Financial markets 2 Flashcards
1
Q
what is a money market
A
where financial assets are bought and sold with IOU’s less than or equal to a year
2
Q
why does the demand curve slope downwards on a money market diagram
A
- The interest rate represents the opportunity cost of holding money instead of investing it in interest-bearing assets like bonds or savings accounts. When interest rates are high, people are less inclined to hold money because they can earn more by investing it. ther than investing it.
- As interest rates fall, money becomes more attractive relative to other financial assets. People substitute away from bonds or savings accounts (which offer low returns) and hold more money instead, increasing the quantity of money demanded.
3
Q
why is the money supply curve vertical
A
- : The central bank determines the money supply. Since the central bank sets the money supply, it does not change in response to the interest rate. Whether the interest rate is high or low, the central bank controls the quantity of money, so the supply of money remains fixed at a particular level in the short run.
4
Q
when supply=demand on money market diagram, we get…
A
equilibrium interest rate
5
Q
factors affecting the supply of money
A
- reserve requirements
- change in discount rate, repo rate, bank rates
- open market operations
6
Q
what is reserve requirement
A
the amount of money commercial banks need to keep in the Bank of England (by law)
7
Q
what is bank rate
A
the rate at which commercial banks borrow from the bank of England in order to meet their liquidity need
8
Q
what are open market operations
A
the buying and selling of govt bonds
9
Q
how can central banks alter money supply using reserve requirements
A
- When the central bank lowers reserve requirements, banks need to hold less money in reserve, freeing up more funds for lending
- Banks can lend out a greater proportion of their deposits. Since loans create deposits, the money supply in the economy increases through the money multiplier effect.
- As banks lend more, the total money supply (M) in the economy rises because more loans mean more deposits and, hence, more money in circulation.
-
10
Q
how can central banks alter the interest rate using discount/repo/ bank rates
A
- When the central bank lowers the bank rate, long-term borrowing becomes cheaper for commercial banks
- Lower costs encourage banks to borrow more, increasing their capacity to lend to businesses and consumers
- With more lending capacity, banks may reduce the interest rates they charge to attract borrowers, leading to lower market interest rates.
- Lower interest rates stimulate investment and consumption, boosting economic growth
11
Q
how do central banks use open market operations to alter interest rates
A
When the central bank buys government bonds from commercial banks or the public, it pays for these bonds by crediting the reserves of the banks. This increases the total reserves in the banking system.
- With more reserves, banks have more money to lend, which increases the supply of credit in the economy.
- The increased supply of credit leads to a decrease in the interest rates, particularly the short-term rates like the federal funds rate in the U.S. This is because banks now have more reserves and thus are more willing to lend at lower rates to attract borrowers.
- Lower interest rates make borrowing cheaper for businesses and consumers, encouraging investment and spending. This can lead to economic expansion, particularly when the economy is operating below its potential.
12
Q
what is a bond
A
a piece of paper (IOU) that guarantees the holder of the bond 2 things:
- regular interest payments every year
- they get the value of the bond back once it matures
13
Q
who issues bonds and why
A
government - need to raise finances to help them with their spending in the economy (if they havent got enough tax revenue), they will issue government bonds
firms looking to invest - if they dont have the retained profit, they will borrow to invest, corporate bonds
14
Q
who can buy bonds and why
A
- anyone, individuals, firms,govt
why? - the return on the bond might be better than the retun on other financial assets
15
Q
what would be on a bond
A
- name(treasury gilts)
- coupon(interest rate fixed over duration)
- maturity(when the bond expires/is paid back)
- market price -
16
Q
nominal value of bond
A
face value or par value, is the amount that the issuer agrees to repay the bondholder at maturity
17
Q
difference between nominal value and market price
A
The nominal value is the fixed amount that the issuer agrees to pay the bondholder at maturity, while the market price is the current price at which the bond can be bought or sold in the market, which can fluctuate above or below the nominal value based on interest rates, credit risk, and other factors.
