Role and Functions of Capital Markets and Money Markets

This report compares and contrasts the role and functions of capital markets and money markets. It also discusses how activities in the money market influence asset prices in capital markets.

Financial Markets

Table of Contents
INTRODUCTION...........................................................................................................................3
MAIN BODY..................................................................................................................................3
Q1 A) Difference between different levels of market efficiency................................................3
B) Critical analysis of efficiency of London Stock Exchange....................................................4
Q2 Compare and contrast role and functions of the capital markets over money markets.
Discuss how an activity of money market influences asset prices in capital markets.................6
Q3 A) Discussing nature of potential risks in global transactions and explaining how
international traders manage risks...............................................................................................7
B) Discussing functions and operations of Eurocurrency market and importance of this market
in trade transactions.....................................................................................................................7
Q4 A) Explaining various terms related to financial markets.....................................................8
B) Critically explain need for regulation of financial markets....................................................8
CONCLUSION................................................................................................................................9
REFERENCES..............................................................................................................................10

INTRODUCTION
Financial markets are helpful for channeling funds to the ultimate borrowers from he
lenders who have enough quantum of surpluses. Present report deals with importance or
significance of financial markets in the economy by which requirements of funds can be met
with much ease. In relation to this, money market and capital market both are explained with
their key roles and functions in effectual manner. Moreover, money market leads to influence
asset prices in capital markets are explained. Different forms of EMH are explained along with
efficiency of LSE. Various risks and their nature are discussed which occurs in global trade
transactions and how this can be managed through forward foreign market is discussed as well.
Key functions of Eurocurrency market and importance in trade transactions is enumerated in the
report. Furthermore, terms related to financial market are discussed along with need for
regulating financial market. Thus, it can be said that these markets are utmost vital in
international level as it help to achieve economic efficiency.
MAIN BODY
Q1 A) Difference between different levels of market efficiency
The Efficient Market Hypothesis (EMH) is quite useful for analyzing the current share
prices of the company in the market in effective manner. It incorporates all the relevant
information which help investors to easily analyze share prices of the firm in the best possible
way (Baharumshah, Slesman and Devadason, 2017). There are basically three types of EMH
such as weak, strong and semi-strong which can be distinguished below-
Weak Strong Semi-strong
1. This form of EMH means
that stock prices of company
in current scenario and as
such, it reflects past prices and
is based on historical data.
1. The form of EMH states it
is effective to assess share
prices as both information
available to public and
privately held information is
provided as well (Slabinski.
2016).
1. Semi-strong form states that
only information which is
imparted to use by public is
provided to the investors
2. This is weak form of the
company as it has no technical
analysis of the market can be
used to assist investors in
taking effective decisions.
2. This is termed as strong
form as all the necessary
information is listed of public
and private information and as
such, these are accounted for
current share prices.
2. It has only public
information and no private and
as such, technical analysis
cannot be used by investors
for taking decisions.
3. The weak form states that
all information such as
publicly held and private is
not included than investors
3. It is strong as private
information such as future
earnings prospectus, new
products and legal issues
3. It incorporates public
information such as financial
statements, income earnings
report etc. are only provided in

