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This paper is a literature review of the monetary and fiscal policies that are implemented, and how such policies can affect the prices of stock on London stock market. The research will provide information to policy makers in terms of London stock markets and other stock markets around the world on how to come up with policies that will benefit all stock markets in case of difficult financial times such as a recession or even global financial crisis. The research will provide information that can breach the gap between the interrelatedness of monetary and fiscal policies in stock markets, which are connected as a result of globalization, and the London stock market that is susceptible to a number of factors, which can affect the performance of stock prices. Studies on the money-stock market relationship centres on the question of whether money is a leading indicator of stock prices. The study by Charpe, Flaschel and Hartmann (2011, p. 2933) supported the views that past increases in money led to the increase in the equity returns.

While using the US data, Geske and Roll (1993, p. 23) studied the relationship between money and stock market and established a lead/ lag and cross spectrum in the stock returns and dynamics in the supply of money. These were consistent with the Efficient Market model and the Monetary Portfolio models. In both of them, anticipation of changes in monetary returns was in tandem with returns in the stock. Managing risks using different financial options like puts, calls and spread on stock prices presents a number of challenges that are inherent on the London stock market. However, a careful approach to stock prices can produce results that are applicable to real stock markets. The policy makers on the London Stock Market need to have strong analytical as well as mathematical abilities in order to come up with policies that combine the unique needs of the stock market and global financial markets. Meanwhile, a combination of specific skills and knowledge related to such spheres as finance, economics, accounting and mathematics contributes towards the preparation of an individual aspiring to build a career in the particularly related fields, such as investment and risk management, as well as banking. The paper also presents the calculations of payoffs based on the long position and short position in stock with regard to different strategies.

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The prevailing monetary and fiscal policies on the London stock market require investors to adhere to certain rules that ensure fairness in trading activities on the market. For instance, Chen, Roll and Ross (1999, p. 156) note that in order for a buyer to realize a riskless profit for a long period there is a need to assess the value of the premium available for hedging, using different economic models. In this case, a strategy of analyzing the premium value, using available option will give the buyer a clear picture of the situation that can result in maximizing the premium value. In a long position, while using the call option, the buyer will not be obligated to buy the agreed shares should the stock prices escalate beyond a reasonable level. The stock prices, thus, are hedged against the strike. A viable strategy in using the long position as the underlying reason for purchasing the stock will be the assumptions that the call option purchase will result in the rising prices in the future. In case the underlying instrument moves up, the most profitable choice is the call option as it allows the price of this underlying instrument to become closer to the strike price. The strategy is to hedge prices against the widespread decline in a long period. Such strategy can result in immense profits, even though it is limited in terms of height of the underlying instruments, which identifies the rise in the price of stocks. In case the call option leads to prices beyond the strike price, the buyer will then make a profit.

There is a number of advantages that are associated with selecting a long call for long position (Portes 2012, p. 158). One of the reasons is that the long call will does not concern a one to one ration with the prices of the stock even as the pricing models give a reasonable estimate about how each change is going to affect the call’s value. However, this factor depends on other external factors like the need for other derivatives to remain constant.   It is more significant, when using this strategy is the realization of the forecast, which states that the premium can be considerable in relation to the percentage gains relative. As the call buyer plans a reselling of the option at a profit, he or she tend to search for appropriate options in order to close the position out at an unspecified period; thus, any increase in the volatility of the stock prices will not be worrisome to the buyer.  However, this strategy will not be helpful to some investors, who have re-evaluation dates as well as price targets in a long position strategy. In whichever way that the buyer might chose to go, timing is of the essence as there is a need to realize the hedged values, before options expire (Portes 2012, p. 160).  On the spot anticipation of the increase in the stock price will not serve any meaning in case it is beyond the expiration period. In view of this strategy, if there is a lack in materialization of the anticipated gains, along with the approaching of the expiration period, there will be a need to revise the implemented strategy and possibly use long spreads instead of long calls. A more calculated approach is to anticipate the process of rallying of the stock before the expiration. In case this process is initiated, the strategy, eventually, can end up generating a satisfying profit.

The London stock market is affected by several macroeconomic variables because of the special position that the UK economy holds in the financial world. This is because it is one of the largest stock markets in the world, and, therefore, a small change in a macroeconomic variable is likely to compound the effect on the stock prices in the UK and the final economic outlook of the country for a given period. Pastor and Veronesi (2012, p. 1217)  observed that dynamics of variables, such as the money supply, exchange rate and retail prices within the UK economy, can result in substantial changes in the stock prices because of their tendency to affect the flow of cash and interest rates. Similarly, prices of commodity and oil have been found to have considerable influence on the stock market, even if the changes are marginal and for a short period. The analysis of De Grauwe (2012, p. 22) showed that this is because these changes are reflected in the final industrial costs of commodities and revenues that companies listed on the LSE possess. Consequently, dividends due to investors are also affected by marginal changes in any of the macroeconomic variables (Bilson, Brailsford & Hooper 2001, p. 415).

The study by De Grauwe (2012, p. 45) revealed that the consumer confidence indicator also forms a strong macroeconomic variable that has the ability to influence the final economic outlook of any economic environment to a considerable extent. The consumer confidence indicator is the level of psychological expectations that investors are anticipating in terms of the performance of their investment, wealth creation and the overall economic outlook of the country. If these indicators are low, the London stock market is affected, since investors will reduce the level of the investment. However, this variable is easily controlled through the government bonds and analysis of other variables that have a greater impact on the final stock prices. As such, the analysis of the consumer confidence indicator can be done as a contributing factor to the overall performance of the stock market in the UK, rather than focusing on it as a major factor.

