This essay seeks to demystify the role of financial markets in the creation of wealth in the U.S. and to also to put into picture financial market types and transactions supported by each market. And to assess the risks of these and develop strategies to manage them. Financial markets play a huge role in the promotion of overall economic growth.
According to Brigham & Ehrhardt (2016), the financial sector always creates a strong reason for investment and, also, enhances business and trade links thereby easing improved resource use and technical flow. Through marshalling an entity’s savings for productive investments, financial markets stimulate investment. Any financial entity will channel savings to more productive uses by collecting and analysing information about saving and investment prospects. Through monitoring management and setting up corporate controls, it is argued that financial systems promote effectiveness and efficiency in the finance and corporate field. Suppose a person invests in equities, the investor in this case automatically becomes an owner or shareholder of the firm that issues the shares, thus becoming entitled to the share of profits which is distributed in form of dividends. The other role is that the entities in the public and private sector utilize various financial securities to accumulate and invest funds on a short-term basis which can be rapidly honoured or liquidated, if need be, in order fulfil short term necessities. Any government, for instance, can acquire borrowed funds from the public in general by issuing treasury bonds to finance long term investment or development projects like road and infrastructure development. Most investors make meaningful returns in the capital market from buying and selling of financial instruments. When an investor buys a debt instrument like a corporate bond, he receives a payment or return from the debt security issuer including interest together with the principal amount at the end of the period of the loan. The higher the rate of interest, the higher the return. In a nut shell, the financial markets aim is to generate and accumulate money, circulate, invest and lend savings and finally, transfer and market financial assets.
There are several types of financial securities. But the three types of securities selected are; treasury bills, treasury bonds, and shares. First are treasury bills. A treasury bill is defined as a short-term or makeshift debt instrument issued by the United States federal institution to meet its borrowing obligations on a short-term basis when there exists disparities between government expenditure and tax returns. They are generally have maturity periods of between 90 days and 365 days. The treasury bills are initially sold at a discount, that is, an amount lower than the amount they are redeemed at on maturity. This amount is sufficient to cover both the initial investment and the interest to the investor. Investors buy treasury bills for liquidity and safety reasons since they are the most liquid and most actively traded of all the money market securities. They are the safest in that the chances of default are minimum. Thus, treasury bills are popular due to their zero default risk, ready marketability and high liquidity (Mishkin & Eakins, 2014).The other type of security is the bond or treasury bonds. These are long term trade security issued by the federal administration that have a maturity period of between 5 years and 20 years. They are basically sold to accumulate money required solely to rectify long term imbalances between tax returns and government expenditure. Treasury bonds do have lower chances of defaulting thus becoming less risky. They are also more convenient for investors in that they can easily be bought and sold in the secondary securities markets. A good illustration is, if an individual buys a 15 year government bond and at a future date wants to dispose, the bond will be simply transferred or sold in the secondary security market. The other types of bonds are like the municipal bond, which is issues by the local government or state, Eurobond and foreign bonds. The third type of security are the shares, often called stocks in a company. These are units of ownership or interest in a corporation or financial asset. They give the holder an ownership interest and corresponding right to select and oversee the management, to receive a proportionate share of the earning (if any) and in any asset remaining after payment of creditors should the company dissolve.
For any investment decision making strategy, the relationship between risk and return is very vital. For every investment that a firm undertakes, it must offer a return that is as high as the return on a correspondingly risky venture on a financial market. Or else investors would chose to invest in financial instruments rather than in the company. Investment risk is often associated with high volatility. According to Madura (2014), the riskiness of any investment is an entity is leads to the expected returns. Generally, the higher the risk of investment, the higher the return prospective while the lower the impending risk, the lower the expected return is likely to be. All investors are unable to predict with certainty the economic conditions of the future. As such, it is hard to know what rate of return their investment will yield. Consequently, investors base their judgements on anticipations concerning the future. In finance, when appraising potential investment in financial securities, these dimension of making decisions is called expected risk and return. The different investments types, such as stocks, treasury bills and bonds carry different risk and return potentials. Stocks generally have great return potential than treasury bonds, but the underlying risk is higher. Short term Treasury bond have lower risk than long term treasury bonds. However, they as well also do have lower yields. For short term investments whose safety is fully guaranteed, like treasury bills, are considered to have little or no risk. Unfortunately, the lower the risk, the lower the returns. As much as treasury bills have zero to very minimal risk, their rate of return is also quite low compared to other form of security investments. There is also a predisposition to the risk of locking an investor into lower yielding investments just before interest rates rise. For any investor who would want to play safe or want to be conservative, will entirely invest in treasury bills, and a more aggressive investor or risk taker, will invest wholly in stocks for high returns. The conservative investor with his low risk strategy will yield a much lower income in the long run. An aggressive investor will face large market turbulences over the period but will do much better in the long run. In the case of treasury bonds, they strive to bring in steady income from the portfolio. For the reason of the risk added from fluctuations of price characteristic in long term treasury bonds, return differ based on the tenure of the bond in the fund’s portfolio. In this case, Treasury bonds funds are always considered to be safer but tend to pay, more yields than riskier long term Treasury bond. All transitional Treasury bonds offer higher returns than the short term bonds which have lesser threat than the long term treasury bonds.
There are several strategies for maximising returns on the invested securities. For treasury bonds, the best strategy is through immunization. A portfolio manager could use bond immunization strategy to immunise the treasury bonds against interest rates changes. Immunization is the process that is intended to eliminate interest rate risk by eliminating the two components of price risk and interest rate risk or coupon reinvestment risk. For the case of treasury bills, the capital asset pricing model can be used. This theory focuses on what part of security could be eliminated and what part could not. It measures efficient risk of a particular security and relates it with systematic risk of well-diversified group of securities. It basically determines minimum required return rate for new investments a firm intends to invest in. Lastly is the stocks. Diversification is the best strategy in this case. An investor can diversify in the various stock options. In investor can do speculation and market timing, that is, sell the stocks before the market falls and buy before they rebound- which is guaranteed. The other is to save up an amount every year and buy stocks once in bulk (Brooks, 2012).
The monetary policy of the Federal Reserve may affect the financial markets in several ways. First, while the main function of the monetary policy is to realise long term economic growth, the Federal Reserve has a varied objective other than this. The Monetary policy aims are to ensure steady prices and to control long term rates of interest. (Bernanke, 2015). The other role is to lower inflation as much as possible by adjusting interest rates, that is, by lowering the short term interest rates when the economy is sluggish and raising when the inflation is high. Stocks or equities do not perform well during stringent monetary policy periods. There is always a considerable gap in between the time when the Federal Reserve commences evaluating monetary policy and when stock prices peak. Treasury bonds always suffer in the markets when the Federal Reserve raises its fund rates drastically.
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