FINANCIAL MARKETS

Financial Market: An Overview

Debt and Equity Market
Financial Markets
- perform the essential economic function of channeling funds from households, firms, and * The most common method is to issue a debt instrument:
governments that have saved surplus funds by spending less than their income to those that Bond or Mortgage
have a shortage of funds because they wish to spend more than their income - a contractual agreement by the borrower to pay the holder of the instrument fixed
 banks amount at a regular interval until maturity period
 insurance companies
 finance companies * Other method of raising funds is by issuing equities:
 other financial intermediaries Common Stock
- for these organizations to thrive in the financial markets, decision makers need to have an - claims to share in the net income (income after expenses and taxes) and the assets of
understanding of factors that affect prices of financial products to rise and fall—government a business
regulations, interest rates, market risk, return on investments, behavior of investors and other key
players, and even the law of supply and demand Dividends
- a means for the buying and selling of stocks, bonds, and other financial instruments - periodic payment to of the company
- also a means where individuals and organizations who need funds find investors and lenders
Primary versus Secondary Market
Three Players in the Financial Markets Primary Market
1. Borrowers - individuals and businesses - a market in which securities are bought and sold for the first time (new issues are traded)
2. Savers - mostly individuals - the firm selling securities receives the money raised
3. Financial Institutions - intermediaries (ex. Commercial banks)
Secondary Market
Financial Markets, Institutions, and the Circle of Money - a market for subsequent trading of previously issued securities
- the issuing firm does not receive any new money

Brokers - agents of investors who match buyers with sellers of securities

Dealers - link buyers and sellers by buying and selling securities at stated prices
* The primary market is a source of new securities for the secondary market.
* How the securities perform in the secondary market is an indication of how a firm will perform in the primary
market in the subsequent trading of new stocks.

Exchange and Over the Counter (OTC)

Exchange
- where buyers and sellers of securities (or their agents or brokers) meet in one central location to
conduct trades
- refers to an organized and established trade system where stocks are traded with defined rules
and regulations
- the intricate network where there is constant surveillance on the action of the participant so that
Flow of Funds through Financial System there is no obligation of rules by the participants (ex: PH Stock Exchange and Makati Stock Exchange)

Over The Counter (OTC)

- the market that is operated through a dealer and is largely disorganized
- a decentralized market that happens through a dealer therefore there are no rigid rules and
obligations
- handled by agents and brokers who are oftentimes paid through commissions

Money and Capital Market

Money Market
- a financial market in which only short-term debt instruments (generally those with original
maturity
of less than one year) are traded
- less fluctuation and more widely traded than long-term instrument
- corporations and banks actively use money market to earn interest

