Introduction
The following essay examines the role of bond markets and relative derivative contracts in the financial crisis beginning in 2007.The essay specifically gives an overview of the main bond and bond-type contracts, the main derivative and Credit Default Swaps.
Also, the essay examines the criteria for effective regulation, the objectives of regulation and the various potential measures. The financial crisis that nearly brought down the financial sector has exposed various cracks in the entire system. The global financial crisis was mainly generated by the collapse of the housing market in the first months of 2006.
The collapse of the housing market saw an increase in the rate of sub prime defaulters. Scholars have identified that both the housing bubble and the credit boom were the main cause of the financial crisis. The events that followed contributed to collapse of many firms among them Lehman brothers among others and this has in turn called for an effective regulation so as to ensure that the financial crisis does not happen again in the near future.
An overview of the main bond and bond-type contracts
Bonds form the key ingredients of debt-capital markets of the world. The prices of bond are directly affected by the political and economic events and the bond yield level. The bond yield level is the key economic indicator for a given nation. Bonds refer to financial instruments that characterize the amount of cash payable during a given period of time. Bonds are debt instruments and the cash flows that they represent forms the loan redemption and the interest on loan.
Unlike bank loans, bonds can be traded in a derivative market i.e. a secondary market. Bonds are usually identified by such aspects as the type of the issuer and the term to maturity. The issuer is the main characteristic of a bond. The issuers of a bond are mainly comprised of the self-governing governments together with their agencies, the local government, the corporations and the supernatural bodies e.g. the IMF and the World Bank.
A corporate bond market is characterized with various issuers and each issuer has differing abilities so as to meet their contractual requirements to investors. The term to maturity refers to the time period in years that the issuer is required to repay the contractual obligation. The issuer is also required to pay the periodic interest amount during this period.
The bonds’ maturity refers to the actual date that the debt will expire and it is during this date when the issuer redeems the bond. The maturity of a bond plays an important role of indicating the period of time that the bondholder is expected to receive his or her coupon payments. Bonds are usually valued using the present value techniques. Bonds which are source of long-term funding for businesses can be valued by summing up the present value of all the expected cash flows to a given bond.
The cash flows include the following; coupon payments, interests, face value and sometimes reinvested coupons. The most stable cash flows include the coupon payments and the face value. For this reason, the value of bond Vo=Present Value of coupons + Present Value of face value. When a bond is purchased and held to maturity, it earns a unique return called Yield to Maturity (Archarya and Richardson 1-56).
An overview of the main derivative
Starting the period between 1970’s and 1990’s,the world turned to be riskier as far as financial investment was concerned .This caused swings in financial instruments interest rates to widen and also there were increased volatility with regards to bond markets. The organizational leaders thus sought for solutions of minimizing the risks that surrounded the financial institutions .Financial innovation was considered as an ideal way of reducing the financial risks and as a result, financial derivatives came into being.
Derivatives are financial instruments that are used so as to hedge risks associated with buying, selling and holding assets that have fluctuating prices. Derivatives usually entitle a buyer or a seller to acquire or trade an underlying asset at a future period of time at a given price. Derivatives are traded either directly between the financial institutions or over the future exchanges. Instruments that are exchanged directly have a firm standardization, higher liquidity and posses a fixed price (Butle 129).
Derivative market makes use of such financial instruments as options, futures and forward contracts. Options entail the financial instruments that provide the investors with the right of buying or selling an asset at a fixed price on or at an earlier specified date. Options are of two types i.e. call option and put option. A call option refers to financial instruments that provide the owner with the right to buy an underlying asset at a given price for a particular time.
A call option is thus a financial contract between the buyer on one hand and the seller on the other hand. The seller is usually free to sell the underlying goods if the buyer demands so and as a result, the buyer gains premium. The profitability of a call option is based on the ability of the underlying good to move up. Put option entails a financial instrument that provides the investors with the right of selling the underlying asset at a given price for a particular time.
For both the call and put option, the payment by the buyer ceases to exist once the option trades. Both the put and call options are commonly used in hedging against possible movements of stock prices. The mutual funds, pension funds and insurance companies are some of the financial institutions that uses call and put options for hedging (Hull 78-145).
Forward contracts entail the financial derivative instrument in which there is an agreement between the buyer and the seller to transact at a future period. However, there is no money that changes during the time of signing the deal. Forward contracts are mostly traded by telephone or on Over the Counter market.
When the contract is being written, a given price known as the delivery price is fixed which explains the price at which an asset is sold or purchased. Companies that can estimate the receivables or payables of foreign currency over the next few years use two hedging techniques i.e. parallel loan and long-term forward contract. A parallel loan also referred to as a back to back loan refers to a currency exchange between the seller and the buyer with a guarantee to re-exchange the currencies at a given exchange rate at a particular date.
