Financial markets Flashcards
financial markets (48 cards)
1
Q
what are financial marketss
A
places where buyers and sellers can trade financial assets
- brings together lenders and borrowers
2
Q
what are lenders
A
those who have excess cash - eg savers and investors
3
Q
what are borrowers
A
ppl who need cash right now but dont currently have it - eg individuals, firms, govts
4
Q
objectives of commercial banks
A
-Earn profits by providing financial services and charging interest on loans.
-takes funds from lenders, a return is then paid on this money. from these savings, loans can be made, and lent out to individuals or firms who need to borrow and an interest rate is charged
- the interest rate to the borrowers is higher than the return to the lenders, so the commercial bank can make profit
5
Q
what is the primary objective of all intermediaries
A
to make profit
6
Q
pension funds
A
- take huge sums of money from individuals looking to save for retirement
- theyll invest it normally in stock markets
- then theyll pay an annuity to pensioners when they reach pension age
7
Q
what are the types of intermediaries
A
- commercial banks
- investment banks
- pension funds
- hedge funds
- mutual funds
- stock exchanges
- insurance companies
7
Q
hedge funds/mutual funds
A
institutions that take huge sums of money from lenders and will buy huge amounts of debt from it (debt issued by borrowers)
- theyll collect interest rates as the payments on all their debt theyre buying
- then will give a rate of return to their investors
8
Q
difference between hedge funds and mutual funds
A
hedge funds engage in riskier transactions, eg hedge funds will buy up debt in leverage deals, which if they went wrong, large sums of money could be lost
- mutual funds are less regulated than hedge funds
9
Q
similarities between hedge and mutual funds
A
both take huge amounts of money from investors, buy a lot of debt, get an interest rate and a rate of return
10
Q
types of financial markets
A
- capital markets
- money markets
- currency markets
11
Q
features of money markets
A
- the buying and selling of financial assets here, are ones that have a maturity or payment date of a year or less - eg govt bonds or corporate bonds, any interbank lending
12
Q
features of capital markets
A
- buying and selling of assets that have a payback date of greater than a year, not as liquid as money market assets
13
Q
What is the difference between debt capital and equity capital?
A
Debt capital is any financial asset that pays back in interest rate - eg bonds
Equity capital is where the return is a dividend - eg shares
14
Q
what is a dividend
A
a share of the profit
15
Q
what is a primary market
A
a primary market is where brand new bonds will be issued, eg through an investment bank
16
Q
what is a secondary capital market
A
where new bonds and shares can then be bought and sold again - eg through investment banks or stock exchange
17
Q
what is a spot currency market
A
- where you can buy currency at the current exchange rate and get it delivered to you right now
18
Q
what are futures/forward markets
A
- where you can buy currency at the given exchange rate, but that currency is delivered to you some time in the future
19
Q
why would ppl engage in futures market transactions
A
- eg if ur an importer, and worried about a weak exchange rate in a few months time(WIDEC), importing raw materials when exchange rate is weak causes higher costs
- you could buy your currency now at current exchange rate, get it delivered to u in a few months time when the currency gets weaker, and you’re not affected by it
Market Efficiency and Price Discovery
- Futures markets play a crucial role in price discovery by providing a platform where current expectations about future prices are reflected in contract prices.
- This helps set transparent and consistent pricing for both producers and consumers
Speculation and Profit Potential
- Speculators engage in the futures market to profit from price movements, hoping to buy low and sell high (or vice versa).
- These market participants don’t necessarily own the underlying asset; they seek to make a profit by predicting price trends.
