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Question 1

what are the main components of the financial system? (5)

Answer 1

1. Money
2. Financial instruments
3. Financial markets
4. Financial institutions
5. Central banks

Question 2

3 main functions of money

Answer 2

Median of exchange (action of buying and selling, makes transactions easy)

unit of account (provides a standards way to measure and compare values of goods)

store value (money holds value overtime allowing people to save without it losing too much purchasing power)

Question 3

what do financial instruments do

Answer 3

transfer resources from savers (lenders) to investors (borrowers) and to transfer risk to those best equipped to bear it.

Question 4

what are financial markets

Answer 4

a place to Buy and sell financial instruments

Question 5

what are financial institutions

Answer 5

Provide access to financial markets, collect information, and provide services

Question 6

what do central banks do (3)

Answer 6

Monitor financial institutions

stabilize the economy

conduct policy.

Question 7

4 key principles of money and banking

Answer 7

1. Time has value.
   Time affects the value and return of financial instruments.
2. Risk requires compensation.
   In a world of uncertainty, individuals will accept risk only if they are compensated in some way.
3. Information is the basis for decisions.
   The collection and processing of information stand at the foundation of the financial system.
4. Markets determine prices and the allocation of resources.
   The “places” where buyers and sellers “meet” are the core of the economic system.

Question 8

3 functions of financial markets

Answer 8

Connecting Savers and Borrowers – Financial markets help move money from people or institutions with extra funds (savers) to those who need funds for investment (businesses, governments, or individuals)

Promote economic efficiency by producing an efficient allocation of capital, increasing production.

Better Financial Planning for Consumers – Financial markets allow people to save, invest, or borrow, helping them manage spending and plan for future needs, such as buying a home or retirement.

Question 9

what is direct finance

Answer 9

borrowers borrow funds directly from lenders in financial markets by selling them securities.

Question 10

what is indirect finance

Answer 10

financial intermediary stands between lenders and borrowers.

Question 11

what is an asset

Answer 11

something of value that is owned.

Question 12

what is liability

Answer 12

something of value that is owed.

Question 13

what is debt and equity markets

Answer 13

markets where financial claims are bought and sold e.g. bonds and stocks, for immediate cash payment

Question 14

what are debt instruments

Answer 14

Debt instruments are contractual agreements where borrowers make regular payments to the holders (both principal and interest) until the debt reaches its maturity date.

Question 15

what is equity in financial markets?

Answer 15

claims to share in the net income (dividends) and assets of a business.

Question 16

what are derivative markets

Answer 16

Derivatives markets involve financial claims based on underlying assets. These financial instruments are bought and sold for payment at a future date, often used for hedging or speculative purposes.

Question 17

what are primary markets

Answer 17

trade in newly issued securities

example: Investment Banks underwrite securities

Question 18

what are secondary markets

Answer 18

trade in existing securities

example:
NYSE, LSE, NASDAQ;

Foreign exchange markets, futures markets, options markets.

Question 19

what are brokers

Answer 19

agents matching buyers with sellers of securities (buy/sell for their clients)

Question 20

what are dealers

Answer 20

link buyers and sellers by buying/selling securities at stated prices (buy/sell on their own account).

Question 21

which market do brokers and dealers work in?

Answer 21

secondary market

Question 22

what is a centralised exchange

Answer 22

Physical location where trading takes place.

e.g. NYSE.

Question 23

what are Over-the-Counter (OTC) markets

Answer 23

Network of dealers connected electronically. Set price.

Foreign exchange, Federal funds

Question 24

what are money markets and capital markets

Answer 24

Money markets: deal in short-term (<1 year) debt and equity.

Capital markets: deal in longer-term (>1 year) debt and equity.

Question 25

examples of money market instruments

Answer 25

Government bonds (Treasury bills) Bank certificates of deposit Commercial paper Repurchase agreements (Repo) Eurodollars Banker’s acceptances

Question 26

examples of capital market instruments

Answer 26

Government securities and bonds (long-term) Corporate stocks Corporate bonds Mortgages and mortgage-backed securities Bank commercial loans

Question 27

What is the store of value function in financial market instruments?

