The Role of Financial Markets in Creating Wealth
Financial markets play a crucial role in creating economic wealth in the United States of America. A well-functioning financial sector creates incentives for investment and forester trading and help in the creation of business linkages. In fact, financial markets can be used as an indicator of how an economy is fairing (Ritter & Silber, 2004). Financial market creates wealth by transforming savings into investments which translates to investment incomes. Financial market mobilizes savings for productive investments and facilitates capital inflows. This stimulates investment both in human and physical resources. It is also the role of financial market to channel Americans’ savings to more productive uses by analyzing and collecting information about investment opportunities in the economy (Ritter & Silber, 2004).
Through this information and data, people are able to make an informed decision which in return creates wealth for them. It is also argued that a well-functioning financial market can enhance efficiency in the corporate sector by closely monitoring management and exerting corporate controls. Private and public sectors operators make use of various financial market instruments to invest and raise short term funds (Ritter & Silber, 2004). In case there is a need, this can be liquidated to satisfy short-term needs. The central government also creates wealth through the financial market. It borrows money from the public so as to finance long-term projects through the issuance of bonds and treasury notes. The proceeds from the treasury notes or bonds are then used to build hospitals, provide public transport or construct roads. All these activities translate or entail national wealth creation for economic growth. Many investors in the USA also make a lot of money in the capital market which is a key component of financial market. They make this money by selling and buying financial securities (Ritter & Silber, 2004). When investors buy debt instruments such as bonds, they receive an interest, and in the process they create wealth.
Overview of Three Securities
Money Market Securities
Money market securities are short-term financial instruments or assets that allow participants trade on securities exchanges (Coyle, 2001). They consist of negotiable certificates of deposits, United States treasury bills, municipal bonds or note and bankers acceptances. These securities are essential in an organization’s short term liquidity management strategy (Coyle, 2001). Money market securities were developed in the early 1970s. They were developed as an option for investors to buy a pool of securities that provide higher returns than interest-bearing bank accounts. Money market securities have grown and currently hold approximately $2.9 trillion assets (Coyle, 2001).
Capital Market Securities
They are also known as stocks and bonds, and they are traded in different markets. Capital market securities are used by corporations, government and companies (Liaw, 2004). As a component of capital market security, bonds enjoy a vast international market estimated at $45 trillion. Another important component of capital market securities is the stocks. They are preferred by many investors because they provide a possibility of huge returns. Companies use stock market to trade their stocks, derivatives and securities (Liaw, 2004). At times, the government also uses stock market to generate money. Capital market securities date back to the 1990s and have continued to provide the life blood of capitalism in the United States of America.
These are government debts that are issued by the Department of the Treasury through the Bureau of the Public Debt, and it is a form of a debt security (Roll, 2010). They have a maturity time frame of less than a year. Treasury bills are issued with a minimum of $1,000 (Roll, 2010). They are initially sold through an auction where maximum purchase amount is $5 million. In the USA, treasury bills were first used during the First World War. The government used then as an emergency source of funds to finance the war and pay for debts. Treasury bills have been issued depending on the needs of the government (Roll, 2010).
Current Risk Return Relationship
Money Market Securities
Money market securities are popular cash management instruments in the United States of America. In most cases, money market securities offer a higher rate of return unlike the traditional bank accounts. The current situation in money markets has been enhanced by the US money market funds. Unlike other mutual funds, there are attempts to ensure a stable $ 1 per share. This makes money markets have high credit quality, and this means that there is a reduced risk of their issuers being unable to repay their debts. Currently, money market securities offer investors a conservative access to a low risk investment, and they can be used during volatile market performances. Money markets also allow an investor to be exempted from paying taxes. However, investing in money market securities is risky because fund managers try to keep the share price constant at $1 per share. There is no guarantee that the share price will remain stable. In case the share price goes down, an investor will lose some or their entire principal.
Capital Market Securities
The greatest risk involved in capital market securities is fluctuations in security prices. Risks involved in capital markets cannot be diversified, and return and risk cannot be separated. In capital markets, risks increases proportionally with returns (Liaw, 2004). If there is a chance of a high return, there is also a high risk. Investing in capital markets is associated with market, regulatory, industry, and business risks. Stock market falls and rises depending on many factors, and this increases the risk involved in capital markets (Mandron, 2011).
Treasury bills are issued by the United States government, and they mature in less than one year. The ones that are sold at a discount from face value then bought and later sold are the safest to invest in over short-term savings. The current risk return relationship involved in treasury bill is regulated through securities laws (Mandron, 2011). This makes treasury bills an investment opportunity with the least risks. However, the downside of treasury bills is that investors will not get a high return because treasuries are safe; they will only get the returns after the maturity date (Mandron, 2011).
Strategies for Maximizing Return for the Current Risk Return Relationship
Money Market Securities
Maximizing returns involved in money market instruments will require an understanding of all the risks involved and will form the foundation. This will enable investors manage any risk in money market. Understanding the various risk involved in money market will include understanding the market risk, interest rate risk, inflation risk, and credit risk. Awareness of all of these risks will help an investor make informed decision based on current issues (Mandron, 2011).
Capital Market Securities
Risks involved in capital market securities are hard to minimize. Therefore, adapting and making informed decisions based on research will reduce risks involved in these markets. Paying close attention to capital markets, an investor can increase returns (Liaw, 2004). Since the risks increases as returns increase, it is advisable to accept losses. However, an effective strategy to minimize risks is to maximize profits and minimize losses.
Treasury bills have been known to have reduced risks compared to other securities; however, an investor cannot get his or her money before the maturation date. Although treasury bills are considered to be less risky, they deny the chance to use the return often. To minimize this impediment, an investor should consider diversifying investments (Mandron, 2011).
How the Federal Reserve and Its Monetary Policy Affect Securities
The Federal Reserve is responsible for the monetary policy, and this affects availability and cost of credit and money in the economy. Through activities such as open market operations, the Federal Reserve and its monetary policy contributes to better economic performance and financial stability in the country. Preventing financial disruption ensures that capital and money markets securities are not affected. This prevents risks that may arise from disrupted economic environment. The Federal Reserve and its monetary policy affect securities through a number of ways. It sets the discount rate that banks pay on short-term loans. However, the use of open market operations is the most essential tool that affects money markets, capital markets and treasury bills. Open market operations manipulate the economy’s monetary systems. The main aim of the Federal Reserve and its monetary policies in trading the securities is to affect the federal funds.
Experts in the financial markets predict the US GDP growth to be 2.5% in the next 10 years. This will mean that investing in money markets securities for the period of 12 months and 5 years will be a good idea. This will also be true with capital markets securities and treasury bills. All of these securities are dependent on the growth of the economy (Mandron, 2011). Financial experts claim that the USA cannot witness another financial recession like the one in 2008. Therefore, investing in all of these three securities will be good because the economy will remain stabilized despite the mounting debt issues facing the world. However, if the predictions given by the financial experts are accurate, money market funds and cash equivalents will yield less than 1% for several more years (Mandron, 2011). This will generate little returns on all the securities because the Federal Reserve will continue their low rate policy. Investing in treasury bills will return lower in the next ten years as inflation levels are expected to rise. Hence, in the next 10 years, investing in stocks will be a good idea because equity returns beforehand valuation changes is a role of earning growth (Mandron, 2011).