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

This guide covers financial markets for OxfordAQA International AS and A-level Economics (9640), specification section 3.4.2.3, for exams from May/June 2022 (International A-level). Section 3.4 is extra International A2 content and sits outside the International AS. Every figure below is invented for teaching, and the currencies, firms and banks are fictional. The balance of payments and exchange-rate determination have their own sections and are not repeated here.

Related pages: course hub · printable checklist · revision notes · practice questions · monetary policy · diagnostics.

What the specification asks for

Outcome in 3.4.2.3	What you must be able to do
Characteristics and functions of money	List them and judge how well an asset performs each
Money, capital and foreign exchange markets	Say what each trades and over what time span
Spot and forward markets in currencies and commodities	Explain the difference and work out who gains or loses
Role in saving, lending, exchange and insurance	Explain how each is facilitated
Debt and equity	Compare cost, risk and control
Commercial and investment banks	Distinguish them and explain the risk of combining them
Why a bank might fail	Explain long lending funded by short borrowing
Central bank functions, including lender of last resort	Explain each, plus required reserve ratios
Moral hazard, asymmetric information, bubbles	Apply to lenders, insurers and asset prices
Regulation, shadow banking, systemic risk	Evaluate their effect on the real economy

Quantitative skills in 3.5 (percentages, index numbers, real values) can be tested in any unit, so they appear below.

1. Money

Money is whatever people will take in return for goods and services, and to clear what they owe. Good money is acceptable to everyone, durable, portable, divisible, uniform (one unit is like another), limited in supply, and stable in value.

Money does four jobs:

• Medium of exchange: sellers and buyers no longer need a double coincidence of wants, as barter does.
• Unit of account: prices, wages and debts are quoted in one unit.
• Store of value: you can hold purchasing power for later.
• Standard of deferred payment: contracts for future payment can be written in it.

Inflation weakens the store of value. Worked example (invented): a saver keeps 1,000 units in cash while prices rise 4% a year for 3 years. Real value = 1,000 / 1.04³ = 889.00 (to 2 d.p.), so about 11% of purchasing power has gone. A deposit paying a nominal 2.5% when inflation is 4% has a real return of 1.025 / 1.04 − 1 = −1.44%.

2. Money, capital and foreign exchange markets

• Money markets trade short-term funds and assets, with a life of up to about a year, such as interbank loans and short-dated government bills. They help banks, firms and governments manage day-to-day cash.
• Capital markets trade long-term finance: shares (equity) and bonds (debt). They fund investment that takes years to repay.
• Foreign exchange markets trade one currency for another. Importers, exporters, investors and speculators all take part.

A bond pays a fixed coupon. Its yield = coupon / price × 100. Take a bond with face value 100 and a coupon of 6 a year:

Market price	Yield
120	5.0%
100	6.0%
80	7.5%

Prices and yields move in opposite directions. When market interest rates rise, existing bonds fall in price so that their yield matches new bonds.

3. Spot and forward markets

A spot deal is settled at once (in practice within a couple of days) at the spot price. A forward deal fixes today a price for delivery and payment at a set future date. Forward contracts let buyers and sellers remove price uncertainty. This is hedging. Speculators take the other side, hoping to profit from price changes.

Currency example. Country A’s importer owes 400,000 betas in 3 months. Today the spot rate is 1 alpha = 2.00 betas, and the 3-month forward rate is 1 alpha = 1.90 betas.

• Forward cost = 400,000 / 1.90 = 210,526.32 alphas, fixed today.
• If the spot rate then falls to 1.80, the unhedged cost is 400,000 / 1.80 = 222,222.22 alphas. The forward contract saved 11,695.91.
• If the spot rate rises to 2.10, the unhedged cost is 190,476.19 alphas. The forward contract cost an extra 20,050.13, but the firm bought certainty, which is what hedging is for.

Commodity example. A small bakery agrees to buy 40 tonnes of flour in 3 months at 500 per tonne (20,000). If the spot price is then 560, it would have paid 22,400, so the contract saved 2,400. If the spot price is 450, it would have paid 18,000, so it paid 2,000 more than necessary.

Speculation can be stabilising or destabilising. Speculators who buy when they think a price is too low, and sell when too high, push prices back towards fundamental value. If they follow the trend instead, buying because the price is rising, they push it further from value.

4. What financial markets do

• Saving: savers place funds with banks or buy assets and earn a return, so deferring spending is rewarded.
• Lending: markets match savers with borrowers who have investment projects. Banks and bond markets do the matching, and spread the cost over many savers.
• Exchange of goods and services: payment systems and currency markets let buyers and sellers who are far apart settle in money.
• Insurance: risk is pooled. Worked example: 2,000 households each face a 0.4% yearly chance of a 15,000 loss. Expected loss per household = 0.004 × 15,000 = 60, so expected claims are 120,000. A premium of 75 raises 150,000, leaving 30,000 to cover costs and profit.

