Financial Systems and Markets PDF

BM2004 Overview of Financial Systems and Markets Nature of Financial System Finance draws its theoretical foundation from the field of economics, and for th...

BM2004 Overview of Financial Systems and Markets Nature of Financial System Finance draws its theoretical foundation from the field of economics, and for this reason, it is often referred to as financial economics. However, the tools used in financial decision making are drawn from many areas outside economics, and accountancy is one of them. Accounting, which deals in providing quantitative information, primarily financial, integrates with economics and another discipline by requiring an in-depth analysis of the transaction and even financial results. This enables them to provide a reasonable opinion which among the courses of action should be considered. So, where does the financial system come in? Finance provides the framework for making decisions as to how funds are obtained and invested. The financial system, on the other hand, provides the platform by which those funds are transferred from entities that have funds to those entities that need funds. Sources of Wealth From the above, you have learned that finance provides the framework in decision making in obtaining and investing funds, making it a key player in ensuring continuity of operations in the world of commerce. But how does it obtain funds? It is by generating money or wealth. In economics, there are different sources of wealth. Figure 1 shows the sources or origin of wealth and the type of wealth that can be obtained from them. Labor Salaries Wages Entreprenuership Land Profit Rent Capital Interest Figure 1. Origin of Wealth Source: Fundamentals of Financial Markets, 2019, p. 8 How does the above figure works? Labor through hard work will allow a person to earn a salary or wage. As the person continuously earns, he can save and eventually acquire land which may be used in his business or be leased to someone else, which will ultimately generate wealth in the form of rent. As land and labor become profitable, he will start aiming for a higher return, thus venturing to higher risk. He starts to invest his capital either in financial or industrial, which makes him an investor. As the venture realizes good returns, the capital will earn interest. Moreover, when the business matures and grows, it needs more focus; thus, he will eventually take active participation in the venture. Then, from being an investor, he becomes the entrepreneur, which requires entrepreneurial skills in managing commercial affairs and ensuring that the company continuously grow and generate profit. Profits will be accumulated, and investment will be diversified as it grows, a new breed of 01 Handout 1 *Property of STI  [email protected] Page 1 of 8  BM2004 individuals and labor force will now be employed, and the cycle goes on. That is how finance plays in a system called business. (Lascano, Baron, & Cachero, 2019) The Flow of Funds As stated, the financial system provides the platform by which funds are transferred from those entities that have funds to those entities that need funds to invest. The generated funds from the various sources of wealth will now flow in the financial system, as shown in Figure 2. INDIRECT FINANCE FUNDS FUNDS Financial Intermediaries Lenders Borrowers 1. Household 1. Business FUNDS Financial FUNDS 2. Business 2. Government 3. Government Markets 3. Households 4. Foreigners 4. Foreigners DIRECT FINANCE Figure 2. The Flow of Funds Source: Fundamentals of Financial Markets, 2019, p. 10 The primary lenders, otherwise known as savers, investors, fund providers, and surplus units, are the households, business firms, government, and foreigners who received more money than they spend. The excess of the money they received over the money they spent is called savings. They lend out the said savings to other entities for a required return. On the other end are the borrowers, otherwise known as spenders, fund demanders, and deficit units, who are primarily composed of business firms and governments. They spend more money than they received; thus, they need to borrow funds from the lenders. Businesses borrow funds to support growth and expansion while the governments use the funds to finance infrastructure and other community projects. There are two (2) routes where funds can be transferred from the lenders to the borrowers: direct and indirect financing. Direct financing is the route where fund demanders borrow directly from the fund providers by selling financial instruments in the financial markets. Indirect financing, on the other hand, is the route where borrowing between both parties happens indirectly through the intervention of another party called the financial intermediary. Example: Cathy maintains a savings account in Bank of the Philippine Islands (BPI). BPI uses her money and the money of other depositors to loan to other individuals and organizations. Thus, it makes Cathy and other depositors as lenders; other individuals and organizations as borrowers; and BPI as the financial intermediary. Moreover, 01 Handout 1 *Property of STI  [email protected] Page 2 of 8  BM2004 the funds are transferred through indirect financing. However, if Cathy decided to loan her money directly to a business or other individual, then the funds are transferred through direct financing. Elements of the Financial System Financial system is a set of arrangements or conventions embracing the lending and borrowing of funds by non-financial economic units and the intermediation of this function by financial intermediaries. The purpose of which is to facilitate the transfer of funds, to create additional money when required, and to create markets of debt and equity instruments (and their derivatives) so that the price and allocation of funds are determined efficiently. (Faure, 2013) Below are the seven (7) essential elements of the financial system: 1. Lenders and borrowers (Who are the players?) – They are the non-financial economic units that undertake the lending and borrowing process. Lenders – Also known as fund providers, they are parties that have excess funds that they can lend out to other entities for a required return. Borrowers – Also known as fund demanders, they are the parties who are willing to pay the required return to obtain additional funds to finance their investment initiative. 