Economics Assignment on Money, Banking & Financial System

Question

Task: Read the book “Money, Banking and the Financial System” and prepare an economics assignment answering the below questions:

1. How can a “bad” company be a “good” stock?
2. Why did some investors consistently invest in stocks from 2000-10, even though they received a negative real return over that period?
3. Why might a bank buy a credit default swap (CDS)? What counterparty risk does the bank buyer incur from holding the CDS?
4. Why do low inflation countries tend to have appreciating currencies and high inflation countries have depreciating currencies?
5. Does a high yen mean that it takes more or less yen to exchange (purchase) one US dollar? Does the high yen hurt or help Japanese exporters? How could a high yen help elderly people in Japan?

Answer

Answer 1:
It is stated herein economics assignment that the financial position of a company may not always be the determining factor for its stock value. Sometimes, a company that loses a lot of money can be a good stock. The stock price of a company, which has gone through financial draining, may not always exhibit a drop (Alexander, 2017). There are reports of few companies who stated that although they lost a significant amount of their revenues, their stock prices rose. This might seem as an impossible condition. However, it is possible because the actual amount of money that the company lost was lower than the speculation of the market. Thus, in such cases, the market expectations do not match the real stock prices. This depicts a rise rather than a fall in the stock price of the company running at a loss. On the contrary, there are few good companies, which have shown a growing trend in terms of their revenues but have experienced a low stock price. As per Kurniawan (2017), a company that is doing well financially may not always be a great investment. When a company is good and its financial position in the market is strong, everyone wants to invest in that company. This is factored into the price of the stock. However, this does not necessarily mean that one should buy the stocks of companies that are not doing well and sell the stocks of the companies that are doing good. The stock market experts suggest that there are several factors one needs to consider before choosing a company for investment (Jamaluddin, 2018). Choosing a company that is ‘good’ may not be a sufficient and deciding factor for a ‘good’ investment. This has often been noticed that for good to great companies, it gets difficult to meet the expectations of the people who invest in them. This leads to a situation where the people lose their money for investing in profitable companies. Therefore, a bad company can also prove to be a good stock.

Answer 2:
According to Al-hajj, Al-Mulali and Solarin (2018), between 2000 and 2010, the world faced a severe recession. In the early 2000s, the recession hit many developed nations of the world. The United States as well as the European Union was affected by this recession. During the recession most of the economic activities were adversely affected. The decade which ended in 2010, had been the worst phase for the economy of the United States. The job growth during the recession had been zero. The economic output had reached its lowest after the crisis of 1930.

As per Al-Nasseri and Ali, (2018), during this recession, the stock prices dropped. The stock market became extremely volatile after the economic recession of 2000. The stock prices swung wildly with least predictability. However, even when the stocks yielded negative real return, the investors chose to invest in the stocks from 2000-2010.

One major reason was hedging. Through currency hedging the yield of bonds can be transformed from negative to positive. The investors in speculation of earning positive yields in the long run kept investing in negative return generating stocks. However, leaving the currency hedging aside, if the investors who have invested in negative yielding hold back their money until maturity, they are likely to face a loss. Some investors invest in negative yielding stocks with the expectation that if the returns drop further, they could reap the benefit from capital gains. After realising the gains, the stocks could be sold out and the gain could be crystallised (Chen and Chiang, 2020).

Answer 3:
According to D’errico et al (2018), credit default swap or CDS is a form of credit derivative, through which one can get the protection against various risks and defaults. By purchasing a credit default swap, the buyer has to make some payments at periodic intervals to the seller of the CDS. These payments need to be made until the maturity date of the credit is reached. As per the CDS agreement, the seller makes a commitment that in any situation where there arises a default from the side of the debt issue;the buyer will be paid all the interest and premiums by the seller. These would mean all the payments that were made periodically by the buyer until the maturity date.

Sometimes, the banks purchase CDS. Hedging is a common activity of the banks. Through hedging the banks try to minimise the risks arising out of negative price movements. For hedging against the risks of a default by a loanee, the banks often enter CDS contracts (Li, Abraham and Cai, 2017). This is a measure to buy protection. In case, the borrower or loanee default, the proceeds out of the CDS contract will eventually balance off the debt that has been defaulted. When the bank does not have a CDS contract, they sell off the loan to some financial institution or some other bank.

