4.4.1 Role of Financial Markets

Question 1

What is a financial market?

Answer 1

A financial market is any exchange that facilitates the trading of financial instruments, such as stocks, bonds, foreign exchange, or primary commodities such as oil and gas.

Question 2

What are the key roles of financial markets?

Answer 2

1. To facilitate saving by businesses and households: Offering a secure place to store money and also earn
   interest - This allows households to smooth their consumption over time, and build up deposits/ funds for
   large purchases
2. To lend to businesses and individuals: Financial markets provide an intermediary between savers and
   borrowers - Banks channel funds from savers to borrowers, who would otherwise be unable to connect in an efficient way
3. To facilitate the final exchange of goods and services: They provide payments mechanisms e.g. contactless
   payments: Money is essential in a market economy in which division of labour is used and money allows a much more efficient operation of an economy, because without money, there would
   be a barter system
4. To provide forward markets in currencies and commodities
5. To provide a market for equities: Allowing businesses to raise fresh equity to fund investment and growth:

Question 3

How do businesses gain finance for investment?

Answer 3

• Businesses gain finance for investment and growth from a number of sources, including retained
  profits, loans from banks, borrowing from money and capital markets via issuing corporate bonds
  (“debt financing”), or gaining funds by issuing shares (“equity financing”)

Question 4

What are the characteristics of money?

Answer 4

• Durability i.e. it needs to last
• Portable i.e. easy to carry around, convenient, easy to use
• Divisible i.e. it can be broken down into smaller denominations
• Hard to counterfeit - i.e. it can’t easily be faked or copied
• Must be generally accepted by a population
• Valuable – generally holds value over time

Question 5

Explain the key functions of money

Answer 5

1. Medium of exchange: money allows goods and services to be traded without the need for a barter system.
   Barter systems rely on there being a double coincidence of wants between two people involved in an
   exchange
2. Store of value: this can refer to any asset whose “value” can be used now or used in the future i.e. its value
   can be retrieved at a later date. This means that people can save now to fund spending at a later date.
3. Unit of account: this refers to anything that allows the value of something to be expressed in an
   understandable way that allows the value of items to be compared.
4. Standard of deferred payment: this refers to the expressing of the value of a debt i.e. if people borrow today,
   then they can pay back their loan in the future in a way that is acceptable to the person who made the loan

Question 6

What is narrow money?

Answer 6

The narrow money definition of the money supply is a measure of the value coins and notes in
circulation and other money equivalents that are easily convertible into cash such as short-term
deposits in the banking system

Question 7

What is broad money?

Answer 7

o Broad money is a measure of the total money held by households and companies in the economy
o Broad money is made up mainly of commercial bank deposits — which are essentially IOUs from
commercial banks to households and companies — and currency — mostly IOUs from the central
bank

Question 8

What is a long term loan and give examples?

Answer 8

It finances whole business over many years
Examples:
Share capital
Retained profits
Venture capital
Mortgages
Long-term bank loans

Question 9

What is a medium term loan and give examples?

Answer 9

Finances major projects or assets
with a long-life
Examples:
Bank loans
Leasing
Hire purchase
Government grants

Question 10

What is a short term loan and give examples?

Answer 10

Finances day-to-day trading of a
business
Examples:
Bank overdraft
Trade creditors
Short-term bank loans
Factoring

Question 11

What is debt financing?

Answer 11

Debt financing means borrowing money from an outside source with the promise of paying back the borrowed
amount, plus the agreed-upon interest, at a later date

Question 12

What are the key features of bank loans?

Answer 12

1. Loan is provided over a fixed period (e.g. 5 years)
2. Rate of interest payable is either fixed or variable
3. Timing and amount of loans repayments are set by the lender e.g. a commercial bank
4. Non-performing loans (“bad debts”) occur when the borrower is unable to repay some or all of the debt

Question 13

What is unsecured loan?

Answer 13

Money supported only by a borrower’s creditworthiness, rather than by any type of collateral

Question 14

What is secured loan?

Answer 14

Money you borrow that is secured against an asset you own, usually your home

Question 15

What are examples of equity finance?

