CHAPTER 2 FINANCIAL MARKETS Believe you can and you've halfway there. Theodore Roosevelt <% . Bs ollie = aalll A om oe Ah iepS Manners INTRODUCTION At the forefront of secondary securities transactions in the Philippines is the Philippine Stock Exchange (PSE). PSE was formed from the country’s two former stock exchanges, the Manila Stock Exchange (MSE), established on August 8, 1927 and the Makati Stock Exchange (MkSE), established on May 27, 1963. Although both MSE and MKSE traded the same stocks of the same companies, the bourses were separate stock exchanges for nearly 30 years until December 23, 1992 when both exchanges were unified to become the present-day PSE. In June 1998, SEC granted PSE a self-regulatory organization (SRO) status, which means that the bourse can implement its own rules and establish penalties on erring trading Participants (TPs) and listed companies. In 2001, one year after the enactment of the Securities Regulation Code, PSE was transformed from a non-profit, non-stock, member. Boverned organization into a shareholder-based, revenue-earning corporation headed by a President and a Board of Directors. (PSE.com.ph 2016) In the advent of increased trade and globalization, the need for facilities, like PSE, and Systems that will enhance availability of funds are of utmost importance. Individuals and business institutions need funds to finance their needs. These needs Bive rise to the clamor for sources to fund financial activities. On the other hand, those with excess funds need to find ways and means to make their savings earn. Money in one’s hand does not earn anything. This need required the facilities and system that will help them make profitable investments. tis in this light that financial markets evolved. In this chapter, students will learn about financial markets, primary markets, secondary | __ Markets, money markets, and capital markets. They will be acquainted with the different money markets and the different capital markets. In addition, market for government securities (GS) will be discussed. Market offerings and private placements will be differentiated. The students will also have a preview of the different money market and capital market instruments dealt with in these markets, which will be discussed fully in the next chapter. FINANCIAL MARKETS: DEFINITION Financial markets are structures through which funds flow. They are the institutions and systems that facilitate transactions in all types of financial claim. A financial claim entitles a Creditor to receive payment from a debtor in circumstances specified in a contract between them, oral or written. Depositors have financial claims on banks where they hold their deposits; bondholders have financial claims on companies issuing the bonds they hold, Financial markets are the meeting place for those with excess funds (investors or lenders referred to as surplus/ Savings units) and those who need funds (borrowers or issuers of securities referred to as deficit units). Savings from households and businesses are channeled to those individuals and businesses which need the funds. The needs of deficit units and surplus units gave rise . to financial markets. Financial markets are at the heart of financial system determining the volume of credit available, attracting savings, and setting interest rates and security prices (Rose 1994),Cuaprer 2: FINANCIAL MARKETS Financial markets are classified as either (1) primary or secondary market or (2) money or capital market. Although we have other classifications of financial markets, these two are the basic classifications of financial markets. PRIMARY MARKETS Financial claims are initially sold by deficit units in primary markets. Primary markets are markets in which users of funds (e.g., corporations) raise funds, through mew issues of financial instruments such as stocks and bonds (Saunders and Cornett 2011). They consist of underwriters, issuers, and instruments involved in buying and selling original or new issues of securities referred to as primary securities. In other words, primary markets are markets for primary securities (new issues of financial instruments like stocks and bonds). They raise cash for the issuing company, which acts as borrower by increasing its current capital stock when it issues stocks, or outstanding liabilities when it issues bonds. The government also acts as a borrower when it issues bonds or Treasury bills. The primary market transaction involves either equity security (stock) or debt security (bond). These new issues are issued to initial suppliers of funds or investors. The following figures depict primary market transactions. The corporation needing funds issues new or original issues of either stocks or bonds directly to the investors (Figure 8) or to underwriters/financial intermediaries (Figure 9) who in turn sell them to the investors. Financial intermediary acts as the middleman or bridge that will satisfy the needs of the deficit units and the surplus units. Deficit Units Borrowers/Users of Funds flow pera ae funds; Corporations oranges issuing peviorers) Households and issues of stocks or eri meses bonds Figure 8: Primary Markets Involving Direct Selling (Without an Intermediary) Deficit Units : Borrowers/Users of Surplus Units funds; Corporations Underwriters Initial supplier of Investment/ funds; Households Merchant banks and businesses intermediary (investors) Issuing new/original issues of stocks or bonds Legend: Funds flow <——— Securities flow = ———__________» Figure 9: Primary Markets Involving an IntermediaryMost primary market transactions are done through investment banks, also called ‘merchant banks, which help the corporations issuing the stocks or bonds sell these stocks or bonds to interested investors. Investment or merchant banks purchase shares issued by the issuing company in an underwriting transaction and then sell these issues to the public. ‘An underwriter guarantees the sale of the issues, but does not intend to hold the shares or bonds in his own account. However, if the issue is unsuccessful and public investors refuse to purchase the issues, the underwriter carries the issues as its own investment, while waiting for more favorable market conditions. Investment banks provide the following services: 1. Provide funds in advance (giving cash to the issuer based on the agreed price of the security, usually a certain percentage of the total agreed price) Give advice to issuing corporations as to the price and number of securities to issue Attract the 2y 3. ial public purchasers of the securities 4. Act asa market analyst and advisor to the issuing company 5. Absorb the risk and cost of creating a market for the securities Primary market issues are generally for public offerings or publicly traded securities like stocks of companies already selling stocks in the stock market or stock exchanges. If these companies need additional funds, they create new issues to raise the firm’s capitalization or create new issues of bonds or debt instruments, thereby increasing its outstanding liabilities to meet the need for the funds. First-time issues for the public are called initial public offerings (IPOs). At times, it takes several investment banks to undertake such issues. Primary market securities also include the issue of additional equity or debt instruments of an already publicly traded firm. SEC requires corporate borrowers in the money market to register their issues unless they are specifically exempted from doing so (Chapter III, Sections 9 and 10 of the Securities Regulation Code). Prior to registering with the SEC, a company seeks a credit rating from the Credit Information Bureau. Rather than public offering, primary market sale can also take the form of private placement, particularly for closed corporations, that is, corporations whose stocks are only sold to family or a few close friends, relatives, and other private individuals. In addition, in private placement, the corporation issuing the stocks or bonds may seek to find an institutional buyer—such as a pension fund or group of buyers to purchase the whole issue. Merchant banks conduct private sale of shares to a few individuals or institutions but a vigorous and broad-based secondary market requires an efficiently operating securities exchange. Stocks | of closed companies are not publicly traded. These banks remain under the management and control of private companies and individuals. Larger companies, on the other hand, like the San Miguel Corporation, PLDT, Petron, Yahoo, and Google are publicly traded in large volumes.SECONDARY MARKETS Once financial instruments are issued in primary markets, they are then traded in secondary markets. Secondary markets are like used car markets. Secondary markets are markets for currently outstanding securities, referred to as secondary securities. These securities were previously bought and owned and now being resold either by the initial investors or those who have purchased securities in the secondary market. Secondary markets provide liquidity for investors as they sell their financial securities when they need cash. All transactions after the initial issue in the primary market are done in the secondary markets. For instance, A owns stocks initially issued by Co. X and later on sells these Co. X stocks to B; the sale of A to B or anyone else is done in the secondary market. Transactions in the stock and bond market exchanges are secondary market transactions. Shares held by the public are termed outstanding shares or securities. They do not increase the capital stock of the original issuing company or its outstanding liabilities unlike in primary market transactions. Secondary markets only transfer ownership, but do not affect the total outstanding shares or securities in the market. Only when the issuing corporations redeem bonds or retire stocks will outstanding shares or securities be reduced. Redemption of bonds decreases total outstanding , debt securities in the market and at the same time reduces the outstanding liabilities of the issuing company. Retirement of stocks reduces the total outstanding equity securities in the market and the outstanding capital of the issuing corporation. Transfer of ownership does not affect the volume of these securities in the market. The securities