Role of Financial Markets
Financial markets are essential since they act as the agents of economic development in a country (Benito, 2012). This occurs through the support of industrial development, national growth, and entrepreneurship growth in a country. Financial markets play this role by facilitating flow of funds and availing the necessary financial resources, which are essential for economic growth and development. Moreover, financial markets support individuals saving mobilization and investment activities, which contribute towards economic growth. This occurs through the provision of liquidity, which is essential in the process of funds trading, enabling lenders have an access to necessary assets, and making sure that borrowers are able to attain desired funds. In addition, financial markets support resources transfer, sale of assets to investors, determination of securities prices, and provide crucial information to all parties interested in financial markets activities.
Securities Overview
Stock
A business stock indicates investment or capital, which its founders put in place at the start (Babenko et al., 2011). Creditors use the business stock as the security means. For all business organizations, stocks are regarded as shares, which are either preferred stocks (does not have voting rights) or common stocks (has voting rights) traded within financial markets. The forces of demand and supply influence pricing of stocks. With demand associated with the total number of various share investors who are willing to buy shares and supply being regarded as the float, which is total shares that are available for sale. This results in stock price movement in order to attain equilibrium of the stock price. Stocks have a positive historical performance, which can be traced back to 1600 when East India Company was the first to use stocks, which enabled favoring of India trade privileges. Since then, most companies have adopted stocks in the form of shares as a means of raising capital when investors purchase the same.
Bond
Bond is a debt security, which grants one an opportunity of providing loan to a country or a company (Bao et al., 2011). Bonds are found within the financial market. Once issued, bonds are paid in terms of interest rates that are fixed, which are often regarded as coupon rates to their maturity periods. The pricing of bonds is based on perceived risk and interest rates, which are available in the stock market. As such, bonds have to sell when mature to ensure that their value is not affected. Price sensitivity of bonds is based on convexity, and duration of interest rates movements. This makes it possible to price bonds at par, discount, or premium. Bonds have being around for years and their roots can be traced to 1889. Since then, investors have used bonds as an effective means of earning income and enabling them to run trade activities. United States is one country, which has benefited from the use of bonds.
Options
Stock options exist within the financial market. Options grants one an opportunity of use stocks as elements for trade without being active in the process of buying stocks (Lund, & Roxburgh, 2012). The value of options is based on time of expiration, cash dividends, intrinsic value, interest rates, and volatility. Options have being modernized since 1973. Since then, business people and other investors regard options as the modern or current financial innovation. This is because options have evolved and investors have found credible benefits from using them in running of their business activities. This has resulted in attainment of considerable benefits to them.
Securities Risk Return
Stock
Stocks carry more risks when compared to other security types. On the other side, stocks are more profitable than the other securities. The loss or earnings from stocks are determined by company’s stock price rise or fall.
Options
Options have a risk, which is attributed to their ability of value changing with elapse of time. These risks are complicated and at the same complex to comprehend and predict. On the other hand, returns from options are never linear (Lund, & Roxburgh, 2012). As such, their variability is non-linear with options value based on underlying factors. Examples of option risks are pin risk and counterparty risk.
Bond
When compared to stocks, bonds are less risky since their market is less vulnerable, investors obtain an income, which is based on fixed interest rates from most bonds, and bonds are characterized of the ability of the issuer to ensure that the security is returned at its face value. In terms of returns, bonds have lower and stable returns. Yield-to-maturity affects the current price and coupon rate of bonds. However, investors in corporate bonds earn higher returns in comparison to investors in government bonds.
Strategy for Maximizing Return on Securities
Stock
The most effective means of maximizing returns from stocks is portfolio asset allocation (Small et al., 2012). This involves basing the investment on investors’ objectives, time frame and risk tolerance on the portfolio design. This is essential since each asset has a monetary value, which influences risks.
Options
Improvement on returns of options is possible through the adoption of the various option strategies. These strategies focus on analysis of a risk profile, which affects movements within a particular security. Examples of such strategies include covered call, iron condor, straddle, and strangle among others.
Bond
Maximizing returns on bonds is reliant on investors’ goals and tax statues, as well as time frame. On the same note, there is a need for focusing on diversification. This adds towards attainment of protection from all possible losses, which may be experienced in a market sector. As such, returns on investment is improved significantly through management of interest rate risks.
Effect of Federal Reserve and Monetary Policy
Monetary policy influences the price of assets in the financial market. These assets include the stocks. In addition to assets, Federal Reserve monetary policy influences interest rates for equities and stocks. This indicates that financial markets have to operate at stock prices, which are determined by the Federal Reserve. This has the impact of distracting investors when the prices are unfavorable and attracting investors when the prices are favorable.
Options
Federal Reserve and monetary policy influences the various open-market operations of the financial markets (Dittmar, & Yuan, 2008). This includes interest rates and level of reserve within the banks. Consequently, performance of options is influenced as the dynamics on reserve levels and interest rates are experienced in the financial markets. This may be either positive (favorable to investors) or negative (unfavorable to investors).
Federal Reserve influences the performance of financial conditions. This includes fund rates, which are charged by banks. This further affects the economic activity of a nation since it influences how loans are issued and how borrowers repay the loans. This more on interest rates, which are charged for such loans (Small et al., 2012). Consequently, the performance of bond security is affected as the changes on monetary policy and Federal Reserve influence the interest rates, which are levied by banks and financial markets. In addition, monetary policy influences inflation, which is a key determiner of the performance of the financial markets.
Stocks
Stocks are a good investment. This is because they depict ownership of shares in a company. This ownership attracts dividends and the rate of return is high with stock securities investment. However, higher risks are anticipated, but careful consideration of the shares one is buying will ensure that the risk is suppressed. This includes focusing on buying shares from the better performing companies only. The rationale used on this case is the rate of return on investment and earnings on dividends. This investment is good for 10 years. This is because within 12 months, shares may not earn adequate dividends and interest rates may not have increased.
Options
On the other hand, options are suitable for 12 months investment. This is because their rate of return at a longer duration cannot be predicted and trading options can take place easily within a short period. As such, options may be traded at any time when their prices attract higher prices than initial buying prices. This results in earning more revenues. Moreover, at longer periods, options risk is high than a short period. The rationale used in this security is the risk period for the investment process.
Bonds are good investment when they considered for10 years. This is because they attract interest rates. As such, investing in bonds for a longer period creates adequate room for earning more from the interest rates. The rationale used in this case is interest rates from the investment.
References
Babenko, I., Lemmon, M., & Tserlukevich, Y. (2011). Employee Stock Options and
Investment. Journal of Finance, 66(3), 981-1009.
Bao, J., Pan, J., & Wang, J. (2011). The Illiquidity of Corporate Bonds. Journal of Finance,
66(3), 911-946.
Benito, J. (2012). The role of market infrastructures in OTC derivatives markets. Journal of
Securities Operations & Custody, 4(4), 346-357.
Dittmar, R. F., & Yuan, K. (2008). Do Sovereign Bonds Benefit Corporate Bonds in
Emerging Markets? Review of Financial Studies, 21(5), 1983-2014.
Lund, S., & Roxburgh, C. (2012). How the role of equities may shrink. Mckinsey Quarterly,
(2), 16-19.
Small, K., Wansley, J., & Hood, M. (2012). The impact of security concentration on adverse
selection costs and liquidity: an examination of exchange traded funds. Journal of Economics & Finance, 36(2), 261-281.
