Essay 2 Course Textbook Graham R J Smart S B Megginson W L

Essay 2course Textbook Graham R J Smart S B Megginson W L

Identify the theories discussed in the unit’s readings and unit lesson. Discuss how these theories applied to the global financial collapse of 2008 and the scenario in the unit lesson. Keep the following in mind while writing your paper: · What are the problems associated with the design of financial innovations? · How can financial innovations be decomposed to predict potential outcomes? · Defend the strategy used to construct financial innovations. · Your essay should be at least two pages in length, double-spaced. · Use a minimum of three scholarly articles, in addition to the textbook or other scholarly sources to support your work. · In-text citations and reference page must be properly formatted using APA style guidelines.

Paper For Above instruction

The global financial collapse of 2008 stands as one of the most significant economic events in recent history, highlighting numerous deficiencies in financial theories and innovations. Central to understanding this crisis are the various financial theories that explain market behavior, risk management, and the role of financial innovations. These theories include Efficient Market Hypothesis (EMH), Agency Theory, and the Principles of Risk Management, each providing a lens through which the crisis can be analyzed.

The Efficient Market Hypothesis, which posits that financial markets are informationally efficient and that prices fully reflect all available information, was fundamentally challenged during the 2008 collapse. Many financial innovations, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), were believed to distribute risk efficiently. However, the widespread mispricing of risk, coupled with asymmetric information and irrational exuberance, led to a significant market failure. Investors and institutions relied heavily on flawed models and assumptions, believing markets to be perfectly efficient, which contributed to the systemic risk manifesting during the crisis.

Agency Theory underscores conflicts of interest between managers, shareholders, and other stakeholders within financial institutions. The misaligned incentives and lack of proper oversight encouraged risky behaviors, such as the issuance of subprime mortgages and the securitization of these high-risk loans. The theories reveal that the design of financial innovations often failed to incorporate adequate controls or considerations for systemic risk, which was exploited by some actors seeking short-term gains.

Financial innovations, when decomposed analytically, can be understood through components such as the underlying asset, risk transfer mechanisms, and market infrastructure. Predicting potential outcomes involves assessing the transparency of these components, understanding the risk exposure of involved parties, and evaluating how innovations might alter market behaviors. For example, innovations like structured financial products can obscure the true risk levels and create complex interdependencies across financial institutions, increasing systemic vulnerability.

The strategy used to construct financial innovations must be defended on the basis of their potential to improve market efficiency, liquidity, and risk distribution. Properly designed innovations can enable firms to diversify risk, facilitate capital allocation, and respond to market demands more effectively. Yet, the 2008 crisis demonstrated that inadequate regulatory oversight and poor design strategies, such as overly complex structures and misaligned incentives, can magnify systemic risk. A prudent strategy involves transparent, well-regulated innovations grounded in sound financial theory and thorough risk assessment.

In conclusion, the theories discussed—Efficient Market Hypothesis, Agency Theory, and risk management principles—offer vital insights into the causes of the 2008 financial collapse and the scenario discussed in the unit lesson. The design and deployment of financial innovations should be approached with caution, emphasizing transparency and systemic risk considerations. Decomposing innovations into their fundamental components enables better prediction of potential negative outcomes, and a strategic approach grounded in sound theory can help mitigate future financial crises.

References

• Graham, R. J., Smart, S. B., & Megginson, W. L. (2010). Corporate finance: Linking theory to what companies do (3rd ed.). Mason, OH: South-Western.
• Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25(2), 383-417.
• Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2), 323-329.
• Stulz, R. M. (2003). Risk management and derivatives. Journal of Economic Perspectives, 17(3), 133-152.
• Minsky, H. P. (1977). The financial instability hypothesis: An interpretation of Keynes and contemporary American macroeconomics. Antioch Review, 35(4), 379-387.
• Acharya, V. V., & Richardson, M. (2009). Restoring financial stability: How to repair a failed system. Wiley Finance.
• Gorton, G. (2010). Slapped in the face by the invisible hand: Banking and the panic of 2007. Journal of Financial Economics, 97(3), 24-40.
• Brunnermeier, M. K. (2009). Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic Perspectives, 23(1), 77-100.
• He, Zhiguo, & Xiong, Wei. (2012). Rollover risk and credit risk. Journal of Finance, 67(2), 391–431.
• Tarullo, D. K. (2014). Financial regulation after the crisis. Bank of International Settlements Quarterly Review, 65, 19-26.