Financial Markets and Institutions

This document provides insights into financial markets and institutions. It discusses the differences between stock market falls in 2007 and 1998, the importance of T-bills, and the implications of future pessimism on capital markets. It also offers recommendations for investing in money markets.

FINANCIAL MARKETS AND INSTITUTIONS
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FINANCIAL MARKETS AND INSTITUTIONS
Question 1
While there are periods when the stock market may have witnessed falls, the movement
cannot be compared to 2007 where the fall in the stock market was sustained with intense
selling pressure. On the contrary in 1998, there were intermittent periods of selling in the
middle of a recovering economy which had some challenges. The current fall in stock market
is not on account of poor macroeconomic fundamentals as the various indicators in the US
economy show improvement which has prompted the Federal Reserve to increase interest
rates and reduce their balance sheet (Bris, 2018). On the contrary, the fall in 2007 was
accompanied by a economic recession on account of subprime crisis which led the Federal
Reserve to cut rates and embark on quantitative easing so as to flush the system with
liquidity. Also, the US stock markets are in the middle of a multi-year bull run which is
fuelled by improving fundamentals of the US economy (Collett, 2018). This is unlike the
situation in 2007 when the economy had overheated and Fed rates were on the record highs.
It does not seem possible to have a financial crisis similar to 2007 considering that that
macroeconomic indicators in US are improving coupled with continued support from low Fed
rate. Also, it is noteworthy that this economic growth in US would have been much stronger
had there been no trade war with China. The US policies regarding trade are also having
adverse impact on the global growth scenario. However, there does not seem to be any
systemic issue especially with the US economy at the present hinting at creation of any asset
bubble.
Question 2
The importance of T –bills stems from the fact that it is often considered a risk free
investment as people do not expect US government to default on their interest and debt
obligations. As a result, a significant amount of money is parked in the form of T-bills by not
only investors but also governments. The interest rate offered on the T-bill is often used to
indicate the respective yield of other debt instruments by adding a risk premium. Therefore,
any turmoil in the financial markets with regards to T-bill would have significant
implications for the financial markets (Damodaran, 2015).
Besides, it needs to be considered that issuance of T-bills is done by Federal Reserve in order
to fund the deficit of the government or to absorb the excess liquidity. Any increase in
associated risk of the T-bill would essentially be associated with deteriorating economic
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FINANCIAL MARKETS AND INSTITUTIONS
fundamentals of the US economy (Parrino & Kidwell, 2014). For instance, a cut in the rating
of the T-bills would have implications for the global financial system as a number of
investors and governments tend to park their money only in AAA rated paper. Therefore, a
higher interest rate would have to be offered by the T-bills to lure investors. This would have
direct implication for the funding of various businesses which would witness a higher costing
which would reduce their profitability. This may trigger a sell-off in the stock market
(Brealey, Myers & Allen, 2014).
Question 3
In order to highlight the appropriate markets to invest, it is pivotal to understand the
implications of the future pessimism of the economy. A pessimistic outlook for the economy
would imply that the economic growth rate would slow down. This would have an adverse
impact on a host of businesses and cause their earnings to drop (Petty et. al., 2015). This is
because during economic slowdown, there is a drop in consumer spending coupled with
lower private investment leading to lower demand for various products and services. The
drop in earnings would imply a fall in the stock markets. Also, the analyst may revise the
future earnings downwards leading to further declines in the capital markets (Damodaran,
2015). The market participants would be weary of capital markets owing to risky nature and
thereby would shift to money markets owing to significantly lower risk. Owing to higher
demand for these instruments, there prices would increase as the interest rate expectations of
investors would fall (Parrino & Kidwell, 2014)
Considering the above, it is evident that in the given future assessment of the economic
performance, the capital markets is not a preferred bet considering that stock prices are
expected to fall. On the contrary, investment in money markets would be preferred
considering their less risky nature which would lead to appreciation in their prices and better
returns for investors (Brealey, Myers & Allen, 2014). Hence, I would invest my money in
money markets instead of capital markets.
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FINANCIAL MARKETS AND INSTITUTIONS
References
Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance (6thed.) New
York: McGraw-Hill Publications
Bris, A. (2018) Three reasons not to worry about the stock market ‘crash’, Retrieved from
https://theconversation.com/three-reasons-not-to-worry-about-the-stock-market-crash-
91338
Collett, M. (2018) US markets turmoil: Why this is a correction and not a crash, Retrieved
from https://www.abc.net.au/news/2018-02-09/what-makes-a-market-correction-
different-to-a-crash/9412530
Damodaran, A. (2015). Applied corporate finance: A user’s manual (3rd ed) New York:
Wiley, John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance (3rd ed.) London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. & Nguyen, H. (2015).
Financial Management, Principles and Applications (6th ed.) NSW: Pearson Education,
French Forest Australia
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