8.1 The Structure of Financial Markets and Financial Assets

Draw a Diagram to Illustrate some of the Main Financial Markets in the UK and Global Economies

(Figure 8.3)

Compare Money Markets and Capital Markets

(Table 8.1) The function of money markets is to supply both private sector commercial firms and the government with a source of short-term finance. For a firm, bill finance is an alternative to a conventional bank loan. Bills are short-dated financial assets or securities, which mature within a year of their date of issue. There are two main types of bill, or bills of exchange: commercial bills and treasury bills. Commercial bills are sold by investment banks on behalf of client firms. Treasury bills, which are sold as new issues by the BofE on behalf of the government, provide the gov with a method of financing the differences that emerge at certain times in the financial year between tax revenues and government spending. Treasury bills are in fact short-dated gov loans. Shares, corporate bonds and government bonds are the mains securities traded on capital markets.

Define Broad Money

The part of the money supply made of cash, other liquid assets such as bank and building society deposits, but also some less liquid assets. The measure of broad money used by the Bank of England is called M4. Includes other financial assets, which although stores of value, are too illiquid, at least for the time being, to function as a media of exchange.

Define Bonds

Financial securities sold by companies (corporate bonds) or by governments (government (gilt) bonds) which are a form of long-term borrowing. Bonds usually have a maturity date on which they are redeemed, with the borrower usually making a fixed interest payment each year until the bond matures.

Define Liquidity

Measures the ease with which an asset can be converted to cash without loss of value. Cash is the most liquid asset.

Define Narrow Money

The part of the stock of money (or money supply) made of cash and liquid bank and building society deposits. Restricts the measure of money to cash and bank and building society sight deposits, and reflects the medium of exchange function of money, namely money functioning as a means of payment.

Define Maturity Date

The date on which the issuer of a dated security, such as a gilt-edged security (long-dated) or a Treasury bill (short-dated), pays the face value of the security to the security's owner.

Define Coupon

The guaranteed fixed annual interest payment, often divided into two 6-month payments, paid by the issuer of a bond to the owner of the bond.

Define Shares

Undated financial assets, sold initially by a company to raise financial capital. Shares sold by public companies or PLCs are marketable on the stock exchange, but shares sold by private companies are not marketable. Unlike a loan, a share signifies that the holder owns a part of the enterprise.

Define Equity

Wealth; shares are known as equities. However, equity can also mean fairness or justness; it depends on the context.

What are the Two Principal Functions of Money?

- A medium of exchange or means of payment: the economy we live in is a monetary economy in which most of the goods and services produced are traded or exchanged via the intermediary of money, rather than through barter. Whenever money is used to pay for goods or services, or for the purpose of settling transactions and the payment of debts, it performs this function. - A store of value or store of wealth: money is also an asset, something people own which has value. Most people store some of their wealth in the form of money in preference to holding other financial assets, such as stocks and shares, or physical assets, such as house or car. When stored rather than spent, money's purchasing power is transferred to the future, although over time inflation may erode money's purchasing power.

What are the other Two Functions of Money?

- Measure of Value - Standard of Deferred Payment = The 'Unit of Account' function. Money is the unit in which the prices of goods are quoted and in which accounts are kept. This allows us to compare the relative values of goods even when we have no intention of actually spending money and buying goods - for example, when we 'window shop'. This is the measure of value function. Money's function as a standard of deferred payment allows people to delay paying for goods or settling a debt, even though goods or services are being provided immediately. Money acts as a standard of deferred payment whenever firms sell goods on credit or draw up contracts specifying a money payment due at a later date.

What is Positive/Negative Equity?

- Positive Equity: assets are larger than liabilities. Home owners experience this as the value of mortgages has remained unchanged in recent history, but house prices have risen. - Negative Equity: Occurs when what is owed exceeds the value of what is owned: that is, the amount owed on the mortgage is more than the value of the house. People in the negative equity trap often have crippling debt from which it is very difficult to escape.

How have Financial Markets Evolved in recent years?

24/7 global markets have grown up, facilitated by the development of the internet. This has enabled many markets to become truly global and to function on a worldwide basis.

Explain Portfolio Balance Decisions

A wealth portfolio contains the different wealth assets that an individual owns and holds at a particular point in time. Everyone makes decisions, consciously or subconsciously, on the form of asset in which to keep their wealth. In the first instance, people choose between holding physical assets (non-financial assets), such as houses, and holding financial assets. (Physical assets such as property, fine art, classic cars and antiques can be attractive because they tend to go up in value or appreciate, thus providing a hedge against inflation.) When choosing the assets to hold, people make portfolio balance decisions. A portfolio balance decision is depicted in (Figure 8.2), which, besides making the distinction between physical and financial assets, arranges financial assets according to liquidity and profitability. Shares and government bonds (gilt-edged securities, or gilts) are marketable (they can be sold second-hand on the stock exchange), but they are less liquid than money. In contrast to money, which earns little or no interest, shares and gilts generally hold out the prospect of providing a profit for their owners.

