Role of Financial Markets 4.4.1

Question 1

Role of Financial Markets

Answer 1

• To facilitate saving
• To lend to businesses and individuals
• To facilitate the exchange of goods and services
• To provide forward markets in currencies and commodities
• To provide a market for equities

Question 2

The money market:

Answer 2

o This is a market for short term loan finance for businesses and households.
o Money is borrowed and lent normally for up to 12 months.
o Includes inter-bank lending i.e. the commercial banks providing liquidity for each other.
o Includes short term government borrowing e.g. 3-12 months Treasury Bills – to help fund the
government’s budget (fiscal) deficit

Question 3

Capital market:

Answer 3

o Market for medium & longer-term loan finance.
o Capital markets are the markets where securities such as shares, and bonds are issued
o Includes raising of finance by the government through the issue of long-term government bonds for example 10 year and 20-year bonds (loans).
o The bond market includes companies, governments and non-profits such as universities that raise money by issuing bonds, essentially borrowing money at interest from investor

Question 4

Foreign exchange market:

Answer 4

o A market where currencies (foreign exchange) are traded. There is no single currency market – it is made up of the thousands of trading floors.
o Gains or losses are made from exchange rates – speculative activity in currency markets is often high. o The spot exchange rate is the price of a currency to be delivered now, rather than in the future.
o The forward exchange rate is a fixed price given for buying a currency today & delivered in the future.

Question 5

What is a financial market?

Answer 5

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

Question 6

To facilitate saving by businesses and households

Answer 6

Offering a secure place to store money and earn interest.

Question 7

To lend to businesses and individuals:

Answer 7

Financial markets provide an intermediary between savers and borrowers.

Question 8

To allocate funds to productive uses

Answer 8

Financial markets allocate capital to where the risk-adjusted rate of return is highest.

Question 9

To facilitate the final exchange of goods and services:

Answer 9

They provide payments mechanisms e.g. contactless
payments.

Question 10

To provide forward markets in currencies and commodities:

Answer 10

Forward markets allow agents to insure against price volatility.

Question 11

To provide a market for equities

Answer 11

Allowing businesses to raise fresh equity to fund investment and growth.

Question 12

Characteristics of Money

Answer 12

• Durability i.e. it needs to last.
• Portable i.e. easy to carry around, convenient, easy to use.
• Divisible i.e. it can be broken down into smaller denominations.
• Hard to counterfeit - i.e. it can’t easily be faked or copied.
• Must be generally accepted by a population.
• Valuable – generally holds value over time.

Question 13

Key Functions of Money

Answer 13

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 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 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 14

Narrow Money

Answer 14

o The narrow money definition of the money supply is a measure of the value coins and notes in
circulation and other money equivalents that are easily convertible into cash such as short-term deposits in the banking system

Question 15

Broad Money

Answer 15

Broad money is a measure of the total money held by households and companies in the econom

Question 16

Debt financing means

Answer 16

borrowing money from an outside source with the promise of paying back the borrowed amount, plus the agreed-upon interest, at a later date.

Question 17

Key Features of Bank Loans

Answer 17

1. Loan is provided over a fixed period (e.g. 5 years).
2. Rate of interest payable is either fixed or variable.
3. Timing and amount of loans repayments are set by the lender e.g. a commercial bank.
4. Non-performing loans (“bad debts”) occur when the borrower is unable to repay some or all of the debt.

Question 18

Liquidity risk for commercial banks

Answer 18

• Banks tend to attract short term deposits e.g. from savers.
• They often lend for longer periods of time e.g. a 20-year or 30-year property mortgage.
• As a result, a bank may not be able to repay all deposits if savers decide to withdraw their funds in one go.
• To reduce their risk, commercial banks will try to attract long term deposits but hold some liquid assets e.g. cash as capital reserves.

Question 19

Credit risk for commercial banks

Answer 19

• This is the risk to a bank of lending to borrowers who turn out to be unable to repay some or all of their loans.
• Credit risk can be controlled by research into the creditworthiness of borrowers and by banks having sufficient capital in reserve. Minimum capital reserves may be imposed by the financial authorities.
• Most banks after the Global Financial Crisis have increased their capital reserves so that they can withstand an increase in bad debts during an economic downturn.