Answer 15

• Angel Investors - Individuals who inject capital for business start-ups
• Venture Capital - Firms specializing in building high risk equity portfolios
• Stock Market Listing - Offering shares to public & institutional investors e.g. via an initial public offering (IPO)
• Crowd Funding - Raising capital from a large number of individual investors via platforms such as Kickstarter

Question 16

What are the main functions of a commercial break?

Answer 16

• Commercial banks provide retail banking services to household and business customers
• Banks are licensed deposit-takers providing savings accounts
• They are licensed to lend money and thereby create money e.g. via bank loans, overdrafts and mortgages
• Commercial banks are nearly all profit-seeking businesses
• A bank’s business model relies on charging a higher interest rate on loans than the rate paid on deposits
• This spread on their assets and liabilities is used to pay the operating expenses of a bank and make a profit

Question 17

How do banks create credit?

Answer 17

Banks create credit by extending loans to businesses and households. They do not always need to attract deposits from savers to do this. When a bank makes a loan, it credits their bank account with a bank deposit of the size of the loan/mortgage. At that moment, new money is created in the financial system.

Question 18

How do commercial banks make a profit?

Answer 18

• Interest-rate spreads – i.e. charging a higher interest rate on loans than the rate that is paid to savers
• Service fees - Includes fees charged by a bank to borrowers when arranging loans
• Brokerage percentages - many banks provide currency & share-dealing services and charge a brokerage fee
  for doing so

Question 19

How can banks fail?

Answer 19

1. Run on the bank
   a. Depositors panic and withdraw their money fearing that the bank may collapse
   b. This creates a liquidity crisis for the bank, and they may need to find emergency sources of funding
2. Credit crunch
   a. A bank may be unable to borrow money from other banks even on an overnight basis
   b. Heavy losses and collapsing capital threaten their commercial viability
3. High losses from bad debts / loan defaults as borrowers fail to repay
   a. Credit rating of bank declines and their share price falls – this makes it harder to raise fresh finance

Question 20

What are limits to credit creation by banks?

Answer 20

• Market forces – i.e. the scale of profitable lending opportunities
• Regulatory policies e.g. higher capital reserve requirements imposed by a central bank
• Behaviour of consumers and businesses e.g. decisions about how much of their debt to repay
• Monetary policy – the level of policy interest rates influences the demand for loans from households and
  businesses, for example the demand for business loans and mortgage loans in the housing market

Question 21

What is the liquidity risk for commercial banks?

Answer 21

• Banks tend to attract short term deposits e.g. from savers
• They often lend for longer periods of time e.g. a 20-year mortgage
• As a result, a bank may not be able to repay all deposits if savers decide to withdraw their funds in one go
• To reduce their risk, commercial banks will try to attract long term deposits and also hold some liquid assets
  e.g. cash as capital reserves

Question 22

What is the credit risk for commercial banks?

Answer 22

• This is the risk to the bank of lending to borrowers who turn out to be unable to repay some or all of their
  loans
• Credit risk can be controlled by research into the credit-worthiness of borrowers and also by banks having
  sufficient capital in reserve. Minimum capital reserves may be imposed by the financial authorities

Question 23

What are examples of investment banks?

Answer 23

Question 24

What are investment banks?

Answer 24

• An investment bank provides specialized services for companies and large investors:
  o Underwriting and advising on securities issues and other forms of capital raising
  o Advice on mergers, acquisitions & corporate restructuring
  o Trading on capital markets (bonds and equities)
  o Corporate research and private equity investments
• An investment bank trades and invests on its own account
• Commercial banks can provide investment banking services

Question 25

What are money markets?

Answer 25

Money markets provide short-term finance to banks (and other financial institutions), companies, governments and individuals. This short-term debt will have a repayment period of up to about a year (and it could be as little as 24 hours).

Question 26

What are capital markets?

Answer 26

Capital markets provide governments and firms with medium- and long-term finance.
Governments and firms can raise finance by issuing bonds. Firms can also raise finance by issuing shares or by borrowing from banks.

Question 27

What is a foreign exchange market?

Answer 27

1) Foreign exchange markets are where different currencies are bought and sold. This is usually done to allow international trade and investment, or as speculation (to make money on fluctuations in currency prices).

Question 28

What are forward markets?

Answer 28

Prices are agreed on the day of the deal, but delivery happens later