Financial Systems and Markets

Introduction to Financial System and Financial Market

• A financial market serves as a marketplace where investors can raise capital to expand their businesses.
• This is where financial instruments such as shares, bonds, derivatives, and currencies are traded.
• Financial markets include the stock market, forex market, derivative market, and bond market.
• Financial markets are vital to a country's economy.

Nature and Importance of Financial System

• Finance is the management of money and the process of obtaining necessary funds.
• It is essential for businesses to maintain operations.
• Finance involves using economic principles to make decisions about allocating money under uncertainty.
• It determines how funds are secured and invested.

Functions in Financial Management

• Accounting aims to maximize profits for employees through rewards and promotions.
• Finance seeks to maximize the wealth of the owners.
• Maximizing wealth is the ultimate goal for owners in financial markets.

Sources of Wealth

• Capital assets, such as money, can earn interest.
• Land and buildings can generate rental income.
• Labor and profession provide wages, salaries, or fees.

Elements of Financial System

• Lenders are entities seeking funds.
• Borrowers are entities receiving monetary credit.
• Financial intermediaries act as middlemen in financial transactions.
• These include commercial banks, investment banks, mutual funds, and pension funds.
• They facilitate borrowing and lending activities.
• Financial instruments are stocks, bonds, commodities, currencies, interest rates, and market indexes.
• Financial markets are venues for trading, including money markets and capital markets.
• Regulatory environments control standards for quality and risk management. Central banks regulate trading activities.
• Money creation increases a country's money supply or an economic region's.
• Price discovery is the valuation process for financial instruments, driven by risk levels.

Types of Financial Markets

• Money markets deal with instruments maturing in one year or less.
• Companies use them as both borrowers and lenders for short term cash
• Capital markets involve instruments maturing in over one year.
• These markets include equity (share certificates) and debt (PN, bonds).
• Primary markets are where fund demanders raise funds via new instruments.
• Secondary markets involve the trading of instruments previously issued in the primary market.

Primary Market Types

• Public offerings are available for subscription to the general public.
• Private placements involve single investors purchasing entire issuances.
• Auctions are available to all for treasury bills/bonds.
• Tap issues allow issuers to accept bids at any time.

Secondary Market Participants

• Securities brokers act as facilitators.
• Sellers demand while buyers provide funds.

Philippine Financial System & Bangko Sentral ng Pilipinas (BSP)

• The BSP and Monetary Board play a crucial role
• History of currency and notes in the Philippines involves several eras.

Pre-Hispanic Era

• Cowry shells were used as money.
• Gold was used for jewelry, barter rings, and local coins ("Piloncitos").

Spanish Era

• Silver coins, macuquinas/cobs, were brought by Spanish galleons.
• Dos mundos coins were used between 1732-1772, also known as the Mexican Pillar Dollar.
• "Barya" means small change, from barrilla.
• Gold coins and paper money called pesos fuertes were introduced.

Revolutionary Period

• In 1898, the Philippine Republic issued its own coins and paper money with natural resource backing.

American Period

• In 1898, Americans pegged the peso to the US dollar at a 2:1 ratio.
• In 1912, El Banco Espanol Filipino became the Bank of the Philippine Islands, and currency was translated to English.
• By May 1918, treasury certificates replaced silver certificates.

Japanese Occupation

• Japanese forces printed paper money, nicknamed "Mickey Mouse" money.
• Guerra notes were issued by provinces and municipalities.

Philippine Republic

• Old treasury certificates were marked with "Victory."
• In the late 1960s, currency was Filipinized, adding national symbols.
• New banknotes replaced the ABL series in 1985, and the Bangko Sentral ng Pilipinas logo was introduced.

Financial Reporting

• Financial reporting uses financial statements to disclose financial information over a specific period.
• Financial Reporting aims to facilitate decision-making and build trust.
• Financial statements summarize a company’s financial performance and position.
• These include the balance sheet, income statement, cash flow statement, changes in equity statement, and notes.
• Users of financial statements are regulators, investors, creditors, management, depositors, analysts, government, and employees.
• The Philippines adopted the International Financial Reporting Standards (PFRS).
• Sets of accounting principles (PAS) are used for financial statements.
• The Bangko Sentral ng Pilipinas (BSP) is the regulatory body for banks.
• Operations of banks are supervised by Bangko Sentral.
• Banks analyze financial statements to manage risks, while non-financial companies track sales and revenue growth.

