4.2.4.1 The structure of financial markets and financial assets Flashcards
What are the functions of money?
- Medium of exchange
- Store of value
- Standard of deferred payment
- Unit of account
Money as a medium of exchange
- Barter relies on the ‘double coincidence of wants’
- No need for barter
- Enables specialisation in work (and living standards can rise) - safe in knowledge that people’s output can be exchanged for money
Money as a unit of account
- Giving products a monetary value - enables comparison of prices and values of different products
- Works if inflation remains low
Money as a store of value
- Can be stored until needed and doesn’t have to be spent immediately
- Inflation erodes this function
Money as the standard of deferred payment
- Money can be used now or in the future
- Lending now makes sense only if, once repaid, it can be used at a later date
Characteristics of money
- Acceptable
- Durable
- Portable
- Divisible
- Scarce
- Difficult to forge
Define the money supply
- The value of the stock of money that exists within an economy at a point in time (there are various measures of the money supply)
Narrow money
- Measure of the money supply that includes balances that can be used immediately as a medium of exchange, such as notes and coins, and accessible bank balances
Broad money
- A measure of the money supply that includes notes and coins, as well as most balances held by banks and other financial institutions
Consists of all components of narrow money with other deposits
Importance of financial markets
- Shift money from those with a surplus of money they don’t wish to spend to those who wish to spend more than they currently have
- Operate internationally - with money moving between people and organisations across borders
Three main financial markets
Money market, capital market, foreign exchange market
Money market
- Provides short-term finance to individuals, firms and governments
- Mainly deals w/ short-term debts (ranging from loans due to mature in hours to loans due to mature in months)
- Covers interbank lending and money lent to the govt through the purchase of Treasury bills
Treasury bill
- Very short-term from of govt borrowing (usually repaid within 3 months)
Capital market
- Deals with medium-and long-term finance to firms and governments
- Deals, typically, w/ raising finance through share or bond issues
Divided into primary and secondary markets
Primary (capital) market
- Deals w/ issue of new securities (bonds and shares) by firms or governments to raise finance
Secondary (capital) market
- Deals w/ trend in bonds and shares already issued
- World stock markets largely dealing w/ this (buying and selling existing shares)
- Makes it easier for bondholders and shareholders to raise money through buying and selling the shares
Bonds
- Form of borrowing giving the holder a fixed rate of interest
- The money is repaid within a set period of time
- Can be traded
Shares
- Issued by firms raising finance, giving the holder the cane to receive dividend out of the firm’s profits and often allowing the holder to vote in company affairs
- Not repaid by the firm and can be traded
Foreign exchange market
- International trade and investment flows involve converting and holding different currencies
- Divided into spot market and forward market
Both are subject to large amounts of speculation - buying and selling currencies to profit from XR changes
Spot market
- Immediate conversion of one currency into another at the current market exchange rate
Forward market
- Agreement to buy foreign currency at an agreed exchange rate at some specified date in the future
Role of financial markets in wider economy
- Govt often finance budget deficits by issuing bonds to finance the shortfall - the stock of outstanding bonds represents the national debt
- Large firms use capital markets to raise large amounts of money either by issuing their own boss (debentures) or by issuing shares
Capital markets ensure finance is available in the economy for firms seeking to maximise their profits
Debentures
Another name for bonds - debentures usually issued by companies (corporate bonds)
Equity
- Value of share capital issued by firms as part of their financial capital
- Firms seeking to raise large amounts of capital to finance business activities can sell shared to potential investors (become shareholders)
- Usually get vote in running of company - not the motivation for most investors buying shares, though
- Shares = attractive - value often rises quickly + annual dividends
Bond - coupon and maturity date
- Bonds pay a fixed rate of interest (coupon) and have a fixed maturity date
- Typically have a ten-year term to maturity - some have shorter or longer maturity dates
Most bondholders = institutional investors - other banks and companies hoping to maximise returns on their investments
How can the UK govt finance its budget deficit?
- Through the issue of new bonds
- Govt bonds also called ‘gilts’
Relationship between market interest rates and bond prices?
- Inverse - i.e., if interest rates rise, we would expect bond prices to fall, because the cost of borrowing falls, and vice versa
Bond yield calculation
Yield (%) = coupon on bond / market price of bond x 100
Determinants of bond yields
- Expectations of future interest rate movements - price of current bonds to fall if interest rates are expected to rise
- How near the maturity date is - the nearer to it, the closer the current price of the bond will be to its original nominal value
