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CHAPTER 1 - FINANCIAL SYSTEMS AND - The borrowing activity between both

THE FINANCIAL MARKET parties still happens through the intervention
of a financial intermediary.
Sources of Wealth

1. Labor - will allow them to earn a Elements of the Financial System

salary/wage 1. Lenders and borrowers (Who are the
2. Land - generate wealth in the form of rent players?) The most essential stakeholders
3. Capital - will earn interest when the venture that make up the foundation of a
is realizing good returns transaction in the financial system.
4. Entrepreneurship - generate more profit
Lenders - parties that have excess funds that
Finance they can lend out to other entities for a
- Key player in ensuring continuity of required return Borrowers - parties who are
operations willing to pay the required return to
- The application of economic principles to obtain additional funds
decision making that involves the
allocation of money under conditions of 2. Financial Intermediaries (How will the change
occur?)
uncertainty.
- Came from the french word “finer” which - Acts as a third party to facilitate the
means “to end and settle a debt”. borrowing activity between lenders and
borrowers.
Financial System
- Allows households, companies and the 3. Financial Instruments (What will be used?)
government who have available funds to
invest these funds in more potentially - Medium of exchange of
productive vehicles that can result in faster contractual obligation of a party, where
growth in the economy. such contract can be traded.
- Composed of interrelated systems of
financial markets, intermediaries and Represent claims on future income or assets
services. of the borrower
Enhances the welfare of individual consumers
as they have immediate access to funds allowing Borrowers - Liabilities
them to purchase things as they prefer Lenders - Asset

Fund Providers 2 types of Financial Instruments

a. Cash
- Households (primary fund provider),
b. Derivative Financial Instruments
companies and government agencies who have
available funds
Fund Demanders 4. Financial Markets (Where will it be
- Households, companies and government traded?)
agencies (main fund demanders) who have
shortage of funds - Where suppliers and buyers of
financial instruments meet.
 Direct Financing
- Borrower-spenders borrow and deal Money Market - Cash Financial Instruments
directly with lenders through selling Capital Market - Derivative Financial
financial instruments Instruments
Ex. Buying stocks
5. Regulatory Environment (How is it
 Indirect Financing
controlled?)

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- The governance body to ensure - Determines how the available funds

that the transactions that occur within the from providers are allocated towards the
financial systems comply with the laws and demanders based on the demanders'
regulations. willingness to accept the return required by
- They are normally regulated by the fund.
Central Banks
2. Liquidity
6. Money Creation (What is the value it - Through Financial Markets, holders
creates? can sell their own financial instruments to
other investors to earn cash.
-Money is used to either be reinvested or - Easy access to a venue where
earned out from the system flows investors can sell financial instruments for
cash in an appealing feature when
7. Price discovery (How much is created?) circumstances may occur that push investors
to sell a financial instrument.
- The process of determining or - Without liquidity, an investor is
valuing the financial instrument in the forced to hold to financial instrument up
market. until…
- Debt instrument: Maturity date
Equity instrument: Voluntary or
involuntary liquidation

3. Reduction in transaction costs

Financial Markets
- Help in creating a more efficient allocation Types of Transaction Costs:
of capital which results in higher production
and efficient that ultimately leads to Search Costs
economic growth.
- costs incurred to look for financial
instruments that can be purchased or sold by
a party.
Main economic function:
- Serve as a channel transfer excess Explicit Search Costs
funds from fund - Expenses needed to advertise intent
- providers to fund demanders. to purchase or sell a financial instrument.
- Participants: household, government Implicit Search Costs
and businesses, financial intermediaries, - Include value of time consumed to
brokers and dealers, regulators, fund look for a counterparty
managers and financial exchanges. Information Costs
- “Trading” - Exchanging of Financial - costs related in evaluating investment
Instruments characteristics of a financial instrument.
Major economic functions of Financial Market: TYPES OF FINANCIAL MARKETS
1. Price discovery 1.Based on Instruments Traded
- Interaction between buyers and
Money Market
sellers in the financial market in order to
-Where Financial Instruments that will
come up with price of the traded financial
mature or be redeemed in one year or
instrument.
less(short-term) from issuance date are
- Price is set at the level wherein the
traded.
buyers are willing to buy, and sellers are
willing to sell.

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For long term investors: they invest in Secondary market:

money market to meet their short-term Buyers - suppliers of fund
liquidity needs. Sellers - demanders of funds

Importance to fund demanders: Primary Market

They need it since immediate cash Where fund demanders raise funds through
requirements of individuals, government new issuance of financial instruments
and corporations do not necessarily coincide
in the timing of their cash receipts. e.g. bonds and stocks.

Importance to fund providers: Transactions are coursed through

They need it because excessive holdings of Investment Banks that act as intermediaries
cash also generates opportunity cost in the between issuing companies (demanders)
form of foregone interest. and potential investors (providers).

