Chapter 2: Borrowing and Saving

Question 1

What is a ‘High Net Worth Individual’?

Answer 1

Individuals who have substantial amounts of surplus money.

Question 2

Give the three main ways financial markets provide the link between borrowers and savers.

Answer 2

1) By the banks
2) By equity
3) By bonds

Question 3

How do banks provide a link between borrowers and savers?

Answer 3

Traditionally, banks have provided a convenient link between savers and borrowers, making a profit on the difference between what they pay savers and what they charge borrowers.

Question 4

What is equity?

What are the two key differences between debt and equity?

Answer 4

For businesses looking to raise money, an alternative to borrowing from banks is for the business to sell equity.

Equity is alternatively referred to as shares or stock and it represents
ownership.
The holders of the equity in a company own that company.
So, if a business is set up as a company, it can raise money by selling shares.

Interest needs to be paid on borrowing, and the money borrowed has to be repaid.
There is no interest paid on equity and equity does not need to be repaid.

Question 5

What are bonds?

Answer 5

Bonds are issued directly to the investors, missing out the banks.

Like a loan from a bank, borrowing money by issuing bonds is another form of debt on which the borrower will pay interest and which needs to be repaid.

Question 6

Which is more expensive (in terms of annual cash costs), borrowing or equity? (1)

Answer 6

Borrowing
1) Requirement to pay interest each year. Equity does not require interest payments.

Question 7

Which is likely to need to be paid earlier, borrowing or equity? (1)

Answer 7

Borrowing
1) Borrowing is generally required to be repaid on or by an agreed future date. There is no such requirement to shares.

Question 8

Which is more likely to be available to a start-up, borrowing or equity? (3)

Answer 8

Equity
1) Since a start-up has often not established a pattern of making money, borrowing is often unavailable.
2) Equity finance may be available from investors willing to take a risk in the hope of a substantial return if the start-up is successful.
3) Governments often provide incentives for equity investors in early stage and start-up companies that enable them to save some tax. The logic of the incentives is to encourage job creation and increase the attractiveness of investing in the equity of a start-up.

Question 9

Which is more likely to be risk to the finance provider, borrowing or equity? (3)

Answer 9

Equity
1) If the company is a start-up, both forms of finance are risky
2) If the business gets off the ground but does not prove successful, lenders will at least receive some interest.
3) If the company fails and there is some money left, the borrowing is repaid before the equity.

Question 10

Which is more likely to have the largest potential upside for the finance provider, borrowing or equity? (3)

Answer 10

Equity
1) When a company does well, it is the shareholders as owners who benefit.
2) The upside for lenders is simply to get paid interest and repaid the loaned money in full.

Question 11

What are the different types of borrowers (3)

Answer 11

1) Companies
2) Individuals
3) Governments

Question 12

What is the main way that governments collect money?

What do they spend it on?

Answer 12

Governments collect substantial amounts of money in the form of taxes.

Taxes are spent on things like roads, hospitals, defence, education and the wages of government staff.

Question 13

Why do governments borrow money?

How do governments borrow money? Who are the main lenders? (2)

Answer 13

In some cases government expenditure exceeds government revenue, the difference is generally borrowed.

Government borrowing is financed through regular bond issues bought mainly by individuals and firms.

In early 2021, the UK government had outstanding bonds that added up to more than £2.1tn and the us had more than $28tn. This is known as the national debt.

Question 14

Name three countries in which the government generates a surplus and provide a reason.

Answer 14

1) Norway - this is often due to an abundance of natural resources - particularly oil & gas.
2) Some Guld states - same as above.
3) Singapore - due to a very successful economy and careful government spending.

Question 15

What is the link between risk and reward when making an investment?

Answer 15

There is a direct link between the risk the investor is willing to take and the reward the investor might realise on their investment.

The higher the level of risk the investor is willing to take, the higher the potential reward might be.

Question 16

What may determine the level of risk between two bonds or two equities?

Answer 16

When looking at two bonds, or two equities, the bonds or equities
issued by the smaller, less financially secure entity are going to be more risky than the bonds or equities issued by the larger, more financially secure entity.

Question 17

What are the main reason investors buy equities? (4)

Answer 17

1) Fundamentally, they hope the company will perform well and generate profits.
2) A share of these profits might be paid by the company to the shareholders in the form of dividends.
3) Holders of equity know that they will be able to sell the equities they own to someone else.
4) Selling the equities will enable them to realise their investment, potentially for more money than they paid for the shares.

Question 18

How can equities be bought and sold?

Answer 18

Facilities to sell equities are provided by the
equity markets and include world-famous
exchanges such as the New York Stock Exchange (NYSE).

Question 19

Name six major exchanges.

Answer 19

1) NYSE
2) ADX (Abu Dhabi Securities Exchange)
3) LSE
4) Europe’s Euronext Exchange
5) TSE (Tokyo Stock Exchange)
6) SSE (Shanghai Stock Exchange)

Question 20

How are bonds traded?

What is OTC?

Answer 20

Bonds can be bought or sold before they reach their repayment dates. However, in contrast to equities, most bonds tend to be bought and sold away from the big exchanges.

Those buyers of bonds that do wish to sell before the repayment date are brought together with sellers of bonds via electronic facilities that are generally described as over-the-counter (OTC) facilities.

OTC is simply a term for trades that are arranged away from the established exchanges.

Question 21

What is the main provided by the insurance industry?

What does an insurance company do?

Answer 21

Risk Management

The insurance company will take on specified risks in exchange for a series of premium payments. If the risk materialises, the insurance company will pay out.

Question 22

What is a ‘life policy’?

Answer 22

Where an individual insures that, if they die, their dependants will receive a lump sum of money sufficient to clear the mortgage loan on the family home.

Question 23

How do insurance companies manage risk when it sell insurance for a risk that may be too big to bear alone?

Answer 23

To manage the risk, insurance companies can, and do, take out insurance themselves and this is generally referred to as reinsurance. Reinsurance allows the risk taken on by insurance companies to be shared.

Question 24

What is Foreign Exchange?

Answer 24

Foreign exchange (Forex, or FX) is simply
changing a particular quantity of one currency, for a particular amount of another currency.

Question 25

Which currency is regarded as most important in terms of foreign exchange?

Answer 25

The US dollar is regarded as the most important
currency in the world, and as a result it is typical
that the way foreign exchange tends to be
quoted is by the number of a particular currency
that a US dollar is worth.

Question 26

What is the attraction of foreign exchange to banks and their dealers? (3)

Answer 26

1) Providing services their clients need, arising from international trade and international travel in particular.
2) The banks and their dealers will earn fees as a result.
3) In 2019, the daily activity in foreign exchange is reportedly exceeding a massive $6.6 trillion (that’s $6,600 billion), reflecting the scale of international trade.