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Global Financial Market Essay

Title:

Discuss the reasons why bonds are held by variety of financial institutions such as pension fund, insurance companies and banks.

Summary:

Any country’s Bond market returns are determined by: global, sectarian, and cross-country factors and country-specific effects. Bilateral linkages between the world’s 5 largest economies and about 40 other markets to decompose the cross-country factor loadings into: direct trade flows, competition in third markets, bank lending, and foreign direct investment. Estimates suggest that both cross-country and sectored factors are important determinants of stock and bond returns, and that the U.S. factor has in recent times gained importance, while the Japanese and U.K. factors have lost importance.  Real and financial linkages became more important determinants of how shocks are transmitted from large economies to other markets that the Financial Institutes holding Bonds

Why Bonds Are Held By Variety Of Financial Institutions Such As Pension Fund, Insurance Companies And Banks.

Introduction:

In economics organisations that facilitate the trade of financial products such as stocks, bonds and warrants is called Financial market. Financial marke has the types  as Capital Market , Stock Market , Bond Market, Commodity markets, Money markets, Derivatives markets, Futures markets, Insurance markets and Foreign exchange markets. Factors that influence the financial market are as

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forces of supply and demand and allocation resources over the time through a price mechanism such as interest rate.

In the era of Globalization financial markets have inter linkages among countries. Movements in the world’s major markets often have such large effects on other financial markets. , These cross-market linkages have changed over time. The factor model by which a country’s market returns is determined by global, cross-country factors, sectarian, and country’s specific effects.

In global financial market Stock and Bond are determined by the both cross-country and sectarian factors. U.S. factor has recently gained significance when Japanese and U.K. factors have lost importance.

Reasons Why Bonds Are Held By A Variety Of Financial Institutions Such As Pension Funds, Insurance Companies, And Banks:

All of we know that over the long run nothing beats the stock market. This is the reason why anyone would invest in bonds? Though they pale in comparison, which would be equities in the long run. The bonds have several traits that stocks simply can’t match. To discuss why Bonds Are Held By Variety Of Financial Institutions Such As Pension Fund, Insurance Companies And Banks.

Contractual Savings Institutions:

The institutions those who do not accept deposits, but acquire their liabilities on a regular basis through contractual payments in return for obligations that are fairly predictable as much more so than the withdrawals of depositors. In relation to depository institutions, their assets are more long-term and less liquid.

The Life insurance companies receive premiums in return for protection of risk of death. Mortality rates are predictable so that the timing and size of payouts for these companies are also predictable enough. Life insurance companies also sell a variety of investment products as well as annuities and guaranteed investments contracts (GICs). Life insurance companies are the biggest buyer of corporate bonds, and invest heavily in mortgages as well. They hold very little stock or municipal bonds.

Fire and casualty insurance companies receive premiums in return for protection from the risk of property damage, loss, liability, and disability. Size and time of their payouts are less predictable, since natural disasters such as a major earthquake or bad hurricane season can greatly affect the amount of property damage that occurs in that year. Because of this, their assets are more liquid than life insurance companies. They hold municipal bonds, corporate bonds, stocks, and U.S. government bonds.

Pension funds

They are privately sponsored or government-sponsored, but in both case they provide retirement income in return for contributions from employees and employers during their working years. The Pension funds receive very favourable tax treatment at the federal level. The payouts are predictable thus assets are long term such as corporate bonds and stocks.

Investment intermediaries
The institutions are behind much of the explosion in indirect investment and the decline in traditional banking by allowing alternatives for individuals and firms for save or borrow funds.

Finance companies

Have taken much of the consumers and commercial loan is the business away from depository institutions. Issuing commercial paper they do play. They then utilize these funds to make business loans, construction loans, auto loans and other consumer loans. As for example all 3 major U.S. auto companies GM, Ford, and Chrysler have finance companies to help consumers finance for auto purchases. Other finance companies are specializing in credit cards.

Mutual funds sell shares to individuals and use those funds to purchase and manage a diversified portfolio of stocks or bonds. The value of the shares mostly fluctuates with the value of the underlying portfolio. Why don’t just buy stock directly? Reasoning that the mutual funds investors can diversify with small initial capital and receive professional management of their investments and save on transactions costs. From these advantages explain why the number of mutual funds has grown from less than 500 in 1980 to over 6000 today.  Mutual funds vary according to their investment objectives and the type of securities they hold in. Some funds focus on a particular sector, like technology or health care, while some focus on U.S. government bonds or municipal bonds.