Money market instruments Investment Banks

-Offer an investment opportunity that yields a - provide advice to issuers about
higher return than just mere holding of prices of the securities, transaction
cash(which generates zero interest) costs and number of securities to be
Are very liquid and has very little default issued based on their fund needs.
risk because of the associated short maturity - Responsible to legal and financial
term. exchange requirements,
appointments of lawyers and
Ex. Treasury bills, Commercial papers, auditors, due diligence, etc.
- They underwrite securities
Certificate of deposits, Repurchase
agreement, Banker’s acceptances.
Underwriting
Capital Market Investment banks guarantee the price for the
Where Financial Instruments issued by securities of the issuing company and then
governments and corporations that will sells to the public.
mature one year from issuance date (long-
term) are traded. Types of issue methods that can be done in
the primary markets:
The foundation of the capital market is 1. Public Offering
made up by the dealers and brokers market Securities are offered for sale to the
which creates a venue for bond and stock general public through issuing a
transactions. prospectus or placing document

Capital Market Securities: Private companies who will sell

a. Equity Instruments shares to the general public for the
b. Debt Instruments very first time is said to undergo an
Initial Public Offering (IPO)
through the help in investment banks

Can either be an offer for

2. Based on Market Type
subscription or an offer for sale
In primary market:
An underwriter is appointed for
Lenders - suppliers
public offerings. It provides an
undertaking to purchase the
fund Borrowers - demanders of remaining securities if the offer will
funds not be fully subscribed to the public.

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2. Private Placement(Limited Public Offer) Ex. Foreign exchange market, futures market and
Issuers look for a single investor, an options market
institutional buyer or group of buyers to
purchase the securities issuance Economic functions:
● Price discovery
An underwriter subscribes to all The higher the price of the security in the
securities at a certain price and secondary market, the higher the price that
consequently, sell the same issuing companies can set on new securities
securities at a higher price that they will issue.

3. Auction ● Liquidity and reduction in borrowing

Used for issuance of treasury bills, bonds costs Allows active trading which
and other securities issued by the improves liquidity and marketability of the
government and are commonly executed securities.
exclusively with market makers.

Dutch Auction
● Support to the primary market
● Implementation of monetary policy
Seller begins the sale at a high price. The
price of securities is continuously lowered
Secondary Markets provide liquidity to the
down at specific intervals until the potential
investors who hold the securities as they are
buyer agrees
able to convert the securities to cash quickly
English Auction by selling to other participants.
Prospective buyers commerce the auction by
Classifications based on Market Structure:
submitting an initial bid price. The bidding
stops when no other bidders wants to top the
Order-Driven Market Structure
last bid.
Buyers and sellers propose their price
through their brokers who conveys the bid
Descending price sealed Auction (First-price
in a centralized location. Also called as
sealed auction)
Auction Market.
Bidders submit sealed bids to the sellers that
will be ranked from highest to lowest price.
Types of orders:
Highest priced bids receive full allocation
➢ Market Orders (At-best orders) -
while lower bids receive allocation
orders placed with broker-dealers
distributed pro rata.
with the instruction to execute
transactions at the prevailing best
4. Tap Issue
market price.
Issuers are open to receive bids for their
securities at all times, and they maintain the
➢ Limit orders
right to accept or reject the bid prices.
Orders placed where clients set a
Secondary Market price or price range that may be
Securities issued in the primary market are below/above the existing price.
subsequently traded i.e. resold and repurchased.
➢ Day orders
Buyers are the ones who have excess funds while Orders placed that only valid until
the sellers are those who need funds. the end of the business day.

Transactions usually occur through the help of ➢ Good-until-cancelled orders

securities broker which acts as a facilitator between Orders placed that remains valid for
the seller and the buyer of the security. a sustained period up until the client

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voluntarily cancels and remove these Domestic Market - issuers who are
from the system. considered residents in a country issue the
securities
Quote-Driven Market Structure
Foreign Market - issuers who are not
Also called as primary dealer markets, residents of a country can sell or issue
professional markets or market-made securities subsequently traded. The rules of
markets. the regulatory authority where the
security is issued will prevail.
Market makers establish a price quote at
which the market participants should trade  External Market
with. Refers to the Financial market where
securities that have two unique
Market makers set a bid quote(to buy) and characteristics are being traded:
offer quote(to sell).
a. Upon issuance, these securities
Spread offered simultaneously to investors
- difference bet the bid and offer quote in different countries
- Inures to the benefit of the market b. Securities are issued outside the
makers as profit regulatory jurisdiction of any single
- Represents the transactional costs country
and
reflects liquidity Ex. International Market, Offshore market
and
Narrow Spread - Signals liquidity Euromarkets
Wide Spread - Indicates illiquidity
4. Based on the manner of Financial
Primary and Secondary Market can also be Intermediaries
classified based on where the financial instruments
are traded: Broker Market
Buyers and sellers are brought together by a
Exchange (or Formalized)
broker and the trade occurs at that point.
Centralized trading locations where financial
instruments are purchased or sold between market Dealer Market
participants. Buyers and sellers are not brought directly
together by a third party. Market makers
In order to be traded, all Financial Instruments execute the sell or buy orders.
should be listed by the organized exchange.

Over-the Counter Market (or Informal)

A place where unlisted financial instruments are
allowed to be traded, in addition to listed financial
instruments.

Ex. Labor market, Fish market, Vegetable market

3.Based on Country’s Perspective

Internal or National Market
Refers to the financial market operating in a
certain country.

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