1 - The Role & Structure of the Financial Markets

Question 1

Money must have what properties

Answer 1

1 - Sufficient Quantity
2 - Generally Acceptable by all parties
3 - Divisible into small units
4 - Portable

Question 2

What are the main roles of the Bank of England (BoE)?

Answer 2

1 - Issuer of banknotes. To provide sufficient notes in circulation.
2 - Banker of the Govt. Govt own account held at the BoE, the bank covers any deficit through an automatic loan and any surplus is automatically lent out.
3 - Banker of Banks - All major banks of accounts with the BoE; depositing and withdrawing of cash, settling any clearing and other transactions.
4 - Adviser to the Govt. Helping the Govt to formulate monetary policy and Banks Monetary Policy Committee (MPC) given responsibility for setting interest rates.
5 - Foreign Exchange Market. Manages official reserves of Gold and Foreign currency on behalf of the treasury.
6 - Lender of Last Resort - Providing liquidity to the banking system to maintain confidence when problems arise. (Northern Rock for example).

Question 3

What are the two main ways the Financial Markets work?

Answer 3

A means for borrowers and lenders to come together to transact. Lenders will lend to borrowers a charge an interest rate to the borrower.

Question 4

What five areas do the Financial Banking & Forex Markets work within broadly?

Answer 4

1 - The maturity or term of the borrowing and lending, from overnight to long-term.
2 - Retail or wholesale business;
3 - secured or unsecured business;
4 - primary or secondary business;
5 - domestic currency or foreign currency business.

Question 5

What are the short term and long term business (lending) activities undertaken when referring to Maturity Term Transactions?

Answer 5

Short Term: Financial markets where short‑term borrowing and lending take place are known as the money markets. Examples of these markets are the interbank market and those for Treasury bills and commercial paper; they provide liquidity to institutions.

Long Term: Financial markets where long‑term borrowing and lending take place are known as the capital markets. Examples are the bond and equity markets, which provide businesses and governments with longer‑term funding for investment and projects.

Question 6

What are the key differences between retail and wholesale banking?

Answer 6

The key difference is one of the size of the transaction and those involved. Retail focuses more on ‘person in the street’, retail products and smaller companies. Lending is more expensive on the retail market; the money lent is usually found on the wholesale market and then an additional amount of interest is added.

Wholesale is larger corporations, Govts and consist of much larger amounts of money, but with lower margins - the cost of borrowing is smaller on the wholesale market, simply because of the large volumes of money involved.

Question 7

What are the main differences between unsecured & secured?

Answer 7

Unsecured means that there is no asset security provided for the loan amount to act as a guarantee, should the loan default.

Secured means that there is an asset/security provided to act as a guarantee should the loan default.

Question 8

What is the primary market?

Answer 8

Raised new capital: for example from an IPO issue that received money for the shares issued.

Question 9

What is the secondary market?

Answer 9

The secondary market is where such financial securities are traded in the broader market; it provides a means of transacting the sale and purchase of shares in this instance. Allowing for liquidity within the market.

Question 10

What is the Repo Market?

Answer 10

A repo is the sale and repurchase agreement, most commonly based on gilts. In essence, it is a means of raising short term capital through the use of providing a gilt as a guarantee. The amount borrowed is less than the value of the gilt, but the lender pays back the full value of the gilt at the time of the agreement. If they fail to pay back the full amount, the gilt remains the lender.

Question 11

Is a repo a loan agreement?

Answer 11

Technically no, there is only a temporary change of ownership of the gilt. Hence the meaning ‘Sale & Repurchase’ - the borrower has a legal right to buy back the gilts.

Question 12

What is the gilt repo market?

Answer 12

This is different from the gilt markets and the most important repo market in the UK. Main bodies involved are banks, building societies, mutual funds, hedge funds and central banks around the world.

The rate charged in the gilt repo market is based on the level credit rating of the gilt being offered.

Question 13

What could someone investors do in the gilt repo market with the gilts they own?

Answer 13

They could buy the gilts and then immediately repo the securities, getting back most of the cash used to buy the gilts. Given that the agreement value is based on the valuation of the gilt at the time of the agreement and not the value of the gilt at maturity. It is possible for an investor to release the cash, buy more gilts, and the original gilt goes up in value and make a profit, but still during that term be able to use most of the money used to buy the original gilt.

Question 14

Broadly what is the Interbank market?

Answer 14

Is an unsecured market where banks and other large institutions can borrow and lend large wholesale sums with each other for short periods.

It also acts as a means of providing a means of liquidity between banks, to allow for any deficit in a banks books (for example) to be borrowed on the Interbank market, from another than has a surplus.

Question 15

What is Libor and what market does it relate to?

Answer 15

London Interbank offered rate (Libor) is the interest set from banks submitted data and is the rate charged between banks for the liquidity they provide to one another.

Question 16

What is SONIA?

Answer 16

Sterling Overnight Index Average - going to replace Libor and used as a benchmark for calculating interest rates on the Interbank markets. Namely because of the Libor scandal where some banks were providing misleading data, to swing the Libor interest rate, which traders were then trading on that LIBOR rate.

Question 17

What are Treasury Bills?

Answer 17

A short term gilt raised by the Govt as a means of raising short term funds (usually 91 days) but can be as long as 1 year. The profit is made from redeeming the bill at the end of the time scale for a higher value than the discount paid.

Considered to be exceptionally low risk, as they are issued by the Govt.

