Introduction to Financial Markets

Question 1

What are the most fundamental definitions in the financial markets?

Answer 1

• Security: A claim on the issuer’s future income/assets
• Bond: A debt security that promises to make payments
• Interest rate: Cost of borrowing or the prices paid for funds
• Asset: Something of value that is owned
• Liability: Something of value that is owed

Question 2

What is the difference between Bond Market/Stock market?

Answer 2

• Bond Market: Bond Prices are determined therefore interest rates are required
• Stock Market: Effects on Wealth / Investment Decisions

Question 3

What did the research by the St. Louis Fed. suggest about assets and the risks?

Answer 3

• 3-month Treasury prices are lower than US Government Long Term Bonds
• Less risky for 3 months than long-term
• Corporate BAA bonds are quite risky, hence IR is high
• This means that risk can be compensated for

Question 4

What is the Stock Market?

Answer 4

• Common stock represents a share of ownership in a corporation
• A share of stock is a claim on residual earnings and asset
• Firms issue stock and sell it to the public to raise funds to finance activities

Question 5

What are the definitions of Financial Intermediaries, Financial Innovations and Financial Crises?

Answer 5

• Financial Intermediaries: Institutions that borrow funds from people who have saved and then lend to loans (Banks, Pension Funds…)
• Financial Innovation: The development of new financial products/services (Bitcoin/E-banking)
• Financial Crises: Major disruptions in financial markets, characterised by falls in asset prices

Question 6

What is Money? What is Money Theory all about?

Answer 6

• Money is anything that is generally accepted as payment for goods/services or for repaying debt
• Important for the business cycle
• Money theory suggests that changes in money supply alter aggregate economic activity/price level
• Aggregate PL = average price of goods and services
• Average increase in Price level = inflation
  An increase in MS has an increase in PL [causation =/= correlation] GOOD CORRELATION PRIOR TO 1980s {not now}

Question 7

How can monetary/fiscal policy be used to tackle financial crises?

Answer 7

• Joint action is required during financial crises
• Understanding monetary policy helps predict if i rises/falls- decisions can be made on how to act
• Interest rates are the price of money

Question 8

What is the general idea of the interconnectivity/function within the financial markets?

Answer 8

• Financial markets funnel funds from lenders/savers to borrowers/spenders
• Promotes economic efficiency and the reallocation of resources
• Increases Capital, Production, GDP
• Improvement of welfare to economic agents
• There is also intra-FM funding for short-term liquidity

Question 9

Why do we need financial intermediaries?

Answer 9

• Channel funds the best: Yield best return / analyse risk
• Lower Transaction cost via economies of scale
• Reduce information costs: Addresses asymmetric information
• Risk Sharing: FIs can buy more risky assets and because they are lending to a large number, they can absorb loss with IR
• Maturity transformation: Lending can occur for a long period of time, because people are unlikely to want all of their money at one time
• Diversification: Portfolios are less risky than single assets

Question 10

What are the two types of asymmetric information?

Answer 10

• Moral Hazard: Ensure borrowing party does not engage with activities that would make repayment less likely [AFTER]
• Adverse Selection: Try to avoid selecting risky borrowers by gathering information [BEFORE]

Question 11

What is Direct finance? What are some of the benefits?

Answer 11

• Borrowers borrow funds directly from lenders
• Direct finance in organised markets reduces search costs and risk

Question 12

What are some Key Principles of Money and Banking?

Answer 12

• Time has Value- Impacts returns
• Risk requires compensation
• Information is the basis for decision
• Markets determine prices & allocation of resources
• Stability improves welfare- reduces uncertainty

Question 13

What are some of the regulation inputted into the financial markets?

Answer 13

• Increasing information for investors, reducing adverse selection, moral hazard and insider trading
• Increasing soundness of financial intermediaries
• This includes barriers to entry, disclosure of information, restriction of assets/activities, deposit insurance
• Regulatory bodies (FCA/PRA)

Question 14

What are the different denominations of markets?

Answer 14

• 1. Debt/Equity Markets suggests claims are bought/sold for cash, whilst Derivatives Markets suggest claims are bought/sold for money paid on a future date
• 2. Money Markets are short term debt instruments (<1yr), whilst Capital Markets are long term debt/equity (>1yr)
• 3. Primary Markets have newly issued stocks that are traded, whilst Secondary Markets trade with existing securities
• 4. Centralised markets have physical locations, whilst Over-the-Counter markets have Network of dealers electronically