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Economics of the financial system > Key terms > Flashcards

Key terms Flashcards

1
Q

What is a fixed exchange rate regime?

A
  • where the value of a currency is pegged relative to the value of another currency- this second currency is called an anchor currency
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2
Q

What is a floating exchange rate regime?

A
  • where the value of a currency is determined by the S and D forces on other currencies, therefore fluctuates against it
  • left to its own devices
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3
Q

What is a managed float regime (dirty float)?

A
  • attempt to influence ER by buying and selling currencies
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4
Q

What is a bond?

A
  • a security paying the investor fixed regular payments. These regular payments are known as coupons. The borrower (the bond issuer) then repays the full or par value at a final date referred to as the “maturity” or “redemption” date.
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5
Q

Define bond yields.

A

The yield (or ‘yield to maturity’) of a bond is the rate of return to the investor from the bond’s coupon payments.

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6
Q

Real vs nominal interest rates?

A

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.

A nominal interest rate refers to the interest rate before taking inflation into account.

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7
Q

Define Equity.

A

An equity is a share in the ownership of a company, entitling the owner to payment of dividends and also to the right to vote at annual general meetings.

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8
Q

Define credit spread

A

A credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity.

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9
Q

What are interchange fees?

A

transaction fees that the merchant’s bank account must pay whenever a customer uses a credit/debit card to make a purchase from their store

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10
Q

What is a Four party Payment system?

A
  • four‐party system because alongside the payer (Cardholder) and payee (merchant) there are also two others institutions involved, the issuer that provides the card and the merchant acquirer who engages with the retailer
  • the acquirer takes the consumer details and payment details and contacts the card issuer if the card is valid and funds are available, the issuer checks card details and if it is being used by the correct person and authorises payment.
  • The link between the two are card schemes that facilitate the transaction
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11
Q

What is a Bank settlement?

A
  • A transfer of assets between two bank entities so the balance sheet remains unchanged. Settlement is almost always through a transfer of deposits (central bank reserves) held by commercial banks at the central bank.
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12
Q

What is a network good or service?

  • give one eg of how utility increases
  • one eg of how cost reduces
  • and one of both
A

A network good or service is one that is of greater value to consumers, the larger the number consuming or using that good or service. OR has a reduced cost per unit as more people use it.

Prime eg- the internet and sites like etsy, need to reach critical mass to be able to be used

or

Financial network eg: money, based off the willingness to use as a medium of exchange

House hold utilities: the more households in an area the cheaper electricity bills will be for the area as the cost is shared

Payment schemes

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13
Q

Define payment scheme

A
  • a set of rules agreed upon by PSPs to execute transactions with a specific payment instrument
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14
Q

What is a 2-sided payment platform?

A
  • where both payer and payee are part of the same platform but have different needs, incentives, and reasons for using the product.
  • outcomes can be effected by different pricing, for example the merchant may reduce prices to increase access for buyers
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15
Q

What is a peer-to-peer (P2P) payment?

Provide example, think about how the app works during exam.

A

Platforms allowing 1 person to send or receive payments instantly electronically- normally an app.

EG: Revolut, Monzo

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16
Q

Define critical mass.

A
  • the amount of participants a payment scheme needs in order to cover its costs.
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17
Q

Define Primary and Secondary security markets.

eg for both

A
  • Primary: the opportunity to buy securities when they are first issued, usually from the issuer, done in huge trades, prices set by the bank.
    EG: IPOs
  • Secondary: any purchase of securities after the initial offering, price is set by demand and supply of the market.
    EG: NYSE
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18
Q

Define book building.

A
  • The process where an underwriter determines the price that a IPO will be delivered
  • arriving at a price involves recording investor demand for shares
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19
Q

What is an underwriter?

A
  • in investment banking this is where a bank raises capital for a client (corporation or government) from investors in the form of equity or debt securities
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20
Q

Broker meaning?

A
  • anyone executing a buy or sell order on behalf of their client - not themselves.
  • their duty is to achieve the best price, ie buy low and sell high
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21
Q

Outline high-frequency trading.

A
  • rapidly buying or selling small amounts of equities to identify patterns in market price movements, price inconsistencies on different platforms and trading traditions.
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22
Q

Explain what a limit order book is.

