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Economics > Financial Markets > Flashcards

Financial Markets Flashcards

1
Q

What are financial markets and how do they work?

A

Where buyers and sellers can trade financial assets (e.g bond market, stock market)

Brings together lenders (e.g savers and investors) with borrowers (individuals, firms, governments).

Intermediaries help lenders and borrowers trade their assets by offering a return to lenders and interest rates to borrowers. They make profit from the difference.

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2
Q

What are the 3 types of financial markets?

A
  • Money markets
  • Capital markets
  • Currency markets
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3
Q

What is bought and sold on money markets?

A

Financial assets with a maturity of a year or less (bonds, interbank lending)

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4
Q

What is bought and sold on capital markets?

A

Financial assets with a payback date of greater than a year (bonds, shares).

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5
Q

What is the difference between the primary and secondary capital markets?

A

Primary: brand new bonds or shares are issued
Secondary: bonds and shares can be bought or sold again

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6
Q

What is bought and sold on currency markets?

A

Spots: buy currency at the current exchange rate and recieve it instantly
Futures: buy currency at the current exchange rate but receive it sometime in the future

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7
Q

What is the difference between debt capital and equity capital?

A

Debt capital: financial asset which pays back in interest rate (form of borrowing for the issuer)

Equity capital: own a stake in the business and return is through dividends (share of profits)

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8
Q

List the 4 functions of money.

A
  • Medium of exchange
  • Store of value
  • Measure of value
  • Standard of deferred payment (able to borrow)
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9
Q

List the 6 characteristics of money.
(PADDDL)

A
  • Portable
  • Acceptable
  • Durable
  • Divisible
  • Difficult to forge
  • Limited in supply
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10
Q

What is the difference between commodity money and fiat money?

A

Commodity money has an intrinsic value (e.g gold)

Fiat money has no intrinsic value (e.g notes and coins)

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11
Q

Define the money supply and state the difference between narrow money and broad money.

A

The money supply is the total supply of money circulating in the economy.

Narrow is comprised of notes and coins anddeposits.

Broad also includes non-cash financial assets which are relatively liquid, such as certificates of deposits and bonds.

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12
Q

State the Fisher equation and each of the variables.

A

MV = PQ
- M = money supply
- V = velocity of circulation
- P - average price level (inflation)
- Q = quantity of goods and services

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13
Q

What is the quantity theory of money?

A

There is a direct link between money supply and inflation.

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14
Q

Why do monetarists argue that inflation is only affected by the money supply?

A

Data shows that velocity of circulation (V) and real GDP (Q) don’t change enough to affect price levels.

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15
Q

Give an example of increase in the money supply without inflationary pressure (Keynesian view).

A

During a recession, economy can be caught in a liquidity trap, where money supply (M) is significantly increased but velocity of spending (V) is significantly reduced.

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16
Q

List the 3 factors controlled/ carried out by the central bank that affect the money supply.

A
  • Reserve requirement
  • Bank Rate
  • Open market operations
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17
Q

What is a bond?

A

An IOU which guarantees the holder with regular interest payments as well as the value of the bond when it matures.

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18
Q

Who buys and sells bonds, and why?

A

Governments can issue bonds to finance spending in the economy, and firms can issue bonds to finance investment.

Any economic agent can buy a bond. They may do so if the return on the bond is better than other available financial assets, and they’re generally safe (likely to be paid back).

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19
Q

State the bond yield calculation.

A

Yield = (coupon/ market price) x100

20
Q

Why is the bond yield useful?

A

An investor will look at the yield on the bond and compare it to interest rates/ returns on other financial assets to decide whether or not to buy/ hold the bond.

21
Q

What happens to bond yields over time?

A

The yield will equalise with average returns on other financial assets (either through the coupon or market price).

22
Q

How is the money multiplier calculated?

A

Money multiplier = 1/reserve ratio

23
Q

List the functions of commercial banks.

A
  • Accept savings
  • Lend
  • Act as financial intermediaries
  • Allow payments from one agent to another
  • Advice
24
Q

List the functions of investment banks.

A
  • Prop trading
  • Market making
  • Mergers and Acquisitions
  • New issues
  • Manage large investment portfolios
25
Q

What is meant by systemic risk in banking?

A

The risk of the collapse of the entire financial sector or an entire market due to the failure of one institution/ market.

26
Q

How can systemic risk occur?

A

Most banks have both a commercial and investment banking side. If one side is to fail, it could bring down the whole bank. As so many banks are interconnected, one bank failing could bring down the whole financial sector.

27
Q

What is a commercial bank’s Balance Sheet?

