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Chapter 7 - The Financial Market - An Overview
Chapter 7 - The Financial Market - An Overview
Overview
INTRODUCTION
A developed economy relies on financial markets and institutions for efficient transfer
of funds from savers to borrowers.
Financial markets are the meeting place for people, corporations and institutions that
either need money or have money to lend or invest. In a broad context, the financial
markets exist as a vast global network of individuals and financial institutions that may
be lenders, borrowers or owners of public companies worldwide.
The flow of money around the world is essential for businesses to operate and grow.
Stock markets are places where individual investors and corporations can trade
currencies, invest in companies, and arrange loans. Without the global financial
markets, governments would not be able to borrow money, companies would not have
access to the capital they need to expand, and investors and individuals would be
unable to buy and sell foreign currencies.
Participants in the financial markets also include national, state and local governments
that are primarily borrowers of funds for highways, education, welfare and other public
activities, their markets are referred to as public financial markets. Large corporations
raise funds in the corporate financial markets.
Study Guide
Learning Outcomes
Topic Presentation
Thanks to the global financial markets, money flows around the world between
investors, businesses, customers, and stock markets. Investors are not restricted to
placing their money with companies in the country where they live, and big businesses
now have international offices, so money needs to move efficiently between countries
and continents. It is also important for the growth of the global economy that people
are able to invest money outside of their domestic markets.
Corporations rely on the financial markets to provide funds for short-term operations
and for new plant and equipment. A firm may go to the markets and raise financial
capital by either borrowing money through a debt offering of corporate bonds or short-
term notes, or by selling ownership in the company through an issue of common stock.
When a corporation uses the financial markets to raise new funds, the sale of securities
is said to be made in the primary market by way of a new issue.
After the securities are sold to the public (institutions and individuals), they are traded
in the secondary market between investors. It is in the secondary market that prices
are continually changing as investors buy and sell securities based on their
expectations of a corporation's prospects. It is also in the secondary market that
financial managers are given feedback about their firm's performance. Those
companies that perform well and are rewarded by the market with high priced
securities have an easier time raising new funds in the money and capital markets than
their competitors. They are also able to raise funds at a lower cost.
This Chapter offers a preliminary overview of the fascinating study of financial markets.
The more detailed treatment of the regulation, structure and evaluation of financial
markets are covered in Units III and IV.
Financial markets (bond and stock markets) and financial intermediaries (banks,
insurance companies among others) have the basic function of getting people together
by moving funds from those who have a surplus of funds to those who have a shortage
of funds. Well-functioning financial markets and financial intermediaries are crucial to
our economic health. Indeed, when the financial system breaks down, as it has in
Europe and in Southeast Asia recently, severe economic hardship results.
Discussion:
Those who have savings and are lending funds (the lender savers), are at the left and
those who must borrow funds to finance their spending (the borrowers spenders), are
at the right.
The principal lender-savers are households, but business enterprises and the
government as well as foreigners and their government, sometimes also find
themselves with excess funds and so lend them out.
The arrows show that funds flow from lender-savers to borrower-spenders, both
directly and indirectly.
Funds flow from lenders to borrowers indirectly through financial intermediaries such
as banks or directly through financial markets, such as the Philippine Stock Exchange.
Financial markets take many different forms and operate in diverse ways. But all of
them, whether highly organized, like the New York Exchange, or highly informal, like
the money changers on the street corners of some African cities. serve the same basic
functions.
• Raising capital. Firms often require funds to build new facilities, replace machinery or
expand their business in other ways. Shares, bonds and other types of financial
instruments make this possible. The financial markets are also an important source of
capital for individuals who wish to buy homes or cars, or even to make credit card
purchases.
• Price setting. The value of an ounce of gold or a share of stock is no more, and no
less than what someone is willing to pay to own it. Markets provide price discovery, a
way to determine the relative values of different items, based upon the prices at which
individuals are willing to buy and sell them.
• Asset valuation. Market prices offer the best way to determine the value of a firm or
of the firm's assets, or property. This is important not only to those buying and selling
businesses, but also to regulators. An insurer, for example, may appear strong if it
values the securities it owns at the prices it paid for them years ago, but the relevant
question for judging its solvency is what prices those securities could be sold for if it
needed cash to pay claims today.
• Investing. The stock, bond and money markets provide an opportunity to carn a return
on funds that are not needed immediately, and to accumulate assets that will provide
an income in future.
• Risk management. Futures, options and other derivatives contracts can provide
protection against many types of risk, such as the possibility that a foreign currency
will lose value against the domestic currency before an export payment is received.