Monetary Policy

• Monetary Policy manages the supply and cost of money
• Monetary policy aims to influence demand and attain price stability.

Contractionary and Expansionary Monetary Policy

• Contractionary policy involves higher interest rates, less borrowing, more savings, and less spending.
• Expansionary policy involves lower interest rates, more borrowing, less savings, and more spending.

BSP Monetary Policy Over the Years

• 1940s: Rehabilitation efforts after war.
• 1950s: Safeguarding initial growth through exchange rate and trade controls.
• 1960s: Heading towards a market-determined exchange rate through decontrol.
• 1970s: Stabilizing the economy.
• 1980s: Navigating turbulent times with currency stabilization.
• 1990's: Gaining policy independence.
• 2000-Present: Inflation targeting focusing on price stability.

Policies Implemented

• Central Bank Act introduced in 1948 was given a developmental role.
• Republic Act No. 265 shifted to maintaining monetary stability.
• New Central Bank Act passed in 1993 restructured the central bank with price stability objective.
• RA 11211 restored authority to issue debt papers and required information from a non-bank private sector, strengthening policy formulation.

Characteristics of Money Market

• Sold in large denominations
• Low default risk
• Matures in less than a year

Participants in Money Market

• Bureau of Treasury sells government securities
• Short-term issuances raise funds
• Commercial banks issue securities and offer investment accounts
• Private individuals invest through money markets
• Institutions manage their cash, trade, underwrite, and invest on behalf of clients.
• Money market mutual funds enable small investors to invest.

Financial Instruments and Market Participants

• Tangible assets have physical properties.
• Intangible assets don’t have physical substance.
• Cash equivalents mature within 90 days.
• Investments mature after 90 days.
• Issuers create the instrument and provide future payments.
• Investors own instruments.

Types of Money Market Instruments

• Treasury bills are government securities maturing in less than a year.
• Cash management bills mature in less than 91 days.
• Treasury bills have three tenors

Treasury Bills - Tenors and Rates

• 91 days or 4 months
• 182 days or 6 months
• 364 days or 1 year
• Quoted based on yield and price
• Sold via auction or bidding

Annualized Discount Rate (Treasury Bills)

• Terms: Bv = Face Value, Bp = Purchase Price, D = tenor
• Bv-Bp/Bv x 360/D = Discount Rate

Annualized Investment Rate (Treasury Bills)

• Terms: Bv = Face Value, Bp = Purchase Price, M = days to maturity
• Bv - Bp/Bv x 360/M - Investment Rate

Repurchased (repo) Agreements

• Involve a sale agreement to repurchase at a higher price.
• Secured by collateral, considered low-risk.
• Open repos - repos that do not have an indicative date of repurchase

Certificates of Deposit

• Negotiable CDs are secured by banks.
• Classified as bearer instrument
• Long-term negotiable certificates have a minimum maturity of 5 years

Commercial Paper

• Unsecured notes issued by large corporations
• Short term maturities - less than 365 days
• Long term maturities - greater than 365 days
• Not required to register with SEC:
• issued to not more than 19 non-constitutional lenders
• Payable to a specific person
• Neither negotiable nor assignable and held to maturity
• amount not exceeding Php 50 million

Banker’s Acceptance

• An order can be made to the bearer on a specified date
• Used in purchasing, imports and exports.

Credit and Risk

• Credit is and agreement allowing a borrower to receive funds or serices now for repayment later.
• Risk is uncertainty about future outcomes.

Credit Risk

• Credit risk is the potential that a bank borrower or counterparty will fail to meet its obligation in accordance with agreed terms.

Credit Categories

• Export credit is for international export operations, managed by financial or government institutions.
• Trade credit is an agreement where goods/services are delivered with expectation of future payment
• Consumer credit is purchasing used goods/services with high deprecation

Operational, Market and Other Risks

• Operational risks include credit, trading, concentration, earnings, funding/liquidity, value, solvency, strategic, and reputation risks.
• Market risks include interest rate, exchange rate, and legal/regulatory risks.
• Other risks include weather, terrorist, and money laundering risks.

