Financial Markets and Systems

• Financial Markets are marketplaces for investors to raise money to grow businesses
• Financial markets facilitate the sale, purchase, creation, and trading of financial instruments like shares, bonds, derivatives, debentures, and currencies
• Securities trading occurs in the stock market, forex market, derivative market, or bond market

Nature and Importance of Financial System

• Finance represents money management and acquiring necessary funds, as well as a business' lifeblood for continuity
• It applies economic principles to decision-making, allocating money under uncertainty
• Financial management has two functions: accounting to maximize profit for employee benefits, and finance to maximize owner wealth

Sources of Wealth

• Capital assets such as money earn interest
• Capital assets such as land or buildings earn rent
• Labor/profession earns wages/salaries/fees

Flow of Funds

• Direct Financing: Borrowers/spenders deal directly with lenders via financial instruments/securities
• Borrowers see financial instruments as liabilities, while lenders see them as assets
• Indirect Financing: Borrowers and lenders transact through intermediaries

Elements of Financial System

• The financial system provides a platform to transfer funds from entities with funds to invest to those needing funds
• It serves as a regular, time-efficient, and cost-effective link between fund providers and demanders
• Fund providers have available funds because they spend less than their income
• Fund demanders experience a fund shortage because they spend more than their income
• Demanders (borrowers) and suppliers (lenders) are the players

Financial Markets

• Demanders are individuals or corporations needing financial support to start a business
• Suppliers are those willing to provide and/or have excess wealth and seek opportunities to grow it
• Financial Intermediaries act as third parties, facilitating borrowing between borrowers and lenders (e.g., banks, credit unions, insurance companies, stock exchanges)
• Financial Instruments are mediums of exchange of contractual obligations which can be traded (tangible or intangible)
• Cash or derivative instruments are common, having underlying assets (stocks, bonds, commodities, currencies, interest rates, and market indexes)

Financial Instruments (IFRS Definition)

• IFRS defines financial instruments as contracts where one party recognizes it as an asset while the other treats it as a liability

Financial Markets (Place of Trading)

• Financial markets are venues where suppliers and buyers of financial instruments meet
• The money market is used for cash financial instruments (e.g., financial institutions, banks, money dealers)
• The capital market is used for derivative financial instruments (e.g., stock and bond market, forex markets)

Regulatory Control Environment

• Regulatory control involves a governance body ensuring transactions comply with laws/regulations

Function of financial systems

• Financial systems comply with laws and regulations imposed on entities and their elements
• Money Creation: The value created
• Price Discovery: Reflects how much is created

Three Economic Functions

• Price Discovery is the interaction between buyers and sellers that determines the price of financial instruments
• The price is driven by risks (high risk/return, low risk/return)
• Liquidity refers to how easily assets can be bought or sold, but it can be disruptive if it dries up
• Debt instruments have liquidity on their maturity date
• Equity instruments have voluntary or involuntary liquidation

Reduction in Transaction Costs

• Transaction costs are expenses incurred when parties trade a financial instrument
• Search costs are costs incurred looking for financial instruments to buy or sell
• Information costs relate to evaluating investment characteristics of financial instruments (profitability, liquidity, stability, market value)

Types of Instruments

• Financial Markets act as the mechanism bridging surplus and deficit economic units, directly or indirectly

Based on Instruments Traded

• Money Market: Short-term securities are traded
• They address differing cash requirements
• They generate opportunity cost from investing excess cash
• Capital Market: Financial instruments with maturity beyond one year are traded
• The two types of instruments are equity (share certificate) and debt (bonds)

Based on Market Type

• Primary Market: Fund demanders raise funds through new issuances of financial instruments (bonds or stocks)
• Used to finance projects or expansions through services of investment banks
• The borrower is the fund demander and the lenders are the fund providers
• Public Offering: Issuer offers subscription or sale to general public
• Private Placement: The issuer looks for a single investor to purchase the whole securities issuance than to general public
• Auction: Offering treasury bills, bonds, and other securities issued by the government to the public
• Tap Issue: Issuer is open to bids for their securities at all times, maintaining the right to accept or reject bid prices

Secondary Market

• The secondary market is where securities issued in the primary market are subsequently traded (resold and repurchased)
• Securities brokers are facilitators
• Sellers are demanders and buyers are fund providers

Based on Country's Perspective

• Internal Market: Includes the domestic and foreign markets
• The domestic market is where securities of residents of a country are issued and traded
• The foreign market is where securities of non-residents are sold and traded

External Markets

• External markets are financial markets where, upon issuance, securities are offered simultaneously to investors in different countries

Based on Trading Modality

• Broker Market: National and regional securities exchanges (e.g. Philippine Stock Exchange)
• Dealer Market: Buyers and sellers are not brought together by a third party but consist of market maker networks

Financial Intermediaries

• Includes participants such as financial intermediaries and others
• Financial intermediation describes the process of indirect financing, using financial intermediaries to transfer funds from lenders to borrowers
• Financial intermediaries offer trading of financials through brokering, trading with their own capital, forming financial assets needed by customers and distributing them, investment consultation, financial asset management, and payment mechanisms.

Benefits of Financial Intermediaries

• Acceleration of flow of funds
• Efficient allocation of funds
• Creation of money
• Support in price discovery
• Improved liquidity for lenders
• Reduced price risk for lenders
• Diversification
• Economies of scale
• Risk mitigation
• Implementation of monetary policy function

Classification of Financial Intermediaries

• Depository Institutions: firms that accept cash deposits from individuals, companies, and other entities
• Earnings are generated through interest (main source of revenue) and loans (main revenue-generating assets)
• E-Wallets: electronic cards which are used for online transactions
• They need to be linked with the individual’s bank account to make payments
• Contractual Savings Institutions: They obtain funds at periodic intervals and can project payment needs
• Investment Intermediaries: Their primary objective is to maximize return from investments
• Finance Companies: They raise their funds thru issuing of stocks and bonds or selling commercial papers