They also enable the markets to attach a price to risk, allowing firms and individuals to
trade risks so they can reduce their exposure to some while retaining exposure to
others.
Now that we understand the basic function of financial markets, let us study their
structure. The essential categories and features of these markets are described in the
following sections.
There are many different financial markets in a developed economy each dealing with
a different type of security serving a different set of customers, or operating in a
different part of the country.
The main disadvantage of owning a corporation's equities rather than its debt is that
an equity holder is a residual claimant; that is, the corporation must pay all its debt
holders before it pays its equity holders. The advantage of holding equities is that
equity holders benefit directly from any increases in the corporation's profitability or
asset value because equities confer ownership rights on the equity holders. Debt
holders do not share in this benefit because their peso payments are fixed.
Financial Market functions as both primary and secondary markets for debt and equity
securities.
• Financial Market
Corporations engage in two types of primary market transactions, public offerings and
private placements. A public offering, as the name suggests, involves selling securities
to the general public whereas a private placement is a negotiated sale involving a
specific buyer. Public offerings of debt and equity must be approved by and registered
with the Securities and Exchange Commission. Registration requires the firm to
disclose a great deal of information before selling any securities. The accounting legal
and selling costs of public offerings can be considerable.
To avoid partly the various regulatory requirements and the expense of public
offerings, debt and equity are often sold privately to large financial institutions such as
insurance companies or mutual funds. Such private placements need also to be
approved and registered with the SEC. An important financial institution that assists in
the initial sale of securities in the primary market is the investment bank. It does this
by underwriting securities. It guarantees a price for a corporation's securities and then
sells them to the public.
•Secondary Market
After the securities are sold to the public institutions and individuals) they can be traded
in the secondary market between investors. Secondary market is popularly known as
Stock Market or Exchange.
1. The Organized Stock Exchange. The stock exchanges will have a physical location
where stocks buying and selling transactions take place in the stock exchange floor
(e.g., Philippine Stock Exchange, New York Stock Exchange, Japan Nikkei, Shanghai
Components, NASDAQ, etc.)
2. The Over-the-Counter (OTC) Exchange. Where shares, bonds and money market
instruments are traded using a system of computer screens and telephones. The
NASDAQ is an example of an over-the counter market in which dealers linked by
computer buy and sell stocks. Dealers in an over-the-counter market attempt to match
up the orders they receive from investors to buy and sell its stock. Dealers maintain an
inventory of the stocks they trade to help balance buy and sell orders. Many common
stocks are traded over the counter although the majority of the largest corporations
have their shares traded at organized stock exchange.
1. They make it easier to sell these financial instruments to raise cash; that is they
make the financial instruments more liquid. The increased liquidity of these instruments
then makes them more desirable and thus easier for the issuing firm to sell in the
primary market.
2. They determine the price of the security that the issuing firm sells in the primary
market. The firms that buy securities in the primary market will pay the issuing
corporation no more than the price that they think the secondary market will set for this
security. The higher the security's price in the secondary market, the higher will be the
price that the issuing firm will receive for a new security in the primary market and
hence the grater the amount of capital can raise. Conditions in the secondary market
are therefore the most relevant corporations issuing securities.
Stock Exchange
The stock exchange supplies a platform from which to buy and sell shares in certain
listed companies. It regulates the company's behaviour through requirements agreed
upon by the company in order to be listed. This is called a listing agreement which
ensures that the company provides all the information pertaining to its working from
time to time, including events that affect its valuation, such as mergers, amalgamations
and such other sensitive matters. Large volumes are possible in these markets
because of two things. One is the ease of settlements. The shares that are traded in
are received and delivered through an electronic entry in the books of buyers and
sellers. The second reason is guarantee of trades. Sellers get their money, buyers get
their shares. The stock market is known as barometer of the company's economy. The
companies listed on stock exchanges collectively contribute to the country's gross
domestic product (GDP).
Stocks that trade on an organized exchange are said to be listed on that exchange. To
be listed, firms must meet certain minimum criteria concerning, for example number of
share holder and asset size. These criteria differ from one exchange to another.
marketability to listed securities and ensure effective monitoring of trading for the
benefits of all participants in the market. A company desiring to get listing has to enter
into listing agreement with the concerned stock exchange and is required to pay the
specified listing fees. Thereafter, the company is required to comply with all clauses of
the listing agreement and to send details of book closure, record dates, copies of
annual report, quarterly and half-yearly reports and cash flow statements to the
respective stock exchange where the securities are listed. A recognized stock
exchange means a stock exchange being recognized by the national government
through the Securities and Exchange Commission (SEC). Securities are bought and
sold in recognized stock exchanges through members who are known as brokers. The
price at which the securities are bought and sold on a recognized stock exchange is
known as official quotation.
