AAF040-6 Financial Markets and Portfolio Management
Download the data on the exchange rate for the currencies of your choice from a reputable source for a minimum of last 12 months on a daily basis. Using the downloaded data, critically explain at least 4 significant fluctuations with evidence using the downloaded data and link it with the theory.
Answer:
Introduction
The financial market is described a marketplace where sellers and buyers engage in the trade of assets such as currencies, bonds, equities and derivatives. These are typically defined by having basic regulations on cost and payment, trading transparent pricing and market pressures, which and identify the prices of securities. The financial market is in every country in the global market. The financial market may be small in some countries while others like New York stock exchange and the Forex market trade dollars in trillions daily. This report is written to demonstrate an understanding of the financial market’s role and structure, the role of intermediaries and determine the portfolio selection and balancing returns and risk. This report also includes the mitigation strategies which can help in reducing the risk associated with the investment(Adam, 2016).
Financial system structure and functions
The financial system plays a prominent role in particular system or stage of an economy by arousing interest or encouraging the economic growth by affecting the economic welfare and influencing the performance of the actors in terms of economics. This can be successfully attained by financial infrastructure in which the segments with funds are allocated to the people who have potential for, to invest those funds in more productive financial system and with a more efficient way of transferring. The funds make a financial system possible. Also, one party may possess more information of transactions and the other party; this may lead to the asymmetric problem of Information and inefficient allocation of the resources of finance. The financial system helps in balancing between those needing funds and those who want to invest, which subsequently overcome the problem of asymmetric information(Gan, 2010).
The financial system of an economy comprises of main elements according to the structural approach. These components are known as financial markets, financial intermediaries, and financial regulators. A significant role is played by each of the components in the economy. The financial market helps the movement of funds to make sure to make the investments by individuals, governments, corporations, and according to functional approach. The financial regulators carry out the key role of regulating and monitoring the members or contributors in the financial system. The Financial Institutions play a vital role in the financial markets as they determine the flow of funds and perform the function of intermediation based on the capital market theory(Li, et al., 2015). The financial market study specifically focuses on the financial system pricing of financial assets and the structure of interest rate. The financial instruments also known as financial assets or intangible assets which are anticipated to provide the advantages in the future in the way of asset to future cash. Some of the financial instruments also known as securities generally include bonds and stocks. In the financial instrument, any transaction related includes at least two parties known as the issuer and investor. The issuer is the individual or person that agrees to provide the future cash payments and the investor is the individual or person that owns the financial instrument and has all the rights to get the payments sent by the issuer. There are three economic functions provided by the financial assets. The financial asset allows the transaction of cash from entities who have enough funds to the entities who need funds to invest in tangible assets. The financial asset redistributes the risk, which is unavoidable related to surplus economic units and cash generation among deficit(Chakraborty & Ray, 2006). The claims made by the last economy holders, distinct from the liability provided by the entities, who generally request those cash or economy. The financial intermediaries play a role by the certain entities for controlling the functions in financial systems.
Financial market structure
There are a number of financial instruments in the financial market place. The major market participant uses these instruments depending upon the offered return and risk features obtainable in wholesale and supermarkets. The categories in the financial instrument include the general view as shown in the figure below:
The financial instrument is categorized by the kind or category of claims made by the investor on the issuer.The debt instrument is the instrument in which the issuer’s consent to repay amount and pay the interest. It is also known as instrument of indebtedness. The instrument of indebtedness can be formed in the type of Bond, loan, or notes. The interest payments are fixed contractually by the investor(Darskuviene, 2010). Thus, the debt instruments are known as fixed income instruments. The fixed income market is classified in diversified fixed income instruments and the key features of fixed income instruments are as shown in below figure
The equity instrument differ strikingly to the debt obligation describes that the issuer pays the wealth based on earnings to the investor, after the issuer makes the obligations which is needed to make debt instrument that has been paid to investors. The example of equity instrument is common stock and due to some of the financial instruments, their features can be viewed as a mix of equity and debt. The preferred stock is the category of financial instrument, which has the feature of Debt because a fixed contractual amount is received by the investor. However, preferred stock is relevant to an equity instrument because the debt instruments are satisfied and the payments are made only after payment is made to the investor. Thus, fixed income instrument includes preferred stock and Debt instruments(Fredholm & Taghavi-Awal, 2006). The characteristics of equity and debt instruments are shown in below table which specifies that the grouping of equity and Debt is especially prominent because of the 2 factors. The first factor arises when in the issuer bankruptcy case, the investor has a predominance on the assets of the issuer over equity. The other legal reason is the tax reception of payments from the issuer that distinct determined upon the financial instrument class type(Paroush & Peles, 1978).
