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Economics Q1Chapter 8
The money and capital markets are the market on which notes are exchanged for money. The
interest rate ensures that there is a balance on the capital market between demand and
supply. The main function of the money and capital market is to bring together the deficits
and surpluses of liquid assets within an economy to create a balance between them. Market
parties with a surplus of money entrust this surplus to financial institutions. With these funds,
credit can be extended to parties that are short of money. Financial institutions match the
needs of the capital provider in terms of size, time span and risk with those of the capital
demander.
The money market deals with promissory notes with a residual maturity of less than two
years. The capital market deals with promissory notes with a residual maturity longer than
two years. The primary market deals with new promissory notes (f.e emission of shares and
bonds). Existing promissory notes (mainly securities) are traded on the secondary market.
The trade in shares on the stock exchange is an example of trade on the secondary capital
market.
The money market
Wholesale money market Retail money market
- Only accessible to big market parties - Small and medium sized businesses
such as banks, government, institutional - Traded amounts are smaller
investors and some large companies. - Interest rates are the credit and debit
- The interest rate is the Euribor (interest interest rates of financial institutions.
rate that banks rate each other)
Wholesale money market
Financial institutions have a wholesale function on the money market. They make an
inventory of the liquidity surpluses and deficits of their clients. Balancing these amounts will
produce a net deficit or a net surplus. If there is a net surplus, the bank can deposit the surplus
liquid assets with another bank. If there is a net deficit, the bank will have to. Borrow liquid
assets from another bank.
If demand for money increases, the interest rate will rise; if the supply of money increases,
the interest rate will drop. The following factors determine demand and supply in the short
term:
1. Monetary policy → the Euribor is dependent on the objectives of the ECB
2. International capital flows → foreign money market interest rate, short-term
exchange rate expectations and political and economic news.
3. Economic fundamentals (f.e. inflation)
The retail money market
The interest rates are the debit and credit rates of banks. The banks interest rates are
determined by:
, 1. The Euribor
2. The interest margin
3. A credit risk surcharge
The credit rate is lower than the Euribor rate and the debit rate is higher. The interest margin
is the difference between the debit and credit interest and depends on the competitive
conditions on the market. If competition increases, the margin will decrease. A company with
a strong financial position. And business assets will have a. high credit standing. If so, the
bank’s credit risk surcharge can be low.
The capital market
Official market Private market
- Trades in shares and bonds - Transactions are made by direct
- Is public (transparent) negotiation
- Greater negotiability - Private loans, home mortgage loans or
- Prices are based on the stock exchange real estate investments.
rate (fluctuates). and nominal yield - Is private
(dividend or interest). - Interest is the only form of yield
Capital market yields
An share has a nominal value. This is the value that is given on the share certificate. The
annual profits on a share is termed the dividend. Dividend divided by stock exchange rate is
the dividend yield on a share.
The interest that is paid annually on a bond is termed the coupon rate. The coupon yield (flat
yield) may differ from the coupon rate. The flat yield is calculated by dividing annual interest
receipts by the bond price. Bonds are redeemed at the end of their maturity against their
nominal value, shares are not. The effective yield of a bond is the sum of the flat yield and
redemption yield.
Capital market interest rate
In the EU, the effective yield on the most recent ten-year government bond is used as an
indicator for the capital market interest rate. The interest rate on government bonds forms
the bottom interest rate because of its negligible credit risk. Companies that want to issue a
ten year loan will have to pay the capital market interest rate plus a surcharge that is related
to their credit. The capital interest rate depends mainly on market factors
In the three main economic blocks in the world—EMU, USA and Japan—the interest rate is
mainly determined by domestic economic development. The two main economic
fundamentals behind the long-term interest rate are:
1. The propensity to save and invest within an economy
If there is a little saving or a lot of investing going on in a country, there will be a high
capital market interest rate. An important indicator of the propensity for saving and
investing within a country is the current account of the balance of payments (national
savings balance). A country with long-term surplus on the current account has a large
supply of liquid assets, which can keep the interest rate low
2. Expected inflation
, In practice there is usually little difference between the capital market interest rates of the
USA and EU. The main risk in international traffic is the currency risk. The difference in capital
market and interest rates between two countries within the euro zone reflects the difference
in market liquidity and the difference in the financial position of the government. A larger
capital market indicates a higher liquidity. This also means that the negotiability of bonds is
greater. The financial situation of the government determines its credit rating.
Chapter 24
The financial system consists of institutions that help to match on person’s saving with
another person’s investment. Financial institutions can be grouped into two categories—
financial markets and financial intermediaries.
Financial markets
Financial markets are the institutions through which a person who wants to save can directly
supply funds to a person who wants to borrow. The two most import ones are the bond
market and the stock market.
A bond is a certificate of indebtedness that specifies the obligation of the borrower to the
holder. It identifies when the loan will be repaid, maturity, and the rate of interest that will
be paid. The buyer can hold the bond until maturity or can sell the bond earlier. Long-term
bonds are riskier than short-term bonds because holders have to wait longer for repayment.
Therefore, long-term bonds have a higher interest rate. The probability that the borrower will
fail to pay the interest or principal is called credit risk. Such a failure is called a default. Bonds
for national governments are called sovereign debt. You can have gilt-edged bonds (good as
gold) or junk bonds (very high interest rate). Yield of the bond is the coupon rate/price * 100.
As bond prices rise, the yield falls. And vice versa.
Stock represents ownership in a firm and is a claim to the future profits the company makes.
The sale of stock to raise money is called equity finance, whereas the sale of bonds is called
debt finance. If a company is very profitable, the shareholders enjoy the benefits of these
profits, whereas bondholders get only interest on their bonds. Stocks offer a higher risk and
potentially a higher return. The demand for a stock reflects people’s perception of the
corporation’s future profitability. A stock index is computed as an average of a group of share
prices.
Financial intermediaries
Financial intermediaries are the financial institutions through which savers can indirectly
provide funds to borrowers. The most important ones are banks and investment funds.
Small businesses most likely finance their business expansion with a loan from the bank. A
primary function of banks is to take in deposits from people who want to save and use these
deposits to make loans to people who want to borrow. banks pay depositors interest on their
deposits and charge borrowers slightly higher interest on their loans. Another function a bank
fulfills is to create a special asset that people can use as a medium of exchange.
An investment or mutual fund is an institution that allows the public to invest in a selection
(portfolio) of various types of shares, bonds or both. The shareholder accepts all the risk and
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