Answer Finance Question
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ella.docxASSIGNMENT 3
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[Name of the Student]
[Name of the University]
Running Head: ASSIGNMENT 1
General Essay Questions (5pts each)
1. What are TIPs? How do these securities provide a hedge against inflation? Discuss the spread between traditionally-structured Treasury notes and TIPs. What factors influence this spread relationship?
TIPs are the Treasury Inflation Protected securities. These are the bonds issued by the government that offer return after the inflation which is also known as a real return. they are different from the nominal or traditional bonds in which the returns are specifically before inflation. This is the way for the investors for offsetting the risk that comes with the inflation. These TIPs offer the hedge against inflation by providing a return which is calculated after taking out the risk of inflation. This is the best way for investors to offset the risk that comes due to the inflation in society. With the strengthening of the economy, inflation can increase, and the return is not expected to increase in the high rate of inflation, so for affording protection against inflation in the economy, TIPs are used in the form of fixed income investment for the destruction of inflation. TIPs are backed by the government and they offer high attractiveness for the investors because the level of risk in these securities is less.
TIP spread is when the yield of TIPS and other US Treasury securities is compared having the same date for the maturity. The difference that exists between both of them is used as payment adjustment for the inflation. The traditionally structured treasury notes do not consider inflation at the start and the yield is used for compensating the investors for the expected future rate of inflation. This spread between both securities is the indication for the market about inflation. The most important factor in influencing the spread relation is inflation because this spread is basically dependent on the inflation rate change. The spread is basically the projection for the inflation and it cannot be predicted how it will change in the future. Comprehensively, the TIP spread is considered to be a reliable measure for predicting the appropriate level of inflation.
2. Fully describe the fixed-income instruments of the money and capital markets. Make sure you cover all the money and bond markets we discussed. Do not just list the instruments.
Among financial markets, there are two most commonly used concepts, one is a capital market and the other one is the money market. The money market is used by the corporate entities and government for lending and borrowing money for a short term. In contrast, capital market contains long term assets with having the maturity of more than a year. In the capital market, the bonds and stock options are available. The securities in the capital market which offer a fixed rate of return are called as fixed - rate capital securities and a combination of features for the common and preferred stocks are offered to them. there is a fixed yield in these securities. Preferred stock is the best option here in which the dividend payment is fixed and must be given to the people.
The most commonly used fixed income security is a bond in the capital market. This is a form of borrowing in which the continuous return is given every year by the investors. These bonds can be further divided into corporate bonds or government bonds. Corporate bonds are offered by companies having a strong financial position while the governments offer municipal bonds. The government also offer treasury bonds which are offered for the funding of its debt. Some other types of fixed income securities include the certificate of deposit, treasury notes, T – bills, and preferred stocks. The T – bills and T – notes are same as the T – bonds offered by the US government. However, these bills and notes are short - term and issues on a discounted value. Certificates of deposit are issued by the bank in the return of money saved in banks for a predetermined time period and the banks pay the interest amount for the account holders. There is the lower rate on these securities as compared to the bonds but in comparison to the traditional saving accounts, they offer more rates. Preferred stocks are another type of fixed income securities in which fixed dividend is offered to the investors based on the percentage share or a dollar amount. Interest rate and the inflation rate in the state are the determinants of the price of preferred stocks. The yield on these shares is high as compared to other bonds because the life time is longer.
3. Fully discuss the concept of risk in the bond market. Describe the different types of risk and how these risks can cause realized return to being different from expected return.
Bonds are used as a great source for the generation of income and it is commonly considered to be a safe investment. When this is compared with the stocks, it is safe, but investors need to consider some of the risks that are associated with the bond market as well. The biggest risk for the bond market is a change in interest rate. There is an inverse relationship between bond prices and interest rate. This mostly happens because when the decline in interest rates occur, an investor tries to lock their investment in the high rates. This result in scooping up of the bonds which offer high return rate as compared to the market rate of interest. The increase in the demand resulting in the increase in prices of bonds as well.
