4.4 The Financial Sector

Question 1

What is a financial market?

Answer 1

Any system where there’s buying, selling and trading of financial assets
Such as stocks, bonds, currencies and derivatives

Different from product markets, as they sell physical products, but financial markets buys rights
e.g a bond gives give you the right to receive interest payments and the principal amount back at maturity
- so basically money

Question 2

What are derivative markets?

Answer 2

Trade of financial instruments, based on the value of other financial instruments

So trading financial instruments for money

Question 3

What is a financial instrument?

Answer 3

Contracts or assets that represent a financial value

E.g a bond as it represents a financial value of the Govs debt

Question 4

Why do financial markets exist?

Answer 4

Provide services services demanded from households, firms and Govs
e.g loans for firms, insurance on a car, Govs issuing gov bonds
Speculation and help people realise financial gains

Question 5

What do financial markets offer?

Answer 5

1. Facilitate saving
2. Lend to individuals and firms
3. Facilitate the exchange of goods and services by providing ways of exchanging money
4. Provide forward markets for commodities and currencies
5. Provide a market for equities

Question 6

What are the different types of financial institutions?

Answer 6

Retail Banks
Commercial Banks
Investment Banks
Saving Vehicles like pensions, private equity, hedge funds, assurance, unit trust and investment trust
Speculators
Insurance companies

Question 7

What is a Retail Bank?

Answer 7

Deliver private services to individuals and some small firms
Offer saving accounts, debt and credit cards
Profit made from borrowing money at low interest rates and lending at higher rates
E.g Barclays, HSBC, Lloyds, Santander

Question 8

What is a Commercial Bank?

Answer 8

Provide variety of services to businesses
Borrow money from businesses and keeps in secure place to keep their funds safe
Borrow money at low interest rates and lend at higher (Net interest margin)
Fees and charges also make profit
E.g JP Morgan does a lot of this

Question 9

What is an Investment Bank?

Answer 9

Engage in a variety of activities
Trade FX, commodities, bonds, shares and derivatives
Advice companies how to raise money, including issuing new shares
Advice on mergers and takeovers
E.g JP Morgan, Goldman Sachs, Morgan Stanley, Deutsche Bank, UBS, Citigroup

Question 10

How can market failure happen in financial sector?

Answer 10

Asymmetric information
Externalities
Moral Hazard
Speculation and market bubbles
Market rigging

Question 11

What is a moral hazard?

Answer 11

When an economic agent increase risks as they know if they fail it’ll only effect other economic agents and not them

Question 12

What are market bubbles?

Answer 12

When there’s a high supply of money in a market, meaning a lot of speculation, which increases the chance of a price for stock/asset rising exponentially over a period of time, way over intrinsic value

Quantitive easing can cause this

Question 13

What is an intrinsic value?

Answer 13

A true value

Question 14

What is market rigging?

Answer 14

Where a group of individuals or institutions collude to fix prices or exchange info that leads to them profiting but at the expense of others in the market

E.g rigging key interest rates to profit maximise

Question 15

What 4 roles does a central bank do?

Answer 15

Implementation of monetary policies
Banker to the gov
Banker to the Banks - lender of last resort
Regulation of the banking industry

Question 16

What is systematic risk?

Answer 16

The danger of the whole financial system collapsing because of failure of parts of the financial system

Question 17

What’s an incremental change of an interest rates?

Answer 17

Done by the central bank
The incremental change is only a small, step-by-step adjustment in interest rates
E.g rates going up from 5% to 5.25%, the incremental change is only 0.25%

Question 18

What is the transmission mechanism?

Answer 18

When incremental change in the base interest rates ripples through the economy
It effects AD, which effects exchange rates, market rates, prices, confidence, inflation etc.

Question 19

What are required reserve ratios?

Answer 19

Where a central bank requires commercial and retail banks to reserve a certain % of their money that has been deposited with them
Ensures stability of these banks
Manages the supply of money in the economy