P2307 - CAPITAL MARKET

CHAPTER I
OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS

OVERVIEW
Individuals and business organizations in civilized society are involved directly or
indirectly in the financial system as money is used in procuring goods and services. Money is
saved and invested, as well as borrowed from banks and other institutions like financing
companies, investment houses and money markets. This chapter provides the information in
understanding the general structure and operation of the financial system by looking at how
funds flow from savers (lenders) to users (borrowers) through financial markets and financial
intermediaries.
Lesson 1. THE FINANCIAL SYSTEM

Financial System is a system that allows the flow or exchange of funds between savers
(Surplus Spending Unit, SSU) and users (Deficit Spending Unit, DSU). It operates at national and
global levels.

COMPONENTS OF THE FINANCIAL SYSTEM

1. Monetary System – creates money which serves as a medium of exchange for goods and
services. It is responsible for creating and transferring money.
2. Financial Institutions – accumulates and gathers savings to be used for loans and
investments.
3. Financial Markets – avenues to facilitate financial transactions of financial instruments and
securities.

FUNCTIONS OF FINANCIAL SYSTEM

1. Mobilize and allocate savings
2. Monitor corporate performance
3. Provide payment and settlement system
4. Optimum allocation of risk-bearing and reduction
5. Disseminate price-related information
6. Portfolio adjustment facility

The primary function of the financial system is to channel surplus funds to sectors with
shortage. An efficient financial system is a crucial prerequisite for an advanced economy as a
well-functioning financial system directs funds to their most productive uses in the economy.

ELEMENTS OF FINANCIAL SYSTEM

1. Financial Claims – comprise the money and rights to receive money, evidenced by
financial instruments for claims (debts and equities)
2. Financial Institutions – private or government organizations
3. Financial Markets – institutions that expedite transactions in financial claims

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 4. Government Agencies – the Monetary Board and Central Banks
5. Laws and Policies – Government regulations to supervise the behavior of the whole
economy

ECONOMIC SECTORS INVOLVED IN FINANCIAL SYSTEM

➢ Government
➢ Business
➢ Households

BUDGET POSITIONS OF ECONOMIC UNITS

➢ Balanced Budget: Income = Expenditure
➢ Surplus Saving Position
Saving units (SSUs) have income for the period that exceeds deficit spending
units (DSUs) resulting in savings
Income > Expenditure
➢ Deficit Position
DSUs have spending for the period that exceeds income
Income < Expenditure

The Philippine Financial System

1. Bangko Sentral ng Pilipinas
2. Banking Institutions
- Universal Banks
- Commercial Banks
- Thrift Banks
- Rural Banks
- Cooperative Banks
- Islamic Banks
- Microfinance Banks

3. Non-Bank Financial Institutions (with quasi-Banking Functions)

- Investment House
- Financing Companies
- Securities Dealers
- Investment companies
- Fund Managers

ROUTES OF FINANCING (FUND CHANNELS)

1. Direct financing - direct exchange of money and financial claims between the
borrower and the lender
2. Indirect financing - financing which is done through financial intermediaries or financial
institutions (FI).

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Lesson 2. THE FINANCIAL MARKETS
The types of markets in an economy can be divided into (1) the market for products
(manufactured goods and services), or the product market; and (2) the market for the factors of
production (labor and capital), or the factor market. In this book, we will focus on one part of the
factor market, the market for financial assets, or, more simply, the Financial market. This market
determines the cost of capital. In this chapter we look at the basic characteristics and functions of
financial assets and financial markets.

Financial markets are avenues for the sale and purchase of assets like stocks, bonds, derivatives,
foreign exchange and commodities. Their essential economic role is to channel the funds from people
who spend less than their income (with surplus funds or savings) to people who need additional funds
because they have spent beyond their earnings. This also applies to government and businesses who
could act either as lenders or borrowers.

FUNCTIONS OF THE FINANCIAL MARKETS

1. Puts savings into more productive use

As mentioned in the example above, a savings account that has money in it should not just let that
money sit in the vault. Thus, financial markets like banks open it up to individuals and companies that
need a home loan, student loan, or business loan.
2. Determines the price of securities
Investors aim to make profits from their securities. However, unlike goods and services whose price is
determined by the law of supply and demand, prices of securities are determined by financial
markets.
3. Makes financial assets liquid
Buyers and sellers can decide to trade their securities anytime. They can use financial markets to sell
their securities or make investments as they desire.
4. Lowers the cost of transactions
In financial markets, various types of information regarding securities can be acquired without the
need to spend.

