FNM106 Capital Market Reviewer PDF

REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 1 Topic title: Course Des...

REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 1 Topic title: Course Description This course focuses on Capital Market Theory, its efficiency and implications. It establishes its coherence with the rest of the financial institutions within the financial environment. The course also deals with the relationship of the financial market with the government and how the latter stands a powerful influential tool. The course likewise attempts to develop the analytical ability of the students through various financial case presentations. INTRODUCTION ➔​ Financial System includes: banking institutions, non-banking financial intermediaries, investments and loan associations. ➔​ It is necessary for the growth of the economy. ➔​ Financial institutions are the key intermediaries in financial markets because they transfer funds from savers to individuals, firms and government. ➔​ An investor who deposits money in a bank, buys and stock through an online brokerage account, or contacts her broker to buy a mutual fund places her money and trust in the hands of the financial institutions that provide her with advice and transaction services FINANCIAL ASSETS ​ Tangible assets depends on particular physical properties - example–buildings, land, or machinery ​ Intangible assets, the typical future comes in the form of a claim to future cash. ​ Issuers of a financial asset are entities that agree to make future cash payments. The owner of financial assets is referred to as an investor. ​ Example of Financial Assets ​ A bond issued by the Philippine government ​ A bond issued by San Miguel Corporation ​ A bond issued by the municipality of Palawan ​ A bond issued by the government of Japan ​ An automobile loan ​ A home mortgage loan ​ Common Stock issued by Ayala Land Corporation ​ Common stock issued by Honda Motor Company In the case of bond issued by the Philippine government and bond issued by Sanl Miguel Corporation, bond issued by the municipality of Palawan, the issuer agrees to pay the investor interest until the bond matures, then at the maturity date repay the amount borrowed. ​ In the case of the Japan government bond, the cash payments are known if the Japan government does not default. ​ The cash payment is not denominated in Philippine peso but in Japanese Yen. ​ The cash payment is known in the number of yen that will be received, from the perspective of Filipino investors, the number of Philippine peso remains unknown. ​ It depends on the exchange rate between yen and Philippine peso when the cash payment are received and converted into Philippine peso. ○​ For the automobile loan and the home mortgage loan, the issuer is the individual who borrowed the funds. ○​ The investor is the entity, such as the bank, that lent the funds to the individual. ○​ The loan agreement will include a schedule specifying how the borrower will repay the loan and how the interest will be paid ​ The common stock of Ayala Land Corporation entitles the investor to receive dividends distributed by the company and holds a claim to a pro rata share of the net asset value of the company in case of liquidation. ​ The common stock of Honda Corporation applies to the same cash payment. An investor in Honda Corporation is subject to uncertainty about the cash payment, it depends on the exchange rate at the time of conversion between Philippine peso and the Japanese yen. Debt versus Equity Claims ​ In a debt instrument, the claims of the holder of a financial asset may either be a fixed dollar amount or varying, or residual, amount. (Bond issued by the Philippine government, San Miguel Corporation) ​ An equity claim (also called a residual claim) obligates the issuer of the financial assets to pay the holderan amount based on earnings. ​ Convertible bonds allow investors to convert debt into equity under certain circumstances. ​ Both debt and preferred stock that pay a fixed dollar amount are called fixed income instrument. The Value of a Financial Asset ​ Valuation is the process of determining the fair value or price of a financial asset. ​ Present value that an amount of money today is worth more than the same amount in the future. ​ Present value shows that money received in the future is worth as much as an equal amount received in the future is not worth as much as an equal amount received today. Estimating the Cash Flow ​ Cash flow is the cash that is expected to be received each period from investing in a particular financial asset. ​ The type of financial assets (debt or equity) determine the degree of certainty of the cash flow. ○​ For example the bonds issued by the government never defaults on the debt instrument, the cash flow of securities issued by the government is known with certainty. ​ Because of inflation, the purchasing power of the cash flow is uncertain even if the nominal dollar of the cash flow is certain. REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 Targeting Inflation: 2 These help in reducing inflation to within the BSP target range of 2-4 percent in the first quarter of 2024, averaging at 3.7 percent for full year 2024 and at 3.2 percent in 2025. This progress is expected to yield positive influence on consumer spending and investments in the coming year and beyond. Enero 7, 2024. The Appropriate Interest Rate for Discounting the Cash Flow To determine the appropriate rate, the investor must address the two following questions? 