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11 18 2015 | by Victor Xing | Capital Markets

What role does trading serve in the financial system?

In addition to being a necessary process to establish investment positions, active trading also reduces an asset’s liquidity risk premium, which factors into asset prices.

Currency market is a flow-driven market – exchange rates are shaped by countless market participants’ transactions based on expectations of economic condition (and the resulting central bank policy intervention / guidance), plus actual central bank operations.  Without trading, we will no longer have a currency market where price levels give valuable signals to investors.

Without trading flows, many of the market-based economic indicators such as the GS Financial Conditions Index (which factors in dollar valuation, bond yields, stock valuation, corporate credit spreads) will cease to function, denying investors (and policymakers) aglimpse into state of the financial market.

Trading and its utilities
Trading help determine asset prices and lead to the creation of asset-level based economic indicators

Additionally, indicators monitored by central bank policymakers, such as 5y5y forward inflation expectations (gold line below) are determined by market conditions.  This indicator is derived from actively traded Treasury Inflation-Protected Securities (TIPS).

Trading and market implied measures of inflation expectations
Market implied measures of inflation expectations

Finally, trading also enables inter-institutional lending (take reverse repo for example).  This helps ease credit conditions and give institutions another way to acquire funding for operations.

Next article11 18 2015 | by Victor Xing | Central Banks

How does Bank of England’s MPC differ from FED’s FOMC?