Financial Markets and Institutions (PART 2)

Financial Markets and Institutions (PART 2)

Financial markets provide an avenue for the sale and purchase of financial assets, including equity, bonds, derivatives, and foreign exchange. Financial markets have different names in the U.S., such as the capital markets and Wall Street, but they are the same and serve similar purposes. Financial markets provide a platform whereby businesses can raise capital to launch or expand their businesses (Davidson, 2003). They also offer a platform for investors to expand their wealth by investing in securities.

First, financial markets play a vital role in creating and accumulating goods services, and capital. Depending on the price of a loan/credit and the likely return from an investment, participants in the financial markets make critical investment decisions. The signals in the current market environment determine whether businesses will borrow or whether investors will be willing to lend their cash (Davidson, 2003). Apart from aiding the transfer of money internally, financial markets are also crucial for the flow of funds between countries.

Also, financial markets lower the transaction and search costs in an economy. That is achieved through the provision of various products with varying risk, maturity, and returns. Investors and lenders (financial participants) then make decisions based on the data they acquire from the financial market. Besides, financial participants in need of funds use financial market data to discover institutions that can lend them at the most favorable cost. Investors can then make investment decisions based on the expected returns from the securities and according to their needs.

Securities

Stocks

Stocks, a common type of equity securities, are extended to individual investors who help raise capital. By investing in stocks, the investor also gets partial ownership of the company they invest in (Cartas, Cartas & He, 2015). The returns of investing in stocks include periodic dividends and corporate voting rights. It is worth noting that investing in securities is a risky affair because the value of a company fluctuates from time to time. Despite being a risky endeavor, the returns are high if the company is doing well.

Bonds

Bonds are a form of debt securities used by companies to raise investment capital. Governments also use bonds to raise money for funding development projects. Like loans, bonds have guaranteed fixed rates of return called coupon rates, essentially the return for the invested funds (Vineer Bhansali, 2011). Bonds also have a par value and maturity date. The bond’s par value is the bond’s face value, while the maturity date is when the issuing company is expected to repay the bond value.

Since bonds are traded in the open market, there is a likelihood of getting profits or losses. When the bond trades below the par value, then that means it trades at a discount. On the other hand, when the bonds trade above par value, then it means they are trading at a premium.

Preferred shares

Preferred shares have qualities of both equity and debt. Their fixed dividends are usually paid before common stockholders receive their payment. However, preferred shares remain inferior to bonds. If the business faces financial difficulties, dividends to bonds can be paid while preferred stock dividends remain unpaid (Cartas, Cartas & He, 2015). Another notable feature of preferred shares is that the initial investment is not repaid. However, in case of bankruptcy, preferred stockholders will claim their payouts before their common counterparts.

Risk-return Relationship

Stocks

Investing in equity stocks is more risky than investing in common stocks. However, the returns are equally desirable. It is, therefore, incumbent upon the investor to analyze the risk-return relationship before deciding to invest in stocks.

One of the most important considerations when analyzing equity stocks is their volatility. Volatility is a change in the prices of stocks. A significant and quick change in prices affects an investor’s portfolio (Thomas, 2012). To avoid the uncertainty that characterizes equity stock, investors should diversify their portfolios instead of just focusing on a single company.

There is also the foreign exchange risk. An investor owning the stocks of a foreign company is likely to experience currency changes that affect returns (Thomas, 2012). If the currency of the investor’s country is stronger relative to the company’s mother country, then returns will deteriorate. On the other hand, a weaker home country currency relative to the company’s country signals higher returns.

Preferred Shares

Preferred shares are hybrid security integrating both bonds and common stock. Preferred shares tend to be riskier compared to bonds but not as risky as common stock (Thomas, 2012). Although preferred stocks tend to share the name with common shares, they are quite different regarding risks and returns.

Unlike bonds, preferred shares are perpetual. That means that there is no definitive maturity date unless the issuing company decides to repurchase them. The perpetuity exposes them to increased risk.

Another risk characterized by preferred stock is the window that permits the issuing company to forfeit dividend payments. Companies are allowed to postpone dividends due to cumulative preferred shares and pay later (Thomas, 2012). The situation is even worse regarding non-accumulative preferred shares since the issuing company is allowed to forfeit payment entirely. However, nonpayment tendencies can only damage the issuing company’s reputation and reduce the likelihood of getting capitation in the future.