1.​ What is the minimum interest rate the investor should require? 2.​ How much more than the minimum interest rate should the investor require? The Central Bank of the Philippines held its benchmark interest rate at 6.50% in December 2023, in line with market expectations, and paused for the second consecutive meeting as inflationary pressures began to ease. In November, the country’s headline inflation slowed to a one-and-a-half-year low of 4.1%, falling from 4.9% in the previous month and nearing the regulators’ target range of 2% to 4%. Also, inflation forecasts were revised lower to 6.0% from 6.1% in 2023 and to 4.2% from 4.4% in 2024. The Role of Financial Assets ​ Financial assets transfer funds from those parties who have surplus funds to invest to those who need funds to invest in tangible assets. ​ They transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing funds. ​ To illustrate these two economic functions in three situations: ○​ Johnny dela Cruz obtained a license to manufacture wristwatches. He estimated that he needs $1million to purchase the plant and equipment to manufacture the item. Unfortunately, he has only $200,000 to invest, his life savings, which he does not want to invest even though he feels confident a receptive market exists for the watches. ○​ Juanita Carlson recently inherited $730,000. She plans to spend $30,000 on some jewelry, furniture, and a few cruises, and to invest the balance of $700,000. ○​ Larry Gabon, an up-and-coming attorney with a major in New Law For, received a bonus check that netted him $270,000 after taxes. Plans to spend $70,000 on a BMW and invest the balance, $200,000. ○​ Suppose the three accidentally meet in New York City and discuss their financial plan. By the end of the day, they agree to a deal. Johnny agrees to invest $100,000 of his savings in the business and sell a 50% interest to Juanita for $700,000. Larry agrees to lend Johnny $200,000 for 4 years at an interest of 18% per year. Gene will be responsible for operating the business without the assistance of Juanita and Larry. Johnny now has $1million to manufacture the watches. ○​ Two financial claims are present in this agreement. First, is an equity instrument issued by Johnny and purchased by Juanita for $700,000. Second, is a debt instrument issued by Johnny and purchased by Larry for $200,000. Juanita and Larry has surplus funds and invested to Johnny who needed funds to invest in tangible assets in order to manufacture watches. This transfer of funds carries out economic function of financial assets. Properties of Financial Assets 1.​ Moneyness – financial assets act as a medium of exchange or in settlement of transactions, this asset is called money. ○​ Near money instruments include time and savings deposits and a security issued by the government with a maturity of three months called three month Treasury bill. ○​ Moneyness clearly offers a desirable property for investors. 2.​ Divisibility and Denomination – refers to the minimum size at which a financial asset can be liquidated and exchange for money. Thus, many bonds come in $1,000 denominations, while some debt instruments come in $1million denomination. Divisibility is desirable for investors. 3.​ Reversibility (round-trip-cost) – refers to the cost of investing in a financial asset and then getting out of it and back into cash again. The most relevant cost is the so-called bid-ask spread, to which might be added commissions, time and cost, if any, of delivering the asset. ○​ The bid-ask-spread consists of the difference between the price at which a market maker is willing to sell a financial assets. Properties of Financial Assets 1.​ Maturity - The term to maturity is the length to interval until the date when the instrument is scheduled to make its final payment, or the owner is entitled to demand for liquidation. Maturity of debt instruments can range from one day (Treasury bills), to 100 years (Treasury bonds). Financial assets with stated due maturity may terminate before its stated maturity due to bankruptcy and reorganization. 2.​ Liquidity - Liquidity and illiquidity is in terms of how seller are willing to lose if they wish to sell immediately against engaging in a costly and time consuming search. 3.​ Convertibility - Convertibility to other financial assets, as when a bond is converted into another bond. Convertible corporate bonds can be converted into equity, preferred stocks can be converted into common stock. The timing, costs, and conditions for conversion are clearly stated in the legal descriptions. 4.​ Currency - Financial assets can be denominated in one currency. Some issuers, responding to investor’s wishes to reduce foreign exchange risk, have issued dual currency securities. For example, some pay interest in one currency but principal on the other currency. Some bonds carry a currency option that allows the investor to specify payments of either principal or interest be made in either one of two currencies. ○​ Financial assets can be denominated in one currency. Some issuers, responding to investor’s wishes to reduce foreign exchange risk, have issued dual currency securities. For example, some pay interest in one currency but principal on the other currency. Some bonds carry a currency option that allows the investor to specify payments of either principal or interest be made in either one of two currencies. REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 3 5.