4.4.1 Role of financial markets

Question 1

4.4.1 Role of financial markets

What are financial markets?

Answer 1

Financial markets are where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature.

Question 2

4.4.1 Role of financial markets

Why do financial markets exist?

Answer 2

They exist for two main reasons: to meet the demand for services , such as saving and borrowing, from individuals, businesses and the government and to allow speculation and financial gains.

Question 3

4.4.1 Role of financial markets

Why are financial markets very important?

Answer 3

Financial markets are extremely important to the general health of an economy. With effective markets for credit and capital, borrowing and investment will be limited and the whole macro-economy can suffer. Financial markets often fail to form in command economies and in less developed economies, causing low levels of investment and low growth rates.

Question 4

4.4.1 Role of financial markets

What are the main roles of the financial market?

Answer 4

• Facilitate savings
• Lend to businesses and individuals
• Facilitate the exchange of goods and services
• Forward markets
• Market for equities

Question 5

4.4.1 Role of financial markets

How do the financial markets help facilitate savings?

Answer 5

Allows people to transfer their spending power from the present to the future. It can be done through a range of assets, such as storing money in savings account and holding stocks and shares.

Question 6

4.4.1 Role of financial markets

How do the financial markets increase consumption and investment?

Answer 6

They lend to businesses and individuals which allows consumption and investment. They are sometimes referred to as a financial intermediary, the step between taking money from one person to give to another since money from savings is used for investment.

Question 7

4.4.1 Role of financial markets

How do the financial markets facilitate the exchange of goods and services?

Answer 7

They facilitate the exchange of goods and service s by creating a payment system. Central banks print paper money, institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy and sell foreign currencies.

Question 8

4.4.1 Role of financial markets

How do the financial markets provide forward markets?

Answer 8

They provide forward markets . This is where firms are able to buy and sell in the future at a set price, for example if a farmer wants to sell the crop they are growing at a guaranteed price in a month’s time. The forward market exists for commodities and in foreign exchange and helps to provide stability.

Question 9

4.4.1 Role of financial markets

How do the financial markets provide a market for equities?

Answer 9

They provide a market for equities , company’s shares. Issuing shares is an important way for companies to finance expansion but people would be unlikely to buy shares if they were unable to sell them on in the future. Financial markets provide the ability for shares to be sold on in the future, making the asset more appealing.

Question 10

4.4.1 Role of financial markets

What are the three main financial markets?

Answer 10

• Money Market
• Capital Market
• Foreign Exchange Market

Question 11

4.4.1 Role of financial markets

What are the money markets?

Answer 11

This is the market for short term loan finance for businesses and households. Money is borrowed and lent normally for up to 12 months. Includes inter-bank lending i.e. the commercial banks providing liquidity for each other. The money market also includes short term government borrowing e.g. 3-12 month Treasury Bills – to help fund the government’s budget (fiscal) deficit.

Question 12

4.4.1 Role of financial markets

What are the capital markets?

Answer 12

Market for medium-longer term loan finance. Capital markets are the markets where securities such as shares and bonds are issued to raise medium to long-term financing. Includes raising of finance by the government through the issue/sale of medium-term and long-term government bonds for example 10 year and 20 year bonds (loans).

Question 13

4.4.1 Role of financial markets

What are the foreign exchange markets?

Answer 13

A market where currencies (foreign exchange) are traded. There is no single currency market – it is made up of the thousands of trading floors. Gains or losses are made from the movement of exchange rates – speculative activity in the currency market is often high.

Question 14

4.4.1 Role of financial markets

What is a commodity market?

Answer 14

A commodity market is a marketplace for buying, selling, and trading raw materials or primary products.

Question 15

4.4.1 Role of financial markets

What is a spot market?

Answer 15

The spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery. Delivery is the exchange of cash for the financial instrument. A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date.

Question 16

4.4.1 Role of financial markets

What is a forward market?

Answer 16

A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, but the term is primarily used with reference to the foreign exchange market.

Question 17

4.4.1 Role of financial markets

What is a bond?

Answer 17

A bond is a specific type of security that is sold by firms or governments. It is a way for the firm or government to borrow money at a certain interest rate. In return for buying the bond and investor gets a certain interest rate for the duration of the bond.

Question 18

4.4.1 Role of financial markets

What are the advantages of bonds?

Answer 18

• Security
• Liquidity
• Legal protection

Question 19

4.4.1 Role of financial markets

How do bonds provide security?

Answer 19

The volatility of bonds (especially short and medium dated bonds) is lower than that of equities (stocks). Thus bonds are generally viewed as safer investments than stocks.

Question 20

4.4.1 Role of financial markets

How are bonds liquid?

Answer 20

It is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much, which may be more difficult for equities. In effect, bonds are attractive because of the comparative certainty of a fixed interest payment twice a year and a fixed lump sum at maturity.

Question 21

4.4.1 Role of financial markets

How do bonds provide legal protection?

Answer 21

Under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company’s equity stock often ends up valueless. Furthermore, bonds come with indentures (an indenture is a formal debt agreement that establishes the terms of a bond issue) and covenants (the clauses of such an agreement). Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing.

Question 22

4.4.1 Role of financial markets

What are the disadvantages of bonds?

Answer 22

• Reinvestment risk

- Exchange rate risk

Question 23

4.4.1 Role of financial markets

How do bonds provide a reinvestment risk?

Answer 23

The reinvestment risk is the possibility that the investor might be forced to find a new place for his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Question 24

4.4.1 Role of financial markets

How do bonds provide a exchange rate risk?

Answer 24

The exchange rate risk is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies.

Question 25

4.4.2 Market failure in the financial sector

What is asymmetric information?

Answer 25

This is a situation where there is imperfect knowledge. In particular, it occurs where one party has different information to another.

Question 26

4.4.2 Market failure in the financial sector

How is asymmetric information an issue in the financial sector?

Answer 26

One problem with the financial sector is that financial institutions often have more knowledge compared to their customers , both consumers and other institutions. This means they can sell them products that they do not need, are cheaper elsewhere or are riskier than the buyer realises.

Question 27

4.4.2 Market failure in the financial sector

What is an example asymmetric information in the financial sector?

Answer 27

The Global Financial Crisis was partially caused by banks selling packages of prime and subprime mortgages, but advertising them as all prime mortgages.

Question 28

4.4.2 Market failure in the financial sector

What is an example externalities in the financial sector?

Answer 28

Significant externalities are created by financial markets, for instance the cost to the taxpayer of bailing out banks in situations like the 2008 GFC, where the overall cost to the UK taxpayer was £1.162 trillion.

Question 29

4.4.2 Market failure in the financial sector

What is market rigging?

Answer 29

Market rigging occurs when individuals or institutions collude to fix prices or share information to maintain position in a market.

Question 30

4.4.2 Market failure in the financial sector

What is an example of market rigging in the financial sector?

Answer 30

In the Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important rates in the world.