Financial Markets and Institutions Research Assignment

Financial Markets and Institutions
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Financial Markets and Institutions
Introduction
The Bretton Woods Conference of 1944 formally laid the foundation for the modern global financial system. The Conference was partly in response to the Second World War that was caused partly by economic strife amongst the belligerents of the world war. The agreements of this conference laid the basis for key bodies that have the mandate for shaping the modern financial system. These bodies include; The World Bank, The International Monetary Fund, and the World Trade Organization. The conference adopted the liberalization of national economies spearheaded by the then US Secretary of State Henry Morgenthau. The new global order would discourage the formation of trade blocs that had provided the economic component that led to the Second World War CITATION Doo05 \l 1033 (Dooley, Folkerts-Landau, & Garber, 2005). The Conference also began the exchange rate system that pegged global currencies against gold and the US dollar CITATION Bre \l 1033 (Bretton Woods Final Act, Section VII, n.d.). Financial Markets and Institutions are the fundamental blocks of the modern financial system. Thus, an understanding of these bodies is critical in gaining an appreciation of how the global marketplace works. The paper will, therefore, examine key financial markets and institutions in the modern era and their contribution to the stability of the financial system.
1 Financial Market
A market simply refers to a platform where buyers and sellers of a commodity can interact. Thus, a financial market is a mechanism or platform where long-term capital is provided by some entities e.g. venture capitalists to institutions that require the said capital. The following are some examples of financial markets in the global economy; capital markets, commodity markets, money markets, futures and derivatives markets and, foreign exchange markets. The paper will in this section concern itself with capital markets as an avenue of raising capital.
Capital markets can be divided into two namely; primary and secondary markets. Primary markets deal with shares that are issued for the first time by a company e.g. through an Initial Public Offering, placing of the share, etc. The secondary market deals with trading of shares amongst members of the public. The mechanism allows shareholders to divest from their shareholding without affecting the asset holding of the company that would result in a liquidity crisis CITATION Mic96 \l 1033 (McLindon, 1996).
The key mandate of a capital market is to provide long-term capital for business. They allow buying and selling of securities. Thus, a company can raise capital that is underwritten by the assets or equity of the firm. The company can also raise capital by offering to pay premium interest rates on loans offered to it through debentures. As such, capital markets are critical to the financial well-being of the American economy. The vibrancy of the capital markets systems can be used as an indicator of the global economic progress. During the 2007-2008 financial crisis, capital markets in the United States e.g. the New York Stock Exchange (NYSE), NASDAQ, Chicago Stock Exchange, etc. experienced a severe drop in their market capitalization during the crisis CITATION USS12 \l 1033 (U.S. Securities and Exchange Commission, 2012). The Public pulled capital away from the capital market resulting in the collapse of major institutions e.g. Lehman Brothers and the reorganization of the American Banking Industry. The crisis indicated to the global population how critical the capital markets are to the global financial system CITATION Mic09 \l 1033 (Melvin & Taylor, 2009).
2. Factors Affecting Interest Rates
There are a myriad of factors that affect the interest rates in the global economy. The paper will specifically address these with reference to the US economy CITATION Kan14 \l 1033 (Kanwal & Abbasi, 2014). The first factor is the condition of the US economy CITATION Dav13 \l 1033 (Garr, 2013). Where the US economy is performing adequately and experiencing positive growth, interest rates will be positive and could rise. The discount rate provided by the Federal Reserve to banks also influences interest rates. The discount rate is the rate at which banks lend money to each other, and the Federal Reserve lends money to the banks. The lower the discount rate, the lower the final interest rate offered to the public CITATION Jen14 \l 1033 (Calonia, 2014). The dollar as the de facto international trade currency affects interest rates. A strong dollar results in higher interest rates as it is stronger compared to its peers in the global economy CITATION Fin15 \l 1033 (FinancialWeb, 2015). The Federal Reserve as the body mandated with controlling the US dollar and setting monetary policy for the United States ultimately has (through its Federal Open Market Committee) the final say of the interest rates. As an agency of government with autonomy from other bodies, it can and does set interest rates as it deems fit.
The Federal Reserve Bank is the most critical determinant of interest rates in the United States. As the United States is a global economic powerhouse, the Federal Reserve decision on the benchmark nominal interest rates has a domino effect across the globe affecting interest rates in most economies CITATION Bro15 \l 1033 (Brookings Institute, 2015). The Federal Reserve attempts to use interest rates to control economic growth and ensure inflation remains at 2% +-1 similar to other central banks e.g. the Swedish Central Bank and the European Central Bank CITATION Eco11 \l 1033 (Economics.com, 2011) CITATION Sve11 \l 1033 (Sveriges Riksbank, 2011). The Federal Open Market Committee of the Federal Reserve holds meetings quarterly to determine interest rates. The decision of the committee is widely anticipated by both financial experts and the general public. Widespread speculation on its options are common and can lead to upheavals in the financial markets e.g. when the Committee raised interest rates for the first time in December 2015 ending a seven-year run of keeping the interest rate near zero CITATION Jim16 \l 1033 (Jim Puzzanghera - Los Angeles Times, 2016).
3. Ease and Difficulty of Forecasting Interest Rate Changes
Analysis of interest rate changes is fraught with challenges. Key among this is the large number of variables that affect the decision on interest rates. As such, it is practically impossible to forecast future interest changes CITATION Kim06 \l 1033 (Kim, Mizen, & Thanaset, 2006). The Federal Reserve while acting singularly in determining the nominal benchmark interest rates, it takes into consideration all factors to ensure the macroeconomic stability of the US economy. The Federal Reserve also has the mandate of keeping the US economy in continued growth trajectory through its monetary policy. Thus, interest rate changes are a reflection of a deep discourse that occurs between policymakers and the financial players. The Federal Reserve must balance the needs and demands of all its stakeholders CITATION Cha11 \l 1033 (Goodhart & Lim, 2011).
Analysts who attempt to forecast interest rate changes often fail to account for their innate bias towards interest rate changes in a particular direction. We are, as a species, largely irrational. Thus, it is critical that any forecast admits to this flaw and bases its decision on data alone CITATION CAE09 \l 1033 (Goodhart C., 2009). However, data has noted, that the interest rates changes and the factors that influence these changes, are not rational CITATION Lou16 \l 1033 (Barnes, 2016). They do not follow a defined linear path, thus making forecasting impossible and akin to gambling CITATION Jam15 \l 1033 (Hamilton., 2015).
4. The Federal Reserve
The Federal Reserve is the Central Bank of the United Stat...