​ Cash Flow and Return Predictability - Predictability of return depends on the predictability of the cash flow, the riskiness of an asset can be equated with the uncertainty or unpredictability of its return.​ ○​ For example, if the nominal return for a 1-year investment of $1,000 is 6%, then at the end of one year the investor expects to realize $1,060, consisting of interest of $60 and the repayment of the $1,000 investment. However, if the inflation rate over the same period of time is expected to be 4%, then the purchasing power of $1,060 is only $1,019.23 (1,060 divided by 1.04). The real expected return is 2% (6% - 4%). ○​ Complexity - The combination of two simpler assets, to find the true value, one must decompose into component parts and price each component separately. ○​ Tax status - Government code for taxing the income from ownership or sale of financial assets widely vary from year to year, country to country and even among municipality within a country. FINANCIAL MARKET The Role of Financial Market 01.​ The interactions of buyers and sellers in a financial market determine the price of the traded assets; or the required return on a financial asset is determined. 02.​ Financial markets provide a mechanism for an investor to sell a financial asset, it offers liquidity on which it motivates investors to sell. In the absence of liquidity, investors will hold a debt instrument until it matures. 03.​ Financial market reduces the search and information costs of transacting. Search cost represents explicit cost. 04.​ The monetary spent to advertise the desire to sell or purchase financial assets, and implicit cost such as the value of time spent in locating a counterparty of buyer. Information costs are incurred in assessing the investment cash flow expected to be generated. ​ Derivative Markets ​ Some contracts give the contract holder either the obligation or the choice to buy or sell a financial asset. ​ Such contracts derive their value from the price of underlying financial assets. ​ Derivative instruments include options contracts, futures contracts, forward contracts, swap agreements. Strong Financial System A stable financial system is capable of efficiently allocating resources, assessing and managing financial risks, maintaining employment levels close to the economy’s natural rate, and eliminating relative price movements of real or financial assets will affect monetary stability or employment levels. ​ A well-functioning financial system has complete markets with effective financial intermediaries and financial instruments, allowing: Investors to move money from the present to the future at a fair rate of return. Borrowers to easily obtain capital. Hedgers to offset risks. EMPLOYMENT LEVEL TYPES OF RISK IN THE CAPITAL MARKET I.​ Market Risk – The risk of investments declining in value because of economic developments or other events that affect the entire market. The main type of market risk are:​ ○​ Equity risk – applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares. ​ ○​ Interest Rate Risk – applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example if the interest rate goes up, the market value of bonds will drop. ​ ○​ Currency Risk – applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, US stocks will be worth less in Canadian dollars. REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 II.​ 4 Liquidity Risk – The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. III.​ Concentration Risk – The risk of loss because your money is concentrated in one investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations. IV.​ Credit Risk – The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. ○​ For example, long term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk. V.​ Reinvestment Risk – The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. ○​ Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest at 4%. Reinvestment risk also applies when the bond matures and you have to reinvest the principal at less than 5% VI.​ Inflation Risk – The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. ○​ Inflation erodes the purchasing power of money over time- the same amount will buy fewer goods and services.Inflation risk is particularly relevant if you own cash or debt investments like bonds. VII.​ Horizon Risk – The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the market is down, you may lose money. VIII.​ Longevity Risk – The risk of outliving your savings. The risk is particularly relevant for people who are retired, or are nearing retirement. IX.​ Foreign Investment Risk – The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the share of companies in emerging markets, the risk of nationalization. COST of Financial System 1.​ Increase Capital Requirement: Banks don’t rely on deposits alone to fund loans. They can go out and borrow money from other banks, which they can in turn loan to customers, this is called taking on leverage. Leverage increases return but also increase risk. ○​ Banks responds to higher capital minimums in two ways: ​ Making fewer loans ​ Rising additional equity ○​ Lending is an important ingredient in consumption and business investment. So if lending slows down and gets more expensive, GDP takes a hit. The Central Bank can encourage lending by keeping interest low. 2.