cannot assess share prices of
the company.
related information and public
one is also included by which
investors can assess current
market prices of stock in the
best possible manner.
current stock price. Thus,
shareholders cannot attain
price of shares and technical
analysis cannot be performed.
4. This type of form is weak
enough as historical data is
taken into account and as
such, current prices cannot be
ascertained in a better way
(Jermann, 2017).
4. This form is applicable
mainly where there is perfect
market. It is not possible when
restrictions on trading are
present.
4. Fundamental analysis
cannot be possible as only
partial information is available
by which decisions cannot be
made in effectual manner.
5. The example of weak form
is that just because Marks &
Spencer’s (M&S) have 30 day
down share price does not
imply that share price will
raise or not in the future. Here,
historical data is gathered
which classifies as weak form
of EMH.
5. Example of strong form is
that private information such
as equity shares’ offering
which only top management
has the access is incorporated
in the stock price.
5. Example is that partly
information of public such as
financials and partly private
includes when firm releases
income and as such, shares
prices changes in after trading
hours (Lin, Sun and Yu,
2018).
B) Critical analysis of efficiency of London Stock Exchange
London Stock Exchange (LSE) is one of the largest and oldest stock exchanges operating
since 300 years ago. It has admitted more than 3000 companies from several countries for the
purpose of trading. Thus, it is well-structured stock market and important financial institution
among other bigger stock markets. The efficiency of LSE can be seen that there are various high
performance companies which are producing good quantum of profits in the country. Moreover,
firms are competing with another in order to attain greater market share in the best possible
manner. The EMH clarifies whether market is weak, semi-strong or strong which are three forms
of EMH market. These have already been discussed in above paragraphs. Weak form is that
future stock prices cannot be predicted by seeking the historical data and as such, technical
analysis cannot be possible. Investors are not able to take decisions in effective way. Semi-strong
is the one in which information is made publicly available and investors can analyze current
share price. On the other hand, strong form means that there are both public and private
information incorporated in stock price and reflected after trading hours to investors to
effectively analyze the same (Barucci and Fontana, 2017).
In relation to EMH, theory on financial market named as APT (Arbitrage Pricing Theory)
can be explained. The theory implies that it is asset pricing model means that return on asset can
be estimated by utilizing relationship between such asset and risk factors. This means that risky
asset expected return is provided by APT theory which is opposite of CAPM (Capital Asset
Pricing Model) which is based on the market expected return. Thus, risk related to asset can be
evaluated with the help of APT theory. M&S Company which is the biggest firm in UK listed on

LSE has good market capitalization and as such, investors are attracted towards the firm for
making investment and earn higher returns in the best possible manner.
1/3/2017
1/13/2017
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Open
Adj Close
Figure 1 M&S Company
The above stock chart shows that performance of company is overall good. For testing
market efficiency of company, daily historical share price indices are taken. There are 120
observations made during the period from 3rd January 2017 to 23rd June 2017. This means that
120 days of share prices were made in this analysis of M&S Company. It can be observed from
the chart that there are various high and low points in the same of historical stock prices. The
four high points are 386.3, 386.9, 389.3, and 393.4. These were the high points observed on the
closing of trading of shares on daily basis in the period. On the other hand, low points were 330,
323.4, 323.8, and 325.5. Thus, it can be analyzed that highest point was 393.4 and lowest was
330 n which share prices of the company was attained. This means that stock price hiked up to
393.4 and fallen down to 330 in the period of observations done in this context (Domowitz,
2018).
The performance of company is increased without many ups and downs in the market.
This shows that LSE is efficient enough in accordance to EMH and as such, it can be said that
performance of firm is maximized in the observation period as stock price which was declined,
again hiked to much extent and as a result, LSE is efficient. The efficiency of the exchange can
be made on this behalf as it is able to regulate markets in effective manner by which companies
are able to perform as per the desire of shareholders in the best possible way. Moreover, more
potential investors are attracting towards high performing companies such as M&S Company
and as a result, higher returns are garnered by them because of the desired earnings generated by
company with much ease (Van der Sterren, 2017). Furthermore, share prices of M&S Company

had not drastically fallen. It had picked up pace within short time duration without affecting
overall efficiency of market. Thus, it can be said that LSE is highly efficient stock exchange.
Figure 2 GBP/USD Exchange rate
It can be interpreted that GBP has gone high up to 1.5417 in comparison to USD.
Figure 3 Euro to Dollar
The Euro is also hiked in recent years as depicted by the graph.

Figure 4 UK Inflation rate
It can be interpreted that UK inflation rate has been gone down which is good for the
country.
Figure 5 UK Interest rate
It can be interpreted that interest rate has come to 0.5 % as sharp slowdown has observe
in overall GDP of the nation.