A
  • a record of outstanding limit orders maintained by a security specialist.
  • a limit order is an order to buy or sell a security at a specific price
  • therefore, if the price is not met then a limit order book forms
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23
Q

Define market order

A
  • buying or selling a security as quickly as possible at its current market price
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24
Q

Difference between market and limit order

A

market = as quickly as possible at current price
‘based on market’
Limit = sets the maximum and minimum limits you are willing to buy or sell
‘based on limit’

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25
Q

Define algorithmic trading.

A
  • using computers to break up large market orders reallocate them to different venues or introduce them into the market carefully and gradually as to not impact price too drastically
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26
Q

Define dark pools

provide eg

A
  • asset exchanges where orders are not displayed to other participants of the market.
  • this anonymity prevents the order from majorly effecting price

eg: if an investment bank is going to sell 1,000,000 shares of a company, the stock price would most likely plummet. Ordering in a dark pool limits the effect on price.

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27
Q

Dealer quote markets definition. provide eg

A
  • buyers and sellers do not trade directly with eachother, instead they buy and sell off a dealer who post prices they are willing to buy or sell a security at.
  • eg : the NASDAQ
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28
Q

Define Interdealer brokers

A
  • allows dealers to trade anonymously with one another, avoiding large impact on market prices
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29
Q

What is a derivative?

What derivatives are there?

A
  • a contract between two parties which derives its value/ price from an underlying asset
  • examples the underlying asset can be a stock, commodity and currencies
  • futures, forwards, swaps and options are all derivatives
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30
Q

Define swaps

give an example

A
  • contracts to exchange one set of future payments with another different set of payments
  • credit default swaps, a buyer of a bond may buy cds from an insurance company for a premium to mitigate loss incase the bond issuer defaults, shifting risk to the insurer
  • or interest rate swaps,
    a less established company with a worse credit rating receives a lone with a variable interest rate of 6%, where an established company with a good credit rating has a fixed rate of 5%. They may swap as the established company will receive a lower variable IR and the less established receives 5% instead of 6%.
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31
Q

Define futures and forwards.

A
  • contracts to buy or sell an asset at a certain price by a certain date
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32
Q

Define proprietary trading

A
  • when a financial institution, brokerage firm, investment bank or other liquidity source uses a their own capital to conduct self-promoting financial activities
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33
Q

What is the difference between a futures and forwards contract?

A
  • futures are traded on public exchanges
  • forwards are between two private parties
  • futures = low risk, high regulation
  • forwards = more risk due to low regulation
  • futures are settled daily whereas forwards are settled on maturity
34
Q

Define securities lending.

A
  • when the owner of a security transfers them temporarily to a borrower
  • the borrower transfers their securities as collateral and pays a borrowing fee
35
Q

Define market liquidity.

A
  • a market feature whereby an individual or firm can quickly buy or sell an asset without causing a major change in the asset’s price.
36
Q

Insider trading definition

A
  • the trading of a pubic company’s stock or other securities based on non-public information. Often illegal
37
Q

Define market manipulation

all egs

A
  • type of market abuse involving deliberate attempts to interfere with the free and fair operation of the market
  • most blatantly, creating false or misleading information about price to create a profit

methods include:
- spoofing, insider trading, cornering, wash trades

38
Q

Define short-selling

provide eg

A
  • selling a borrowed security with the intention of buying it back at a later date for a cheaper price, taking advantage of the speculated decline of a security
  • second hand car during covid
39
Q

Leveraged purchase definition

A
  • the purchase of a security with only a partial initial payment, borrowing the rest of the purchase.
  • remember they also borrow the risk when price falls
40
Q

Define market corner

A

Cornering the market is obtaining and holding/owning enough stocks, assets, or commodities to effectively control the market price of said items.

41
Q

Define a short squeeze

A
  • Buying a short is betting a stock will decline, if the stock infact inclines then those who own shorts lose money.
  • to mitigate losses they sell their shorts and buy shares of the underlying asset
  • this further increases the stocks value and intensifies the squeeze, leading to more and more investors selling their shorts
42
Q

What is a long squeeze?

provide eg

A
  • if a security experiences a sharp decline in price owners of the security will close their positions to mitigate losses.
  • this causes a further decrease of the stock and intensifies the squeeze- positive feedback loop
  • the squeeze is far worse if positions are leveraged
  • this happens when there is no fundamental reason for the price to drop further it is just because it has dropped that it drops further
  • eg- happens in day trading seen on intraday charts
43
Q

What is a wash trade?