Answer 27

The store of value function refers to instruments that preserve value over time, such as stocks, bonds, loans, mortgages, and asset-backed securities.

Question 28

What does transfer of risk mean in the context of financial market instruments?

Answer 28

Transfer of risk refers to the use of instruments like insurance contracts and derivatives (e.g., futures contracts and options) to transfer financial risk from one party to another.

Question 29

How do financial intermediaries lower transaction costs? (2)

Answer 29

Financial intermediaries lower transaction costs through economies of scale, where the cost per transaction decreases as the size of transactions increases, making financing more affordable for corporations Liquidity services allow individuals and firms to easily convert assets into cash, such as offering liquid savings accounts or short-term investments.

Question 30

How do financial intermediaries reduce risk? (2)

Answer 30

Financial intermediaries reduce risk through risk sharing (asset transformation), where they pool funds from many investors and diversify investments, thereby spreading risk across various assets. Diversification refers to the practice of spreading investments across various assets to reduce the overall risk to investors by avoiding concentration in one investment.

Question 31

How do financial intermediaries reduce information costs?

Answer 31

Financial intermediaries reduce information costs by screening and monitoring borrowers, addressing problems of asymmetric information where one party has more information than the other.

Question 32

What is Adverse Selection in financial markets?

Answer 32

Adverse selection occurs before the transaction, where financial intermediaries are more likely to select borrowers with higher risks due to limited information about the borrower's true risk level.

Question 33

What is Moral Hazard in financial markets?

Answer 33

Moral hazard occurs after the transaction, where a borrower may be less likely to repay the loan or act responsibly, knowing that the lender is bearing the risk.

Question 34

types of financial intermediaries (3)

Answer 34

Depositary institutions e.g. commercial banks Investment intermediaries e.g. finance companies Contractual savings institutions e.g. life insurance companies

Question 35

Internationalisation of financial markets (5)

Answer 35

- Foreign Bonds - Eurobond - Eurocurrencies - Eurodollars - World Stock Markets

Question 36

what are foreign bonds

Answer 36

Foreign bonds are bonds that are sold in a foreign country and are denominated in that country’s currency. For example, a U.S. company issuing bonds in Japan denominated in yen.

Question 37

what are eurobonds

Answer 37

A Eurobond is a bond that is denominated in a currency other than that of the country in which it is sold. For example, a bond issued in London but denominated in U.S. dollars.

Question 38

what are eurocurrencies

Answer 38

Eurocurrencies refer to foreign currencies that are deposited in banks outside the home country. For example, Japanese yen deposited in a bank in London.

Question 39

what are eurodollars

Answer 39

Eurodollars are U.S. dollars that are deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. These deposits are used in international finance.

Question 40

What are World Stock Markets?

Answer 40

World Stock Markets refer to stock exchanges and financial markets around the globe where stocks, bonds, and other financial instruments are bought and sold. They facilitate international investment and capital flow.

Question 41

why do we need to regulate the financial systems

Answer 41

To increase the information available to investors To ensure the soundness of financial intermediaries

Question 42

why do we need to increase the information available to investors

Answer 42

- reduce adverse selection - reduce moral hazards - reduce insider trade

Question 43

why do we need to ensure the soundness of financial intermediaries (6)

Answer 43

Restrictions on entry (chartering process) - governments ensure only reliable firms enter the market. Disclosure of information - regularly report their financial status and risk exposure to regulators and the public. Restrictions on assets and activities (control holding of risky assets). - prevent excessive risk taking Deposit Insurance (avoid bank runs) - to protect depositors' money and prevent panic-driven bank runs. Limits on competition (in the past) - prevent reckless lending and instability Restrictions on interest rates - to control inflation and ensure financial stability

Question 44

Principal regulatory agencies in the UK (2)

Answer 44

- Bank of England - Financial conduct authority (FCA)

Question 45

Principal regulatory agencies in the USA (7)

Answer 45

- Securities and Exchange Commission (SEC) - Commodities Futures Trading Commission (CFTC) - Office of the Comptroller of the Currency - National Credit Union Administration (NCUA) - State banking and insurance commissions - Federal Deposit Insurance Corporation (FDIC) - Federal Reserve System