CHAPTER II

CAPITAL MARKETS

TOPICS:
1. Types of Investors
2. Bulls and bears markets, chickens and pigs markets
3. Components of Capital Markets
4. Financial Instruments
5. Underwriting of Securities
6. The Middlemen of Securities
7. Comparison of Capital Markets and Money Markets

LEARNING OUTCOMES:
After this Chapter, you should be able to:
1. Learn the different types of investors.
2. Distinguish the bulls and bears markets, chickens and pigs markets.
3. Identify the major corporate securities, components of capital markets and the
middlemen of securities.
4. Determine the comparison of Capital Markets and Money Markets.

LECTURE PROPER
Investors consist of individuals or firms wanting to purchase assets in capital goods or
embark resources with the object of obtaining benefits. The amount of invested funds may
consist entirely of the investors’ own money or it may be supplemented by outside sources. The
foregoing brings out two significant areas of concern.
1. The available funds provided by the savers/investors, and
2. The capital funding requirements of individuals and firms.

There are three different types of investors, the following:

1. Risk-averse investors (bulls and chickens). They are the type of investors who, when
faced with two investment alternatives with equal returns but one is riskier than the
other, will ultimately choose the less risky investment.
2. Risk-taker investors (bears and pigs). They are the investors who are ready to pay a
higher price for an investment regardless of the risk involved.
3. Risk-neutral investors. They are investors who do not take into account the risk
involved in the investment and who are focused only on the expected return.

THE BULLS AND BEARS MARKETS

A “bull market” is significant when the stock market is showing confidence for
prospective investors, that is, stock prices are going up and market indices go up which
proportionally recorded the rise in number of shares traded and high number of companies
entering the stock market showing precisely that the market is confident. Bull markets are most
common in expanding economic perspectives with low unemployment and inflation. The huge
rise of the Dow and Nasdaq during technology boom is an example of a bull market.
A “bear market” id the opposite of a bull market. It is when the economy is bad,
recession is looming, and stock prices are falling, hence, shying way investors who have
pessimistic beliefs that their investments will not work and would be gone losing. This bleak
scenario would draw “bearish outlook” for investors as they are in tough position to pick
profitable stocks.
However, a “short selling” technique would become a potential leverage used by
investors who are trying to make profits from the market recession. Short selling is a very risking
technique which involves and precise and goes contrary to the overall direction of the market.
Assume you want to sell short 200 shares of a Company because you believe sales slowing down
and earnings will drop, your broker will borrow the shares from someone with the promise to
return them later. You immediately sell the borrowed shares at the current market price. When
the price of the shares drop, you cover your short position by buying back the shares and return
them to the lender. Your profit is the difference of the price at which you sold the stock and its
buy back cost minus the broker’s commission and expenses in borrowing the stocks.
Another strategy is to wait that the bear market is nearing end, and only to buy in
anticipation at the onset of a bull market which you can sell them at the time for you to make
profits (Investorguide.com).

THE CHICKEN AND PIGS MARKETS

For investors, “chickens markets” are risk-averse free investments in which their fears
override their need to make profits and so they turn only to money markets securities or get out
of the markets entirely. Avoiding the market completely and never taking any risk will not give
an investor any return.
The “pigs markets” are the opposite of chickens markets. They are high-risk investors
looking for a one big deal in a short period of time, as it construe with “the higher the risk, the
higher the return” investment maxim. Investors in pigs markets are more than dynamic as they
are impatient, greedy and emotional about their investments. Mostly professional traders are
seasoned to the climate of the trading environment.

The financial markets maybe classified into two: (1) the money market, and (2) the capital
market.
Money markets cover markets for short-term debt instruments usually issued by
companies with high credit standing including the national government. They consist of a
network of institutions and facilities for trading debt securities with a maturity of one year or
less. Money markets are developed into a convenient channel for the placement of excess
funds, and for obtaining of funds for temporary short-term needs.
Capital markets is defined as the portion of financial market which deal with longer term
of wanable funds. It consist of all institutions that serve as conduit for the supply and demand of
long-term capital and claims of capital as well. Long-term securities are like debt securities
(bonds, notes, mortgages, leases), and equity securities (stocks).

