4.4.1 - financial sector

define financial market

a financial market is any exchange that facilitates the trading of financial instruments such as stocks, bonds, foreign exhcnage, insurance or commodities such as oil or gas

what are the key 5 roles of a financial market

1. to facilitate saving by households and business (secure place to save - store money - earn interest)

2. lend to businesses and individuals (financial market = intermediary between savers + borrowers)

3. facilitate the final exchange of goods and services - cash credit card contactless or foreign exchange

4. provide forward markets in currencies and commodities

5. to provide a market for equities

what are the three main types of financial markets

• the money market - short term finance - up to 12 months - provided by commercial banks - provides short term gov borrowing to fund government budget deficit (fiscal)

• the capital market - company shares or bonds are sold - long term 10 - 20 year loans - universities government and companies

• foreign exchange market - currencies are traded - forward exchange or spot exchange

what is a forward market (currency)

a forward market in currency is a binding contract ( cant be broken ) in the foreign exchange market

locks in exchange rate for the buying and selling rate in the future

risk management technique + gives certainty - to guard against any changes in exhange rate

what is the forward market ( commodities )

it is a binding contract between buyers and sellers of a commodity

agreeing on a price of a commodity on a future date

binding means cant be broken

risk management technique and creates more certainty against changes in the price of the commodity

draw the link between financial markets and borrowers - describe it

commercial banks objective is to take lenders money, in a deposit, and return is payed

from savings, loans can be made and lent out to consumers and firms

they will charge a higher rate of interest to borrowers and reward savers with a lower rate of interest.

what are the characteristics of money

• durability

• portability

• divisibility

• acceptability

• hard to counterfeit

• valuable

what are the key functions of money

• medium of exchange

• store of value

• unit of account

• standard of deferred payment

what is market failure - and the types of market failure

market failure - occurs when a market fails to allocate recourses in an efficeint way, leading to a loss in economic and social welfare

1. externalities from financial instability

2. monopoly power in financial institution

3. market rigging/ collusion

4. speculative bubbles and irrational behaviour

5. moral hazard and attitudes to risk taking

6. asymmetric information + complexity

explain externalities from financial instability and give examples

third party effects by UK banks taking too much risk

• tax payer - bail out cost - tax burden goes up

• employees - higher unemployment rate

• government - fiscal deficite

describe asymmetric information and give examples

one party holds more information then the other party

1. buyers and sellers of shares - insider information on stock

2. credit risk - banks knows more about the debtor

what is a moral hazard and examples of moral hazzard in the financial market

• state bails out failing banks - this causes banks to be more risky as the state is likely to bail out

• generous health insurance can lead to over prescription of drugs

describe market power and give examples

companies in the market act together ( collude ) to stop a market from acting as it should, in order to get an unfair advantge

illegal - stops market forces - supply and demand - harms rate of competition

e.g price fixing in the bond market

what is market power ( oligopoly/ monopoly ) and give examples

banking sector

• high barriers to entry

unlikely to switch - habitual behaviour

what is speculative bubbles - give examples

a bubble exists when the market price is driven well above what it should bee - herd behaviour - market booms then busts

stages -

1. displacement stage - excitement grows

2. price boom - demand surges + limited ( inelastic supply )

3. euphoria - investors take advantage ( irrational exuberance )

4. profit taking stage - investors sell when prices are out of line with fundamentals

5. panic - herd mentality - desperate selling