simply change hands. Secondary markets transfer shares, but do not raise funds for companies which issued the securities. They do not affect the issuing company, except to transfer ownership of the stocks or bonds in its books for purposes of dividend or interest payments, respectively. Figure 10 depicts secondary market transactions: Financial Markets (Owners Securities of outstanding Other Suppliers of Funds (Buyers erokers of outstanding, securities: Investors) securities: investors) Dealers Legend! Funds flow <¢ Securities flow > Figure 10: Secondary Market Secondary Securities Offered for SaleSecondary markets exist for the purpose of marketability or ea8¥ selling/transfer of ownership and liquidity or easy convertibility to cash of securities. Marketable securities ea classified in the balance sheet as cash equivalents because of these characteristics. The role of the secondary market is to assure that a holder can sell and convert to cash his security at any time. departments that are major Commercial banks have trust departments and treasury i d money market and capital players in the secondary market. Trust departments recommen pit market securities for their clients. Treasury departments carry inventories of market securities as part of the bank's trading portfolio. Investment houses, finance companies, insurance companies, and other financial institutions are also leading participants in the secondary market. Other than the financial institutions mentioned, securities brokers and securities dealers are included among the ones dealing in secondary markets. Securities dealer is a financial institution organized usually as a corporation or a partnership, which principal business is to buy and sell securities, whether registered or exempt from registration for the dealer’s own account or the client's. Before dealing in securities, a securities dealer is required to obtain a license from SEC pursuant to the Revised Securities Act. Security dealers buy the securities as their assets and resell them. They earn from the difference of the cost and the selling price of the sold securities. Securities brokers do not buy for their own account. Their earnings are mere commissions. Security brokers find the purchasers for the securities that others wish to sell. These are done in the secondary markets. The securities exchange serves the following purposes: 1. Provides marketability by allowing savers to sell their securities immediately 2. — Provides liquidity by raising cash any time 3. _ Provides valuation by serving as a means for determining current values of shares and ultimately of companies The value of the companies’ shares reflects the companies’ own value or worth. It generally reflects the value of stockholders’ holdings/wealth. The higher the value of the shares in the exchange, the better the companies will be in the eyes of investors, reflecting good company performance. This is the reason investors follow the values of stocks listed in the exchanges. MONEY MARKETS Money markets cover markets for short-term debt instruments, usually issued by companies with high credit standing. They consist of a network of institutions and facilities for trading debt securities with a maturity of one year or less (Saldana 1997). They are markets in which commercial banks and other businesses adjust their liquidity position by borrowin lending, or investing for short periods of time (Kidwell et al. 2013). The government acid uses money markets to finance its day-to-day operations. Business and households res Use money markets to borrow and lend. Money market instruments that generally have short maturities are highly liquid and have low default risk. There is no formally ‘orgenizedNANCIAL MARKETS HAPTER 2 exchange for money markets such as PSE. Dealers and brokers are at the core of money market transactions, At the trading room of dealers and brokers, when the market is open, these rooms are characterized by tension and a frenzy of activities. Each trader sits in front of phones and computers that link the dealer/broker to other dealers/brokers and their major customers. Only debt securities are short-term. Stocks or equity securities are long-term and therefore dealt with in the capital market. Short-term means a period of one year or less. These securities usually comprise of short-term Treasury bills (T-bills) issued by the government, bankers’ acceptances, negotiable certificates of deposit, money market deposit accounts (MMDAs), money market mutual funds (MMMFs), and commercial papers (CPs). These are often termed marketable securities because they are highly marketable and highly liquid. They are issued by companies needing short-term funds and bought by investors with short-term excess funds. Those who buy these securities have excess funds in the short-term needing to convert the same quickly to cash as the need arises. These securities give higher yields than cash in the bank and have relatively low risk of default, particularly those issued by the government. Individual investors deal with these securities indirectly through the help of financial intermediaries. Being short-term, these securities are at low risk of interest rate changes. Money market securities are traded in massive quantities. Working capital needs like purchase of inventories, payment of operating expenses, and among others are met in the money markets. Major participants are electronically linked all over the United States and in major European and Asian financial centers. Money markets are also distinct from other financial markets because they are wholesale markets and because there are large transactions involved. Although some small transactions do take place, most involve $1 million or more (Kidwell et al. 2013). Most money market transactions are referred to as open market transactions due to their impersonal and competitive nature. Open market transaction is an order placed by an insider after all appropriate documentation has been filed, to buy or sell restricted securities openly in an exchange. The Philippine money market started in 1965 primarily as a facility for trading excess funds among commercial banks (Saldana 1997). The Bangko Sentral ng Pilipinas (BSP) requires banks to maintain a daily minimum cash reserve with them set as a percentage of deposit liabilities. Other than the level of cash reserves, BSP has certain strict requirements on banks. Banks with temporary cash surpluses led commercial banks to set up the money market as an auction house for excess reserves. It is called the interbank call market, a money market. Similarly, small bank deficits are funded through the money market. This allows banks to correct their reserve position in the interbank call loan market. Interbank call loans are credits of one bank to another for a period not exceeding 4 days. The 4-day limit is based on the BSP regulation and beyond this period, BSP presumes that a bank could not fund its assets from its deposit, that is, the bank is in trouble. Interbank call loans are treated as deposit substitutes. Deposit substitutes are alternative ways of getting money from the public other than traditional bank deposits. They are borrowings by commercial banks from the public through other banks or money market. Later on, other companies learned to borrow through the market for their temporary cash requirements.AARKETS pur in May 1972 by the Chicago tional financial derivatives, ‘on interest rates and stock 1M trade derivatives on the nment bond, and the U.S. The International Monetary Market (IMM) was opened i Mercantile Exchange (CME) pioneering the trading of internal most notably futures. It later expanded into trading derivatives indexes before fully merging with the CME in 1986. Today, the IMI London Interbank Offered Rate (LIBOR), the 10-year Japanese gover e Consumer Price index (CP). It has developed an index to price interest-rate futures This index has become a standard for pricing all interest-based financial futures and is known 3& the IMM Index. It gives a price to securities that were previously quoted only by yield into price-quoted, and vice-versa, The IMM Index has since become a standard for pricing all interest-based financial futures. country’s central bank to provide liquidity le at premiums to a bank's target rates, rol. These are called repo rates, and they ‘at which the central bank of a country shortfall of funds. Repo rate is used by allow participants to undertake rapid In financial crisis situations, itis the duty of the to stabilize markets. This is because risk may tradi called money rates that central bankers cannot cont are traded through the IMM. Repo rate is the rate lends money to commercial banks in the event of any monetary authorities to control inflation. Repo market: refinancing in the interbank market independent of credit limits to stabilize the system. A repurchase agreement (repo) is a sale of securities for cash with a commitment to repurchase them ata specified price at a future date. A borrower pledges securitized assets such as stocks in exchange for cash to allow its operations to continue. Asian governments, banks, and businesses need to facilitate business and trade in a faster way rather than borrowing US dollar deposits from European banks; hence, Asian money markets linked up with the IMM. Asian banks, like European banks, were saddled with dollar-denominated deposits because all trades were dollar-denominated as a result of the Us dollar's dominance. So, extra trades were needed to facilitate trade in other currencies, particularly euros. Asia and the EU would go on to share not only an explosion of trade but also two of the most widely traded world currencies on the IMM. For this reason, the Japanese yen is quoted in US dollars, while eurodollar futures are quoted based on the IMM Index, a function of the three-month LIBOR. The IMM Index base of 100 is subtracted from the 3-month LIBOR to ensure that bid prices are below the ask price. These are normal procedures used in other widely traded instruments on the IMM to insure market stabilization LIBOR is the benchmark interest rate that banks in the London money market are prepared to lend to one another for overnight, 1-month, 3-month, 6-month, and 1-year | Itis the benchmark for bank rates all over