GLOBAL FINANCIAL MANAGEMENTQ. No 1
INTRODUCTION TO FINANCIAL MARKET
A market for the exchange of capital and credit, including the money markets and the capital markets.
Financial markets allows people to easily buy and sell financial securities such as stocks and bonds, commodities such as precious metals or agricultural goods, at low transaction costs and at prices that reflect the efficient-market hypothesis.
There are two types of financial markets
THE FINANCIAL MARKETS CAN BE DIVIDED INTO DIFFERENT SUBTYPES:
- Capital markets
- Commodity markets
- Money markets
- Derivatives markets
- Insurance markets
- Foreign exchange markets
CONTRIBUTIONS OF EXPERTS
CONTRIBUTION OF CHARLES H DOW
Charles H. Dow was the founder of the Dow-Jones financial news service, and the founder and 1st editor of the Wall Street Journal. Charles Dow is considered to be the founder of technical analysis because he created the 1st stock market index, the Dow Jones Industrial Average (DJIA).
William Peter Hamilton succeeded Charles Dow as the editor of the Wall Street Journal and expounded on the basic trends of the Dow Theory. However, it was Robert Rhea who refined the ideas into 3 basic trends that served as the foundation of the Dow Theory:
The Dow Theory posits that there are 3 concomitant trends in the market: the primary trend, the secondary trend, and the minor trends.
The primary trend is the overall direction of the market and is the longest lasting trend. Often, the trend lasts for years. The primary trend is also always an uptrend or a downtrend; it is never a sideways trend. A sideways trend is secondary and temporary.
Primary trend in a bull market
Primary trend in a bull market is characterized by 3 phases.
- In the 1st phase, buyers are buying because of the cheap prices that were the result of the ending bear market.
- The 2nd phase begins when the economy starts to prosper and as it does, companies benefit and start reporting increased earnings. This, in turn, entices more stock buying, raising the market higher.
- As the market rises ever higher, even people who have never traded before start to take notice. Speculation constitutes the 3rd phase.
starts as markets start declining.
- In the 1st phase of a bear market, people start to get anxious
- In the 2nd phase of the bear market, selling is increased.
- In the 3rd phase of the market, the market has declined so much that people sell out of despair, or they are forced to liquidate their leveraged holdings, causing a further decline in price which makes a person to feel of Credit Crisis of 2008 and 2009.
- Secondary Trend
Secondary trend, which is a price movement in the opposite direction of the primary trend and over a shorter period of time. Because of its unpredictability and shorter time frame, Dow believed it was risky to try to profit from the secondary trend.
The minor trends of the market are the daily and weekly fluctuations that result from the imbalance of supply and demand over short periods of time. Since the instantaneous supply-demand equilibrium is impossible to predict, Dow theorists considered minor trend plays as being too risky.
CHARLES DOW'S ANOTHER CONCEPT
Charles Dow introduced another concept central to technical analysis. Dow had created another index of railroads, which eventually become the Dow Jones Transportation Average. Railroads transported the bulk of materials in his day; hence, the state of the economy could be gauged by the state of the railroad industry. If the railroad industry was doing well, then business in general was doing well. Increased transportation meant not only increased business for railroads, but also for most other businesses; otherwise, there would be fewer transported goods. This comports with modern economicsgeneral economics affects all businesses, and, therefore, the financial markets.
So, if both indexes reversed trend, then this was a good confirmation that the primary trend was reversing and that the reversal was not just a secondary or minor trend.Charles Dow believed that the best way to make money in the markets was to ride the primary trend. Secondary and minor trends were considered too unpredictable. Too much money would be lost because of transaction costs and errors in judgment.
CONTRIBUTION OF JOSEPH A. SCHUMPETER
Joseph A. Schumpeter is one of the key economists of the twentieth century. Schumpeter's economics is viewed in the context of its relation to purer Austrian theories of the free market, Keynesian macroeconomics, the early neoclassicism of Marshall and Walras, and a persuasive argument made for its centrality to the discipline as a whole.
Schumpeter's contributions are summarized in the following seven factors.Joseph Schumpeter's contributions
Growth: Joseph Schumpeter argued that new inventions stimulate expansion, and eventually over-expansion. Sooner or later the markets will correct the mistakes that occurred during the expansions. These expansive periods are "hot markets", incubators for financial crises.
Complexity: This may be related to growth. But the macro economy evolves with more complexity that makes it hard for depositors and investors to know what is going on. Complexity is reflected in factors such as the expanding size and scope of the economy, technological change, and growing demographic diversity.