What is Goodhart's Law?

An issue that led to the decline of monetarism as a major force influencing UK governments stemmed from what has become known as Goodhart's Law. He argued that, as soon as a government tries to control the growth of a particular measure of the money supply, any previously stable relationship between the targeted measure of money and the economy breaks down. The more successful the BofE appears to be in controlling the rate of growth of the financial assets defined as money supply, the more likely it is that other financial assets, regarded previously as near money outside the existing definition and system of control, will take on the function of a medium of exchange and become money. Although what is defined as money may be controlled, when other financial assets become money, this becomes irrelevant. The difficulties of, first, defining the money supply and, second, exerting control over its rate of growth contributed to the downfall of monetarism after 1985.

Explain Assets and Liabilities

Banknotes and coins function as both financial assets and financial liabilities. A £10 note is an asset to the owner, since it gives them £10 worth of spending power. However it is a liability for the Bank of England which issued it. The Bank's liability is to replace an old and dirty note, or a destroyed note, with a brand-new one. From a commercial bank's POV, a loan (or credit) granted to a customer is an interest-earning asset, which the borrower is liable to repay. But the act of creating credit or a loan simultaneously creates a bank deposit owned by the customer to whom the loan is made. Bank deposit is the customer's asset, but it is a liability for the bank itself. The bank must honour cash withdrawals and cheques and debit card payments drawn on the deposit, which transfer ownership of part of the deposit to other people. Loan-creating process increases the bank's assets and liabilities by equal amounts. The creation of credit simultaneously increases by the same amount customers' deposits held in the bank. When a bank creates an interest-earning asset, it is simultaneously adding to its deposit liabilities, since it must now honour customers' withdrawals from their deposits of cash or payments they make to other people. The act of creating an asset simultaneously creates a liability.

How do you calculate a bond's current market price?

Bond's Current Market Price = Annual Coupon Payment / Yield X 100 (Question Practice: Quantitative Skills 8.2)

Define Corporate Bonds

Debt security issued by a company and sold as new issues to people who lend long-term to the company. They can usually be resold second=-hand on a stock exchange.

Define Government Bonds

Debt security, in the UK known as gilt-edged securities or gilts, issued by a government and sold as new issues to people who lend long-term to the government. They can be resold second-hand on a stock exchange.

Explain the Inverse Relationship between Bond Prices and Interest Rates

Gilts are fixed-interest securities sold by the government (or companies) when they borrow in the long-term. The bond in (Figure 8.4) is a 30-year bond with a face value of £100 carrying a guaranteed annual interest payment, known as the coupon, of £5. £5 is 5% of £100. Suppose, however, that after the bond has been sold on its day of issue for £100, its second-hand price on the London Stock Exchange or bond market rises to £200. This means that the bond's yield falls to 2.5% (£5 as a % of £200). (A bond's yield is in effect the long-run rate of interest earned by the holder of the bond. It is determined primarily by the coupon and the price the holder paid for the bond.) Suppose, by the contrast, the bond's price falls to £50. This means that the bond's yield rises to 10% (£5 as a % of £50). Both these simple calculations display the inverse rel/ship between bond prices and long-run interest rates. If bond prices rise, yields or long-term interest rates fall, and if bond prices fall, yields of long-term interest rates rise. The guaranteed interest (or coupon) earned each year by gilt holders is paid in two installments at 6-month intervals. Gilts and other bonds usually have a specific maturity date.

Define Foreign Exchange Markets

Global, decentralised markets for the trading of currencies. The main participants in this markets are large international commercial banks. Collectively, foreign exchange markets are the largest markets in the global economy.

