Financial Instruments and Institutions: A Comprehensive Report

This report analyzes financial instruments and institutions, addressing key aspects of financial markets. The report begins by examining the circumstances under which a central bank might intervene in the foreign exchange market within a floating exchange-rate regime, followed by a discussion on the factors contributing to fluctuations in the AUD/USD exchange rate. The second part of the report focuses on financial risk, defining it and identifying five major risk categories, while also exploring their interrelationships. Finally, the report provides strategic advice to Heritage Bank on managing the risks it confronts, including managing interest rates and risk premiums. The report concludes with an analysis of yield curves pre and post the Global Financial Crisis (GFC), highlighting investor expectations and market performance. The assignment covers topics such as exchange rates, financial risk, central bank interventions, interest rates, and risk management strategies.

Running head: FINANCIAL INSTRUMENTS AND INSTITUTIONS 1
Financial Instruments And Institutions
Students Name:
Institutional Affiliation:

FINANCIAL INSTRUMENTS AND INSTITUTIONS 2
Financial Instruments And Institutions
1) a) There are two fundamental circumstances under which the central bank of a
nation may conduct transactions in the foreign exchange market. Firstly, in the case of
stabilizing fluctuations, when the exchange rates are unpredictable, the investors will not be
willing to invest; hence, it will force the central bank to intervene. Secondly, In the case of
reversing the trade deficit, when the currency of a country is higher, the goods in the foreign
market are cheaper while the domestic goods are expensive, hence low export meaning a
trade deficit, the central bank will be compelled to reduce the currency value of the country.
b) The graph presented shows fluctuations in the exchange rates of the Australian
currency in relation to the USD. Diversity factors present fluctuations in AUS USD exchange
rate. For instance, speculations of the investors present a significant impact. A negative view
among investors will make them shun from investing hence, the currency value falls due to
low demand while a positive view will present a high currency value. Secondly, political
stability uncertainty in Australia causes fluctuations in the exchange rate. The value of the
Australian currency rises when the government is stable and falls during political instability
circumstances as investors tend to shun away from investing.
2) a) Financial risk refers to the possibility that the corporate stakeholders will incur
losses if the company’s investment doesn't provide an adequate return (Giglio, 2016). Some
of the risks include Inflation risk; it is whereby the market commodity prices will increase or
decrease according to the market conditions. Default risk is the money lend to a borrower
being unrecovered in the future. Liquidity risk is a financial asset being difficult to convert to
monetary form. Maturity risk refers to the maturity of financial instruments being uncertain
or volatile. Equity risk refers to the difference between the rate of return of a risk-free rate
investment and the one in an individual stock.

FINANCIAL INSTRUMENTS AND INSTITUTIONS 3
b) Increased inflation rates lead to high default risk due to increased interest rates,
which increase the cost of capital and vice versa. Increased inflation rate also increases the
interest rate, which then decreases the maturity risk. Inflation rate also affects the equity risks
through increasing the cost of capital when the inflation rate is high, causing the equity risk
also to be high.
c) Heritage Bank should reduce their interest rates to sustainable levels to balance the
demand of the mortgages and the costs incurred in mortgage enterprise.
3a) A risk premium is a return over a risk-free financial asset that should be present in a risky
asset so that an investor will choose the risky instrument rather than the riskless instrument
(Engel, 2016). The greater the risk premium, the higher the yield curves. About the bank's
policy, the commercial bank increases the risk premium to compensate for the risk available
to the borrower at the corporate enterprise level.
b) Yes, any borrower will need certainty in the financial instrument to reduce the
inconveniences in the future paying up of the borrowed capital.
c) Post – GFC yield curve shows that investors are expecting a higher rate of return
for compensation of loss of liquidity in the future long term securities because the market is
perceived to perform better.
Yield curve during FGC shows that the investors are still optimistic about the
performance in the market hence they require compensation for lack of liquidity in the future,
but the rate of change of the yield is lower due to the current prevailing crisis.
Pre- GFC yield curve shows the investors are worried about the rate of return of long
term securities; thus they are willing to invest in the current short term securities rather than
the long term.

FINANCIAL INSTRUMENTS AND INSTITUTIONS 4
References
Engel, C. (2016). Exchange rates, interest rates, and the risk premium. American Economic
Review, 106(2), 436-74.
Giglio, S. (2016). Credit default swap spreads and systemic financial risk (No. 15). ESRB
Working Paper Series.