This chapter mainly focuses on the bond market and the term structure of interest rates. The two are linked because the discussion of the term structure of interest rates is mainly conducted in the context of government securities. The chapter briefly discusses the reasons why different securities have different interest rates (i.e. the general structure of interest rates) and surveys the differing theories of the level of interest rates. It examines the general nature and valuation of bonds by highlighting the standard bonds and the Sukuk Islamic bonds. The chapter looks at the market for UK government securities (the gilt-edged market) in terms of new issues, secondary market trading and the innovation of gilt strips. It also examines the nature of corporate bonds and credit ratings.
This chapter provides an introduction to the role of a financial system in an economy. It presents a very simple model of an economy and establishes some of the basic financial concepts which will be drawn upon throughout this book. In this model the economy is divided into two distinct groups or sectors. The first is the household sector and the second is the firms sector. The chapter examines the nature of the financial claims which underlie the transfer of funds from those with surplus funds to those who wish to borrow. It also provides a sectoral analysis of the financial system, focusing on households, non-financial corporations, financial corporations, general government and rest of the world. The chapter discusses three sets of national accounts that are relevant to the analysis of the financial sector: national wealth, financial wealth and flow-offunds accounts.
The prices of assets or interest or exchange rates can be subject to unexpected changes that can create losses. This chapter surveys the various methods that are open to traders to manage risk. It discusses in more detail the precise nature of exchange and interest rate risk. Exchange rate risk can arise in a number of different ways: transaction risk for exporters and importers; translation risks, which arises when it is necessary to value overseas assets and liabilities; economic exposure; and hidden exposure. On managing of exchange rate risks, the chapter also discusses how firms may reduce exchange rate exposure by methods internal to the firm such as doing nothing or hedging, and the role of methods external to the firm such as the use of the forward exchange market, temporary foreign currency deposits and loans, forfaiting, options, and back-to-back loans. It also examines strategies to manage interest rate risk.
The market for equities is part of the capital market, which refers to the market for long-term finance. This chapter deals with equity markets and examines some general issues relating to the raising of long-term finance by private firms. It focuses on the primary market for equity issues, which is followed by a discussion of the secondary market, where equity securities are traded. The chapter also examines the nature of and causes of the global stock market crash of October 1987 and the 'technology bubble' in the late 1990s that led to global stock market falls from 2000. It considers the degree to which stock markets conform to the efficient markets hypothesis. Two markets exist in London. The main market is the London Stock Exchange (LSE), which deals in the securities of established companies. The second market is the Alternative Investments Market, which is owned and operated by the LSE.
The rules concerning the regulation of non-bank financial institutions have mainly originated from the European Union. This chapter discusses the main features of the regulations. It looks at regulation of life insurance companies and pension funds. This is followed by a discussion of the regulation of investment funds in and of market infrastructure. The European Market Infrastructure Regulation came into force in August 2012 and covers over-the-counter derivatives, central counter-parties and trade repositories. The regulation requires anyone who has entered into a derivatives contract to report and risk manage their derivative positions. The chapter also looks at the EU's Market in Financial Instruments Directive, which, in the area of protection, categorises clients into three groups: eligible counter-parties, professional clients and retail clients.
Bank regulation has seen significant change as a consequence of the 2007-8 global financial crisis. One development that was evident before the crisis but which has come more to the fore since is global harmonisation of regulation. There are two broad methods used by governments to control and support the banking industry, namely provision of a safety net and regulation. This chapter discusses the rationale for regulation, before moving on to consider how regulation should be structured. The rationale for regulation includes the major failures that have occurred in the UK and the various types of risks faced by the banks. The chapter examines the elements of the safety net such as bank supervision, stress tests and deposit insurance, as well as capital adequacy and the Basel I and II accords. It discusses the Basel III framework and examines banking recovery and 'resolution'.
The sterling money market located in London is a wholesale market for short-term funds and consequently provides facilities for economic units to adjust their cash position quickly. This chapter discusses the nature of the London money markets. It reviews the assets traded in the money markets and their valuation, and examines the supply of central bank money. The chapter also reviews the Bank of England's (BofE) and Debt Management Office's (DMO) operation in the money markets. The BofE is the price setter in the money market, as the Monetary Policy Committee (MPC) sets the bank rate, but, on the other hand the DMO is a price taker. The primary object of BofE's intervention is to ensure that short-term interest rates are consistent with the bank rate set by the MPC. This objective also includes the objective that day-to-day and intra-day volatility be limited.
The early part of the twenty-first century has witnessed a sea-change in regulation of the financial system following the financial crisis of 2007-2008. Prior to that financial crisis, the official policy was directed to deregulating the financial system, whereas after 2008 the move is towards increased regulation. This book begins the study of the UK financial system with an introduction to the role of a financial system in an economy, and a very simple model of an economy. In this model the economy is divided into two distinct groups or sectors. The first is the household sector and the second is the firms sector. The book describes the process of financial intermediation, and in doing so, it examines the arguments as to why we need financial institutions. It highlights the nature of financial intermediation, and examines the various roles of financial intermediaries: banks as transformers, undertaking of transformation process, and providers of liquidity insurance. The nature of banking, the operations carried out by banks, and the categories of banking operations are discussed next. The book also examines the investment institutions and other investment vehicles. It examines the role of central banks in the financial system in principle, particularly, the role of the Bank of England. Primary market for equity issues, secondary market, the global stock market crash of October 1987 and efficient markets hypothesis are also covered. The book also looks at the trading of financial derivatives, risk management, bank regulation, and the regulation of life insurance companies, pension funds.