Financial markets Flashcards
financial markets
what are financial marketss
places where buyers and sellers can trade financial assets
- brings together lenders and borrowers
what are lenders
those who have excess cash - eg savers and investors
what are borrowers
ppl who need cash right now but dont currently have it - eg individuals, firms, govts
points how the financial market works
- lenders can go directly to bond markets or stock markets, eg can go to debt management and buy govt bonds, lending to the govt
- they can go directly to companies and buy shares(equity capital)
- they can go to an intermediary,
objectives of commercial banks
-Earn profits by providing financial services and charging interest on loans.
-takes funds from lenders, a return is then paid on this money. from these savings, loans can be made, and lent out to individuals or firms who need to borrow and an interest rate is charged
- the interest rate to the borrowers is higher than the return to the lenders, so the commercial bank can make profit
what is the primary objective of all intermediaries
to make profit
pension funds
- take huge sums of money from individuals looking to save for retirement
- theyll invest it normally in stock markets
- then theyll pay an annuity to pensioners when they reach pension age
what are the types of intermediaries
- commercial banks
- investment banks
- pension funds
- hedge funds
- mutual funds
- stock exchanges
- insurance companies
hedge funds/mutual funds
institutions that take huge sums of money from lenders and will buy huge amounts of debt from it (debt issued by borrowers)
- theyll collect interest rates as the payments on all their debt theyre buying
- then will give a rate of return to their investors
difference between hedge funds and mutual funds
hedge funds engage in riskier transactions, eg hedge funds will buy up debt in leverage deals, which if they went wrong, large sums of money could be lost
- mutual funds are less regulated than hedge funds
similarities between hedge and mutual funds
both take huge amounts of money from investors, buy a lot of debt, get an interest rate and a rate of return
types of financial markets
- capital markets
- money markets
- currency markets
features of money markets
- the buying and selling of financial assets here, are ones that have a maturity or payment date of a year or less - eg govt bonds or corporate bonds, any interbank lending
features of capital markets
- buying and selling of assets that have a payback date of greater than a year, not as liquid as money market assets
What is the difference between debt capital and equity capital?
Debt capital is any financial asset that pays back in interest rate - eg bonds
Equity capital is where the return is a dividend - eg shares
what is a dividend
a share of the profit
what is a primary market
a primary market is where brand new bonds will be issued, eg through an investment bank
what is a secondary capital market
where new bonds and shares can then be bought and sold again - eg through investment banks or stock exchange
what is a spot currency market
- where you can buy currency at the current exchange rate and get it delivered to you right now
what are futures/forward markets
- where you can buy currency at the given exchange rate, but that currency is delivered to you some time in the future
why would ppl engage in futures market transactions
- eg if ur an importer, and worried about a weak exchange rate in a few months time(WIDEC), importing raw materials when exchange rate is weak causes higher costs
- you could buy your currency now at current exchange rate, get it delivered to u in a few months time when the currency gets weaker, and you’re not affected by it
Market Efficiency and Price Discovery
- Futures markets play a crucial role in price discovery by providing a platform where current expectations about future prices are reflected in contract prices.
- This helps set transparent and consistent pricing for both producers and consumers
Speculation and Profit Potential
- Speculators engage in the futures market to profit from price movements, hoping to buy low and sell high (or vice versa).
- These market participants don’t necessarily own the underlying asset; they seek to make a profit by predicting price trends.
what are the four functions of money
- a medium of exchange
- a store of value - cant deteriorate overtime
- measure of value
- method of deferred payment - people that dont have money rn can borrow it from those that do, then they can pay that money back overtime
characteristics money needs to have
- has to be acceptable
- has to be portable
- durable
- divisible
- limited in supply so it keeps it’s worth
- difficult to forge
what is commodity money
money which has intrinsic value - eg gold
what is fiat money
money with no intrinsic value, eg if the money loses value, u cant trade it for something else
- eg notes and coins
types of money
- notes and coins
- deposits - high liquidity
- near money
what is liquidity
the ease at which money can be converted into cash
what is the money supply
the total amount of money circulating in the economy
what is M0
a measure of the money supply which includes the total amount of notes and coins in the economy, and all the deposits that individuals have in bank accounts, eg savings
what happens as we go from m0 to m4
we add more non cash financial assets into our measure of the money supply
- NonCashFinancialAssets are liquid, but not as liquid as notes and coins
what are the roles of financial markets
- To lend to businesses and individuals to help them consume/invest
- to facilitate the exchange of goods and services by providing a flat currency ,increasing consumption/investment
- to provide forward markets in currencies and commodities to reduce risk
- to provide a market for equities to facilitate raising of finances by businesses
what is the quantity theory of money
the theory that links growth rate in the money supply to growth rates in prices eg inflation
what is near money
non cash assets which can be easily converted into money, eg bonds, with maturity dates of years, can convert into cash easily
fisher equation (the quantity theory of money)
MV=PQ -
-M = money supply
- V = velocity of circulation (how many times the cash has been spent)
- P = average price level
Q = Quantity of goods/services sold
the quantity theory of money explained
- An increase in the money supply, holding V constant, could lead to a proportional increase in either the price level or real output
- If money circulates more quickly (higher, it can have the same effect as increasing the money supply, potentially driving up prices or output.
