MACRO Financial Markets

Question 1

Define liquidity

Answer 1

Liquidity - the ability to turn an asset into cash without loss
of value

Question 2

Define assets

Answer 2

Asset -what someone owns.

Question 3

Define liability

Answer 3

Liability - what someone owes.

Question 4

Define equity

Answer 4

Equity - How much a shareholder has put into a firm or the % they own

Question 5

Define security

Answer 5

Securities - Assets that have monetary value that can be traded, bought and sold

Question 6

Define shares

Answer 6

Shares-one of the equal parts into which a company’s capital is divided, entitling the shareholder to a proportion of the profits.

Question 7

Define cooperate bonds

Answer 7

Corporate bonds-financial securities sold by corporations and the owners become creditors

Question 8

Define government bonds

Answer 8

Govt bonds (gilts)-financial securities sold by govts and the owners become creditors

Question 9

What are the key functions of money

Answer 9

1. Medium of exchange: money allows goods and services to be traded without the need for a barter system. Barter systems rely on there being a double coincidence of wants between the two people involved in an exchange
2. Store of value: this can refer to any asset whose “value” can be used now or used in the future i.e. its value can be retrieved at a later date. This means that people can save now to fund spending at a later date.
3. Unit of account: this refers to anything that allows the value of something to be expressed in an understandable way, and in a way that allows the value of items to be compared.
4. Standard of deferred payment: this refers to the expressing of the value of a debt i.e. if people borrow today, then they can pay back their loan in the future in a way that is acceptable to the person who made the loan.

Question 10

What is a financial market

Answer 10

A financial market is any exchange that facilitates the trading of financial instruments, such as stocks, bonds, foreign exchange, or primary commodities such as oil and gas.

Question 11

What are the benefits of bank loans?

Answer 11

• Greater certainty of funding, provided terms of loan complied with
• Lower interest rate than a bank overdraft
• Appropriate method of financing fixed assets

Question 12

What are the drawbacks of bank loans?

Answer 12

• Requires security (collateral)
• Interest paid on full amount outstanding
• Harder to arrange
• Startups and small businesses often excluded

Question 13

What is a bank overdraft

Answer 13

• Short-term finance, widely used by businesses of all sizes
• An overdraft is really a short-term facility - the bank lets the business “owe it money” when the bank balance goes below zero
• A flexible source of finance: only used when needed
• Excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time

Question 14

Benefits of a bank overdraft

Answer 14

• Relatively easy to arrange
• Flexible - use as cash flow requires
• Interest - only paid on the amount borrowed under the facility

Question 15

Drawbacks of a bank overdraft

Answer 15

• Can be withdrawn at short notice
• Interest charge varies with changes in interest rate
• Higher interest rate than a bank loan

Question 16

Define equity finance

Answer 16

Equity financing means raising capital by selling shares of a business to investors

Question 17

Advantages of debt finance

Answer 17

1. Less capital required to be invested by the shareholders
2. Debt can be a relatively cheap source of finance compared with dividends
3. Easy to pay interest if profits and cash flows are strong

Question 18

Disadvantages of debt finance

Answer 18

1. Business may be vulnerable to unexpected changes in interest rates e.g. when the central bank decides to tighten monetary policy
2. Businesses have less control of events if they are highly geared i.e. have a high ratio of debt to equity

Question 19

Advantages of equity finance

Answer 19

1. Equity is risk capital and does not offer a fixed return - business has some control over when if to pay a dividend to investors
2. Equity finance gives a business more flexibility e.g. raising fresh equity capital at different stages of the business development

Question 20

Disadvantages of equity finance

Answer 20

1. Dilution of ownership for the original founders
2. Ultimately, equity requires a higher return than debt because it is risk capital (investors can lose their money)
   Growing expectations over time that dividends will be paid

Question 21

What is a bond?

Answer 21

• A bond is an I.O.U. It pays a fixed interest (coupon) annually with a promise to repay the full nominal value of the bond at a future date. o Issued to raise finance
O Govt bonds (GILTs)
O Corporate bonds

Question 22

Why do we buy bonds?

Answer 22

a Generally safer (GILTs)
O During a period of downturn, good place to put money that’s low risk
• Marginally higher rate of interest than a savings account but.
o Ties up money for a long period of time a Low returns compared with other investments

Question 23

Define yield

Answer 23

Yield- the annual interest payment or
Coupon as a % of the market price of a bond

Question 24

Yield equation

Answer 24

Yield= annual coupon payment /
current market value x100

Question 25

What is the purpose of commercial banks

Answer 25

O Retail or ‘high street’ banks o Purpose:
O They channel funds from those that have surplus (savers/lenders) to those that need it (borrowers)
a General public and businesses

Question 26

What is the function of commercial banks

Answer 26

O Functions;
• Accepting deposits (savings) - money in
• Lending out (loans) - money out eg O/D, mortgages
• Providing efficient means of payment (transfers in/out)-B/D, cheques, online
• Subsidiary services eg

Question 27

Explain the conflict of interest commercial banks experience

Answer 27

O PROFIT - Retail banks are private organisations *
Owned by shareholders and they aim to make a profit from their services need to lend to charge interest
O LIQUIDITY - hold sufficient amounts of liquid assets (cash) to meet customer needs but higher liquid assets yield lower returns
a SECURITY-banks take risks when they lend.
Secured loans are less profitable than unsecured more riskier loans

Question 28

Why does a bank fail

Answer 28

• It suffers a fall in the value of its assets that is so large it wipes out its capital. Eg if a number of loans not repaid like the US housing market
• It does not have sufficient liquidity to meet the needs of its depositors- this may lead to a belief that the bank will go bankrupt so there is a run on the bank hastening its insolvency. Eg Northern Rock-customers queuing up to withdraw their deposits
• Central bank is lender of last resort and provides liquidity insurance - underwrites UK banks.- danger?

Question 29

What is moral hazard

Answer 29

When one economic agent decides to take on risk, knowing that someone else will bear the cost if it goes wrong

Question 30

What is the purpose of investment banks

Answer 30

O Merchant banks, global banks
• In the City and Canary Wharf
• Purpose: They help private companies and the govt

Question 31

What is the function of investment banks?

Answer 31

Function:
o To raise funds through selling shares or bonds
• Help govt with privatisation eg sale of Royal Mail
O Help firms plan for mergers and takeovers
• Buy and sell securities on the secondary markets O Riskier activities include commodity and currency trading

Question 32

What is the Bank of England’s objectives

Answer 32

• Maintain financial stability
• Help the govt maintain macroeconomic stability via the monetary policy
a Lender of last resort- providing banks money for short term needs and providing liquidity insurance

Question 33

Describe the bank of England’s monetary policy

Answer 33

• Interest rates -Price stability - 2% inflation (CPI)
Quantative Easing (QE)
control money supply
Influence exchange rates
(€)
• Forward guidance
• Aim-to create conditions for sustainable growth and employment

Question 34

What is liquidity ratio

Answer 34

o Liquidity ratio;
O Analyses the ability of a company to pay off both its current and long-term liabilities as they become due.
• Cash ratio- amount of cash held as a proportion of its loans

Question 35

What is capital ratio

Answer 35

o Capital ratio;
O Analyses the relationship between a bank’s capital and its risk level
O the amount of capital as a proportion of its loans

Question 36

What is the equation for capital ratio?

Answer 36

Capital ratio = initial deposit/
total lending

Question 37

Problems with regulation

Answer 37

• Restricts economic activity
• May divert financial services abroad
• Requires time and money to plan, implement and monitor
• Any penalties need to be used to maintain regulation
• Unintended consequences