Another risk is called as reinvestment risk in which the proceeds are reinvested on a lower rate as compared to the previous earning. The fall in interest rates is a common way of presenting the risk. This callability feature helps the issuer in redeeming the bond prior to their maturity date. Another risk is called as the inflation risk in which the when the rate of inflation is increased in the economy in comparison to the income investment, the purchasing power of the investors start to decrease and result in giving a negative rate of return.
Default risk is another type of bond risk which can occur when dealing with them. when any person purchases a bond, this means that the company has to repay the amount of bond on maturity. However, it is not guaranteed that all the corporate bonds will offer full credit and faith at the end of the period. It is important to consider the possibility of default while making the investment decision. The credit rating of the company is another important risk which must be considered while investing in the bonds. When the rating companies downgrade the bonds of a specific company, this result in reducing the prices of bonds. The last risk that bonds have to face is known as liquidity risk. This risk involves the idea that the investor might not be able to sell his bond in the market which is a threat to the liquidity. All these risks play an important role in bringing a difference in the realized and expected returns of the bonds. When the risks increase, this result in decreasing the value of bonds and investors get less return in comparison to the one expected by them.
4. What is securitization? Discuss the benefits of securitization from the issuer and investor perspective. What is a CMO? How does it differ from a pass-through security? How did the development of the CMO structure expand the appeal of mortgage securities? What is negative convexity as it relates to mortgage securities?
Securitization is the method in which the group of assets or illiquid assets are taken, and then financial engineering is used for transforming it into the form of security. These illiquid assets are then packed, purchased and then securitized for selling them to the investors. The best example used for defining securitization include mortgage - backed securities. The benefit investors get out of the securitization to include the advantage of getting the proportionate amount which is treated as the return on investment. This proportionate amount is because of the securitization on the back of security and reduces the risk of default. On part of the issuer, the mortgage pool is divided into different parts which are helpful in spreading and diversifying the risk.
CMOs are the collateralized mortgage obligations which are the securities formed from the pool of mortgages. The formation of CMOS is similar to the creation of pass – through securities. CMOS is developed for providing investors with a large range of cash flow certainties and time frames as compared to the pass – through securities. The difference in both these securities is that in CMOS, the structuring is done and there are different securities which are created by the help of pools of securities. The cash flows of interest and principal are redirected in this process. The portions of cash flows are segregated from the CMOS so that the interest payments and principal can be segregated based on the distribution schedule of the creation of CMO.
When the yield curve of the bonds is concave, negative convexity exists. This is basically the rate of change in the duration and it is measured by using the second derivative for the bond price in comparison of its yield. When this thing is seen in terms of mortgage securities, they are convex in shape which results in lower yield and negative convexity.
5. What types of securities does the Treasury issue? Fully explain the Treasury auction system process. Discuss the Treasury’s decision to move to a single-price system. How does the auction system differ from a traditional underwriting?
The treasury securities issued by the government include treasury bonds, treasury bills, treasury inflation protected securities and treasury notes. There are the marketable securities issued on the part of government and state is responsible for fulfilling all the obligations behind these securities. There are some other non – marketable treasury securities which include the State and Local Government Series and the government account series which are issues to the government managed saving bonds and trust funds.
In the treasury auction process system, there are various steps involved. The first step is the announcement of the issuance of securities to the general public. Once the announcement is made, it is done for attracting the dealers, financial institutions and brokers. There are various details included in the issuance of auctions. Further, there is bidding in which the dealers and other persons interested in the purchase of securities offer their bid to make a purchase. There are two types of budding options, one is called competitive while the other is noncompetitive. The auctions are available for the public and then the bidding is made by them. after the bids are made, the Treasury securities are issued to the person having the highest bid. The account of the bidder is charged for the amount he has offered for the securities. There is a standard interest rate applied on these treasury options and there are few cases in which accrued interest is also paid by the purchaser of the securities.
Treasury bills come under the single – payment securities and this means that they are sold on a discount and have to pay some specific face amount when the maturity arrives. The treasury conducts are done in the format of the single price. This is done so that the non-competitive bid can be subtracted from the offered quantity of the securities.
