Financial Markets and Institutions
Financial markets can be categorized into three; namely, money markets, capital markets, and forex markets. Financial markets are the markets where trading in securities such as stocks, bonds, forex, and derivatives takes place. The financial markets in the US create a platform that helps in allocating resources and creating liquidity for businesses and entrepreneurs alike. Financial markets are known for providing open and regulated systems for corporates to raise capital through the use of stock and bonds. Therefore, the financial markets in the US make it possible for sellers and buyers of financial holding to meet their needs (Rousseau, & Sylla, 2005). These markets create economic wealth in the United States due to the creation of securities’ products that provide a return for investors and lenders as they make the fund to be accessible to borrowers. Thus, it is prudent to say that the financial markets help in directing the flow of savings and investments in the US economy efficiently. Through such acts, there is an accumulation of capital and the production of goods and services in the economy hence creating economic wealth.
The financial markets promote the creation of economic wealth by reducing the risks since they make information readily available to investors and traders. The markets are held in public places openly and transparently making them set prices on everything that is being traded. This makes them reflect on all the available knowledge as pertains to the assets and securities that are traded in them. Thus with an efficient flow of information, the investors can choose among the available securities the best they will get maximum return leaving behind the others with minimal returns (Wurgler, 2000). The information is easily availed by consulting financial intermediaries or consultants who guide the potential investors. Therefore, due to the desire to create transparency in information flow, new job opportunities are created in the economy that plays a role in creating economic wealth. The financial markets bring about economic wealth by creating investors’ confidence. This is because the financial markets also allow businesses to offset risk by accessing commodities, foreign exchange futures, and derivative markets.
Potential investors get a chance to gauge the company’s performance by looking at the value of its stock in the market as compared to its competitors. Also, the company’s interest to invest beta value over 5 year period in the industry gives the impression of the company’s performance as analyzed among its competitors. Therefore, the investor gets to understand the true picture of the economic performance of the country shielding it from shocks due to sudden falls in interest rates and prices. Therefore, the renewed investors’ confidence helps in stabilizing the economies of the country (Colombage, 2009). The size of the financial markets helps in creating economic wealth due to the provision of liquidity. The size makes the sellers dispose off assets every time they need to raise cash. Therefore, the size helps in reducing the cost of doing business making it easier for companies and investors to find buyers or sellers of their securities or financial assets promoting the creation of economic wealth.
General overview of T-Bills, Eurodollar securities, and Structured Notes
A treasury bill (T-Bill) is issued by the US government as a short-term debt obligation that is backed by the treasury with a maturity of less than one year. They are sold in dominations as low as the US $ 1000 with some reaching US $ 5 million and are usually sold in auctions using either a competitive or non-competitive bidding process. They are considered low-risk and secure investments. A treasury bill with a longer maturity rate makes the investor receive a higher interest rate unlike the one with a shorter maturity date (Zaremba, et al, 2019). Eurodollar securities are time deposit account that is in denominations of the US dollar and are kept in banks outside the US or in a foreign branch of a US bank. Initially, they were restricted to Europe but later countries like the Bahamas and Caymans islands were included as destinations for the US dollar deposits. Eurodollar needs a steady supply of depositors who put their money in foreign banks hence they experience liquidity problems if the supply of deposits declines. The Eurodollar deposits are usually large with the minimum amount being US$ 100,000 and more than US $ 5 million. In overnight market, the bank can accept a single deposit of US $500 million. The Federal Reserve Bank holds that there is an average daily volume in the market of US $140 billion in Eurodollar deposits (Ivashina, et al, 2015). A structured note is a security for a debt that has both bond and derivative components issued by the financial institution. The return for structured notes depends on equity indexes, single equity, and a basket of equities, interest rates, commodities, or foreign currencies. Its performance can be attributed to the return on an underlying group of assets or index.
