Financial markets = where buyers and sellers meet to trade financial assets (loans, foreign
exchange, shares)
Lenders (savers/investors) with excess cash reserves and aim to have a return provide
loans to borrowers (individuals/firms/govt,) who are willing and able to pay an interest rate on
this loan
- e,g bond markets: lenders go directly to UK debt management office and buy
😁
government bonds = lends to govt
- Bonds are -> can be traded second hand on bond markets (done to either:
- reduce/increase savings OR speculative activity by financial institutions like
investment banks aiming to make short-term profit
- e,g stock markets: lenders go directly to companies and buy shares = equity capital
for companies = lends to firms
e,g intermediaries
- commercial banks: take funds from lenders + loans provided to borrowers: return
paid to lenders at lower rate and IR on loans at higher rate = commercial banks make
profit of the difference between rate of return and IR
- investment banks
- hedge funds = buy up debt with high leverage deals = more risky than mutual funds;
thus more regulation
- pension funds // stock exchanges // insurance companies
Banks create credit through fractional reserve banking.
When a bank receives a deposit, it is required to hold only a small fraction of that deposit as
reserves, while the rest can be lent out as loans. These loans create new deposits in the
banking system, effectively expanding the money supply.
The Minsky Hypothesis (LEARN)
- during periods of prolonged economic stability, financial markets become increasingly
complacent and take on higher levels of risk = speculative bubbles + excessive
borrowing -> financial crises (demand side shock)
Risk of collapse of an entire banking system leading to widespread economic turmoil
= financial contagion (systemic risk) = credit crunch
Can regulate commercial banks via
- stress testing (helps identify if bank can survive economic downturn, if not they must
recapitalise)
- ensure they adequately high reserve ratios and liquidity thresholds are met
4.4.1 Role of financial markets
1. To facilitate saving so consumers can build up money to purchase expensive items //
banks have more funds for lending, facilitating investment = can help with
development of economy = growth
2. To lend to businesses and individuals to help them invest and consume respectively
-> Loans allow firms to grow and expand more quickly as they can increase their
capital stock = Firms can invest in innovation = Increase in productivity = Helps boost
AD = increased economic growth
, 3. To facilitate the exchange of goods and services increasing consumption/investment
-> Businesses will already have accounts+loans with banks so banks are in a
position to quickly issue these loans to their customers
4. To provide forward markets in currencies and commodities so firms can reduce the
risk of fluctuating prices -> Loans provide finance for firms suffering a drop in demand
- firms can imports raw materials more cheaply + increase exports = increased
size of their market
5. To provide a market for equities so firms can seek investment from shareholders ->
this enables businesses to raise finances
risk of corruption
risk of market failure in financial markets
lack of financial literacy in developing countries may limit potential
other factors play (e,g healthcare/infrastructure/education)
Types of financial markets
Money markets
determines the rate of interest
- provides short-term borrowing and lending (IOU of up to one year)
- very liquid due to short pay back date
- e,g bonds / interbank lending
- government borrows short term by issuing Treasury Bills that are repayable
liquidity: how easily/efficiently an asset can be converted into ready cash without affecting its
market price (cash, money in bank account, stocks, cars, houses)
Capital markets
stocks and shares are traded
- provide long-term borrowing and lending (IOU of more than one year)
- less liquid than money markets due to longer pay back date
- debt financing: Debt capital = financial assets w returns of IR -> buying & selling of
govt, bonds
- may risk loss of personal assets
- if profit isn’t made, interest payments have to be made
- possible loss of entire business
- repayments reason contestant no matter how the business performs
- equity financing: Equity capital = share in business w returns of dividends -> buying &
selling of shares
- loss of management control
- do not have to pay the finance back
- have to share the profits
- investor takes all the risk
- assets traded are bonds (UK stocks) and shares (US stocks)
- Debt represents borrowed funds that must be repaid, while equity represents
ownership in a company.
- Higher capital ratios indicate a higher ability to absorb losses.