Importance of Financial Markets

There are many things that financial markets make possible, including the following:
 Financial markets provide a place where participants like investors and debtors, regardless of
their size, will receive fair and proper treatment.
 They provide individuals, companies, and government organizations with access to capital.
 Financial markets help lower the unemployment rate because of the many job opportunities it
offers

The Role of Financial Markets

The two primary economic functions of financial assets-were already discussed. Financial
markets provide three additional economic functions.
First, the interactions of buyers and sellers in a financial market determine the price of the
traded asset; or, equivalently, the required return on a financial asset is determined. The inducement

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for firms to acquire funds depends on the required return that investors demand, and this feature of
financial markets signals how the funds in the economy should be allocated among financial assets.
Second, financial markets provide a mechanism for an investor to sell a financial asset. This
feature offers liquidity in financial markets, an attractive characteristic when circumstances either
force or motivate an investor to sell. In the absence of liquidity, the owner must hold a debt
instrument until it matures and an equity instrument until the company either voluntarily or
involuntarily liquidates. Although all financial markets provide some form of liquidity, the degree of
liquidity is one of the factors that differentiates various markets.
The third economic function of a financial market reduces the search and information costs of
transacting. Search costs represent explicit costs, such as the money spent to advertise the desire to
sell or purchase a financial asset, and implicit costs, such as the value of time spent in locating a
counter party. The presence of some form of organized financial market reduces search costs.
Information costs are incurred in assessing the investment merits of a financial asset, that is, the
amount and the likelihood of the cash flow expected to be generated.

Classification of Financial Markets

Of the many ways to classify financial markets, one way is by the type of financial claim. The
claims traded in a financial market may be either for a fixed dollar amount or a residual amount.
As explained earlier, the former financial assets are referred to as debt instruments, and the
financial market in which such instruments are traded is referred to as the debt market.
The latter financial assets are called equity instruments and the financial market where such
instruments are traded is referred to as the equity market. Alternatively, this market is referred to as
the stock market.
Preferred stock represents an equity claim that entitles the investor to receive a fixed dollar
amount. Consequently, preferred stock shares characteristics of instruments classified as part of the
debt market and the equity market. Generally, debt instruments and preferred stock are classified as
part of the fixed income market. The sector of the stock market that does not include preferred
stock is called the common stock market.
Another way to classify financial markets is by the maturity of the claims. For example, a
financial market for short-term financial assets is called the money market, and the one for longer
maturity financial assets is called the capital market. The traditional cutoff between short term and
long term is one year. That is, a financial asset with a maturity of one year or less is considered short
term and therefore part of the money market. A financial asset with a maturity of more than one
year is part of the capital market.
Thus, the debt market can be divided into debt instruments that are part of the money
market, and those that are part of the capital market, depending on the number of years to maturity.
Because equity instruments are generally perpetual, they are classified as part of the capital market.
Figure 1-3 depicts financial market classifications based on maturities.
A third way to classify financial markets is by whether the financial claims are newly issued.
When an issuer sells a new financial asset to the public, it is said to “issue” the financial asset. The
market for newly issued financial assets is called the primary market. After a certain period of time,
the financial asset is bought and sold (i.e., exchanged or traded) among investors. The market where
this activity takes place is referred to as the secondary market.

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 Finally, a market can be classified by its organizational structure. These organizational
structures can be classified as auction markets, over-the-counter markets, and intermediate markets.
We describe each type in later chapters.

Types of Financial Markets

1. Stock Markets - These are venues where companies list their shares and they are bought and sold
by traders and investors. Stock markets, or equities markets, are used by companies to raise capital
via an initial public offering (IPO), with shares subsequently traded among various buyers and sellers
in what is known as a secondary market. Most trading in stocks is done via regulated exchanges, and
these play an important role in the economy as both a gauge of the overall health of the economy as
well as providing capital gains and dividend income to investors, including those with retirement
accounts.
Typical participants in a stock market include (both retail and institutional) investors and traders, as
well as market makers (MMs) and specialists who maintain liquidity and provide two-sided
markets. Brokers are third parties that facilitate trades between buyers and sellers but who do not
take an actual position in a stock.