18
Q
bond yield equation
A
yield = coupon/market price (x100)
19
Q
relationship between market price and yield
A
as the market price goes up, yield goes down
- If the bond price goes up, the yield goes down because the fixed coupon payment represents a smaller percentage of the higher price.
20
Q
how does fractional reserve banking work
A
- A customer deposits money into a bank, which becomes part of the bank’s reserves.
- The bank is required to hold a certain percentage of the deposit as reserves (e.g., 10%) and can lend out the rest.
- ## Each bank in the chain repeats the process, lending out a portion of the deposits it receives, which increases the total money supply in the economy
21
Q
how to work out the extra money can be created from an initial deposit
A
the money multiplier equation
22
Q
money multiplier equation
A
1 / reserve ratio, eg if the reserve ratio is 10%, its 1/0.1
23
Q
what is the reserve requirement in the US
A
10%
24
Q
how to work out the increase in money supply from the deposit and money multiplier
A
multiple the money multiplier answer by the original deposit, then take away the money multiplier answer from the previous answer
25
evaluation points for fractional reserve banking
- The system relies on depositors’ confidence that they can withdraw their money when needed. Loss of confidence, eg in a recession, can lead to bank runs, undermining the system.
- Strong regulatory oversight is crucial to ensure that banks manage their reserves prudently and do not take excessive risks.
- Excessive money creation through fractional reserve banking can lead to inflation if the money supply grows faster than the economy’s productive capacity.
- The effectiveness and safety of fractional reserve banking heavily depend on the reserve ratio set by the central bank. A lower ratio increases the potential for money creation but also raises the risk of liquidity shortages.
26
roles of a commercial banks
eg NatWest,HSBC
- accept savings
- lend to borrowers
- to act as financial intermediaries (give a smaller rate of return on savings compared to the interest rate charged to borrowers so they make profit
- to allow payments from one agent to another
- offer advice, insurance,financial etc
27
role of investment banks
eg JP morgan
- prop trading -taking any excess capital that investment banks have and try to get a better rate of return
- market making - ensuring that markets can exist, eg a place where ppl can buy and sell bonds
- mergers and acquisition - advisory roles that help people wanting to merge etc
- new issues
28
what is underwriting
the process where the bank helps companies raise capital by buying their securities (like stocks or bonds), add a percentage fee, and then sell them to investors
29
what is systemic risk
refers to the potential for a major disruption in the financial system, where the failure of one or a few banks can trigger a widespread crisis, leading to severe economic consequences.
30
what is a banks balance sheet
a record of all assets,liabilities and capital at any given moment in time
31
what are assets
anything of value that can be converted into cash that a commercial bank owns
- Cash and Reserves: The most liquid assets, including physical cash held by the bank and deposits with the central bank
- Loans and Advances: The largest category on most bank balance sheets, consisting of money lent to individuals, businesses, and governments. These loans generate interest income, which is a primary source of revenue for the bank.
- Investments: Securities such as government bonds, corporate bonds, and other financial instruments that the bank holds
- fixed assets: Physical assets like buildings, branches, and equipment that the bank owns and uses to operate its business.
-
32
what are liabilities
anything that a commercial banks OWE,eg deposits,short and long term borrowing
33
what is capital (banking)
a section within the liability component, comprises of:
- shareholder funds
- retained profit
34
the balance sheet must balance when
assets = liabilities +capital
35
What are the key functions of central banks
Implementation of monetary policy: Managing inflation, interest rates, and money supply to stabilize the economy.
Banker to the government: Managing the government’s accounts and debt issuance.
Banker to the banks (lender of last resort): Providing liquidity to commercial banks during times of financial strain.
Role in regulation of the banking industry: Supervising and regulating banks to ensure financial stability and protect consumers.
