Financial Markets: Structure, Functions and Types of Asset
Financial markets are markets in which savers with surplus funds are brought together with borrowers needing funds, enabling funds to flow to their most productive uses.
Before you start
No specific prerequisites - this is a good place to start.
Method
- Learn the five core functions of financial markets, facilitating saving, lending, the exchange of goods and services, forward markets and hedging, and a market for equities, and be ready to explain each with an example.
- Learn the difference between the money market, short-term borrowing and lending, typically under a year, and the capital market, longer-term finance such as shares and bonds.
- Learn the key features of equities: a variable return, dividends plus capital gain or loss, ownership rights, and generally higher risk and higher expected return than bonds.
- Learn the key features of bonds: a fixed coupon payment and a fixed maturity value, an inverse relationship between a bond's price and prevailing interest rates, and generally lower risk than equities.
- Learn the concept of asymmetric information in financial markets, e.g. a borrower knowing more about their own creditworthiness than a lender, and how this can lead to problems such as adverse selection and moral hazard.
- Learn the role of financial markets in allocating capital efficiently: in principle, funds flow to the businesses or projects expected to generate the best risk-adjusted return, supporting investment and economic growth.
- For an evaluation question, weigh the benefits of well-functioning financial markets, efficient capital allocation, risk-sharing and liquidity, against the risks that can arise when markets fail, mispricing of risk, asset bubbles and systemic risk.
Worked example
A company issues a corporate bond with a face value of 1,000 pounds and an annual coupon of 40 pounds. Calculate the bond's coupon rate, and explain what is likely to happen to the market price of this bond if the general level of interest rates in the economy rises.
- Calculate the coupon rate: coupon payment divided by face value, multiplied by 100.
- Calculate: (40 / 1000) x 100 = 4 percent, so the bond has a coupon rate of 4 percent.
- If general interest rates in the economy rise above 4 percent, newly issued bonds will offer a higher coupon than this existing bond.
- To remain attractive to buyers, the existing bond's market price must fall, so that its fixed 40 pound coupon represents a competitive return relative to its new, lower price.
- This illustrates the inverse relationship between bond prices and interest rates: as interest rates rise, existing bond prices fall, and vice versa.
Practice questions
Try each question, then tap to reveal the answer.
Q1State two functions of financial markets.Show answer
Answer: Facilitating saving and facilitating lending, or providing a market for equities and providing forward markets for hedging risk.
Q2Distinguish an equity from a bond.Show answer
Answer: An equity, a share, is a stake of ownership in a company offering a variable return, dividends and capital gains; a bond is a form of debt offering a fixed coupon payment and a fixed maturity value.
Q3Which asset class, equities or bonds, is generally considered higher risk, and why?Show answer
Answer: Equities, because their return is variable and shareholders are paid only after a company's other obligations, including bondholders, are met, and in the event of failure, shareholders can lose their entire investment.
Q4What is meant by asymmetric information in a financial market?Show answer
Answer: A situation in which one party to a transaction, e.g. a borrower, has more or better information than the other party, e.g. a lender, which can distort decisions.
Q5Give an example of the money market and an example of the capital market.Show answer
Answer: Money market: short-term government borrowing such as Treasury bills; capital market: long-term finance such as company shares or bonds.
Q6State the relationship between a bond's price and prevailing interest rates.Show answer
Answer: An inverse relationship; when interest rates rise, existing bond prices fall, and when interest rates fall, existing bond prices rise.
Q7Give one reason a firm might choose to raise finance by issuing bonds rather than shares.Show answer
Answer: Issuing bonds does not dilute ownership or control of the company, and interest payments may be tax-deductible, whereas issuing shares gives up part-ownership and future profits to new shareholders.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain two functions performed by financial markets in a modern economy.
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Assess the extent to which well-functioning financial markets contribute to a country's economic growth.
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See real A Level Economics past-paper questions, with official mark schemes →
Free printable worksheet
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