4.4 The financial sector Flashcards
What is the stock market
Enabling the buying and selling of shares on listed stock
markets. Firms can use stock markets to issue more shares and raise
finance.
What is the bond market
This involves buying and selling government bonds, to
fund public sector borrowing. As well as government bonds, there are
also private sector bond markets for firms.
What is commercial banking
Offering firms the chance to save and borrow for
investment.
What is a personal bank
Offering individuals the opportunity to save and
borrow
What are money markets
means for lenders and borrowers to meet their short term financial needs.
· Assets bought and sold usually have a maximum maturity of a year (24 hours-365 days) and are easily convertible into cash.
What are the main roles of financial markets
- Saving - gain interest through bonds/bank to transfer spending power to future
- Lending –> fund investment
- Facilitate the Exchange of Goods - creation of a payments system
-
Reducing Risk –> enables companies to hedge (swaps, forwards, options)
e.g. Forward Market in Commodities -
Shares –> raising finance for investment
e.g. Eurotunnel financed by selling shares to investors
What is the money supply
money supply measures the total amount of money in the economy at a particular time. It includes actual notes and coins and also any deposits which can be quickly converted into cash.
What is M0 to M4
M0 = This is the level of notes and coins in circulation + banks operational balances at the Bank of England. (This is the most liquid form of money)
· M4 = This is notes and coins in circulation plus private sector deposits in banks and building societies.
How do you increase the money supply
· Print more money
· Quantitative easing – electronic creation of money by Central Banks
· Increased bank lending – banks lending higher % of their deposits
* Central Bank purchasing bonds from private individuals which can be spent.
What are financial markets
where financial assets (eg loans) or securities (stocks/bonds/treasury bills) are traded.
What are capital markets
Shares and bonds are issued to raise medium and long term financing for both firms and government
divided into the primary market, newly issued, and the secondary market, second-hand securities
What is the foreign exchange market
market in which different currencies are bought and sold.
traded on either the spot market (immediate exchange) or the forward market.
What is the relationship between the price of a bond and the yield
there is an inverse relationship between the price of the bond and the interest, it is the coupon that remains fixed.
What are the main functions of Commercial Banks (High Street Banks)
· Accepting deposits
· Lending to economic agents
Providing efficient means of payment (bills etc)
Provide foreign currency
Offer other functions-give advice, insurance etc.
Banking is private, what does this imply
· Need to be profitable to provide a return for shareholders
· There needs to be certain level of liquidity to meet the needs of depositors
· There is a balance that needs to be found between liquidity and profitability
What is the balance sheet of a Commercial Bank
Assets - cash, balances at the BofE, Loans (advances), securities (e.g. bonds), fixed assets
Liabilities - customer deposits, money owed to bond holders, money owed to other banks
How do banks create credit
When a bank makes a loan, for example to someone taking out a mortgage to buy a house, or a business taking out a loan to finance their expansion it credits their bank account with a bank deposit of the size of the loan/mortgage.
At that moment, new money is created.
’ Bank making loans and consumers repaying them are the most significant ways in which bank desposits are created and destroyed in the modern ecnonomy’
What are the benefits of a bank attracting fresh deposits
- By attracting new deposits, the bank can increase its lending without running down its reserves.
- Longer-term savings deposits therefore typically offer a higher rate of interest for savers, a reward for the inconvenience of sacrificing some of their liquidity
What are the limits to money creation by commercial banks
- Market forces – the scale of profitable lending opportunities
- Regulatory policies e.g. capital reserve requirements
- Behaviour of consumers and businesses e.g. decisions about how much debt to repay
- Monetary policy - level of policy interest rates influences the aggregate demand for loans
Evaluate the role of banks
- Banks are not the only source of finance, may turn to private investors, stock market, government grants or personal savings
- In times of recession, banks may not be willing to lend e.g. 2008
- Poorest consumers often do not have access to bank account
What are Bank Stress Tests
- Put in after 2008, test the liqudity and capital of a bank in simulations of an ecnomic crisis
Banks that fail stress test mistake steps to rebuild capital reserves
EU stress tests cover 70% of banking institutions,US Banks with over 50 billion pounds or more in assets are required to undergo
What are the criticisms of Bank Stress Tests
- Stress tests are over-demanding, and require too much capital
- Thus there is an under provision of credit to the private sector; which many argue led to the relatively slow pace of economic recovery after 2008
- Timing is hard to know making banks overly cautious during normal fluctuations
What is a Hedge Fund and it’s goal
- Pool contributed to by a limited number of partners and operated by a professional managers
- Only open to qualified investors ( over a million net wealth or annual income over 200,000)
- Common goal is market direction neutrality; make money despite market fluctuations
What is the structure of a hedgefund and what is the issue with this structure
- 2 and 20 fee structure: gives the hedge fund manager 2% of the assets and an incentive fee of 20% of the profits each year
- But even if the hedge fund loses money, the manager get sa good amount ( moral hazard )
What are the type of Hedgefunds
1) Macro hedge funds try to maximise on changes in macroeconomic variables; biggest busts and highly leveraged
2) Equity hedge funds is maintying ‘long’ positios in stocks you own and ‘short’ positions in stocks you don’t tha you believe will decrease
3) Relative value arbitrage hedge fund buy securities that are expected to appreciate while simultaneously shorting a similar security that is expected to depreciate in value
4) Distressed hedge fund help companies turn themselves around by buying some of the securities in hopes they will appreciate
What is a building society
a mutual organisation; all elligible customers are known as members
· They have rights to vote and speak at meetings
· Each member always has one vote and there is a board of directors
· Societies have no shareholders requiring dividens; allowing lower costs, cheaper mortgages, better interest rates