- If the price level rises (inflation), it might indicate that more money is chasing the same amount of goods and services, reflecting inflationary pressure
- Increases in Q reflect economic growth, assuming that prices (
P remain constant. - MV represemnts what is bought (nominal)
- PQ represents what is sold (nominal)
MV=PQ application
- The Quantity Theory of Money suggests that if M increases and Q remains constant (or grows slower than M), the price level
P will rise, leading to inflation. - : Central banks can use the equation to predict the impact of changes in the money supply on the economy. For example, increasing M can stimulate economic activity, but it may also risk higher inflation if Q does not keep pace.
- The equation highlights the importance of both the money supply and the velocity of money in driving economic activity. If
Q increases (economic growth), the economy can accommodate a higher money supply without inflationary pressure.
P= MV/Q, how do the 3 variables affect price
- If the money supply increases while
V and Q remain constant, more money is available to purchase the same amount of goods and services. This increased demand can push prices up, leading to inflation. - VELOCITY
- If the velocity of money increases, it means that money is changing hands more frequently, which can increase the effective demand for goods and services, pushing prices up.
If the velocity decreases, it suggests that money is circulating more slowly, which might reduce demand and lead to lower price levels, assuming the money supply and output remain constant. - OUTPUT
- If real output increases while
𝑀
M and
𝑉
V remain constant, it means more goods and services are available. This can lead to lower prices since the supply of goods and services has increased relative to the money supply.
If real output decreases (e.g., due to a recession), with M and V constant, fewer goods and services are available. This can lead to higher prices, as more money chases fewer goods.
monetarists view on the quantity theory of money
- Monetarists argue that in the long run, the money supply is the primary factor influencing the price level with velocity of money and real output assumed to be stable or fixed.]
- The central bank increases M, such as through lower interest rates or open market operations.
- Monetarists believe V remains stable, so the increase in M directly increases total spending power (MV)
- In the long run, Q is determined by factors like labor and technology, and is assumed to be constant at its potential level.
- With V and Q fixed, the increase in M leads to a proportional increase in P (inflation), as more money chases the same amount of goods and services.
Why do Keynesians disagree with monetarists M=P
- Keynesians argue that
V is not fixed and can fluctuate due to various economic factors - Keynesians believe that
V, or the rate at which money circulates, is not constant. It can vary due to changes in consumer confidence, financial innovations, or economic conditions. - If V increases, the same amount of money circulates more rapidly, boosting aggregate demand without necessarily increasing the money supply. This can lead to higher prices and inflation if the economy is at full capacity.
- Prices and wages may not adjust immediately due to rigidities. This stickiness means that changes in
M might temporarily boost output and employment before leading to inflation.
why was quantitative easing used following the GFC 2008
- to stimulate growth by increasing money supply
- to increase bank liquidity so they would be more willing to lend
- interest rates were already very low so limited scope for further reductions
- to prevent deflation by increasing the money supply
what are forward markets
- markets where firms buy they currency in advance
- firms agree a fixed price for purchase of foreign currency in the future
impacts of forward markets
- enables firms to reduce risk/uncertainty
- firms can be certain about the cost of their imports in pounds
how did the 1986 big bang increase the risk of systemic risk - removal of liquidity ratios
- Banks hold fewer liquid assets, reducing their ability to meet sudden demands for cash, such as large withdrawals.
- With fewer liquid assets, banks unable to absorb shocks
- if depositors sense this, they may withdraw their funds due to fear of not getting repaid
- the baks may sell assets quickly often at a loss
- this causes them to become insolvent
