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Financial Markets Financial Institutions and Financial Instruments Ilene D. Padilla CPA, MBA 3-1  Introduction The international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very spe...

Financial Markets Financial Institutions and Financial Instruments Ilene D. Padilla CPA, MBA 3-1  Introduction The international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. We obtain financial resources through this system: Directly from markets, and Indirectly through institutions. 3-2  Introduction Indirect Finance: An institution stands between lender and borrower. We get a loan from a bank or finance company to buy a car. Direct Finance: Borrowers sell securities directly to lenders in the financial markets. Direct finance provides financing for governments and corporations. Asset: Something of value that you own. Liability: Something you owe. 3-3 Figure 3.1: Funds Flowing through the Financial System 3-4  Introduction Financial development is linked to economic growth. The role of the financial system is to facilitate production, employment, and consumption. Resources are funneled through the system so resources flow to their most efficient uses. 3-5  Introduction We will survey the financial system in three steps: 1. Financial instruments or securities Stocks, bonds, loans and insurance. What is their role in our economy? 2. Financial Markets New York Stock Exchange, Nasdaq. Where investors trade financial instruments. Philippine Stock Exchange (PSE) 3. Financial institutions What they are and what they do. 3-6  Financial Instruments Financial Instruments: The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. The enforceability of the obligation is important. Financial instruments obligate one party (person, company, or government) to transfer something to another party. Financial instruments specify payment will be made at some future date. Financial instruments specify certain conditions under which a payment will be made. 3-7  Uses of Financial Instruments Three functions: Financial instruments act as a means of payment (like money). Employees take stock options as payment for working. Financial instruments act as stores of value (like money). Financial instruments generate increases in wealth that are larger than from holding money. Financial instruments can be used to transfer purchasing power into the future. Financial instruments allow for the transfer of risk (unlike money). Futures and insurance contracts allows one person to transfer risk to another. 3-8  The use of borrowing to finance part of an investment is called leverage. Leverage played a key role in the financial crisis of 2007-2009. How did this happen? The more leverage, the greater the risk that an adverse surprise will lead to bankruptcy. The more highly leveraged, the less net worth. 3-9  Characteristics of Financial Instruments These contracts are very complex. This complexity is costly, and people do not want to bear these costs. Standardization of financial instruments overcomes potential costs of complexity. Most mortgages feature a standard application with standardized terms. 3-10  Characteristics of Financial Instruments Financial instruments also communicate information, summarizing certain details about the issuer. Continuous monitoring of an issuer is costly and difficult. Mechanisms exist to reduce the cost of monitoring the behavior of counterparties. A counterparty is the person or institution on the other side of the contract. 3-11  Characteristics of Financial Instruments The solution to high cost of obtaining information is to standardize both the instrument and the information about the issuer. Financial instruments are designed to handle the problem of asymmetric information. 3-12  Underlying Versus Derivative Instruments Two fundamental classes of financial instruments. Underlying instruments are used by savers/lenders to transfer resources directly to investors/borrowers. This improves the efficient allocation of resources. Examples: stocks and bonds. 3-13  Underlying Versus Derivative Instruments Derivative instruments are those where their value and payoffs are “derived” from the behavior of the underlying instruments. Examples are futures and options. The primary use is to shift risk among investors. 3-14 A Primer for Valuing Financial Instruments Four fundamental characteristics influence the value of a financial instrument: 1. Size of the payment: Larger payment - more valuable. 2. Timing of payment: Payment is sooner - more valuable. 3. Likelihood payment is made: More likely to be made - more valuable. 4. Conditions under with payment is made: Made when we need them - more valuable. 3-15  A Primer for Valuing Financial Instruments We organize financial instruments by how they are used: Primarily used as stores of value 1. Bank loans Borrower obtains resources from a lender to be repaid in the future. 2. Bonds A form of a loan issued by a corporation or government. Can be bought and sold in financial markets. 