4.4 Financial Markets- Dal

Question 1

What is a financial market

Answer 1

where buyers and sellers can trade financial assets

Question 2

Types of lenders and borrowers

Answer 2

-savers
-investors

-individuals
-firms
-government

Question 3

Direct vs Intermediaries

Answer 3

-stock markets
-bond markets

-commercial banks
-investment banks
-pension funds
-hedge funds
-mutual funds
-intermediaries offer a lower rate of return to lenders than the rate for borrowers

Question 4

Types of financial markets

Answer 4

-money markets: IOU’s of < 1 year
-capital markets: primary, secondary. IOU’s>1 year : bonds, shares, debt capital financial asset that pays back an interest rate, equity capital return is a dividend, new shares/bonds issued, trading existing securities
-currency markets: spot, futures

Question 5

Functions of money and the money supply and commodity/fiat money.

Answer 5

-Medium of exchange
-store of value (fruits go bad over time, inflation can erode the store of value)
-measure of value
-standard of deferred payments (borrow money and pay back over time)

Commodity money: intrinsic value, e.g. gold standard
Fiat money: no intrinsic value

Money supply:
-total value of money circulating the economy
-M0-M4

Question 6

Quantity theory of money/Fisher equation (monetarist belief)

Answer 6

-Direct link between money supply and inflation
-Fisher equation MV=PQ
-M=money supply
-V=Velocity of circulation
-P=Average price level
-Q=Quantity of goods/services sold
-V and Q can be ignored as they are constant when looking at data over time so P=M
-more money chasing the same quantity of goods mean prices will rise to compensate

-Keynesian’s:
-V cannot be fixed during times of recessions
-V decreases in a recession, inc in money supply, liquidity trap, money not feed through the economy to an increase in the inflation rate.

Question 7

How central banks set interest rates and diagram

Answer 7

-Factors effecting the supply of money:
-Reserve requirements: amount of money required by the commercial bank to keep with the central bank
-Discount rate/repo rate/bank rate: the rate on borrowing for commercial banks borrowing from the central bank
-Open market operations: buying and selling of bonds

Question 8

What is a bond ?

Answer 8

An IOU that pays regular interest payments and the face value of the bond on maturity

Question 9

Who issues a bond and why ?

Answer 9

-Governments who need to raise finances for spending
-Corporations looking to invest

Question 10

Who buys bonds and why

Answer 10

• Anyone
  -Yield on the bond may be better than other financial assets out there
  -Safe security, Governments unlikely to go bankrupt

Question 11

Yield for a bond

Answer 11

Yield=coupon/market price x100

Question 12

Relationship between Price and yield on bonds and how they change to reflect market interest rates

Answer 12

-Inverse relationship
-IF yields are high (higher than other market interest rates) individuals will buy up these bonds increasing the prices and bringing the yield back down to match other interest rates.

Question 13

Credit creation/Fractional reserve banking and the money multiplier

Answer 13

-Money multiplier=1/reserve ratio
-Based on trust, breaks down if a bank run occurs.
-Banks keep percent of a deposit and loan the rest, the loan is spent in the economy and re-circulates back into the bank, the bank takes this deposit and the cycle repeats.

Question 14

Commercial banks and investment banks:
-and systemic risk

Answer 14

-Accept savings
-lend
-financial intermediaries (profit maximising)
-allow payments
-advice

-Propriety trading: taking excess capital and investing
-Market making:
-Mergers and acquisitions: when, structure, due diligence (hidden secrets), paperwork, regulation, media, charge a fee in the process.
-New issues: underwriting

Systemic risk:
-due to banks carrying out commercial and investment bank activities
-integration of commercial banks

Question 15

Commercial banks balance sheet

Answer 15

-Record of all assets, liabilities and capital (shareholders equity).
-Assets:
Cash

Question 16

Bank failure:
-liquidity crisis (bank run )
-Insolvency

Answer 16

-Bank run: not enough liquid short term assets to meet short term liabilities
-Insolvency: not enough capital to offset losses in asset values Liabilities>Assets

Question 17

Financial market failure

Answer 17

When free financial markets fail to allocate financial products at the socially optimum level of output.

