Financial Markets and Institutions
One Financial Market and the Types of Transactions
A financial market is a market in which financial assets (securities) such as stocks and bonds can be purchased or sold (Madura, 2008). Consequently, financial markets allow the transfers of funds from those who have excess funds to those who need funds. Several types of financial markets are in existence. However, this analysis focuses on the capital market. In its basics, a capital market is a type of financial market where institutions and individuals trade securities. Besides, this market is known for its trade in long-term securities. In their analysis, Vasudev and Watson (2017) point out that in a capital market, buyers and sellers trade in financial securities such as bond and stocks.
Importantly, the capital can be either as primary or second market depending on the type of security or stock issued. Madura (2008) maintains that a primary capital market deals with the trade of new issues of stocks and securities. In particular, the primary capital market provides investors with the opportunity to participate in a new security issuance. On the other hand, a secondary capital market deals with the trade of previously issued securities.
Alternatively, capital markets can be classified basing on the type or nature of the stock traded. In this categorization, two divisions of capital markets are derived; the bond market and the stock market. The United States and the global capital market support transactions in bonds and stocks. The bond market is synonymously referred to as the debt or credit market. As stated by Madura (2008, p. 141), “bonds are long-term debt securities that are issued by government agencies or corporations.” By purchasing the bonds, investors serve as creditors to the institutions issuing the bonds. As a result, the issuer of the bond is obligated to pay interest payments periodically and the principal amount at maturity.
On the other hand, the stock market a place that sells stocks. Stock, in this case, refers to partial ownership of a company. In this respect, the stock market enables investors to have ownership in companies while at the same time enabling companies to obtain the capital required to run their vital operations (Furgang, 2010). The stock market is one of the most important sectors in the market economy. For instance, in the United States, the performance of the Wall Street, where the New York Stock Exchange is located serves as a vital indicator of the health of the United States economy.
Therefore, the value of the transactions undertaken in the capital market in the United States and globally cannot be underestimated. Capital markets are vital socio-economic institutions in the contemporary world. For instance, these markets serve as a source of capital for local and international firms. Besides, they serve as a gauge for measuring the economic wellbeing at the local and international level. In fact, Vasudev and Watson (2017) point out that promoting capital markets and preserving share value are currently treated as goals of public policy. This move illustrates how the United States and the global economy rely on the transactions occurring in the capital markets. Thus, the stability of the capital market defines the health and sustainability of the United States and global economy.
Factors Affecting Interest Rates
Interest rate is an influential factor in the financial market. This rate encourages people and companies to borrow, lend and use the money thus triggering economic progress. Specifically, interest rate alterations have a direct implication on the markets value of debt securities such as bonds and mortgages. Moreover, interest rate determines the amount of interest that financial institutions accrue from the money they lend to investors. Players in the commercial market are highly sensitive to interest rates.
Notably, several factors affect interest rates. One of the vital elements that affect interest rates is economic growth. The type of economic growth experienced, either positive or negative has significant implications on the interest rates. According to Madura (2008), changes in economic conditions result in a shift in the demand schedule for loanable funds, subsequently affecting the equilibrium interest rates. A positive trend in economic growth increases the demand for loanable funds as investor and businesses are willing to acquire more loans int any interests. This increase in demand for loans from investors drives the interest rate up. On the other hand, a negative trend on economic growth lowers the need for credits thus reducing the interest rates.
Inflation is another key factor that affects interest rates. On the word of Madura (2008), the relationship between inflation and interest rate is best explained by what is commonly referred to as the Fisher effect proposed by Irving Fisher. In this theory, Fisher proposed that nominal interest payments compensate savers in two ways. Firstly, they compensate for a saver’s reduced purchasing power (Madura, 2008). Secondly, they provide an additional premium to savers for forgoing present consumption (Madura, 2008). Therefore, the higher the inflation rate, the higher the interest rates are likely to rise. This rise in interest rates because of the high inflation rate emanates from the decreasing purchasing power of the money that will be paid in the future. As a result, high-interest rates protect lenders from incurring losses due to the low purchasing power of the lent money that will be paid in the future.
