Financial Sector

Question 1

Define what a financial market is

Answer 1

Any exchange that facilitates the trading of financial instruments.

Question 2

What are the 5 roles of the financial markets

Answer 2

1. Facilitate savings by households and firms
2. Lend to firms and individuals
3. Facilitate exchange of goods and services
4. Forward markets in currencies and commodities
5. Provide market for equities

Savings
Lending
Exchange
Forward markets
Equity

Question 3

Explain the types of Forwards markets

Answer 3

1. Currency forward market
   (locks in exchange rate of a currency by “hedging”, to reduce uncertainty and risk.
2. Commodity forward market
   (locks in a price for, eg raw material to be exchanged, to reduce uncertainty and risk.

Question 4

What are the functions of money

Answer 4

Medium of exchange
Unit of account
Store of value
Deferred payment

Question 5

How do banks fail?

Answer 5

1. Run of out liquidity
2. Credit crunch - fear of not being paid back
3. loses from bad debts

Question 6

Definition Financial market failure

Answer 6

When free market forces of demand and supply does not lead to a social optimum output.

Question 7

What are the causes of market failure

Answer 7

1. Asymmetrical information
2. Externalities
3. Moral hazard
4. Speculation and market bubbles
5. Market rigging

Question 8

What are the key functions of the central bank

Answer 8

1. Implement monetary policy (QE, Interest rate)
2. Banker to the government and other banks
3. Regulating the banking industry (stress test)

Question 9

What is asymmetrical information

Answer 9

When one party know more than the other in a transaction.

Question 10

What is speculative bubble? Develop the chain of reasoning

Answer 10

When the price of an asset rises far above its intrinsic value due to excessive demand driven by speculation

When banks speculate housing prices rises -> banks offer subprime mortgages -> demand for housing rise -> price for housing rises -> More profit from selling houses when people default -> More subprime mortgages -> Increased demand for houses -> Increases house prices -> Housing bubble

Question 11

What are negative externality?

Answer 11

Cost affecting the third party outside of the price mechanism

Question 12

Give an example of negative externality of the 2008 market crash

Answer 12

Banks run of the liquidity to lend money -> businesses could not borrow -> had to make cutbacks on workers -> decrease in employment -> decrease in consumption -> decrease in Real GDP

Question 13

What is moral hazard

Answer 13

When someone is more likely to take risk because someone else is bearing the cost

Question 14

What is market rigging

Answer 14

when firms illegally manipulate financial markets (e.g. increase price) for personal gain.

Question 15

What are the Advantages and disadvantages of regulation

Answer 15

✅ Advantages:
Prevents excessive risk-taking
– Rules stop banks from making dangerous loans or investments that could lead to a financial crisis.

Protects consumers and investors
– Regulation ensures transparency and reduces fraud, giving people more confidence in the financial system.

❌ Disadvantages:
Reduces efficiency and innovation
– Too many rules can limit how quickly firms adapt or innovate with new financial products.

Increases costs
– Compliance with regulation can be expensive for firms, leading to higher costs for customers and less competitiveness.

Question 16

How to reduce market failure

Answer 16

Better Regulation: stress test - moral hazard

Better Education: avoid selling tactics - avoid irrational consumer behavior

Better Information: avoid information gap -
asymmetrical information