Figure 6 FTSE 100
The above graph shows that FTSE 100 listed companies are performing good as recent
five years, market capitalization has increased up to a high extent.
Q2 Compare and contrast role and functions of the capital markets over money markets. Discuss
how an activity of money market influences asset prices in capital markets.
The business requires finance so that it may meet its financial needs in the best possible
manner. It is important for company to raise amount in order to attain finance for carrying out its
daily activities in effective manner. M&S Company also requires funds so that it may be able to
perform well and achieve its objectives. Capital market has the main role to raise funds by
issuing securities. This market helps investor to attain higher dividends by investing in the
securities of the company. Capital markets satisfy needs of lenders and borrowers. Another
function of this market is that funds can be raised by issue of shares, debentures or bonds.
Moreover, foreign funds can be flowed through foreign investment which channelizes foreign
inflows of money in the best possible manner (Du and Zhu, 2017).
On the other hand, money market is known as the market where short-term requirements
of money are traded. This clearly shows that major role of this market is to firm raises money to
meet short-term needs. The function of money market is that to effectively maintain balance
between supply and demand of monetary transactions. Another function is to discount bills of
exchange helping in injecting trade growth in the best possible manner. Next function is short-
term financing help to produce short-term savings as well. This market help to impart funds to
developing sectors which requires adequate liquidity position for carrying out activities with

much ease. Another function of this market is that implementation of monetary policy is based
on the activities of money market. This means that it is a base for formulating and initiating
monetary policy by the government in effective way (Balduzzi, Brancati and Schiantarelli,
2017).
The money market activities influences asset prices in the capital markets. There are
various asset prices such as loans, equity prices, property prices etc. These prices tend to change
when money market affects these assets. The monetary policy which is prepared by the
government is highly influenced by money market. The capital market asset prices consist of
equities, shares and related securities. Investors’ expectation such as speculative or rational is the
main driving force in the capital market which eventually influences asset prices in relation to
future development of economy which automatically affects NPV (Net Present Value) of return
on assets in the future. This is evident from the fact that capital market asset prices are changed
by long-term expectations of investors and also economic development is done (Armour, Mayer
and Polo, 2017). This affects and influences changes in level of productivity, inflation level,
interest rates and taxation policy to name a few. Moreover, if liquidity of the business reduces up
to a high extent, then due to lack of liquidity, credit instruments in the capital market gets
affected and it gradually influences asset prices. Thus, it can be said that money and capital
market are part of financial markets and when monetary policy is changed, interest rate also
undergoes changes which eventually leads to influence prices of asset. Hence, money market is
quite correlated to capital market.
Q3 A) Discussing nature of potential risks in global transactions and explaining how
international traders manage risks
The nature of potential risks in the international transactions are more because it is based
on various parameters such as foreign exchange risk, political risk, economic risks and many
other as well. It can be said that these have immense danger to international investors and traders
who have their operations in the abroad and as such, it affects them. Foreign exchange danger
arises because of constant changes occurring in the currency (Black, Devereux, Lundborg and
Majlesi, 2018). This risk prevails when value of domestic currency depreciates leading to
decrease income in abroad. On the other hand, political risk is of the nature that government
makes changes related to taxation policies, implementing trade barriers, then international
transactions cannot be made and there is a risk with respect to such policies. Economic risk
means that insolvency of buyer may prevail; concession risk in the context of economic control
may be present.
The risks can be managed effectively with the help of forward exchange markets. The
term forward market means that it is an over-the-counter (OTC) place that effectively sets the
price of assets or any instruments in financial terms for delivery in the future. This means that if
risk prevails in the foreign this market if have no influence from government, then supply and
demand is the mechanism for regulating forward market. The foreign exchange risk is managed
with much ease as it helps to eradicate uncertainty over expenses of receipts and payments in

