Entries Tagged 'finance' ↓

Readers Question: In early American banking history, banks would issue banknotes to patrons that were supposed to be backed by gold and silver. My questions is, what did the patrons give the banks to get the bank notes, and why were many banks unable to make payment on demand when the patrons tried to exchange their notes?

Banknotes have evolved over time. Initially bank notes were issues in lieu of precious metals and were essentially I O U’s. A more technical term is that bank notes were ‘promissory’ – Rather than give gold to customers, banks gave a credit note saying they promised to exchange this credit note for an equivalent sum of gold or silver.

Over time, gold and silver were no longer used in the monetary system, thus bank notes became effective credit notes.

It was the  banks who were most keen to use promissory notes rather than deal in precious metals. Bank notes had the advantage that is was easier to transport, lower costs and, most importantly, enabled the banks to make better use of their assets. Continue reading →

Readers Question: with econonomic scare, do you advise to invest? how do you predict inflation and interest rates will affect business?

I answered this question at my economic essay blog: Investing in a recession 

As I said in the post, I doubt a penniless Economist is the best person to ask for investment tips; but economists are, if nothing else, never short of giving advice

One thing worth bearing in mind is that some investments can give a good return during a recession. Even stock markets have been known to rise during a recession because analysts have already priced the downturn into share price.

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Readers Question: What do you think would happen if all depositors of a bank requested their deposits?

The Banking would probably collapse, unless it could secure unlimited funding from a Central Bank or other banks.

If a bank has deposits of £10billion. The bank will keep perhaps 1% in liquid assets (i.e. cash that can quickly be given to customers who demand it. Therefore, out of £10 billion, the bank will have cash reserves of say £100million. We say it has a liquidity ratio of 1%. Therefore, if customers asked for £100 million to be withdrawn the bank could do it. However, once customers require more cash, it faces a problem – The bank doesn’t have the deposits in a liquid form.

What banks do is they lend out deposits to other people. This is how they make a profit.  They pay you 2% a year to save money, then lend to someone else and charge 7%. They can do this because usually people don’t want to suddenly withdraw all their money and it is more profitable than simply keeping money behind the counter. Continue reading →

The banking system in the UK is highly concentrated with the top 10 banks having over 90% of market share.

In recent years, the advent of internet banking has provided a new source of income, but, at the moment the banking system is still dominated by these top 10 banks.

Note: Recent merger of HBOS and Lloyds TSB

This is a rough guide to the biggest 10 British banks.

Some interesting facts about British banks.

• They employ 0.5million people Continue reading →

In a way stock markets are an example of perfect competition. There are hundreds of buyers and sellers, with equal access to regularly updated information. We can assume most stock market traders are rational people who seek to maximise their profits. There are few barriers to entry and exit; anybody can buy shares if they have enough money. Shares in one company are homogenous.

But despite this, stock markets tend to behave erratically with large swings in share prices. This suggests that the market is not perfectly competitive.

For example, if investors have perfect information how do we explain stock market crashes?

1. Herding behaviour. ‘Wisdom of the Crowds’

It is often assumed that if markets are rising there must be a good reason for the rise in prices. If professional investors are buying dot com shares why should we not? Therefore, it is often the case that people get caught up in the prevailing mood of the market.  When prices rise this encourages other people to buy. When prices fall the opposite occurs and investors seek to sell before prices fall anymore.

2. Information is poor.

The other assumption is that investors have accurate information. Firstly, it is difficult to be completely aware of the current profits of a company. But the key for share prices are forecasts for the future. People buy shares on expectations of future profits. However, there are many factors that can make it difficult to accurately predict profit growth. Often profit forecasts are extrapolated by looking at past profit trends. However, just because a company has had profit growth of 20% for the past 5 years, there is no guarantee it will continue to have similar profit growth.

• Effects of a falling stock market 

I wrote a brief explanation to the current credit crunch, breaking it down into 10 stages – including why It occured and who does it  affect.

Some Common questions on Credit Crisis

Why Do US Mortgage Defaults Affect the UK?