Inflexibility: Inflexibility refers to the absence of sufficient safety buffers or cushion against shocks. A systems engineer would call this "tight linkage". Parts of a system are linked. Such linkage is "tight" where there are few firewalls or safety buffers. In financial systems, inflexibility could refer to the insufficiency of reserves of cash to meet the withdrawal demands of depositors or of capital to absorb loan losses.
Cognitive biases: Daniel Kahneman, have documented cognitive biases in markets, such as over-optimism, over-pessimism, deal frenzy, failure to ignore sunk costs, and so on.
Adverse leadership: Leaders do things advertently or inadvertently in the advance of crises that elevate riskthey may say or do things to promote speculation, increase the uncertainty of investors, and/or amplify cognitive biases.
Economic shock: The sixth driver of crises is some kind of real economic shock that spooks depositors and investors. Each crisis has a trigger of some sort. Trouble breaks out and spreads rapidlythe trouble could be a natural disaster.
Collective action: Seventh, the depth and duration of every crisis is affected by the quality of leadership in organizing collective action. People can behave in ways that promote individual welfare, but worsen societal welfare. The prime example would be the rush to withdraw funds from a bank during a panicsuch behaviour, while individually sound, may produce a self-fulfilling prophecy of bank failure.
CONTRIBUTIONS OF NIKOLAI DMYITRIYEVICH KONDRATYEV
What is a Kondratieff wave?/Wave Theory
It is the central concept in a controversial but intermittently fashionable theory of economic history, which holds that major capitalist economies tend to grow, boom, bust and grow again in long waves or 'supercycles' lasting around 50-60 years. In each long wave, according to the theory, capitalist economies pass naturally through distinct and measurable stages of growth, plateau, contraction and renewal, which closely relate to periods of intense technological innovation.
Nikolai Kondratieff (also spelt 'Kondratiev'). Kondratieff was a Russian economist born in 1892 and active in the 1920s who 'discovered' that capitalism reinvigorates itself after a crisis. As part of his work for Stalin's Agricultural Academy and Business Research Institute, Kondratieff made an in-depth study of the emerging capitalist economies from 1789 to 1926, focusing on prices, interest rates, and output data. His work was published as Long Waves in Economic Life in 1926. But unfortunately for the young economist, who had previously impressed Lenin with his talent, this new work for Stalin appeared to show that capitalism (while subject to periodic slumps) never destroys itself completely.
Badly. The Soviet leader - firmly wedded to the view that capitalism brings forth its own gravediggers and is thus doomed to a miserable death - was notably unamused by Kondratieff's findings. The former high-flyer was exiled to the Siberian Gulag, where he went mad and (it is believed) was executed in 1938. But Kondratieff's work, published in German, still attracted international attention. Austrian economist Joseph Schumpeter, who is most famously associated with the idea of capitalism's 'creative destruction' and the role of technological innovation in driving economic history, took up the Russian's ideas and championed them in the 1930s - coining the expression 'Kondratieff wave'.The four phases of a Kondratieff wave
In the model Kondratieff wave, the economy moves through four distinct phases within each long cycle, known as spring, summer, autumn and winter Spring, which lasts about 25 years, sees mostly beneficial inflation and growth - a long upwave ending in severe recession as the economy overheats and boils over (summer - lasting around five years). Eventually, the economy recovers, beginning a period of selective expansion lasting up to a decade, known as the secondary plateau, or autumn. Last, the exhausted economy enters winter - a collapse of roughly three years, which is followed by a 15-year deflationary retrenchment.Do all economists agree that such cycles exist?
No - far from it. The idea of long-wave cycles in economic history has been widely criticised as an overly ambitious and dogmatic ideology that reinterprets reality to fit a theoretical straitjacket, rather than the other way round (much like Marxist philosophy of history). Even in the 19th century, many economists were sceptical about the idea that the economy developed in predictable cycles, preferring to think of recessions as 'crises' interrupting the flow of things. Most modern orthodox economists still regard long-wave theory with scepticism, with many seeing it as no more than crankery - the economic equivalent of Nostradamus's prophecies.