Currency markets (foreign exchange)
foreign currencies are bought and sold
where different currencies are traded via transfers of money between countries (FDI)
1. Spot markets
exchange, shares)
Lenders (savers/investors) with excess cash reserves and aim to have a return provide
loans to borrowers (individuals/firms/govt,) who are willing and able to pay an interest rate on
this loan
- e,g bond markets: lenders go directly to UK debt management office and buy
😁
government bonds = lends to govt
- Bonds are -> can be traded second hand on bond markets (done to either:
- reduce/increase savings OR speculative activity by financial institutions like
investment banks aiming to make short-term profit
- e,g stock markets: lenders go directly to companies and buy shares = equity capital
for companies = lends to firms
e,g intermediaries
- commercial banks: take funds from lenders + loans provided to borrowers: return
paid to lenders at lower rate and IR on loans at higher rate = commercial banks make
profit of the difference between rate of return and IR
- investment banks
- hedge funds = buy up debt with high leverage deals = more risky than mutual funds;
thus more regulation
- pension funds // stock exchanges // insurance companies
Banks create credit through fractional reserve banking.
When a bank receives a deposit, it is required to hold only a small fraction of that deposit as
reserves, while the rest can be lent out as loans. These loans create new deposits in the
banking system, effectively expanding the money supply.
The Minsky Hypothesis (LEARN)
- during periods of prolonged economic stability, financial markets become increasingly
complacent and take on higher levels of risk = speculative bubbles + excessive
borrowing -> financial crises (demand side shock)
Risk of collapse of an entire banking system leading to widespread economic turmoil
= financial contagion (systemic risk) = credit crunch
Can regulate commercial banks via
- stress testing (helps identify if bank can survive economic downturn, if not they must
recapitalise)
- ensure they adequately high reserve ratios and liquidity thresholds are met
4.4.1 Role of financial markets
1. To facilitate saving so consumers can build up money to purchase expensive items //
banks have more funds for lending, facilitating investment = can help with
development of economy = growth
2. To lend to businesses and individuals to help them invest and consume respectively
-> Loans allow firms to grow and expand more quickly as they can increase their
capital stock = Firms can invest in innovation = Increase in productivity = Helps boost
AD = increased economic growth
, 3. To facilitate the exchange of goods and services increasing consumption/investment
-> Businesses will already have accounts+loans with banks so banks are in a
position to quickly issue these loans to their customers
4. To provide forward markets in currencies and commodities so firms can reduce the
risk of fluctuating prices -> Loans provide finance for firms suffering a drop in demand
- firms can imports raw materials more cheaply + increase exports = increased
size of their market
5. To provide a market for equities so firms can seek investment from shareholders ->
this enables businesses to raise finances
risk of corruption
risk of market failure in financial markets
lack of financial literacy in developing countries may limit potential
other factors play (e,g healthcare/infrastructure/education)
Types of financial markets
Money markets
determines the rate of interest
- provides short-term borrowing and lending (IOU of up to one year)
- very liquid due to short pay back date
- e,g bonds / interbank lending
- government borrows short term by issuing Treasury Bills that are repayable
liquidity: how easily/efficiently an asset can be converted into ready cash without affecting its
market price (cash, money in bank account, stocks, cars, houses)
Capital markets
stocks and shares are traded
- provide long-term borrowing and lending (IOU of more than one year)
- less liquid than money markets due to longer pay back date
- debt financing: Debt capital = financial assets w returns of IR -> buying & selling of
govt, bonds
- may risk loss of personal assets
- if profit isn’t made, interest payments have to be made
- possible loss of entire business
- repayments reason contestant no matter how the business performs
- equity financing: Equity capital = share in business w returns of dividends -> buying &
selling of shares
- loss of management control
- do not have to pay the finance back
- have to share the profits
- investor takes all the risk
- assets traded are bonds (UK stocks) and shares (US stocks)
- Debt represents borrowed funds that must be repaid, while equity represents
ownership in a company.
- Higher capital ratios indicate a higher ability to absorb losses.
Currency markets (foreign exchange)
foreign currencies are bought and sold
where different currencies are traded via transfers of money between countries (FDI)
1. Spot markets