20
Q
what are the four functions of money
A
- a medium of exchange
- a store of value - cant deteriorate overtime
- measure of value
- method of deferred payment - people that dont have money rn can borrow it from those that do, then they can pay that money back overtime
21
Q
characteristics money needs to have
A
- has to be acceptable
- has to be portable
- durable
- divisible
- limited in supply so it keeps it’s worth
- difficult to forge
22
Q
what is commodity money
A
money which has intrinsic value - eg gold
23
Q
what is fiat money
A
money with no intrinsic value, eg if the money loses value, u cant trade it for something else
- eg notes and coins
24
types of money
- notes and coins
- deposits - high liquidity
- near money
25
what is liquidity
the ease at which money can be converted into cash
26
what is the money supply
the total amount of money circulating in the economy
27
what is M0
a measure of the money supply which includes the total amount of notes and coins in the economy, and all the deposits that individuals have in bank accounts, eg savings
28
what happens as we go from m0 to m4
we add more non cash financial assets into our measure of the money supply
- NonCashFinancialAssets are liquid, but not as liquid as notes and coins
29
what are the roles of financial markets
- To lend to businesses and individuals to help them consume/invest
- to facilitate the exchange of goods and services by providing a flat currency ,increasing consumption/investment
- to provide forward markets in currencies and commodities to reduce risk
- to provide a market for equities to facilitate raising of finances by businesses
● to facilitate saving * to facilitate lending to
businesses/individuals
● to facilitate the exchange of goods and
services
● to provide forward markets in currencies and
commodities
● to provide a market for equities
● commercial interest rate determination
30
what is the quantity theory of money
the theory that links growth rate in the money supply to growth rates in prices eg inflation
31
what is near money
non cash assets which can be easily converted into money, eg bonds, with maturity dates of years, can convert into cash easily
32
fisher equation (the quantity theory of money)
MV=PQ -
-M = money supply
- V = velocity of circulation (how many times the cash has been spent)
- P = average price level
Q = Quantity of goods/services sold
33
the quantity theory of money explained
- An increase in the money supply, holding V constant, could lead to a proportional increase in either the price level or real output
- If money circulates more quickly (higher, it can have the same effect as increasing the money supply, potentially driving up prices or output.
- If the price level rises (inflation), it might indicate that more money is chasing the same amount of goods and services, reflecting inflationary pressure
- Increases in Q reflect economic growth, assuming that prices (
P remain constant.
- MV represemnts what is bought (nominal)
- PQ represents what is sold (nominal)
34
MV=PQ application
- The Quantity Theory of Money suggests that if M increases and Q remains constant (or grows slower than M), the price level
P will rise, leading to inflation.
- : Central banks can use the equation to predict the impact of changes in the money supply on the economy. For example, increasing M can stimulate economic activity, but it may also risk higher inflation if Q does not keep pace.
- The equation highlights the importance of both the money supply and the velocity of money in driving economic activity. If
Q increases (economic growth), the economy can accommodate a higher money supply without inflationary pressure.
35
P= MV/Q, how do the 3 variables affect price
- If the money supply increases while
V and Q remain constant, more money is available to purchase the same amount of goods and services. This increased demand can push prices up, leading to inflation.
- VELOCITY
- If the velocity of money increases, it means that money is changing hands more frequently, which can increase the effective demand for goods and services, pushing prices up.
If the velocity decreases, it suggests that money is circulating more slowly, which might reduce demand and lead to lower price levels, assuming the money supply and output remain constant.
- OUTPUT
- If real output increases while
𝑀
M and
𝑉
V remain constant, it means more goods and services are available. This can lead to lower prices since the supply of goods and services has increased relative to the money supply.
If real output decreases (e.g., due to a recession), with M and V constant, fewer goods and services are available. This can lead to higher prices, as more money chases fewer goods.
36
monetarists view on the quantity theory of money
- Monetarists argue that in the long run, the money supply is the primary factor influencing the price level with velocity of money and real output assumed to be stable or fixed.]
- The central bank increases M, such as through lower interest rates or open market operations.
- Monetarists believe V remains stable, so the increase in M directly increases total spending power (MV)
- In the long run, Q is determined by factors like labor and technology, and is assumed to be constant at its potential level.
- With V and Q fixed, the increase in M leads to a proportional increase in P (inflation), as more money chases the same amount of goods and services.
37
Why do Keynesians disagree with monetarists M=P
- Keynesians argue that
V is not fixed and can fluctuate due to various economic factors
- Keynesians believe that
V, or the rate at which money circulates, is not constant. It can vary due to changes in consumer confidence, financial innovations, or economic conditions.
- If V increases, the same amount of money circulates more rapidly, boosting aggregate demand without necessarily increasing the money supply. This can lead to higher prices and inflation if the economy is at full capacity.
- Prices and wages may not adjust immediately due to rigidities. This stickiness means that changes in
M might temporarily boost output and employment before leading to inflation.