the world. It is also the most common oft rea interest rate indexes used to make adjustments to adjustable rate loans, including In ar only mortgages and credit card debt, as well as for interest rate swaps and c ‘i set swaps. These are a form of insurance against the default ofloans Lendercrv nea nado or two to create a profit, lers typically add a point LIBOR is calculated and published by ICE Benchmark Administrat Reuters each day at 11 a.m. in five currencies—the Swiss franc, euro, pound dit erie taee Rises and falls in the LIBOR interest rates en fs ee intrest ates in alot of banking products such a8 savings accounts, mortgages, and iaanet , MM switched from a non-profit to a profit, membership and shareholder. ition and published byCuarrer 2: FrvanciaL MARKETS owned entity. It opens for trading at 8:20 EST to reflect major US economic releases reported at 8:30 a.m. Banks, central bankers, multinational corporations, traders, speculators, and other institutions all use its various products to borrow, lend, trade, profit, finance, speculate, and hedge risks. (Twomey 2009) In the Philippine money market, trading of government securities is regularly observed. The following discussion relative to government securities is from the Bureau of the Treasury's official website. The Philippine Government issues two kinds of government securities: Treasury bills (T-bills) and Treasury bonds (T-bonds), so-called because it is the Bureau of the Treasury which originates their sale to the investing public through a network of licensed dealers. Government agencies, local governments, and government-owned or controlled corporations may float securities but these are not labeled as treasuries. Government securities are no longer certificated; they are known as “scripless,” just like in USA, Canada, China, and Korea. GS discounts or coupons are subject to 20 percent final income tax which is withheld upon floatation of T-bills or upon payment of the coupon for T-bonds. No other tax is imposed on the secondary market buyer. Tbills are government securities which mature in less than a year. There are three tenors of T-bills: (1) 91-day, (2) 182-day, and (3) 364-day bills. The number of days is based on the universal practice around the world of ensuring that the bills mature on a business day. T-bills are quoted either by their yield rate, which is the discount, or by their price based on 100 points per unit. Tbonds are government securities which mature beyond one year. At present, there are five maturities of bonds: (1) 2-year, (2) 5-year, (3) 7-year, (4) 10-year, and (5) 20-year. These are sold at its face value on origination. The yield is represented by the coupons, expressed as a percentage of the face value on per annum basis, payable semi-annually. Tbills are sold at a discount (less than the principal); hence, the yield to the investor is the difference between the purchase price and the principal. On the other hand, T-bonds are sold at face value (the amount of the principal) and are coupon bonds; that is, they bear coupons, which represent the interest on the principal and are presented when claiming interest payments on interest payment dates. The Automated Debt Auction Processing System (ADAPS) is an electronic mode by which the national government sells government securities to a network of government securities eligible dealers (GSEDs) which are linked to BTR using Bridge Information Systems (BIS), every Monday for T-bills and every second and fourth Tuesday for T-bonds, whereby GSEDs tender their bids (both competitive and non-competitive) by keying-in the amount (minimum of 10M) and yield of their choice for a maximum of seven competitive bids and one non- competitive bid per tenor for any amount above P10M using a BIS terminal in the GSED office. Within seconds, the bids are arrayed by the System in the terminals of the BTR. After the cut- off time of 1:00 PM, the array is viewed by the Auction Committee, which then decides on the award. The award is keyed-back to the respective terminals of GSEDs. GSED is a SEC-licensed securities dealer belonging to a service industry supervised/ regulated by Government (SEC, Bangko Sentral ng Pilipinas, or Insurance Commission) whichZAPITAL MARK _ has met the (1) ®100M unimpaired capital and surpl lus account, (2) the statutory ratios Prescribed for the industry, and (3) has the infrastructure for an electronic interfaces devs after the auction, the government securities are credited to the Securities Principal Account of the GSED in the Registry of Scripless Securities (RoSS) an \d the Demand Deposit Account of the GSED at the Bangko Sentral ng Pilipinas is debited in favor of the Treasurer of the Philepines for the cost of the government securities awarded to the GSED concerned. This eae eres e trade in the primary market. This is also known as origination of GS as shown in Figure PRIMARY MARKET (GSEDs ADAPS accept is fom 00am t0100 pm ATCO pm. the bs are ‘arayed by the system from he west othe highest ye ‘SECONDARY MARKET I i re emt et cn Procesung Sytem "ADAPS" RoSS System prepares the Daty Statement of Secures Report and the Trade Report for Setlement GSEDe (GSEDs hey he ids through ther own Dow shones terminate sel ‘Aucton Commie confirms ‘he decsion and awards are eyed back to he GSEDs (GSED GSED elecroncaly "pont secondary rade ‘through Dow JonesCuarrer 2: Financial MARKETS Over-the-counter (OTC) non-formally organized markets are another mode of originating GS for specific investors, namely, the government-owned or controlled corporations (GOCCs), the local government units (LGUs), and the tax-exempt institutions (TEls), such as pension funds, GSIS, SSS, etc. It is non-competitive. OTC is open every day. The applicable yield rates for T-bills issued to GOCCs/LGUs/TEls shall be priced based on the rate of the immediately preceding TB auction. For GOCCs, the rate shall be the lowest accepted yield rate; for LGUs, the weighted average yield rate; and for TEls, the yield shall be 90% of the weighted average yield rate. T-bonds issued to GOCCs/LGUs/TEIs shall be priced based on the current market yield. The coupon rate for GOCCs and LGUs shall be based on the rate corresponding to the auctioned T-bonds. The applicable coupon rate for TEls shall be based on the 90% of the coupon rate. ROSS is the official registry of absolute ownership, legal, or beneficial titles or interest in GS (T-bills and T-bonds). Upon award of GS to GSEDs at ‘the auction, the securities awards are electronically downloaded to the RoSS system. On issue date, the Principal Securities Accounts of the GSEDs are credited of the winning bids. The GS trades are entered by both parties in their respective trading terminals using their confidential identification and password and to activate the system and authorize every transfer instruction between 9:30 a.m. to 1:30 p.m. The RoSS system checks the securities in the seller’s securities account and earmarks these for transfer. The system then sends an electronic settlement file to BSP containing the amount to be debited and credited to the Regular Demand Deposit Account (RDDA) of the buyer and seller. Once settlement is processed, the BSP Philippine Payment and Settlement System (PhilPASS) will send back a file message that settlement was done and the RoSS system will now transfer the earmarked securities from the seller securities account to the buyer securities account. A posted message will then be sent back by RoSS to the system provider. Securities and cash settlement of GS transaction to the secondary market is done via delivery-versus-payment (DVP) mechanism on a Real Time Gross trade for trade basis. Cut- off time for peso funding in the PhilPASS is until 2:00 p.m. All transactions which have been unsettled after the 2:00 p.m. cut-off time will be declared failed transaction and the earmarking on the company securities at RoSS will be lifted. Yield is the increment or interest on an investment in GS. It is the discount earned on Treasury bills or the coupon paid to the holder of Treasury bonds. Both the discount and the coupon are expressed as a percentage of the value of the GS on a per annum basis. Conventionally, the yields on longer-dated GS are higher than the yields of shorter-dated GS. Competitive bid is a tender to buy an amount of GS at an indicated yield rate per annum that a GSED believes will wrest an award for the GSED by out-bidding other GSEDs in the primary market auction of GS. A non-competitive bid is a tender to buy a specified amount of GS by a GSED in the primary auction of GS, without indicating any yield rate, on the understanding that the award shall be at the weighted average yield rate of the competitive bids awarded at the same auction.Capra, Markers —— Price discrimination or English auction is a method in which successful competitive bidders pay the price they have bid, and all the winning bidders may pay different prices. Uniform price or Dutch auction is a method of pegging a uniform coupon rate of a T-bond at the stop-out level of arrayed amounts of bid with the corresponding yield rate tendered. Conventionally, the rate must be divisible by one-eighth of 1%. Settlement of trades is the payment process both in the primary and secondary markets for GS traded. Settlement of trades is undertaken by BSP being authorized by GSEDs to debit their respective demand deposit accounts with BSP in favor of the demand deposit account of the Treasurer of the Philippines or their counterparty GSED also with BSP or vice-versa. Price of a GS is the value based on 100 points per unit. T-bills are conventionally in terms of the discount rate, while T-bonds are quoted in terms of the coupon rate or the price. If a T-bond is quoted in terms of its price, the price is either at a discount, at par, or at a premium and the coupon is a rate in relation to the maturity date of the bond. Withholding tax is equal to 20% on the discount. To determine the discount yield of a T-bill, the following formula is used (adapted from Saunders and Cornett 2011): 360 t where — d, = Discount yield P, = Face value of the T-bill P, = Purchase price of the T-bill t = Term of the Till . ‘Assume a 182-day 10,000 T-bill maturing on October 5, 2016 purchased for 9,846.67. g -PoPe 360 Ve t =P 10,000-79,846.67_ 360 10,000 182 = £15333. _ 91533 x 1.978 = 3.032% 10,000 uy determine the semi-annual coupon payments on T-bonds, the following formula is used: where K = Coupon P, = Face value of the T-bill i = Coupon rate m = Number of conversions per year‘Assume a 100,000 bond with a coupon rate of 4.69% paying interest semi-annually (m = 2). The semi-annual coupon amount on the T-bond will be: 0} k = 100,000 x —(4:59%) = 100, —_ = P100,000 .02345 = £2,345 Take note that the computation of the coupon on a bond is simply the formula for computing interest, which is |= P rt; hence, the coupon payment on the above bond will be: 1 o=PrTt = P'100,000 x 4.96% x 180/360 = 100,000 x 4,96% x % = P2,345 To determine the amount of tax on the discount or coupon, the formula is as follows: T =d(r) or K(r) where T=Tax d= Discount K = Coupon r= Tax rate Using our foregoing examples, the 10,000 182-day T-bill bought at 9,846.67 and the 100,000 T-bond that earned ®2,345 semi-annual coupon payment, the tax on the discount or coupon considering a withholding tax of 20% on the discount will be: T =d(r) or K(r) = (P:10,000 - ®9,846.67)(20%) + (P2,345)(20%) = £30.67 + P469 = P499.67 Other than government securities, investors also place their money in Eurodollar certificates of deposits, primarily for the big commercial banks, insurance companies, and other financial institutions. Because of the importance of the dollar as an international medium of exchange, foreign governments and financial institutions, like banks, hold a store of funds denominated in dollars outside of the United States. Moreover, US corporations conducting international trade often hold US dollar deposits in foreign banks overseas as Eurodollar deposits or Eurodollar CDs. Eurodollar certificates of deposits are US-dollar-denominated CDsCapitan Markets in foreign banks. Maturities of Eurodollar CDs are less than 1 year, and most have a maturity | of week to 6 months. The market in which these Eurodollar deposits are traded is called ‘the Eurodollar market, a type of money market. Eurodollars may be held by governments, Corporations, and other investors from anywhere in the world. These Eurodollar deposits are not subject to US bank regulations because they are not in the US. As a result, the rates Paid on Eurodollar CDs are generally higher than that paid on US-domiciled CDs (Sanders and Cornett 2007). | The rate for Eurodollar funds is known as the London Interbank Offered Rate or LIBOR. Funds traded in the Eurodollar market are an alternative to the federal funds in the United States and the interbank call loan in the Philippines used as a source of overnight funding for banks. As such, the federal funds rate and LIBOR are closely associated. If the LIBOR rate is | lower than the federal rate, institutions borrow from the LIBOR market than the federal fund. |__ These changes in interest rates make one market desired over the other. Investors go to the | Market with the higher interest rates. In fact, the LIBOR rate is often used by US financial __ institutions and other worldwide institutions in their commercial and industrial loans. The | UBOR rate has been widely used as a reference rate. However, because US bank deposits are less risky than foreign bank deposits and are covered by deposit insurance.up to a certain |__ level, US financial institutions still prefer the federal funds over Eurodollar CDs. Maturities on | Eurodollar CDs are less than one year mostly 1 week to 6 months. These CDs, because they | _ are in foreign banks and outside the US, are not subject to the reserve requirements as the | Fegular deposit accounts in the US. Adjustable rate loans in the US are generally tied up to the US federal funds rate. However, the vigorous growth of the Eurodollar market has caused LIBOR to become the standard rate by which loan rates are now priced. | CAPITAL MARKETS Capital markets are markets for long-term securities. Long-term securities are either |_ debt securities (notes, bonds, mortgages, leases) or equity securities (stocks). Major suppliers | of capital market securities are corporations for stocks and corporation and governments for Capital markets are composed of stock market for & markets for debt securities, mortgage market for mortga | derivative securities markets, direct loan market, and lease quity or stock securities, bond es, foreign exchange markets, market, among others, term excess funds meet, and financial leases; cor, term Treasury notes and bonds, These long-term securities corpbrate stocks and bonds; and Security ‘exchanges, over-the-counter _ Include long-term loans, mortgages, government lon;Carrer 2: Financial S loose network of security traders known as broker-dealer, dealers, and brokers. The capital market consists of: 1. securities market; and 2. negotiated (or non-securities) market. Securities Market In securities market, companies issue common stocks or bonds, which are marketable/ negotiable, to obtain long-term funds. An instrument that is transferable by endorsement oF delivery is negotiable. Negotiability allows securities to be traded anonymously. The identity of the seller need not be known. Negotiability improves liquidity because anyone who holds the security can immediately sell the security when the holder needs cash. The holder can even sell the security prior to maturity. Securities market is composed of: 1, _ stock market for equity or stock securities; 2. bond market for debt securities; and 3. derivative securities market for securities deriving their value from another security. ‘Stock Market Stock market serves as the medium or agent of exchange transactions dealing with equity securities. Itinvolves institutions and analysts who review the performance of listed companies. When companies are successful in their operations and investments, analysts recommend buying of their stocks creating demand and increasing share prices and shareholders’ wealth. Shareholders can penalize poor management of companies by selling off their holdings driving share prices down. All markets follow the basic economic law of supply and demand. If there are a lot of shares of any one company in the market, its prices go down. The scarcity of the shares drives the share prices up. If many are buying the stocks, it creates demand and raises prices up. Classifying stocks into boards enabled PSE to calculate stock indexes (indices) for each group. A stock index is a measure of the price level of the shares listed in the exchange by the indicated category. Index reflects the prices of selected stocks. It is useful as a track record of changes in stock prices over time. PSE tracks four indices: commercial and industrial, property, mining, and oil. The overall index, which is called the Philippine stock index (Phisix), is a composite of the four indices. (Saldana 1997) Saldana (1997) listed the following prices in a trading day: 1. Open—the stock price for the first transaction at the start of trading day 2. Low— the lowest stock price for transactions during the day 3. _ High - the highest stock price for transactions during the day 4, . Close ~ the stock price for the last transaction of the dayCaprtat MARKETS: ifthe closing price is higher than the opening price, there will be an upward trend in the price of the stock. This is especially when the opening price coincides with the low price and the high price with the closing price. A wide difference in the low and high price indicates high volatility and therefore, risk in investment in the stock, that is, the more volatile a stock is, the more risky it will be. Index also reports price movements of groups and the entire market. Other indicators of the market are changes in averages and price movements of stocks according to the number of stocks that increased in price (advances) or decreased in price (declines) PSE also reports the volume of shares traded. Other reported data are the price range during the year, earnings per share, and dividends per share. Earnings per share and dividends per share are important to stockholders and potential stockholders because they depict the return that stockholders will get in investing in a patticular stock. The higher they are, the more enticing the stocks will be to current and potential stockholders. However, a company’s stock price does not represent the value of the stock as an investment. The value of the stock is the relationship between the benefits and the cost of the stock. The value of a stock is determined by various methods, but generally based on the return on equity or return on invested capital. The benefits are in terms of cash or stock dividends and the relationship of these benefits to the cost is the value of the stock. The benefits of investing in stocks are the income in terms of dividends, and increases in prices of the stock, called capital gain. The yield or cash yield of the stock is the ratio of cash dividends to stock price. Price-earnings (PE) ratio is the ratio of stock price to earnings per share. Bond Market Bond market is the market where bonds are issued and traded. It is generally classified into: 1. Treasury notes and bonds market; 2. municipal bonds market; and 3. corporate bonds market. Treasury notes and bonds are issued by the government's treasury. Like T-bills, T-notes and T-bonds are backed by the full faith and credit of the government and are therefore free from risks. As a result, they pay relatively low rates of interest (yields to maturity) to investors. However, because of longer maturity, they are subject to wider price fluctuation than money market instruments and therefore subject to interest rate risk. In contrast to T-bills that sell at a discount, T-notes and T-bonds pay coupon interest semi-annually..They have maturities of over 1 to 10 years. Municipal bond (LGU) is an important financial instrument for development. In the Philippines, LGU bonds have only recently been acknowledged as a potential tool for development. LGU bond reduces the dependence of LGUs on the national government in implementing their development programs, and most importantly, transparent good governance among local government executives while attracting private institutional capital and Providing the i alternative long-term investment instrument. encourages and rewards LGU bond does all these investing public