Functions of Financial Markets and Discusses Why Essay

  • Length: 10 pages
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  • Subject: Economics
  • Type: Essay
  • Paper: #7792090

Excerpt from Essay :

functions of financial markets and discusses why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. Furthermore, the paper explains the cash flows associated with a bond to the investor. And discusses the term "price-earnings (P/E) ratio." In addition, the paper discusses the certainty equivalent approach to estimating the NPA of A project and discusses the problems associated with capital investment process. Lastly, the paper contrasts and compares capital budgeting and strategic planning assesses the agency problems associated with capital budgeting.

Explain the functions of financial markets

The existence of the financial market is just to help and maintain the relations between the users of the capital and the providers of the capital. They also provide an opportunity for both the parties to do transactions with mutual benefits. It is there so that the investor and the investment can do the business smoothly and at ease. They offer a pricing function for both the parties that mean both the seller and the buyer are provided with reasonable evaluation of assets in the financial markets. Then another point that has to be kept in mind is that the financial markets are properly regulated which further motivates the issuers of the securities to restrict the dealings that market thinks as unsafe to the worth of their assets. There are some particular needs of both the lenders and the borrowers and these needs cannot be dealt by these financial markets and so this is the reason why financial intermediaries exist. They work towards matching the complex requirements of both the parties which means they look for counterparties with precisely opposite needs as this will assist in decreasing the costs. The lenders want some safety as well as liquidity and they have a few wishes such as (Groz, 2009):

* The risk minimisation which means the minimization of the risk of non-payment which is that the borrowers don't meet their repayment requirements and the risk related to assets falling in worth (Groz, 2009).

* The cost minimisation (Groz, 2009).

* The maximisation of return which basically means that all the money invested by the lender is received back by him.

* The ease of changing a financial claim into cash without any loss of capital value this is Liquidity which lenders value.

Borrowers too have some wants (Groz, 2009):

* Funds at a specific time which is that the borrower would appreciate getting funds at his choosen date.

* Funds for a particular time period, most likely long-term for the reason that in order to have positive returns the funds can't be given back in the short-term.

* Funds at the least achievable cost which means low interest rates.

Direct finance and indirect finance have particular dissimilarities. There is an advantage to indirect finance over the direct finance however there are extra costs incurred like spread of interest rate and having additional fees when making use of the financial intermediaries. To announce that indirect finance is a lot more beneficial than direct finance it is necessary that the advantages of such activity offset the costs related with the indirect finance (Groz, 2009).

A dollar tomorrow cannot be worth less than a dollar the day after tomorrow

A minute's reflection can persuade you that the cash at present is always value more than cash tomorrow. If you do not trust me then provide me with the money now. I will give you back every penny of it in exactly 1 year (Taleb, 2008).

You'd be stupid certainly to let go food, attire, home, car and entertainment for 1 year for no payment whatsoever. That's the reason a dollar at present is valued more than a dollar tomorrow. (An additional rationale that a dollar at present is valued more than a dollar tomorrow is that, in current economies, for reasons explained in Chapter 17, Monetary Policy Targets and Goals, prices suppose to increase each year. So $100 in future will buy lesser goods as well as services than $100 at present will. Of inflation on the interest rates will be explained in detail at the conclusion of this chapter. Right now, we will discuss just the nominal interest rates, not actual interest rates.) But let's say you were told that if you provide me $100 at present, I'd provide you $1,000 in 1 year? Most providers would jump at this (provided they think I will pay as said and not run away), but I wouldn't provide it and nor would many borrowers. Actually, about $110 will be the maximum amount that I'd be eager to provide you in 1 year for $100 at present. This is an interest rate of 10% ($10/$100 = .1 or 10%), that, as humorist Adam Sandler will say, is "not too shabby." If we allow the loan ride, as is said, capitalizing the interest or, in different words, giving interest on the interest each year, called annually compounding interest, the $100 investment will increase in value, like shown in Figure 1, "The luck of $100 invested at 10%, compounded annually (Taleb, 2008)."

Figure 1: The destiny of $100 invested at 10%, compounded annually

The values in the table are with no trouble determined by multiplying the last year's value by 1.10, 1 showing the principal amount and .10 showing the interest rate. Then $100 at present that is year 0 is, at 10% interest compounded annually, valued $110 in 1 year (100 x 1.1), $121 following 2 years (110 x 1.1), $131.10 following 3 years (121 x 1.1), and so forth. The fastest way to determine this for several different years is to use the below given formula (Taleb, 2008):

FV = PV (1 + i) n

Where

FV = the future worth (the future value of one's investment)

PV = the current worth (the value of one's investment today)

(1 + i) n = the future worth factor (also acknowledged as the present value variable or discount variable in the equation under)

i = interest rate (decimalized, for instance, 6% = .06; 25% = .25, 2.763% = .02763, etc.)

n = number of terms (at this time, years; somewhere else days, quarters, months)

For $100 borrowed at present on 10% compounded yearly, in hundred years I'd be indebted to you by $1,378,061 (FV = 100 x 1.1100) (Taleb, 2008).

What if somebody says they will pay you, about, $1,000 in five years? How much will you be keen to pay at present for that? Definitely somewhat less than $1,000 and rather than using a PV and increasing it through multiplication to decide an FV, you should do the reverse or in other words, lessen or "discount" an FV to a PV. You will do this by using below given equation (Taleb, 2008):

PV = FV / ( 1 + I ) n or PV = 1000 / ( 1 + I ) 5

Clearly, we can't work out this formula except when one of these two outstanding variables is provided. If the interest rate is provided as 5%, you will pay $783.53 at present for $1,000 payable in five years (PV = 1000/1.055). If it is 20%, you will provide only $401.88 (PV = 1000/1.25). If it is one percent, you will provide $951.47 (PV = 1000/1.015). Observe when the interest rate increases (falls), the value of the bond decreases (rises). It can be said that, the value of some prospect payment (some FV; basically, a bond) and the interest rate have an inverse relation between them. This can be seen algebraically by observing that this term is in the denominator, therefore, as it becomes bigger, PV should be less (holding FV unvarying, of course). Economically it is alright because a greater interest rate basically means a greater opportunity cost for value, more important the money the less valued in the sum owed in the future (Taleb, 2008).

If payments were to be provided in 10 years instead of 5 of the bond explained just above, at 1% interest per year, you will pay $905.29 (PV = 1000/1.0110). See here that, keeping the interest rate unvarying, you pay less at present for a payment in the future ($905.29 < $951.47). This also makes some sense since you're with none of your money required to be rewarded for this by giving a lesser price for the bond/promise/IOU today (Taleb, 2008).

Explain the cash flows associated with a bond to the investor

Bonds are vulnerable to a variety of risks and these risks include the following (Bernardo, Cai, and Luo, 2002):

Interest-rate risk: Interest rates may increase or decrease at any time, ensuing in a rise or fall in a bond's value. Increasing interest rates need that the prospective cash flows should have a greater rate of return. The principal value of the bond must be lessened to recompense for an elevated required return since future cash flows are fixed in bonds (Bernardo, Cai, and Luo, 2002).

Inflation risk: An increase or decrease in inflation…

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