CHAPTER 1 - Enhances welfare of individual consumers as they have

Financial Systems and The Financial Market immediate access to funds.

Financial Management – an important process to ensure Information Asymmetry – one stakeholder to a transaction
maximization of profit and wealth. holds superior information than the other party which causes
inefficient allocation of financial resources as one party may
Sources of Wealth (Origin) be in a better negotiating position
1. Labor – salary/wage ELEMENTS OF FINANCIAL SYSTEM
2. Land – rent
3. Capital (financial/industrial) – interest 1) Lenders and Borrowers
4. Entrepreneurial skills – profit - Who are the players?
- Most essential stakeholders that make up the
Finance – also known as financial economics foundation of a transaction
- Application of economic principles to decision-making - Lenders: have excess funds that they lend for a return
that involves the allocation of money under conditions of - Borrowers: willing to pay the return for additional
uncertainty. funds
- Provides the framework for making decisions as to how 2) Financial Intermediaries
those funds should be obtained and then invested - How will the exchange occur?
- Life-blood of the company - Special type of financial entity that acts as a third
- “finer” (French): to end and settle a debt party to facilitate the borrowing activity
- Gathers funds from lenders and redistribute it to
Study of Capital Markets (key areas) borrowers through an investment vehicle like loans
1. Financial system 3) Financial Instruments
2. Structure of interest rates - What will be used?
3. Pricing of assets - Medium of exchange of contractual obligation of a
party, where such contract can be traded (tangible or
FINANCIAL SYSTEM intangible)
- Provides the platform by which funds are transferred from - A contract where a party recognize it as an asset and
those entities that have funds to invest to those entities another is as liability (IFRS 32)
that need funds to invest. - Types: cash/derivatives
- Composed of network of inter-related systems of 4) Financial Markets
financial markets, intermediaries and services. - Where will it be traded?
- Main reason for existence: matching the difference - Where suppliers and buyers of financial instruments
between the spending of fund providers and fund meet
demanders. - money market – cash; capital markets – derivative
- Regular, time-efficient and cost-effective link between 5) Regulatory Environment
fund demanders and fund providers. - How is it controlled?
- Households: primary fund provider - Governance body to ensure that the transactions that
- Business Firms & Government: main fund demander occur within the financial systems complies with the
laws and regulations imposed to the actors as well as
Faure’s definition of financial system:
the elements that plays within the system
Set of arrangements/conventions embracing the lending and - Financial systems are normally regulated by Central
borrowing of funds by non-financial economic units and the Banks
intermediation of this function by financial intermediaries in 6) Money Creation
order to facilitate the transfer of funds, to create additional - What is the value it creates?
money when required, and to create markets in debt and - Money is used to either be reinvested or earned out
equity instruments (and their derivatives) so that the price from the system flows
and allocation of funds are determined efficiently. - May be converted into another form
Flow of Funds (two routes) 7) Price Discovery
- How much is created?
1. Direct Financing – borrower-spenders borrow and - Process of determining or valuing the financial
deal directly with lenders through selling financial instrument in the market
instruments - Price is normally driven by the level of risk on how
o Financial Instruments – claims on the future the issuer of the financial instruments
income or assets of the borrower
o Borrowers – liabilities; Lenders- assets THE FINANCIAL MARKETS
o Ex: buying stocks directly from a company - Channels or places where funds and financial instruments
2. Indirect Financing – happens through the are exchanged. (e.g. NYSE, PSE)
intervention of a financial intermediary - Intend to establish a consistent, efficient, and cost-
FINANCIAL MARKETS effective bridge between lenders and borrowers.
- Participants (e.g. household, gov’t, businesses, financial
- Help in creating more efficient allocation of capital intermediaries, broker and dealers, regulators, fund
(physical/financial) managers and financial exchanges)

Financial Markets | Chapter 1 | M.J.R.

