OxfordAQA International AS and A-level Economics: Financial markets (9640) – Revision Notes

These revision notes condense specification section 3.4.2.3 (financial markets) of OxfordAQA International AS and A-level Economics (9640). Section 3.4 is the extra International A2 content, examined from May/June 2022. For full explanations, read the study guide. Then try the practice questions, the course hub, the printable checklist and the free diagnostics. Related: monetary policy. All figures are invented.

Money

Idea	Key points
Characteristics	Acceptable, durable, portable, divisible, uniform, limited supply, stable value
Functions	Store of value, medium of exchange, standard of deferred payment, unit of account
Weak point	Inflation erodes the store of value

Real value = nominal value / (1 + inflation rate) for each year.

Reminder: 2,000 held for 2 years at 3% inflation is worth 2,000 / 1.03² = 1,885.19 in today’s purchasing power.

Real interest rate (exact) = (1 + nominal) / (1 + inflation) − 1.

The three markets

Market	Trades	Time span	Who uses it
Money	Short-term loans and assets, for example government bills	Up to about a year	Banks, firms and governments managing cash
Capital	Shares and bonds	Long term	Firms and governments funding investment
Foreign exchange	Currencies	Immediate and forward	Traders, investors, speculators, governments

Bond yield = coupon / price × 100. Price and yield move in opposite directions.

Reminder: face value 100, coupon 4. At price 90 the yield is 4.44%. At price 125 it is 3.20%. If market rates rise, existing bond prices fall.

Spot and forward

• Spot: delivered and paid for now at today’s price.
• Forward: price fixed now, delivery and payment later.
• Hedging removes uncertainty. Speculating accepts it for profit.
• A forward contract can lose compared with spot, but it fixes the cost.

Method in steps for a currency forward:

1. Write down the amount to pay or receive in the foreign currency.
2. Divide by the forward rate (foreign units per home unit) for the fixed home cost.
3. Divide by the possible future spot rates for the unhedged cost.
4. Compare and say who gained.

Reminder (invented): an exporter will receive 300,000 betas in 6 months. Forward rate 1 alpha = 1.60 betas gives 187,500 alphas. If the spot rate is then 1.50, the unhedged receipt is 200,000, so the forward contract lost 12,500. If the spot rate is 1.75, the unhedged receipt is 171,428.57, so the contract gained 16,071.43.

Commodities work the same way: a farmer or a baker can fix the price of grain or flour in advance.

Speculation. Stabilising: buying cheap, selling dear, pushing price to its fundamental value. Destabilising: following the trend, which pushes price further away. Herding behaviour means copying others and creates large swings in asset prices.

What markets do

Function	How it works
Saving	Savers earn a return, so they are paid to defer spending
Lending	Matches savers with borrowers and spreads risk
Exchange	Payment and currency systems settle trade
Insurance	Pools risk across many people

Debt versus equity

	Debt	Equity
What it is	Loan or bond	Share of ownership
Return to provider	Fixed interest	Dividends if paid, plus share price gains
If profit falls	Interest still owed	Dividends can be cut
Control	None	Votes
Risk to firm	Higher	Lower

Debt versus equity: method in steps

1. Find the interest cost: borrowing × rate.
2. Subtract it from operating profit for the debt option.
3. Divide by the shares in issue (existing shares for the debt option, existing plus new shares for the equity option).
4. Repeat for a low-profit year and compare the risk.

Reminder: a firm with 100,000 shares needs 500,000. A 6% bond costs 30,000 a year. The alternative is 50,000 new shares at 10, giving 150,000 shares. At a profit of 80,000: bond option 50,000 / 100,000 = 0.50 per share, share option 80,000 / 150,000 = 0.53 per share. At a profit of 25,000: the bond option is 25,000 − 30,000 = −5,000, so the firm cannot meet the interest from profit, while the share option gives 0.17 per share. The comparison shows how debt magnifies both gains and risk.

Banks

	Commercial bank	Investment bank
Main work	Taking deposits, making loans	Raising capital, advising on mergers, trading assets
Customers	Households and firms	Firms, governments, investors

Many banks do both, which can raise systemic risk because trading losses can reach depositors.

Why a bank fails

• Maturity mismatch: short-term borrowing funds long-term lending.
• Illiquid: cannot meet withdrawals now. Insolvent: assets are worth less than liabilities.
• Capital ratio = equity / assets. Leverage = assets / equity.

Reminder: assets 2,000, equity 120. Capital ratio = 6.0%, leverage = 16.67. A 6% fall in asset values removes all equity.