2. Over-the-Counter Markets - these are decentralized markets—meaning it does not have physical
locations, and trading is conducted electronically—in which market participants trade securities
directly between two parties without a broker. While OTC markets may handle trading in certain
stocks (e.g., smaller or riskier companies that do not meet the listing criteria of exchanges), most
stock trading is done via exchanges. Broadly speaking, OTC markets and the transactions that occur
on them are far less regulated, less liquid, and more opaque.

3. Bond Markets
A bond is a security in which an investor loans money for a defined period at a per-established
interest rate. You may think of a bond as an agreement between the lender and borrower that
contains the details of the loan and its payments. Bonds are issued by corporations as well as by
municipalities, states, and sovereign governments to finance projects and operations. The bond
market sells securities such as notes and bills issued by the United States Treasury, for example. The
bond market also is called the debt, credit, or fixed-income market.

4. Money Markets
Typically the money markets trade in products with highly liquid short-term maturities (of less than
one year) and are characterized by a high degree of safety and a relatively low return in interest. At
the wholesale level, the money markets involve large-volume trades between institutions and traders.
At the retail level, they include money market mutual funds bought by individual investors and
money market accounts opened by bank customers. Individuals may also invest in the money
markets by buying short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills,
among other examples.

5. Derivatives Markets
A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Derivatives are secondary
securities whose value is solely derived from the value of the primary security that they are linked to.
In and of itself a derivative is worthless. Rather than trading stocks directly, a derivatives market

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trades in futures and options contracts, and other advanced financial products, that derive their
value from underlying instruments like bonds, commodities, currencies, interest rates, market
indexes, and stocks.
Futures markets are where futures contracts are listed and traded. Unlike forwards, which trade OTC,
futures markets utilize standardized contract specifications, are well-regulated, and
utilize clearinghouses to settle and confirm trades. Options markets, such as the Chicago Board
Options Exchange (CBOE), similarly list and regulate options contracts. Both futures and options
exchanges may list contracts on various asset classes, such as equities, fixed-income securities,
commodities, and so on.

6. Forex Market
The forex (foreign exchange) market is the market in which participants can buy, sell, hedge, and
speculate on the exchange rates between currency pairs. The forex market is the most liquid market
in the world, as cash is the most liquid of assets. The currency market handles more than $6.6 trillion
in daily transactions, which is more than the futures and equity markets combined.1
As with the OTC markets, the forex market is also decentralized and consists of a global network of
computers and brokers from around the world. The forex market is made up of banks, commercial
companies, central banks, investment management firms, hedge funds, and retail forex brokers and
investors.

7. Commodities Markets
Commodities markets are venues where producers and consumers meet to exchange physical
commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil, gas,
carbon credits), precious metals (gold, silver, platinum), or "soft" commodities (such as cotton, coffee,
and sugar). These are known as spot commodity markets, where physical goods are exchanged for
money.
The bulk of trading in these commodities, however, takes place on derivatives markets that utilize
spot commodities as the underlying assets. Forwards, futures, and options on commodities are
exchanged both OTC and on listed exchanges around the world such as the Chicago Mercantile
Exchange (CME) and the Intercontinental Exchange (ICE).

8. Cryptocurrency Markets
The past several years have seen the introduction and rise of cryptocurrencies such
as Bitcoin and Ethereum, decentralized digital assets that are based on blockchain technology. Today,
thousands of cryptocurrency tokens are available and trade globally across a patchwork of
independent online crypto exchanges. These exchanges host digital wallets for traders to swap one
cryptocurrency for another, or for fiat monies such as dollars or euros.
Because the majority of crypto exchanges are centralized platforms, users are susceptible to hacks or
fraud. Decentralized exchanges are also available that operate without any central authority. These
exchanges allow direct peer-to-peer (P2P) trading of digital currencies without the need for an actual
exchange authority to facilitate the transactions. Futures and options trading are also available on
major cryptocurrencies.