with anAPTER 2: FINANCIAL MARKETS Corporate bonds are long-term bonds issued by private corporations. Bond indenture is the legal contract that specifies the rights and obligations of bond issuer and bondholders (investors), term of the bond, interest rate, and interest payment dates. It may include such term as the ability of the issuer to call the bond or redeem bonds prior to maturity, and restrictions on the issuer’s dividend payments, among others. Derivative Securities Market The term “derivative” is commonly used to describe a type of security which market value is directly related to or derived from another traded security. Derivative securities market refers to the market where derivative securities are traded. Derivative securities are financial instruments which payoffs are linked to another, previously issued securities. They represent agreements between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price 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. Option, futures, and forward contracts are examples of derivatives as well as stock warrants, swap agreements, mortgage-backed securities, and other more exotic variations. While derivative securities have been in existence for centuries, the growth in derivative security markets occurred mainly in the 1990s and 2000s (Saunders and Cornett 2011). An example of a derivative would be a call option on a company’s stock. The most important determinant of the price of the option is the current price of the company’s shares (the underlying asset) in the open market. Futures contracts would also allow a farmer to keep his product (e.g., rice) until some time in the future, yet remain in the current price at the time of harvest. The contract would, in effect, sell off the price uncertainty to someone in the market who is willing to hold it. In this case, the farmer has hedged his risk of a price drop. The person who accepts the risk is engaged in the practice of speculation. It was the need for this type of transaction that spawned the first derivative securities markets. Another example would be the mortgage-backed securities, which are instruments that are secured/ guaranteed by mortgages. Capital markets and money markets include the exchanges where securities or financial instruments are traded or sold. These exchanges can be formally organized or informally organized (OTC). Organized security exchanges are like the PSE and other international stock exchanges, including ASX, SZSE, National Stock Exchange of India (NSE), OSE, American Stock Exchange (AMEX), and Nasdaq Stock Market of the United States. There are also electronic exchanges like the US Futures Exchange (USFE), Bats, and Boston Equities Exchange. Negotiated/Non-Securities Market Negotiated or non-securities market does not involve securities, thus called non- securities markef. This is so-called negotiated because it results from negotiation between a borrower and a lender. It includes a direct loan by a company or a person from a lending institution, like a bank. Also, a personal loan that someone asks from a parent or a relatives. negotiated loan occurring in a negotiated market. A negotiated market is where the ee the seller deal with each other, either directly or indirectly through a broker or dealef with regard to both price and volume. Buyers and sellers are given sufficient time to locate one 43CAPITAL Markers another to do the trade. Borrowing transactions that are large in volume may not be easily traded in the auction market, instead these are done in the negotiated market. If 2 company needs ®3M to expand its manufacturing facilities, it can go to its bank where it maintains its current or checking account. Generally, banks grant their depositors, especially companies and big individual depositors, lines of credit up to a certain limit, for example P5M or P10M, depending on the average amount of deposits they have with the bank. The larger the averag fe amount of deposit a depositor has with a bank, the higher the line of credit the depositor is granted. Suppose the company needing ®3M has a line of credit with its bank. It can borrow ®3M from that bank if the amount is within its line of credit. If its line of credit is ‘only ®2M, then it can only borrow ®2M maximum. The loan agreement is called term loan agreement. A term loan agreement is an agreement between a borrower and a lender for a definite period of time, hence the word “term.” Term of the loan is the length of period from the date the loan is taken to its maturity date, the date the loan is to be repaid. The loan is non-negotiable and therefore less liquid than capital issues like shares and bonds that can be merely endorsed and transferred because they are negotiable. The loan is a negotiated loan, but non-negotiable. When the company needs more than its credit line, the resort it can have is to issue additional shares of stocks or bonds in the capital market if the company is big and prominent or well known. While all corporations are empowered to sell stocks and bonds in the open market, not all are able to do so. Only corporations of high credit standing and are well known in the business community can sell their stocks and bonds in the open market. It would be very difficult for a small company to do this. A small company does not have the capital, credit standing, and connections that big companies have. A direct loan from a bank is part of the capital market and still the predominant means of financing, especially for a developing country like the Philippines. This is because only Prominent and outstanding and well-known companies can issue securities. Small companies and individuals cannot issue these securities. Consequently, smaller companies still borrow directly from banks and other financial institutions. The disadvantage of a term loan agreement is the higher cost of financing borne by the borrowing company as compared to borrowing in the open markets. A direct loan has a higher cost because only one borrower shoulders the cost. In the open market, costs are shared by several participants. IF the amount of financing or funds needed is large, instead of borrowing from a single bank, a syndicated loan can be obtained from a group of banks called a syndicate. The SM Megamall in Pasig was financed by a P1 billion loan from a bank syndicate headed by PNB (Saldana 1997). Long-term loans usually require stockholders to personally guarantee the loan. When these companies become in default and the stockholders are personally liable, the lender(s) can run after the personal assets of the stockholders, The negotiated or non-securities market includes, but is not limited to, the following: hy loan market 3. lease market - « jortgage marketLoan Market Loan market is where a one-on-one transaction takes place between a borrower and a lender. As in the foregoing example, a loan by an individual or company from a bank is a direct loan transaction and an example of a loan market. Even the government negotiates with the World Bank for certain types of loans. Mortgage Market Mortgage market is where a real property (property with more or less permanent life, like land (residential, agricultural, or industrial), building (residential, commercial, etc.), and big machineries, among others are used to guarantee or secure big loans. It is also a type of loan, but a secured loan guaranteed by the mortgage on the property. At times, a mortgage is used as a means of buying properties. Those who want to own properties go to a bank or mortgage company and get the loan to buy the property then use the property as the collateral for the loan, that is, the company mortgages the property. The mortgage market also includes the market for foreclosed properties. These are the properties that are taken by lenders because the borrowers were unable to pay their loan and since the property is used as the collateral for the loan, the property is taken over by the lender. Other than banks and other financial institutions, government agencies like the National Home Mortgage Finance Corporation (NHMFC), Government Service Insurance System, Social Security System, and Pag-IBIG HDMF grant mortgage loans that belong to the capital market. Lease Market Lease market is where equipment, building, or other property is being leased/rented out to another party. The one who owns the property and who is renting the property out is the lessor and the party who is to use the property in exchange of the rent or lease is the lessee. The lease could be an operating lease or a capital lease. OTHER MARKETS Other markets are a combination of the money and capital markets, because they deal with both short- and long-term loans and securities. These may include the following: 1. Consumer Credit Market Consumer credit market involves parties and transactions related to loans granted to households who desire to buy properties, such as cars or appliances, travel, obtain education for themselves or their loved ones, or other similar needs. It is called consumer credit market because the borrowers are the consumers. Consumer credit usually takes the form of character loan, car loan, appliance loan, educational loan, and among others. They can be short-term, like character loans, or longer-term like car loans (usually five years), or appliance loans (usually three years). These can also include pawnshops, SSS pension lending companies, and other, smalh. consumer loan companies.