2. Financial intermediaries (How will the exchange occur?) – They intermediate the lending and borrowing process. They gather funds from lenders and redistribute them to borrowers through an investment vehicle like loans. 3. Financial Instrument (What will be used?) – It is the medium of exchange of a contractual obligation of a party, where such a contract can be traded. These can be marketable or non-marketable. 4. Financial Markets (Where will it be traded?) – They are the economic market where the suppliers and buyers meet. 5. Regulatory Environment (How is it controlled?) – It is the governing body that ensures the compliance of transactions that occur within the financial system with the laws and regulations imposed on the actors as well as the elements that play within. 6. Creation of money (What is the value created?) - With the flow of financial instruments, money is created. Then, the money is either reinvested or earned out of the system flows. 7. Price discovery (How much is created?) – It is the process of determining or valuing the financial instrument in the market. In addition to the above essential elements, given below, are also allied participants/players/entities in a financial system, without which the system would not function. 1. Brokers and Dealers – They are members of financial intermediaries that facilitate the trade of financial instruments. Some examples of brokers-dealers in the Philippines are COL Financial Group, Inc., BPI Securities Corporation, BDO Nomura Securities, Inc., and First Metro Securities Brokerage Corporation. 2. Fund Managers – They are corporate entities or departments of financial intermediaries that manage funds on behalf of principals (owners or holders of money). Some examples of fund managers in the country are BPI- Asset Management & Trust Corp (BPI-AMTC); BDO Unibank, Inc. (BDO); BSP Provident Fund Office (BSPPFO); and Land Bank of the Philippines (LBP). 3. Financial Exchanges – They allow the broker-dealers to facilitate trading in securities, and create a mechanism for clearing and settlement of trades in a risk-minimizing manner. The national exchange in the country is the Philippine Stock Exchange (PSE). 4. Credit Rating Agencies – They analyze relevant financial and economic data about the issuers of securities and assign ratings to the securities reflecting the probability of the issuers meeting their 01 Handout 1 *Property of STI  [email protected] Page 3 of 8  BM2004 financial obligations (interest and principal). The three (3) major rating companies are Standard & Poor’s Corporation (S&P), Moody’s Investor Service, and Fitch Ratings. Nature of Financial Markets The financial market refers to channels or places where funds and financial instruments such as stocks, bonds, and other securities are exchanged between willing individuals and/or entities. Popular examples of financial markets are the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotation (Nasdaq), and the Philippine Stock Exchange (PSE). (Lascano, Baron, & Cachero, 2019) There are three (3) major economic functions of financial markets: 1. Price Determination or Price Discovery – This refers to the interaction between buyers and sellers in the financial market wherein price is set at the level the buyers are willing to buy, and the sellers are willing to sell, to come up with the price of the traded financial instrument. Example: Hanna Hartendorp sells her 10,000 shares from Aboitiz Equity Venture at the Philippine Stock Exchange (PSE). Initially, the shares were offered at a spot price of P150.00 per share. Many buyers offer to buy the said shares; thus, increasing the price of each share at P180.00 (increase in demand results to a rise in price). The shares were sold at the agreed price of P175.00. 2. Liquidity – Financial markets serve as a forum where holders can sell their financial instruments to other investors to earn cash. Easy access to a venue where investors can sell financial instruments for cash offers liquidity to the investors. Liquidity is significant because without it, an investor will be forced to hold the financial instrument, and the seller will not be contractually obligated to pay, up until such time when the conditions in the agreement to dispose or sell the instrument, respectively, happens. Example: Santi Corporation plans to increase its production of cleanroom products. The plan will eventually increase the needed raw materials. To finance the materials, Santi Company may just enter in the money market and issue its instrument, rather than personally searching for a company to buy it. 3. Reduction in Transaction Costs – The financial markets reduce the cost of asymmetric information between the buyer and the seller, specifically in terms of economies of scale and expertise. Economies of scale can be achieved when the company has cheaper access to capital. Asymmetric information occurs when one party to an economic transaction possesses greater material knowledge than the other party. Example: Lite Shipping Incorporated plans to add six (6) vessels that will serve passengers from Bohol to Cagayan De Oro City. The Chief of Financial Officer (CFO) of the shipping line is looking for a possible financial instrument to be issued in financing the plan. Instead of establishing an in-house department to look for potential investment, the CFO may just enter in a financial market. Entering the market will reduce the cost of information in evaluating the characteristics of an instrument (e.g., profitability, marketability, liquidity, etc.). Moreover, it will also eliminate the search cost in advertising its intent to sell a financial instrument. 