Chapter 3

FINANCIAL MARKETS
FINANCIAL MARKETS: AN OVERVIEW
Financial Markets – the meeting place for people, corporations, and institutions that either need
money or have money to lend or invest.
- Exist as a vast global network of individuals and financial institutions that may be lenders,
borrowers or owners of public companies worldwide.
 Participants in the financial markets also include national, state and local governments that
are primarily borrowers of funds for highways, education, welfare and other public activities;
their markets are referred to as public financial markets. Large corporations raise funds in
the corporate financial markets.

What Financial Markets Do

1. Raising capital
Firms often require funds to build new facilities, replace machinery or expand their
business in other ways. Shares, bonds and other types of financial instruments make
this possible. The financial markets are also an important source of capital for
individuals who wish to buy homes or cars, or even to make credit-card purchases.
2. Commercial transactions
As well as long-term capital, the financial markets provide the grease that makes
many commercial transactions possible. This includes such things as arranging
payment for the sale of a product abroad and providing working capital so that a firm
can pay employees if payments from customers run late.
3. Price setting
The value of an ounce of gold or a share of stock is no more, and no less, than what
someone is willing to pay to own it. Markets provide price discovery, a way to
determine the relative values of different items, based upon the prices at which
individuals are willing to buy and sell them.
4. Asset valuation
Market prices offer the best way to determine the value of a firm or of the firm’s
assets, or property. This is important not only to those buying and to selling
businesses, but to regulators. An insurer, for example, may appear strong if it values
the securities it owns at the prices it paid for them years ago, but the relevant
question for judging its solvency is what prices those securities could be sold for if it
needed cash to pay claims today.
5. Arbitrage
In countries with poorly developed financial markets, commodities and currencies
may trade at very different prices in different locations. As traders in financial
markets attempt to profit from these divergences, prices move towards a uniform
level, making the entire economy more efficient.
6. Investing
The stock, bond and money markets provide an opportunity to earn a return on funds
that are not needed immediately, and to accumulate assets that will provide an
income in the future.
a. Risk management
Futures, options and other derivatives contracts can provide protection against many
types of risk, such as the possibility that a foreign currency will lose value against the
domestic currency before an export payment is received.
 They also enable the markets to attach a price to risk, allowing firms and individuals
to trade risks so they can reduce their exposure to some while retaining exposure to
others.

Structure of Financial Markets

 There are many different financial markets in a developed economy each dealing with a
different type of security serving a different set of customers, or operating in a different part
of the country.

Debt and Equity Markets

A firm or an individual in two ways can obtain funds in a financial market.

1. Issue a debt instrument, such a bond or a mortgage, which is a contractual agreement by

the borrower to pay the holder of the instrument fixed peso amounts at regular intervals
(interest and principal payments) until a specified date (the maturity date)

The maturity of a debt instrument is the number of years (term) until that instrument’s
expiration date.

 A debt instrument is short-term if its maturity is less than a year and long-term if its
maturity is 10 years or longer.
 Debt instruments with a maturity between one and ten years are said to be intermediate-
term.

2. By issuing equity instruments, such as common or ordinary shares, which are claims to
share in the net income (income after expenses and taxes) and the assets of a business.
Equities often make periodic payments (dividends) to their holders and are considered long-
term securities because they have no maturity date.
Owning shares mean that you own a portion of the firm and thus have the right to vote on
issues important to the firm and to elect its directors.
The main disadvantage of owning a corporation’s equities rather than its debt is that an
equity holder is a residual claimant; that is, the corporation must pay all its debt holders
before it pays its equity holders.
The advantage of holding equities is that equity holders benefit directly from any increases
in the corporation’s profitability or asset value because equities confer ownership rights on
the equity holders. Debt holders do not share in this benefit because their peso payments
are fixed.

Financial Market functions as both primary and secondary markets for debt and equity securities.

