5.4Summary

The money markets are markets in which funds are lent and borrowed for short

periods, usually a matter of months, but sometimes for no more than a day. In

some cases the loans take the form of securities which can be traded between third

parties. In such cases, the return to the holder will come in the form of the differ-

ence between what was paid for it and the price received either at maturity or when

it is re-sold. With such instruments, a change in market price means a change in

the rate of return. Some money market instruments have their return quoted on

a ‘discount’ basis and some on a ‘yield’ basis, which means we must be careful in

making comparisons.

In most countries, the primary instrument of monetary policy is the level of

some designated, short-term interest rate. Whichever rate is chosen, it will be deter-

mined in one or other of the money markets. This means that central banks are

active participants in money markets. In the event of a general shortage of liquidity,

which they can themselves create if they wish, they become the monopoly suppliers

of short-term funds and this gives them considerable power to inuence money

market rates as a whole. In the UK, the Bank of England used to operate mainly in

the discount market, setting treasury bill rate via its transactions with discount houses.

Because money market instruments are close substitutes for one another, this would

affect all short-term rates to a large degree. Since 1997, however, it has exercised

its inuence directly across a wider range of money markets by dealing with a wider

range of institutions.

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Further reading

Questions for discussion

1	How do money markets differ from capital markets? Who are the main users of moneymarkets?

2	What is the difference between money market instruments quoted ‘on a discountbasis’ and ‘on a yield basis’? Suppose that one-month treasury bills and one-monthCDs are both quoted as having a rate of return of 5 per cent. Which gives the higherreturn to an investor?

3	Suppose the expectation develops that long-term interest rates are likely to fall infuture. What is this likely to do to the supplyof commercial paper and why?

4	Suppose that the government makes a major sale of bonds to the M4 private sector.Explain the likely effect of this on (a) the liquidity of the banking system and (b) thedemand for money market instruments.

5	Discuss the various ways in which the central bank could respond to the money market developments identied in (4).

6	Imagine that the central bank is concerned about the rate of growth of credit in theeconomy. Explain how it might use its position in the repo market to tackle this problem. Work an example to illustrate how it might use gilt repos to raise interestrates from 5 per cent to 5.5 per cent.

Further reading

AD Bain, The Financial System(Oxford: Blackwell, 2e, 1992) ch. 12

Bank of England, ‘The rst year of the gilt repo market’, Bank of England Quarterly Bulletin,

37 (2), May 1997

Bank of England, ‘Changes at the Bank of England’, Bank of England Quarterly Bulletin,

37 (3), August 1997

Bank of England, factsheet, ‘Monetary Policy’ (www.bankofengland.co.uk/factmpol.pdf)

Bank of England, ‘The transmission mechanism of monetary policy’, Bank of England Quarterly

Bulletin, 39 (2), May 1999

Bank of England, ‘Implementing monetary policy: reforms to the Bank of England’s operations

in the money market’, Bank of England Quarterly Bulletin, 45 (2), Summer 2005

C Bean, ‘The new UK monetary arrangements: a view from the literature’, Economic Journal,

108 (451), November 1998

M Buckle and J Thompson, The UK Financial System(Manchester: Manchester UP, 4e, 2004)

ch. 10

A Budd, ‘The role and operations of the Bank of England Monetary Policy Committee’,

Economic Journal, 108 (451), November 1998

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Chapter 5 • The money markets

PGA Howells and K Bain, The Economics of Money, Banking and Finance:A European Text

(Harlow: Financial Times Prentice Hall, 3e, 2005) ch. 15

K Pilbeam, Finance and Financial Markets(London: Macmillan, 2e, 2005) ch. 5

J Vickers, ‘Ination targeting in practice: the UK experience’, Bank of England Quarterly

Bulletin, 38 (4), November 1998

http://www.bankofengland.co.uk

http://www.dmo.gov.uk

Answers to exercises

5.1	(a) £97,250; (b) £98,900; (c) better (equivalent treasury bill rate = 11.3%); (d) £97,000.
5.2	(a) £50,749; (b) £50,848.
5.3	12.63%.

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CHAPTER6

The capital markets

Objectives

What you will learn in this chapter:

lWhat the capital markets are, who uses them and why they are important

lThe characteristics of the instruments traded in the capital markets

lThe arrangements for trading these instruments

lSome basic principles relating to the pricing of these instruments

lWhat causes their prices to change

lHow to read and analyse news and data relating to capital markets

Capital markets provide funds for long-term use. There is no strict denition of ‘long

term’ but the original maturity of the debts will usually be more than ve years. The

main instruments which are traded in these markets are bonds and equities or com-

pany shares. Many bonds are issued with a projected life of more than twenty years,

while a company’s shares have no specied maturity but continue for as long as the

rm exists.

In this chapter we shall start by looking at who uses the capital markets and

why the behaviour of these markets is important. In section 6.2 we shall look at

the particular characteristics of bonds and equities and at the way in which they

are bought and sold in the UK. In section 6.3 we focus on bonds, looking at factors

inuencing supply and demand and at the basics of bond pricing. In section 6.4 we

do the same for equities. We shall see that demand uctuates with changing views

of what these securities are worth. This takes us into the theory of asset valuation.

It involves some fairly simple arithmetic and some ideas which we explain more

fully, for those who are interested, in Appendix I: Portfolio theory. In section 6.5

we shall look at some typical real world events that cause security prices to change

and see whether our theory helps us to understand whythese events affect prices.

In section 6.6 we look at the way in which information about shares and bonds is

reported.

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Chapter 6 • The capital markets