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Impact of Credit Crisis on Financial Market: Assignment

Added on -2019-09-16

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Running Head: IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYAssignment TitleStudent NameCourse NameInstructor NameDate1
IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYCredit CrisisThe credit crisis is a major threat to the economy. It is a situation where the availability of lending gets tightened due to the various activities. It will have an impact on the short-term debt, long-term debt and the day to day operations of the bank. These credit crises are popularly known as the credit crunch, in this case, the amount that is available for companies to obtain a loan for the commercial purposes gets tightened, and there will be less supply of funds (FRBSF, 2012). On the other hand, there will be a reduction in the amount ofcredit available for the retail customers, and it creates more crunch to the money supply.The credit crisis is mainly used for referring the crisis that took place during 2007 and2008 in the United States. The main reason for terming the great recession as credit crisis is that it has created a catastrophic effect on the entire economy of the country and the rest of the world. Having an understanding of the reasons for such crisis is essential. The credit crisisis triggered when the event of non-repayment of loan is increasing in the market. In other words, when the default rate of the borrowers is increasing it is the initiation phase of the credit crisis, and it is the primary reason for the 2007-08 crisis (FRBSF, 2012).In the US, due to the housing bubble, many sub-prime loans were disbursed at the higher rate of interest on the mortgage-backed securities and asset-backed securities vehicles.These instruments were more famous and highly demanded in the market by the investors as they were providing a higher rate of interest to the people. Many investors invested in varioustranches of these instruments (FRBSF, 2012). These instruments had various tranches with each tranche having their identifying characteristics like the rate of interest, level of risk, repayment method, etc. Based on the requirement and as per the risk tolerance level and amount of investment that can be made by the institutions and individual investors investment were made on these instruments. 2
IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYThese instruments were not transparent in disclosing the information about their investment portfolio to the investors and provided a loan to subprime customers with poor credit rating and repayment ability. These borrowers were unable to repay the borrowed amount resulting in huge amount of default. It resulted in the loss of investment by the investors who invested in the MBS and ABS. It resulted in fall of huge institutions and the created great recession. The consequences of the credit crisis are negative yields in Treasury bill trade. Risk premium soars in corporate bonds, the worst performance of the stock market, increase in illiquidity and increase in unemployment, etc. The credit crisis will have a direct impact on both the bond market and stock market. The credit crisis will result in lack of liquidity in the debt market that further adds more trouble to the entire economic system.Lack of Liquidity in Debt Market and Credit CrisisLack of liquidity takes place when the amount of transaction taking place is lower thatis there is a lower level of purchase and sales of bonds or lower level of trading activities taking place in the bond market (Adrian, Fleming, Shachar, & Vogt, 2016). Debt market consists of both Treasury bonds and corporate bonds. During the good economic time, more people have a better inflow of money, and they make more focus on generating a better returnon investment. The MBS and ABS were at a peak during this period.More investors began to invest in all these assets and various other mutual funds with an intention to generate a higher return on investment when compared to the bond market (Adrian, Fleming, Shachar, & Vogt, 2016). It is the time when the emerging economies were providing attractive bond interest rate to sell their bonds and raise more capital when compared to the advanced economies. It resulted in more focus on the bond market that was providing lower yield on the investment due to the best available alternatives.3
IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYEventually, when the credit crisis hit the market, it created more shock to the entire economy, and it affected the bond markets too (Adrian, Fleming, Shachar, & Vogt, 2016). More investors faced huge loss due to their investment decision of investing in more risky assets and began to focus on making more investment in the risk-free asset. It resulted in more switch to the treasury bond investment. When the level of investment on the treasury instruments was increasing, it was creating more pressure on the US economy, and it requiresthem to reduce the interest rates.On the other hand, many companies in the US were adversely affected by the recession and investors were reluctant to invest in the corporate bonds even though they wereproviding higher risk premium due to the risk associated with them (Adrian, Fleming, Shachar, & Vogt, 2016). When the amount of investment in the government securities was increasing, it caused more pressure on the debt management of the country as they are responsible for repaying the amount to the investors as per the maturity. It resulted in negative yield and lowering of the transaction in the debt market by lowering the interest rate to nearly zero making the investment avenue more unattractive. When the rate of return on the investment is nil, and they are expected to provide negative yield it reduces the investor attraction over the bonds, and it resulted in lower level of trade inthe bond market and it resulted in lack of liquidity in the market (Adrian, Fleming, Shachar, & Vogt, 2016). People were not ready to buy the bonds, and at the same time, people were focusing on squaring off their position to guard themselves against the adversities.It resulted in increasing more volatility in the market without any considerable changes in the prices that caused more pressure to the liquidity in the bond market (Adrian, Fleming, Shachar, & Vogt, 2016). The bond market is not the best destination for protecting the people from the recession. They are not the destination for protecting the people from the stock market crash. There is a detailed way of looking at them is essential to understand the 4

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