4.4.1 The Role of Financial markets Flashcards
What are the five roles of financial markets?
- To facilitate saving
- To lend to businesses and individuals
- To facilitate the exchange of goods and services
- To provide forward markets in commodities and currencies
- To a market for equities
Identify 3 examples of financial markets
- FOREX (Foreign Exchange market
- Capital markets (share, and bonds
- Derivatives markets (futures)
- Money Markets (treasury bills)
Why are financial markets important?
Because the financial markets support the real economy - without them businesses would find it hard to raise finance for investment, and could not run efficiently day to day. The Global Financial Crisis is an illustration of how important financial markets are to the smooth running and growth of economies.
What is meant by liquidity?
Liquidity refers to the ease with which an asset can be converted into cash in order to settle a liability - if it is cost free and quick to turn an asset into cash, then it is said to be liquid.
Name 2 assets that are liquid
- Bond
- Shares
Name 2 assets that are less liquid
- Houses/property
- Paintings
What is the purpose of a forward market for currencies?
It reduces risk for businesses around exchange rate fluctuations - if you have a forward contract for currencies, then you know in advance and can plan what your liabilities will be in the future (if those liabilities need to be settled in a foreign currency)
What is the purpose of a forward market for other commodities?
It also reduces risk for business around price fluctuations in those commodities. If your business purchases a large volume of commodities, having a futures contracts guarantees supply of the commodity and guarantees price too, so that you can plan your liabilities and ensure you have enough liquid assets to cover your liabilities when the time comes to pay.
What is meant by narrow market? (M0)
Narrow market is notes and coins in circulation - it makes up less than 3% of all money in circulation in the UK economy
What is meant broad money? (M4)
Broad money includes M0, plus money kept in bank accounts as deposits by households, businesses and financial institutions
What is meant by asymmetric information in financial markets and give an example?
Asymmetric information is when either the buyer or the seller of financial products/services has more information than the other party - this allows one party to exploit this to their advantage.
An example of this is mis-selling of pensions which are a complex product, where the company selling the pension has more information than the buyer
What is meant by market rigging in financial markets and give an example?
Market rigging is when the market is fixed by a producer or group of producers so that they benefit - it is a form of collusion that gives some parties an unfair advantage over others in the market. i.e. fixing the LIBOR rate
What is meant by a ‘bubble’ and give an example?
A bubble is when an asset rises in value, and herd mentality means that people continue to buy into this rising market even after the price rises higher than the true value of the asset. This can then cause an abrupt crash as people reverse their actions and sell quickly
What is meant by negative externalities in financial markets, and give an example?
Negative externalities are costs to a third party in a financial transaction who were not part of the transaction. i.e. when traders took excessive risks in the GFC and shareholders and depositors suffered third party costs.
What is meant by moral hazard in financial markets, and give an example?
Moral hazard is when the negative effects of a decision do not fall on the person making the decision, leading to risky behaviour. i.e. banks were ‘too big to fail’ and that the government will bail them out of any financial difficulties they get into. This means there is little incentive to manage risk effectively, and the cost of failure is picked up by the government.
