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AQA 2.4 Financial markets and monetary policy

2.4.1 The structure of financial markets and financial . assets. Did you know?. The World's . first.  p. aper . m. oney.  . was . created in China . 1,400 . years . ago. More Monopoly m. oney is .

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AQA 2.4 Financial markets and monetary policy






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Slide1

AQA 2.4 Financial markets and monetary policy

2.4.1 The structure of financial markets and financial

assets

Did you know?

The World's 

first

 p

aper

m

oney

 

was

created in China 

1,400

years

ago

More Monopoly m

oney is

printed every

year than

 

real money

At

a spending rate of $1 million a day, it would take Bill Gates 218 years to spend all his 

money

Until

World War 2

, tea bricks were used as money in

Siberia

Sea shells were once commonly used in many parts of the world as money

The 100 richest people in the world earned enough money in 2012 to end global poverty 4

times

The first transaction 

of Bitcoins

 was to buy pizza for 10,000 Bitcoins, which later increased in value to over US$12 millionSlide2

2.4.1 What you need to know

The characteristics and functions of money

Definitions of the money supply, and the distinction between narrow and broad money

The difference between the money market, the capital market and the foreign exchange market

The role of financial markets in the wider economy

The difference between debt and equity

Why there is an inverse relationship between market interest rates and bond prices

The different ways in which firms raise finance, such as issuing shares, corporate bonds ad bank borrowing

Understand the terms coupon and maturity in relation to government bonds and be able to calculate the yield on a government bondSlide3

The Functions of Money

A medium of exchange

In today’s economy, we use notes and coins as money, rather than barter as a medium of

exchange. Crucially,

money enables goods and services to

be exchanged, transactions to be settled and debt to be paidMoney avoids the problems of barter, principally the double coincidence of wants, which is inefficient and would stifle specialisation and division of labourA store of value or wealthMoney acts as a store of value over time. Of course, this may be eroded by inflation, but it enables individuals to transfer spending to future time periods secure in the knowledge that it will have a future valueA measure of value/unit of accountAs a unit of account, money serves as the common base of comparison that people use to present prices and record debts. Money also provides a measure by which we can value different goods and servicesA standard for deferred paymentMoney allows individuals to pay for goods and services later, despite their consumption taking place now. Because money is an accepted medium of exchange, it enables credit to be offered so payment can take place at a future date

Money has four core

functions.Slide4

The Characteristics of Money

Durability

Money must be able to withstand being used repeatedly

Portability

Money must be easily transportable so it can be easily transferred to other individuals

DivisibilityIt is also preferable that money can be divided into smaller units of valueAcceptabilityMoney must be widely accepted for it to be usable for different types of transactionsScarcityMoney must be in limited supply to ensure its value remains relatively stableSecurity

Money must also be extremely difficult to counterfeit, as if it is easily duplicated it will cease to become a medium of exchange

Money has six core

characteristics.

All of the following have been used as money in the

past:

Eggs

Feathers

Cows

Rice

Salt

Pigs

Leather

Vodka

Shells

Discuss why these forms of money aren’t used

today.Slide5

The Money Supply

Definition:

“The

total amount of money in the economy at a particular

time”

Whilst this may seem a simple definition, in reality, the definition of money requires more precision given the different types of financial assets that existNarrow Money – The basic amount of notes and coins and operational deposits/reserve balances at the Bank of England. It is approximately equal to the amount of cash in circulationBroad Money – This includes all notes and coins AND deposits in savings accounts and other less liquid assets. As such, this is the most inclusive definition of the money supply. The main measure at the Bank of England is called M4Liquidity – The ease and speed with which an asset can be turned into cash.Cash is a highly liquid asset, whereas property for example is more illiquid.Slide6

Source: Bank of England

Narrow MoneySlide7

Source: Bank of England

Broad Money

Activity:

Some economists believe there is s strong relationship between the money supply, the growth of aggregate demand and inflation (see 2.3.3).

