Financial Markets

Question 1

4 Functions of Money

Answer 1

1. Medium of Exchange
2. Store of Value (eg. savings and investments)
3. Standard of deferred payments (Future payments)
4. Unit of Account

Question 2

Characteristics of money

Answer 2

Portability
Divisibility
Durability
Hard to counterfeit (not easy replicable)

Question 3

Difference between ‘Narrow’ and ‘Broad’ Money

Answer 3

Narrow money is the stock of money made from cash and liquid deposits.

Broad money is the stock of money made from cash and liquid deposits, and less liquid assets.

Question 4

Roles of financial markets

Answer 4

To lend to businesses and households
To facilitate savings by businesses and households.
To facilitates exchange of goods and service
Provide a market for equities eg. stocks and bonds

Question 5

3 different ways firms can raise capital…

Answer 5

1. Borrowing a bank loan
2. Selling shares to investors
3. Selling corporate bonds

Question 6

Money Markets

Answer 6

Money markets are short term finance to firms and household. Money is borrowed and lent within 12 months from commercial banks.

Question 7

Capital markets

Answer 7

Capital markets are medium to longer term finance, through shares and bonds for PLC’s.
- eg. sales of government bonds

Question 8

Bonds & Coupons

Answer 8

Bonds are financial securities which are a long term form of borrowing. (gov. borrows from investors)

Coupons are the fixed annual interest, paid by the issuer to the owner of the bond.

Question 9

Yield on bond

Answer 9

Coupon / Bond price x 100

Question 10

Why is the relationship between bond prices and interest rates.

Answer 10

If coupon rate is higher than interest rate, investors demand for bond will increase, and so will bond price.
As more investors buy bond, yield on bond falls.
Investors than save in accounts for interest.

Question 11

Investment banks

Answer 11

Investment banks provide services for companies and large investors.

• Advise on security issues and capital raising methods
• Trading on capital markets and equity investments.
• Trade and invest on its own account.

Question 12

Commercial banks

Answer 12

Commercial banks help with the flow of money in the economy by providing deposit and credit eg. HSBC and Barclays - operate on profit.

Question 13

Objectives of commercial bank

Answer 13

• Liquidity (to pay deposits)
• Profitability
• Security

Question 14

Central Bank

Answer 14

Central banks formulate monetary policies of the economy on behalf of the government - described as ‘monetary authorities’. eg. bank of England
- Also act as a banker to the government.

Question 15

Funding for Lending - Central Banks

Answer 15

Funding for Lending is when the B of E makes funds available for commercial banks to loan.

Question 16

Forward Guidance - Central Banks

Answer 16

Making announcements about changes in the Interest Rates so agents can adapt accordingly.

Question 17

Causes of Bank Failure

Answer 17

Borrowing and Lending issues

Liquidity and Capital Ratios

Moral Hazard eg. Government promises to bail out banks, leading to excessive risk taking by banks and firms leading to losses.

*Systemic Risk

Question 18

Monetary Policy Committee (MPC)

Answer 18

MPC meet once a month to review the British economy, and vote on interest rate levels.
When setting the bank rate, they look at….

*Real Wages
*Inflation rate
*Consumer confidence
*Economic shocks

Question 19

Transmission Mechanism of Monetary Policy

Answer 19

How changes in bank rate affects the economy…

1. Change in the Bank Rate
2. Impact on consumer confidence
3. Impact on output, jobs and investment
4. Real GDP and inflation.

However, it can take 12-24 months for the impact of IR to occur, depending on the responsiveness of the economy .

Question 20

Financial Policy Committee (FPC)

Answer 20

Identify, monitor and protect against systemic risk, by telling commercial bank to alter capital reserves to protect against losses.

Question 21

Prudential Regulation Authority (PRA)

Answer 21

Maintain the stability of commercial banks, through ratio requirements.

Question 22

Financial Conduct Authority (FCA)

Answer 22

FCA Report to the treasury.
Prevent market abuse and ensure consumers and firms get fair deals from financial authorities.

Question 23

Liquidity Ratio (Current Ratio)

Answer 23

Current Assets / Current Liabilities

Question 24

Capital Ratio

Answer 24

Capital (Profit + Shareholder) / Advances

Question 25

Leverage Ratio

Answer 25

Capital / Loans + Long term investments

Question 26

Examples of Financial market regulation

Answer 26

FPC altering capital reserve ratio to ensure cash is accessible to loan to firms and households to protect against systemic risk.

Regulatory supervision of commercial banks. eg. Stress tests after the 2008 financial crisis, to test whether banks can adhere to economic shocks. Protects against Moral Hazard.

Question 27

Fishers Equation

Answer 27

Fishers equation shows that the total spending in an economy (MV) is equal to the total value of goods and services produced (PQ). MV = PQ

M = Money supply in the economy
V = Velocity of money in the economy
P = Price of goods and services produced
Q = Quantity of goods and services produced