Current risk-return relationship of T-Bill, Eurodollar securities, and Structured Notes and the strategy to maximize returns
The T-bills are issued at a discount from their face value hence the purchase price is less than the face value of the bill. Thus, the Treasury bill pays a fixed rate of interest providing stable income. When the interest rates are rising the existing T-bills will fall out of favor since their interest rates will be unattractive as compared to the available market. This implies that they suffer from interest rate risk since the existing bondholders lose out due to higher interest rates in the future (Zaremba, et al,2019). Also despite the treasury bills having zero default risks, their returns are lower than corporate bonds and some certificates of deposit. Likewise, a treasury bill sold before the maturity date fetches lower sale price than the original purchase price. Therefore, they are a good investment vehicle if one waits until maturity and the interest rates have low potential to increase above coupon rate. The Eurodollar market is free of regulation makes the deposits attract higher interest (Rousseau, & Sylla, 2005). Due to their offshore location, they are subject to political and economic risk in the country they are domiciled. Eurodollar deposits made overnight to a week are priced using the fed funds rate. However, the prices for more than a week are based on London interbank offered rate (LIBOR). The best strategy for investing in Eurodollar is for overnight or one week due to the stability of Fed rates guarantying investor of his return. The structured note bond portion takes up the larger part of the investment as it provides principal protection. The remaining part of the investment is used to purchase a derivative product providing upside potential to the investors due to the exposure it gives to any asset class (Wurgler, 2000). For example, the structured note can consist of a fairly stable bond matched with out-of-the-money call-out options on risky stocks. This limits the losses while creating the potential for huge gains as well lead to repeated small losses in case the call options are too far out of the money. Thus a structured note can offer limited losses in return for limited gains as compared to other assets. The best investment plan is to invest in structured notes having fairly stable bonds coupled with out-of-money call-out options on risky securities.
Effect of Federal Reserve, and its monetary policy on T-bills, Eurodollar, and Structured Notes.
When the federal funds rate rises, investors move money from treasuries to higher-yielding investments since the treasury rates are unattractive. Therefore T-Bill prices will rise when Fed adopts expansionary monetary policies that make it buy treasuries while T-bill prices will fall as Fed sells its debt securities. If the Federal funds rate declines, more deposits will be held in Eurodollar for overnight and one-week transactions since banks will be having more money to lend as loans. Thus it will increase the money available in financial institutions dealing with Eurodollar securities (Ashraf, 2020). When Federal funds increase federal rates, it makes investors buy more structured notes since the higher rates will be more attractive in short term. The T-bill is an attractive investment in twelve months at the moment since the economy is recovering from the effect of COVID 19 and there is less likelihood of higher interest rates. Eurodollar is an ideal investment for the next 5 years since the will not be entirely regulated by Fed rates. The structured notes can be used as investment vehicles over the next 10 years as investors wait for the complete recovery of the economy from the effect of COVID 19 and the fed continue to adopt the expansionary monetary policy.
References
Ashraf, B. N. (2020). The economic impact of government interventions during the COVID-19 pandemic: International evidence from financial markets. Journal of behavioral and experimental finance, 27, 100371.
Colombage, S. R. (2009). Financial markets and economic performances: Empirical evidence from five industrialized economies. Research in International Business and Finance, 23(3), 339-348.
Ivashina, V., Scharfstein, D. S., & Stein, J. C. (2015). Dollar funding and the lending behavior of global banks. The Quarterly Journal of Economics, 130(3), 1241-1281.
Rousseau, P. L., & Sylla, R. (2005). Emerging financial markets and early US growth. Explorations in Economic History, 42(1), 1-26.
Wurgler, J. (2000). Financial markets and the allocation of capital. Journal of financial economics, 58(1-2), 187-214.
Zaremba, A., Kambouris, G. D., & Karathanasopoulos, A. (2019). Two centuries of global financial market integration: Equities, government bonds, treasury bills, and currencies. Economics Letters, 182, 26-29.
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