5. Debt and equity

Debt is borrowed money (loans, bonds) repaid with interest on fixed dates. Equity is ownership (shares), which earns dividends only if the firm chooses to pay and gives a vote.

Worked example. A firm with 400,000 shares needs 1,200,000. Option 1: an 8% bond, interest 96,000 a year. Option 2: 120,000 new shares at 10 each, giving 520,000 shares. Operating profit is 200,000.

• Bond: (200,000 − 96,000) / 400,000 = 0.26 per share.
• Shares: 200,000 / 520,000 = 0.38 per share (to 2 d.p.).

If profit falls to 80,000, the bond option leaves 80,000 − 96,000 = −16,000, because interest is owed regardless. Under the share option the owners just receive less (0.15 per share). Debt raises returns in good years and raises the risk of failure in bad ones. Equity costs the existing owners control and a share of profit, but it is safer for the firm.

6. Commercial and investment banks

A commercial bank accepts deposits and lends the funds to households and firms. An investment bank helps firms and governments raise capital (arranging share and bond issues), advises on mergers, and trades financial assets. You do not need a detailed knowledge of investment banking. Many banks do both, and this can raise systemic risk: losses on trading can threaten the deposits of ordinary savers, and a failure becomes more damaging and harder to resolve.

Other institutions also operate in financial markets. Pension funds collect contributions and invest them in shares and bonds to pay retirement incomes. Insurance companies pool premiums and invest the funds until claims are paid. Both are large buyers of long-term assets.

7. Why a bank might fail

A bank borrows short (deposits that can be withdrawn on demand) and lends long (loans repaid over years). This is maturity mismatch.

Worked example. A bank has assets of 1,000: cash reserves 120 and long-term loans 880. Its liabilities are deposits 920 and shareholders’ equity 80.

• Capital ratio = 80 / 1,000 = 8%, leverage = 12.5.
• If 15% of depositors withdraw, 0.15 × 920 = 138 is needed, but cash is 120: a shortfall of 18. The bank is illiquid even though its assets exceed its deposits. Selling loans quickly may force prices down.
• If 10% of loans default, the loss is 88, which is more than equity of 80. The bank is now insolvent.
• Interest risk: deposits cost 2% (18.40) and loans yield 5% (44.00), a margin of 25.60. If funding costs rise to 6%, the cost is 55.20 and the bank makes a loss of 11.20.

Fear of failure can itself cause failure: a bank run is self-fulfilling.

8. Central banks

A central bank typically prints the currency, holds accounts for the government and for the commercial banks, sets the policy interest rate, looks after the exchange rate and foreign reserves, and supervises banks. It is also the lender of last resort: it lends to a sound but illiquid bank to stop a run spreading.

A required reserve ratio makes banks hold a fraction of deposits as reserves. The maximum credit multiplier = 1 / reserve ratio. With a 10% ratio, a new deposit of 100 can support deposits of 1,000. At 20% it supports only 500. A higher ratio makes banks safer against withdrawals but reduces lending.

9. Moral hazard, asymmetric information and bubbles

• Asymmetric information: one party knows more. Borrowers know more about their risk than banks, and insurers know less about customers than customers do. This can cause bad lending and mispriced risk.
• Moral hazard: a party takes more risk because someone else bears the cost. If banks expect rescue, they may lend recklessly. Insured people may take less care: in the insurance example, if the claim chance rises to 0.6%, claims are 180,000 against 150,000 of premiums.
• Bubbles: asset prices rise far above fundamental value because buyers expect further rises. Herding behaviour (copying others) feeds the rise. Example: an index goes 100 → 160 → 250 (+60%, then +56.25%). A 45% fall brings it to 137.5, and it would then need an 81.82% rise to get back to 250. Falls are damaging for borrowers who used the asset as security.

10. Regulation, shadow banking and the real economy

Regulation can set capital and liquidity requirements, require reserves, supervise risk-taking, and insure deposits. Its costs: compliance costs, less lending, and moral hazard from deposit insurance.

Shadow banking means lending by non-bank institutions (for example some investment funds) that often borrow short and lend long, with little regulation and no access to central-bank rescue. It can transfer risk out of sight.

Systemic risk is the risk that one failure spreads through the whole system. Banks owe each other money and hold similar assets, so panic spreads. Real economy effects: credit dries up, firms cut investment, households cut spending. If investment falls by 40 and the marginal propensity to withdraw is 0.4, the multiplier is 1 / 0.4 = 2.5 and GDP falls by 100.

Evaluation: effects depend on how big and how connected the institution is, how quickly the authorities act, and how healthy the rest of the economy is.

Common errors

• Confusing illiquid with insolvent.
• Saying a rising bond price raises its yield.
• Treating a forward contract as a bet that always wins.
• Saying money is wealth. Money is one form of wealth.
• Describing moral hazard without saying who bears the cost.

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.