​ Increased Liquidity Requirements: Liquidity Requirements push banks to consider not just how much cash they need to get by on a day-to-day basis. Similar to capital requirements, liquidity requirements slow down lending because they increase the amount of cash that banks must set aside rather than lend out. Cash reserve set by the Central Bank. 3.​ Increase Compliance: Banks submit annual and quarterly reporting to industry regulators to disclose their financial position. Costs associated with regulation should be reflected on bank’s financial statements as increased noninterest expense, which include many expenses like employee wages. FINANCE Definition of Finance We can define Finance as the management of cash or funds. While accounting and finance deal with the same account titles in the preparation of the Balance Sheet, the Income Statements, and all other financial statements, they differ in perspective. Finance would view all transactions similar to cash management. Accounting views all transactions in the accrual method. Accrual is an accounting method that recognizes income when earned and expenses when incurred regardless of when cash is received or disbursed. Example ​ Capricorn is in the business of buying and selling computers. In Dec 2016, the company bought and sold 40 units at the price of P20,000 payment to be received in March 2017. Each of the computers has a cost of p10,000 paid in cash. In addition, the company spent P50,000 for marketing and selling expenses, all paid in cash. The income statement of the company for the month ended Dec 31, 2015 is shown below: ○​ In the accounting perspective (accrual method), Capricorn company realized an operating income amounting to P550,000. From the credit sales, it gives rise to an account in the Balance Sheet known as accounts receivable. This account cannot be considered as cash until such time it is collected at a future date. ○​ In the Finance perspective (Cash flow point of view), Capricorn merely spent P250,000 (cost and expenses) but never got anything in return this can be explained by the fact that Finance will always concentrate on actual cash inflows and outflows, and not merely expect something in the future. This means that no income can be recognized until such time that the accounts receivables have been collected and converted into cash. ○​ While there is a difference in the perspective between accounting and finance, it should be noted that the accounting system of recording of transactions should always be used in the development of the financial statements. The two Functions of Finance I.​ The Treasury group is responsible for managing the company’s funds. The cashier’s office, which deals with receipt of payments, and the disbursement unit of the company, are part of this group. Financial planning, company investment section, foreign exchange section, credit and collection department, and even pension administration are under this group. The Treasurer heads this group. II.​ The Accounting group is responsible for the preparation of the financial statements and all other accounting-related activities. This include tax planning, business unit financial statement group, and the cost accounting group. The Controller heads this group. REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 Activities of a Finance Manager 5 The primary activities of a financial manager are investing, financing and financial statement analysis and planning. ​ The balance sheet of the company is broken down into the account form of reporting: the left side represents the asset side where investing decisions will come into play, while the right hand side represents the liability and capital of the firm. The assets of the firm is the portion where the Finance manager will decide as to how the company’s investment will be distributed in the specific accounts like cash, accounts receivable, inventories and fixed assets. ​ The right side of the balance sheet shows the accounts where the financing decisions will come. Financing sources may come from the liabilities or capital (equity), or a combination of both. It should be noted that the investment side will ultimately have an equivalent financing side in terms of value. External sources of funds include borrowing from banks or creditors, obtaining funds though financial markets, or sourcing funds through direct transactions (without using middlemen). GOAL OF FINANCE It has always been widely believed that the highest goal of finance is profit maximization. This can immediately be obtained by looking at the net income account of the income statement. However the highest goal of finance is maximizing the value of the firm. In achieving this goal, one has to consider the perception of would-be investors of the company. ​ Example 1.1 Capricorn and Aquarius are same size competitors, both having same five year profits, differing in timing of the profits, but investing in the same manner. Below is their profit history in the last five years. Financial Market and Institution Under normal circumstances, the company will first take the option of financing its long-term projects with the profits it has generated. In corporations, the profit