The accountants usually interprets parallel loan as a loan implying that it is recorded on the financial statements. Long-term forward contract came into use a few years ago. Today; they are popularly used by international banks. Long forwards are usually attractive to those companies that aim at protecting their cash flows from the fluctuations of exchange rates.
An overview of Credit Default Swaps
Credit Default Swaps commonly referred to as CDS have been in existence since 1998.CDS refers a contractual agreement between the buyer and the seller of financial instrument whereby, the buyer is protected incase of credit default by paying a protection fee. The investor is not required to pay any fee unless there is a credit default. The agreement is usually termed as a credit default option if the protection fee is paid up in advance.
The agreement is termed as a swap if the protection fee is paid in due course. CDS can be delivered either physically or in cash. If a credit event does not occur, the protection buyer is required to pay a quarterly swap premium for the entire period of trade. In case there is a credit event, the protection buyer is required to pay the accrued premium and also, a termination value is settled on for the exchange. The process of determining the termination value is based on the terms for exchange.
Criteria for effective regulation
Regulation refers to the legal system, the institutions that enforce it and also the dynamism of the legal system to respond to changing demands of participants in the financial market. In the context of financial sector, the legal environment, the efficiency of financial sector, the legal environment, the efficiency with which the judicial system makes and forces laws are quite critical to the functional efficiency of financial markets.
The adequacy of commercial law is also important in not only guaranteeing protection of investors but also to make it possible for intermediaries to perform their functions which includes mobilizing savings, allocating resources, hedging of risks e.t.c.
For financial market to function effectively there must be a set of rules that are enforceable. The stage of financial sector development in addition to market structure and regulatory framework can also determine how players in financial sector functions.
By financial sector development, the focus is on four things i.e. (i) the evolution of the entire financial system which means seeing how financial markets, financial institutions and financial instruments have evolved over time.(ii)The mode of operations that characterize the financial system e.g. computerized as opposed to manual e.t.c.(iii) The structural form of the financial sector and (iv) The types of financial claim that characterize the financial markets i.e. either direct or indirect. Countries whose financial sector is well developed is said to be financially deep.
Indicators of financial depth includes the following i.e. volume of bank credit by the private sector as a proportion of the country’s GDP, degree of access to banking services i.e. banking density as measured by the number of depositors or the number of people served by any given financial intermediary for defined period of time usually one year, the degree of information collection and dissemination by financial institutions as measured by presence of facilities such as credit bureaus, the extent of risk hedging i.e. the availability of financial products that can be used by participants in the financial markets to hedge against exposure of financial loss(Herendeen 229).
The objectives of regulation
The following are the main objectives of financial regulation; Regulation is aimed at protecting investors. Given the recent financial crisis, the regulators should have adequate information in order to supervise the activities of the financial market participants that play an important role in financial system. The investors whether private or professionally requires to have an appropriate, air and efficient bond market which is not associated with any form of abuse or misconduct.
Emerging derivatives markets are aiming at developing a regulatory model that is founded on principles of self regulation, disclosure and arms-length transactions. This approach is crucial as it will ensure that there is timely and full disclosure of all the material facts that the investors require in order to make key decisions.
This approach will also help in protecting against anticompetitive capital market behavior by the market participants and also protect the investors from dishonest practices and operators. A good regulation represents a win-win scenario for both the investors and bond issuers (Vea 3).
Regulation also ensures that the market functions effectively and fairly. Regulation plays an important role of guaranteeing a speedy management of transactions and a fairly scale. Within the capital market, there are clearing houses that not only serve to provide advisory services but also to reduce the instances of default. Settlement systems significantly determine the efficiency of financial market institutions because they directly determine the speed with which these institutions handle the pressure placed on them by both the demanders and the issuers.
The other objective of financial market regulation is to reduce systematic risks. Regulation ensures that there is a variety of financial assets that not only permit exchange but also facilitate provision of liquidity facilities to the financial market participants. This offers them a chance to take positions that reduce their exposure to risk i.e. a variety of financial instruments guarantee the effectiveness of financial markets institutions with regards to hedging, diversifying and managing investment risks (Siddaiah 399).
Regulations are also aimed at supporting the macroeconomic objectives i.e. regulators are concerned with improving the efficiency financial system. A financial system is deemed to be efficient if it is capable of allocating savings to the most efficient uses. there than allocating the financial resources, an efficient financial system ensures that there is information arbitrage efficiency i.e. it determines as to whether or not the market prices reveals all the information that is available.
An efficient financial system has the role of ensuring that there is efficiency in fundamental valuation i.e. it determines whether the valuations of a firm are shown in stock prices. Also, an efficient financial system ensures that there is efficiency with regards to full insurance i.e. it determines as to whether the economic agents are capable of insuring against future contingencies (Helleiner and Commonwealth Secretariat 21).
