Financial Sector

Question 1

Define financial market

Answer 1

Any exchange that enables the trading of financial instruments such as bonds.

Question 2

5 roles of the financial markets

Answer 2

1. Facilitate savings by households and businesses
2. Lend to businesses and individuals
3. Facilitate the final exchange of goods and services
4. Provide forward markets in currencies and commodities
5. Provide a market for equities

Savings
Lending
Exchange
Forward markets
Equity

Question 3

Formula of yield

Answer 3

Y = interest/price

Question 4

Types of Forwards markets

Answer 4

1. Currency forward market (locks in exchange rate of a currency by “hedging”
2. Commodity forward market (locks in a price for, usually a raw material to be exchanged between buyers and sellers)

Question 5

How a financial market connects lenders and borrowers

Answer 5

Lenders (savers and investors) -> lend their money to financial markets -> which borrowers (individuals, firms, government) would borrow form them.

Lenders will receive their return from intermediaries (commercial banks, pension funds, mutual funds) or (investment banks, hedge funds).

Intermediaries will set an interest rate, which borrowers will pay, for the return for the lenders.

Question 6

Characteristic of money

Answer 6

Durability
Portability
Divisibility
Acceptability
Hard to counterfeit
Valuable

Medium of exchange
Unit of account
Store of value
Deferred payment

Question 7

Types of money in the money supply

Answer 7

Broad money (measure of total money held by households and companies in the economy)

Narrow money (measure of the value coins and notes in circulation and other money equivalents that are easily convertible into cash such as short-term savings deposits in the banking system)

Question 8

Functions of a investment bank

Answer 8

1. Provides specialised services for companies and large investors
2. Underwriting and advising on security issues
3. Advise on mergers, acquisitions and corporate restructuring
4. Trading on capital market
   Corporate research and private equity investments
5. Trades and invests on its own account

Question 9

How do banks fail?

Answer 9

1. “Run” on the banks - bank faces liquidity crisis (savings lent out, not enough liquidity to give savers their funds) from depositors confidence drops, withdrawal money
2. Credit crunch - banks fear of not paid back
3. High loses from bad debts - loan default rate may rise in recession as borrowers struggle to make loan repayments. Credit rate falls and share price falls

Question 10

Definition Financial market failure

Answer 10

When a market fails to allocate scarce resources in an efficient and/or equitable way leading to a loss of economic and social welfare.

Question 11

Types of market failure

Answer 11

1. Externalities from financial instability (caused by banks, bailed by government using taxpayer money)
2. Monopoly power in financial markets (ability of business to set price above a level that would exist in a highly competitive market)
3. Market rigging (company in market act to stop market from working as it should to give themselves an unfair advantage and gain)
4. Speculative bubbles and irrational behaviour (when market price is driven above what it should be due to herding behaviours of consumers/ investors in financial markets)
5. Moral hazard and attitudes to risking taking (state bailouts of failing banks, bank taking most of the risk knowing government will bail them)
6. Asymmetric information and complexity (insider information in stock markets, bank knows less than a debtor)