The auction system is different from the underwriting system used traditionally. In the auctions, there is a minimum price set by the company which is also called as the floor price and all the interested parties made auctions in the ascending order. In comparison, the underwriting system was operated by the agents of the company who are known as underwriters. They are helpful for the company in the selling of shares while the issuance of new shares. These parties take their commission for selling the shares to the market parties. So, there is no commission or third party involved in the issuance of shares using auctions while the contrary happens when this thing is done by the underwriters.
6. Fully explain the two perspectives of return in the money and capital markets. Fully describe the models of return in the bond and equity markets.
In the two types of markets, there are capital and money market involved. The buyers and investors have their reasons for selecting the securities from each market. In the capital market, there are high - risk investments while the money market assets are safer. The returns from the money market are low but they are at a steady pace. In comparison, the returns in the capital market are higher. The magnitude from the returns of the capital market have a direct correlation with the risk level but this is not always true. The markets are considered efficient in the long run and inefficient in the shorter term. These are the issues which are tried to recover by the investors in the capital market. So, overall, the returns offered by the capital markets are high, but the money market offers less level of return. the money market is considered to be safe but there are sometimes negative returns of this market as well because of some adverse factors. These are the unusual conditions and it is important to consider it before putting the money in the capital or money market.
The returns of equity and bonds are divided into the cash distribution and capital gains. There are periodic interest payments in the bond returns however the equity returns consist of the capital gains mainly which are obtained on the sale. The portfolio consists of both the bonds and equity, so the overall return is a combination of both these securities. When the comparison of both these securities is done in the longer run, this means that the equities will perform better in comparison of the bonds. The bonds are commonly determined by the interest rate they offer, and it is always fixed depending on the market conditions. The equity investment always results in periodic dividends as well as the capital gain that is obtained when the sale of these securities takes place. So, the equity investment is known for the capital return.
II. Presentation Questions (5pts each)
1. What are the major types of derivatives? Define futures, forwards, and options. What benefits do derivatives provide to the money and capital markets?
The derivatives are commonly characterized in four major categories. These categories include futures, forwards, options and swaps. The first type is forward contracts which is the simplest among all and the oldest form of derivatives. This is the arrangement in which the agreement is made for selling the securities on a future date. The price for selling the security in the future is decided at the present time. The second type of contract is a futures contract which is somewhat similar to the forward contracts. The price of selling a commodity is decided in advance but the difference lies in the fact that the future contracts are listed in stock exchange. This makes the exchange as an intermediary. This means that the future contracts are of standard nature and there can no modification take place in the agreement.
The third type of derivatives is options which are different from the other two types. Options are asymmetric in nature and bounds one party whereas the other party has to decide on another date which is the expiry date of the contract. The obligation is on a single party, but the option of choice is given to another party. the fourth type is swaps which are the most complicated type of derivatives. This enables the participants for exchanging the stream of cash flows. The uncertain cash flow can be switched by a party with a certain cash flow. The best example for swap can be the switching of fixed interest rate for the floating interest rate. This is used by the companies for reducing the foreign exchange risk.
In the capital and money markets, the derivatives can be used for changing the interest rates in the markets. This is helpful in the shifts of currency exchange rates. The prices change in the markets is based on the flow of information that occurs in the markets on a unique degree. The money market and capital market instruments can be dispersed on the basis of the derivative market securities. The changes occurring in both markets are managed by the investors using the speculation and other information on the market for getting maximum returns from their decisions made.
2. What are emerging markets; converging markets and frontier markets? What characterizes the emerging markets of Brazil and Eastern Europe?
The economic market of Brazil has increased the sustainability level in the previous few years. This market is considered to be among 10 of the largest economies of the world. The capital, as well as financial market of Brazil, still has a great potential for growth. The integration of Brazil in the financial market on the global market is ensured with the help of introducing a new product. There are many new securities and methods introduced in the market for improving the growth level of this market. This involves introducing products with the collaboration of UK.
The emerging market of eastern Europe has a huge amount of part in the real sector which includes the global integration and considerable trade on the period of post – transition. The financial sector of this market shows that the ownership of foreign banks is associated with the increased efficiency of the banks. The ownership of domestic banks along with the high amount of returns has transmitted this into the European financial market. There are significant effects of wealth from the communication of central banks on the financial markets and this has also reduced the uncertainty in the financial markets.
