Financial Markets

Question 1

Functions of money

Answer 1

Medium of exchange

Unit of account

Store of value

Standard of deferred payment

Question 2

Characteristics of money

Answer 2

Acceptable

Durable

Potable

Divisible

Scarce

Difficult to forge

Question 3

Types of money

Answer 3

Narrow money
Consists of notes and coins, any balances that can be immediately used as a medium of exchange

Broad money
A measure of the money supply that includes notes,coins as well as most bank balances held by banks and other financial institutions

Question 4

Financial markets

Answer 4

Markets that enable transfers between those that wish to deposit funds and those looking to borrow funds

Question 5

Money market

Answer 5

The market which deals in short term finance between firms, individuals and governments

Focusing on debts which are due to be repaid in the near future

Question 6

Capital market

Answer 6

The market which deals with the medium term and long term finance

Such as share and bond issues

Between individuals,firms and governments-focusing on debts due for repayment more than a few months ahead

Question 7

Foreign exchange market

Answer 7

The market that deals with transactions requiring conversion from one currency into another currency

Question 8

Treasury bill

Answer 8

A very short term form of borrowing by the government, usually repaid within three months

Question 9

Bonds

Answer 9

A form of borrowing which gives the holder a fixed rate of interest and the money is repaid within a set period of time- bonds can be traded

Coupon-the (fixed) interest interest on a bond

Maturity date- the date of repayment for a bond

Question 10

Shares

Answer 10

Issued by firms raising finance-these give the holder the Chance to receive dividends out of the firms profits and often allow the holder to vote in the company affairs

These are not repaid by the firm

Question 11

Debt v equity

Answer 11

I Equity- the value of share capital issued by firms as part of their financial capital (shares in a firm) stocks and trading

More risky greater returns- more volatile market

Debt- investments in debt securities (e.g. Bonds)

Less risky so lower returns

Question 12

Calculating yields on bonds

Answer 12

Inverse relationship between binds and interest rate rates

Yield is the interest paid as a percentage of the bonds current price in the capital market

Yield%=the coupon/the market price x 100

Question 13

Commercial/retail banks

Answer 13

Commercial- accepts deposits from and lends money to businesses

Retail - same as commercial but for individuals

Functions:
Accepting deposits
Lending to economic agents
Providing an efficient means of payment

Objectives:
Liquidity
Profitability
Security

Conflicts between liquidity and profit as firms will lend riskier long term ventures which will be elsewhere when the bank may need it

Question 14

Investment banks

Answer 14

A bank that does not accept customer deposits and normally provides financial services to other businesses such as arranging share or debenture issues

Assist governments with share issues of the privatisation of state owned enterprises

Also buy and sell securities in the secondary capital market, as well as buying and selling in the foreign exchange markets

Securities will be carried out to generate returns for investment banks
But also for private investors looking for someone to buy and sell on their behalf

Question 15

Assets and liabilities of a commercial bank

Answer 15

Assets represent sources available for use often presented in order of liquidity

Most liquid to least liquid assets:

• Notes,coins and balances held at the BofE
• Money borrowed from banks to meet short term needs
• Investments- normally bonds or shares
• Advances- loans SR(overdraft) LR(mortgage)
• Tangible non current assets - physical assets (headquarters or branches)

Liabilities:
What banks owe to individuals and groups
-Share capital-sell shares to raise revenue but need to pay profits to shareholders
-reserves- profits used in the business to generate growth instead of being paid to shareholders
-long term borrowing- money borrowed from the money markets and mainly serves to provide liquidity for any shortfall in cash needs
-deposits- accounts open and maintained by banks customers
Sight deposits- (can be accessed immediately)
Time deposits- (require a period of time before they can be accessed)

Question 16

Credit creation

Answer 16

Bank knows customers are unlikely to withdraw their full balances

They can create credit lending by lending out their customers money and making profit off of the interest

Fractional banking- the ability for a bank to hold a small amount of the their customers deposits at any time, thus allowing them to lend out money and earn Interest

However “run on the bank” - occurs when all of a banks customers withdraw their deposits and a bank may not have enough money to meet the demand

Question 17

Regulation of financial system

Answer 17

Prudential regulation authority

Supervision of banks, building societies,credit unions,insurers and major investment firms

Wants to achieve financial stability by making sure the banks are managed properly

Financial conduct authority

Aims to protect consumers and ensure healthy competition between firms

Charging a fee to financial institutions
Can also investigaste into an industry

Financial policy committee
Identify,monitor and take action to avoid systematic risks

And to take action to make the financial system more robust

Question 18

Why banks fail

Answer 18

If they have insufficient capital, at risk in a fall in false of their assets.

This may occur if a number of loans made by a bank fail to be repaid

Insufficient liquid assets make a bank vulnerable to a run on the bank

The BofE are a lender of last resort and provides liquidity insurance

However this leads to moral hazard
Where on firm takes on too much risk,knowing that if the risk fails, someone else will cover the costs of the failed risk

As in this instance banks will take on risks as they feel the BofE will support them if they run short of cash

Question 19

Liquidity and capital ratios

Answer 19

Liquidity ratios :
Cash or reserve ratios
Is the requirement for banks to hold a specific amount of their deposits in the form of cash

The higher the ratio the less the bank can lend out and less able It is to create credit

Capital ratio:
A ratio of A banks equity to the amount of lending made by the bank

It’s believed that specifying a ratio will stop a bank from building up a large number of amounts lent compared to its permanent capital

A higher ratio means a bank can lend a smaller proportion compared with its capital base

Question 20

Systematic risk

Answer 20

A risk that applies to a whole sector e.g. Banking sector

E.g. Financial crisis

Question 21

Issues with regulation

Answer 21

Restricts economic activity - harder to lend

May divert financial services industry to output to other countries with jobs being lost

Regulation requires time and money to plan,implement and monitor

Any penalties will need to be used as to maintain the regulations credibility

Unintended consequences are likely-e.g. Development of a shadow banking sector

Question 22

Regulation

Answer 22

PRA- supervision of financial institutions

FPC- systematic risks

FCA- charging financial institutions fees to promote healthy competition separate from government