The Philippine Stock Exchange, Inc. (Filipino: Pamilihang Sapi ng Pilipinas; PSE: PSE)
is the national stock exchange of the Philippines. The exchange was created in 1992
from the merger of the Manila Stock Exchange and the Makati Stock Exchange.
Including previous forms, the exchange has been in operation since 1927.
The main index for PSE is the PSE Composite Index (PSEI) composed of thirty (30)
listed companies. The selection of companies in the PSEi is based on a specific set of
criteria. There are also six additional sector-based indices. The PSE is overseen by a
15-member Board of Directors, chaired by José T. Pardo.
On February 3, 1936, the Securities and Exchange Commission announced that it had
"relinquished control of the Manila Stock Exchange."
The Philippine Stock Exchange was formed on December 23, 1992 from the merger
of the Manila Stock Exchange (MSE) (established on August 12, 1927, based on
Muelle de la Industria, Binondo, Manila) and the Makati Stock Exchange (MkSE)
(established on May 15, 1963, based in the Makati Central Business District, within
Ayala Tower One). Both exchanges traded the same stocks of the same companies.
In June 1998, the Securities and Exchange Commission (SEC) granted the PSE a
"Self-Regulatory Organization" (SRO) status, which meant that the bourse can
implement its own rules and establish penalties on erring trading participants (TPs)
and listed companies.
In 2001, the PSE was transformed from a non-profit, non-stock, member governed
organization into a shareholder-based, revenue-earning corporation headed by a
president and a board of directors and on December 15, 2003 listed its own shares on
the exchange (traded under the ticker symbol PSE). On July 26, 2010 the PSE
launched its new trading system, PSEtrade, which was acquired from the New York
Stock Exchange.
In 2019, the PSE introduced a new index that will help track the overall returns of the
main index. The Total Return Index (PSE, TRI), is part of the effort to create a broader
investor base for the market.
The Philippine newspapers publish daily the activities in the Philippine Stock Exchange
by reporting (a) the PSE index, gain / loss and (b) individual trading outcome of
publicly-listed securities.
A list of companies (323) registered with the Philippine Stock Exchange where stock
are actively traded as of September, 2019 is shown in Appendix B.
The vast majority of publicly available equities are seldom bought or sold and are of
no interest to institutional investors. Such shares are usually traded over the counter
(OTC). In the United States, which has far more publicly traded companies than any
other country, an estimated 25,000 firms trade over the counter, about three times as
many as trade on organized exchanges. Most of these are very small firms, and some
do not file the periodic financial reports and audited financial statements required by
stock exchanges. (In the United States, trading on the NASDAQ stockmarket is
sometimes referred to as over-the counter trading, but this convention is outdated).
OTC trading requires a brokerage firm to match a prospective buyer and a prospective
seller at a price acceptable to both. Alternatively, the brokerage firm may purchase
shares for its own account or sell shares that it has been holding. Several electronic
services post bid and offer prices for OTC shares as well as information about trading
volume. However, as such shares trade infrequently, a trade may be difficult to arrange
owing to a lack of sellers or investors, and the price at which the transaction is
completed may be very different from the last price at which those shares were traded
days or even hours before. Firms, whose shares trade over the counter normally have
few shareholders and little equity outstanding. If a firm wishes to raise larger amounts
of capital in the equity market and to appeal to a broader shareholder base, it will seek
to list its shares on a stock exchange.
DAY TRADING
Day trading is the buying and selling of shares, currency, or other financial instruments
in a single day. The intention is to profit from small price fluctuations - sometimes
traders hold shares for only a few minutes.
How it works
Investors typically buy or sell a share based on their analysis of economic or market
trends, research into specific companies, or as part of a strategy to benefit from the
regular dividends that companies issue. Unlike such investors, day traders look for
small movements in prices that they can exploit to make a quick profit.
Day traders favor shares that are liquid -- those are easy to buy and sell in the
secondary market. They may hold shares only momentarily, buying at one price and
selling when the price rises by a few cents, perhaps only minutes later. Day traders
make profits by trading large volumes of shares in one transaction, or by making
multiple trades during the course of the day. They buy or sell) shares and then sell (or
buy) them again before payment becomes due, and usually "close out" all trades
(selling the shares they have bought, and vice versa) at the end of the day to protect
themselves from off-hours movements in the market. This is different from long-term
investing, in which assets are held for longer periods in order to generate growth or
income.