Classification of financial markets
There are various distinct methods to categorize the financial market. The financial market is categorized as per the financial instruments key market participants, trading procedures, characteristics of services and the location of the markets. The financial market categorization is as follows:
From the perspective of the origin of the country, the financial market is classified as internal as well as external market. The internal market is also known as the domestic market, which comprises of local markets. The domestic market is where the securities are subsequently traded and domiciled by the issuer. In the foreign market, the securities are traded and sold outside the country also known as offshore or international market. The financial market can also be categorized as derivative and cash market(Gadanecz & Jayaram, 2013).
Financial intermediaries and their functions:
Financial intermediary is a financial unit as a whole which is responsible for performing the role of issuance of funds for investors or lenders of wealth to communicate with borrowers in financial markets, when there are situations that make it complex. The financial intermediaries comprise of pension funds, investment banks, insurance companies, regulated investment companies, depository Institutions, etc. The financial intermediaries play a vital role in creating favorable transfer terms which could be discerned by investors and lender and borrower who are dealing directly with each other in the financial market. The funds required by the financial intermediaries depend on the financial claim on either the equity participant or the liability of the financial intermediary. The financial intermediaries are especially engaged in lending or investing the cash that they borrow and obtaining funds from investors or lenders(Mensah, 2012). There are the economic functions of the asset transformation known as maturity intermediation, cost Reduction for contracting and information processing, and risk reduction via diversification. The following is the comparison of roles among Financial Institutions. These functions are performed by the participant of Financial Market by providing the financial services. The financial intermediaries provide the other services which include providing payment mechanism, managing the financial asset of customer, providing investment advice to customers, assistant in building financial asset and then distributing financial asset to another participant in the market, facilitating the trading by using own capital, and facilitating the trading for financial intermediaries customers through the arrangements of brokering(Kerr & Nanda, 2014)
Portfolio Selection
The aim of every investor is to minimize the risk and maximize the returns. The method adopted for risk removal or reduction is known as diversification, which results in the construction of the portfolio. The aim of portfolio construction is to create a portfolio that helps in assessing the lowest risk and highest return. This portfolio is known as optimal portfolio and the procedure of searching for the optimal portfolio is known as portfolio selection. The analytical tools and conceptual framework for assessing the optimal portfolio in the objective and disciplines manner is known has been shared by Harry in 1952 in the journal of Finance article.
Selection of optimal portfolio
The portfolio selection problem is the process of describing the portfolios, which are efficient in nature and then selecting the best portfolio from the efficient portfolios. The investors prefer to invest in the efficient portfolios and it depends on the degree of aversion to risk. The selection of optimal portfolio is controlled or determined on the risk aversion of investor or risk tolerance of investors. The optimal portfolio can be graphically represented through the indifference curves, or through a series of risk return utility curves. The distinct combination of returns and risks are equally satisfactory as represented in the graph to the concerned investor. Each successive curve in the graph which is getting to the left hand side in the upward direction represents a high phase of utility or satisfaction. The aim of the investor is to improve their satisfaction by getting towards the curve of higher utility. For an investor, the optimal portfolio would be at the tangent line to a plane curve at a given point is the straight line that "just touches" the curve at that point between the risk and return utility and efficient Frontier in the indifference curve. The optimal performance is represented as an O’ in the below graph:
To identify the efficient portfolios, the above graph is used using the risk and expected return of security for all possible portfolios(Ganga, 2013).
The analysis of risk and return in the financial management is associated with the number of distinct uncorrelated Investments in portfolio. It is considered as overall return and risk of the portfolio. The portfolio consists of the collection of multiple investments and large scale organizations maintain their portfolio considering all the different Investments in which the return and risk are considered. The portfolio in the large-scale organizations may be comprised of two or more stocks, bonds, investment, securities, and combination of all. The concept of financial return and risk is a prominent factor of responsibilities of the financial manager within the organization or business. The risk in the finance, in general, is directly proportional to the chances of financial return. However, there are different instances of irrational risk that may not correspondingly brings the high returns.
The volatility is described as the concept of financial risk and return which defines the method in which the prices for definite securities transform for a certain period. It has been noted that greater the uncertainty, greater will be the volatility of the security. Thus, the managers involved in the financial statements are very concerned with the volatility of the business as well as stock in which they have invested.
Financial leverage: Most of the business is capitalized through either equity or Debt. The Dept capitalization comes from institutional lending while paying the regular interest payments to the lender. The equity capitalization comes from the company’s owner and sharing the company earnings in some proportion. To magnify the profits and Finance the operations, it is suggested to the company that they use Debt rather than equity. This also helps in magnifying the losses through financial leverage. It is considered as the risk and return which is fundamental in company financing(Richards, 2017).