The US mortgage companies funded their mortgage lending by selling their loans onto other financial companies. This is known as rebundling debt; ironically, it was aimed at making the debt appear safer because the risk was shared amongst other financial institutions. (This is one reason why US subprime loans got a triple AAA credit rating). Therefore, when US mortgage defaults occured, it wasn’t just US mortgage firms who were in trouble. Many big banks who had bought the mortgage bundles lost money. Also because of the crisis it has become more difficult and expensive to borrow money, financers don’t want to get burnt with buying any more bad subprime debt.

What is actually meant by Subprime?

Subprime was primarily used in the US, but, has quickly slipped into British English use. Subprime essentially means lending to people without perfect credit histories. For example, if you miss a payment or go overdrawn without authority, you get a negative credit rating. This means you will be classed as subprime. In practice subprime can refer to any type of risky lending. This could be people with bad credit histories, or people with irregular income.

• In the UK subprime is sometimes referred to as ‘bad credit’ payments.
• There can be different levels of subprime. For example, one missed payment could cause a credit rating of subprime. But, if your home was repossessed this is clearly a more serious form of subprime.

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Readers Question: How and why do firms use derivatives to hedge risk?

Financial derivatives are a mechanism for managing risk. They involve options to buy or sell at a certain price in the future. This means that a firm can guarantee being able to buy or sell a contract at a certain price.

Why Firms Use Financial Derivatives.

The main reason firms use financial derivatives is that  it is way to manage risky price movements. In a way derivatives are a type of insurance and enable them to ‘hedge’ against adverse price fluctuations. This is important in volatile commodity prices or when exchange rates may be volatile.

It is ironic that financial derivatives are often considered to be ‘risky speculation’ when there intended purpose is to insure against volatile markets. Of course, derivatives can be misused by speculators. Rather than insuring against positions, derivatives can be used to gamble on a way one increase in stock markets e.t.c. But, the initial purpose of derivatives is to reduce risk.

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Readers Question: To what extent can the subprime crisis affect the global financial market?

The subprime crisis refers to the rising number of defaults on US subprime mortgages. Basically, US mortgage companies sold a lot of inappropriate mortgages to people on low income and poor credit histories. Rising interest rates, and falling house prices are causing many of these mortgage owners to struggle with repayments. Therefore, many mortgage companies have lost significant amounts of money. Some of the leading US subprime mortgage firms have gone under and bankrupt. If it was just mortgage companies who went bankrupt, it wouldn’t be so much of a problem.

However, many of these mortgages were financed through securitization. Basically, the mortgage companies would lend the money to homeowners but would finance the mortgage loan by selling ‘mortgage bundles’ to other financial institutions. Basically, mortgage loans were financed by many different financial companies, not just the mortgage companies.

In the US, upto 70-80% of mortgage loans were financed by securitisation. In the UK, the rate is much lower about 21%. The only British bank to get into trouble was the Northern Rock. The Northern Rock, unsurprisingly had the highest rate of 61%.

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Yesterday, I mentioned future contracts could be used as a way to insure against risky commodity prices. This is one way that future contracts can be used. Unfortunately, future contracts and options can also be used to speculate on the stock market. Stock market options enable investors to take a position on the stock market rising or falling. If you expect the stock market to buy you can take out a contract to buy at a certain price. If the stock market rises you can then buy at the fixed price and immediately sell for the higher price. Options enable an investor to magnify his gains, but also can magnify his losses. Continue reading →

This is part of a new series to understanding pages in the Financial Times. There are a lot of terms which seem quite complicated. This is an attempt to demystify financial jargon and make sense out of all the series of data and figures

Future markets are basically a paper market where traders ‘hedge’ against volatile prices. It is really a way to insure people against unexpected fluctuations in prices. In commodity markets, prices can often be volatile due to factors such as the weather. (basic economics – demand and supply for commodities are often inelastic and this makes prices more volatile)

For example, suppose you made a contract to buy coffee beans in the future. If the price of coffee beans rose significantly, your costs would be much higher than expected. Therefore, you can enter the coffee future market and place a parallel but opposite contract. Therefore, if the price of coffee rises, your future contract will appreciate in value, allowing you to put this gain towards buying the more expensive commodity.

Although future markets may be seen as encouraging speculation. They are often seen as a good thing because they enable physical goods markets to operate more efficiently

• Commodity Future Markets
• List of Traded Commodities