01 Handout 1 *Property of STI  [email protected] Page 4 of 8  BM2004 Types of Financial Markets Financial markets are classified depending on the transactions that are being observed or the exchange that is done, to whom it is traded, the market where it is traded, the manner how it is traded, and the perspective of the country. (Lascano, Baron, & Cachero, 2019) A. Based on Market Type 1. Primary Market - The type of financial market wherein fund demanders such as a corporation or a government agency raises funds through new issuances of financial instruments. Usually, transactions in the primary market are coursed through investment banks. Investment banks are financial institutions that act as intermediaries between fund demanders (borrowers) and fund providers (lenders). They provide advice to providers on matters related to prices of the securities, transaction cost, and the number of securities to be issued, based on their fund needs. Through the assistance of an investment bank, the issuer reduces the risk and the cost of establishing a market for its securities. Moreover, investment banks are the ones who are already responsible for the proper execution of the issues such as legal and exchange requirements, appointments of lawyers and auditors, etc. Investment banks also perform underwriting. Underwriting means that investment banks guarantee the price for the securities of the issuing company, and then sell them to the general public. Moreover, most of the time, underwriters are appointed for public offerings. They provide an undertaking to purchase the remaining securities if the offer will not be fully subscribed by the public, thus giving comfort to potential investors as they are willing to take the risk of guaranteeing those securities. There are four (4) issue methods that can be done in the primary markets: a. Public Offering – This occurs when securities are offered for sale to the general public. It is done by issuing a prospectus or placing a document that contains an offer to the general public to purchase or subscribe to the securities at a stated price. The process of selling the shares of private companies to the public, for the first time, is called initial public offering (IPO). A public offering can either be an offer for sale or offer for subscription. Offer for sale – The existing potential shareholders invite potential subscribers to buy a portion of the shares they own. The proceeds from this offer are enjoyed by the current shareholders and not by the company. Offer for a subscription – The general public is invited to subscribe to unissued shares of the company. The proceeds from this offer are enjoyed by the company and can be used to finance their investment activities. b. Limited public offer – This is also known as a private placement. It is when the issuer looks for a single investor, an institutional buyer or group of buyers, instead of offering the securities to the general public. However, because of very limited parties, securities sold through private placements tend to be illiquid, which are not easily converted into cash. One form of a private placement is that an underwriter subscribes to all securities at a specific price and, consequently, sells them to a group of investors at a higher price. The difference between the two (2) prices is termed as underwriting spread. c. Auction – It is usually used for issuance of treasury bills, bonds, and other securities issued by the government and are commonly executed exclusively with market makers. It can be done in three (3) methods. 01 Handout 1 *Property of STI  [email protected] Page 5 of 8  BM2004 Dutch Auction – Type of auction where the seller begins the sale at a high price. The price is continuously lowered down at specific intervals until the potential buyer agrees to purchase the securities. English Auction – Type of auction where the prospective buyers commence the auction by submitting an initial bid price. Other buyers who are interested in purchasing the securities submit a new bid to top the previous one. The bidding stops when no other bidders want to top the last bid. The last highest bid price becomes the price of the securities that the highest bidder should pay. Descending Price Sealed Auction – Type of auction where bidders submit sealed bids to the sellers. The sealed bids are ranked from highest to lowest price. The number of securities is allocated first to the highest bid price and follows a descending order. The highest bid price receives full allocation while the lower bids receive pro-rata allocations. d. Tap Issue – It occurs when issuers are open to receive bids for their securities at all times. They maintain the right to accept or reject the bid prices based on how much funds they needed and when they need the funds. 2. Secondary market - The type of financial market wherein the securities issued in the primary market are subsequently traded. It also becomes a centralized marketplace wherein buyers and sellers can quickly and efficiently transact with each other allowing them to save on search and information as they do not need to look for transactions on their own. The original issuer of the financial instrument is not involved in the subsequent transactions in the secondary market. Although they are not involved, they benefit from the transactions by acquiring an idea of how much is the fair market value of their securities. Moreover, the market price of the securities also gives the issuers an idea of how they are effectively and efficiently using the funds obtained from the securities issuance and as well as how much funds the subsequent debt or equity issuances can raise for the firm. Also, securities that are traded in the secondary market are perceived to be more liquid; thus, issuing firms can easily sell more securities in the future as investors will find it to be more desirable. There are two (2) classifications of secondary markets according to market structure. a. Order-Driven Market Structure - It is also known as the auction market wherein the buyers and sellers propose their price through their brokers who convey the bid in a centralized location. The securities will be awarded to the buyer with the same offer price as the selling price of the seller. These are the types of orders in an order-driven market structure: i. Day orders – Orders that are only valid until the end of the business day. All orders not executed at the