 Primary Market
Primary market – original sales of securities by governments and corporations.
The primary markets for securities are not well known to the public because the selling of
securities to initial buyers often takes place behind close door.
In a primary market transaction, the corporation or the government is the seller and the
transaction raises money for the corporation or the government.

Corporations engage in two types of primary market transactions:

a. Public offerings – involve selling securities to the general public.
- public offerings of debt and equity must be approved by and registered with
the Securities and Exchange Commission
 - registration requires the firm to disclose a great deal of information before
selling any securities. The accounting, legal and selling costs of public
offerings can be considerable.
b. Private placements – a negotiable sale involving a specific buyer
- to avoid partly the various regulatory requirements and the expense of public
offerings, debt and equity are often sold privately to large financial institutions
such as insurance companies or mutual funds.
- Such private placements need also to be approved and registered with the
SEC.
- An important financial institution that assists in the initial sale of securities in
the primary market is the investment bank. It does this by underwriting
securities. It guarantees a price for a corporation’s securities and then sells
them to the public.
 Secondary Market
After the securities are sold to the public (institutions and individuals) they can be traded in
the secondary market between investors. Secondary market is popularly known as Stock
Market or Exchange.
Security brokers and dealers are crucial to a well-functioning secondary market.
Brokers – are agents of investors who match buyers with sellers of securities
Dealers – link buyers and sellers by buying and selling securities and stated prices.

Segments of Stock Markets

1. The Organized Stock Exchange – the stock exchanges will have a physical location where
stocks buying and selling transactions take place in the stock exchange floor (e.g. Philippine
Stock Exchange, New York Stock Exchange, Japan Nikkei, Shanghai Components, NASDAQ,
etc.)
2. The Over-the-Counter Exchange – where shares, bonds and money market instruments are
traded using a system of computer screens and telephones.
The NASDAQ is an example of an over-the-counter market in which dealers linked by
computers buy and sell stocks.
Dealers in over-the-counter market attempt to match up the orders they receive from
investors to buy and sell its stock. Dealers maintain an inventory of the stocks they trade to
help balance buy and sell orders. Many common stocks are traded over the counter
although the majority of the largest corporations have their shares traded at organized stock
exchange.

Functions of Secondary Markets

1. They make it easier to sell these financial instruments to raise cash; that is, they make the
financial instruments more liquid. The increased liquidity of these instruments then makes
them more desirable and thus easier for the issuing firm to sell in the primary market.
2. They determine the price of the security that the issuing firm sells in the primary market.
The firms that buy securities in the primary market will pay the issuing corporation no more
than the price that they think the secondary market set for this security.
The higher the security’s price in the secondary market, the higher will be the price that the
issuing firm will receive for a new security in the primary market and hence the greater
amount of capital it can raise.
Conditions in the secondary market are therefore the most relevant corporations issuing
securities.
Stock Exchange

Stock Exchange – an organized secondary market where securities like shares, debentures of public
companies, government securities and bonds issued by municipalities, public corporations, utility
undertakings, port trusts and such local authorities are purchased and sold. In order to bring
liquidity, the stocks are traded systematically in a stock exchange.

- An entity (a corporation or mutual organization) which is in the business of bringing buyers

and sellers of stocks and securities together.
- The purpose of stock exchange is to facilitate the exchange of securities between buyers
and sellers, thus providing a market place, virtual or real.
- The stock market that does not have a physical presence, it is a virtual market.

Trading Ring – a place where share brokers are assembled and bought and sold shares.

 Technology has enabled the ring to be located on a central computer, which has millions of
buyers and sellers attached to it through a telecommunications network.
 These buyers and sellers indicate their intentions through a computer at home or the office,
their own or their broker’s.
 Buyers’ and sellers’ orders are matched by the central computer, and if quantities and
prices correspond, then a trade is set to be executed.
 The entire process of sending the order to the stock exchange computer, confirmation of
order, and execution, if any, is communicated within a fraction of a second.

Listing Agreement – requirements agreed upon by the company in order to be listed.