A
  • a form of market manipulation where an investor will list a security on the market and then it buy it from themselves to create artificial market activity.
44
Q

Define the term spoofing.

A
  • to place a substantial order on a limit order book to create a false idea in the market
  • however, the idea is that this order is never going to be placed, it is just to create an illusion- illegal and unethical
45
Q

What is benchmark manipulation?

A
  • conducting large trades right at the end of the day to push the bench mark up or down.
46
Q

Define the term front running

A
  • trading a financial asset for a customer with the knowledge of a future transaction which will dramatically change the price, the broker continues the trade, making a profit for themselves.
  • illegal and unethical
47
Q

What is meant by the term best execution?

Name something that contradicts it.

A
  • the duty of an investment services firm executing orders on behalf of customers to ensure the best execution possible for their customers’ orders
  • eg front running contradicts
  • eg 2008 crisis moral hazard
48
Q

What is the difference between direct and indirect finance? egs for both

A
  • direct: channelling funds directly from economic players that have surplus to those in deficit
    eg: your friend giving you money in return for interest in the future
  • indirect: financial intermediaries reducing transaction costs

eg : borrowing a loan from a bank and paying interest

49
Q

Define options

A
  • contracts giving the holder the RIGHT BUT not OBLIGATION to buy or sell an asset at an agreed price for a known amount of time until a future date
  • eg: A man wants the option to buy a car for 10k from a lady at some point in the next month
    He’ll pay a down payment as a fee for reserving the product at that price
50
Q

What is a benchmark?

A
  • a standard yardstick with which to measure the performance of an asset.
51
Q

Define asymmetric information.

Provide EG

A
  • Where buyers have information that sellers don’t have and vice versa
  • risky lifestylers may take out a larger disability insurance
52
Q

When does the free-rider problem occur?

A
  • the free-rider problem occurs when a public good is non-excludable and can be used unlimited times without effecting utility for other uses
53
Q

Define the free-rider problem and give an example

A
  • burden of a shared resource, where people who aren’t paying for it can utilise it
  • for example, if the neighbourhood wants to chip in to refurbish the sidewalk
  • some have no incentive to pay as they can use it anyways if everyone else pays for it
54
Q

Define Moral hazard.

Give eg

A
  • when an economic actor may take on greater risk as they know someone else burdens the risk.
  • eg: if you have car insurance you have less incentive to protect your car as you technically do not lose anything if it is damaged
55
Q

Define securitization

give eg

A
  • To transform illiquid assets (eg mortgages) into marketable capital securities.
  • eg: sub-prime mortages
56
Q

Define shadow banking

give eg

A
  • lending through unregulated institutions, called ‘non-bank financial institutions’
  • eg investment banks like morgan stanley
57
Q

Define loophole mining

A
  • a legal and ethical way where financial players look for creative ways to find away round certain regulations
58
Q

Define lobbying

A
  • a legal and ethical way of innovation where financial players try to change regulations
59
Q

What is a money market mutual fund? Give eg

A
  • a type of fund that invests in high-quality, short-term securities, offering relatively low risk but also reward
  • eg: JP Morgan
60
Q

Define idiosyncratic risk, how to mitigate it and an eg

A
  • the inherent risk of a specific asset affecting one particular investment (eg moving a stock) as opposed to the threatening the whole market
  • mitigated through diversifying your portfolio
  • eg: some may say Elon Musk is an idiosyncratic risk of Tesla stocks due to his unpredictability
61
Q

What is a sweep account?

A
  • To use capital most efficiently, at the end of the day, balances over a certain amounts will be SWEPT out of their accounts and will be invested in over-night securities.
  • these funds are subject to no reserve requirements as they are not classified as deposits
62
Q

Define open banking.

What kind of tech?

A
  • open banking uses API (application programming interface) to provide more information to consumers about the bank and the products they provide
  • attempting to increase competition between banks by providing more information to customers
  • efficiency tech
63
Q

P2P lending meaning?

What kind of tech?

eg?