is classified as appropriated or restricted to mean that such earnings will be used for specific purposes. However if funds are not sufficient to cover for the financial requirements, the enterprise or corporation may resort to two possible external financing option, borrowing through financial institution and or/selling equity through financial market. ​ Financial intermediaries like banks are entities that convert funds supplied by depositors (individuals, businesses and government). As depicted in Figure 1.4, they facilitate in bringing the funds from the providers to the users. The loanable funds carry an interest which the borrowers will pay for the use of money, together with the principal amount. Upon repayment, part of the interest earned by the bank will be retained for their operations, while the rest are shared to the depositors (interest income from bank deposits). REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 ​ 6 An example of financial Market is the Philippine Stock Exchange (PSE). Private corporations which would like to raise funds through capital infusion (equity) will go public by having it listed at PSE. The share of stocks of corporation will now be offered in the market at a specific value during the initial public offering (first time the stock is offered in the market). Individuals and businesses having money (supplier of funds) can buy the shares of stock through the PSE. The sales of the stock enables the public corporations to raise funds, the buyer will now become stockholders of the corporations for buying and selling of shares of stock. ​ There are two types of Financial Markets – money market and capital market: ○​ Money Market is the forum where short term (maturities are usually one year or less) financial transactions occur. Example of Financial instruments transacted in this market are the treasury bills (government securities), and commercial papers. Treasury bills are debt instruments issued by the government in order to raise funds (borrowing) in the short term horizon. Individuals and businesses can purchase or invest in the securities at a discounted value (interest is collected in advance) and the government in turn return the principal amount at the specified maturity date. Such financial instrument is deemed to be practically no risk (as the government guarantees repayment) but also earns low interest rate. The usual maturity dates for a Treasury bills are 91 days, 182 days, and 364 days. ​ Commercial papers are documents of indebtedness issued by a private company to raise short term funds for their projects. Similar to resorting to bank loans, commercial paper also carry interest to entice investors to buy such papers. Not all company can issue this type of debt security. Only those companies with high credit standing and financial status are successful in issuing commercial papers. In addition, these papers have slightly higher risk than the treasury bills. Maturity of these papers may range from 3 days to 270 days. ​ Capital market is the forum where long term financial transactions take place (perspective is more than one year). Corporate shares of stocks and bonds (long term debt securities) are examples of transactions that take place in the capital market. Arbitrage Pricing Theory (APT)​ Arbitrage Pricing Theory is a multi-asset pricing model based on the idea that an asset returns can be predicted using a linear relationship between the asset’s expected return and a number of macroeconomic variables that captures systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in order to identify securities that maybe temporarily mispriced. ​ The principle of arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the assets listed price. ​ The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market. The difference in the cost price and the selling price is the return you earn. ​ The formula for the Arbitrage Pricing Theory Model: E(R) I = E(R)z + (E(I) – E (R)z) x βn ​ where: ○​ E(R)i = Expected return on the asset ○​ Rz = Risk free rate of return ○​ βn = sensitivity of the asset price to macroeconomic factor n ○​ Ei = Risk premium associated with factor i​ ○​ Gross Domestic Product Growth (GDP) growth: β = 0.6, RP = 4% ○​ Inflation Rate: β= 0.8, RP = 2% ○​ Gold Prices: β = -0.7, RP = 5% ○​ Standard and Poor’s 500 index return: β = 1.3, RP 9% ○​ The risk free rate is 3% Expected Return = 3% + (0.6 x 4 %) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x9%) ○​ 15.2% CAPM (Capital Asset Pricing Model) ​ The CAPM describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost capital. Investors expect to be compensated for risk and the time value of money. The risk free rated in the CAPM formula account for the investor taking additional risk. ​ The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return.​ ​ For example, imagine an investor is contemplating a stock worth $100 per share today that pays a 3% annual dividend. The stock has a beta compared to the market of 1.3, which means its riskier than a market portfolio. Also assume that the risk-free rate is 3% and this investor expect the market to rise in value by 8% per year.