- Ensures that the company provides all the information pertaining to its working from time to
time, including events that affect its valuation, such as mergers, amalgamations and such
other sensitive matters.
 The stock market is known as barometer of the company’s economy.
 The companies listed on stock exchanges collectively contribute to the country’s gross
domestic product (GDP).
 Stocks that trade on an organized exchange are said to be listed on that exchange. To be
listed, firms must meet certain minimum criteria concerning, for example number of
shareholder and asset size. These criteria differ from one exchange to another.

Listing – admission of securities to dealings on a recognized stock exchange of any incorporated

company, central and stage governments, quasi-governmental and other financial
institutions/corporations, municipalities, electricity boards, housing boards and so forth.

 The principal objective of listing is to provide liquidity and marketability to listed securities
and ensure effective monitoring of trading for the benefits of all participants in the market.

The Philippine Stock Exchange

The Philippine Stock Exchange, Inc. (Filipino: Pamilihang Sapi ng Pilipinas, PSE) – the national stock
exchange of the Philippines.

- Created in 1992 from the merger of the Manila Stock Exchange and the Makati Stock
Exchange.
- Including previous forms, it has been in operation since 1927.
- The main index for PSE is the PSE Composite Index composed of thirty (30) listed
companies.
- Overseen by a 15-member Board of Directors. (who is the current chairman)

The Forces of Change

1. Technology
2. Deregulation
3. Liberalization
4. Consolidation
5. Globalization

Code of Ethics Governing Market Activities in the Philippines

The Code of Ethics Governing Financial Market Activities in the Philippines is presented in Appendix
A.

MONEY MARKETS AND CAPITAL MARKETS

Money Market – refers to the network of corporations, financial institutions, investors and
governments which deal with the flow of short-term capital.

- Exists to provide the loans that financial institutions and governments need to carry out
their day-to-day operations.
- Provide borrowers such as banks, brokerages, and hedge funds with quick access to short-
term funding.
- The markets for short-term funds

Who Uses the Money Market

1. Companies
a. When companies need to raise money to cover their payroll or running costs, they
may issue commercial paper short-term, unsecured loans for P100,000 or more that
mature within 1-9 months.
b. A company that has a cash surplus may “park” money for a time in short-term debt-
based financial instruments such as treasury bills and commercial paper certificates
of deposit or bank deposit
2. Banks
a. If demand for long-term loans and mortgages is not covered by deposits from savings
accounts, banks may then issue certificates of deposit with a set interest rate and
fixed-term maturity of up to five years.
 3. Investors
a. Individuals seeking to invest large sums of money at relatively low risk may invest in
financial instruments. Sums of less than P50,000 can be invested in money market
funds.

Types of Money Market Instruments

1. Commercial Paper – a short-term debt obligation of a private-sector firm or a government-

sponsored corporation.
2. Bankers Acceptances – a promissory note issued by a non-financial firm to a bank in return
for a loan. The bank resells the note in the money market at a discount and guarantees
payment.
Acceptances usually have a maturity of less than six months.
3. Treasury Bills – often referred to as t-bills.
- Securities with a maturity of one year or less, issued by national governments.
- Issued by a government in its own currency.
- Generally considered the safest of all possible investments in that currency.
4. Government Agency Notes – national government agencies and government-sponsored
corporations are heavy borrowers in the money markets in many countries. These include
entities such as development banks, housing finance corporations, education lending
agencies, and agricultural finance agencies.
5. Local Government Notes – are issued by provincial or local governments, and by agencies of
these governments such as school authorities and transport commissions.
6. Interbank Loans – loans extended from one bank to another with which it has no affiliation.
7. Time Deposits – another name for certificates of deposit or CDs.
- Are interest-bearing bank deposits that cannot be withdrawn without penalty before
a specified date.
8. Repos – repurchase agreements play a critical role in the money markets. They serve to
keep the markets highly liquid, which in turn ensures that there will be a constant supply of
buyers for new money-market instruments.

Capital Markets

Capital Market – a financial market in which longer-term debt (original maturity of one year or
greater) and equity instruments are traded.