Interest Rate risk: The manager in the financial institution faces different obstacles and risk. For example, when the manager uses the financial leverage, they need to take into consideration the rates of interest the business is paying due to the interest payments which may put a notable stress on the cash flow of the company which could ultimately declare bankruptcy and Default in its loans.
Risk premium: It is the concept in which the greater risk occurs through greater returns. It is a prominent Concept for the managers of financial institutions who hope to borrow money. Also, it has been studied that if the lender agrees to lend money to the business which is risky, they may get higher interest rates.
Mitigating the risk
The following strategies which can help in reducing the risk associated with investment and to earn more returns over time:
- Portfolio diversification: It is a process of selecting different investment within each class of asset to help reduce the risk. It also helps in reducing the impact of major changes in the market on the portfolio. The portfolio diversification helps if the company buys stock in different companies in different industries to reduce the potential for a substantial loss(Ameriprise Financial, Inc., 2018).
- Asset allocation: It is the way to measure the investment in a portfolio to meet the aim and it can be considered as a prominent aspect in the success of a portfolio. There are rewards and risk associated with major asset classes known as bonds, stocks, money market instruments, etc. Also, the past performance doesn't necessarily shows that it will impact the future result as with any security and also asset allocation does not guarantee a profit.
- Dollar cost averaging: It is an investment strategy that helps in smoothing the effects of fluctuations in the market in the portfolio. In this strategy, the company applies a dollar amount towards the purchase of bonds, stocks, Mutual Funds, on a certain period of time. In this strategy, the shares are purchased by the company when prices are low and fewerwhen prices are high. This strategy is systematic and helps in avoiding making emotional investment decisions(Roberts, 2011).
Conclusion
It has been scrutinized from this report that financial system plays a prominent role and each component of the financial market like financial markets, financial intermediaries, and financial regulators add to the economy. Also, investment includes the risk and returns which can be accessed through the optimal portfolio. However, there are also the mitigating strategies like Portfolio diversification, Asset allocation, Dollar cost averaging, which can help in reducing the investment related risks
References
Adam, J., 2016. Understanding the Different Types of Financial Markets and Their Role, Available at: https://www.morganintl.com/blog/finance-treasury/understanding-the-different-types-of-financial-markets-and-their-role/
Ameriprise Financial, Inc., 2018. 3 strategies to help reduce investment risk, Available at: https://www.ameriprise.com/research-market-insights/financial-articles/investing/strategies-to-help-reduce-investment-risk/
Chakraborty, S. & Ray, T., 2006. The Development and Structure of Financial Systems, Available at: https://www.isid.ac.in/~tridip/Research/FinancialStructure-September2006.pdf
Darskuviene, V., 2010. Financial Markets, Available at: https://www.bcci.bg/projects/latvia/pdf/7_Financial_markets.pdf
Fredholm, J. & Taghavi-Awal, B., 2006. Capital markets in developing countries - A model for capital market diagnostics, with a field study implementation in Georgia, Available at: https://www.diva-portal.org/smash/get/diva2:196476/FULLTEXT01.pdf
Gadanecz, B. & Jayaram, K., 2013. Measures of financial stability – a review, Available at: https://www.bis.org/ifc/publ/ifcb31ab.pdf
Gan, C., 2010. Role and Function of Financial Markets, Available at: https://www.fimm.com.my/pdf/seminar%20slides/role%20and%20function%20of%20financial%20markets_v1_cg.pdf
Ganga, S., 2013. Portfolio Selection, Available at: https://shodhganga.inflibnet.ac.in/bitstream/10603/102693/13/13_chapter%206.pdf
Kerr, W. & Nanda, R., 2014. Financing Innovation, Available at: https://www.hbs.edu/faculty/Publication%20Files/15-034_c08817a4-7eac-4c62-b58b-8632585180b5.pdf
Li, W., Qian, W. & Yin, M., 2015. Portfolio selection models in uncertain environment, Available at: https://ieeexplore.ieee.org/document/7381988/
Mensah, D., 2012. Describing the current situation of the financial market, Available at: https://www.theseus.fi/bitstream/handle/10024/41024/Thesis%20Work.pdf?sequence=1
Paroush, J. & Peles, Y., 1978. Search for information and portfolio selection. Journal of Banking & Finance, 2(2), pp. 163-177.
Richards, L., 2017. Risk &Return in Financial Management, Available at: https://bizfluent.com/info-8166312-risk-return-financial-management.html
Roberts, K., 2011. Strategies to mitigate risk and imnprove investment return in large capital projects. The Journal of Private Equity , p. 16.
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