Explain Capital Gains and Losses and Bond and Share Prices

In (Quantitative Skills 8.1), the fact that the gilt does not mature until 50 years after the date of issue means that an approaching maturity date has no noticeable effect on the gilt's current market price or on its yield. If, by contrast, the maturity dare were next week, the market price would be very close to maturity value (£50), and its yield would have converged to be very close to 2.5%. For a gilt or a corporate bond with many years to go until maturity, another factor affecting changes in its market price is the expectation of making a capital gain (and the fear of suffering a capital loss). Suppose the current bond price is £100, but speculators expect the price to rise shortly to £150. If the bond can be bought now at or near its current price of £100, and its price does indeed shortly rise, speculators who buy the bond make a capital gain when selling the bond later - for example, for £150. If a sufficiently large number of speculators decide to buy the bond at or near the price of £100, increased demand for the bond pulls up the market price, until eventually it may indeed reach £150. Conversely, a fear that the bond price will fall, say to £50, will induce speculative selling of the bond, which in turn causes the bond's price to fall. Provided a sufficiently large number of speculators behave in the same way, speculative buying and selling, in the hope of making a capital gain - or avoiding a capital loss - is an important determinant of short-run changes in bond prices.

What is the Principal Function of Secondary Capital Markets and the London Stock Exchange?

Increase the liquidity of second-hand securities (bonds and shares), making it easier for buyers to manage their investments and sell these securities when required. This in turn makes it more likely that those with surplus funds will be willing to buy new issues of shares and bonds, thus facilitating expansion in the economic activities of PLCs and government.

What are Capital Markets composed of?

Made up of two parts: the new-issues market )or primary market) and the second-hand market (or secondary market). In the UK, the London Stock Exchange functions as the main secondary market. There are, however, other secondary markets. These include the Alternative Investment Market (AIM), which is run by the LSE, mainly for small PLCs, and second-hand trading, which takes place online and outside the LSE's control. The LSE is part of the capital market.

What is the Function of Foreign Exchange Markets?

Over the last 60 years, foreign exchange markets have become more and more important in facilitating growth of international trade and capital movements between countries. Arguably, the growth of international trade has been the main driver of economic growth, both in the world as a whole, and in trading nations such as the UK. FX markets are financial markets in which different currencies are bought and sold. International trade means that exporters and importers need to convert the funds they use to finance trade from one currency to another - for example, the UK pound sterling into euros or dollars. Foreign exchange can be traded on either the spot market or the forward market. Spot transactions involve the immediate exchange of currency whereas forward markets involve the exchange of foreign currencies at some specified time in the future. Forward markets are used by, for example, exporters and importers to protect themselves against exchange rate risks.

Define Money Markets

Provide a means for lenders and borrowers to satisfy their short-term financial needs. Assets that are bought and sold on money markets are short term, with maturities ranging from a day to a year, are are normally easily convertible into cash. The term 'money market' is an umbrella that covers several markets, including the market for Treasury Bills and Commercial Bills. Provide mechanisms for banks to arrange their assets in terms of liquidity and profitability. Organising their assets this way enables commercial banks to perform the most important function, namely that of a financial intermediary linking savers to borrowers.

Explain the Relationship between the Primary and Secondary parts of the Main Capital Markets?

Relationship is shown through (Figure 8.5). Actual raising of new capital or long-term finance takes place in the primary market when public companies (private sector) or the government (public sector) decide to issue and sell new marketable securities. Companies can borrow long-term by selling corporate bonds, or they may sell an ownership stake in the company by issuing shares or equity. When selling corporate bonds, the company extends its debt, and the purchaser of the bond becomes a creditor of the company. New issues of shares are sold when a company 'goes public' for the first time, or when an existing public company decides to raise extra capital with a new equity issue. In the latter case, the new share issue is most often a rights issue, in which the company's existing shareholders are given the right to buy the new issue of shares at a discount. New issues of shares are seldom sold directly on the stock exchange. Instead, the direct sale of new issues to the general public takes place in the primary market, usually being arranged by investment banks, via newspaper advertisements and the post. Without the existence of a second-hand market, PLCs would find it difficult, if not impossible, to sell new share issues. The shares issued by private companies, which don't have a stock market listing, are generally illiquid and difficult to sell. Without the stock exchange, the general public would be reluctant to buy shares that could not easily be resold. An important source of funds necessary to finance the growth of a firm would be denied to public companies.

What is a Security?

Secures a claim against a person or institution - for example, a share secures ownership of a fraction of the company which initially sold the share to the general public.

Define Capital Markets

Where securities and bonds are issued to raise medium to long-term financing, and where shares and bonds are then traded on the 'second-hand' part of the market, e.g. the London Stock Exchange. Provide the mechanism through which PLCs, which are arguably the most important form of business organisation in the UK, can raise the funds to finance their long-term growth. The part of the capital market known as the bond market performs a critical role in gov finance - for example, by enabling a government to finance a budget deficit.

How do you calculate the yield on a bond?

Yield = Annual Coupon Payment / Gilt's Current Market Price X 100 (Question Practice: Quantitative Skills 8.1)