Question 18

What are Wholesale Certificates of Deposit?

Answer 18

Issued by an authorised deposit-taking institution, a bank for example, as an official certificate showing the amount of deposit. Borrowing can then be secured on the amount in deposit as security, plus either a fixed or variable interest rate. Or, there could be a discounted value given, with the par value of the CD handed over to the lender upon maturity.

Question 19

What is the commercial paper market?

Answer 19

An unsecured primary and secondary wholesale market for large corporations to raise funds using short term loans. By providing a ‘promissory note’ a security ‘commercial paper’ a corporation can raise funds un the primary market, providing they have a good credit rating. The ‘Commercial Paper’ states the terms, whether that be a discounted rate similar to a repo, or an agreed interest rate.

There is a very small secondary market for commercial paper.

Question 20

What is common for a corporation to do within the ‘Commercial Paper’ market?

Answer 20

It is common for the corporation to keep rolling over its commercial paper constantly, financial a constant amount of their assets.

Question 21

What is a bond and why is that different from a gilt?

Answer 21

A bond is a long term gilt, the difference being is that the maturity is 5 or more years. They can be issued by the government, local government and companies. Used to aid funding in large schemes over long periods of time.

Question 22

What is the ‘coupon’ and how would you what would be the calculation?

Answer 22

The coupon is the interest rate set by the lender. The lender receives £5 for example on ever £100 of face value loaned would be a 5% coupon. If they bought a bond for £90 the yield on that bond would be calculated as follows: £5 / £90 x 100 = 5.56 yield. If they paid more say £120 to buy the bond, the yield would be lower. £5 / £120 x 100 = 4.17%

It is important to note that the coupon is fixed. The only way a yield can be adjusted is by a change in the selling price. So for example, if there was a higher yield percentile wanted, the selling price needs to be lower and the price of the bond will drop say to a 7% yield, would equal to the following: £5 / £71 x 100 = 7%.

Therefore higher bond yields reduce the sale price of the bond.

Question 23

What are Corporate Bonds and how do they differ from Government-issued Bonds?

Answer 23

Corporate Bonds are issued by companies that want to finance long term projects at a fixed interest rate. The interest rate is based on the companies credit rating, issued by organisations such as Moody’s and Standards & Poors. The higher the credit rating, the lower the interest on a bond issue, but the more likely the bond will reach maturity and be paid to the investor/loan provider.

Question 24

What is the purpose of the Primary and Secondary markets within the Equities Markets?

Answer 24

Primary Market is used as a means for a company to raise cash through an IPO to go public and issue shares as an initial offering.

The secondary market is where the shares are bought and sold between investors on stock exchanges as a means of either long to short term investment strategies.

Question 25

What are the three main ways shares can be issued?

Answer 25

1 - Prospectus Issue: Company offers new shares to the public usually through an investment bank, who would advise the company and distributes them to the public.

2 - Private Placement: New shares are placed with institutional investors, such as investment companies, insurance companies and pension funds. Usually administered by investment banks who provide the information on the share issue through a memorandum, rather than a prospectus.

3 - Rights issue: A rights issue, is only available to a company should they already be a PLC and have an adequate number of shareholders. They can offer further shares to existing shareholders at a discount (3 for 2 for example) in return for further investment in the company. This is by far the fasted means for a company to raise further funds with existing shareholders.

Question 26

What is the main advantage of owning a share in a company?

Answer 26

The main advantages of owning stock (having shares) in a company, would be actual ownership of a percentage of the company and the chance of receiving a share in the profits of the company by means of dividends.

Question 27

What is the purpose of a Stock Exchange?

Answer 27

A Stock Exchange is a secondary market to allow the purchase and sale of shares issued in that country. Various Stock Exchanges exist for different sections; FTSE 100 (top 100 companies) for example.

Question 28

What are the main stock exchanges in the World?

Answer 28

FTSE, NYSE, DAX, CAC40, Nikkei, Dow-Jones and NASDAQ

Question 29

What stockbroking services are available?

Answer 29

Agency brokers: Act as a clients agent and arrange deals to taking the order and contacting the market maker to complete the deal at the best price.

Market Makers: hold stocks in their own name and make profits by correctly
anticipating market‑price movements and buying and selling shares accordingly.

Broker‑dealers – purchase shares from clients and then sell them in the market, or
buy shares in the market to sell to clients, with each transaction intended to create
a profit for their own account. They can act as agency brokers or market makers. To
ensure that this does not work against the client’s interest they may only use their
own stock if it is being traded at better than the best price being offered elsewhere.

Question 30

What are the four main areas in which the Forex Market is used?

Answer 30

1 - international trade in goods – companies in different countries purchase raw
materials, components and finished goods from each other;

2 - international trade in services – companies buy financial services from banks
and insurance companies in other countries and send their goods on foreign ships;
individuals travel to other countries and need currency;

3 - short‑term investment – a company with a surplus can deposit money in an account
or purchase a security that is denominated in the currency that is currently paying
the highest interest rate, even if only for a short period, in order to earn a return;

4 - long‑term investment – individuals and companies buy shares and make longer‑term loans to borrowers in other countries. A company may open an outlet in another country and will need that country’s currency.

Question 31

What is the purpose of the reinsurance market?

Answer 31

The reinsurance market is where insurers that have already accepted risks parcel the risks up and sell ‘bits’ of them to other insurers, while themselves buying parts of the risks of other insurers. In this way, all risks insured are divided up between many insurers.