As with many grand theories in the social sciences, the more zealous supporters of Kondratieff's theory have tended to puff it up into an overly ambitious predictive 'science'. However, that doesn't mean it should be dismissed outright. It may have a solid basis in historic fact, and its advocates believe that it can provide helpful insights to investors. Although views differ on exactly when waves start and finish, there is broad agreement there have been three Kondratieff waves. The first ran from about 1787 to 1842, driven by the textile, iron and other steam-powered industries of the Industrial Revolution, including a depression from about 1814-1827. The second ran from c.1843 to 1897, sparked by the advent of the railways, and including a depression from 1870-1885. The third wave ran from 1898 and lasted until about 1950, driven by the electricity and car industries - and including the slump of the 1930s, which Kondratieff predicted.Question No2: Efficient Market hypothesis
Market efficiency is referring to the degree to which the aggregate decisions of allthe market's participants accurately reflect thevalue ofpublic companies and their common shares at any moment in time. This requires determining a company's intrinsic value and constantly updating thosevaluations as new information becomes known.The faster and more accurate the market is able to price securities, the more efficient it is said to be.Efficient market hypothesis
This concept is called as EMH. An investment theory that states that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information is referred to efficient market hypothesis. According to the EMH, this means that stocks always trade at their fair value on stock exchanges, and thus it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Thus, the crux of the EMH is that it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investmentsHISTORY
It is only in 1960 EMH emerged as a prominent theory when Paul Samuelson made an effort to see this in relation to random walk hypothesis. Later experts like Paul Cootner, Eugene Fama refined and extended the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong and strong. Studies by Firth (1976, 1979, and 1980) found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient. However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors. David Dreman has criticized and stated that stocks response to dividend cuts or increases over three years found that after an announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-year period, while stocks outperformed 24.8% for the three years afterward after a dividend increase announcement.
Many believe that as per EMH security's price is a correct representation of the value of that business, as calculated by what the business's future returns will actually be. However, EMH makes no such statement. Rather, it says that a stock's price represents an aggregation of the probabilities of all future outcomes for the company, based on the best information available at the time. Whether that information turns out to have been correct is not something required by EMH. Put another way, EMH does not require a stock's price to reflect a company's future performance, just the best possible estimate or forecast of future performance that can be made with publicly available information. That estimate may still be grossly wrong without violating EMH.DISPUTE
Investors and researchers have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of biases such as overconfidence, overreaction, representative bias, information bias, an inability to use configural rather than linear reasoning, and various other predictable human errors in reasoning and information processing. These errors in reasoning lead most investors to avoid high-value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.
Empirical evidence has been mixed, but has generally not supported strong forms of the efficient markets hypothesis. According to Dreman, in a 1995 paper, low P/E stocks have greater returns. In an earlier paper he also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta, whose research had been accepted by efficient market theorists as explaining the anomaly in neat accordance with modern portfolio theory. The main result of one such study is that losers have much higher average returns than winners over the following period of the same number of years. Another study at a later stage showed that beta cannot account for this difference in average returns. This tendency of returns to reverse over long horizons (i.e., losers become winners) is yet another contradiction of EMH. Losers would have to have much higher betas than winners in order to justify the return difference. The study showed that the beta difference required to save the EMH is just not there.
The recent global financial crisis has led to renewed scrutiny and criticism of the hypothesis. Market strategist Jeremy Grantham has stated flatly that EMH is responsible for the current financial crisis, claiming that belief in the hypothesis caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking. At the International Organization of Securities Commissions annual conference, held in June 2009, the hypothesis took center stage. Martin Wolf, the chief economics commentator for the Financial Times, dismissed the hypothesis as being a useful way to examine how markets function in reality. Paul McCulley, managing director of PIMCO, was less extreme in his criticism, saying that the hypothesis had not failed, but was "seriously flawed" in its neglect of human natureQ.3 The Current Global Financial & Economic Crisis
The financial crisis developed out of the housing bubble. A financial bubble itself is nothing special. It occurs every so often. There are no policies that can prevent it. It happens with any market. Lesser the regulations the more severe the consequences. The main reason for THIS bubble in particular, the sub prime mortgage bubble, was very low interest rates by the FED. In order to get the Economy going again after the dot-com bubble and 9/11 interest rates were lowered immensely. This made cheap money available encouraging many to buy a house, perhaps also because they believed that a house was, compared to stocks, a safe investment. Due to a lack of regulations something called securitization came into existence - Banks could now sell on mortgages in large bundles.
Now imagine you're a bank; you can issue a mortgage - and sell it (with all risks) on. Where is the point in checking whether the debtor can afford it? Just sell it to him. So loads of mortgages were issued to people who couldn't afford it. Often the debtors were not even thoroughly informed about the mortgage they obtained in order to sell more mortgages. These mortgages payments rates of many so called ARM (Adjustable Rate Mortgages) were set to increase - without the debtor knowing. Now here is what happened. People could not afford the mortgages anymore. Those who had bought the mortgage bundles form the banks realized that, the bundles they had bought for millions of dollars were worth nothing. They had to write them off. Needed new money - pulled it from the stock market and every one lost there. Banks could not sell on the mortgages anymore and themselves had bought bundles. So they lost there. As a consequence they stopped lending money - so many people had to stop buying. More losses on the SE and so on - a chain reaction.