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However, as noted by Charpe, Flaschel and Hartmann (2011, p. 2133), the exchange rate, which is pegged on the Dollar/Sterling, is the main macroeconomic variable that continues affecting the performance of the London stock market as has been evidenced in the last five years. The stock prices have reacted strongly to reports of a change in the rate of exchange, causing the UK economy to report the lowest stock prices in its history. Retail sales, industrial production and rate of unemployment together form the real economic activity that also affects the performance of the stock market in the UK. Afonso and Sousa (2011, p. 1880) indicated that this is initiated by the influence that real economic activities have on the cash flow.

In this sense, the money supply in the UK economy also influences the stock prices to a considerable degree. A small change in the real economic activity is likely to produce effects that are felt for a longer period in the stock market. This is unlike that of the other macroeconomic variables, such as inflation, which are easier to offset using market policies and investor readjustments. However, with an unfavourable change in the real economic activity, it becomes challenging to control the effects caused on the stock market, since investors, who might be holding the money from the circulation, become wary of the conditions on the market and may further withdraw or withhold their investment in the economy. With the recent global financial crisis, the economy of the UK was affected like any other leading economy in the world. However, the end of the financial crisis has seen the economy registering a slow growth with indices less than 1%. The International Monetary Fund (IMF) has downsized the monetary forecast for the economy of the UK and an index much less as compared to any developed country in the world. The group predicts that the economy of the UK will grow at the rate of 0.2% as opposed to the earlier projection of 0.8 % of the GDP in 2012. This comes amid the warning of a weakening economy due to the falling stock prices in the London Stock Exchange and general unfavourable conditions in the marketing business around the world (Charpe, Flaschel & Hartmann 2011, p. 2133)  

However, policy makers expect that the GDP growth for the UK will increase with the anticipation that the current recession is not going to remain for a long period. With the projection’s increase of about 1.4% in the near future, it is expected that several sectors of the economy, such as manufacturing, financial services, including banking and travel, will contribute to the reduction of the interest rates and increase the money supply to enable the supply of labour prices within the marketing sectors (Alcidi & Gros 2011, p. 675). This will undoubtedly have the effect of lowering the stock prices in the London Stock Exchange that contributes immensely to the growth of the economy. Reports by the Bank of England indicate that the economy of the UK has reduced by 0.3% in the last quarter of 2011. The first quarter of 2012 was also marked with a similar percentage in the reduction, and this has, therefore, led the country into an economic recession. The overall economic outlook of the UK is affected by difficulties caused by key trading partners, together with the financial disruption in the Eurozone. In this context, there are strong evidences that the UK economy will continue to be stained, especially with the reduction in government spending. The UK economy continues to underperform with regards to estimations of the Bank of England in almost all key sectors. For instance, the estimated reduction of 3% in the construction sector escalated to 4.8% reduction during this period. There was also an unchanged growth in some of the sectors, such as service industries, which only recorded a change of 0.1%. However, the increased government spending was essential in offsetting the unanticipated contractions in the performance of vital economic sectors (Panetta 2012, p. 444).

Furthermore, as a result of the regulatory policies by the Bank of England in the wake of the recession caused by the global financial crisis, the overall growth in 2011 fell by a percentage of 0.1% as compared to the previous year, and this was the first, since the last quarter of 2009. The UK economic performance in general and the London stock market in particular are affected by the continuing crisis in the Eurozone because of the connection with the London stock market as the largest trade partner. Booth and Booth (1997, p. 37) argued that part of the reason why effective monetary and fiscal policies are crucial to the performance of the London stock market is that the entire economy of the United Kingdom is substantially reliant on the international trade as a key driver of the economy. The increased inflation and dwindling labour markets continue to put pressure on the United Kingdom’s economy, because the household spending is held back, even as other economic factors continue to retrain the public expenditure. Projections, therefore, indicate that the UK economy will grow at a mere 1% in 2012 as opposed to 3% that the country recorded before the global financial crisis. However, indicators show that this situation will improve in the future, and even the economy will grow at the initial 3% after three to four years (Afonso & Sousa 2011, p. 1875).

As a result of the volatility and sensitivity of the stock prices on the London stock market, the best approach is to have monetary and fiscal policies that transform, depending on the prevailing circumstances in the UK and the global financial market, as well. This is because the London stock market is not shielded from the shocks of the global market. In fact, it is directly connected with the international financial markets to the extent that a small rubble in the international financial market is likely to have a substantial impact on the London stock market. This is evident by the recent global financial crisis that started in the Wall Street, but whose effects were reflected in the London stock market (Kaul 2004, p. 35). The London stock market is in the centre of the global financial market. Therefore, understanding the monetary and fiscal policies that are put in place by stakeholders, including the Bank of England, will allow analysing the behaviour of the stock prices for better and secure investments in stocks. Moreover, this information will assist many stock markets around the world in terms of aligning their stock market policies in order to avoid being negatively affected by the policies of the London stock market. The London stock market acts as a nerve centre for stock markets in Europe, Asia, Australia and Africa. The market is also directly related to the New York stock market and many other stock markets in South America. Thus, having a proper approach to the setting of monetary and fiscal policies will contribute a lot to the implementation and management of stock markets around the world. 

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