Capital Market
 FINANCIAL MARKETS
- the market in which longer-term debt (generally with original maturity of one year or greater) and
equity instruments are traded Investment Banks
- stocks and long-term bonds usually held by the financial intermediaries - specialized financial intermediaries that help companies and governments raise money and
- where buying and selling of stocks issued by corporations also take place advisory services to client firms when they enter into major transactions such as mergers
Philippine Stock Exchange - facilitates the trading of those stocks
Mutual Funds
International Bond Market - professionally managed according to a stated investment objective
Foreign Bonds - individuals can invest by buying shares at the net asset value (NAV)
- sold in a foreign country and are denominated in that country’s currency - can either be load or no-load funds * Load - refers to sales commission
ex: if the German automaker Porsche sells a bond in the United States denominated in U.S. dollars,
Exchange-Traded Fund (ETF)
it is classified as a foreign bond
- similar to a mutual fund except that the ownership shares in the ETF can be bought and sold on
Eurobond - the recent innovation in international bond market the stock exchange
- most ETFs track an index, such as the S&P 500
Financial Intermediaries
- help bring together those who have money (savers) and those who need money (borrowers) Hedge Funds
ex: financial institutions like commercial banks, finance companies, insurance companies, investment - similar to mutual funds but are less regulated, take more risk, and are generally open only to high
banks, and investment companies net worth investors (typically $1 million and above)
- in addition to management fee (about 2%), most funds include an incentive fee (typically 20% of
Financial Institutions Categories profits) based on the fund’s overall performance
 Central Banks
 Retail and Commercial Banks Private Equity Firms
 Internet Banks - a financial intermediary that invests in equities that are not traded on the public capital markets
 Credit Unions, Savings, and Loans Associations
 Investment Banks
Venture Capital Firms
 Investment Companies - provide financing for private start-up companies when they are first founded
 Brokerage Firms ex: initial financing of Google was provided by a venture capital firm
 Insurance Companies
 Mortgage Companies Leveraged Buyout (LBO) Firm
- acquire established firms that typically have not been performing well with the objective
Types of Financial Intermediaries of making them profitable again and then selling them
Commercial Banks - typically uses debt to fund the purchase of a firm
- “Everyone’s Financial Marketplace”
Savings and Loan Association and Mutual Savings Banks
- collect the savings of individuals as well as businesses and then lend those pooled savings to
- obtain funds primarily through savings deposits (often called shares) and time and checkable
other individuals and businesses
deposits
- earn money by charging a rate of interest to borrowers that exceeds the rate they pay to savers
Primary Liabilities / Source of Fund – Deposit
Source of Fund / Liability – Deposit
Primary Assets / Use of Fund – Mortgages
Primary Asset / Use of Fund – Business and Consumer, Mortgages, Private and Government
Securities Credit Union
Non-Bank Financial Intermediaries (NBFIs) - typically very small cooperative lending institutions organized around a particular group:
- comprise a mixed bag of institutions union members, employees of a particular firm, and so forth
ex: Financial services corporations (GE Capital Division) - acquire funds from deposits called shares and primarily make consumer loans
Insurance companies (Prudential)
Investment banks (Goldman Sachs)
Role of Intermediaries in Financial Markets
Investment companies (mutual funds, hedge funds and private equity firms) a. Reduced Costs
Capital Division Transactions between savers and providers of funds will be more costly and time
consuming--transactions are more cost efficient because they already know which financial
Financial Services Corporations
products to offer to particular individuals and firms who need access to additional funds at the
- the lending or financing business, but they are not commercial banks
ex: GE capital – it provides commercial loans, financing programs, commercial insurance, equipment
same time ensuring that the savers of funds earn a reasonable return on their money. They
leasing, and other services in over 35 countries also handle more transactions-able to spread transactions costs over a larger number of
– also provides credit services to more than 130 million customers transactions.

Insurance Companies b. Risk Sharing

- sell insurance to individuals and businesses to protect their investments Intermediaries create and sell assets with risk characteristics that people are
- they collect premium and hold the premium in reserves until there is an insured loss and then pay comfortable with, and the intermediaries then use the funds they acquire by selling these
out claims to the holders of the insurance contracts which are deployed in various types of assets to purchase other assets that may have far more risk.
investments including loans to individuals and businesses
 FINANCIAL MARKETS
Asset Transformation – turning risky assets are into safer assets for investors Preferred Stock
- an equity security that gives preference, relative to common stockholders, with regard
Intermediaries help savers of funds lower their risk by helping them choose the types of to dividends and claim on assets
financial products that they will include in their portfolio. The process is called diversification.
When risk assumed by the savers of funds is lowered, it also becomes beneficial for Stock Markets
borrowers because they are able to borrow funds at a lower interest. - a public market in which the stock of companies is traded

c. Financial Flexibility Organized Security Exchanges

Intermediaries offer a variety of financial products to both savers and borrowers of funds. - physically occupy space and financial instruments are traded on their premises
ex: New York Stock Exchange (NYSE)
Individuals and firms are served with different choices as to what financial products they will
- located in New York, a hybrid market, allowing for face-to-face trading on the floor
invest in or what type of loans they will avail. of the stock exchange in addition to automated electronic trading
There are firms who have to decide whether to use short-term vs. long-term financing. NASDAQ (National Association of Securities Dealers Automated Quotations)
Having options on types of loans that firms can apply for allows decision makers to maximize - an over-the-counter market and describes itself as a “screen-based, floorless market”
their return while minimizing their risks. - in 2013, nearly 3,200 companies were listed, including Starbucks, Google, Intel and
Whole Foods
d. Pooling of Funds
Intermediaries can pool funds from several savers in order to grant a loan involving a Common Stock Price Quotes
huge sum of money to a single borrower. 1. Stock Prices and Change from Previous Day (Monday P100, Tuesday P110)
2. Name and Symbol (ex: Ayala Land Inc. - ALI)
The Financial Marketplace: Securities Markets 3. Open, High and Low (ALI stock opened the day at P110 and range between a high of 120
Security and a low of 95)
- a negotiable instrument that represents a financial claim 4. Market Capitalization – refers to the value of company’s stock outstanding
- can take the form of ownership (stocks) or a debt agreement 5. 52 week High and Low
6. Volume and Ave.
Securities Market * Volume - represents the number or volume of shares of stock that were traded so far during the day
- allow businesses and individual investors to trade the securities issued by public corporations 7. P/E – the stock price dividends earned by the firm on a per share basis over the previous 12
months
8. Earnings Per Share (EPS)
9. Dividends and Yield