Method in steps for a bank balance sheet:

1. Check that assets equal liabilities plus equity.
2. Liquidity test: compare possible withdrawals with cash and easily sold assets.
3. Solvency test: compare possible loan losses with equity.
4. State which problem the bank has, and what remedy fits: a lender of last resort for illiquidity, new capital for insolvency.

Reminder: equity 100, loans 1,400. A 10% default rate loses 140, which is 40 more than equity, so the bank is insolvent.

Central bank

• Prints currency; holds the accounts of government and of banks.
• Sets the policy rate and manages reserves.
• Supervises banks.
• Lender of last resort to a sound but illiquid bank.
• Required reserve ratio: the maximum credit multiplier = 1 / ratio.

Reminder: a new deposit of 500 and a ratio of 12.5% allows deposits of 500 / 0.125 = 4,000, which is new lending of 3,500. At 20% the totals are 2,500 and 2,000. A higher ratio improves stability but cuts lending.

Market failures in finance

• Asymmetric information: one side knows more, giving adverse selection.
• Moral hazard: taking more risk when someone else bears the cost, for example expecting a rescue.
• Bubble: price rises far above fundamental value as buyers expect more rises. Herding feeds it.

Regulation, shadow banking, systemic risk

• Regulation: capital and liquidity rules, reserve ratios, supervision, deposit insurance. Costs include less lending and moral hazard.
• Shadow banking: non-bank lenders, lightly regulated, often borrowing short and lending long.
• Systemic risk: one failure spreading through linked institutions to damage the real economy through lower credit, investment and spending.

Reminder: if lending to firms falls by 60 and the multiplier is 2, GDP falls by 120.

Evaluation chain for any shock: size and links of the institution, speed of response, strength of the wider economy, confidence.

Evaluation prompts

• Short run versus long run: a rescue may stop a panic now but encourage risk-taking later.
• Size and links: a small, isolated institution may fail without much effect on the real economy; a large, connected one may not.
• Evidence: bubbles are easier to spot afterwards. Say what data you would want.
• Winners and losers: savers, borrowers, taxpayers and shareholders are affected differently by regulation and rescue.

Must-know distinctions

• Money market versus capital market: time span.
• Hedging versus speculating.
• Spot versus forward.
• Debt versus equity.
• Liquidity versus solvency.
• Moral hazard (behaviour after a contract) versus asymmetric information (knowledge gap).

Quick self-test

1. List the four jobs that money does.
2. A bond has face value 100 and coupon 5. Its price is 80. Calculate the yield.
3. Why do bond prices fall when interest rates rise?
4. A firm will pay 90,000 betas in 3 months. The forward rate is 1 alpha = 1.50 betas. What is the fixed cost in alphas?
5. What is the difference between a spot and a forward contract?
6. Prices rise 5% a year. What is the real value of 800 after 2 years?
7. Give one difference between debt and equity.
8. A bank has assets of 500 and equity of 40. Calculate its capital ratio.
9. A reserve ratio is 5%. State the maximum credit multiplier.
10. Explain one way a failure in financial markets could reduce output.

Answers

1. Store of value, medium of exchange, standard of deferred payment, unit of account.
2. 5 / 80 × 100 = 6.25%.
3. New bonds offer higher coupons, so buyers will pay less for older bonds until their yield matches.
4. 90,000 / 1.50 = 60,000 alphas.
5. Spot is settled now at the current price. Forward fixes a price now for settlement later.
6. 800 / 1.05² = 725.62.
7. Debt is repaid with fixed interest and carries no control. Equity gives ownership and dividends only if paid.
8. 40 / 500 = 8%.
9. 1 / 0.05 = 20.
10. Banks cut lending, firms cut investment, and output falls through the multiplier.

Where marks are usually lost

• Using “liquid” and “solvent” as if they meant the same thing.
• Giving a bond yield calculation without the price of the bond.
• Dividing a currency amount by the wrong rate, or flipping the direction of the exchange rate.
• Describing a bubble without explaining herding or expectations.
• Listing central bank functions without linking one to stability.
• Treating regulation as only good, with no cost or limit.
• Stating that a failure “causes a recession” without a chain through credit, investment and spending.
• Giving real-economy effects without an evaluative judgement about size, speed or confidence.

Official syllabus

OxfordAQA International AS and A-level Economics (9640) specification, version 1.2, section 3.4.2.3, first teaching September 2020, published by OxfordAQA.