1. Financial Markets & Monetary Policy - Structure of Financial Markets

Question 1

What is a financial market?

Answer 1

Any place where buyers and sellers meet to trade financial assets.

Question 2

What do financial markets do?

Answer 2

They bring together lenders and borrowers.

Question 3

Who are the lenders and borrowers in a financial market?

Answer 3

Lenders are savers and investors while borrowers are individuals, firms and government in need of cash.

Question 4

What are the functions of money?

Answer 4

1. Accepted medium of exchange 2. Store of value3. Measure of value4. Standard of deferred payment

Question 5

What are the characteristics of money?

Answer 5

1. Acceptable2. Durable3. Portable4. Divisible5. Limited in supply6. Difficult to forge

Question 6

What is the money supply?

Answer 6

The money supply is the total amount of money circulating in the economy.

Question 7

What are the different types of money and how are they distinguished?

Answer 7

There is M0 money - Narrow Money - The Monetary Base & M4 money - broad money - The Wider Money Supply. (There is also M1,2,3 but these are less important). The types of money are distinguished by liquidity. M1 includes only cash assets (high liquidity) as you move through to M4 more non-cash illiquid assets are included.

Question 8

What are the three different parts of the financial market?

Answer 8

The money marketThe capital marketThe currency market (foreign exchange market)

Question 9

What are money markets?

Answer 9

This is the market for the buying and selling of financial assets that have a payback date of a year or less.e.g. some bonds and interbank lending

Question 10

What are capital markets?

Answer 10

This is the market for the buying and selling of financial assets that have a payback date of more than a year.e.g. debt capital and equity capital

Question 11

What is debt capital?

Answer 11

Any financial asset that pays back an interest rate, a form of borrowing for the issuer.e.g. buying and selling gov. bonds in the l-term

Question 12

What is equity capital?

Answer 12

Equity capital is when someone has a stake in a business so receives returns through dividends rather than interest.e.g. the buying and selling of shares

Question 13

How can capital markets be further divided?

Answer 13

Capital markets are either primary or secondary markets.Primary capital markets - new issue markets, where brand new bonds may be bought.Secondary capital markets - the purchase and sale of existing bonds.

Question 14

What does the existence of the secondary capital markets do?

Answer 14

The presence of secondary capital markets makes bonds a fairly liquid form of money, it is fairly easy to convert your bond to cash by selling it on in a secondary market.

Question 15

What are currency markets?

Answer 15

This is there market for the buying and selling of the financial asset that is currency.e.g. the buying and selling of $s

Question 16

How can currency markets be subdivided?

Answer 16

Currency markets are either spot markets or future markets.Spot Markets - the buying of currency at the current ER and getting it delivered to you immediately. Future Markets - the buying of currency at the current ER but it will be delivered to you at a later date.

Question 17

Why may people choose to purchase currency in future market?

Answer 17

Businesses may use it to protect against suspected future ER falls.Speculators may use it to try and make money.

Question 18

What are bond markets and which of the three parts of the financial market do they fall into?

Answer 18

Bond markets are markets for the purchase and sale of bonds - this may be in either the money market or capital market depending on the length of the bond.

Question 19

What are bonds?

Answer 19

Bonds are essentially an ‘I owe you’ - the issuer will borrow money off someone else in exchange for a bond stating the amount they owe them.

Question 20

How do bonds work?

Answer 20

Bonds have a maturity date, when the bond reaches this date the holder can retrieve the full value of the bond. The holder is also guaranteed regular interest payments on the bond - the coupon rate.

Question 21

What is the coupon rate?

Answer 21

The coupon rate is essentially the rate of interest a holder receives on a bond. In the old days bonds would come with coupons on the end for certain amounts that could be redeemed annually, this is the equivalent of an interest rate.

Question 22

Who may issue a bond and why?

Answer 22

Bonds may be issued by the government to finance spending on infrastructure.Bonds may be issued by corporations in order to finance investments.

Question 23

Who may buy a bond and why?

Answer 23

Anybody can buy a bond, they may choose to do this if the rate of returns is better than other financial assets like loans. Also, bonds offer a very safe investment as banks and businesses rarely default on bond payments.

Question 24

What are bond yields?

Answer 24

The bond yield is the return a bond will give - this is important for investors because this allows them to compare the profitability of bonds to other assets.

Question 25

How do you calculate bond yield?

Answer 25

Bond Yield = (Coupon Rate/Market Price) x 100

Question 26

Why, considering the bond yield formula, is there an inverse relationship between the price and yield of bonds?

Answer 26

As the price of bonds rises the yield that bond offers will fall. This is because the coupon rate is fixed, if the market price rises the coupon rate is divided by a larger number, giving it a smaller yield.

Question 27

Why does it make sense that there is an inverse relationship between the price and yield of bonds?

Answer 27

If you think about it if a bond offers a maximum return, taking into account the maturity payback value and the full interest rate the yield will be that figure - what you pay for the bond. If what you pay (the price) rises, the yield falls.

Question 28

How does the inverse relationship between bond price and yield equalise bond yields to interest rate?

Answer 28

If bond yields are high compared to the interest rate returns on saving in banks demands for bonds will rise, this will drive bond prices up, this will drive bond yields down, therefore levelling bond yields and interest rates.

Question 29

At what yield will issuers generally provide bonds and may when they not do this?

Answer 29

Generally bond issuers will provide bonds with yields equal to the interest rate, they may choose to provide better bond yields if they’re desperate to borrow.

Question 30

How else may be governments/firms raise financial assets other than through bonds?

Answer 30

They may issue shares or borrow from a bank.

Question 31

How does issuing shares raise financial assets?

Answer 31

The process works largely in the same way as bonds with a subtle difference;It is a more risky investment bc they don’t have a stable interest rate, instead returns are paid as dividends so they depend on the performance of the business.

Question 32

How does borrowing from a bank raise financial assets?

Answer 32

As simple as it sounds - the borrower obtains a loan from a bank and will pay an interest rate on that loan based on the interest rate.

Question 33

What are the three key ways borrowers may raise financial assets?

Answer 33

1. Bond Markets2. Share Markets3. Through intermediaries such as banks