38
why was quantitative easing used following the GFC 2008
- to stimulate growth by increasing money supply
- to increase bank liquidity so they would be more willing to lend
- interest rates were already very low so limited scope for further reductions
- to prevent deflation by increasing the money supply
39
what are forward markets
- markets where firms buy they currency in advance
- firms agree a fixed price for purchase of foreign currency in the future
40
impacts of forward markets
- enables firms to reduce risk/uncertainty
- firms can be certain about the cost of their imports in pounds
41
how did the 1986 big bang increase the risk of systemic risk - removal of liquidity ratios
1. Removal of Liquidity Ratios → Lower Reserve Requirements → Reduced Bank Stability
1986 Big Bang reforms removed traditional liquidity ratio requirements → banks no longer had to hold a fixed proportion of liquid assets (like cash or gilts) → they began operating with tighter liquidity cushions → increased risk that they wouldn’t meet short-term obligations during shocks → heightened systemic risk
2. More Risk-Taking → Greater Leverage → Contagion Risk Increases
With fewer liquidity constraints, banks were incentivised to chase higher returns → took on more risk and became more leveraged → a problem in one bank (e.g., default or insolvency) could more easily spread to others due to interconnected balance sheets → systemic risk rises
3. Short-Term Funding Reliance → Vulnerability to Credit Freezes
Banks could rely more on short-term, wholesale funding instead of maintaining liquid buffers → in times of market stress (e.g. credit crunch), access to these funds could dry up → banks unable to roll over debt → increases chance of failures that affect the whole system → systemic risk increases
4. Weak Regulation + High Interconnectedness → Domino Failures Possible
The Big Bang also involved deregulation and merging of roles between brokers and banks → led to higher interconnectedness within the financial sector → without liquidity requirements as a cushion, one institution’s failure could trigger a chain reaction → amplifies systemic risk
42
roles of financial markets explained
💰 Facilitate Saving
Financial institutions (e.g., banks and pension funds) provide safe places for households and firms to save their money →
Interest is paid on savings, acting as a reward for individuals and businesses that choose to save rather than spend →
Saving differs from investment because saving refers to putting money aside for future use, while investment involves spending money on capital goods with the intention of generating future profits →
This function is essential for economic stability, as it provides the funds that can be used for investment in the future.
💸 Lend to Businesses and Individuals
Banks and financial intermediaries assess risk through credit ratings and other factors to decide whether to lend money →
By providing loans, they enable businesses to invest in projects or individuals to purchase goods, leading to higher consumption →
Interest rates play a crucial role in determining the cost of borrowing; higher rates discourage borrowing, while lower rates encourage more loans →
Lending drives economic growth by enabling firms to expand and consumers to purchase goods and services, which in turn boosts aggregate demand.
💳 Facilitate Exchange of Goods and Services
Financial institutions enable payments and transactions through tools like debit cards, credit cards, and online banking, allowing consumers to exchange goods and services →
The importance of money as a medium of exchange means people and businesses can engage in transactions efficiently without the need for bartering →
Banking infrastructure such as ATMs and clearing systems enables easy access to money, ensuring smooth financial transactions →
This function supports the overall flow of the economy, helping to maintain liquidity and efficient exchange of goods and services.
📊 Provide Forward Markets in Currencies and Commodities
Forward markets are contracts that allow buyers and sellers to agree on a price for a good or service to be delivered at a future date →
These markets reduce uncertainty and risk (e.g., protection against exchange rate fluctuations) by locking in future prices →
Common users of forward markets include importers, exporters, and oil companies, who need to hedge against risks in international trade →
By offering risk management tools, forward markets contribute to the stability of trade and investment decisions, reducing exposure to market volatility.
📈 Provide a Market for Equities (Shares)
Equities are ownership stakes in companies, and stock markets facilitate the buying and selling of shares →
Share prices are directly linked to a company’s business performance; as a company grows and becomes more profitable, share prices tend to rise →
The stock market serves as a platform for business funding by allowing companies to issue shares to raise capital for expansion or projects →
This function supports economic growth by enabling firms to access the financial resources they need to innovate and expand.
43
What is meant by a market for equities?
A place where shares of companies are issued and traded, e.g. the stock market.
44
Why are equity markets important for firms?
They enable firms to raise capital by selling shares, which can fund expansion and investment.
45
How do equity markets benefit individual investors?
They allow individuals to invest in firms, earn dividends, and benefit from capital gains.
46
Give an example of a positive externality from banking.
Efficient lending can lead to increased business investment, creating jobs and boosting economic growth.
47
What causes speculative bubbles to burst?
A sudden loss of confidence, triggering panic selling, often due to news revealing overvaluation or poor fundamentals.
