Liquidity can be defined as the ability to convert an asset into cash quickly. In order to further explain, we can say that cash is the most liquid of all assets. With respect to financial assets liquidity is an important concept because the volatility of financial markets makes it an asset more valuable in the eyes of investor if its liquidity is high. If a particular asset is easily convertible into cash, we say that it has a high level of liquidity. A liquid asset has features such as rapid sale, with minimum loss of value, in the market. An illiquid asset is one that is cannot be sold readily at market value. Usually, examples of such assets can be found in the form of mortgage-related assets when there is severe economic recession and the housing market falls extensively. Discussing liquidity with respect to financial assets, it can be said that securities are liquid at any time if they can be sold in the market without loss of considerable value and in less time. Taking into account, the liquidity of financial assets, ranking them in descending order of liquidity can give a fair idea of the liquidity concept with respect to financial assets (Houston & Brigham 2009). These are ranked as follow: Corporate Bonds, Treasury Bills, Certificate of Deposits and ordinary shares of unquoted company. Summarizing this list of financial assets, it can be said that Corporate Bonds are least liquid of all financial assets listed above while ordinary shares are most liquid.
Money multiplier and Its Relationship with the Reserve Ratio
Money multiplier is a measure of the magnitude of changes in income. It shows the change that is brought about in national income due to a change in aggregate expenditure. The concept of multiplier explains that the initial change in aggregate expenditure in an economy will lead to an multiple changes in national income until the effect is nullified. The effect of such a multiplier in national income depends on the size of aggregate expenditure in an economy and the initial increase that is leading to the multiplier effect. For example, the government spends $10 million on government hospitals. The government expenditure of $10 million will inject money into the economy. This money will pass through the hands of labor that was involved in the construction of hospitals, the engineers involved in planning and the contractors. The expenditure of government is the income of these people. Such labor, engineers and contractors will save a part of their income and spend a part of it. The expenditure of such people than becomes the income of others and the cycle carries on until the expenditure is nullified. The multiplier effect finally comes to an end because every person's expenditure is the income of another but such person who receives it as an income, spends only a part of his income as expense. If a person spends $100 to buy a mobile phone, the expense of such a person is the income of the mobile shop owner. Now the mobile shop owner will spend a part of his income, so supposing that he spends $60, than such expense will become the income of another and so the cycle carries on. As the marginal propensity of not spending increases, the rate of multiplier decreases and so does its effect on national income.
The money multiplier is of great significance in the financial markets due to its deep relationship with the reserve ratio. If a customer deposits cash with a bank, that deposit is an asset to such a person but a liability to the bank. The bank holds the cash as an asset so its assets equal its liabilities. If the bank advances a loan to any other person on the basis of the money deposited, that will be an asset to the bank, but any deposit created will be a liability. But banks usually advance...
This is due to the multiplier effect. To understand this concept, we need to understand the concept of the reserve ratio and its relationship with the multiplier effect. The reserve ratio is the percentage of amount that the banks intend to hold against the amount of deposits they have. For example, ten banks of equal size receive a deposit of $100 each. Each bank now enters in its books, assets and liabilities of $100. The banks are on a fractional reserve system and we assume that they wish to hold 10% reserves against all deposits. The new deposits put the banks into disequilibrium since they have 100% reserves against these new deposits. As the banks have maintained a reserve ratio of 10%, therefore their deposits increased to $1,000 and their loans increased to $900. The maintenance of reserve ratio by the banks created a multiplier effect with a numerical of 10 (Lipsey & Chrystal 1997).
Factors Affecting Market Price of Straight Bonds
Straight bonds are primarily debt instruments, the purpose of which is to lend money to private and public entities. These bonds are required to be paid back with the principal amount that was lent to the entity. Apart from that, the respective entity, which borrows the straight bond, is required to pay an interest at a fixed interest rate on given time intervals. Unlike many other bonds, a straight bond is not convertible into any other financial instrument.
There are several factors that influence the market price of a straight bond. These factors include the interest rate at which a bond is offered, the maturity date at which the bond is required to be repaid, the coupon rate, which is the annual interest rate to be paid as a percentage of the bond's face value, credit value of the bond, tax status and the risks associated with the bond.
The tax status of a bond implies that how an investment and earnings from a bond will be taxed. Some bonds may be completely tax free, some are taxed at the federal level while some are taxed only at the state level (Singh 2001).
Credit value of any bond is referred to its credit worthiness. In simple words it primarily reflects the risk of default associated with a bond. Determining an associated risk of default is extremely important for an investor because in case an entity selling a bond goes bankrupt, the investor will lose all his money and will not be able to reclaim it. This is why investors are very particular about the credit value or credit ratings of a bond before making an investment. Credit ratings of a bond range from a highest AAA and goes down to a C. The higher credit rating a bond has, the less risk of default is associated with the bond. These credit values are determined by independent private agencies. The most popular of these agencies include Moody's, Fitch and Standard and Poor's. Summing these all influences, an ideal bond for an investor would be the one that offers a highest interest rate and coupon rate, that has a high credit rating and minimal risk, early maturity date and easy tax status. Of course, the more lucrative a bond will be, the more investment it will attract. This means that investors will demand more of that particular bond (Doherty 2000).
This leads to another important factor that influences the prices of a bond, the price mechanism. Under a price mechanism, the prices of a bond are determined by the market forces, that is the forces of demand and supply. In this case the demand force will be the investors that are willing and able to invest in a particular bond, and the supply force will be the entity that is willing to put its bonds on sale at a particular interest and maturity date. If the demand of a bond exceeds the supply of bond in the market, the price of a bond will rise. Conversely, if the supply of a bond exceeds its demand, the price will go down. Of course the more risk free and the more lucrative a bond will be, the more it will be demanded.
Apart from that the price of a bond may also be affected by its transactional costs. The transactional cost refers to the mark up that is charged by the dealer who buys and sells the bond to the investor. A high mark up would mean that the investor will now have a lesser return on his investment. It should be noted that if certain bond is new in the market, the chances are that it will be sold at or close to its face value.
Risk Management and the Basel Capital Accord
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