A

A record of all assets, liabilities and capital at any given point in time.

The Balance Sheet must balance where assets = liabilities + capital

28
Q

What are the 2 types of commercial bank failure, and what wider impacts can they have?

A

Bank run: not enough liquid short-term assets to meet short-term liabilities.

Insolvency: not enough capital to offset losses in asset values. Liabilities > assets

Systemic risk, deep recession, bank bailouts (and associated negative externalities)

29
Q

List the 4 roles of the central bank.

A
  • Implement monetary policy
  • Act as a banker to the government (buy and sell bonds)
  • Act as a banker to the banks (offer immediate/ periodic liquidity) and allow banks to fail safely
  • Regulate the financial system
30
Q

What 4 issues arise from the central bank acting as a ‘lender of last resort’?

A
  • Promotes moral hazard
  • Banks may not hold sufficient liquidity knowing they can rely on the central bank
  • Regulatory capture (regulators impose relaxed conditions due to having contacts in banks)
  • Why should banks have this luxury and not other firms?
31
Q

What 2 groups do financial market failures fall into, and what impacts do they have?

A
  1. Excessive risk leading to the overall collapse of the financial system (overproduction of financial assets)
    Consequences:
    - Systemic risk (loss of confidence and faith in banks)
    - Recession, lost incomes and jobs, financial crisis
    - Bank bailouts - negative externalities
  2. Collusion and fixing of interest/ exchange rates - monopoly pricing
32
Q

What is a leveraged deal?

A

Borrowing to amplify the end outcome of a deal.

33
Q

Outline how speculation and market bubbles lead to financial market failure.

A
  • Buy assets cheap and sell at a higher price.
  • What if prices fall and the deal is leveraged?
  • Excessively high estimates of future price increases can create a market bubble and overpaying for assets.
  • Eventually demand and price will fall leading to worthless assets and huge debts.
34
Q

Outline how asymmetric information can lead to market failure.

A

When most likely buyers are those the seller would prefer not to sell to due to imperfect information (adverse selection), leading to excessive risk being taken.

35
Q

List the 4 ways deregulation of financial markets in the UK and US increased likelihood and severity of financial market failure and systemic risk.

A
  • Taking away regulated capital/ liquidity ratios
  • Scrapping reserve requirements
  • Using commercial bank funds for investment bank activities
  • Banks can take greater risks, so will fail hard when they do
36
Q

List the 4 ways negative externalities lead to financial market failure?

A
  • Cost to the taxpayer of bailouts
  • Loss of savings
  • Lost jobs, incomes and growth
  • Risks are ignored, leading to an overproduction of risky financial assets
37
Q

What is market rigging, and how can it lead to financial market failure?

A

Where traders/ bankers/ intermediaries collide to manipulate markets and make huge profits

e.g rigging LIBOR and FOREX markets

Heavy fines and regulations in place but rigging can still occur if punishment and enforcement is too weak

38
Q

Outline the role of the Financial Policy Committee (FPC).

A
  • Macro-prudential regulation
  • Identify, monitor and protect against systemic risk
  • Instruct PRA and FCA in tackling financial stability issues
  • Advise government (response to shocks, bailouts)
  • Carry out stress tests and provide emergency liquidity
39
Q

Outline the role of the Prudential Regulation Authority (PRA).

A
  • Microprudential regulation
  • Maintain stability of banks
  • Supervise management of risk
  • Setting industry standards for conduct and management and enforcing these
  • Specify ratios and requirements
40
Q

Outline the role of the Financial Conduct Authority (FCA).

A

Protect consumers and increase confidence in financial institutions/ products by:
- Supervising conduct of firms/ markets to ensure legal business activity
- Promote competition so consumers get better deals
- Banning financial products against interest of consumers
- Banning or changing misleading adverts for financial products

41
Q

List the 9 types of financial market regulation.

A
  • Banning market rigging
  • Prevent sale of unsuitable products to consumers
  • Maximum interest rates
  • Deregulation
  • Deposit insurance
  • Ringfencing
  • Set limits on bank lending
  • Liquidity assurance with conditions and punishments
42
Q

How is the cash ratio calculated?

A

Cash assets / short term liabilities

43
Q

How is liquidity ratio calculated?

A

Short term assets / short term liabilities

44
Q

What is the reserve requirement?

A

The fraction of deposits that must be held at the BoE.

45
Q

How is capital ratio calculated?

A

Capital / Loans
(can specify which loans)

46
Q

How is the leverage ratio calculated?

A

Capital / loans & long term investments

Economics (4 decks)

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