Structure of Financial Markets and Financial Assets

Question 1

Summary

Answer 1

1. The characteristics and functions of money
2. Definitions of the money supply and the distinction between narrow money and broad money
3. The difference between the money market, the capital market and the foreign exchange market
4. The role of financial markets in the wider economy
5. The difference between debt and equity
6. Why there is an inverse relationship between interest rates and bond prices
7. Purpose of Bonds:
8. Purpose of Shares:
9. Purpose of Borrowing:

Question 2

1. Characteristics and Functions of Money

Answer 2

• Medium of exchange: without money, transactions were conducted through bartering.
- Goods / services were traded with other goods and services
- Problems with Bartering: goods / services exchanged were not always of the same value,
- Exchange could only take place if there was a coincidence of wants (both parties have to want the good the other party offer)
- Using money eliminates this problem.
• measure of value: Money provides a means to measure the relative values of different goods and services.
- E.g. a piece of jewellery might be considered more valuable than a table because of the relative price, measured by money. Money also puts a value on labour.

Question 3

2. Definitions of the Money Supply and the Distinction between Narrow Money and Broad Money

Answer 3

• Money Supply: the stock of currency and liquid assets in an economy.

• Includes cash and money held in savings accounts.
• Keynesian Era: little attention was given to the supply of money
• Monetarist Era: control of money supply became important

• Narrow money: physical currency (notes and coins), as well as deposits and liquid assets in the central bank.
• Broad money: includes the entire money supply.
- Cash could be in restricted accounts, which makes it hard to calculate the money supply.
- Includes liquid and less liquid assets.

Question 4

3. Difference between the Money Market, Capital Market and Foreign Exchange Market

Answer 4

• Money market: liquid assets are traded.

• It is used to borrow and lend money to satisfy short term needs.
• E.g. London Interbank Market (LIBOR interest rate)

• Capital market: is where equity and debt instruments are bought and sold.

• Where bonds and shares are traded to raise funds to finance long-term growth.
• This is within public (gov bonds) and private sector (corporate bonds / shares)
• E.g. the London Stock Exchange.

• Foreign exchange market: where currencies are traded, mainly by international banks.

Question 5

4. Role of Financial Markets in the Wider Economy

Answer 5

• Financial liquid assets are exchanged in a financial market.
- E.g. the stock market and the bond market are two examples of financial markets.
• To facilitate saving
- Financial markets provide somewhere for consumers and firms to store their funds.
- Savings are rewarded with interest payments from the bank.
• To lend to businesses and individuals
- The transfer of funds between agents is aided by financial markets.
- The funds can be used for investment or consumption.
• To facilitate the exchange of goods and services
- Financial markets can make it easier to exchange goods and services from the physical market, by providing a way that buyers and sellers can interact and transfer funds.
• To provide forward markets in currencies and commodities
1. Currency market is another kind of financial market.
- They are used to trade one currency for another currency.
2. Commodity markets are where investors trade primary products (e.g. wheat, gold and oil)
- Future contracts are a method for investing in commodities.
- This involves buying or selling an asset with an agreed price in the present, but a delivery and payment in the future.
o Forward market: informal financial market where these future contracts are made.
• To provides Equity Markets
- Equity markets involve the trade of shares (also called a stock market)
- Equity markets provide access to capital for firms
- Allow investors to own part of a market.
- Returns on the investment are based on future performance.
- Returns are usually in dividends (a share of the firm’s profits)

Question 6

5. Difference Between Debt and Equity

Answer 6

• Debt: money which has been borrowed from a lender, and is owed.
- There is little flexibility, and the loan is later repaid with interest.
• Equity: a stock which represents interest in owning (e.g. shares, a car or a house)
- When there is no outstanding debt (e.g. when a loan for a car has been fully paid off), The owner’s equity is then the car, which can be sold for cash.

Question 7

6. Why there is an Inverse Relationship between Interest Rates and Bond Prices

Answer 7

• There is an inverse relationship between market interest rates and bond prices.

• When a bond is bought, money is lent to the issuer.
• Issuer agrees to pay the value of the bond back when it matures, in addition to periodic interest payments.
• The rate of interest is FIXED when the bond is issued.

• New bonds have rates close to the market interest rate.

• If the market interest rate falls, the bond would be worth more
• This is because it has a higher interest rate than current market conditions.
• Similarly, the bond is worth less is the rate increases.
• This is because the bond has a lower interest rate than the current market.

Question 8

7. Purpose of Bonds

Answer 8

• Firms can raise finance by issuing corporate bonds
• Corporate bonds are issued to raise funding for large projects (E.g. develop a product, move to a new premise, or takeover another firm.)

• Bonds could be traded in a similar way to shares, and they are partially protected against variable interest rates or economic changes.
- However, the firm will have to pay the investors who buy the bonds interest.

• In relation to government bonds, the term coupon is an interest payment to the bondholder Between the date of issue and the date of maturity.

• Maturity is the period of time for which the financial asset is outstanding.
• When it finishes and has been repaid, it has matured.

Question 9

8. Purpose of Shares

Answer 9

• Firms can raise finance by issuing shares
• Raising finance through shares is relatively cheap for firms.
• Firms are then legally obliged to pay their shareholders dividends (a proportion of their profits as a reward for investing in them)
• They only pay dividends when there are distributable profits

Question 10

9. Purpose of Borrowing

Answer 10

• Firms can raise finance by borrowing from a bank.
• Borrowing could involve paying back loans with high interest rates (expensive)
- This might be unaffordable for new, smaller firms.