Financial Markets and Institutions
The Role of Financial Markets in Creating Economic Wealth in the U.S.
Financial markets play an instrumental role in the creating economic wealth in the United States. Financial markets serves as a source of capital to drive economic expansion in the U.S. (Skousen, 2013). These markets facilitate the transfer of money from those who have it to investors or the government through equities or bonds. Wealth creation requires a stable and sufficient supply of finances. The U.S. financial markets support this steady and adequate flow of money in the economy resulting in wealth creation. The money that individuals invest in corporates promotes economic expansion thus increasing the amount of money that the government collects through taxes and corporate levies.
Chami and Fullenkamp (2009, p.3) maintain that “financial markets allow the transfer of resources from savers to investors, and contribute to making an economy robust to shock by allowing risks to be allocated appropriately.” In practice, economic wealth cannot be created without adequate resource and suppression of risks. Financial markets provide a forum where resources are amassed and redistributed to activities that facilitate economic expansion and development. Through financial markets, the U.S. government is able to raise financial resources to drive its various development projects to stabilize the economy.
Financial markets create wealth for the U.S. economy through foreign direct investments (Alfaro, Chanda, Kalemli-Ozcan, & Sayek, 2004). The U.S. financial markets are considered one of the most advanced and stable markets in the world. These attributes make the U.S. a key target for foreign investors who invest their resources in companies based in the United States.
Financial markets create wealth for the U.S. economy through local and foreign investment. The markets provide a platform where resources are accumulated and re-channeled back into the economy. Financial markets enable citizens and foreigners to actively engage in growing the U.S. economy through property acquisition and injecting financial into both private and public companies (Chami & Fullenkamp, 2009).
These activities result in wealth accumulation for the economy. The wealth of a country’s economy is a function of the economic activities undertaken by its citizens, government, companies, and foreigners. By offering a forum for optimizing economic engagement for the various economic players, the financial markets result in wealth creation for the U.S. economy. These markets facilitate the effective flow of finances in the U.S. economy resulting in wealth creation.
Types of Securities
Different types of securities characterize financial markets. Financial experts categorize securities into three broad classes: debt securities, equity securities, and derivatives securities. This analysis focuses on three types of securities entailed in the capital market: bonds, stocks, and mortgages. Capital market securities are issued in most cases to finance the purchase of capital assets such as buildings or machinery (Madura, 2008). One of the distinctive attributes of the capital market securities is that they have a maturity span of more than one year. They play a vital role in supporting long-term investment activities.
Bonds are long-time debt securities issued by corporations or government agencies to support their operations (Madura, 2008). Bonds allow investors to serve as creditors to the government agencies or firms issuing them. The issuer of the bond pays back the borrowed money to the investors through fixed or variable interest rates over a specified period. At present, bonds are key strategies that governments and companies use to raise money to finance their projects. Most investors invest in government bonds due to their security.
Bonds help governments and companies raise money instead of taking loans from financial institutions. The high interest rates by banks make it unprofitable for firms and governments to use them as their principal source of financing (Madura, 2008). Bonds have several characteristics that investors must understand. These attributes include face value, coupon rate, coupon dates, maturity date and issue price.
The interest rates that a bond attracts are defined by credit quality and duration. Credit quality defines the worthiness of a bond issuer to repay the bond. Poor credit rating makes investors reluctant to acquire the bonds thus attracting high interest rates. As Madura (2008) expounds, firms with poor credit ratings serve as a high-risk investment option for those willing to acquire the bonds. Equally, bonds with long maturation times also attract high interest rates since they are faced with significant uncertainties and investment risks.
The U.S. bonds market has undergone an unstable historical performance. According to Dimson, Marsh, and Staunton (2009), the market illustrated minimal growth in the 10950s to the 1970s due to it low investment return abilities. Although policy interventions and invention assisted the market to experience growth in the later stages of the 20th century, occurrences such as the global economic crisis of 2008 further pushed the bond price down affecting the overall performance of the bonds market.
The other types of securities in the capital market are stocks. Stocks are equity securities that give investors partial ownership in corporations that issue them (Madura, 2008). A single stock represents fractional ownership in the company issuing the stocks. Stocks empower investors to have ownership in firms of their choice and enabling these firms to raise capital to finance their various operations. In the capital market, stocks usually are sold in the form of shares. Investors purchasing the stocks of a company usually do so by buying shares. The higher the shares that an individual has in a company, the higher the control they have in the corporate decision-making process.
There are two types of stocks: common and preferred stocks. Common stock gives the shareholder voting rights in corporate decisions while preferred stocks do not give the shareholder voting right (Madura, 2008). Preferred stockholders are entitled to receive the company’s dividends before the common shareholders. Parameswaran (2011) asserts that shareholders are exposed to profits and losses when they seek to dispose their shares at a subsequent point in time. For instance, if the investors bought the stock at $60 per share, then the company’s stock rises over time to $70 per share. Such investors make profits if they dispose their shares when the price is high. Similarly, a company’s shares can depreciate; therefore, making shareholders to incur losses when disposing their shares. It is always advisable to conduct a thorough market analysis before purchasing stocks.