· Building societies have a limit on what proportion of their funds that building societies can raises from the wholesale money markets ( can only raise 30%)
What makes the longer length of a bond give it a higher yield
Longer length of the bond makes it more risky as there can be more factors ( raising IR value, default)
e.g. SVB collapse from purchasing longer length bonds for a higher yield
What is a bond default
- Occurs when an issuer fails to make an interest payment or pincipal payment
- usually a last resort and is often solved by restructuring
- In case of coporate bands the bondowner usually recieves a compensation, in a high yield market the avergae recovery rate from 19577-2011 was 42%
How do distressed debt investors utilise defaulted bonds
- When bonds default they continue to trade as sharply reduced prices, attracting distressed debt investors who believe they will be able to recover more than the disperal of the company’s assets than the price of the bond reflects
In the 42 year period till 2011 how many AAA rated municipal and coporate bonds paid out interest and principal
- In the 42 year period through 2011, 100% of AAA rated municipal bonds paid alll of the epexcted interest and principal payments
From 1920-2009, only 0.9% of AAA rated coporate bonds default
What are derivatives
Financial securities with a value that is reliant upon an underlying assert or a group of assets
- Derivatives can be used to hedge, speculate or give leverage
What is the difference between over the counter (OTC) derivatives and exchange based
- Over the counter derivatives have counterparty risks - the danger that one of the parties involved in the transaction might default; this is private and unregulated
Exchange based derivatives are standardised and heavily regulated
What are futures
- Agreement between 2 parties for the purchase and delivery of an asset at an agreed upon price at a future date; obliged to fufill
- Can undwide (sell) before expiration
- Requires Margin Payments
- Market has high liquidity; exchange based
What are forwards
- Only over the counter; greatter counterparty risk but customised
- Parties in a forward contract can offset their position with counterparties
- To reverse you have to go to same counterparty who has monopoly over you
- No margin required
What are swaps
- Used to exchange one kind of cash flow with another e.g. interest rate swap to switch from variable to fixed
- Swaps can also be used to exchange currency exchange rate risk or the risk of default on a loan
- swaps on the cash flow and the potential defaults of mortgage bonds led to the counterparty risk that caused the credit crisis of 2008
What are options
- Similar to futures to but buyer has no obligation to exercise the agreement
- Options are used to hedge or speculate on future prices
- Investors buy a put ( sell ) or call (buy) option at a strike price to buy at a date in the future - the expiration date
Options have time decay; value of assets decline over time and severely reduce profitability
What are the advantages of derivatives
- Mitigate risk
- Lock prices
- Hedge
- Can be purchased on margin to make less expensive
What are the disadvantages of derivatives
Buffet describes them as ‘financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’
- Difficult to value because based on prices of another asset
- Counterparty risks that are difficult to value
- Sensitive to changes in amount of time to expiration, cost of holding asset and interest rates; hard to value
- Leverage can have externalities e.g. 2008
- difficult for regulators to maintain oversight to the market since they are so hard to value
What 2 sections is the financial market split into
- Money Markets - assets w a maturity of less than a year
e.g. Bonds, Interbank Lending
Capital Markets - assets w a maturity of more than a year
What is the quantity theory of money
- Theory that links growth in money supply, to growth in inflation
- Embarced by Monetarists; it is the reason for inflation
1) M (money supply)
2) V (velocity of circulation; no. of transactions given an amount of money)
3) P (Avg. Price Level - Inflation )
4) Q (Quantity of Goods/services sold) i.e. real gdp
Fischer Equation:
MV (what is bought ) = PQ ( what is sold )
P = MV / Q
But V and Q are fixed in the long run or their changes are negligible
Therefore only M can influence price
Evaluate the Quantity Theory of Money
- Assumptions of V and Q same
- Recession
- Doesn’t hold
- Big increases in money supply doesn’t translate due to liquidity traps
What do investment banks do
- Proprietary Trading - taking any excess capital and investing it to get a better rate of return
- Market Making - a place where markets can be made; where you can buy shares + bonds but also issue bonds and shares
Advisory Roles:
* Mergers and Acquisitions: Companies might go through an investment bank for advice: when? Structure? Due diligence? Paperwork? Media? Regulation?
* New Issues and IPO’s
Underwriting IPO’s: buying all the shares up and then charging a higher price to sell to the market
What is systemic risk
most banks like hsbc and barclays are nor pure commercial or investment. Thus it makes them vulnerable to black-swan events to bring down the entire financial system
What is capital on the banks balance sheet
Shareholder’s Funds + Retained Profit (reserves)
- since you need to pay them back to the shareholder
What is SONIA
reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial instiutions
How did the Housing bubble affect the Irish House prices
Irish house prices rose 30% in just two years, but fell 35% when the housing bubble ended.
100% mortgages were common
What are the types of market bubbles
- Market Bubble - When a particular market sees a rapid increase in price
- Commodity bubble e.g. price of gold, e.g. in the 1970s and 1980.
- Credit bubbles- a rapid growth in consumer and business credit to finance higher consumer spending
-
Economic boom/bubble- AD grows faster than LRAS
*
What are some examples of market bubbles
- Tulip mania of the 1630s. When the price of tulips rose to over 500 times their previous price before collapsing when buyers stopped entering the market.
- Dot Com Bubble
- House Price Bubbble- Between 2000 and 2006, house prices rose 80% and house price to earning ratios rose above long-term averages. This was partly fuelled by a growth in mortgage lending to subprime customers
What is the Minsky Moment
point where the financial system moves from stability to instability. It is that point where over-indebted borrowers start to sell off their assets to meet other repayment demands.
Can lead to a balance sheet recession
What is the impact of increasing the money supply on interest rates
Usually, an increase in the money supply will lead to a fall in interest rates.
However, in a liquidity trap, an increase in the money supply may have no effect on reducing interest rates.