36
reasons for credit crunch
💳 Decline in Bank Liquidity
Banks experience a reduction in available funds due to economic uncertainty
➡️ Banks become more risk-averse and unwilling to lend
➡️ This reduces the availability of credit to consumers and businesses
➡️ Leads to a credit crunch, making borrowing more difficult
🏦 Increased Bank Capital Requirements
Regulatory authorities increase capital adequacy requirements for banks
➡️ Banks need to hold more capital in reserve to cover potential losses
➡️ This reduces the amount of capital banks have available to lend
➡️ Can result in a reduction in the supply of credit in the economy
📉 Fall in Asset Prices
A significant fall in the value of assets like real estate or stocks
➡️ Banks face higher levels of non-performing loans (bad debts)
➡️ They become more reluctant to lend, fearing defaults
➡️ The overall supply of credit in the economy contracts
🏚️ Economic Downturn
Economic slowdown or recession reduces confidence in borrowers' ability to repay loans
➡️ Banks tighten lending criteria and increase interest rates to mitigate risk
➡️ Consumers and businesses find it more difficult to access affordable loans
➡️ Leads to a credit crunch, limiting economic recovery
37
How does quantitative easing alleviate
💰 Increase in Bank Reserves
The central bank purchases financial assets (like government bonds) from banks
➡️ This injects new money into the banking system
➡️ Banks’ reserves increase, which improves their liquidity
➡️ Banks are more likely to lend as they have more available funds
📉 Lowering Interest Rates
QE pushes down long-term interest rates by increasing demand for bonds, driving up their prices
➡️ Lower interest rates make borrowing cheaper for businesses and consumers
➡️ This increases the incentive to borrow and spend, helping stimulate the economy
➡️ It helps to ease credit conditions and encourage lending during a credit crunch
💳 Increased Lending Capacity
As banks receive more liquidity from QE, they become more willing to lend
➡️ The larger supply of credit helps to reduce the cost of borrowing
➡️ This encourages both businesses and individuals to take out loans for investment and consumption
➡️ This helps to counteract the effects of a credit crunch by improving access to finance
🏦 Boost to Confidence
QE signals that the central bank is committed to supporting the economy
➡️ This increases confidence among investors, businesses, and consumers
➡️ Banks feel more secure about lending, knowing that the economy is being supported
➡️ This promotes lending and reduces the likelihood of a sustained credit crunch
38
EV points for QE helping credit crunch
📉 Dependence on Bank Behaviour
QE may not automatically translate into increased lending if banks are still risk-averse or hesitant to lend
➡️ If banks remain reluctant to lend despite having more liquidity, QE might not alleviate the credit crunch effectively
➡️ Banks might prefer to hold onto reserves instead of lending, especially in uncertain economic conditions
🔴 Asset Price Inflation
QE can lead to higher asset prices (such as housing and stocks)
➡️ This can increase inequality as wealth is concentrated in those who own assets, while those without access to capital may not benefit
➡️ It can create a bubble in asset prices, which may distort the economy, leading to future financial instability
💡 Limited Impact on the Real Economy
QE mainly affects financial markets rather than the real economy
➡️ The increased liquidity may flow into financial markets, boosting asset prices rather than directly boosting lending for businesses or consumers
➡️ This means that the real economy may still face challenges in terms of investment and consumption, limiting the effectiveness of QE in a credit crunch
🏦 Diminishing Returns Over Time
The effectiveness of QE may diminish over time as markets become accustomed to it
➡️ Repeated QE actions might lead to less significant impacts on interest rates or lending behaviour
➡️ If businesses and consumers don't respond to lower borrowing costs, QE's ability to stimulate lending and ease a credit crunch can weaken
🏚️ Potential for Future Inflation
While QE can help combat a credit crunch, it can also create inflationary pressures in the long term
➡️ If the money injected into the economy is not absorbed productively, it could lead to higher prices and undermine the purchasing power of consumers
➡️ This could lead to the need for tightening monetary policy in the future, potentially stifling economic recovery after the credit crunch
