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Financial Market Essay

An investor is usually expected to buy stocks that are projected to appreciate as well as stocks with high expected earnings. The performance of Polaroid stock over recent past has oscillated from a low of $ 49 in November 2007 to high of $ 57 in December to the current price of $ 53. This indicates that this stock is volatile and is not a good buy when one’s wealth has declined. Moreover the stock has not significantly appreciated over the past year. b) Expect to appreciate in value

A stock’s price is expected to appreciate if the company releases better earnings forecasts or news of an event like an acquisition/merger that is expected to add value to the company. The earnings are expected to rise to $ 3. 85 up from last years $ 3. 41 according to Market Watch analyst predictions. The strong reported earnings is also expected to boost the price therefore buying this stock now is advisable also due to projected improved 2008 earnings (Market Watch) c) Bond market becomes more liquid The bond market liquidity and stock market liquidity are linked and movement in either liquidity affect both.

The stock and bond market are also affected by

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volatility in either market. Increased bond market liquidity leads to a reduction in the liquidity of the market and vice versa. (Guyenko, Ruslan 2005) Liquidity is the ability of investor to acquire and dispose large quantities of an asset quickly and at a minimal transaction cost. Therefore increased bond liquidity leads to the stock market being less liquid and thus not advisable to buy the stock. d) Appreciation of gold The general down turn of the economy and the depreciation of dollar has been the main factor for gold appreciation in the recent past.

Economic downturn leads to companies making less profit and therefore the stocks decline on the fact that the companies are earning less. As long as the gold keeps on appreciating then it would be advisable to invest in gold and not stocks e) Bond market prices become volatile As seen earlier, the bond market and the stock market are linked in two ways i. e. the liquidity of the market and the volatility of the markets. The volatility can have an impact on the liquidity of the markets by changing the stock risks undertaken by the market making agents. An increase in volatility of the bond market reduces the liquidity of the stock market.

A reduction in the liquidity consequently makes the stock market less attractive for investments. (Guyenko, Ruslan 2005) 2 bond effects on interest rates The money supply in an economy can be increased or decreased by the use of expansionary or concretionary policies. Expansionary policies. It can be achieved by using either open market operations, lowering rates while the decline in reserve requirement leads to lenders having more money to invest. These investments can be in bonds and therefore the prices will increase thereby reducing the interest rates.

(Moffat, Mike 2008) The increase in bond prices will make them unattractive therefore making the investors to sell the bonds and buy foreign bonds Contractionary policy The supply money in the economy can be reduced by selling bonds (open market operations), raising federal discount rate and raising reserve requirements. This works in opposite way of expansionary policies. From the above graph, it is clear that an increase in the supply of the bond leads to an increase in the price of the bond while at higher bond price, the demand for the bond is lower.

From the previous analysis, it is worthwhile to remember that the higher the price of the bond the lower the interest rate. Federal deficit on interest rates There has been no statistically proven relationship between the level of federal deficit/surplus and the current real interest rates. The research that has been done shows that the effect is minimal. Crowding out theory states that if the government increases its level of debt by borrowing then supply of funds available to other borrowers’ decline hence increasing real interest rates.

However, this theory can be avoided in an open market economy where money can flow in from foreign economies thereby offsetting the crowding effect. Research on this theory indicates that the effect of the deficit on real long-term interest is minimal. Rircadian equivalence theory states that individuals increase in bond investments due to increase in deficits are increase in their wealth because this increase will require new taxes in the future and thereby one should increase his savings to cater for future tax.

This theory established that the addition savings offset the extra debt issued thereby having no effect on real interest rates (Joint Economic Study- US Congress. December 2003) 5) Riskiness of bonds and interest rates. The effect of the bond price and the level of interest rates have an inverse relationship. This means that an increase in the price of the bond leads to a decrease in the rate of interest and vice versa. This is due to the fact that the new investors demand the effective rate of interest. (Financial Guide 2008).

6) Interest rates and inflation Inflation is the genera increase in commodity prices following in the decline of purchasing power of money. In an economy, the interest rate can be real or nominal. Nominal interest rates are that have not been adjusted for inflation while real rate are rates already adjusted for inflation. Real rate= nominal rate- inflation rate. The higher the inflation rate the higher the nominal rate and vice versa. The announcement by the president that the inflation will be reduced will result in to lower nominal rates.

7) Market interest rate on bond yields The Feds declaration that the interest rates will rise sharply next year will cause the newly issued bonds to increase their yields so that they remain competitive thereby rendering the current bonds in the market less attractive. This is because the investors will want to buy the new bonds offering higher yields rather than existing bonds with low yields. The longer the maturity of the bond the higher the yield demanded by the investors because inflation will rise and thus lower the price of the bond.

(Fidelity Investments 2008) 8) Interest rates and increase in stock prices. The changes in interest rates will affect the risk of any investment be it stocks or shares. An increase in the interest rate increases the risk of investments thereby reducing the value of the investments. Therefore the interest rates will decline if the investors believe that the stock prices will increase. A decline in the interest rates means that the cost of doing business is less. Thereby more returns to companies hence affecting the stock prices.

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