A
  • using online technologies create a marketplace where investors can lend funds to potential borrowers and provide credit through P2P agreements
  • Transformative tech
  • nibble
64
Q

Policy Trilemma definition?

eg: Swiss Bank 2008

A
  • says a country must choose between free capital mobility, ER management and monetary autonomy
  • only 2 of 3 are possible
65
Q

What is a speculative attack?

LONG ANSWER

eg ?

A
  • occurs in forex market when speculators attack the currency of a country attempting to maintain a fixed ER.
  • they attack it by borrowing the threatened currency and converting it to the one it is pegged to.
  • this drains the country’s reserves quicker
  • if the country does not hold enough reserves of its currency then the peg will fail
  • the speculators can then convert back to the devalued currency, pay off their debts and have a remaining profit
    eg: September 1992 crisis, George Soros convinced investors to attack the B of E, devaluing the pound against the dollar
66
Q

Define exchange rate, appreciation and depreciation

A
  • price of one currency relative to another
  • appreciation: a currency rises in value compared to another
  • depreciation: a currency falls in value compared to another
67
Q

Spot transaction definition.

A
  • immediate exchange of bank deposit (2 days)
68
Q

What is the law of one price?

A
  • if 2 countries produce an identical good and trade barriers and transportation costs are low then the price of the good should be the same throughout the world regardless of who produces it
69
Q

Purchasing power parity definition.

A
  • states that ER between two currencies will adjust to reflect changes in the price levels of two countries
  • law of one applied to the national prices
70
Q

Unsterilizied FOREX intervention meaning?

A
  • where domestic currency is sold to buy foreign assets
  • this leads to gain in the international reserves, an increase in the money supply and therefore a depreciation of the currency
71
Q

Sterilized FOREX intervention meaning?

A
  • where a foreign currency is bought or sold by a central bank to influence the ER of the domestic currency without changing the monetary base
72
Q

What is the balance of payments ?

A
  • The balance of payments includes both the current account and capital account.
  • The current account includes a nation’s net trade in goods and services and its net transfer payments.
  • The capital account consists of a nation’s transactions in financial instruments and central bank reserves.
  • The sum of all transactions recorded in the balance of payments should be zero; however, exchange rate fluctuations and differences in accounting practices may hinder this in practice.
73
Q

Define debt deflation.

A
  • a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation
  • causing defaults on loans and mortgages
74
Q

What is the principle agent problem?

give eg

A
  • where one person or entity is able to make decisions and/or take actions on behalf of another person or entity
  • arises from asymmetric information
  • you (principle) mechanic (agent), he could say you need loads of repairs, you do not know if he is saying that to get more money from you because you do not have the information
75
Q

What is the pay-off method?

eg

A
  • government safety net to short circuit bank failures and contagion effect
  • allows banks to fail and pays off deposits up to a specified insurance limit
  • 250k $ in US and 85k £ in UK
76
Q

What is the purchase and assumption method?

A
  • insurer reorganises the bank, typically finding a willing merger to assume takeover of all failed banks liabilities so no depositor loses capital
77
Q

Define macroprudential policy.

A
  • aims to address financial system as a whole by looking at interconnectedness of financial institutions
78
Q

Define microprudential policy

A
  • aims to address financial system by looking at the soundness of individual systems not the whole system
79
Q

Restrictive covenants meaning?

give examples

A
  • legal agreement in debt contracts between two or more parties
  • examples:
  • provide information (eg quarterly reports)
  • encourage desirable behaviour (life insurance mandates for mortgages)
80
Q

Explain the contagion effect.

provide eg

A
  • uncertainty about health of banking systems can affect other banks, and one bank failure can hasten the failure of others
  • even if some banks have no reason to fail
  • eg Lehmann bros 2008
81
Q

Define adverse selection

give eg of how its an issue

A
  • when a better-informed party uses the asymmetric balance of information to take advantage of another party before an exchange has taken place.

For example, a knowingly unsafe driver may take out car insurance as they feel they will need it at some point. The insurer has less information because they cannot reliably tell how safe that person is behind the wheel.

  • the problem with this is that not knowing the information means insurers will precautiously raise insurance premiums and prices for all drivers as they cannot guarantee who is safe and who is not

Economics of the financial system (4 decks)

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