How does the growth of broad money link to inflation? Do some research to track and compare changes over time.What conclusions can you draw? Does this data prove or disprove Fisher’s equation MV = PQ?Slide8

Money, Capital and Foreign Exchange Markets

There are a wide variety of financial markets, but you need to be able to distinguish between money, capital and foreign exchange markets.

The Money Market

The money market provides short term , typically 24 hrs to

12 months

, finance to individuals, firms and governmentsThis includes interbank lending, the purchase of Treasury Bills by the government amongst other short-term financial instrumentsThe Capital MarketThe capital market provides medium to long-term finance to firms and governmentsThis includes, for example, companies issuing shares or corporate bonds, or governments issuing bonds to finance their borrowing requirementsThe primary capital market is where newly issued securities are sold by companies or governmentsThe secondary capital market is where previously issued shares or bonds are traded e.g. The London Stock Exchange is an example of a secondary capital marketThe Foreign Exchange MarketThe foreign exchange market is the market where different currencies are bought and soldInternational trade and investment necessitates the conversion of one currency to another e.g. £s: $sForeign exchange can be conducted in either the “spot” market or “forward” market

The spot market involves the immediate exchange of foreign currency

The forward market involves the exchange of foreign currency at some specified time in the future. These are typically used by exporters and importers to protect themselves against large exchange rate fluctuations and episodes of speculationSlide9

Debt and Equity

It is important to understand the difference between debt and equity

Debt

Money that has to be paid back with interest

Interest on debt is a fixed cost that has to be paid before profits are calculated

Debt includes all funds that firms borrow directly from banks, such as loans and overdraftsEquityGiving the provider of funds to a business an ownership stake and a share of future profitsBroadly speaking, equity investments can be viewed as taking on a greater risk of loss for the chance to earn a potentially higher returnSlide10

Interest Rates and Bond Prices

B

oth companies and governments can issue bonds to raise finance

It is important to understand the key characteristics of a bond in order to understand the relationship between bond prices and interest rates

Importantly, government bonds are traded daily on the secondary market and as a consequence the market price of the bond might be different to the price originally set by the government

Some key termsCoupon – the guaranteed amount of interest paid to the bond-holder expressed as a percentage of the face value of the bond. The amount paid does not change over the life of the bondMaturity – this refers to the date which the borrower will repay the lender. Government bonds typically have a fixed maturity dateYield – this is the income return on an investment and is the amount of interest paid on the bond expressed as a percentage of the current market price of the bond. In effect, it is the long term rate of interest earnedIn the UK, government bonds are also called gilt-edged securities or gilts. The name comes from the fact they are considered a high grade investment with very low risk. For example, it is highly unlikely the UK government will default on a bond.

Are UK Government bonds low risk?Slide11

Interest Rates and Bond Prices

C

onsider the example above

If the 10 year bond is issued on 1

st

September 2016, then the holder can expect to receive £50 each year until the bond reaches maturity in 2026. In other words, the coupon of the bond is 5%. If the market price of the bond remains unchanged through the next 10 years, then the yield on the bond will also be 5%.However, it is unlikely that the market price of the bond will remain the sameIf there is an increase in demand for government bonds on secondary markets, then the price will riseFor example, if the price of the bond rises to £2,000 the government will continue to pay a coupon rate of £50, in which case the yield, or interest rate, will fall to 2.5%Yield can be calculated as follows: Coupon x 100 £50 x 100 = 2.5% Market Price £2,000

10 Year Government Bond

Bond issue price: £1,000

The Bank of England on behalf of HM Government, promises to pay the bearer the sum of £50 every year between 1

st September 2016 and 1st

September 2026

Chief Cashier at the Bank of EnglandSlide12

Interest Rates & Bond Prices

As bond prices rise, the long term rate of interest falls

In other words, there is an

inverse relationship

between bond prices and interest rates

Lets now imagine there is a fall in demand for government bonds, and the bond price falls to £800The coupon remains unchanged at £50We can calculate the new yield as follows: Coupon x 100 £50 x 100 = 6.25% Market Price £800Thus, as bond prices fall, the yield/long term rate of interest rises from its original 5%This relationship is crucial for governments because this affects the cost of government borrowingSlide13

