Role of Financial Markets Research Paper

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Financial Markets and Institutions

Role of Financial Markets

Financial markets play a significant role in creating wealth in the United States. At the heart of this role is that financial markets facilitate the economically efficient allocation of capital. The holders of capital need places to invest that capital in a way that earns them a return, but they do not always have the best ideas with respect to how to use that capital, nor the skills to do so. There are others who have ideas and skills, but lack the capital to maximize those. Financial markets allow for those with capital to allocate their money to those who need it, and those who need it to acquire it. With opportunities to invest, and opportunities for ideas to come to life, the economy benefits significant. The more efficiently the financial markets can allocate capital, the more they will help the economy to grow. Thus, economic wealth is created by putting surplus capital to use in the most efficient manner possible (Duisenberg, 2001).

Financial markets can advantages from either scale or specialization. The United States is the largest financial market in the world, for example, and this facilitates a highly-efficient flow of capital through the financial system. In other countries, the financial markets have specializations that allow them to be highly-efficient with respect to capital flows -- Hong Kong has become a specialist in Asian companies, Toronto in mining companies, for example, and both tap into different capital pools than New York does. But the fewer barriers that there are between those who have capital to invest and those who need investment, the more efficient the capital markets will be. That efficiency will create greater opportunities for economic growth.

Three Securities

The first security is the stock of Tesla Motors (TSLA). The current price of one share of Tesla is $208.26. This company has only been around for a few years, and its stock price has been quite volatile in that time. In the past year, the low was $141.05 and the high $285.65(MSN Moneycentral, 2016). The second company is Google, which is currently priced at $698.88 per share. The company has historically enjoyed strong upward performance for its stock, because it has grown rapidly for most of its history. The 52-week range for Google is $515.18 to $789.87(MSN Moneycentral, 2016), again demonstrating a fair degree of volatility in its price. The third security is perhaps more secure, and that will be Boeing. The current price for Boeing is $127.88, and the 52-week range is $102.10 to $150.59(MSN Moneycentral, 2016), showing a little bit less volatility than the other two companies, which are much younger. Boeing instead has two established income streams, one of the duopoly in commercial aviation, the other from the Department of Defense, where it is one of the major contractors.

Risk-Return Relationship

The risk of a stock is the volatility, and that is expressed by the beta. The beta for the market is 1.0, and the greater the deviation from this, the greater the deviation the company has from the market risk. Higher than 1.0 reflects a security that is more volatile than the market, and lower reflects a security that is less volatile, as a general rule (McClure, 2016). The betas for these three securities are as follows (MSN Moneycentral, 2016):

Stock

Tesla (TSLA)

1.33

Alphabet (GOOG)

1.03

Boeing (BA)

1.09

The betas for these companies are interesting.. Tesla, predictably, is the riskiest of these companies, and for a couple of reasons. It is the youngest, and has the least-certain cash flows. The company is growing rapidly, but has never turned a profit. Tesla is also a stock that speculators and day traders love, so it tends to be much more volatile than the market as a whole.. Google is only slightly more volatile than the general market. The beta can be explained in a couple of ways. First, there is a massive amount of information about the company, because it is such a high profile company, that the stock trades in line with its performance. The other factor is that Google generally outperforms the market over its history, and that should be reflected in a beta that reflects higher risk, because the company delivers higher reward.

Boeing is actually riskier than the market overall, which is somewhat surprising because it is a Dow component. Boeing's commercial aviation income streams are fairly predictable, because it has a multi-year backlog of orders, only one major competitor and a product development cycle that can take upwards of a decade -- there is nothing that can surprise the market about that side of Boeing's business.

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The defense side is about the same -- Boeing will always win a few big contracts as per DoD policy to keep its major suppliers well-funded, but ultimately any surprises with respect to contracts will result in a shock to Boeing's stock. At present, higher volatility probably just reflects superior returns for Boeing, above what most companies are doing right now.

Equity Markets

The role of equity markets for investors is to earn superior returns. Theoretically, those returns are going to be neutral when adjusted for risk, as per the efficient market hypothesis (Investopedia, 2016). For investors, holding money in savings accounts usually results in a negative real return. Bonds are a safe investment, but ultimately they pay only a slight nominal return unless they are risky corporate bonds. Equity is one of the major sources of return, other than real estate, for most personal investors. The equity component of a portfolio is typically structured for long-run investing with the idea that this is where a lot of the growth in a portfolio will come from. Typically, if somebody needs money in the short run, equity is inappropriate because stock markets are volatile, but stock markets have generally moved upward for a couple hundred years, so long-run investing has meant that stock returns have been positive in real terms, and that is what investors use them for.

Interest rates are the price of money in an economy, and they are governed by the forces of supply and demand, more or less. However, the central bank tends to hold substantial influence over the supply and demand of money in the economy. The central bank bases its decisions about the price of money, and the money supply (monetary policy) based on a number of key economic variables. In the U.S., this is typically the unemployment rate, the inflation rate and the GDP growth rate (Federal Reserve, 2016). The Fed usually telegraphs interest rate changes, which makes them easy to predict, but they can also be predicted by the state of the different, important macroeconomic variables on which the Fed makes its interest rate decisions. Usually, monetary policy is highly influential with respect to interest rates because the Fed actually has that much power and influence over both interest rates and the money supply, and it exerts this influence to bring about specific macroeconomic outcomes.

Maximizing the Risk-Return Relationship

For the most part, I believe that EMH holds, but with Tesla in particular there tends to be some irrational investing. This does create opportunity to perhaps outperform the market. Adherence to EMH suggests that attempting to beat the market is akin to gambling, but that being said there are opportunities to leverage irrational investing, in particular by using options to give greater leverage to take advantage of market sentiment. For Google and Boeing, I believe EMH holds too much to make it worthwhile to attempt to beat the market. But with Tesla, the stock fluctuates on the basis of who controls the company's narrative -- the casual investors enamored with the company's potential or the old school investors who are bearish about its current sales and projections. That is one stock where emotional investing seems common, and I would use options to take advantage of that if I felt I had a good read on where market sentiment was heading.

Influence of Monetary Policy

Monetary policy does not actually mean much for these three companies. Tesla might be affected the most because it is highly leveraged but the company's ability to pay its debt is more based on sentiment about its future than on the rate it pays. Still, an increase in rates would make it harder for Tesla to tap the debt markets, if it actually wanted to do so any more. Google has a lot of cash, an increase in the rate wouldn't affect it much. Boeing also has a lot of debt, just like Tesla, over 90% debt/assets ratio. But the stability of its business means that an increase in rates will not hurt Boeing as much as it might hurt Tesla. Still, both of those two companies would be affected negatively by an increase in interest rates because of the high amount of leverage that they have.

Good Investment?

Whether any of these companies is a good investment depends on your view of the….....

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