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FINANCIAL ASSETS
An asset is any possession that has value in an exchange. Assets can be classified as tangible
or intangible. The value of a tangible asset depends on particular physical properties-examples
include buildings, land, or machinery. Tangible assets may be classified further into reproducible
assets such as machinery, or non-reproducible assets such as land, a mine, or a work of art.
Intangible assets, by contrast, represent legal claims to some future benefit. Their value bears
no relation to the form, physical or otherwise, in which the claims are recorded. Financial assets,
financial instruments, or securities are intangible assets. For these instruments, the typical future
benefit comes in the form of a claim to future cash.
The entity that agrees to make future cash payments is called the issuer of the financial asset;
the owner of the financial asset is referred to as the investor. Examples of financial assets include the
following:
 A bond issued by the U.S. Department of the Treasury
 A bond issued by General Electric Corporation
 A bond issued by the state of California
 A bond issued by the government of France
 An automobile loan
 A home mortgage loan
 Common stock issued by Microsoft Corporation
 Common stock issued by Honda Motor Company
The Role of Financial Assets
Financial assets serve two principal economic functions. First, financial assets transfer funds
from those parties who have surplus funds to invest to those who need funds to invest in tangible
assets. As their second function, they transfer funds in such a way as to redistribute the unavoidable
risk associated with the cash flow generated by tangible assets among those seeking and those
providing the funds.
To illustrate these two economic functions, consider three situations.
1. Gene Margolis obtained a license to manufacture Pooh Bear wrist watches. Gene estimates that he
needs $1 million to purchase the plant and equipment to manufacture the watches. Unfortunately,
he has only $200,000 to invest, his life savings, which he does not want to invest even though he
feels confident a receptive market exists for the watches.
2. Susan Carlson recently inherited $730,000. She plans to spend $30,000 on some jewelry, furniture,
and a few cruises, and to invest the balance of $700,000.
3. Larry Stein, an up-and-coming attorney with a major New York law firm, received a bonus check
that netted him $270,000 after taxes. He plans to spend $70,000 on a BMW and invest the balance,
$200,000.
Suppose that, quite by accident, Gene,’Susan, and Larry meet in New York City. Sometime
during their conversation, they discuss their financial plans By the end of the evening, they agree to a
deal. Gene agrees to invest $100,000 of his savings in the business and sell a 50% interest to Susan
for $700,000. Larry agrees to lend Gene $200,000 for 4 years at an interest rate of 18% per year.
Gene will be responsible for operating the business without the assistance of Susan or Larry. Gene
now has his $1 million to manufacture the watches.
Two financial claims came out of this agreement. The first is an equity instrument issued by
Gene and purchased by Susan for $700,000. The other is a debt instrument issued by Gene and
purchased by Larry for $200,000. Thus, the two financial assets allowed funds to be transferred from

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Susan and Larry, who held surplus funds to invest, to Gene, who needed funds to invest in tangible
assets in order to manufacture the watches. This transfer of funds carries out the first economic
function of financial assets.
The fact that Gene is not willing to invest his life savings of $200,000 means that he wanted to
transfer part of that risk. He does so by selling Susan a financial asset that gives her a financial claim
equal to one-half the cash flow from the business after paying the interest expense. He further
secures an additional amount of capital from Larry, who is not willing to share in the risk of the
business (except for the credit risk), in the form of an obligation requiring payment of a fixed cash
flow regardless of the outcome of the venture. This shifting of risk is the second economic function of
financial assets.

Properties of Financial Assets

Financial assets possess certain properties that determine or influence their attractiveness to
different classes of investors. The 10 properties of financial assets are (1) moneyness, (2) divisibility
and denomination, (3) reversibility, (4) term to maturity, (5) liquidity, (6) convertibility, (7)
currency,(8) cash flow and return predictability, (9) complexity, and (10) tax status.
The following paragraphs describe each property:

Moneyness
Some financial assets act as "a medium of exchange or in settlement of transactions. These
assets are called money. In the United States they consist of currency and all forms of deposits that
permit check writing. Other financial assets, although not money, closely approximate money in that
they can 'be transformed into money at little cost, delay, or risk. They are referred to as near money.
In the United States, near money instruments include time and savings deposits and a security issued
by the US. government with a maturity of three months called a three-month Treasury bill.
Moneyness clearly offers a desirable property for investors.