future foreign currency (Calvet, Grandmont and Lemaire, 2017). They are helpful for
international traders as they have flexibility and as such, it can be extended in the future either by
purchasing contract or structuring such option.
B) Discussing functions and operations of Eurocurrency market and importance of this market in
trade transactions
The Eurocurrency market is effective currency which is kept by the banks outside of the
particular nation where the same is regarded as a legal tender and as such, it is borrowed and lent
money in foreign currencies. The currency is not the native one of the nations in which bank is
situated. Moreover, it is type of money market in which currencies can be borrowed and lent to
other countries and are freely convertible as well (Pouget, Sauvagnat and Villeneuve, 2017). The
main function of Eurocurrency market is that medium term funds are effectively transferred from
one nation to another. The funds lead to expansion whenever deposits are made by residents of
US or banks, by central bank of the nation. The operations of Eurocurrency market is that global
capital markets can be effectively integrated with one another and flow of funds can take place in
the best possible manner. These flow of resources have quite initiated improvement in achieving
efficiency of various world economies as money is channelized in a better way.
The importance of Eurocurrency market in conducting international trade transactions is
that it has helped economies which have been in deficits in balance of payment and as such,
surpluses are passed or channelized to weak economies and as a result, foreign currencies are
lent and thus, financing needs or requirements can be met with much ease. Recycling is made by
which surplus amount is passed to deficits in terms of balance of trade and payment. Thus,
Eurocurrency market is useful in carrying out global transactions. Moreover, liquidity problem
can be effectively resolved by the countries running in such adverse situation and thus, it is
useful in making transactions possible internationally.

Figure 7 UK US exchange rate
The exchange rate has come down in the recent couple of year as depicted by the UK US
exchange rate graph.
Figure 8 EURO US market
The EURO US market is hiked as depicted by the graph within the span of three years
and roused in 2017 up to a high extent.
Q4 A) Explaining various terms related to financial markets
A) Asymmetric information

Asymmetric information means that one party knows more knowledge than other party
particularly in an economic transaction in the best possible manner. In simple words, sellers have
more material knowledge in comparison to buyers of the product. It can be said that this situation
applies to all economic transactions it contains information failure or asymmetries. In relation to
this, financial advisors have greater knowledge as compared to investors. Thus, they can provide
advices to clients in which stock they should invest to get higher returns (Kosfeld and Schüwer,
2017).
B) Moral hazard
This means that a party which is protected from any type of risk will behave differently
than if the same has no such protection. This implies that moral hazard prevails when party to a
economic transaction has not act good in faith and as such, party has provided false information
about the assets or liabilities. Thus, this risk occurs whenever there is an agreement made
between two parties. The same applies to the financial market as well where borrowers and
lenders meet in the market (Arthur, 2018).
c) Adverse selection
Adverse selection means that buyers have less knowledge as compared to sellers and as
such, they are at disadvantage because they do not know the same. It can be said that adverse
selection is made as investors do not have much knowledge about the stock market. Thus,
negotiation is attained as one party has more information as compared to other party (Daniel,
Neves and Horta, 2017).
B) Critically explain need for regulation of financial markets
The financial markets comprises of money and capital markets by which borrowers and
lenders meet in order to exchange funds in the best possible manner. The short-term
requirements can be easily met and as such, long-term requirements can be met with the help of
financial markets. This is evident from the fact that firm is able to garner funds in effective way.
M&S Company can easily attain required funds by raising from financial markets and
operational activities may be accomplished with much ease (Vayanos, Eyster and Rabin, 2018).
Since, funds are mobilized from those who have surpluses and those who are in shortage of the
same; there is a need for regulating this market. Regulation is needed as adequate protection
from any type of harm can be provided to the customers who deal in such markets. This helps
them to protect against any markets where competitive forces are not strong. As such, customers
are provided safety through regulation by protecting them from any economic harm in the best
possible manner.
Government initiates control forces of supply and demand which means that what prices
need to be quoted and who should enter financial market with much ease. Thus, it is quite needed

for regulating financial markets in effectual manner in order to protect customers from any
unintended economic harm (Mandes and Winker, 2017). A financial regulation limit and
imposes certain restrictions in order to stabilize financial system quite effectually. These
regulations are made and enacted by government or even non-government companies as well.
CONCLUSION
Hereby it can be concluded that financial markets play crucial role in meeting short-term
and medium term requirements of money in the best possible way. Money market is used for
raising funds for shorter time and has high liquidity as it needs to be repaid within short duration.
On the other hand, capital market is used for raising money by issuing shares, debentures, bonds
so that requirements can be achieved by the firm with much ease. Furthermore, financial markets
help to mobilize surpluses to deficits and enhancing economy in effectual manner. Moreover,
EMH also plays important role in carrying out current stock price of firm. Eurocurrency market
is helpful for lending and depositing in foreign currencies and useful for conducting of
international trade transactions in effective way.
REFERENCES
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