Money market mutual funds have same features like both a mutual fund and a checking account. These funds sell shares, fixed at a price of $1, and use those shares to buy money market instruments. These funds then pay regular dividends in the form of additional shares. These funds also have restricted check writing privileges. They operate like an interest bearing checking account with a large minimum deposit. They have taken away funds from banks by competing for depositors.

C.  Regulation of the Financial System

The financial sector is one of the most heavily regulated areas of the economy. There are also various institutions responsible for regulating financial markets and institutions. The regulations we look at least one of 3 purposes: (1) reduce the asymmetry of information, (2) promote the stability of financial system, and (3) improve the Federal Reserve’s control of the money supply.

Reducing the Asymmetry of Information

Here we have already discussed the problems caused by asymmetric information. The way to minimize these problems is to require the disclosure of information deemed which is valuable to investors. The government has this in several ways including Companies, which sell securities to the public, must report information about their sales, assets, earnings and even their largest stockholders to the Securities and Exchange Commission (SEC). The SEC also restricts insider trading such as the trades made by large stockholders privy to non-public information. All the financial intermediaries, especially depository institutions and must also make certain information available to the public and their balance sheets available to regulators.

Promoting Stability
Some of this worst economic conditions in the history of the United States were triggered by a financial panic where financial institutions and markets ceased to function. Thus it only makes sense for the government to ensure that financial institutions are sound and solvent. Most of them but not all of these regulations came about in response to the Great Depression and massive bank failures of the 1930s.

These regulations include to restricting the ownership of some financial intermediaries to those with spotless professional reputations and ample capital to start up the business. Restrictions on these types of assets that are financial intermediaries are allowed to own. The depository institutions are not allowed to hold common stock because these assets are subject to large fluctuations in their prices even making them too risky. They are also not to allow holding bonds with poor credit ratings. Insuring all deposits up to $100,000 in the event of the failure of a depository institution. Deposit insurance come out about after the 1930-33 bank failures that wiped out the savings of so many depositors. Past restrictions on the branching of banks across state lines to protect small banks from competition. Past restrictions on the interest rate banks could offer to depositors.

Control of the Money Supply
The depository institutions play a central role in determining the supply of money in the economy that is in turn affects inflation and economic growth. The Federal Reserve through the banking system exercises a lot of control over the money supply. Two regulations help with this:

Banks are required to keep a certain percentage of their deposits in accounts with the Fed or as cash. Reserve requirements give the Fed better control of the amount of money in circulation.

Deposit insurance also controls the money supply by preventing massive bank failures, which would cause huge fluctuations in the money supply.

Insurance Companies are the big buyer of Bonds. In the yearend 1998 the life insurance industry with $2.8 billion in assets, it was a major holder of corporate bonds. The insurance industry has  $1.1 trillion in corporate and foreign bonds in 1998 that is 39 percent of life insurance industry assets.

The Life insurance companies play an important role both in the corporate bond market and the financial system. They were the fourth largest category of financial intermediary that is accounting for nearly 12 percent of U.S. financial intermediary assets.

The life insurance companies have entered into many long-term financial contracts for insurance products & annuities with their customers. As a result they have relatively predictable long-term cash inflows by which they can match to any expected payouts. Those predictable long-term contractual flows allow life the insurance companies to invest a sizeable portion of their portfolio in correspondingly long-term financial assets like corporate bonds.

In connection to the life insurance industries the property and casualty insurance industries typically have shorter-term contractual arrangements and experiences potentially larger and less predictable losses caused natural disaster. So in 1998 the property and casualty insurance industries required more relatively short-term financial assets in their portfolio. The property and casualty insurance industries have held less than 18 percent of its assets in corporate and foreign bonds in 1998 which is less than half of the percent held by the life insurance industries.

Why bonds are held by variety of financial institutions such as pension fund, insurance companies and banks, let we take Capital Preservation in consideration. Unless other wise a company goes bankrupt, the bondholder can be almost completely certain that they would receive the amount they originally invested. Stocks are subordinate to bonds and bear the brunt of unfavourable developments. Thus any logical management should chose to invest in Bonds

Bonds pay interest at set intervals of time that can provide valuable income for retired couples, individuals, or those who need the cash flow. For example if someone owned $100,000 worth of bonds that paid 8% interest annually that would be $8,000 yearly. Fraction of that interest would be sent to the bondholder either monthly or quarterly. It provides an extra steady income source for any one and gives them money to live on or invest elsewhere.

There are also have large tax advantage for some people by Bond. When a government or municipality or state agencies issues various types of bonds to raise money to build bridges, roads, etc., the interest, which is earned, is tax exempted. This is really an especial advantageous for those whom are retired or want to minimize their total tax liability.