end of the day will be canceled and removed from the system. ii. Limit orders – Orders where clients set a price or price range that may be below or above the existing price. iii. Good-till-canceled order – Orders that last until they are completed or canceled within a sustained period. iv. Market orders – Orders that are placed under broker-dealers. The client relies on the expertise and integrity of the broker-dealer to execute deals when the current price is considered best. b. Quote-Driven Market Structure – This is also known as the primary dealer market or market- made market. In this structure, market makers play a major role. Market makers are dealers who 01 Handout 1 *Property of STI  [email protected] Page 6 of 8  BM2004 create a market by establishing a bid quote and an offer quote. Bid quote or bid price represents the highest price an investor is willing to pay for a security, while offer quote or ask price represents the price that an investor is willing to sell the security for. Generally, the bid quote is lower than the offer quote, and their difference, which is called the spread, becomes the profit of the market makers. B. Based on Where the Instruments are Traded Generally, primary and secondary markets can also be classified on where the financial instruments are traded, it is either by over-the-counter or exchange. a. Over-the-counter (OTC) – This is the place where in addition to listed securities, unlisted financial instruments are allowed to be traded. This market does not have a trading floor. Instead, the buy and sell orders are completed through a communication network such as the National Association of Securities Dealers Automated Quotations (Nasdaq), Instinet, Selectnet, and Bloomberg Trade book. b. Exchanges – They are centralized trading locations where financial instruments are purchased or sold between market participants. To be traded, all instruments must be listed by the organized exchange. To reiterate, the national exchange in the country is the PSE. C. Based on Instruments Traded 1. Money Market – It is the sector of the financial markets where financial instruments that have short term maturity or be redeemed in one (1) year or less from the date of issuance, are traded. It caters funds to demanders who need short-term funds from fund providers who have excess short-term funds. The traded financial instrument in a money market is also known as money market securities, which are debt securities that have a maturity of one year or less. Because of its associated maturity, these securities have a relatively high degree of liquidity with a low degree of credit (default) risk. The common types of money market securities that are traded include Treasury Bills, Commercial Papers (issued by corporations), Certificates of Deposit (issued by depository institutions), Repurchase agreement, and Banker’s acceptances. Why is the money market important for fund demanders and providers? It is for the reason that immediate cash requirements of fund demanders (e.g., individuals, government, and corporations) do not necessarily coincide with the timing of their cash receipts. For example, cash receipts from sales of a corporation do not take place at the same pattern of their salaries, utilities, and other expenses. On the other hand, for fund providers, holding excessive cash generates opportunity cost in the form of foregone interest. 2. Capital Market – It is the sector of the financial markets where financial instruments that have a long- term maturity or will mature beyond one (1) year from the date of issuance, are traded. Capital market securities are classified into two (2): equity and debt. a. Equity – Stocks or equity securities represent a share of ownership in the corporations that issue them. They are classified as capital market securities because they have no maturity, and therefore, they serve as a long-term source of funds. b. Debt – Debt securities refer to debt instruments such as government bonds, corporate bonds, certificates of deposit, municipal bond or preferred stock, that can be bought or sold between two (2) parties. 01 Handout 1 *Property of STI  [email protected] Page 7 of 8  BM2004 The price of securities in an efficient market, which is a product of the interaction between buyers and sellers in the market, is believed to be a fair estimate of its real value. D. Based on the Country’s Perspective 1. Internal or National Market – This is the financial market that is operating in a certain country. It can be divided into two (2): a. Domestic Market –The issuers who are considered residents in a country, issue securities, and afterward trade them inside their country. For example, a Philippine company issues and trades securities within the Philippines. b. Foreign Market – The issuers who are residents of a country issue securities, and subsequently trade them on that country. For example, a US company issues and trades securities within the Philippines. 2. External Market – This is the financial market where securities that have two (2) unique characteristics are being traded. a. Upon issuance, these securities are offered simultaneously to investors in different countries. b. Securities are issued outside the regulatory jurisdiction of any single country. E. Based on the Manner of Financial Intermediaries 1. Broker Market – The buyer and seller of the securities are brought together by a broker in the market and the trade occurs. In the Philippines, the sole broker market is the Philippine Stock Exchange (PSE). 2. Dealer Market – The market makers (dealers who create a market by offering to sell or buy securities) execute the sell or buy orders. The seller sells his securities to a market maker and the buyer buys from the market maker. References: Faure, A. (2013). Financial System: An introduction to financial markets (1st Ed). https://phavi.umcs.pl/at/attachments/2017/0405/133257-financial-system-an-introduction.pdf Lascano, M. V., Baron, H. C., & Cachero, A. T. (2019). Fundamentals of financial markets. n.p Madura, J. (2020). Financial markets and institutions. Cengage Learning. 01 Handout 1 *Property of STI  [email protected] Page 8 of 8