Excessive risk leading to overall collapse of the financial system.
Consequences:
-Systemic risk
-recession, lost incomes, jobs, output
-bank bailouts: taxpayer burden

Collusion and fixing of interest rates/exchange rates.
Consequences;
-Loss of welfare
-maximising profits against the interests of society’s

-De-regulation of financial markets in the UK and USA increased financial market failure and systemic risk
-Taking away capital/liquidity ratio
-Scrapping reserve requirements
-Using commercial bank funds for investment bank activities

Question 18

Speculation and market bubbles-Excessive risk

Answer 18

-buy assets at a low price sell at a high price
-Leveraged loans
-excessively high estimates of future price increases can create market bubbles and overpaying for asset
-Eventually buyers realise assets are not worth as much as they are paying for them, causing demand to fall and prices to fall, leading to worthless assets and huge debts
-bank failures as a result

Question 19

Asymmetric information:
-Moral hazard
-Adverse selection

Answer 19

Moral hazard:
-Banks are too big to fail
-Excessive risk is taken
-Banks know the risks they are taking but can hide it from the regulators and the government.

Adverse selection:
-when most likely buyers are those the sellers would prefer not to sell to due to imperfect information.
-excessive risk taken e.g. with healthcare insurance
-Premiums too high for healthy consumers, good value for poor health consumers
-result is selling to unprofitable consumers, resulting in losses and risk of collapse

Question 20

Negative externalities- Excessive risk

Answer 20

-Negative externalities ignored by commercial bankers taking excessive risk
-Cost to the tax payer for bank bailouts
-loss of savings
-lost jobs, income, growth

Question 21

Market rigging- Collusion and price fixing

Answer 21

-Where traders/banks/intermediaries collude to manipulate markets and make huge profits
-Customers lose out
-Heavy fines and regulation but can still occur if punishment and enforcement is weak

Question 22

Regulators of Financial Markets:
Rational for regulation if public interest is being harmed

Answer 22

-BoE regulators:

Financial policy committee (FPC):
-Macroprudential regulators
-identify, monitor and protect against systemic risk
-Instruct PRA &FCA in tackling financial stability issues
-Advise Gov
-Stress tests

Prudential regulation authority:
-Micro prudential regulators
-Maintain stability of banks
-supervise management of risk
-setting industry standards
-specifying ratios/requirements

Government run:

Financial conduct authority:
-Micro prudential regulation
-Protect consumer and increase confidence in financial institutions
-No market rigging
-Deregulation, promote competition so consumers get better deals
-Mis-Selling, banning financial products against interest of consumers
-Loan sharks

Question 23

Types of financial market regulation

Answer 23

-Ban market rigging: rigging harms consumer, businesses and other financial institutions
-Prevent sale of unsuitable products to consumers: products with excessive risk, charges and limited benefits
-Maximum interest rates: Prevent consumer exploitation (borrowers) whilst preventing excessively risk lending
-Deregulation: more competition (reduce the amount of red tape) higher interest rates for savers, lower for borrowers
-Deposit insurance: protect consumer deposits in case of bank run
-Ring fence commercial banking away from investment banks: lowers systemic risk
-Set limits on bank lending: lower chances of bank failure and systemic risk: cash ratios, liquidity ratios, capital ratios, leverage ratios, reserve requirements.
-Liquidity assurance with conditions and punishments

Question 24

Financial regulation ratios:

Answer 24

-Cash ratio=Cash assets/Current liabilities
Regulation, impose it or raise it
Intention, prevent liquidity crisis
BASEL recommendations, None

-Liquidity ratio=Current assets/Current liabilities
Regulation, impose it or raise it
Intention prevent liquidity crisis
-Basel recommendations, 100% liquidity to cover liabilities owed in 30 days or less.

-Reserve requirements:
The fraction of deposits that must be held at the BoE
Basel recommendation: None, 10% USA

Capital ratio=Capital/Loans
Intention, prevent insolvency
Basel recommendation, 8% minimum.

Leverage ratio=capital/Loans and long term investments
Intention, prevent insolvency
Basel recommendation, 3% minimum

Question 25

Problems with Financial market regulation

Answer 25

-Moral hazard
-Regulatory capture
-Asymmetric information,
-Information failure
-Unintended consequences: deregulation, shadow banking, max interest rates
-Administration and enforcement costs

Question 26

Evaluation:

Answer 26

-Balance needed to protect consumers and against systemic risk but to maintain bank profitability
-Cost vs benefits
-Promotes equity, without damaging efficiency

Question 27

Role of the central bank

Answer 27

-Implement monetary policy
-Act as a banker to the government
Financial stability roles (prevent panic and a run on the bank, reduce financial instability and systemic risk, advise the gov. on bank bailouts)
-Act as a banker to the banks: the lender of last resort
-Regulate the financial system

Evaluate lender of last resort function:
Moral hazard
banks may not hold sufficient liquidity
regulatory capture
why should banks have this luxury and not other firms