3-16 A Primer for Valuing Financial Instruments 3. Home mortgages Home buyers usually need to borrow using the home as collateral for the loan. A specific asset the borrower pledges to protect the lender’s interests. 4. Stocks The holder owns a small piece of the firm and entitled to part of its profits. Firms sell stocks to raise money. Primarily used as a stores of wealth. 3-17 A Primer for Valuing Financial Instruments 5. Asset-backed securities Shares in the returns or payments arising from specific assets, such as home mortgages and student loans. Mortgage backed securities bundle a large number of mortgages together into a pool in which shares are sold. Securities backed by sub-prime mortgages played an important role in the financial crisis of 2007-2009. 3-18  A Primer for Valuing Financial Instruments Primarily used to Transfer Risk 1. Insurance contracts. Primary purpose is to assure that payments will be made under particular, and often rare, circumstances. 2. Futures contracts. An agreement between two parties to exchange a fixed quantity of a commodity or an asset at a fixed price on a set future date. A price is always specified. This is a type of derivative instrument. 3-19  A Primer for Valuing Financial Instruments 3. Options Derivative instruments whose prices are based on the value of an underlying asset. Give the holder the right, not obligation, to buy or sell a fixed quantity of the asset at a pre-determined price on either a specific date or at any time during a specified period. These offer an opportunity to store value and trade risk in almost any way one would like. 3-20  The biggest risk we all face is becoming disabled and losing our earning capacity. Insuring against this should be one of our highest priorities. More likely than our house burning down. It is important to assess to make sure you have enough insurance. One risk better transferred to someone else. 3-21  Financial Markets Financial markets are places where financial instruments are bought and sold. These markets are the economy’s central nervous system. These markets enable both firms and individuals to find financing for their activities. These markets promote economic efficiency: They ensure resources are available to those who put them to their best use. They keep transactions costs low. 3-22 The Role of Financial Markets 1. Liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low. 2. Information: Pool and communication information about issuers of financial instruments. 3. Risk sharing: Provide individuals a place to buy and sell risk. 3-23  Debt and Equity markets Primary and Secondary Markets Exchanges and over-the-counter market Money and Capital Markets 3-24 The Structure of Financial Markets 1. Distinguish between markets where new financial instruments are sold and where they are resold or traded: primary or secondary markets. 2. Categorize by the way they trade: centralized exchange or not. 3. Group based on the type of instrument they trade: as a store of value or to transfer risk. 3-25 Functions of Financial Markets Allow transfer of funds from person or business without investment opportunities to ones who have them. Enhance economic efficiency by allocating productive resources efficiently, which increases production. Improve the economic welfare because they allow consumers to time their purchases better. 3-26 Debt and Equity Markets 3-27  Debt Market cont…. Debt instrument is a contractual agreement that obliges the issuer of the instrument (the borrower) to pay the holder of the instrument (the lender) fix amounts (interest and principal payments) at a regular intervals until a specified date (maturity date) when the final payment is made. The maturity of a debt instrument is the date on which a loan or bond, or other instrument becomes due and is to be paid off. 3-28  A debt instrument is Short-term if its maturity is less than one year. Long-term debt if its maturity is ten years or longer, and Intermediate-term if its maturity is between one and ten years. Examples of debt instruments include government and corporate bonds. 3-29  Equity Market Equity is a contractual agreement representing claims on the issuer’s income (income after expenses and taxes) and the asset of the business. Equities often make periodic payments (dividends) to their holders. Equities are considered long-term financial instruments because they have no maturity date. 3-30  Equity cont….. Since equity holders own the firm, they are entitled to 1) elect members of the firm’s board of directors and 2) vote on major issues concerning how the firm is managed. 3-31 3-32  Function of financial market cont… Increase returns on investment and increase business profit Set firm value Buy and sell risk: allow you to transfer certain risk (arising from accidents, theft, illness, early death, etc.) to another party (in this case, the insurance company). 3-33 Primary versus Secondary Markets A primary market is one in which a borrower obtains funds from a lender by selling newly issued securities. Occurs out of the public views. An investment bank determines the price, purchases the securities, and resells to clients. This is called underwriting and is usually very profitable. 