The Financial Sector and Financial Markets

Question 1

The Financial Sector is a Major Part of the economy

Answer 1

1. The most basic purpose of banks and other financial institutions is to make money avaliable to those who want to spend more than their income (e.g. a business wanting to expand) using the savings of those who don’t currently want to spend.
2. To do this, they:
   - Help people and firms save - through bank a/c’s, pension funds, bonds and other financial products.
   - Provide loans to businesses and individuals.
   - Allow equities and bonds to be issued and traded on capital markets
   a) EVERYDAY FORMS OF BORROWING FOR INDIVIDUALS
   - Personal loans are loans to individuals to be paid back over a small number of years. These can be secured (e.g. bank force sale of asset) or unsecured. Unsecured loans have a higher rate of interest than secured loans because they’re riskier.
   - Mortgages are loans to buy property. The bank owns the property until the loan is repaid.
   - Credit cards allow their holders to borrow money from a bank when purchasing goods or services.
   - Pay-day loans are short-term, small, unsecured loans, usually with high rates of interest.
   - Overdrafts are loans to firms and individuals that occur when the funds in their account fall below zero. A fee might need to be paid for using an overdraft, and interest may need to be paid on the money borrowed.

b) FIRMS USE EQUITY AND DEBT FINANCE TO FUND THEIR ACTIVITIES
- Equity finance is raised by selling shares in a compant. Raising funds this way means that the person providing the finance (by buying shares) become a shareholder in the firm and can claim some ownership of it. This entitles the shareholder to a share of the firm’s profits in the form of dividends.
- Debt finance is borrowing money that has to be paid bacl (usually with interest). This can involve borrowing from financial institutions (e.g. banks), or issuing corporate bonds.

3. Financial institutions and financial markets also perform various other functions in an economy.
   - They make trade easier by allowing buyers to make payments quickly and easily.
   - They provide insurance cover to firms and individuals.

Question 2

The financial sector Helps Economic Growth

Answer 2

1. Effective and efficient financial markets enable economic growth to occur, while unstable institutions and markets can => major problems.
2. Economic growth is driven by the spending of individuals and firms, much of which relies on credit.
3. Businesses (small firms esp) are unlikely to grow without credit. If firms don’t grow, this means fewer new jobs and lower exports.
4. Firms in developing countries, where the financial sector tends to be quite weak or underdeveloped, struggle to get credit and this restricts their growth.

Question 3

The Banking Industry is Regulated

Answer 3

1. Banks are private-sector organisations that aim to make profits for their shareholders. But in some ways banks are treated quite differently from most other private firms.
2. This is partly because problems in a bank or in the banking industry can have an impact beyond those with bank savings - they could potentially destabilise a country’s whole economy.
3. Greater profitability in banking is also often associated with taking bigger risks so there are incentives for banks to take financial risks in the hope of making a large profit.
4. The huge economic importance of banks combined with the incentive to take risks means that banking is regulated industry - i.e. there are rules to control the behaviour of banks, and penalties for any banks that break the rules.
5. Financial institutions are regulated to:
   - Reduce the impacts of financial market failure.
   - Protect consumers by policing individuals and firms to ensure that they act fairly and legally.
   - Ensure the integrity and stability of financial institutions and the services they provide.
   - Maintain confidence in the financial sector and avoid sudden panics.

Question 4

You need to know Three types of Financial Market:

1. Money Markets provide Short-term Finance

Answer 4

• Money markets provide short-term finance to banks, companies, governments and individuals.
• This short-term debt will have a maturity (i.e. a repayment period) of up to about a year (could be as little as 24 hours).

Question 5

You need to know Three types of Financial Market

2. Capital Markets provide Medium and Long-term Finance

Answer 5

1. Capital markets provide governments and firms with medium- and long-term finance. Governments and firms can raise finance by issuing bonds. Firms can also raise finance by issuing shares or by borrowing from banks.
2. A capital market has a primary market and secondary market:
   - The primary market is for new share and bond issues
   - The secondary market is where existing securities are traded (e.g. stock exchange). This increases their liquidity (i.e. being able to sell them means it’s easier to ‘convert them to spendable cash’)

Question 6

You need to know about Three types of Financial Market:

3. Different Currencies are bought and sold on the Foreign Exchange Markets

Answer 6

1. Foreign exchange markets are where different currencies are bought and sold. This is usually done to allow international trade and investment, or as speculation (to make money on fluctuations in currency prices).
2. A foreign exchange market is split into what’s known as the spot market and the forward market:
   - The spot market is for transactions that happen now.
   - The forward market is for transactions that will happen at an agreed time in the future.

Forward Markets: Prices are agreed on the day. but delivery happens later

• On a forward market, contracts (called futures) are made at a price agreed today but for delivery later.
• Futures are useful for firms who export and import goods, as they ‘lock in’ an agreed exchange rate between the buyer’s and seller’s currencies. This certainty allows both firms to be more confident about their future plans.
• Either firm could lose out if the exchange rate changes, but this ‘risk sharing’ encourages more trade.
• Forward markets also exist for commodities - e.g. a price for a future trade in coffee can be agreed in advance.

Question 7

Bonds are a form of Borrowing

Answer 7

1. Governments and large firms can issue bonds to raise money (e.g. a govt might need to finance a budget deficit, while a firm might want to invest in new machinery).
2. Investors buy new bonds at their ‘face value’ and become bond holders.
3. Interest is paid to the bondholder - the amount of interest paid is called the coupon.
4. After they’ve been issued, bonds can be traded in secondary capital markets. Investors can buy or sell bonds at any price - the ‘market price’ may be bigger or smaller than the bond’s nominal value.
5. The bond’s yield is the annual return an investor will get from the bond. The less someone pays for a bond, the higher its yield.
   Yield = Coupon/ Market Price x 100
   look in the book for example
6. When the bond matures, the current bondholder is paid the nominal value of the bond by the issuer. This means the issuer’s original debt has been repaid.