Sources and Management of Credit Risks

• Sources include investment portfolios, overdrafts, letters of credit, and guarantees.
• The initial credit granting process manages this by sound underwriting, an efficient approval process, and competent staff.

Required Information for Credit Risk Analysis

• Purpose and amount of the loan, repayment capacity of the borrow, duration of the loan, borrower's contribution
• Security aspects, borrowers character, business plan, environmental considerations

Assessing Credit Risk: Models, Categories, and Ratings

• Assessing risk is judged from a total risk model
• Models may include total/systematic risk or business/unsystematic risk

Systematic and Unsystematic Models

• Systematic relates to overall economy (example: GPA, Inflation)
• Unsystematic relates to specific business or industry (example: Cash Flows)

Credit Rating

• Credit rating shows assess of ability of a corporation or a government to repay debt with financial obligation.
• Credit ratings show estimate of a level of risk involved in lending money to a business or other entity

Scores and Credit History

• Credit scores are assigned to individuals based on their personal history of acquiring and repaying debt and are checked by lenders.
• A high credit rating indicates that a bond issuer can likely repay its debts.
• Low credit rating suggests that they may struggle to make payments and be in financial trouble.
• Bonds receive credit ratings and interest before being issued.
• The ratings are used by Investors and leaders to help decide do business with the rated entity.

Importance of Credit Rating

• Reduces borrowing costs by credibility
• Increases financial discipline and informs decisions

Types of Credit

• Short-term credit ratings
• Long-term Credit Ratings

Ratings Agencies and their History

• Standard & Poor's Corporation
• Moody's Investor Service
• Fitch Ratings

Standard & Poor's Corporation (S&P Global)

• November 25, 2024, the credit rating was BBB+ with a positive outlook.
• The company uses data gathered from 128 countries using more than 1,500 credit analysts to assess the creditworthiness to the industry

Moody’s Investor Service

• August 23, 2024, credit rating was Baa2 with a stable outlook.
• Information form more than 130 countries, with over 4,000 non-financial corporate issues and more than 4,000 financial institutions.

Fitch Ratings

• June 18, 2024, credit rating was BBB with a stable outlook.
• Conduct assessment over more than 8,000 entities around the globe with 25 different currencies.

Credit Information System

• The Credit Information System (credit reporting system or credit bureau) collects and stores information about individuals' and businesses credit history
• It Includes credit and payment history.

Legislative Framework in the Philippines

• Includes credit reports, credit, ratings, or credit inquires

Credit Data Management

• Gathers credit-related data, secured, processes raw data and generate reports

Functions of Credit

• Assess risk with lending, detect fraudulent activities, provides guidelines on operation

Credit Risk and Conclusion

• Credit Information System (CIS) and the money market are interconnected in several ways, particularly in the context of financial stability, risk management, and efficient allocations of resources.
• Enhancing creditworthiness assesment, facilitating access to short-term financing and risk management for money market participants

Methods to Address Credit Risk

• Measures to measure credit risk are, Credit history, Capacity to repay, Capital, Conditions, and Collatera

Economic Theories; Interest Rates and Relationships

• BSP defines interest rate is a "price".
• For lenders, interest rates is "Lending Rate of Return" and borrowers is "Cost of capital"
• Determined by interest rates in the industry, risk exposure, and market ecpectations

Aspects of Interest Rates

• I = (Rf + Dm)
• I = interest
• Rf = risk-free rate (real risk-free rate – inflation rate)
• Dm = debt margin Rate

Expectations related to the Market

• Driven by expectation of the lenders in risk in futrure
• May be analyzed by pure and biased expectation thereis

Drivers of Interest Rates

• Savings and investment flow assumed with the market segmentation

Cost of Debt

• Refers to the effective rate a company plays on its current debt

Rate of Return

• Requires by the supplier of debt related to interest

Types of Risk In The Market

• Default risk-inability to make consistent payment
• Liquidity risk-entire liquidity of the company of its ability to service its current portion

Components to Assess Risk

• Duration measure the sensitivity of rates
• Financial postion, changing the amount

Interest Risk

• Diversification is a component to assess interest risk