- Main economic function: serve as a channel to transfer - fund demanders such as corporation or a government
funds from fund providers to fund demanders. agency raise funds through new issuances of
- Trading: exchanging of financial instruments. financial instruments e.g. bonds and stocks
- sold to original fun providers
- issuance of additional debt or equity securities of an
already publicly traded company
- non-negotiable instruments: mortgage loan,
Major Economic Functions of Financial Markets savings deposits and life policies (issued only in
1. Price Discovery - determines how the available funds primary market)
from the fund providers are allocated towards the - transactions are coursed through investment banks
fund demanders based on fund demanders’ o Investment banks - provides advice to issuers
willingness to accept the return required by the fund (price, transaction costs, number to be issued)
providers based on their fund needs.
2. Liquidity – easy access to a venue where investors  Responsible in all aspects to ensure proper
can sell financial instruments for cash execution of the issuance.
o Debt instruments – maturity date  Underwrite securities
o Equity instruments – voluntary/involuntary  underwriting – investment banks
guarantee the price for the securities of the
liquidation
issuing company and then sells these to the
3. Reduction in transaction cost
general public
o Transaction Cost – costs incurred of parties’
transaction to trade a financial instrument TYPES OF ISSUE METHODS
o Search Cost: incurred to look for financial
instruments. a) Public Offering
 Explicit Search Cost - needed to - securities are offered for sale to the general
advertise. public through issuing a prospectus or placing
 Implicit Search Cost - value of time. an offer document
o Information Cost: evaluating investment - Private companies who will sell shares to the
general public for the first time shall undergo
characteristics to justify worthiness.
an Initial Public Offering (IPO) through the
TYPES OF FINANCIAL MARKETS help of investment banks.
- Can either be:
Based on Instruments Traded o Offer for subscription – IPO
1) MONEY MARKET – short-term securities are traded - General public is invited to subscribe to
- Cash financial instruments unissued shares.
- Financial instruments that will mature or be - Proceeds: company
redeemed in one year or less from issuance date o Offer for sale
- Traded in secondary market - Secondary offering but first time to be
- Long-term investors for short-term liquidity needs issued to the public.
- Conduit to efficiently transfer large amounts of - Existing shareholders invite the public
money from fund providers to fund demanders for to but portion of their shares.
short maturity term quickly and at a cheap cost. - Proceeds: existing shareholders.
- Instruments are very liquid, easily convertible to - Underwriter provides an undertaking to
cash and have very little default risk. purchase the remaining securities if the offer
will not be fully subscribed to the public (fee
EX: T-bills, Commercial papers, Certificates of Deposit, is paid in exchange).
Repurchase agreement, Bakers’ acceptances, b) Private Placement (Limited Public Offer)
Redeemable preference shares - Issuer looks for a single investor, an
institutional buyer or group of buyers to
2) CAPITAL MARKET – long-term securities are traded
purchase the whole securities issuance instead
- Derivative financial instrument
of offering it to the general public
- Financial instruments that will mature beyond one
- Securities are illiquid and are not easily
year from issuance date and perpetual securities (no
converted into cash
maturity)
- Only firms/financial institution are able to
- Foundation is made up by the dealers and brokers
buy.
market.
- Underwriter subscribes to all securities and
- Classifications:
sells it at a higher price (difference of prices
o Equity (ownership interest)
is underwriting spread).
o Debt
c) Auction
EX: Stocks (no maturity) - usually used for issuance for treasury bills,
bonds and other securities issued by the
Based on Market Type government
- executed EXCLUSIVELY with market
1) PRIMARY MARKET – lenders and borrowers
makers
- Three Methods:

Financial Markets | Chapter 1 | M.J.R.

