Financial Market Lesson 1 PDF

# Chapter 1 OVERVIEW OF FINANCIAL MARKETS ## Learning Objectives - Define financial markets - Identify the different kinds of markets and their functions - Identify the different types of financial institutions and their services - Recognize that financial markets are becoming increasingly global...

# Chapter 1 OVERVIEW OF FINANCIAL MARKETS ## Learning Objectives - Define financial markets - Identify the different kinds of markets and their functions - Identify the different types of financial institutions and their services - Recognize that financial markets are becoming increasingly global ## Financial Markets Financial markets are structures through which funds flow. They are organized institutional structures, or a mechanism for creating and exchanging financial assets. Markets work by placing many interested sellers in one place thus making it easier to find for prospective buyers. An economy, which relies on interactions between buyers and sellers to allocate resources, is known as a market economy. Financial markets could be domestic or international, it includes any type of financial transactions that one can think of, which helps investors and businesses grow. ## Functions of financial markets 1. The raising of funds in the capital market 2. The transfer of risk in the derivative market 3. International trade in the currency market ## Types of Financial Markets 1. **Primary markets** - markets in which corporations raise funds through new issues of securities. 2. **Secondary markets** - markets that trade financial instruments once they are issued. 3. **Money markets** - markets that trade debt securities or instruments with maturities of less than one year. 4. **Capital Markets** - markets that trade debt and equity instruments with maturities of more than one year. 5. **Foreign Exchange Markets** - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted. 6. **Derivative markets** - markets in which derivative securities trade. ## Financial Markets can be distinguished along two major dimensions: 1. Primary versus secondary markets 2. Money versus capital markets ## PRIMARY MARKETS VERSUS SECONDARY MARKETS Primary markets are markets in which users of funds (e.g., corporations) raise funds through new issues of financial instruments, such as stocks and bonds. a. **Stock market** - which provides capital through the issuance of shares and allows the subsequent trading thereof in the secondary market b. **Bond market** - which facilitates financing through the issuance of bonds and enables the subsequent trading thereof. ## Primary Markets | Product created and sold for the first time. | Products sold to other investors from primary markets. | | :--: | :--: | | Company IPO shares issued for the first time | Company shares sold to other investors and so on... | ## Secondary Markets Once financial instruments such as stocks are issued in primary markets, they are then traded - that is, rebought and resold in secondary markets. Sellers of secondary market financial instruments are economic agents in need of funds. Secondary markets provide a centralised marketplace where economic agents know they can transact quickly and efficiently. These markets therefore save economic agents the search and other costs of seeking buyers or sellers on their own. In addition to stocks and bonds, secondary markets also exist for financial instruments backed by mortgages and other assets, foreign exchange and futures and options. Secondary markets offer benefits to both investors (suppliers of funds) and issuing corporations (users of funds). For investors, secondary markets provide the opportunity to trade securities at their market values quickly as well as to purchase securities with varying risk-return characteristics. Corporate security issuers are not directly involved in the transfer of funds or instruments in the secondary market. Secondary markets offer buyers and sellers liquidity - the ability to turn an asset into cash quickly as its fair market value as well as information about the prices or the value of their investments. Further, the existence of centralized markets for buying and selling financial instruments allows investors to trade these instruments at low transaction costs. ## MONEY MARKETS VERSUS CAPITAL MARKETS **Money markets** are markets that trade debt securities or instruments with maturities of one year or less. In the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy money market instruments) to economic agents who have short-term needs or shortage of funds (i.e., they sell money market instruments). The short-term nature of these instruments means that fluctuations in their prices in the secondary markets in which they trade are usually quite small. In the United States, money markets do not operate in a specific location - rather, transactions occur via telephones, wire transfers and computer trading. Thus, most U.S. money markets are said to be over-the-counter (OTC) markets. ### Money Market Instruments - **Treasury bills** are the most marketable money market securities issued by the government because of its simplicity. Their maturities run from three months, six months to less than one year. TB's are bought for a price below their face value. At maturity the government pays the holder of the TB's the full amount of the par value. They are issued in a competitive bidding process at an auction sale. They are issued in denominations of 1,000, 5,000, 10,000, 25,000, 50,000 and 100,000 and 1,000,000. They are considered the safest and risk free among all investments since it is the government that backs it. Besides it is also tax free from both the national and local governments. - **Mutual Fund.