Moreover, the interest rate is affected by monetary policies implemented by Central Banks or in the case of the United States, the Federal Reserve. Fabozzi (2015) asserts that the Federal Reserve can affect the supply of loanable funds regulating the total amount of deposits held at commercial banks. This process entails the Federal Reserve alters the supply of money in the country. Therefore, an increase in money supply by the Federal Reserve brings about a downward pressure on interest rates. On the other hand, if the Federal Reserve reduces the supply of money, without any changes on the demand for loanable funds, an upward pressure is exerted on interest rates.
Interest rates are also affected by budget deficits. Madura (2008) points out that an increase in the federal government budget deficit increases the amount of loanable funds demanded at any prevailing interest rate. Assuming that all other factors remain constant, a high government budget deficit increases the interest rates. On the other hand, assuming that all other financial factors remain constant, a low federal government budget deficit is likely to lower the interest rates.
However, despite the fact that several factors influence interest rates, economic growth remains the most influential factor in determining these rates in today’s economic climate. Analytically, all other forces that influence interest rates are subject to the prevailing economic conditions. Inflation, budgetary deficit, and monetary policies are determined by the trends in economic growth. For instance, during the financial crisis of 2007-2008, the crumbling economic conditions in the United States and globally had significant effects on interest rates. Besides, these dwindling economic conditions forced the Fed and other Central banks around the world to implement monetary policies to alter the interest rates and stabilize the economy.
The Ease or Difficulty of Forecasting Interest Rate Changes
As earlier noted, interest rate is a vital component in the financial markets. Financial and economic experts spend a considerable amount of time assessing and predicting future interest rates trends. However, this process of predicting the interest rates is significantly challenging. The two common strategies used in predicting interest rate changes is the application of economics and assessing historical trends in interest rate changes.
Madura (2008) contends that the accuracy in determining the future trends in interest rates changes is based on an accurate prediction of economic forces such as the demand and supply loanable funds. In his analysis, Madura (2008) elaborates that when projecting household demand for loanable funds, it is vital to evaluable their credit data to establish their borrowing capacity. Equally, business demand for loanable funds is evaluated by assessing the future corporate plans and the future states of the economy. Therefore, Madura (2008) deduct that to predict future interest rates, the net demand for funds (ND) should be forecast: ND= DA-SA
Importantly, if the forecasted level of demand for funds (ND) is negative or positive, disequilibrium will exist temporarily (Madura, 2008, p. 38). According to Madura (2008), if the ND is positive, then, it will be corrected by upward alterations in the interest rates. Then again, if ND is negative, then, it will be corrected by a downward adjustment on interest rates. Besides, Madura (2008) advises that the larger the forecasted magnitude of ND, the larger the adjustments in interest rates.
Although it is possible to predict the future changes in interest rates, the procedure is highly erroneous. The unreliable nature of these predictions emanates from the unpredictable nature of the future trend in the economy. For instance, most experts wrongly predicted the 2008-2009 financial crisis. The uncertainties that characterize the financial sector makes it difficult to correctly predict future interest rates.
Why the Federal Reserve was created
The Federal Reserve is a vital pillar in the United States financial sector and economy. According to Wells (2012), the Fed was created in 1913 in an effort to bring coherence to nationwide banking practices and prevent crises like the financial panic of 1907. In this respect, the Fed was formed to provide the United States with a secure, more flexible, and stable financial and monetary system. Wells (2012) point outs that before the formation of the Fed, the United States financial sector was chaotic.
For instance, Wells (2012) notes that one of the main problems in the United States banking sector before the Fed was established was its lack of a nationwide banking. As a result, there was a very large number and distinctive banknotes making it challenging for the citizens to keep up with the value of each and even intensified the rate of counterfeiting. Moreover, the United States endured frequent cash dilemma, financial panics and high bank failures that made the United States undesirable for both local and international investors.
Notably, the bank panic of 1907 that threatened to crumble the operations of United States economy heartbeat. Wall Street plunged the nation into an economic depression was the final motivator to the establishment of the Fed. Moreover, the creation of the Fed was motivated by the stability illustrated by European nations that had Central Banks (Wells, 2012). Wells (2012) states that the United States policymakers admired the cohesive financial operations exhibited by European nations particularly England and Germany.