3. What countries make up the Eurozone? What are the benefits of the use of a single currency in the Eurozone? How has the evolution of the Eurozone impacted the money and capital markets?
There are all the European countries that come in the eurozone, some of them include Austria, Cyprus, Netherland, Belgium, Malta, Estonia, France, Italy, Finland, Greece, Germany, and Ireland etc. The effect of using the same currency in all these countries has multiple positive impacts on the success of this region. The most prominent benefit of using this same currency in this market is that the risk is shared among all these countries. There are many welfare effects that can be obtained by the monetary union. Other benefits involve mechanical benefits in which the most important one is the cost saving on transactional cost which occurs on the conversion of currency. The loss in the foreign exchange trade is also another effect which occurs because of using the common currency. The liquidity in the region increases which is helpful in reducing the cost of transactions in the selling and buying of financial assets.
This has a huge impact on the money and capital market as well. The risk is shared in the securities on the international level because of using the same currency. The stabilization of the federal budget increase because of the risk sharing among the capital market securities. The financial markets in the European regions are more integrated in this way and the financial reforms are performed on a national level. High level of priority is given to the economic reforms taking place on the overall EU level. Using Euro as a mutual currency for all the markets of members is without any doubt the best strategy for reducing the risk and improving the efficiency level of the market while saving cost in multiple methods.
4. Define all the governmental agencies involved in the securities regulation process. Discuss the major aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, including the Volcker Rule.
The department of commerce is the most prominent governmental body which focuses on the regulation of securities. This is also known as the Bureau of Industry and Securities. The main focus of this department is dealing with local companies and then regulating the procedure of exports in the country. The department which is solely associated with the dealing of securities is known as Securities and Exchange Commission. This department is present in all the economies and every company operating in the country should be listed in this institute. This institute is responsible for retaining the business activities in the country and can extend the companies who operate publicly in the region. Another department is the state department which is the Directorate of Defense Trade Controls. This ensures the commercial level operations of companies working in the economy of any particular company.
Dodd-Frank Wall Street Reform and Consumer Protection Act is a large reform which was implemented in the form of legislation and passed by Obama in the year 2010. This was done as a response to the financial crisis occurring in 2008. This took multiple years to implement as there were 2,300 pages of this legislation. There were multiple new agencies of government which were given the responsibility of multiple different tasks and they looked on various aspects of the banking system. The most important aspects of this act are that it has helped in improving the stability of the financial system in the country. There are various elements in this act which help with the consumer protection. There are many economic aspects of this law as well. This includes the consolidation of multiple regulatory agencies and among the reforms of consumer protection, there are new agencies formed for the protection of consumers. There are many new measures introduced as well for improving the international standards as well as the cooperation so that the improvement in the accounting and regulation can be tightened for the credit rating agencies. Later on, the Volcker rule was also added in this which prohibits the depository banks from doing the proprietary trading. The banks were restricted because of this rule for doing some specific speculative investments.
5. What are hedge funds and private equity funds? What strategies do these entities employ? How are these types of firms regulated today? Explain the structure of a private equity firm.
Private equity funds require direct investment in the public or private companies which are further de – listed from the public exchange. These are the acquisitions and investments which are illiquid and have long - term nature. The capital is increased in them by the help of private partnerships which are known to be private equity funds. In contrast, the Hedge funds are about making an investment in the assets which offer high returns in a short time period. So, the managers of these funds prefer the liquid assets so that the shift can be made between various investments.
The strategy used by the private equity funds include the short - term return companies which can offer a high level of return in the longer run. The basically have requirement of the controlling equity type of interests for the companies in which the investment is made by them. this can be obtained using a leveraged buyout. The money is invested in this type of investment when it is called out and the investor only commits for the capital initially. However, the strategy of hedge funds require the investors to invest the money in one go. There is no restriction of the hedge funds and they can be liquidated at any time.