COMPONENTS OF CAPITAL MARKET

The capital market is composed of three parts:
1. The bond market;
2. The stock market; and
3. The mortgage market
The bond market is where debt instruments of any kind are issued and traded.
Trading in the bond market is primarily done over-the-counter, mostly participated by
financial institutions (insurance companies, pension funds, mutual funds). Bond markets
are generally classified into Treasury notes and bonds markets, and corporate bonds
market.
The stock market serves as the medium or agent of exchange transactions that
deals with equity securities (common and preferred stocks). The organized exchanges
include the Philippine Stock Exchange, New York Stock Exchange, London Stock
Exchange. In the Philippine Stock Exchange, classification/cluster of industry of listed
companies whose stocks are traded:
1. Banks
2. Financial service
3. Communication
4. Power and energy
 5. Transportation services
6. Construction and other related products
7. Holding firms
8. Food, beverages and tobacco
9. Manufacturing, distribution, and trading
10. Hotel, recreation, and other services
11. Bonds, preferred and warrants

The mortgage market deals with loans on residential, commercial, industrial, real
estates, and farmlands on long-term basis. Foregoing assets are to be used as loan
collaterals on securities.

FINANCIAL MARKETS INSTRUMENTS

Money Markets Instruments
Financial instruments traded at the money market are government securities,
commercial papers including promissory notes, banker’s acceptances, repurchase agreements,
and certificate of confirmations.
Treasury bills are issued by the national government through the Bureau of Treasury, of
short-term promissory notes having maturities ranging from 7 to 364 days, tax free. The
government is one of the biggest borrowers from money market to beef up the required
minimum cash balance in operating funds.
Commercial papers are instrument issued by private business firms in form of
promissory notes or trade acceptances, and are registered with the SEC. Other forms of
commercial papers used as primary money market instruments which include:
1. Trade acceptance
2. Money orders
3. Telegraphic transfer, cable transfer
4. Managers checks
Those commercial papers with less than 240 days need not to register with SEC, only
those bearing more than 270 days or more are subject for appropriate registration. Bankers’
acceptances are draft drawn by a bank on another bank and accepted by the drawee bank for
payments. For example, Banco de Oro in Manila draws a draft on Manhattan Bank in New York.
Manhattan Banks accepts this by attaching its authorized signature on the instrument, in which
is negotiable and could be discounted with banks before the due date. Bankers’ acceptance is a
widely used instrument both in foreign trading and local money markets transactions.
Repurchase agreements are instruments whereby the dealer has the option to buy back
or redeem the instruments when the instrument of the fund supplier matures. At the maturity
date of the instrument of the investor, the dealer redeems the instrument. The dealer may
either hold the instrument in its portfolio up to its maturity or sells the paper to other investors.
A certificate of confirmation is issued to investor under an investment management
account, similar to the commingling of funds. The investor entrusts his funds to the dealer who
takes charge of his investment together with funds of other investor.

Capital Markets Instruments

The capital market is made up of institutionalized creators and distributors of long-term
debt (bonds) and equity (stocks) instruments. These are traded either through the investment
bankers for distribution of new issued securities, or through the stock exchanges/organized
markets for seasoned existing securities, or the over-the-counter markets for private/direct
placements. Newly-issued securities or initial public offerings (IPOs) are done mostly in the
primary markets via investment bankers/houses, private placement, direct sale from company
to prospective investors. No new issues are traded through the formal/organized securities
exchanges.
 Seasoned or existing securities are sold in secondary markets, only after which a newly
issued security has passed through testing of its competitive performance and marketability in
the primary market.
UNDERWRITING OF SECURITIES
Underwriting refers to the acct or process of guaranteeing the distribution and sale of
securities of any kind issued by another corporation.
Underwriting agreement is a contract between the investment bank/house and the
issuer where the former undertakers to handle the disposal of the securities of the latter in
varied capacities.
Investment house or bank is an intermediary between the sources of capital (investors),
and its users (business firms). In the performance of its function, an investment bank may
become creditor, investor, agent or consultant. It is call a “bank” because it is a financial
institution that acquires funds for business use. However, it does not accept pecuniary or money
deposits, but only acting as a depository of financial instruments acquired either on an agency
basis or through outright purchase.
Investment banks assist business firms to raise long-term funds through the sale of
securities. The investment banker purchases corporate securities and resell them to investors.
Other principal functions include: (1) investigate the corporation’s financial conditions, (2)
corporate investment counselling, (3) originating new issues, and (4) arranging for syndicate
distribution.
Underwriting syndicate is a union of investment bankers joining or participating in a
certain issue for its disposal to investors where each member firm commits itself to a fixed
percentage of the issue. There is a separate agreement that governs the relationship of the
individual members.