Dataset 1: UK 10 Year Bond Yields

As we can see, the long term trend for UK government 10 year bond yield is downwards, and the UK government can currently borrow money at an interest rate of under 2%. This is an indication that markets are willing to buy UK government bonds (debt), thus the government can borrow more and it is cheaper for the government to borrow

However, whilst UK government bonds might be more attractive than our competitors in Europe, it may indicate that markets are relatively less willing to invest in equivalent private sector investments because of the risk of failure, thus low bond yields might be considered a sign of weak domestic economic growthSlide14

Dataset 2: Greece 10 Year Bond Yields

In contrast, if we consider the experience of Greece in recent times, we can see that bond yields in March 2012 reached a record high of 41.7%

Confidence in the Greek economy was so weak that demand for Greek government bonds collapsed resulting in bond yields that exceeded 40%, thus making government borrowing to help boost aggregate demand

cripplingly

expensive

Whilst confidence has returned in recent times, the Greek government still faces bond yields close to 9% which will still hamper growth and development significantly because of the high cost of government borrowingSlide15

Calculating Government Bond Market Prices, Coupon Rates and Yields

Part of the quantitative element of the Year 2 examination may require you to calculate Government bond prices, coupon rates or yields

Look at the triangle below and cover the term you wish to calculate to find the required formula

Coupon

Bond Market Price

YieldCoupon = Yield x Bond Market PriceYield = Coupon

Bond

M

arket PriceBond Market Price = Coupon YieldSlide16

Sources of Finance for Firms

There are many different ways in which a firm can raise finance. The primary sources to be aware of are:

Issuing shares

These are shares sold by a company in return for a stake in the future profits of the firm

They can be issued by private (LTDs) or public limited companies (PLCs), but only shares issued by PLCs can be traded on the stock exchange

Issuing shares is a good way to raise large amounts of financial capital. However, they have the disadvantage that profits must now be shared with a wider pool of investors and there is a loss of control because shareholders are now part owners of the companyIssuing corporate bondsA corporate bond is a loan made to a company for a fixed period by an investor, for which they receive a defined returnInvestors usually receive annual payments for their cash, usually expressed as a percentage, as well as receiving the principal sum back at the end of the termCorporate bonds, once issued, can then be traded on secondary marketsBank borrowingPerhaps the most traditional source of funds for a firm, a loan can be taken from a commercial bank and repaid with interest over a pre determined time period

It is likely that the loan will be secured against some of the assets of the firm, which the bank will

have a

claim to in the event of defaultSlide17

Financial Markets and The Wider Economy

As we can see, the overall structure of financial markets and financial assets can have a significant bearing on the performance on the wider economy

The money supply, and its control, has an impact on the rate of inflation

Money, capital and foreign exchange markets provide individuals, businesses and governments with vital means of raising finance and trading internationally

Financial markets enable firms to raise money for investment via both debt and equity measures which can offer a balance between different financial instruments

Use Fisher’s equation of exchange to explain bullet point 2.Slide18

Financial Markets & The Wider Economy

B

oth new issue and secondary markets provide businesses looking for finance an opportunity to be matched with investors seeking a return

If any of these markets become inefficient or cease to function as effectively as they might it can

have

large consequences on individuals, firms and governmentsCorporate and government bonds provide additional methods of raising finance. It is important to understand government bonds, their relationship to yields and interest rates and the impact on a governments ability to meet its spending commitments, borrow for capital investment and service existing debtThe 10 year bond yield experience of the UK v Greece provides a good example of the potential impact that financial markets and their instruments can have on the ability of an economy to meet its productive potential and remain internationally competitive