Some other reasons:
We borrow more than we can responsibly pay back.
We produce less than we consume.
It's not profitable to hire people to manufacture things
Our government imposes excessive taxes and regulations on businesses.
All nations that went the socialist route and to the extent they did suffer financial crisis.
Leverage is one of the root causes of the current financial crisisConsequences
Initially the companies affected by the crisis were those directly related to home construction and mortgage lending such as Northern Rock and Countrywide Financial, and financial institutions which had engaged in securitization of mortgages such as Bear Stearns. But as the crisis accelerated in late summer 2008, following placing of Fannie Mae and Freddie Mac into conservatorship, the crisis began to affect both the general availability of credit and larger financial institutions not directly connected with mortgage lending, but which had exposure due to holding of mortgage-backed securities or insurance of them.
The two remaining investment banks, Morgan Stanley and Goldman Sachs, with the approval of the Federal Reserve, converted to bank holding companies, a status subject to more regulation, but with readier access to capital. On September 26, Washington Mutual, the largest savings and loan in the United States, filed for voluntary bankruptcy.Response to the current crisis
The massive mobilisation of US taxpayer money to curb the financial crisis with Paulson's bailout and Washington's eagerness to better regulate financial markets gave a vastly bigger role to the State in a country where laissez-faire capitalism was sacrosanct. Before the outbreak of the current financial crisis, continental European countries called in international fora, such as G7 meetings, for tougher oversight of financial speculation, and especially hedge funds.
The European Commission published its latest interim economic forecasts on 10 September 2008. The basic message was that fundamentals in the euro area and EU economy as a whole were sound, but tensions in financial and asset markets, ongoing moderation of growth in the world economy, the elevated levels of commodity prices and a widening housing shock were taking a toll: growth in the euro area and the EU was expected to slow down sharply and inflation was set to remain higher than usual for some time. Fewer and more expensive loans would tend to result in decreased business investment and consumer spending. Already, the reduction and shift in demand versus supply has resulted in a significant decline in new home construction in many European countries..
The equity capital of investment firms and credit institutions must be adequate to safeguard market stability, guarantee an identical level of protection against bankruptcy to investors throughout the European Union and to ensure fair competition between banks and investment societies on the securities market.
Finally, the leaders of G20, representing more than 80% of the world economic product agreed, Saturday November 15, on the broad outlines of a plan against the drift of the international financial system. It is interesting to reproduce exactly the communiqu concerning their commitments to implementing policies consistent with the following common principles for reform.Crisis Reforms
- Strengthening Transparency and Accountability:
- Enhancing Sound Regulation
- Promoting Integrity in Financial Markets:
- Reinforcing International Cooperation:
- Reforming International Financial Institutions:
Three banks - Lehman Brothers, Merrill Lynch and HBOS - and the world's biggest insurer, AIG, had been brought to their knees in three days. Two more pillars of Wall Street, Morgan Stanley and Goldman Sachs, were teetering on edge of collapse, threatening markets that were already numb with shock. The shock-waves were reverberating around the globe, particularly in Asia, while Russian markets remained closed for a third day running.
Ten of thousands of jobs were threatened while millions of savers and borrowers struggled to grasp how the vague notion of the "credit crunch" had morphed into a real personal threat.
The most important long-term legacy of the present global financial crisis may not be economic, but geopolitical. Professors Menzie Chinn of the University of Wisconsin and Jeffrey Frankel of Harvard ran a simulation showing that the euro would replace the dollar as the world's largest reserve currency within the next 10 or 15 years
Apart from making travel and trade easier, a single currency makes very good economic and political sense.
The single currency is a logical complement to the single market which it sustains and makes more efficient. The second reason for the decline of the dollar as reserve currency is the emergence of a genuine alternative to the dollar, the euro.
After the US financial crisis, they are likely to shift their reserves to euro much sooner than it was formerly expected. The Euro zone economy is almost as large as that of the US and may surpass it as it continues to enlarge. The dollar serves as a reference currency for almost 60% of world trade, whereas American exports represent around 12% of world exports.
The biggest trader and home to the world's second currency, the EU also spends more than 7 billion a year in assistance projects in all continents.
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