- Capital market securities include bonds, stocks, and mortgages.

- Capital market securities are often held by financial intermediaries such as insurance
companies and pension funds, which have little uncertainty about the amount of funds they
will have available in the future.
- The markets for long-term funds (bonds, equity)

Capital Market Participants

1. National and local government – issues long-term notes and bonds to fund the national debt
while local government issues notes and bonds to finance capital projects.
2. Corporations – issue both bonds and stock to finance capital investment expenditures and
fund other investment opportunities.
A. BONDS – any long-term promissory note issued by the firm.

Bond Certificate – the tangible evidence of debt issued by a corporation or a government bond and
represents a loan made by investors to the issuer.
Types of Bonds

A. Unsecured Long-Term Bonds

1. Debentures
2. Subordinated debentures
3. Income bonds
B. Secured Long-Term Bonds
1. Mortgage bonds
a. First Mortgage Bonds
b. Second Mortgage Bonds
c. Blanket or General Mortgage Bonds
d. Closed-end Mortgage Bonds
e. Open-end Mortgage Bonds
f. Limited Open-end Mortgage Bonds

Other Types of Bonds

1. Floating rate or variable rate bonds

2. Junk or low-rated bonds
3. Eurobonds
4. Treasury bonds

B. ORDINARY (COMMON) EQUITY SHARES

Comparative Features of Ordinary Equity Shares, Preferred Shares and Bonds

Ordinary Equity Shares Preferred Shares Bonds

a. Ownership and Belongs to ordinary equity Limited rights when Limited rights under
control of the shareholders through voting dividends are missed default in interest
firm right and residual claim to payments
income
b. Obligation to None Must receive Contractual
provide return payment before obligation
ordinary shareholder
c. Claim to assets Lowest claim of any security Bondholders and Highest claim
in bankruptcy holder creditors must be
satisfied first
d. Cost of Highest Moderate Lowest
distribution
e. Risk-return Highest risk, highest return (in Moderate risk, Lowest risk,
trade off theory) moderate return moderate return
f. Tax status of Not deductible Not deductible Tax deductible
payment by Cost = Interest
corporation payment x (1 – tax
rate)
g. Tax status of A portion of dividend paid to Same as ordinary Government bond
payment to another corporation is tax shares interest is tax
recipient exempt exempt

FOREIGN EXCHANGE MARKET

 From the end of World War II until the early 70’s, the world was on a fixed exchange rate
system administered by the International Monetary Fund (IMF).
  Under this system, all countries were required to set a specific parity rate for their currency
vis-à-vis the United States Dollar.
 A country could affect a major adjustment in the exchange rate by changing the parity rate
with respect to the dollar.
 Then the currency was made cheaper with respect to the dollar, this adjustment was called
devaluation.
 An upvaluation or revaluation resulted when a currency became more expensive with
respect to the dollar.
 A floating rate international currency system has been operating since 1973. Most major
currencies fluctuate freely depending upon their values as perceived by the traders in
foreign exchange markets.
 The determination of exchange rates is influenced by:
a. The county’s economic strength,
b. Its level of exports and imports,
c. The level of monetary activity, and
d. The deficits or surpluses in its balance of payments
 Short term, day-to-day fluctuations in exchange rates are caused by supply and demand
conditions in the foreign exchange market.

Exchange rate – the price of one country’s currency expressed in terms of another country’s
currency.

Factors Influencing Exchange Rates

1. Inflation
2. Interest rates
3. Balance of payments
4. Government intervention
5. Other factors

Two Kinds of Foreign Exchange Rate Transaction

a. Spot transactions – those which involve immediate (two-day) exchange of bank deposits.
Spot exchange rate is the exchange rate for the spot transactions.
b. Forward transactions – involve the exchange of bank deposits at some specified future date.
Forward exchange rate – the exchange rate for the forward transaction

Factors that Affect Exchange Rates in the Long Run

a. Relative Price Levels

b. Trade Barriers
c. Preferences for Domestic versus Foreign Goods
d. Productivity

Foreign Exchange Risk – the possibility of a drop in revenue or an increase in cost in an

international transaction due to a change in foreign exchange rates.