The regulation of hedge funds is done in an open - minded fashion where there are no restrictions imposed on the transferability of the funds. In comparison, the private equity funds are regulated in the form of close ended investment in which the restrictions are imposed on the transferability for a specific time period. The way in which compensation of these funds occurs is also different.
The structure of the private equity firm is made by the general as well as limited partners. The capital is provided, and the institutional investors are included in it in the form of endowment funds, banks, foundations, insurance companies and other individuals having a high net worth. Such individuals are called limited partners because their liability is extended only to the amount of capital they invest in the venture. There is a minimum level of commitment set for this which is commonly 1 million dollars.
III. Market Monitoring Questions
1. You are a reporter for a major financial newspaper. You are asked to write a concise, well-organized article on the major movements in the money and capital markets over the September-November 2018 period, highlighting not only market movements but also the major themes that affected the marketplace during this period. Limit your response to 500 words. (10pts)
In the global markets, the long - term growth prospects are being hindered because of the structural barriers and high level of commodity dependence in 2018. The trade tension among the economies has been intensified which is a risk on the global level and an important threat to the growth outlook. The turbulence in the financial market happening recently has exposed the economies to various vulnerabilities in the developing world. Before October, it was advised in the global market to the investors for taking a defensive approach. They were advised to beware of the momentum, growth style factors and high Beta value in the market.
There were multiple data points which were highlighted in September expecting to be rising in the coming times. The most important thing included in them is the optimism for small businesses which is high for all times and the indices of manufacturing which was hitting high values. The confidence of the consumer is also hitting the top level. It is important for considering the implications of this correction in the market because there are many new things to come until next May 2019. In the fourth quarter of 2019, the growth level is slower as compared to the other quarters.
The positive indicators show that the market of US is not going to be in recession in the near future. The growth expectations for GDP are missed as the shift in economic reality is slowing down and the margin is continuously changing in the analysis. After analyzing the macro environment, there is another important factor which is called the trajectory of the corporate earnings. The corporate earnings are tough while entering in 2019. The most significant reason for this fact is the corporate taxes which were implemented in 2018. The tax cut is implemented in this time period is the main reason behind the change in these factors.
Based on the evaluation models, this slowing growth in the earning can lead to the decrease in the valuation of the equities. The impact of these slowing economies is considered on the top flow and line but this also has an impact on the stock market. In the market returns, the highlighted term at this time is volatility which is rising in all classes of assets but not in the equity market. Another important aspect going on is known as the tech volatility which is going on in high potential. The implications that result in this volatility can be measured by the help of potential move in the prices.
2. Clearly, economic indicators are an important fundamental factor that influences rates and relationships in the money and capital markets. What do you believe are the four key economic indicators (make sure you cite specific indicators)? Why? What do these indicators tell us about the market? What happened to each of these indicators this semester? (10pts)
The most important economic indicator used in the money, as well as capital markets for determining the growth rate of the economy, is GDP or gross domestic product. This is the market value of all the goods as well as services being produced in the country in a set time period and this is helpful in measuring the wealth in the society. this also indicates how far the profits will grow. This is important because it is used by the federal reserves to adjust the policy of the country accordingly. This is based on the estimates at first and the final numbers are given in the market. The reason for the increase or decrease in its value is always given in the quarterly reports of economies. In recent times, GDP has shown positive growth in the economies.
The next indicator is called money supply which is important because it is used by the federal reserve especially for the making of monetary policy and bringing change in the interest rate and changing the money supply in the market. In the recent time period, this is used by the economists for getting information about recession, recoveries, and all the other changes that occur in the stock prices. With the increase in internationalization, the money supply has fallen out of synchronization along with all the other economic indicators.
The third indicator is the CPI or consumer price index. This is a complex indicator which is important for the economy because it helps in estimating inflation. This change occurring in inflation can also have major implications on the overall economic policy and monetary policy as well. In this semester time period, the change in CPI has been positive and this has shown some particular details about specific products.
Another indicator is producer price index also termed as PPI. This is used for tracking the prices in all the sectors of goods production. It is important as it is the first term coming every month as a measure of inflation. This shows the production trends which are increasing in the recent few months. This has a significant impact on the changing of the price levels for the products as well as services.
