4.4 Financial Markets Flashcards
What are 5 roles of financial markets?
- Facilitate saving
- Lend to businesses/individuals
- Facilitate the exchange of goods + services
- Provide forward markets
- Provide a market for equities
What are forward markets and what are 2 benefits?
- An informal financial market where contracts for future delivery are made at a fixed price/rate
- Provide price stability in commodity markets (reduce impacts of currency fluctuations)
- Allow individuals/businesses to lock in current exchange rate
What are financial markets?
A system that provides buyers + sellers the means to trade financial instruments (e.g stocks, bonds, foreign exchange)
What are financial instruments and 3 examples?
A type of asset that can be traded by investors e.g bonds, equities, international currencies
What are 5 types of market failure in financial markets?
- Asymmetric information
- Externalities
- Moral hazard
- Speculation/market bubbles
- Market rigging
How does asymmetric information affect financial markets?
- Financial institutions often have more
knowledge compared to their customers - Sellers often have an information advantage over the buyers
How does externalities affect financial markets?
- Negative externalities of production + consumption
- investors speculate prices = a negative consumption externality
- Young buyers end up paying more (or being forced out of the market) due to the higher prices caused by speculation
How does moral hazard affect financial markets?
- Government intervene to save banks from failure e.g bail outs
- Creates moral hazard + incentive for banks to take excessive risk
How does market rigging affect financial markets?
- Institutions collude to fix prices or exchange information that will lead to personal gains
- Banks rigging key interest/exchange rates in order to profit maximise
How does speculation and market bubbles affect financial markets?
- Speculation leads to predictions of future asset price rises
- The asset is traded more, so demand exceeds supply (price increases sharply above its instrinsic value)
- The bubble ‘bursts’ when price steeply falls to its ordinary level
- This causes panic and investors try to sell their assets.
(results in a loss of confidence, economic decline)
What are the 4 roles of the central bank?
- Controls monetary policy
- Banker to the government
- Banker to the banks
- Regulates financial system
How does the central bank act as a banker to government?
- Hold the government’s bank
account + lend to them - Hold government debt/foreign exchange reserves
How does the central bank act as a banker to other banks?
- Lender of last resort
- Banks can sell their illiquid assets or take a loan
What are bank bailouts?
Financial assistance given by the government to a bank/financial institution (an injection of capital/money)
What are 2 benefits of bank bailouts?
- Bank liquidity (increases lending + restores confidence)
- Risk to savers/pensioners prevented (lower poverty/welfare payments)
What are 2 drawbacks of bank bailouts?
- Government budget (worsening of national debt)
- Moral hazard (banks take excessive risks)
What are 2 alternatives to bank bailouts?
- Tougher rules on lending (prevents undertaking of risky loans/mortgages)
- Bail-in: relief to financial institutions through the cancellation of debts owed to creditors/depositors
How does the central bank regulate the financial system?
- Prevents financial institutions from undertaking harmful/risky activities
What are 3 forms of financial regulation?
- Banning market rigging
- Maximum interest rates (prevent consumer exploitation)
- Deposit insurance (protects consumer deposits into banks)
