Financial Markets Flashcards
Financial Market
Any convenient set of arrangements where buyers and sellers can buy or trade a range of services or assets that are fundamentally monetary in nature.
Role of Financial Markets
To facilitate saving - Financial markets provide somewhere for consumers and firms to store their funds. Savings are rewarded with interest payments from the bank.
To facilitate lending - Households, firms and governments all borrow money (eg households buy TVs on credit cards, firms may borrow money to buy new equipment, banks may borrow to lend more profitably and government may borrow money to finance government spending)
To facilitate the exchange of goods and services - The transfer of real economic resources is facilitated in a financial market. Financial markets can make it easier to exchange goods and services from the physical market, by providing a way that buyers and sellers can interact and transfer funds eg using PayPal or Online Banking.
To provide forward markets in currencies and services - The currency market is another kind of financial market. They are used to trade one currency for another currency. Currencies can have speculative attacks taken on them, which can affect the value of the exchange rate. In commodity markets, investors trade primary products, such as wheat, gold and oil. Future contracts are a method of investing in commodities. This involves buying or selling an asset with an agreed price in the present, but a delivery and payment in the future. A forward market is an informal financial market where these contracts for future delivery are made.
To provide a market for equities - Equity markets involve the trade of shares. It is also called a stock market. Equity markets provide access to capital for firms, and allow investors to own part of a market. Returns on the investment, usually in the form of dividends, are based on future performance. A dividend is a share of the firm’s profits.
Different types of Markets
Money Markets - Financial markets that provide short-term borrowing and lending, usually defined as up to one year.
Capital Markets - Financial markets which provide long-term borrowing and lending, usually defined as over one year.
Currency Markets - This is the market in which currencies are traded
Commodity Markets - Where raw materials are traded eg coffee, sugar.
Derivatives Markets - Markets which trade financial instruments based on the values of other financial instruments. Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity (share), or a contractual right to receive or deliver cash (bond).
Insurance Markets - Insurance Markets are where individuals, firms and governments can buy insurance.
Market Failure in Financial Markets
Asymmetric Information - Financial institutions frequently have more knowledge than their customers or have more knowledge compared to other rival financial institutions. In this case of Payment Protection Insurance (PPI), UK banks in the 1990s and 2000s sold tens of millions of insurance contracts to customers who were taking out a loan, a mortgage or credit card. Banks failed to find out whether the insurance was appropriate for most customers. Those customers did not understand what they were being sold, nor did they realise they could buy the same product for a fraction of the price.
Externalities - Financial markets create significant negative externalities. These are costs that are borne by other firms, individuals and governments but not financial markets
Moral Hazards - A moral hazard is a situation where there is a risk that the borrower does things that the lender would not need desirable, because it makes the borrower less likely to repay a loan. it usually occurs when there is some form of insurance for the mistake. For example, if a house is insured, a borrower might be less careful because they know any damage caused will be paid by the insurance company. Banks might take more risks if they know the Bank of England or the government can help them if things go wrong. The financial crisis has been regarded as a moral hazard, due to the degree of risk taking.
Speculation and Market Bubbles - A market bubble occurs when the price of an asset is predicted to rise significantly. This causes it to be traded more, and demand exceeds supply so the price rises beyond the intrinsic value. The bubble then ‘bursts’ when the price steeply and suddenly falls to its ordinary level. This causes panic and investors try and sell their assets. It results in a loss of confidence and it can lead to economic decline or a depression.
Market Rigging - This is the act of firms coming together to interfere in a market, with the intention to stop it working as it is supposed to, so that firms can gain an unfair advantage. The Libor Scandal is an example of this. It was discovered that banks were inflating or deflating their interest rates to make more profit from trade or to make them seem more financially reliable. Loans such as mortgages, student loans, and other financial products use Libor as a reference rate. This means that manipulating the rate, as the banks were doing, can negatively affect consumers and the financial market.,
