Money, capital and foreign exchange markets
A financial market is any place, real or online, where people trade money and financial assets. Its main job is to move money from savers (who have spare money) to borrowers (who need it now).
- Money market: very short-term lending and borrowing, less than one year. Examples: treasury bills, overnight loans between banks, commercial paper. Banks use it to manage day-to-day cash.
- Capital market: long-term finance, more than one year. Firms sell shares (part ownership) and governments and firms sell bonds (loans). The primary market sells new shares or bonds; the secondary market (a stock exchange) trades old ones.
- Foreign exchange (forex) market: currencies are bought and sold, for trade, travel, investment and speculation. It is the biggest market in the world by daily value.
Other assets include derivatives (contracts whose value depends on another asset) and commodities. Good markets give liquidity (you can sell quickly) and help set prices for risk.
Bonds and interest rates: the inverse relationship
A bond is a loan you give to a government or firm. It has a face value (paid back at the end, on the maturity date) and a fixed yearly payment called the coupon.
Yield = coupon ÷ market price × 100%.
The coupon never changes, but the price in the secondary market does. So:
- Price rises → yield falls.
- Price falls → yield rises.
Why do bond prices fall when interest rates rise? If new bonds now pay 6%, nobody will pay full price for an old bond paying 5%. Its price must drop until its yield also reaches about 6%. The opposite happens when rates fall. Long-dated bonds swing the most. Central banks use this link: buying bonds (for example in quantitative easing) pushes bond prices up and long-term interest rates down.
Systemic risk and moral hazard
Systemic risk is the risk that trouble at one bank or market spreads and harms the whole financial system and the real economy. It happens because banks lend to each other, hold similar assets and depend on confidence. A run on one bank can make savers panic at others.
Moral hazard is when someone takes more risk because someone else will carry the cost if things go wrong. A bank that is "too big to fail" may expect a government bail-out, so it lends recklessly. Insured depositors also stop checking how safe their bank is.
Other market failures in finance: asymmetric information (the borrower knows more than the lender), speculation and bubbles, and market rigging.
Regulation of the financial system
Most countries split the job between two kinds of regulator:
- Prudential regulator (often part of the central bank): keeps each bank and insurer safe. It sets capital requirements (a buffer of the bank's own money), liquidity rules and stress tests. In the UK this is the Prudential Regulation Authority (PRA) inside the Bank of England.
- Conduct regulator: protects customers and keeps markets honest, stopping mis-selling, fraud and insider trading. In the UK this is the Financial Conduct Authority (FCA); India's SEBI does similar work for securities markets.
- A financial policy committee watches risks to the whole system (macro-prudential policy).
Regulation reduces systemic risk and moral hazard, but too much can raise costs and cut lending. Global rules (the Basel agreements) set minimum bank capital in many countries.
Try it: price, yield and buffers
In the 3D free-play step, set the bond price to 800, 1000 and 1250. Write down the yield each time and check it with coupon ÷ price. Then set the capital buffer to 0%, 5% and 8%. How many banks fall each time? This is why regulators ask for bigger buffers.
Key formulas and definitions
- Yield (%) = annual coupon ÷ market price × 100
- Coupon = coupon rate × face value
- Bond price ↑ ⇔ yield ↓ (inverse relationship)
- Market interest rate ↑ ⇒ existing bond prices ↓
- Money market: under 1 year · Capital market: over 1 year
Worked examples
1. A bond has a face value of 1000 and a coupon of 40 a year. It trades at 800. Find its yield.
Yield = 40 ÷ 800 × 100 = 5%.
2. A bond pays 60 a year. Market rates fall so investors accept a 4% yield. What price will the bond trade at?
Price = coupon ÷ yield = 60 ÷ 0.04 = 1500.
3. Explain why a government bond's price may fall after a central bank raises interest rates.
New bonds now offer a higher return. An old bond with a fixed, lower coupon is less attractive, so buyers only take it at a lower price. The price falls until its yield matches the new market rate.
4. A firm issues new shares to build a factory. Which market is this, and is it primary or secondary?
Capital market (long-term finance), primary market (new shares sold for the first time).
Common mistakes
- Thinking a higher bond price means a higher yield. The coupon is fixed, so a higher price gives a lower yield.
- Mixing up the coupon (fixed payment) and the yield (return compared with today's price).
- Calling the stock exchange a money market. Shares are long-term finance, so they belong to the capital market.
- Saying moral hazard means "banks are dishonest". It means taking extra risk because someone else carries the cost.