Role of Financial Markets

Question 1

A forward contract

Answer 1

A forward contract occurs when you fix the price and date of a future transaction now so that you know exactly how much you will pay or receive and when.

Question 2

What is meant by equity?

Answer 2

Equity is a way that a firm can raise finance without having to take out a loan (which has to be paid back!). Equity is when a firm sells a percentage of their company to investors in the form of shares. The investors can then receive a percentage of the profits.

Question 3

What is meant by a forward contract?

Answer 3

A forward contract fixes the price and date of a future transaction now, so that you know exactly how much you will pay in the future.

Question 4

Why is it important to have a market for equities?

Answer 4

Having a market for equities is important for two main reasons:

1. It allows firms to raise finance by selling a share in their company
2. It provides investors with an opportunity to make money by buying shares and then selling them when the price increases

Question 5

Which of the following is a benefit of forward contracts for commodities ?

Answer 5

The main benefit of forward contracts for the person buying the currency or commodity is that they get a guaranteed price, meaning that they have the security of knowing exactly what they will have to pay.
The main benefit of forward contracts for currency and commodity traders is that they have the possibility of making a profit if they set the right price in 6 months’ time.

Question 6

The roles of financial markets are:

Answer 6

1. To facilitate saving
2. To facilitate lending
3. To facilitate the exchange of goods and services
4. To provide a market for equities
5. To provide forward markets

Question 7

Equity

Answer 7

When firms sell a percentage of their company to investors in the form of shares. The investors can then receive a percentage of the profits.

Question 8

Forward Contracts

Answer 8

Fix the price and date of a future transaction now so that you know exactly how much you will pay.

Question 9

How were the bankers able to get away with selling these adjustable-rate mortgages ?

Answer 9

There was asymmetric information - the bankers knew that they were going to significantly increase the interest rates, but the people taking out the mortgage didn’t know/understand this.

They sold these subprime mortgages with adjustable rates, which meant that they could increase significantly over time.

Question 10

What type of interest rate did they sell these mortgages with ?

Answer 10

They sold these mortgages with adjustable rates, which meant that they could entice people in with a super-low teaser rate and then increase the rate over time.

Question 11

Why did the bankers think they had found a win-win formula ?

Answer 11

The bankers thought they could make a profit in two ways. If the borrower managed to repay their mortgage then the bank would make profit from the repayments plus interest. If the borrower didn’t manage to repay then the bank would make profit by selling the house when they defaulted. Since house prices were rising, they thought this was a win-win formula.

Question 12

Which of the following will occur as bankers sell more subprime mortgages?

Answer 12

As bankers sell more subprime mortgages, demand for houses will increase. This will then increase house prices. If someone defaults on their mortgage it means that they are not able to pay it back. This means that the bank can take back their house and sell it. Since house prices are increasing, the bank will make even more profit from selling their house when they default.

Question 13

Which of the above combinations will occur as the bankers start selling more subprime mortgages ?

Answer 13

More subprime mortgages -> Increases demand for houses -> Increases house prices -> More profit from selling houses when people default

Question 14

Subprime Mortgages

Answer 14

Mortgages given to people who couldn’t afford to pay them back.

Question 15

Housing Bubble

Answer 15

As house prices increase, demand for houses increases. This increases house prices further and the cycle continues until houses become hugely overvalued.

Question 16

Which of the above combinations will occur as the bankers start selling more subprime mortgages ?

Answer 16

More subprime mortgages -> Increased demand for houses -> Increases house prices -> More profit from selling houses when people default -> More subprime mortgages -> Increased demand for houses -> Increases house prices -> Housing bubble

Question 17

Two examples of asymmetric information in the financial sector are:

Answer 17

1. Bankers knew much more about their adjustable rate subprime mortgages than the people they were selling them to
2. Bankers knew far more about banking than the financial regulators who were meant to be monitoring their behaviour.

Question 18

Negative externalities (financial markets n market failureS)

Answer 18

After the financial crisis, banks stopped lending money to people or businesses. Firms couldn’t borrow money, so they had to make cutbacks, which meant that millions of people became unemployed. There was therefore a decrease in real gdp. This is a negative externality because the people who lost their jobs were outside the price mechanism in the financial sector.

Question 19

Moral hazard

Answer 19

Moral hazard occurs when you take more risks because somebody else is bearing the cost of that risk.
e.g After the 2008 financial crisis, the US spent about $700 billion of taxpayers’ money in order to stop the banks from going bankrupt. - banks lending more irresponsibly bc they think theyre gonna get bailed out

Question 20

Which of the following is an example of a negative externality as a result of the financial crisis ?

Answer 20

A plumber who lost his job because his manager couldn’t get a loan from the bank

Question 21

LIBOR

Answer 21

The LIBOR rate is calculated by Reuters. Everyday, they ask bankers from 16 banks to submit the interest rate that they use to borrow/lend to other banks. Reuters remove the highest and lowest interest rates and then find the average. If some bankers give an inaccurate number for the interest rate, then this will affect the LIBOR rate.

Question 22

Which of the following explains why the manipulation of the London Interbank Offered Rate (LIBOR) was an example of financial market failure ?

Answer 22

The LIBOR rate is calculated by Reuters. Everyday, they ask bankers from 16 banks to submit the interest rate that they use to borrow/lend to other banks.
This should mean that the LIBOR rate is determined by supply and demand for borrowed money. However, since the bankers lied about the rate, it was manipulated and no longer correctly determined by supply and demand.

Question 23

market RIGGING

Answer 23

This is where firms unfairly try to control prices (possibly by providing inaccurate information) which distorts the price mechanism. One of the most famous examples of market rigging is LIBOR. .

Question 24

Types of Financial Market Failure

Answer 24

Five types of financial market failure are; asymmetric information, speculation and market bubbles, negative externalities, moral hazard and market rigging.

Question 25

Market Bubble

Answer 25

As the price of an asset increases, demand for that asset increases. This increases the price of the asset further and the cycle continues until the asset become hugely overvalued.

Question 26

Moral Hazard

Answer 26

When someone takes more risks because somebody else is bearing the cost of that risk.

Question 27

Market Rigging

Answer 27

Market rigging occurs when firms unfairly try to control prices, distorting the price mechanism.

Question 28

Why might an asset bubble ‘burst’ ?

Answer 28

In a market bubble, the price of an asset begins to increase. As the price of an asset increases, demand for that asset increases. This increases the price of the asset further and the cycle continues until the asset become hugely overvalued. People suddenly realise that they have paid more for the asset than it is actually worth - the bubble starts to burst. They quickly start to sell the asset while the price is still high. As they sell the asset, supply increases and price falls. As the price starts to fall, more people sell and the cycle continues.

Question 29

Which of the following does the central bank manipulate as part of monetary policy?

Answer 29

As part of monetary policy, the central bank manipulates the base interest rate and the money supply.

Question 30

The role of central banks includes:

Answer 30

1. Lending to other banks
2. Lending to the government
3. Implementing monetary policy by manipulating the base interest rate and the money supply.
4. Regulating the banking industry e.g. through stress tests.

Question 31

Which of the following did US Federal Reserve do in 2011?

Answer 31

The strict set of financial regulations imposed on US banks by the Federal Reserve in 2011 was called Basel III.

Question 32

Two types of indirect tax are:

Answer 32

Two types of indirect tax are:

1. Specific taxes, which are a fixed amount on each unit sold
2. Ad valorem taxes, which are a percentage of the price of the good.