4.2.4.1 The structure of financial markets and financial assets

Question 1

What are the functions of money?

Answer 1

• Medium of exchange
• Store of value
• Standard of deferred payment
• Unit of account

Question 2

Money as a medium of exchange

Answer 2

• 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

Question 3

Money as a unit of account

Answer 3

• Giving products a monetary value - enables comparison of prices and values of different products
• Works if inflation remains low

Question 4

Money as a store of value

Answer 4

• Can be stored until needed and doesn’t have to be spent immediately
• Inflation erodes this function

Question 5

Money as the standard of deferred payment

Answer 5

• 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

Question 6

Characteristics of money

Answer 6

• Acceptable
• Durable
• Portable
• Divisible
• Scarce
• Difficult to forge

Question 7

Define the money supply

Answer 7

• 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)

Question 8

Narrow money

Answer 8

• 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

Question 9

Broad money

Answer 9

• 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

Question 10

Importance of financial markets

Answer 10

• 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

Question 11

Three main financial markets

Answer 11

Money market, capital market, foreign exchange market

Question 12

Money market

Answer 12

• 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

Question 13

Treasury bill

Answer 13

• Very short-term from of govt borrowing (usually repaid within 3 months)

Question 14

Capital market

Answer 14

• 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

Question 15

Primary (capital) market

Answer 15

• Deals w/ issue of new securities (bonds and shares) by firms or governments to raise finance

Question 16

Secondary (capital) market

Answer 16

• 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

Question 17

Bonds

Answer 17

• Form of borrowing giving the holder a fixed rate of interest
• The money is repaid within a set period of time
• Can be traded

Question 18

Shares

Answer 18

• 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

Question 19

Foreign exchange market

Answer 19

• 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

Question 20

Spot market

Answer 20

• Immediate conversion of one currency into another at the current market exchange rate

Question 21

Forward market

Answer 21

• Agreement to buy foreign currency at an agreed exchange rate at some specified date in the future

Question 22

Role of financial markets in wider economy

Answer 22

• 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

Question 23

Debentures

Answer 23

Another name for bonds - debentures usually issued by companies (corporate bonds)

Question 24

Equity

Answer 24

• 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

Question 25

Bond - coupon and maturity date

Answer 25

• 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

Question 26

How can the UK govt finance its budget deficit?

Answer 26

• Through the issue of new bonds

- Govt bonds also called ‘gilts’

Question 27

Relationship between market interest rates and bond prices?

Answer 27

• Inverse - i.e., if interest rates rise, we would expect bond prices to fall, because the cost of borrowing falls, and vice versa

Question 28

Bond yield calculation

Answer 28

Yield (%) = coupon on bond / market price of bond x 100

Question 29

Determinants of bond yields

Answer 29

• 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