Various potential regulatory measures
There are two main forms of regulations of financial markets i.e. economic regulation and prudential regulation. There main reason for economic regulations is to control the operations of the market forces. Economic regulations prohibit some of the business activities.
Some of the examples of economic regulation include restriction with regards to new entrants in the market, price controls among others. With regards to bond markets, there are various forms of economic regulations which include the following; foreign access, issuance restrictions, interest rate and price controls, hedging instruments, taxation, custody, clearing and settlement.
Foreign access relates to the rules that limit foreigners from participating in the bond market of a given country. Foreign investors generally include the corporate, banks, speculative money accounts among others. Foreign participation by investors is usually limited in most of the emerging derivatives markets as opposed to local entities.
China is one of the emerging derivatives market where the market is closed for foreign investors. Most counties demand foreign investors to apply for a foreign participation license before they can allow them to enter their local bond markets. This is however a lengthy process and a large number of foreign investors are thus locked out from participating in the local derivatives market (Mathieson and International Monetary Fund 86).
The other form of economic regulation of derivatives market is the bond issuance restrictions. Bond issuance restrictions refer to the procedural controls that add a considerable amount of cost and time when preparing a debt issue. Russia, Ukraine and China are some of the countries that have further restrictions with regards to the issuance of local bond.
These additional restrictions play an important role of encouraging local credit market development. Some of the measures that are applied with regards to bond issuance restrictions includes ;requirement for credit rating requirement for registration with the national authorities ,procedural certification requirements among others(Mathieson et.al. 88).
Price and interest rates controls are the other tools of economic regulation with regards to bond markets. The central bank facilitates this by controlling the borrowing cost. The main aim of this form of economic regulation is to control the costs associated with borrowing and also to allow the financial institutions to have adequate margins between their borrowing and lending rate.
Another aspect that is widely used by many countries as far as interest rates control is concerned is moral suasion. Moral suasion refers to the use of persuasions in order to affect a certain behavior. Moral suasion plays an important role of keeping the interest rates relatively low (Liedekerke et.al. 61)
Another form of economic regulation that is used to regulate the bond market is hedging. The main objective of hedging is to protect an instrument against changes in cash flows or changes in economic value that are as a result of the changes in market prices. Some of the derivatives that are used for hedging against interests rates include Swap, options, and futures e.t.c.
Taxation is the other form of economic regulation of the bond markets. Bond markets are very sensitive as far as tax incentives are concerned. The tax policy of a country has a major impact on financial decisions that are made by firms and investors. Usually, taxation of the financial instruments affects the financial market development.
There are various reasons as to why the government imposes taxation on capital gains. Many countries around the world have developed a policy of not taxing the foreign investors. Therefore, the investors tend to avoid those countries that tax them. Taxation acts as a regulation measure in that, there is much paperwork that is associated with taxation and also the refunds don’t take immediately and this in turn locks out investors from the bond market (Choudhry 429).
The other form of economic regulation of bond market is custody, clearing and settlement. In many countries, bond issuers are required to follow custody, clearing and settlement procedures which are lengthy. Such procedures usually discourage foreign investors from participating in bond markets Shinozaki, Shighehiro and Organization for Economic Co-operation and Development(Shinozaki and Organization for Economic Co-operation and Development 24).
Apart form economic regulation, bond markets can be regulated using prudential regulation. After the 200 financial crises, many governments around the world have considered the use of prudential regulation in an effort to reduce risks in the financial sector. Prudential regulation plays a crucial role of maintaining soundness of bond markets.
Prudential regulation and enforcement are basically aimed at protecting investors by ensuring that activities are carried out in a fair and transparent manner. Prudence regulatory measures are thus the indirect measures that enhance well functioning of the bond markets. They also ensure that the bond markets are stable, efficient and flexible.
Prudential regulations that are well designed help to reduce financial risks. The regulations also increase investor confidence. The main prudential regulatory measures includes the following; minimum capital requirements ,reserve requirements, public disclosure of information, operating guidelines with regards to consolidation and merges, early warning systems, sanctions enforcement in case of violation of rules among others (World Bank 102).
Conclusion
In developing and enforcing regulations in the financial market institutions, responsibility should not be left to a government agent or a private sector exclusively. Instead; there should be a joint partnership between the government and the market institutions.
It has been shown widely in the literature that where regulation has been pursued single handedly by the government, there have been serious consequences which include, but not limited to the following two; inefficient institutions that are characterized by a strong desire to chase collateral other than monitoring and appraising investors and emergence of cartels within financial markets to counter the regulation (Broadman 76).
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