Financial markets 2 Flashcards
what is a money market
where financial assets are bought and sold with IOU’s less than or equal to a year
why does the demand curve slope downwards on a money market diagram
- 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.
why is the money supply curve vertical
- : 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.
when supply=demand on money market diagram, we get…
equilibrium interest rate
factors affecting the supply of money
- reserve requirements
- change in discount rate, repo rate, bank rates
- open market operations
what is reserve requirement
the amount of money commercial banks need to keep in the Bank of England (by law)
what is bank rate
the rate at which commercial banks borrow from the bank of England in order to meet their liquidity need
what are open market operations
the buying and selling of govt bonds
how can central banks alter money supply using reserve requirements
- 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.
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how can central banks alter the interest rate using discount/repo/ bank rates
- 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
how do central banks use open market operations to alter interest rates
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.
what is a bond
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
who issues bonds and why
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
who can buy bonds and why
- anyone, individuals, firms,govt
why? - the return on the bond might be better than the retun on other financial assets
what would be on a bond
- name(treasury gilts)
- coupon(interest rate fixed over duration)
- maturity(when the bond expires/is paid back)
- market price -
nominal value of bond
face value or par value, is the amount that the issuer agrees to repay the bondholder at maturity
difference between nominal value and market price
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.
bond yield equation
yield = coupon/market price (x100)
relationship between market price and yield
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.
how does fractional reserve banking work
- 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
how to work out the extra money can be created from an initial deposit
the money multiplier equation
money multiplier equation
1 / reserve ratio, eg if the reserve ratio is 10%, its 1/0.1
what is the reserve requirement in the US
10%
how to work out the increase in money supply from the deposit and money multiplier
multiple the money multiplier answer by the original deposit, then take away the money multiplier answer from the previous answer
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.
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
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
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
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.
what is a banks balance sheet
a record of all assets,liabilities and capital at any given moment in time
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.
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what are liabilities
anything that a commercial banks OWE,eg deposits,short and long term borrowing
what is capital (banking)
a section within the liability component, comprises of:
- shareholder funds
- retained profit
the balance sheet must balance when
assets = liabilities +capital
