Week 3 Flashcards
The Economy
Consists of all the economic systems in a geographical area e.g UK Economy
Both natural and man-made factors define and develop an economy
In practice, there is always a mixed economy, with different degrees of freedom to market. E.g., UK is largely a capitalist economy. However, some sectors are controlled by the government. E.g., energy, health, transport and even banks.
The Regulator
Government acts as the apex regulator, and have the primary objective and promoting economic development through enforcing law and maintaining stability in the market
Central Bank acts as an independent division of the government
The Markets
Markets are places where buyers and sellers find each other and complete economic transactions.
Price reflects information- new information leads to price changes
Flow of Funds in an Economy
Key Economic Entities
-SSU- Surplus Spending Units (Savers)
-DSU – Deficit Spending Units (Borrowers)
-Financial Intermediaries
-Brokers/Dealers
Financial Intermediation
A financial intermediary is an institution or individual that acts as a middleman between two parties to facilitate financial transactions
Two Main Functions
- Asset Transformation
* Risk Transformation
* Volume Transformation
* Maturity (Liquidity Transformation) - Economies of Scale
* Efficiency in Gathering Information
* Risk Spreading
* Market Creation
* Minimizing Transaction Cost
Financial Intermediation- Asset Transformation
Risk Transformation
Converting risky investments into relatively risk-free (or less risky) investments
Volume Transformation
Intermediaries gather small amounts of deposits from numerous savers and re-package these in larger loans and vice versa
Maturity (Liquidity) Transformation
Intermediaries help matching the time of maturity of
investors to the time that funds are needed by
borrowers
Financial Intermediation- Economies of Scale
Efficiency on Gathering Information
-Analysis of riskiness of lending to a particular firm is difficult and costly for individuals. Banks have Credit Departments which can do this more efficiently.
-Identification of good investment opportunities for small investors is a very time taking and costly work (One market report from Bloomberg costs £1500 approx.), but Mutual funds can afford such costs.
Risk Spreading
Individual investor finds it difficult to spread risk, but intermediaries can manage risk in a much better way owing to large number of investors and assets.
Market Creation
To stand as a counterparty for various financial instruments for their clients
Transaction Cost
Intermediaries reduce the search, agreement and monitoring costs – Too much if borrowers and lenders go for direct transaction
Money Market
Money is the commodity traded and sold; the INTEREST RATE acts as the price.
Short-term lending and borrowing – tenure less than a year
Wholesale Transactions – Large ticket size (Usually £500,000 or more)
Generally Financial Institutions (Banks, Insurance Funds, etc.), Central bank, local bodies and large corporates participate.
Banks borrow/lend each other their deficit/surplus funds in this market, mostly in OTC (Over the Counter) market
Place where monetary policy is implemented. E.g., Quantitative Easing
Determines short-term interest rates – E.g., LIBOR
Instruments – Treasury Bills, Repo, Commercial Papers
Capital Markets
In an economy, the capital markets provide the following functions
Mobilise savings from the idle agents and transfer to the productive agents
Provide finance to companies
Encourage broader ownership of productive assets
Provide facilities for competitive transfer (pricing) of capital resources
Provide liquidity in the market
TWO MAIN TYPES
* Stock Market / Share Market – for Equity transactions
* Bond Market – for Debt transactions
Bond Market (Fixed-Income Market)
Deals in long-term debts issued by corporations, local authorities and governments
Usually have a very active secondary market
Governments use this market to raise public debt
Large market size – in 2022 Global $133 tn, UK $4.3 tn (3%)
More than 40% are government bonds.
Determine long-term pattern of interest rates – e.g., Yield Curve
Foreign Exchange Market
Currencies are exchanged for each other
Both ‘spot’ and ‘forward’ markets
Very important market for firms dealing in more than one currency
Dominated by banks, dealings go on 24 hours a day
Share Market (Stock Market)
Shares of companies are bought and sold.
Normally operated through a stock exchange, however OTC markets also exist
Provides long-term equity for companies
Derivative Market
Markets dealing in derivatives – e.g., Futures, Forwards, Options, Swaps
Both exchange-traded and OTC
Generally large stock exchanges have their derivative sections, e.g., EDX London
Primary and Secondary Markets
Primary market
Also known as the new issues market, this is where companies and governments issue new securities to investors to raise funds. For example, a company might sell new stocks and bonds to the public for the first time through an initial public offering (IPO).
Secondary market
Also known as the stock market or stock exchange, this is where investors buy and sell previously issued securities. The secondary market includes exchanges like the New York Stock Exchange and the Nasdaq
Secondary market provides liquidity, builds confidence and is very
important for the efficient functioning of stock/bond markets
Spot and Forward Markets