However, holding a CDS can have negative impacts. The relationship between the borrower and the bank is damaged due to the CDS contract. The borrower clearly understands that the bank has no faith or trust in the borrower and doubts their intention or ability to pay back the loan. As per Drago, Carnevale and Gallo (2019), the purchase of a CDS facilitates the risk management by the bank, while it maintains the loan as its portfolio’s part. In CDS, the credit protections’ seller and buyer both take counterparty risk. The risk that the buyer takes is that the seller might default. Similarly, the seller takes the risk that the buyer might be a defaulter. If the bank and the CDS issuer both defaults, a case of double default arises, by reference entity the protection against the default is lost by the buyer. ?

Answer 4:
As per Tran (2018), inflation refers to the rise in the price level of the commodities and services being produced in an economy. Inflation further has a negative impact on the currency value. With increase in the inflation rate, the currency value starts deteriorating. Appreciation refers to the rise in the value of any asset or currency during a period of time. On the other hand, depreciation is simply the opposite. This implies that depreciation signifies a fall in the value of the assets or currency (Bahmani?Oskooee, Halicioglu and Neumann, 2018). Inflation as suggested by economists shares an inverse relationship with currency value.

As opined by Turner et al (2019), the inflation rates grow, the currency value starts depreciating. When a country faces high faces, its currency tends to grow weaker as compared to other nations’ currencies. Therefore, it purchases less of the other higher value currencies. On the other hand, the countries that face low inflation, have higher currency value, which means that they can buy more of the currencies of other countries. The most affected people during this appreciation and depreciation of currencies are the investors and international business entities. Along with monetary policies, high inflation is one of the root causes of depreciating currency. The main mechanism behind this depreciating currency is that due to high inflation the input costs become higher for the exports (Cerra, 2019). Therefore, the exports of the country tend to become less competitive in the international market. This eventually creates a trade deficit. Due to this deficit, the currency of the country depreciates. Therefore, a high inflation country has depreciating currency while a low inflation country has an appreciating currency.

Answer 5:
A higher yen implies that there would be fewer yen required for exchange against one U.S dollar. The higher value of yen implies that the currency value of yen has increased against the other currency values (U.S dollar). When the value of Japanese yen increases, the commodities and services that are produced in Japan become more expensive in the international market (Fauceglia, 2020). Thus, appreciation results in exports becoming more expensive. Therefore, the countries that import the commodities or services from Japan would now have to spend more of their currency on purchasing Japanese commodities or services. This might negatively impact the international trade as commodities and services that Japan would export and offer in the global market would become more expensive with its currency appreciation. Now to maintain good business, if the exporters of Japan try to keep their prices constant, they would earn lesser profits. The profit margins or returns in yen would be lower for the exporters as they do not allow the impact of currency appreciation to be reflected in their export prices (Oduyemi and Owoeye, 2020). A higher value of yen would help in making the imports cheaper for Japan. Japan would have to spend lesser yen on purchasing one dollar or goods from international market (Rozo and Maldonado, 2018). Thus, for the people of Japan this would be a beneficial outcome. Japan has a growing elderly population, including pensioners. These people benefit from currency appreciation. Their pension amounts are fixed but when the value of yen improves, they gain more from their pensions. In fact, these people who have retired and have no regular flow of income, other than pension, find it difficultpurchasing expensive commodities from the international market when the value of domestic currency, yen is low. As the yen appreciates, imported commodities become cheaper to afford.

References
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Al-hajj, E., Al-Mulali, U. and Solarin, S.A., 2018. Oil price shocks and stock returns nexus for Malaysia: Fresh evidence from nonlinear ARDL test. Energy Reports, 4, pp.624-637.

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Bahmani?Oskooee, M., Halicioglu, F. and Neumann, R., 2018. Domestic investment responses to changes in the real exchange rate: A symmetries of appreciation versus depreciation. International Journal of Finance & Economics, 23(4), pp.362-375.

Cerra, V., 2019. How can a strong currency or drop in oil prices raise inflation and the black-market premium?. Economic Modelling, 76, pp.1-13. Chen, X. and Chiang, T.C., 2020. Empirical investigation of changes in policy uncertainty on stock returns—evidence from China’s market. Research in International Business and Finance, 53, p.101183.

D’errico, M., Battiston, S., Peltonen, T. and Scheicher, M., 2018. How does risk flow in the credit default swap market?. Journal of Financial Stability, 35, pp.53-74.

Drago, D., Carnevale, C. and Gallo, R., 2019. Do corporate social responsibility ratings affect credit default swap spreads?. Corporate Social Responsibility and Environmental Management, 26(3), pp.644-652.

Fauceglia, D., 2020. Exchange rate fluctuations and quality composition of exports: Evidence from Swiss product?level data. The World Economy, 43(6), pp.1592-1618.

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