Equity shares do not have any maturity date. Instead, they remain in existence as long as the company that issued them exists (Parameswaran, 2011). As a result, they give the shareholders the ability to resell their shares at the opportune time when the firm’s shares are priced higher in the market. According to Dimson, Marsh, and Staunton (2009), the U.S. stock market has experienced positive growth since the turn of the 21st century. A drastic decline was observed during the 2000-2008 financial crisis. However, the market has since recovered making the U.S. stock market one of the largest in the world.
Finally, the third type of securities in the capital market is mortgage-backed securities. A mortgage is a type of asset-backed security that allows investors to earn through interest. Investors who invest in this type of securities serve as lenders to home buyers or real estate businesses. Fabozzi, Bhattacharya, and Berliner (2011) state that the residential mortgage market in the U.S. has emerged as the worlds’ largest in the last decade. This sector played a central role in flouncing the financial crisis that rocked the U.S. in 2007 after the bursting of the housing bubble.
The Current Risk-Return Relationship
Risks and uncertainties are dominant characteristics of the financial markets. In these markets, investors can either incur losses or make profits. These risks vary depending on the type of securities in question. Bond securities have the least return risk compared to stocks or mortgage-backed securities. Madura (2008) contends that bonds issued by the government have the lowest return risk levels. These bonds are also characterized by low returns. Conversely, the stock market is highly volatile. The advantage of investing in this market is the fact that it guarantees investors high returns.
Nonetheless, it is vital to undertake a thorough market assessment before investing in stocks of any firm. Since the 2007-2008 financial crisis, mortgage-backed securities have exhibited steady growth. The various monetary policies implemented by the government have significantly stabilized the sector. In the short-term, it is advisable to invest in the mortgage-backed securities. The risk increases with increase in time since the profitably of these securities depend on the economic attributes of the country and the world.
Strategy for Maximizing Return
The key trend noted in the risk analysis is that risk increases with an increase in time. To suppress this risk and maximize returns, investors should invest in securities that have short maturity duration. This strategy is particularly applicable to debt securities such as bonds and mortgage-backed securities. According to Madura (2008), risks and uncertainties in debt securities increase with an increase in maturity duration. For equity securities such as stocks, investors should invest in promising sectors such as technology and conduct thorough market research to maximize their returns.
The effects of Federal Reserve and its Monetary Policy
The Federal Reserve plays an instrumental role in influencing the activities in financial markets through its various monetary policies. Earning from the three securities discussed in this paper depends on the interest rates. The Federal Reserve is responsible for setting the interest rates in the country (Bernanke, 2013). High Fed rates limit the lending abilities of banks thus impacting on the securities adversely as investors will be unwilling to spend money on securities. However, if the Fed lowers the rates, it encourages individuals to invest thus driving the purchase and resell of securities. For example, the move by the Fed to lower its rates after the 2008 financial crisis encouraged investments in bond, stocks, and mortgage securities. The impact of the Fed on the stocks, bonds, and mortgage-backed securities depend on the perceived impacts of its policy actions on the investors and the financial markets at large.
Determining the Viability of Investing on the Securities
Investing in bond securities has never been appealing to investors who want high returns on their investments. Considering the low investment returns that bonds generate, investing in bond securities in the next twelve months, five years or ten years is not a good investment. The raising Fed rates imply that the value of the bonds is likely to diminish with time. Economic projections predict that the U.S. will experience stable economic growth in the next ten years.
This prediction indicates that it will be a good investment to invest in the stocks listed in the United States. However, this will be a good investment in the next five or ten years. In the next twelve months, it will be a risky undertaking considering the current economic tensions tension between the U.S. and other economic powerhouses such as China and the European Union. The positive trends in the U.S. economy make investing in the mortgage-backed securities a good investment in the next twelve months and five years. However, the risk of a reoccurrence of the housing of the housing bubble makes it undesirable to invest in these securities after ten years. Besides, the rising Fed rates are likely to lower home value in the long-run.
References
Alfaro, L., Chanda, A., Kalemli-Ozcan, S., & Sayek, S. (2004). FDI and economic growth: the role of local financial markets. Journal of International Economics, 64(1), 89-112.
Bernanke, B. (2013). The Federal Reserve and the Financial Crisis. Princeton: Princeton University Press.
Chami, R., & Fullenkamp, C. (2009). A Framework for Financial Market Development. Washington, D.C: International Monetary Fund.
Dimson, E., Marsh, P., & Staunton, M. (2009). Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton: Princeton University Press.
Fabozzi, F. J., Bhattacharya, A. K., & Berliner, W. S. (2011). Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. John Wiley & Sons.
Madura, J. (2008). Financial Institutions and Markets. Mason: Thomson Higher Education.
Parameswaran, S. (2011). Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives. Singapore: John Wiley & Sons.
Skousen, M. (2013). Economic Logic (4th ed.). Washington: Capital Press.