Avoidance of Exchange Rate Risk in Foreign Currency Markets

1. Hedging
2. Minimize receivables and liabilities denominated in foreign currencies.
3. Maintain monetary balance between receivables and payables denominated in a particular
foreign currency.
 4. Use of trigger pricing where future funds are supplied at an indexed price but with an option
to convert to a future-based fixed price
5. Diversification
6. Forward contract

MORTGAGE MARKET AND DERIVATIVES

MORTGAGE MARKET
Mortgage markets – where borrowers – individual businesses and governments can obtain long-
term collateralized loans.

 From one perspective, the mortgage markets form a subcategory of the capital markets
because mortgages involve long-term funds. But the mortgage markets differ from the stock
and bond markets in a number of ways.
1. The usual borrowers in the capital markets are businesses and government entities,
whereas the usual borrowers in the mortgage markets are individuals.
2. Mortgage loans are made for varying amounts and maturities, depending on the
borrowers’ needs.

Mortgages – are long-term loan secured by real estate. Both individuals and businesses obtain
mortgage loans to finance real estate purchases.

Characteristics of the Residential Mortgage

A. Mortgage interest rates
Three factors that affect the interest rate on a loan:
1. Current long-term market rates
2. Term or life of the mortgage
3. Number of discount points paid
B. Loan terms
C. Collateral
D. Down payment
E. Private mortgage insurance (PMI)
F. Borrower qualification
Types of Mortgage Loans

1. Conventional Loan is not guaranteed; usually requires private mortgage

mortgages insurance; 5% to 20% downpayment.
2. Insured mortgages Loan is guaranteed by FHA or VA; low or zero down payment
3. Fixed rate mortgages Interest rate and the monthly payment do not vary over the life of
the mortgage
4. Adjustable-rate Interest rate is tied to some other security and is adjusted
mortgages (ARMs) periodically; size of adjustment is subject to annual limits
5. Graduated-payment Initial low payment increases each year; loan usually amortizes in
mortgages (GPMs) 30 years
6. Growing equity Initial payment increases each year; loan amortizes in less than 30
mortgage (GEMs) years
7. Shared appreciation In exchange for providing a low interest rate, the lender shares in
mortgages (SAMs) any appreciation in value of the real estate
8. Equity participating In exchange for paying a portion of the down payment or for
mortgages (EPM) supplementing the monthly payments, an outside investor shares in
any appreciation in value of the real estate
9. Second mortgages Loan is secured by a second lien against the real estate; often used
for line of credit or home improvement loans
10. Reverse Annuity Lender disburses a monthly payment to the borrower on an
 Mortgages (RAMs) increasing-balance loan; loan comes due when the real estate is
sold

Mortgage Lending Institutions

a. Mortgage tools and trusts

b. Commercial banks
c. Government agencies and others
d. Life insurance companies
e. Savings and loans associates

Mortgage-backed security – a security that is collateralized by a pool of mortgage loans.

- Also known as securitized mortgage

Securitization – the process of transforming illiquid financial assets into marketable capital market
instruments.

DERIVATIVES

Derivatives – are financial instruments that “derive” their value in contractually required cash flows
from some other security or index.

Example: a contract allowing a company to purchase a particular asset (say gold, flour, or coffee
bean) at a designated future date, at a predetermined price is a financial instrument that derives its
value from expected and actual changes in the price of the underlying asset.

Characteristics of Derivatives

A derivative is a financial instrument:

a. Whose value changes in response to the change in a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or similar variable (sometimes called the “underlying”);
b. That requires no initial investment or little net investment relative to other types of
contracts that have a similar response to changes in market conditions; and
c. That is settled at a future date.

Examples of derivatives:

 Futures contacts
 Forward contracts
 Options
 Foreign currency futures
 Interest rate swaps