In this respect, the United States Congress supported the prospect of creating the Fed to stabilize the country’s financial sector. The stability of the financial sector of any country is instrumental as it directly affects the economic progress of the county as well as its attractiveness to investors. Policymakers and financial experts viewed the Fed as the missing link in the stability and security of the United States financial and investment sector.
The Fed has well–articulated roles and responsibilities in the United States. One of the renowned roles of the Fed is the creation of monetary policies. Nonetheless, Wells (2012) point out that the Fed is also responsible for regulating and supervising banks and other financial institutions and maintaining stability in the United States financial systems. The Fed’s major roles are essential to the United States economy since they ensure that the United States remains an attractive environment for investors. For instance, during the financial crisis of 2007-2008, the Fed played a significant role in restoring investors’ confidence through its fiscal and monetary policies such as those that lowered the interest rates to promote investment and accelerate economic recovery.
A Recent Monetary Policy in the United States and its Impacts
The recent monetary policy in the United States by the Fed is the hiking of the federal fund rate by 25 basis points, to between 1.75% and 2.00%. The Fed had significantly lowered this rate during the aftermath of the 2007-2008 financial crisis to boost investment and accelerate economic recovery. However, the observed stability in the United States economy has resulted in the progressive hiking of the Fed rate.
In fact, most financial observers were not surprised by the recent move by the Fed to hikes the interest rate. In justifying their move to raise the Fed rates, the Federal Reserve’s Open Market Committee (FOMC) noted that the United States economy has illustrated stable and strong economic growth. According to Wu and Xia (2016), an increase in Fed find rates will have a significant impact on the borrowing costs for customers and businesses that desire to access credit based on the United States currency. When the Fed rate increases, banks also raise the rates they charge on loans that they to offer the investors and citizens.
On the other hand, the raising of the Fed fund rates will have significant long-term implications for the economic stability of the United States and that of the world. The Fed uses the Fed rates as a tool for regulating inflation and maintaining a healthy economic growth. By raising the Fed rates, the Fed lowers the ability of banks to borrow, forcing these institutions to raise their interest rates thus slowing down the rate of economic growth to prevent inflation. In the long-term, this increment in the Fed rates will slow the rate of the economic development in the United States and globally. The goal of this measure is to lower household spending to prevent inflation in the long-term.
Strategy for the Use of Bond Markets
Smart-Line technologies are renowned throughout the United States for its high-quality electric appliances. The company has illustrated significant and consistent growth in the last five years and intends to expand its manufacturing activities to the smartphone market. To actualize this objective, the firm is considering raising money to finance this project through the bond market. Importantly, as the financial manager for the firm, I have been charged with the responsibility of strategizing how the company can raise the $20 million to initiate the smartphone project. To raise the required finances to oversee the project, Smart-Line needs to venture into issuing corporate bonds. To raise the required $20 million for the expansion process, Smart-Line will issue a 10,000 bond at face value of $20,000. Moreover, the coupon for this bond will be 2.4%, 3.2%, and 5.6% for a five, ten, and a fifteen-year bond respectively. The company is confident that it will repay the bond without defaulting as it has done in its past initiatives.
References
Furgang, K. (2010). How the Stock Market Works. New York: The Rosen Publishing Group, Inc,
Fabozzi, F. J. (2015). Capital Markets: Institutions, Instruments, and Risk Management. Massachusetts: MIT Press.
Madura, J. (2008). Financial Institutions and Markets. Mason: Cengage Learning EMEA.
Vasudev, P. M., & Watson, S. (Eds.). (2017). Global Capital Markets: A Survey of Legal and Regulatory Trends. Cheltenham: Edward Elgar Publishing.
Wells, D. R. (2012). The Federal Reserve System: A History. Jefferson, North Carolina: McFarland & Company, Inc.
Wu, J. C., & Xia, F. D. (2016). Measuring the macroeconomic impact of monetary policy at the zero lower bound. Journal of Money, Credit and Banking, 48(2-3), 253-291.