Bonds

The interest rate risk is one of the most common investment risks that characterize bonds. The inverse relationship between bond prices and interest rates can cause a significant variation between expected and actual returns (Xu, 2020). If, for instance, the market interest rate increases from the time the bond was purchased, its price falls significantly. That essentially means reduced returns for the investor.

Also, bonds are exposed to reinvestment risk. Reinvestment risk occurs if the bond proceeds are reinvested in a market that yields lower returns than the initial bond market (Xu, 2020). Besides, callable bonds suffer the reinvestment risk since the seller can recall them before maturity, leading to losses on the part of the investor.

Return Maximization

An investor investing in common stock is advised to be biased towards value companies than growth companies. One of the reasons to avoid growth companies is that the shares in growth companies are highly-priced, yet the company does not focus on shareholder payouts (Cartas, Cartas & He, 2015). However, value companies have lowly-priced shares relative to the company’s earnings. There is a reduced risk for return losses in value companies.

For bonds, the investor should apply the immunization strategy. An immunization strategy means selecting a market where the return and maturity dates are predetermined and will not be affected by external factors. The strategy protects returns from the impact of interest rates, being one of the major disruptions to bond investments.

Finally, an investor delving into preferred shares investment should go for convertible preferred stock. That is because investors in convertible stock can influence critical corporate decisions (Cartas, Cartas & He, 2015). That essentially means investors control their returns to a large extent.

The Impact of the Federal Reserve’s Monetary Policy on Securities

The Federal Reserve uses monetary policy to influence asset returns depending on the economic situation. For instance, during a recession, the Federal Reserve applies deflationary strategies to reduce the interest rate (Labonte & Makinen, 2008). That will lead to falling bond yields, making it cheap for corporations and the government to borrow from the public.

Interest rate regulation can also affect common stock returns. There is an inverse link between interest rates and common stock returns (Labonte & Makinen, 2008). The effect of monetary policies was visible in the 2007/2008 financial crisis, whereby changes in interest rates led to volatility in stock returns.

Investment Timing

Bond investment is suitable for investing in the short term to the long term. Therefore, one would instead invest in bonds for the next five and ten years. After maturity, the investor can recoup monthly returns until the expiry of the investment period. That means the returns are spread over a long time, but the investor gets short-term returns. Investing in the short will bring gains.

On the other hand, common stock and preferred stock are better for a shorter duration. Upon the expiry of the investment period, the investor can recoup the principal amount and earnings and reinvest in other markets. Shares are flexible, and that allows investors to juggle through different markets.

References

Cartas, J., Cartas, J., & He, Q. (2015). Handbook on Securities Statistics. Washington, D.C:         International Monetary Fund.

Davidson, P. (2003). Financial markets, money, and the real world. Edward Elgar.

Labonte, M., & Makinen, G. E. (2008, December). Monetary policy and the Federal Reserve:      current policy and conditions. Congressional Research Service, Library of Congress.

Thomas, P. G. (2012). Risk-Return relationship on equity shares in India.

Vineer Bhansali. (2011). Bond portfolio investing and risk management: positioning fixed income portfolios for robust returns after the financial crisis. Mcgraw-Hill.

Xu, Z. (2020). Risk Analysis and Suggestions on Bond Investment Transaction of Financial Institutions. Finance and Market, 5(1), 1. https://doi.org/10.18686/

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Financial Markets and Institutions – Part 2
Overview
Choose three types of securities from any of the financial markets covered in the textbook during Weeks 1 through 7. Pick securities you would enjoy researching for this assignment.

Instructions
Write a 5–6 page paper in which you:

Analyze the role financial markets play in creating economic wealth in the United States.
Provide a general overview of each of the three securities you chose. Be sure to include such information as name, company it represents (if applicable), pricing, and historical performance.
Assess the current risk-return relationship of each of the three securities.
Recommend one strategy for maximizing return for the current risk-return relationship identified for each of the three securities.
Suggest how the Federal Reserve and its monetary policy affect each of the three securities today.
Determine whether each of the three securities is a good investment in the next twelve months, five years, and ten years. Provide a rationale for each security with your determination.
Use at least six quality academic resources in this assignment. Note: Wikipedia and other Websites do not qualify as academic resources.
This course requires the use of Strayer Writing Standards. For assistance and information, please refer to the Strayer Writing Standards link in the left-hand menu of your course. Check with your professor for any additional instructions.

The specific course learning outcome associated with this assignment is:

Determine how to maximize returns on specific securities, how they are impacted by monetary policy, and whether they are a good investment over time.