​ ○​ The expected return of the stock based on the CAPM formula is 9.5%: 9.5% =3% + 1.3% x (8% -3%) Overview of Market Participants​ Long term-capital financing, usually supports expansion expenditures where the payback period of investment takes several years. The payback period is the period from the time the sum of money spent on the project was first used to the time this amount is fully recovered. ○​ Capital expenditures, as allocations for expansion expenditures are called investment in fixed assets requiring a large outlay of funds, it takes longer time to recover investments. ○​ Capital expenditures do not usually come the other. Plant facilities may have to be replaced or may need major repairs. New branches may have to be established. New product line may have to be adopted. A firm should choose between these projects with their limited capital availability. It resorts to capital budgeting, a process of ranking projects in the order of their urgency, feasibility and profitability. Short-term capital financing. Short term capital financing provides working capital where there is an expectation of investment flow back within one year or less than a year. Short term funds provide working capital which finances day-to-day operations. REVIEWER: CAPITAL MARKET LECTURE NOTES FNM106 ​ Receivables and inventories must be kept moving towards cash. Efficient management of money position requires avoiding shortage of 7 funds or keeping capital idle. Delays in the flow of funds in the form of slow-moving inventories or gaps in receivables collections are common headache that plaque even the most affluent business firm. ​ The synchronization of operating and long term capital requirements is one of the imperatives of financial planning. Traditionally, working capital needs are financed by tapping such sources as commercial banks, financing companies and the money market, or by availing trade credits to minimize interest charges. Capital expenditures are financed from long-term borrowings, the issuance of bonds or stocks, or purchases of fixed assets in installment basis. Procuring Funds Funds should be obtained at the least cost of capital, with convenient terms of payment and the least burden of the company assets. The cost of capital is of prime importance. This refers to aggregate expenses incurred in obtaining the funds, including but not limited to: interest expense, service charges, selling expenses and underwriting commission in the case of security issues, anticipated increase in relevant taxes, printing costs of documents and certificates, and legal and government fees. ​ To illustrate: Aseca Enterprises is engaged in importing chemicals used in preparing animal feeds which it sells to livestock farms and poultry raisers. Their customers obtain the chemicals from them themselves and mix them in appropriate quantities.​ The owner of Aseca is considering the expansion of his business so they can sell pre-mixed feeds. Estimated expenditures amount to P500,000. Assuming that the cost of capital is 18%per annum (16% on interest and other expenses related to securing the loan and 2% as allowance for anticipated increases in taxes), the anticipated income from the expansion must be substantially higher than 18% per annum for the project to be viable. ​ When the cost of capital exceeds or is at par with the expected income, the firm may completely abandon the project. Or defer its implementation to a more opportune time, when the cost of capital is less or when expected earnings are higher. CAPITAL MARKET ​ Capital Market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying and selling is undertaken by participants such as individuals and institutions, this market trades mostly long- term securities. ​ Example of highly organized capital market are the New York Stock Exchange, American Stock Exchange, London Stock Exchange, in the Philippine we have the PSE. ​ Sector view of Flow of Funds in U.S. Financial Markets for 1993 (Billions of Dollars) The table shows how funds were supplied and raised by the major sectors of our economy. Households were the largest net suppliers (includes personal trusts and non-profit organization) of funds to the financial market, the households made available $155.0 billion in funds to their sectors. In the jargon of economics, the household sector is a savings-surplus sector. By contrast, the nonfinancial sector is a savings-deficit sector, non-financial corporations raise $11.0 billion more in the financial market than they supplied to the markets. US government was savings deficit sector, the federal government raised $285.0 in excess of the funds it supplied to the financial market. This highlights a serious problem for the entire economy and for the financial manager. Persistent federal deficits have increased the government for borrowed funds. Most financial economists agree that this tendency puts upward pressure on interest rates in the financial marketplace and thereby raises the general cost of capital to corporations. This phenomenon has become known as crowding out: The private sector is pushed out of the financial market in favor of the government borrower. FUNCTIONS OF CAPITAL MARKET​ The functions of capital market which comprise capital and money market involve the exchange of one financial asset to another e.g., surplus economic units exchange money into another financial asset that provides future return in the form of interest, dividend and capital appreciation. They bring savers and borrowers together by selling securities to savers and lending that money to borrowers.