The Pension fund managers are desperate for longer-dated papers. The sharp downturns in the stock market in 2000 revealed that their assets had been overvalued and failed to match the liabilities that they owed  the pensioners. By purchasing longer-dated fixed income instruments with steady interest payments and a lump sum some way in the future and more closely mirrors pension liabilities than do stocks.

Traditionally pension funds had invested almost two-thirds in equities and one third in bonds. It indicates  a significant shift in this balance would have a hefty impact on the bond market as money previously devoted. In this year  The US Congress expected to legislate for companies to fund their pension plans more fully increasing demand for longer-dated debt. Reforms in Europe has already led to a such  surge in demand.

Global Aspect:

Gordon Brown who is  UK chancellor of the exchequer mentioned last week of March 2006 in a market conference in London that he would increase the supply of long-dated British government bonds . He also haid that, the Treasury was listening to recommendations in the market almost all of which were urging an increase in the issuance of long-dated bonds and it was in discussion over how better to match the soaring demand for long-dated paper with supply.

At the same time Even Alan Greenspan, the chairman of the Federal Reserve, declared himself low long-term bond yields that have stubbornly refused to rise as the Fed has repeatedly increased short-term interest rates when after a year in which US long bonds failed to budge despite relentless monetary tightening by the Fed, this conundrum is even more challenging.

US government bonds is larger and more efficient and more liquid than any other securities market and  the attention being paid internationally to today’s auction and its implications for the US economy. The recessions tend to lag an inversion by four to five quarters meaning that any inversion implies a recession next year. However some  economists believe the bond market can safely be ignored. They strongly argue that the yield curve can be explained by increasing demand for long-term investments in pension funds. It grow across the developed world or by a one-off secular shift in market psychology as the world’s central banks at last win investors’ confidence that they are capable to control inflation.

Globalisation has had a great impact on Asia’s real economy but a fewer effects on its weak financial sector. This has forced capital to be repelled from Asia into developed bond markets – effectively and  the US acts as a ‘bank’ for the de facto dollar zone.

The low interest rates in Bonds, are a global phenomenon. In Europe the low rates and demand for longer-dated paper led France to issue its first 50-year bond last year.  When UK began a programme of 50-year bonds both at fixed rates and linked to inflation. Appetite for the UK’s ultra-long paper is so strong that nominal 50-year gilts currently yield just 3.8 per cent and 50-year inflation-linked notes were offered last month with a yield of just 0.46 per cent more than inflation .

Intersting thing is that foreigners hold 55 per cent of US government debt and half of that is held by official institutions. Among them Asian central banks have made big purchases of Treasuries and swelling their reserves to record levels. This move has been driven by their policy of buying dollars to manage exchange rates as well as investing the proceeds in US Treasury bonds.

But China has signalled its desire to secure better returns from its reserves and to diversify its holdings. Stephen Jen who is  global head of currency research in Morgan Stanley passes this comments as “ strange behaviour of US bonds needs instead to be understood in the wider context of a dollar zone composed of Asian economies determined to keep their currencies linked to the dollar.”

It is enough difficult for the economists to analyze the finincial interplay of the early 21st century.   Bill Gross the world’s biggest bond manager said “It’s not that academic theory has been dislodged in recent years but it may be asked to take a seat next to the increasingly important variable of global financial flows.”

Conclution :  The difference among the results for bond returns and the subsequent stock returns is that excluding the sectarian factors does not have as large an impact on the cross-country factor loadings, particularly for the U.S. and Japan. This difference certainly reflects that fact that the sectarian factors are stock indices, and therefore more highly interrelated with stock returns than bond returns in the major economies.

Bibliography:

1). Krugman, Paul R.  International Economics: Theory and Policy London: Oxford U.P.(6th Edition),

2) Fabozzi, Frank J., Franco Modigliani, and Michael G. Ferri. 1994. Foundations of Financial Markets and Institutions, Englewood Cliffs, NJ: Prentice Hall Inc.

3) Rose, Peter S. 1994. Money and Capital Markets, Burr Ridge, Illinois: Irwin.

4) Saunders, Anthony. 1997. Financial Institutions Management. Boston: MA Irwin/McGraw-Hill.

5) Source of financial data: Flow of Funds Accounts of the United States, Federal Reserve Statistical Release Z.1, Fourth Quarter 1998.

6) UK signals increase in supply of long bonds By Chris Giles in London Published: March 1 2006

7) Hughes, Jennifer. Predictive Power Of Bonds,  Published: Financial Times. Feb 09, 2006.

 

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