** A mutual fund is a form of a collective investment that pools money from several investors and invest it in stock, bonds, money market instruments and other securities. Here the fund manager trades the fund securities earning capital gains and collecting dividends or interest income from their investments. The fund manager is known as a portfolio manager since he maintains the portfolio of the mutual fund. The mutual fund's net asset value per share which is the value per share of the fund as calculated daily based on the total value of the fund's asset divided by the number of shares issued and outstanding. The net asset value is the current market value of the fund less the funds liabilities. The fund is subject to accounting, tax and regulatory rules. - **Repurchase agreements** - agreements involving the sale of securities by one party to another with a promise by the seller to repurchase the same securities from the buyer at a specified date and price. - **Commercial paper** - short-term unsecured promissory notes issued by a company to raise short-term cash. - **Negotiable certificates of deposit** - bank-issued time deposits that specify an interest rate and maturity date and are negotiable (i.e., can be sold by the holder to another party). - **Banker's acceptances** – time drafts payable to a seller of goods with payment guaranteed by a bank. - **Bank and consumer loans** - loans to commercial banks and individuals. **Capital markets** are markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year. The major suppliers of capital market securities (or users of funds) are corporations and governments. Household are the major suppliers of funds for these securities. Given their longer maturity, these instruments experience wider price fluctuations in the secondary markets in which they trade than do money market instruments ### Capital Market Instruments - Corporate stock – the fundamental ownership claim in a public corporation. - Mortgages - loans to individuals or businesses to purchase a home, land, or other real property. - Corporate bonds - long-term bonds issued by corporations. - Treasury bonds - long-term bonds issued by the government. - State and local government bonds - long-term bonds issued by state and local governments. - U.S. government agency bonds - long-term bonds collateralized by a pool of assets and issued by agencies of the U.S. government ## FOREIGN EXCHANGE MARKETS The Bangko Sentral ng Pilipinas (BSP) maintains a floating exchange rate system. Exchange rates are determined on the basis of supply and demand in the foreign exchange market. The role of the BSP in the foreign exchange market is principally to ensure orderly conditions in the market. The market-determination of the exchange rate is consistent with the Government's commitment to market-oriented reforms and outward-looking strategies of achieving competitiveness through price stability and efficiency. In the Philippines, peso-dollar trading among Bankers Association of the Philippines (BAP) member-banks and between these banks and the BSP are done through the Philippine Dealing System (PDS). Most of the BAP-member banks which participate in the peso-dollar trading use an electronic platform called the Philippine Dealing and Exchange Corp. (PDEx). The BAP appointed PDEx as the official service provider for the US Dollar (USD) / Philippine Peso (PHP) spot trading (which involve the purchase or sale of the US dollar for immediate delivery, i.e., within one day for US dollars), and Reuters, as the exclusive distributor of all PDEx data. Trading through the PDEx allows nearly instantaneous transmission of price information and trade confirmations. Meanwhile, banks which do not subscribe to PDEx can continue to deal peso-dollar spot transactions via their Reuters Dealing screens. ## DERIVATIVE SECURITY MARKETS Derivative security markets are markets in which derivative securities trade. A derivative security is a financial security (such as a futures contract, option contract, swap contract, or mortgaged-backed security) whose payoff is linked to another, previously issued security such as a security traded in capital or foreign exchange markets. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security to be exchanged changes, the value of the derivative security changes. ## FINANCIAL MARKET REGULATION Financial instruments are subject to regulations imposed by regulatory agencies such as the Securities and Exchange Commission (SEC). Its function is to formulate policies and recommendations on issues concerning the securities market, advise Congress and other government agencies on all aspects of the securities market and propose legislation and amendments thereto (Section 5 of the Securities Regulation Code, Rep. Act. 8799). The Securities Regulation Code (SRC) or Republic Act (RA) 8799 in 2000 provided for the SEC reorganization to give greater focus on the Commission's role in capital market development, fostering good corporate governance (CG) and enhancing investor protection. The SRC also provided for the transfer of the Commission's jurisdiction over all cases enumerated under Section 5 of PD 902-A to the Courts of general jurisdiction or the appropriate Regional Trial Court. The SRC also defined in clear terms fraud and criminal offenses related to securities transactions, and strengthened SEC regulatory functions over all entities dealing in securities such as Self-Regulatory Organizations (SROs) or the Philippine Stock Exchange (PSE), Philippine Dealing and Exchange Corporation (PDEx) and Capital Market Integrity Corporation; as well as market professionals such as brokers and dealers, among others. ## OVERVIEW OF FINANCIAL INSTITUTIONS Financial institutions (e.g., commercial and savings banks, credit unions, insurance companies, mutual funds) perform the essential function of channeling funds from those with surplus funds to those with shortages of funds. ### Types of Financial Institutions - **Commercial banks** - depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial banks' loans are broader in range, including consumer, commercial, and real estate loans, than are those of other depository institutions. Commercial banks' liabilities include more nondeposit sources of funds, such as subordinate notes and debentures, than to those of other depository institutions. - **Thrifts** - depository institutions in the form of savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. - **Insurance companies** - financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, and so on. - **Securities firms and investment banks** - financial institutions that help firms issue securities and engage in related activities such as securities brokerage and securities trading. - **Finance companies** - financial intermediaries that make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits but instead rely on short and long-term debt for funding. - **Investment funds** - financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets. - **Pension funds** - financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation. In this economy without financial institutions, the level of funds flowing between suppliers of funds and users of funds is likely to be quite low. There are several reasons for this. 1. Suppliers of funds need to monitor continuously the use of their funds. 2. The relatively long-term nature of many financial claims (e.g., mortgages, corporate stock, and bonds) creates another disincentive for suppliers of funds to hold the direct financial claims issued by users of funds. 3. By allowing fund suppliers to trade financial securities among themselves, fund suppliers face a price risk upon the sale of securities. ## Services Performed by Financial Institutions ### Services Benefiting Suppliers of Funds: - **Monitoring costs** - aggregation of funds in an FI provides greater incentive to collect a firm's information and monitor actions. The relatively large size of the Fl allows this collection of information to be accomplished at a lower average cost (economies of scale). - **Liquidity and price risk** - Fls provide financial claims to household savers with superior liquidity attributes and with lower price risk. - **Transaction cost services** - similar to economies of scale in information production costs, an FI's size can result in economies of scale in transaction costs. - **Maturity intermediation** - Fis can better bear the risk of mismatching the maturities of their assets and liabilities. - **Denomination intermediation** - Fis such as mutual funds allow small investors to overcome constraints to buying assets imposed by large minimum denomination size. ### Services Benefiting the Overall Economy: - **Money supply transmission** - depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the economy in general. - **Credit allocation** - FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy, such as farming and residential real estate. - **Intergenerational wealth transfers** - Fls especially life insurance companies and pension funds, provide savers with the ability to transfer wealth from one generation to the next. - **Payment services** - the efficiency with which depository institutions provide payment services directly benefits the economy. ## REGULATION OF FINANCIAL INSTITUTIONS The financial services industry in the Philippines is supervised by three agencies, namely, the BSP, the Securities and Exchange Commission (SEC) and the Insurance Commission (IC). The BSP supervises banks, quasi-banks, their financial allied subsidiaries and affiliates (except insurance companies); nonstock savings and loan associations; and pawnshops. In addition, the Philippine Deposit Insurance Corporation (PDIC) monitors banks in accordance with its role as the deposit insurer. The SEC oversees investment houses, financing companies, securities dealers/brokers, and investment companies. Finally, the IC supervises insurance and reinsurance companies, insurance brokers, mutual benefit associations, and pre-need