3-34 Cont…. 3-35 Primary versus Secondary Markets Secondary financial markets are those where people can buy and sell existing securities. Buying a share of IBM stock is not purchased from the company, but from another investor in a secondary market. These are the prices we hear about in the news. 3-36 Centralized Exchanges, OTC’s, and ECN’s Centralized exchanges - buyers and sellers meet in a central, physical location. Over-the-counter markets (OTS’s) - decentralized markets where dealers stand ready to buy and sell securities electronically. Electronic communication networks (ECN’s) - electronic system bringing buyers and sellers together without the use of a broker or dealer. 3-37  Trading is what makes financial markets work. Placing an order in a stock market has the following characteristics: The stock you wish to trade. Whether you wish to buy or sell. The size of the order - number of shares. The price you would like to trade. 3-38  You can place a market order. Your order is executed at the most favorable price currently available. Values speed over price. You can place a limit order: Places a maximum on the price to buy or a minimum price to sell. 3-39  Executing a trade requires someone on the other side. Broker Direct access to electronic trading network through an ECN like Acra or Instinet. Customer orders interact automatically without an intermediary. Liquidity is provided by customers. 3-40  For a well known stock, the NYSE is another place from which to order. Liquidity is supplemented by designated market makers (DMMs). The person on the floor charged with making a market. To make the market work, they often buy and sell on their own account. 3-41 Debt and Equity versus Derivative Markets Used to distinguish between markets where debt and equity are traded and those where derivative instruments are traded. Equity markets are the markets for stocks. Derivative markets are the markets where investors trade instruments like futures and options. 3-42 Debt and Equity versus Derivative Markets In debt and equity markets, actual claims are bought and sold for immediate cash payments. In derivative markets, investors make agreements that are settled later. Debt instruments categorized by the loan’s maturity Repaid in less than a year - traded in money markets. Maturity of more than a year - traded in bond markets. 3-43 Primary and Secondary Markets A primary market is a financial market in which newly-issued securities, such as bonds or stocks, are sold to initial buyers by the corporation or government agency borrowing the funds. An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. A corporation acquires new funds only when its securities (IPOs) are sold in the primary market by an investment bank. Investment banks underwrite (insure) securities 3-44 in primary markets.  Cont….. Underwriting is a process whereby investment bankers (underwriters) buy a new issue of securities from the issuing corporation or government entity and resell them to the public. Thus, it guarantees a price for a corporation’s securities and them sells them to the public. 3-45  Secondary market A secondary market is a financial market in which previously issued securities can be resold. Brokers and dealers play an important role in secondary markets. A broker is a securities firms or an investment advisor associated with a firm who matches buyers with sellers of securities. The brokers does not own the securities buy acts as an agent for the buyer. 3-46  Cont…. A dealer is a securities firm links buyer and sellers by buying and selling securities own account at stated prices. Functions of secondary market. They make it easier for the buyers of securities to sell them before the maturity date. That is making the securities more liquid. 3-47 Exchanges and Over-the Counter (OTC) Markets Exchange is a marketplace where buyers and sellers of securities (or their agents or brokers) meet in one central location to buy and sell stocks of publicly traded companies. Over-the-counter (OTC) market is a market in which dealers at different locations trade via computer and telephone networks). 3-48 3-49 MONEY AND CAPITAL MARKETS 3-50  Cont….. Financial market instruments is a financial asset for the person who buys or holds one, and it is a financial liability for the company or institution that issues it. Money market instruments are short-term debt instruments, with maturities less than one year. 3-51  Money market instruments Treasury bills Negotiable bank certificates of deposits Commercial paper Bank acceptance Repurchase agreements (repos) Central bank’s funds 3-52 Treasury bills 3-53 Negotiable bank Certificate of Deposit (CDs) 3-54 Commercial Paper 3-55 Banker’s Acceptance 3-56 Repurchase Agreements (repos) 3-57 The Central Bank’s Funds 3-58 CAPITAL MARKET INSTRUMENT 3-59  Types of capital market instruments include: Stocks Mortgages (residential, commercial, and farm) Corporate Bonds Convertible Bonds Government debt securities Consumer and bank commercial loans 3-60 DERIVATIVE INSTRUMENTS 3-61 Kinds of derivative instruments Futures contracts Options contracts 3-62  Characteristics of a Well-Run Financial Market Essential characteristics of a well-run financial market: Must be designed to keep transaction costs low. Information the market pools and communicates must be accurate and widely available. Borrowers promises to pay lenders much be credible. 