Topic 1 The role and structure of financial markets

Question 1

1. Money must have certain properties in order to be acceptable as a medium of exchange. What are they?

Answer 1

The properties are that money should be:
	sufficient in quantity;
	generally acceptable to all parties in all transactions;
	divisible into small units;
	portable.

Question 2

2. What are the six main functions of the Bank of England in the UK economy?

Answer 2

The six main functions are:
	issuer of banknotes;
	banker to the government;
	banker to the banks;
	adviser to the government;
	managing the UK’s official reserves of gold and foreign currencies on behalf of the Treasury;
	lender of last resort.

Question 3

3. Which two opposing groups take part in markets and what compromise do they have to make?

Answer 3

The two groups that come together in markets are buyers and sellers.

They agree on an equilibrium price, which is the compromise price between what each party starts off by seeking.

Question 4

4. From a company perspective, what is the purpose of the equity market?

Answer 4

The equity market is where companies raise money for long periods (often with no repayment date) to finance long term investment in property, equipment and product development.

Question 5

5. What is the term used for markets where short term borrowing and lending take place?

Answer 5

Markets where short term borrowing and lending take place are called ‘money markets’.

Question 6

6. Why are interest rates usually more competitive in wholesale markets than in retail markets?

Answer 6

Interest rates are usually more competitive in wholesale markets, other things being equal, because the large amounts involved give opportunities for economies of scale.

Question 7

7. Why are secured loans normally cheaper than unsecured loans?

Answer 7

Secured loans are generally cheaper than unsecured loans, other things being equal, because there is a lower risk of loss in the event of default due to the security offered.

Question 8

8. What is the function of the secondary market?

Answer 8

The secondary market enables investors to trade in shares that are already in issue – in other words, second-hand.

Question 9

9. Why is it necessary for a strong secondary market to exist before a primary market in the same securities can be successful?

Answer 9

A primary market depends on the existence of a secondary market because people will invest in new securities only if they know there is an organised market for selling them again.

Question 10

10. Why are foreign exchange markets necessary?

Answer 10

Foreign exchange markets are necessary so that businesses and individuals can change one currency into another.

Question 11

11. What is a repo?

Answer 11

A repo is a sale and repurchase agreement – a reversible cash loan in return for the security of a financial instrument.

Question 12

12. In simple terms, how is the rate of interest on a repo represented?

Answer 12

The rate of interest on the deal is effectively the difference between the amount received for the securities on the day the repo is agreed and the higher amount paid to get them back.

Question 13

13. What is the inter-bank market?

Answer 13

In the inter-bank market, banks borrow and lend large sums to each other on an unsecured basis.

Question 14

14. Why are Treasury bills considered to be a safe investment?

Answer 14

Treasury bills are considered to be safe because the government is the borrower and is unlikely to default.

Question 15

15. In what circumstance could a company borrow money at a favorable interest rate in the commercial paper market?

Answer 15

A company can issue commercial paper for a favorable interest rate if it has a good credit rating.

Question 16

16. In relation to time span, what is the difference between commercial paper, medium term notes and bonds?

Answer 16

 The term ‘commercial paper’ is used for securities issued by companies for up to 1 year.
 Securities with a term between 1- 5 years are known as medium-term notes
 More than 5 years as bonds.

Question 17

17. What is an IPO in the equity market?

Answer 17

An IPO – initial public offering – is the first sale of equities to the public by a company.

Question 18

18. What are the three main ways in which new shares can be offered to the equity market?

Answer 18

 prospectus issue;
 private placement;
 a rights issue.

Question 19

19. What is the function of the reinsurance market?

Answer 19

The reinsurance market is a market in which insurers that have already accepted risks are able to lay off some of the risk to other insurers. In this way, all risks insured are divided up between many insurers.

In the event of a larger than normal loss, the impact is felt not just by those insurers that happened to cover the loss in the first place, but also by most other insurers in the market who have bought parts of the risk.