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.
Financial Derivatives can be categorised according to the type of trade. The first is the category of exchange-traded instruments and the second refers to those instruments bought directly from a bank or other financial institution and these are called over-the-counter derivatives. This chapter examines the main derivative contracts used in financial markets. It considers the reasons for the development and growth of trading of financial derivatives over the last 30 or so years, and examines the organisation of trading at Intercontinental Exchange Futures Europe. The chapter also examines the nature of financial futures, options, swaps, forward rate agreements, contracts for difference and credit derivatives. It includes two case studies that illustrate the dangers of derivatives trading: Metalgesellschaft and Barings bank. The chapter summarises a selection of the studies that have examined the efficiency of derivatives markets.
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.
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 looks at the main financial markets making up the UK financial system. It considers some general issues relating to the nature and role of financial markets, including types of trading system and types of trading activity. The chapter discusses the nature of an efficient financial market and examines the behavioural theory of finance. The emergence of London as an international financial centre can be explained with reference to a number of factors. The first is the time zone factor, with London occupying a position mid-way between the western and eastern time zones, which allows financial trading to take place 24 hours a day, with business switching between the major financial centres. The chapter outlines the role of markets in the completion of deals. It also considers the opportunities offered by financial markets to engage in three specialist activities, namely hedging, speculation and arbitrage.
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 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.
A foreign exchange market (the 'forex') is where one currency is exchanged for another. The UK is the main centre in the world for foreign currency trading. This chapter examines the nature of exchange rates which is followed by a discussion of the determination of exchange rates. There is little, if any, agreement on the factors determining the demand for and supply of currency in the foreign exchange market. Three principal relationships are discussed in the chapter: purchasing power parity, covered interest rate parity and the international Fisher relation. The chapter explores the nature of the foreign exchange market and the types of business carried out on the market. Four types of forex business are conducted: spot transactions, outright forward transactions, foreign exchange swaps and currency swaps. The chapter also briefly summarises the empirical evidence concerning the efficiency of the forex.
Three main areas of international financial activity can be distinguished: banking, bonds and similar types of securities, and equities. This chapter examines the eurosecurities markets which have developed out of the eurocurrency markets and then discusses some of the wider developments in international financing. The eurosecurities markets considered in the chapter are those of eurobonds, euronotes and euro-equities. These markets have been the subject of a great deal of financial innovation over the past 30 years. Two types of money market instruments are highlighted in the chapter: note issuance facilities and eurocommercial paper. The chapter also considers the role of swaps before a review of disintermediation. This process describes how changes in the financial environment and the changing preferences of borrowers and international banks have led to direct financing through greater use of the international capital markets.
Banks are the most important category of financial institution, which provide intermediation services to the economy. This chapter focuses on the nature of banking and the operations carried out by banks. It examines the different categories of banking operations. For expository purposes, the chapter divides discussion of banking into six categories: retail banking, wholesale/investment banking, international banking, universal banking, Islamic banking and narrow banking. The process of financial intermediation can be deconstructed into four constituent parts: loan origination, loan funding, loan servicing, and loan warehousing. The process of securitisation separates loan origination to loan servicing from function loan warehousing so that after the loan is arranged, it is transferred to a third party. The chapter examines the risks faced by banks and how they are managed. The risks include: liquidity risk, market risk, payments risk/settlement risk, operational risk, credit risk, sovereign risk and legal risk.