3-63  Characteristics of a Well-Run Financial Market Because of these criteria, the governments are an essential part of financial markets as they enforce the rules of the game. Countries with better investor protections have bigger and deeper financial markets. 3-64  Financial Institutions Firms that provide access to the financial markets, both to savers who wish to purchase financial instruments directly and to borrowers who want to issue them. Also known as financial intermediaries. Examples: banks, insurance companies, securities firms, and pension funds. Healthy financial institutions open the flow of resources, increasing the system’s efficiency. 3-65 The Role of Financial Institutions To reduce transaction costs by specializing in the issuance of standardized securities. To reduce the information costs of screening and monitoring borrowers. They curb asymmetries, helping resources flow to most productive uses. To give savers ready access to their funds. 3-66  Financial intermediation and leverage in the US have shifted away from traditional banks and toward other financial institutions less subject to government regulations. Brokerages, insurers, hedge funds, etc. These have become known as shadow banks. Provide services that compete with banks but do not accept deposits. Take on more risk than traditional banks and are less transparent. 3-67  The rise of highly leveraged shadow banks, combined with government relaxation of rules for traditional banks, permitted a rise of leverage in the financial system as a whole. This made the financial system more vulnerable to shocks. Rapid growth in some financial instruments made it easier to conceal leverage and risk- taking. 3-68  The Structure of the Financial Institutions We can divide intermediaries into two broad categories: Depository institutions, Take deposits and make loans What most people think of as banks Non-depository institutions. Include insurance companies, securities firms, mutual fund companies, etc. 3-69  The Structure of the Financial Institutions 1. Depository institutions take deposits and make loans. 2. Insurance companies accept premiums, which they invest, in return for promising compensation to policy holders under certain events. 3. Pension funds invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers. 3-70  Cont……… 4. Securities firms include brokers, investment banks, underwriters, and mutual fund companies. Brokers and investment banks issue stocks and bonds to corporate customers, trade them, and advise customers. Mutual-fund companies pool the resources of individuals and companies and invest them in portfolios. Hedge funds do the same for small groups of wealthy investors. 3-71  Cont………. 5. Finance companies raise funds directly in the financial markets in order to make loans to individuals and firms. Finance companies tend to specialize in particular types of loans, such as mortgage, automobile, or business equipment. 3-72  Cont……………. 6. Government-sponsored enterprises are federal credit agencies that provide loans directly for farmers and home mortgagors. Guarantee programs that insure loans made by private lenders. Provides retirement income and medical care through Social Security and Medicare. 3-73 Figure 3.2: Flow of Funds through Financial Institutions 3-74  Most people need to borrow to buy a house. Mortgage payment will be your biggest monthly expense so shop around. Many offers are from mortgage brokers - firms that have access to pools of funds earmarked for use as mortgages. Who offers your mortgage is not important - get the best rate you can. 3-75  Philippine Financial System Categories of Banking Institutions under “The New Central Bank Act” of Banko Sentral ng Pilipinas A. Banking Institutions A. Private banking institutions B. Government banks B. Non-bank Financial Institutions A. Private non-bank financial institutions B. Government non-bank Financial Institutions 3-76  Private Banking Institutions Commercial Banks Universal banks Commercial banks Thrift Banks Savings and Mortgage banks Stocks savings and loan association Private Development Banks Rural Banks Cooperative Banks Islamic Banks Other classification of banks as determined by the Monetary Board of the Bangko Sentral ng 3-77 Pilipinas  Government Banks Development Bank of the Philippines Land Bank of the Philippines 3-78  Non-bank Private Non-bank Investment bank Investment companies Securities dealers/brokers Insurance companies Credit unions Pawnshops Government non-bank financial institutions Government Service Insurance System – GSIS Social Security System 3-79