3. Discuss the “flight to quality” phenomenon. What is it? Cite examples of the effect of “flight to quality” from market movements this semester. (5pts)
The flight to quality is the concept in which the financial market investors sell their securities which are perceived to be having a high level of risk and then make a purchase of safe investments. This is a sign of fear in the market and the investors always want less risk while exchanging lower level of profit. This commonly occurs with the increase in the demand for the assets who have securitization of private agents. This is a sudden shift that takes place in the investment behaviors of the investors in the period when financial turmoil is in the market. The feature of flight to quality is the insufficient taking of risk by the investors.
When the risk - taking becomes excessive, this can become the reason of financial turmoil and many other disturbances in the market in the following period. This type of shift in the portfolio can have multiple negative effects on the financial market. With the increase in negative credit spread and leverage, there can be most liquid assets that are safer and reduce the risk in the asset market. These indicators can have a real effect on the overall economy.
The investors in this semester have been getting the taste of this fine thing and this is the indication that it can lead to future problems. The shares of the companies are considering to be of low quality in the past few years and they are the ones which have outperformed the expectations of the investors. In the dynamic shifts happening in recent years, the conditions have also been adverse than these conditions. In the previous two years, the low - quality stocks have outperformed but the recent period has shown a completely negative impact (Gandel, 2018). This shows that quality is considered as the most important aspect for the investors in the current time period.
https://www.washingtonpost.com/business/flight-to-qualitycould-signal-trouble-for-stocks/2018/10/09/255f100c-cbb3-11e8-ad0a-0e01efba3cc1_story.html?noredirect=on&utm_term=.6a01d5c7e425
4. We began the semester with a discussion of the key themes currently influencing the money and capital markets. What are these themes? Which of these themes are still driving rates and relationships today? (10pts)
There are few themes in the capital as well as money market which are commonly influencing the overall global market. The most prominent of them is the recent fall in oil prices, the survival of the European Union and the worrisome feelings about the slow growth of the Chinese market. Oil is considered an important factor in the global economy. With the increase in its prices, everything goes down and vice versa. This complete year was in a form result of incorrect expectations from every side. So, according to the stats, there is no a difference in the indicators in the time period of start and end of this semester. The economies are going at the same pace but figures are becoming clearer now because it has not almost year end and there is multiple analysis coming on the top of the economic outlooks.
There are various elements in the fixed income securities as well which play their role in bringing change in the overall market. The rate of inflation is much more stable now. So, yes, the rates as well as the relationships which were identified at the start of this semester still stand. With the new administration of Trump, the spending of government has increased while the taxes are reduced. The relations with China are also changing which is a big change on a global level. This change in relations can result in having various other impacts on the overall world trade.
5. The Federal Reserve is clearly a dominant influence on the money and capital markets. Discuss how the markets monitor the Fed and what this information has revealed this semester. What has the market focus been regarding the Fed this semester? (10pts)
The federal reserve is analyzed by the markets and there are many important insights that help in changing the future. The most important conclusion drawn from this time period is that the Fed is looking for increasing the inflation in this time. It is believed by the economists that the high rate of inflation would not hurt the economy. It will be helpful for the central banks for supporting their growth rate and combat the problems that can occur in the upcoming downturn of the economic world. The fed is pushing the economy for driving more inflation and the warning has been issued against deflation for multiple years. The economic downturn which is upcoming can only be encountered using a high rate of return on the economic securities.
For getting the higher rates of interest, it is important to raise inflation in the economy. It is not made clear that which level of inflation or interest rate would be more appropriate. There are many factors such as the aging population, less level of economic growth, and an increase in the saving rates is pushing towards the interest rates which would make the economy grow at a sustainable rate. There are higher targets set by the economists which give fed more room by increasing interest rate by the help of central bank forces. In recent months, the investment community was also obsessed with the interest rates. The rate that prevails among the banks is also changing with the ripple effect in all the economies. There is a huge response of economy on the change of these aspects. So, these indicators show that the interest rate will increase in both the money and capital markets.