‘eeeeeererreereeecereee Garrat Markers they belong to the money market. If long, leases, real estate loans could extend elonging to the capital market, When the loans involved are short-term, they belong to the capital market. Mortgage loans, up to five or ten years or even up to 15 or 30 years, thus b banks, credit unions, savings and loan These loans ai lly granted by ; uments he SSS lending agencies, which lend out associations, and even lending agencies like t : money to SSS pensioners, These lending agencies get the ATM cards of the pensioners, which the pensioners use to get their pensions (directly deposited by the Social Security System to their deposit accounts). The lending agencies then get the payment for the loan obtained by the pensioners directly from their ATM accounts. The ATM card is returned to the pensioner upon full payment of the loan. These are safe (default-free) loans, as far as the lending agencies are concerned, because they get direct access to the pensioner’s money for payment of the loan obtained Pawnshops also belong to this market. They are, in effect, granting short-term loans to people who pawn their jewelry and other items the pawnshops would accept as security for the loan. If the pawned item is not redeemed within usually one year, the pawned item is taken by the pawnshop and then resold in an auction or sale that the pawnshop generally does on a yearly basis. Organized Market Organized markets are the exchanges. Exchanges, whether stock markets or derivatives exchanges, started as physical places where trading took place. Some of the best-known organized markets are NYSE, which was formed in 1792, and the’ Chicago Board of Trade (now part of the CME Group), which has been trading futures contracts since 1851. Today, there are more than a hundred stock and derivatives exchanges throughout the developed and developing world (Dodd 2016). Exchanges are situated in a certain location with definite rules of trading. Exchanges have members and a governing board. Members have seats in the exchange and seat gives the member the right to trade in the exchange. Non-members cannot trade in the exchange. Over-the-Counter (OTC) Market - Unlike exchanges, OTC markets have never been a “place.” They are less formal although often well-organized networks of trading relationships centered on ates more dealers. Dealers act as market makers by quoting prices at which the vil al or buy to other dealers and to their clients or customers. It does not mean oat ter May quote the same prices to other dealers as they post to customers, and th do a necessarily quote the same prices to all customers. Moreover, dealers in an ae oe = can withdraw from market making at any time, which can cause liquidi Sa disrupting the ability of market participants to buy Se eee ee or sell. Exchan ' because all buy and sell orders as well as executio Serene ud Nn prices are exposed to one another.OTC markets are less transparent and operate with fewer rules than do exchanges. All of the securities and derivatives involved in the financial turmoil that began with a 2007 breakdown in the US mortgage market were traded in OTC markets. (Dodd 2016) There are a few dealers who hold inventories of OTC securities that act as a securities market. Included in the OTCs are brokers who act as agents in bringing together dealers and investors. OTCs cannot function without the computers, terminals, and electronic networks that facilitate transaction or trade between and among dealers, brokers, and investors. Auction Market Auction market is where the trading is done by an independent third party matching prices on orders received to buy and sell a particular security. Stocks are sold to the highest bidder on the trading floors. The highest bidder is the one who offered the highest price for a particular security. It is where buyers and sellers are brought together directly, announcing the prices at which they are willing to buy or sell securities. PSE is an example. At the PSE, buyers of securities make their bid and sellers make their offer. Each one makes counter-offers. Bids and offers stipulate both prices and volume and are handled by the third party, called the trader, an agent of the auction market. Counter-offers are matched with one another. If there is a match, the trade or sale is consummated. Buyers and sellers do not directly trade with each other, but all trades are done through the trader. The exchange is a noisy place as the offers are “shouted” by the participants. Foreign Exchange Markets Foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed. A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some other currency. In April 1992, the Bank of International Settlements (BIS) estimated the daily volume of trading on the foreign exchange market and its satellites (futures, options, and swaps) at more than USD1 trillion. This is about five to ten times the daily volume of international trade in goods and services. The foreign exchange market consists of two tiers: interbank or wholesale market and client or retail market. Individual transactions in the interbank market usually involve large sums that are multiples of a million USD or the equivalent value in other currencies. This is the interbank or wholesale market. By contrast, contracts between a bank and its client are usually for specific amounts, sometimes down to the last penny (Colorado.edu). This is the client or retail market. There are spot, forward, and future foreign exchange transactions in the foreign exchange markets.Caprrat MARKETS es iG) Spot Market Spot markets are called such because buying and selling is done “on the spot,” that is, for immediate delivery and payment. The buyer pays immediately and the seller delivers immediately. If you pick up your phone and ask your trader to buy you a certain stock, say PLDT stocks at today’s prices, that is a spot market transaction. You expect to acquire ownership of the PLOT stocks within minutes or hours (Rose 1994). On the spot, however, may mean one or two days to one week, depending on the practice in the particular place where the spot market is located/conducted In the foreign exchange market, where spot and forward transactions are done, spot foreign exchange transactions involve the exchange rate at the date of the transaction that is why it is called spot exchange transaction. If the exchange rate of dollar to peso is $1 = ®47, the spot transaction will compute it at that exchange rate. Therefore, if the transaction is for $20,000, the one buying the exchange contract will need 940,000 to consummate the contract. The spot market is the exact opposite of the futures market and forward market. Futures Market Unlike the spot market, futures market is where contracts are originated and traded that give the holder right to buy something in the future at a price specified in the contract. It is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily. This is the difference between a futures contract and a forward contract. In futures contract, the contract's price is adjusted each day as the price of the asset underlying futures contract changes and as the contract approaches expiration. While the value of the forward contract can change daily when the buyer and seller agree on the deal and the maturity date of the forward contract, cash payment from buyer to seller occurs only at the end of the contract period. In futures contract, because price is adjusted daily, actual daily cash settlements/ funds transfers occur between the buyer and seller in response to these price changes (called marking to market), but the final payoff is done when the contract matures. In essence, marking futures contracts to market ensures that both parties to the futures contract maintain sufficient funds in their account to guarantee the eventual final payoff actually done when the contract matures (Saunders and Cornett 2011). For the buyers of the futures contract, marking to market can result in unexpected payments from their account if the price of the futures contract moves against them (therefore loses), The opposite will happen ifthe price of the futures contract goes lower (i.e, the buyer gains). This is what happens in the foreign exchange futures market, Other than foreign exchange, a commodity such as wheat or a financial asset such as a T-bond may be purchased for future delivery. A futures contract like this is a formal agreement executed through a commodity exchan or securities in the future. One party agrees to accept a sp a specified quality in a specified month. The other party a ge for the delivery of goods 'ecific commodity that meets grees to deliver the specifiedCua FINANCIAL MARKET R commodity during the designated month. Each contract has a standardized expiration, and transactions occur in a centralized market. Futures contracts are entered into through brokers, like stocks and bonds. Brokerage firms own seats on the commodity exchange. Membership on each exchange is limited and only members are allowed to execute contracts. They are paid a commission. The price of the futures contract changes daily as the market value of the asset underlying the futures fluctuates. The price at the time of delivery will be the one to prevail. As previously explained, this is where the difference between the futures market and the forward market lies. In a forward market, the price is fixed at the time of entering into the forward contract. Price changes do not affect the price specified in the contract. In the futures market, the price prevailing at the Contract maturity will be the settlement price, whether it goes higher or lower since the time the futures contract was entered into. There are two participants in the futures markets: the speculators who establish anticipation of a price change and hedgers who employ futures to reduce the risk from Price changes. By hedging, the hedgers pass the risk to the speculators. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedgers enter into offsetting contracts. The buyer (speculator) takes the risk of market price change. Speculators are willing to accept substantial risk for the possibility of a large return. Speculation profits from betting on the direction where an asset will be moving. Speculators make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he may short sell the stock and wait for the price of the stock to decline, at which point he will buy back the stock and receive a profit. Unfavorable or adverse movements in prices can result in increased costs and lower profits and, in the case of financial instruments, reduced value and yield. Even modest changes in prices or interest rates can lead to signified changes in their net earnings. The hedger creates a situation in which any change in the market price of a commodity, security, or currency is exactly offset by a Profit or loss on the futures contract. This enables the hedger to lock in the price or yield what he wishes to earn. Hedging is similar to insurance. Insurance protects against risk to life and property, Hedging protects against the risk of fluctuations in market price of securities, commodity, or currency. The basic difference, however, is that insurance rests on the principle of risk distribution over a large group of policyholders; whereas, hedging does not reduce risk. It transfers the risk of unwanted changes in prices or interest rates from one investor to another. Insurance distributes risk; hedging transfers risk. Futures contracts are normally traded in organized markets like the New York Futures Exchange (NYFE), CBT, and Chicago Mercantile Exchange (CME). There are five major exchanges in the United States and several exchanges in other parts of the globe. Types of futures include T-bonds, T-notes, federal funds, Eurodollars, short sterling, Euro UBOR, Canadian bankers’ acceptances, Euroyen, and German Euro-government bonds. Currencies like the Japanese yen, Canadian dollar, British pound, Swiss franc, Australian dollar, Euro, and US dollars are the ones frequently dealt with in the foreign exchange futures market. A9Se | | Caprrat Markets Trading on the largest exchanges such as the CBT takes place in trading en Trading | pit consists of circular steps leading down to the center of the pit, where traders for each delivery date on a futures contract informally group together. Futures trading occurs using an open-outcry auction method, where traders face each other and “cry out” their offers to buy or sell a stated number of futures contracts at a stated price. Only futures exchange members are allowed to transact on the floor of futures exchanges. Traders from the public (non-members) are placed with a floor broker (exchange member), who is the one authorized to trade with another floor broker or with a professional trader. This is also what happens in any exchange, not only in the futures exchanges. Professional traders are also position traders, day traders, or scalpers who are specialists on the stock exchanges where they trade for their own account. Position traders take a position in the futures market based on their expectations about the future direction of prices of the underlying assets. Day traders generally take a position within a day and liquidate it before the day's end. Scalpers take positions for very short period of time, sometimes only minutes, in an attempt to profit from this active trading. They do not have obligation to provide liquidity to futures markets, but do so in expectation of earning a profit. Scalpers’ profits are related to the bid-ask spread and the length of time a position is held. Specifically, it has been found that scalper trades held longer than 3 minutes, and on average, produce losses to scalpers. Thus, this need for a Quick turnover of a scalper’s position enhances futures market liquidity and is therefore valuable (Saunders and Cornett 2007). Futures trades may be placed as market orders {instructing the floor broker to transact at the best price available) or limit orders (instructing the floor broker to transact at a specified price). The order may be for a purchase of the futures contract, in which the futures holder takes a long position in the futures contract, or the order may be for a sale of the futures contract in which the futures holder takes a short position in the futures contract. A long position means that the dealers purchase securities outright, take title to them, and will hold them in their portfolios as an investment, or until a customer comes along in the hope that prices will rise. In the context of an option, the buying of an options contract constitutes a long position. For example, an owner of shares in Jollibee Corporation is said to be “long Jollibee’s” or has a “lorig position in Jollibee’s.” Another example would be buying all or put options contract from an options writer entitled someone the right, not the obligation to buy a specific commodity or asset for a specified amount at a specified date. The sale of a borrowed security, commodity, or currency, with the expectation that the asset will fall in value, is taking a short position. In the c¢ value -ontext of options, it is the sale (also known as writing”) of an options contract. A short position means that will experience capital gains on other hand, if interest rate rises, the dealer’ i, a lealer’s lon, sition wil i i and the short position will post a gain, eP ane reMarkers Cuarrer 2: FINANcta Once a futures price is agreed upon in a trading pit, the buyer and seller do not complete the deal with each other, but rather with the clearing house overseeing the exchange. The exchange’s clearing house guarantees all trades made by exchange traders. Clearing houses break up every trade into a buy and sell transaction and take the opposite side of the transaction, that is, become the buyer for every futures contract seller, and the seller for every futures contract buyer. Thus, the clearing house ensures that all trading obligations are met. Clearing houses are able to perform their function as guarantor in an exchange’s futures contracts by requiring all member firms to deposit sufficient funds to ensure that the firm's customer will meet the term of any futures contract entered into the exchange. Forward Market Both the futures market and the forward market involve trading contracts calling for the future delivery of financial instruments, commodities, or currencies. If you call your broker today and ask him to purchase a contract for you from another investor calling for delivery to you of ®500,000 T-bonds 6 months from today, that could either be a futures contract or a forward contract. If the contract calls for a fixed price for delivery, for example in 6 months, it is a forward contract. You pay ®500,000 for the T-bonds you wish to purchase, irrespective of the price of the T-bonds on the date of delivery, that is, whether it goes up to, say 550,000 or down to ®450,000. The buyer still pays 500,000. Forward contracts are contractual agreements between a buyer and a seller at time zero (0) to exchange a pre-specified, non-standardized asset for cash at some later date. The forward contract guarantees a future price for the asset today, that is, the price of the forward contract is fixed over the life of the contract unlike the futures contract. The buyer simply wants to be assured that he will have the investment in his own time frame, say 6 months, with the amount of money that he has. Perhaps, he does not have the money right now, but will receive the amount in his time frame, that is, 6 months. Forward markets can be in the commodity market (gold, copper, oil, copra, and among others), the foreign currency market, and even in the interest rate (forward rate agreements or FRAs). Forward contracts involve non-standardized underlying assets, such that the terms of each market contract are negotiated individually between the buyer and the seller. The details of each forward contract, for example, price, expiration, size, and delivery date are unique. An example of a forward contract in the interest rate market would be a 3-month FRA written today with a notional value of 1 million and a contract rate of 6.5%. This means that the buyer of the FRA agrees to the seller to pay 6.5% in borrowing ®1 million starting 3 months from now. The seller of the FRA agrees to lend 1 million to the buyer at the 6.5% indicated in the contract starting 3 months from now. 51PE 7 Caprrat Markers If interest rates rise in the next 3 months, the FRA buyer gains from it. The FRA buyer can still borrow the #1 million at the indicated 6.5% rate rather than the higher, say 7% or 7.5% rate prevailing 3 months from now. If the rate goes down, however, the buyer pays the higher 6.5% interest instead of the lower, say 5% or 5.5% interest rate on the ®1 million he is borrowing. 9. Options Market Options market is where stock options are traded. This is the formal market where the options are bought and sold, and not when a stockholder is given the option or pre- emptive right to buy additional shares of stock to maintain his proportionate share or ‘ownership in a corporation. These options, given by the corporation to the stockholders, can be sold by the stockholders if they do not want to exercise the same. This gives rise to the options market. | Options market offers investors an opportunity to reduce risk by making the trading of options possible on selected stocks and bonds. These agreements give investors the right to buy from the writer of the option designated securities at a guaranteed price at any time during the life of the contract. Options are called warrants if they are issued by corporations, and calls if they are issued by individuals (Brown and Mayo 2015). These are rights, but they are not obligation, meaning, they can be exercised or not. Warrants and calls are the rights to buy, while put is the right to sell an underlying asset at a pre- specified price, called the exercise or strike price for a specified time period. In American- style option, the option can be exercised at any time prior and including the expiration date. In European-style option, the option can be exercised only on the expiration date (Kidwell et al. 2013). Options are derivatives; hence, the options market is a derivative market. Most frequently, the underlying investment on which an option is based is the equity shares ina publicly listed company. There are other underlying investments on which options can be based. This includes the stock indexes, exchange traded funds (ETFs), government Securities, and foreign currencies or commodities like agricultural or industrial products. Stock options contracts are for 100 shares of the underlying stock—an exception would be when there are adjustments for stock splits or mergers. Options Protect from interest rate risks. : Options are traded in securities marketplaces among institutional investors, individual investors, and professional traders, and trades can be for one contract or for many. Fractional contracts are not traded. An option contract is den s defi elements; lefined by the following a. type (put or call) b. underlying security © unit of trade (number of shares) d. strike price €. expiration dateAPTER 2: FINANCIAL MARKETS All option contracts that are of the same type and style and cover the same underlying security are referred to asa class of options. All options of the same class that also have the same unit of trade at the