19.3 - Financial Markets
The role and importance of the financial sector
The financial sector includes institutions like banks and markets dealing with shares, bonds, and related activities. It plays a key part in supporting economic activity by connecting savers with those needing funds.
Functions of financial institutions
Financial institutions help manage money flows in the economy by facilitating savings, providing loans, enabling trading of securities, and supporting trade and protection.
Key functions include:
- Facilitating savings - They offer options like bank accounts, pension funds, and bonds for individuals and firms to save money not currently needed for spending.
- Providing loans - They supply credit to businesses and people who want to spend beyond their current income.
- Enabling trading of securities - They allow shares and bonds to be issued and exchanged in markets.
- Supporting trade and protection - They make payments quick and easy for buyers, and offer insurance to cover risks for firms and individuals.
How the financial sector supports economic growth
Stable financial institutions promote expansion in the economy, while unstable ones can lead to widespread issues.
Ways the financial sector supports growth:
- Enabling spending - Growth depends on purchases by people and businesses, often funded through credit.
- Aiding business expansion - Credit allows firms, especially smaller ones, to invest and grow, creating jobs and boosting exports.
- Challenges in developing economies - Weak financial systems limit access to loans, hindering business development and overall progress.
Forms of borrowing and finance for individuals and firms
Individuals and businesses use various methods to access funds, either through borrowing or raising capital.
Common borrowing options for individuals
People often borrow for personal needs, with different types offering varying levels of risk and cost.
Types of borrowing include:
- Personal loans - These are fixed amounts repaid over a few years, which can be secured (backed by an asset like property that the lender can sell if unpaid) or unsecured (no asset backing, so higher interest rates due to greater risk).
- Mortgages - Long-term loans specifically for buying property, with repayment continuing until the borrower fully owns it.
- Credit cards - These let users borrow instantly for purchases, with repayment flexible but often at high interest if not cleared quickly.
- Pay-day loans - Short-term, small unsecured loans with very high interest, designed for quick cash needs.
- Overdrafts - Automatic loans when a bank account goes below zero, allowing continued spending up to an agreed limit.
Finance options for firms
Businesses raise money through ownership shares or borrowed funds to support operations and growth.
Main finance options:
- Equity finance - Involves selling shares in the company, making buyers part-owners entitled to a portion of profits as dividends.
- Debt finance - Means borrowing money that must be repaid with interest, either from banks or by issuing corporate bonds to investors.
Regulation of the banking industry
Banks operate as private firms seeking profits but face strict oversight due to their economic influence.
Reasons for regulating banks
Regulation aims to balance profit motives with stability, as banking issues can affect the entire economy. Banks pursue higher profits often by taking risks, which can lead to instability. Rules limit risky behaviour, with penalties for violations to prevent widespread economic harm.
Objectives of financial regulation
Key objectives include:
- Minimising market failures - Controls reduce problems like excessive risk-taking that could disrupt financial systems.
- Protecting consumers - Ensures fair and legal practices by institutions towards individuals and firms.
- Maintaining stability - Promotes reliable operations of banks and services to avoid collapses.
- Building confidence - Prevents panics by assuring the public of the sector's soundness.
Types of financial markets
Financial markets provide platforms for trading various forms of finance, categorised by time frame and purpose.
Money markets
Money markets offer loans and funds for up to about a year, sometimes as short as a day. Participants include banks, companies, governments, and individuals needing quick, temporary cash.
Capital markets
Capital markets handle funding over several years or more, through bonds, shares, or bank loans.
Capital markets are divided into:
- Primary market - Where new shares or bonds are first issued to raise fresh capital.
- Secondary market - For trading existing securities, improving their liquidity by allowing easy buying and selling.
Foreign exchange markets
Foreign exchange markets enable buying and selling of currencies for trade, investment, or speculation on value changes.
Types of foreign exchange markets:
- Spot market - Handles immediate transactions at current rates.
- Forward market - Involves agreements for future exchanges at rates set now, using futures contracts to lock in prices.
Futures provide certainty for international traders against exchange rate swings and are also used for commodities like farm goods.
Understanding bonds and their yields
Bonds are debt instruments used by governments and large firms to borrow money for projects like infrastructure.
Features of bonds
- Issuers sell bonds at a face value (nominal amount) to investors, who become bondholders.
- Bondholders receive regular interest payments, known as the coupon.
- Bonds can be traded on secondary markets after issue, often at prices different from the face value.
- At maturity, the issuer repays the face value to the current holder, settling the debt.
Formula for bond yield
Where:
- Yield = Annual return as a percentage (%)
- Coupon = Annual interest payment (£)
- Market price = Current trading price of the bond (£)
A lower market price increases the yield, as the fixed coupon represents a higher percentage return.
Worked example - Calculating bond yield
A bond has a face value of £1,000 and pays an annual coupon of £35. It is currently trading at a market price of £920. Calculate the yield.
Step 1: Identify the values
- Coupon = £35
- Market price = £920
Step 2: Apply the yield formula
Step 3: Calculate the yield
(to 3 s.f.)