There are three major variations of underwriting agreement.

1. On-firm basis. An agreement is said to be “on-firm basis”, if the investment bank
agrees to purchase the issue from the Corporation. The investment banker or the
syndicate takes all the risks in the disposal of the security. The issuing company is
assured of cash payment at specified period agreed upon.
An example of an underwriting agreement “on-firm basis” through a syndicate is
the public offering of 8% debenture bond of XYZ Corporation. Three investment
houses forming a syndicate agreed to purchase the bonds in the following
proportions: Investment House #1 at ₱2 million, Investment House #2 at ₱2 million,
and Investment House #3 at ₱1 million. Likewise, the ABC Corp. was the sole
underwriter on a firm basis of ABBM Corp. 12% guaranteed bonds worth ₱2 million.
2. On stand-by basis, the investment banker agrees to purchase whatever the portion of
the issue will be left unsold after the offering period. The portion of the stocks that
will not be subscribed by the stockholders is bought by the investment banker. In
some instances, stockholders may exercise their pre-emptive rights over the issue.
3. A “best effort basis” is more of selling agreement than an underwriting contract. The
investment banker merely pledge to exert its best efforts to sell the securities. The underwriting
securities may be done in the following methods:
1. Negotiated underwriting of securitiesis one most preferred by the issuer, where they
can directly negotiate with one particular investment banker who have their
confidence, trust and established credibility. The issuing firm and the investment
banker agree on the terms and conditions of the underwriting.
2. Competitive underwriting is similar to the negotiated underwriting except that the
underwriting group bids against other underwriting groups for the initial purchase of
securities at a public auction.
3. Commission sales. When the investment banker acts as a selling agent/broker for the
issuer and not as an underwriter that he is paid by commission basis. He therefore
agree to try his “best efforts” to sell the security.
 4. Direct sale is when the issuer sells the securities directly to the public bypassing the
underwriter entirely,
5. Firm commitment basis is an underwriting agreement wherein the investment house
agrees to purchase the issue from the issuing corporation.
THE MIDDLEMEN OF SECURITIES
When buying or selling the securities, the services of the following middlemen will most
often be required. The middlemen of securities are defined under the Securities Regulation
Code (RA No. 8799) as follows:
1. The broker is a person engaged in the business of buying and selling securities
for the account of others. He is being paid by commission-basis as prescribed
by the Securities Regulations Code.
2. The dealer is any person who buys and sells securities for his/her own account.
He may likewise exercise the functions both of a broker and a dealer.
3. The salesman is a natural person, employed as an agent, by a dealer issuer a
broker only to sell securities on account of others.
4. The associated person of a broker or dealer is an employee thereof who,
directly not exercise control of supervisory authority, but does not include a
salesman, or an agent or a person whose functions are clerical or ministerial.
The brokers, dealers, salesmen, and associated persons are required by law to be
registered with the SEC.

Issuing
firm

Associated

Dealer Broker Salesman

Investor

Fig. 5 The Middlemen of Securities

person
COMPARISON OF CAPITAL MARKETS AND MONEY MARKETS
The money market differs from capital market in four counts, as follows:
1. Maturity structure
The money market is basically short-term financing usually matures of one year
or less, basically provides funds for working capital requirements for routinary
operations, while capital market provides long-term investment requirement, using
bonds or stock securities as medium of the transaction.
2. Differ in flexibility
In money market, there is ready liquidity investments. Money market placements
are made with higher expectation that liquidation can be scheduled. On the other
hand, investment in capital market is committed for longer use, such in primary
markets (bonds) and secondary markets (stocks), hence lesser flexibility.
3. Risk factor
Capital market investments are exposed to broader range of risk longer holding
period, and earnings are determined by the business performance and financial
condition of the issuer. While money market stipulates a fixed return in accordance
with a promissory commitment; and
4. Yield structure
Normally, money market yield is the highest obtainable from comparable outlets.
Yield in the money market investments is in the form of interest at rate being agreed
upon. While capital market carries a wide spectrum of rates of return dependent on
earning power of the enterprise and dividend policy as decided by the Board of
Directors. It has capital appreciation, or it could bring a loss either.