same strike price and expiration date are referred to as an option series. (Nasdaq.com) Options can be call options or put options. Call option gives the buyer the right to in underlying security or futures contract at a strike price. The writer of a call option agrees to sell the security or futures contract if the buyer exercises the option. The writer is the seller of the security. in return, the buyer of the call option must pay the writer an upfront fee known as a call premium of the call option. The call premium can be offset against any profit the buyer makes on the exercise of the option. Since the option is a right and not an obligation, the buyer can either exercise or not exercise the option. If the buyer is sure, he will make a profit—he exercises the option; if unsure, he does not exercise it and just lose in terms of the call premium that he initially paid. If you buy an option, you are buying a call option. The buyer of a call option is the investor. buy ar For example, a call option on X Corp. stocks with an exercise or strike price of P100 entitling the holder of the option to buy 100 shares on or before October 10, 201X. If he buys the shares, it will cost him 100 shares x 100 = 10,000. However, the buyer has to pay a call premium, say 1,000, to the agent immediately. His cost for the shares will go up by P1,000. The total cost for the 100 shares will then be (10,000 + 1,000) = 11,000, or P110/share: In other words, the call premium becomes the price for the option that is added to the cost of the shares at the strike price. If on or before the said date, the X Corp. shares are selling at ®120, the buyer of the call option already makes a profit of P10/share (P120 current price and #110 cost) and should make the buy. If the price of the shares had gone down below the strike price of #100 all the time until October 10, 201x, say P90, the buyer of the call option has the right to refuse to buy and loses the 1,000 call premium he paid to the agent. It is because, as previously stated, the option is a right and not an obligation. Apparently, he will not buy if the market price of the shares goes below the strike price of P100. At any time on or before October 10, 201X, the buyer will feel the market and buy at the exact time within the time frame when he feels that the price of the shares is at its highest, say #122 or 125. If he buys at a time when the price of the stocks is at 115, he still makes a profit of ®5/share. If he buys at a time that the price of the stocks is at P125, he makes a profit of 15. Option buyers only buy when it is profitable to do so. The following shows the difference between the parties in a call option and a put option: Call Option Put Option Writer of the option seller investor (of underlying security) (buyer of underlying security) Buyer of the option investor seller (buyer of underlying security) (of underlying security)10. Options are not only for stocks. Like the futures market, options may involve commodities like gold or copper and securities like T-bills or T-bonds. Options are traded in organized securities exchanges. Options not exercised expire and become worthless. Call options provide greater profits when stock prices are rising and so represent bullish investment vehicles. A market is bullish when stock prices are rising and bearish when stock prices are going down, ‘Swap Market Swaps are agreements between two parties (counterparties) in exchanging specified periodic cash flows in the future based on an underlying instrument or price (e.g., a fixed or floating rate on a bond or a note). Like forward, futures, and options, swaps allow firms to better manage their interest rate, foreign exchange, and credit risks. The swap market is where swaps are traded. There are five general types of swaps: a. Interest rate swaps d. Commodity swaps b. Currency swaps e. Equity swaps c. Credit risk swaps The asset or instrument underlying the swap may change, but the basic principle of a swap agreement is the same in that it involves the transacting parties restructuring their asset or liability cash flows in a preferred direction. To be specific, in an interest rate swap, two parties independently borrow the same amount of money from two different lenders, and then exchange interest Payments with each other for a stipulated period of time. In effect, each party helps to pay off all ora portion of the interest cost owed by the other firm. The result is usually lower interest expense for both parties and a better balance between cash inflows and outflows for both firms. The following figure from Rose (1994) will help enlighten how swaps work: Low-credit-rated borrower Pays long-term gets a short-term loan interest rate from its bank at a floating | + interest rate, but pays High-credit-rated borrower issues long- term bonds carrying a fixed interest rate, but out the fixed interest cost ‘on the long-term bonds + | pays out the floating sad Bras ear Pays short-term short-term interest rate interest rate owed by its swap partner Figure 12: Interest Rate SwapCuarrer 2: FINaNctat MARKETS Result: Both companies save on interest costs and better match the maturity structure of their assets and their liabilities. In reality, the two parties in the swap exchange only the net difference in their borrowing rates, with the party ‘owing the highest rate in the market on the payment date paying the other party the rate difference. 11. Third and Fourth Markets When securities that are listed in organized exchanges as NYSE, AMEX, and London Stock Exchange Group, among others are sold in over-the-counter market, they are referred to as the third market and fourth market. Third market refers to transactions between broker-dealers and large institutions. Fourth market refers to transactions that take place between securities firms and large institutional investors like pension funds and investment companies. These transactions involve large block trades. These markets have grown along with the growth of electronic communication networks (ECNs). Advantages of trading in these markets include speed, reduced trading costs, and anonymity. Third and fourth market transactions occur to avoid placing the orders through the main exchange and do away with the commissions that are paid to floor brokers, which can greatly affect the price of the security. TYPES OF INVESTORS Having studied the different types of markets, let us now study the different types of investors: 1. Risk-averse investors (bulls and chicken). They are the type of investors who, when faced with two investment alternatives with equal returns but one is riskier than the other, will choose the less risky investment. They prefer risk-free assets than risky assets as long as the expected returns on each asset are the same. In order for them to invest in a risky asset, they will require a higher return. 2. Risk-taker investors (bears and pigs). They are the investors who are ready to pay a higher price for an investment regardless of the risks involved. 3. Risk-neutral investors. They are investors who do not take into account the risks involved in the investment and who are focused only on the expected returns. In the stock market, there are what we call “bulls” and “bears.” When the market is showing confidence, that is, stock prices are going up and market indices like the Nasdaq go up, we have a bull market. The number of shares traded is also high and even the number of companies entering the stock market rises showing that the market is confident. Bull markets are most common in an expanding economy with low unemployment and inflation is somewhat constant. Technically, a bull market is a rise in the value of the market of at least 20%. The huge rise of the Dow and Nasdaq during the tech boom is a good example of a bull market. A bear market is the opposite of a bull market. It is when the economy is bad, recession is looming, and stock prices are falling. If a person is pessimistic and believes that stocks are going to drop, he is called a bear and said to have a “bearish outlook.” Bear markets make itCapra MARKETS tough for investors to pick profitable stocks. However, this is the time to make money using a technique called short selling. Short selling is a technique used by people who try to Profit from the falling price of a stock. Short selling is a very risky technique as it involves precise timing and goes contrary to the overall direction of the market. Assume you want to sell short 100 shares of a company because you believe sales are slowing and its earnings will drop. Your broker will borrow the shares from someone with the promise that you will return them later. You immediately sell the borrowed shares at the current market price. When the price of the shares drops, you “cover your short position” by buying back the shares, and your broker returns them to the lender. Your profit is the difference of the price at which you sold the stock and your cost to buy it back, minus the commissions and expenses in borrowing the stock. But if you were wrong, and the price of the shares increases, your potential losses are unlimited, Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market (Investorguide.com). Actually, it makes sense to buy when prices are low so your cost is low. Then, you wait until prices go up and that is the time for you to sell. When people say you are a chicken, it means you are scared easily. For investors, chickens are risk-averse investors whose fear overrides their need to make profits and so they turn only to money market securities or get out of the markets entirely. While it is true that you should never invest in something over which you lose sleep, avoiding the market completely and never taking any risk will not give you any return. Pigs are the opposite of risk-averse investors or chicken. They are high-risk investors looking for the one big score in a short period of time. Pigs buy on hot tips and invest in companies without doing their due diligence. They get impatient, greedy, and emotional about their investments, and they are drawn to high-risk securities without putting in the proper time or money to learn about these investment vehicles. Professional traders love the igs, as they are often from their losses that the bulls and bears reap their profits.