Market data
The current trading information for each day-trading market. Rather than using market
data that is available free of charge but can be up to an hour old, day traders pay a
premium for access to real-time data. Day traders must be able to trade on news or
announcements quickly, so they need to watch the market and stay close to their
trading screens at all times.
Scalping
A strategy in which traders hold their share or financial asset (known as their "position")
for just a few minutes or even seconds.
Margin trading
A method of buying shares that involves the day trader borrowing a part of the sum
needed from the broker who is executing the transaction.
Bid-offer spread
The difference between a price at which a share is sold, and that at which it is bought.
• Day trading is a high risk occupation Day traders typically suffer severe losses in their
first months to trading, and many never graduate to profit-making status.
• Day trading is a stressful - Day traders must watch the market nonstop during the
day, concentrating on dozens of fluctuating indicators in the hope of spotting market
trends.
• Day trading is expensive - Day traders pay large sums in commissions, for training,
and for computers.
The formal financial markets have expanded rapidly in recent years, as governments
in countries marked by shadowy, semi-legal markets have sought to organize
institutions. The motivation was in part self-interest: informal markets generate no tax
revenue, but officially recognized markets do. Every country has financial markets of
one sort or another. In countries as diverse-as China, Peru and Zimbabwe, investors
can purchase shares and bonds issued by local companies. Even in places whose
governments loudly reject capitalist ideas, .traders, often labeled disparagingly as
speculators, make markets in foreign currencies and in commodities such as oil.
Governments have also recognized that if businesses are to thrive they must be able
to raise capital, and formal means of doing this, such as selling shares on a stock
exchange, are much more efficient than informal means such as borrowing from
moneylenders.
Investors have many reasons to prefer financial markets to street-corner trading. Yet
not all formal markets are successful, as investors gravitate to certain markets and
leave others underutilized. The busier ones, generally, have important attributes that
smaller markets often lack:
• Liquidity, the ease with which trading can be conducted. In an illiquid market an
investor may have difficulty finding another party ready to make the desired trade, and
the difference, or "spread", between the price at which a security can be bought and
the price for which it can be sold, may be high. Trading is easier and spreads are
narrower in more liquid markets. Because liquidity benefits almost everyone, trading
usually concentrates in markets that are already busy.
• Transparency, the availability of prompt and complete information about trades and
prices. Generally, the less transparent the market, the less willing people are to trade
there.
• Reliability, particularly when comes to ensuring that trades are completed quickly
according to the terms agreed.
• Suitable investor protection and regulation. Excessive regulation can stifle a market.
However, trading will also be deterred if investors lack confidence in the available
information about the securities they may wish to trade, the procedures for trading, the
ability of trading partners and intermediaries to meet their commitments, and the
treatment they will receive as owners of a security or commodity once a trade has been
completed
• Low transaction costs. Many financial-market transactions are not tied to a specific
geographic location, and the participants will strive to complete them in places where
trading costs, regulatory costs and taxes are reasonable.
• Technology. Almost everything about the markets has been reshaped by the forces
of technology. Abundant computing power and cheap telecommunications have
encouraged the growth of entirely new types of financial instruments and have
dramatically changed the cost structure of every part of the financial industry.
• Deregulation. The trend towards deregulation has been worldwide. It is not long since
authorities everywhere kept tight controls on financial markets in the name of
protecting consumers and preserving financial stability. But since 1975, when the
United States prohibited stockbrokers from setting uniform commissions for share
trading, the restraints have been loosened in one country after another. Although there
are great differences, most national regulators agree on the principles that individual
investors need substantial protection, but that dealings involving institutional investors
require little regulation.
• Globalization. Most of the important financial firms are now highly international, with
operations in all the major financial centres. Many companies and governments take
advantage of these global networks to issue shares and bonds outside their home
countries. Investors increasingly take a global approach as well, putting their money
wherever they expect the greatest return for the risk involved, without worrying about
geography.
On February 24, 2010 Former Deputy Governor Nestor A. Espenilla Jr. issued Circular
Letter No. CL 2010-013 addressed to all banks, their subdivision and other affiliates to
non-bank which contains financial institutes supervised by the BSP. The Code of
Ethics Governing Financial Market Activities in the Philippines is presented in
Appendix A. (will send you on separate file)
REVIEW QUESTIONS
4. What are the basic functions of the financial markets? Explain them briefly.
5. What are the two principal sources of funds in the financial market? Explain
briefly.
8. What are the forces that brought about the major changes in the financial
markets for the last two to three decades?
Assessment
Assignment
References