Divisibility and Denomination

Divisibility relates to the minimum size at which a financial asset can be liquidated and
exchanged for money. The smaller the size, the more the financial asset is divisible. A financial asset
such as a deposit at a bank is typically infinitely divisible (down to the penny), but other financial
assets set varying degrees of divisibility depending on their denomination, Which is the dollar value
of the amount that each unit of the asset will pay at maturity. Thus many bonds come in $1,000
denominations, while some debt instruments come in $1 million denominations. In general,
divisibility is desirable for investors.

Reversibility
Reversibility refers to the cost of investing in a financial asset and then getting out of it and
back into cash again. Consequently, reversibility is also referred to as round-trip cost. A financial
asset such as a deposit at a bank is obviously highly reversible because usually the investor incurs no
charge for adding to or withdrawing from it. Other transaction costs may be unavoidable, but these
costs are small.

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Term to Maturity
The term to maturity is the length of the interval until the date when the instrument is
scheduled to make its final payment, or the owner is entitled to demand liquidation. Often, term to
maturity is simply referred to as maturity.
Instruments for which the creditor can ask for repayment at any time, such as checking
accounts and many savings accounts, are called demand instruments. Maturity is an important
characteristic of financial assets such as debt instruments.
It should be understood that even a financial asset with a stated maturity may terminate
before its stated maturity. An early termination may occur for several reasons, including bankruptcy
or reorganization, or because of provisions entitling the debtor to repay in advance, or the investor
may have the privilege of asking for early repayment.

Liquidity
Liquidity serves an important and widely used function, although no uniformly accepted
definition of liquidity is presently available. A useful way to think of liquidity and illiquidity, proposed
by Professor James Tobin, is in terms of how much sellers stand to lose if they wish to sell
immediately against engaging in a costly and time consuming search.
For many other financial assets, liquidity is determined by contractual arrangements. Ordinary
deposits at a bank, for example, are perfectly liquid because the bank operates under a contractual
obligation to convert them at par on demand. In contrast, financial contracts representing a claim on
a private pension fund may be regarded as totally illiquid, because they can be cashed only at
retirement.
Liquidity may depend not only on the financial asset but also on the quantity one wishes to
sell (or buy). Even though a small quantity may be quite liquid, a large lot may run into illiquidity
problems.

Convertibility
An important property of some financial assets is their convertibility into other financial assets.
In some cases, the conversion takes place within one class of financial assets, as when a bond is
converted into another bond. Some preferred stock may be convertible into common stock. The
timing, costs, and conditions for conversion are clearly spelled out in the legal descriptions of the
convertible security at the time of issuance.
Currency
Most financial assets are denominated in one currency, such as U.S. dollars or yen or euros,
and investors must choose them with that feature in mind. Some issuers, responding to investors’
wishes to reduce foreign exchange risk, have issued dual currency securities. For example, some pay
interest in one currency but principal or redemption value in a second. Further, some bonds carry a
currency option that allows the investor to specify that payments of either interest or principal be
made in either one of two currencies.
Cash Flow and Return Predictability
As explained earlier, the return that an investor will realize by holding a financial asset
depends on the cash flow expected to be received, which includes dividend payments on stock and
interest payments on debt instruments, as well as the repayment of principal for a debt instrument
and the expected sale price of a stock. Therefore, the predictability of the expected return depends
on the predictability of the cash flow. Return predictability, a basic property of financial assets,
provides the major determinant of their value.

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 In a world of non-negligible inflation, it is especially important to distinguish between nominal
expected return and the real expected return. The nominal expected return considers the dollars
expected to be received but does not adjust those dollars to take into consideration changes in their
purchasing power. The real expected return is the nominal expected return after adjustment for the
loss of purchasing power of the financial asset as a result of inflation.

Complexity
Some financial assets are complex in the sense that they combine two or more simpler assets.
To find the true value of such an asset, one must “decompose” it into its component parts and price
each component separately. Most complex financial assets involve a choice or option granted to the
issuer or investor to do something to alter the cash flow. Because the value of such financial assets
depends on the value of the choices or options granted to the issuer or investor, it becomes essential
to understand how to determine the value of an option.

Tax Status
An important feature of any financial asset is its tax status. Governmental codes for taxing the
income from the ownership or sale of financial assets vary widely if not wildly. Tax rates differ from
year to year, country to country, and even among municipal units within a country (as with state and
local taxes in the United States). Moreover, tax rates may differ from financial asset to financial asset,
depending on the type of issuer, the length of time the asset is held, the nature of the owner, and so
on.

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