companies. ## GLOBALIZATION OF FINANCIAL MARKETS AND INSTITUTIONS Global markets are markets in which the law of one price applies, in the sense that it would be possible to buy or sell products for the same price irrespective of geographical location and local circumstances. When products are purchased and sold outside national boundaries, price differentials may remain as long as there are costs specifically associated with cross-border exchange as opposed to exchange within national boundaries. Hence, the process of internationalisation of financial markets is only a step towards global financial markets. This distinction between globalisation and internationalisation seems to apply to financial markets as well as to markets for goods and non-financial services. Financial globalization could, in principle, help to raise the growth rate in developing countries through a number of channels. Some of these directly affect the determinants of economic growth (augmentation of domestic savings, reduction in the cost of capital, transfer of technology from advanced to developing countries, and development of domestic financial sectors). Indirect channels, which in some cases could be even more important than the direct ones, include increased production specialization owing to better risk management, and improvements in both macroeconomic policies and institutions induced by the competitive pressures or the "discipline effect" of globalization. The pandemic has been a watershed not just for the Philippine financial industry, but also globally, with mobility restrictions creating a surge in demand for contactless financial services that traditional banking alone was unable to fulfil. This situation has prompted a pivot to digital finance. Existing providers are expanding their digital offerings in response to an increase in awareness and adoption of such services by customers, and more proactive promotion of the services by the government. These changes will profoundly reshape and usher in a new era for the Philippine financial industry. The COVID-19 pandemic has undoubtedly quickened the financial digitalization trend in the Philippines. Such changes are likely to continue and even speed up when the pandemic is over. Efforts made in improving the policy frameworks and infrastructures will mitigate risks, and the growing awareness of the public to digital financial services will significantly improve market readiness for the mass deployment of fintech applications. Embracing the rapid digital transformation process will help drive financial inclusiveness, improve user experience, and deliver benefits such as convenience and efficiency - to everyone in the country. **Fintech: the natural response to a quarantined economy** Health policies, fiscal policies and stimulus packages have been drafted across South-East Asia and globally to cushion the rapidly deepening economic recession. ASEAN countries provided stimulus budget packages averaging about 6% of their GDP, according to data from the Centre for Strategic and International Studies, SEA COVID-19 Tracker. ASEAN member countries generally focused their stimulus packages on health, cash transfers, SME aid, tax breaks and financing loans. However the massive problems for every aspect of society caused by a fast-spreading virus and global lockdown could not be solved by government aid. One of the main roadblocks hindering the impact of stimulus packages for small businesses has been challenges to their implementation. Delivering incentives to all sectors of the economy was a nightmare. Imagine disbursing money to millions of eligible businesses and individuals claiming cash benefits while safeguarding your health and trying to avoid the contagion. Soon, large private businesses committed to securing food supplies and donating personal protective equipment, medical supplies, alcohol and hand sanitizers, and food; as well as setting up their own quarantine facilities. In Malaysia, a telecommunication conglomerate, Axiata Group and its subsidiaries launched an RM150 million (~$35 million) cash fund for financial assistance to MSMEs through a micro-financing service. During the global lockdown, MSMEs needed Financial Technology (fintech) to keep business operations going. FinTech companies also provided an intrinsic relief to business owners that were at risk of getting sick by continuing to operate manually. It wasn't simply the 24-hour convenience that brought FinTech into the limelight but that it simply eliminated the risk of COVID-19 exposure for many people. ## Review Questions: 1. What is the significance of financial markets in the Philippine economy? 2. Differentiate primary markets from secondary markets. 3. What is the role of the financial institutions? 4. How can you say that our country participates in the global market? **[Image Description: The document is a set of notes that are written on 8 sheets of paper. The document is a lecture from Mater Dei College about Financial Markets and its impact on the Philippine economy. The document covers the different kinds of financial markets, their functions and institutions, and how the COVID-19 pandemic has impacted financial markets in the Philippines. The document includes diagrams and tables.]**