 o Dutch Auction - Issuers can have an idea of how much is the fair
- Seller begins sale at a high price, market value of their financial instruments
lowered down until buyer agrees to - Value of the company can be determined based on
purchase the prices of the financial instruments
o English Auction - Market price > how well they are using the funds
- Prospective buyers submit an initial bid - Market structure: how buyers and sellers interact
price to arrive at the price and quantity of the securities to
- Other buyers submit new bid to top the be traded
previous one, the bidding stops when - Classification based on market structure:
no other bidders want to top the last bid  ORDER-DRIVEN MARKET STRUCTURE
o Descending Price Sealed Auction (First- - buyers and sellers propose their price
price sealed auction) through their brokers who conveys the bid
- Bidders submit sealed bids to sellers. in a centralized location. (auction market)
- Sealed bids are ranked - Types of orders:
- Highest bids receive full allocation a. Market Orders (at-best orders)
while lower bids receive allocation pro  orders placed with broker
rata.  no price set
d) Tap Issue  executed immediately at the
- issuers are open to receive bids for their prevailing best market price
securities at all times b. Limit Orders
- maintain the right to accept or reject the bid  Price/price range that may be
prices below/above the existing price is
set
2) SECONDARY MARKET  Broker executes the transaction
- Where securities issued in the primary market are when prices go higher (sell) or
subsequently traded, resold and repurchased. lower (buy) than the limit price or
- Centralized market wherein buyers and sellers can range.
transact c. Day Orders
- Transactions occur through help of securities brokers  Only valid until the end of the
(facilitator) business day.
- The original issuer of the financial instrument is not d. Good-until-cancelled orders
involved  Remains valid for a sustained
- allows the buyers and sellers to save on search and period (60 days) up until the client
information costs voluntarily cancel and remove
these from the system
EX: foreign exchanges market, futures market, and  QUOTE-DRIVEN MARKET STRUCTURE
options market - Also called as primary dealer markets,
- Economic Functions of secondary market: professional markets, market-made markets
 Price Discovery - Seller dictates price
- provides information about prices of the - Market makers set a bid quote (to buy) and
securities traded which can influence offer quote (to sell), the difference of
economic decisions which is a spread.
- the higher the price of the security in the - Spread represents transactional costs of
secondary market, the higher the price on trading and reflects liquidity.
issuing companies - Narrow spread – liquid; Wide spread –
 Liquidity and reduction in borrowing cost illiquid
- allows active trading which improves - EX: Trading of bonds and currency
liquidity and marketability of the securities Classification of Primary and Secondary markets based on
- reduces interest rates where financial instruments are traded:
- liquid market – parties who want to buy
and sell are equally matched, thus, price 1. EXCHANGE (Formalized)
of securities becomes stable - Centralized trading locations
 Support to the primary market - All financial instruments are listed and must
- setting prices for new issuances be complied with regulations set forth
- assessing receptiveness of the market - Most exchanges are Order-driven
 Implementation of monetary policy - e.g. NYSE, PSE, Chicago Board of Trade for
- Influence liquidity and interest rates commodities
- Investors can sell securities at fair market value if 2. OVER-THE-COUNTER MARKET (Informal)
they need cash (liquidity) - Where unlisted financial instruments are
- Provides information to investors on the market traded
value of the investments. - Can be done through computers
- Minimized transaction costs because it is a - Do not have formalized mechanisms
centralized market - Bonds, loans, spot money and foreign
exchange markets

Financial Markets | Chapter 1 | M.J.R.

 - Negotiable certificates of deposit, banker’s
acceptances

Based on Country’s Perspective

1) Internal or National Market

- financial market operating in a certain country
- two parts:
a. Domestic Market - issuers who are considered
residents in a country issue the securities
b.Foreign Market – market where issuers who are
not residents of a country can sell or issue
securities
2) External Market
- financial market where securities that two unique
characteristics:
a. securities are offered simultaneously to investors
in different countries
b.securities are issued outside the regulatory
jurisdiction of any single country
EX: international market, offshore market, and
Euromarkets

Based on Manner of Financial Intermediaries

1) Broker Market
- buyer and seller of the securities are brought together
by a broker and the trade occurs at that point
- usually composed of national and regional securities
exchanges
- Philippine Stock Exchange – sole broker market in
the Philippines
2) Dealer Market
- buyer and seller are not brought directly together by
a third party
- market makers execute the sell or buy orders
- Two distinct trades: (a) seller sells his securities to a
dealer and (b) buyer buys his securities from a dealer
- ask price – lowest price of a security offered a sale
- bid price – highest proposed price in order for
investors to buy a security
- Investors pay the ask price when purchasing
securities and receives the bid price when selling
them
- Dealers earn profit through spread between bid and
ask prices
- Do not have centralized trading floors
- Consist of many market makers
- Market maker: dealers who create market by
offering to sell/buy securities at ask/bid prices)

Financial Markets | Chapter 1 | M.J.R.