations will involve in exchange of obligations for a considerably shorter periods.

Conclusions

In light of the foregoing discussion, it becomes apparent that financial markets play a pivotal role in any economy and hence the need for measures to be undertaken tailored at improving the markets (United States, 2010). Among the measures that can be undertaken, increasing the general awareness of public for the existing securities is the key to making these securities safe, desirable, and accepted. In addition, it is clear that numerous factors affect the operations of security markets. Cases of fluctuation of currencies are presented as detrimental to the sale of securities. This, therefore, presents the need for parties involved in the financial markets to critically identify these factors and then adopt suitable strategies and measures that will mitigate the risks.

References

Burke, W. & Litwin, G. (1992). A Causal Model of Organization Performance and Change. Journal of Management, 18 (3): 523–545
Essential dental public health. (2013). Oxford: Oxford University Press.
Ireland, R. D., Hoskisson, R. E., & Hitt, M. A. (2008). Understanding business strategy: Concepts and cases. Mason, OH: South-Western Cengage Learning.
McDonald, M., & Keegan, W. J. (2002). Marketing plans that work: Targeting growth and profitability. Boston: Butterworth-Heinemann.
Tushman, M. & O'Reilly, C. (1997). Winning through innovation: A practical guide to leading organizational change and renewal. Boston, MA: Harvard University Press.   
United States. (2010). The world factbook 2010. Washington, D.C: Potomac.