Stocks Bid Ask

EMP 7.52 7.63
BPI 86.30 86.40
MBT 78.15 78.45
BDO 132.90 133
ALI 43 43.30
FLI 1.51 1.52
IDC 5.03 5.04

Characteristics of Different Financial Instruments

For the Borrower:
 Good way of inexpensively raising money for short periods of time
 Rates tend to be lower than long-term rates
Types of Securities Money  Can borrow money to match short-term needs
Debt Securities Market  If interest rates rise, the cost of borrowing will immediately rise accordingly
- firms borrow money by selling debt securities in the debt market Debt For the Investor:
 Very liquid–you have access to your money when you need it
- debt is classified based on maturity period:
 Safe–generally invested in high-quality investments for brief periods
 Less than one year (issued in money market)
 Low returns–rates tend to be close to the rate of inflation
 one to ten years (called Note, issued in capital market)
 more than 10 years (called Bond, issued in capital market) Treasury Bills
- short-term government debt instruments with maturities of one year or less, and are sold at a
Equity Securities
discount without paying a coupon
- represent ownership of the corporation
Riskiness – Default Free
Common Stock Maturity – 4 weeks to 1 year
- represents equity ownership in a corporation, provides voting rights, and entitles the Interest Rates – 0.033 to 0.286
holder to profits in the form of dividends
 FINANCIAL MARKETS
Banker’s Acceptance
- a firm’s promise to pay, guaranteed by a bank Minimum Investments – PHP100,000 and increment of PHP10,000
- legally binding obligation by the accepting bank to pay the stated amount at the maturity date of Riskiness – Risk is dependent upon the financial strength of the issuer
the time draft Maturity – 2 - 20 Year
Interest Rates – 2 – 4 percent
Commercial Paper
For the Borrower:
- a short-term debt instrument issued by companies to raise funds generally for a time period up to  Dividends can be omitted without the risk of bankruptcy
one year  Has the disadvantage that dividends are not tax deductible for the issuer,
- an unsecured money market instrument issued in the form of a promissory note whereas interest payments from debt are tax deductible
Riskiness - Low default risk For the Investor:
Maturity – Up to 270 Days  To corporate investors, it has a tax advantage because at minimum, 70% of
Interest Rates – 0.13 – 0.30 percent Preferred dividends received are tax free
Stock Major Original
Negotiable Certificates of Deposits (CD’s) Market Riskiness Interest Rates
Participants Maturity
- a product offered by banks and credit unions that provides an interest rate premium in exchange Issued by
corporations to Riskier than Dependent upon
for the customer agreeing to leave a lump-sum deposit untouched for a predetermined period of individuals, other corporate bonds, risk, generally
Capital Equity No maturity date
time corporations, and but less risky than ranging from
Minimum Investments – PHP50,000 and increment of PHP10,000. institutional common stock 4.03% to 8.47%
investors
Riskiness – Default risk depends on the strength of the issuing banks.
Maturity – 2 weeks to 1 Year
Interest Rates – 0.20 – 0.25 percent
For the Borrower:
 The issuing firm is not legally obligated to make payments
Money Market Funds
 Does not have a maturity date
- a kind of mutual fund that invests in highly liquid, near-term instruments  Issuance of common stock increases creditworthiness because the firm has
- include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a more investor money to cushion the firm in the case of a loss
short-term maturity (such as PHP. Treasuries)  Has a tax disadvantage relative to debt; whereas debt interest payments are
Riskiness – Low degree of risk deductible for tax purposes, common stock dividends are not
Maturity – No specific maturity date (can be redeemed any time) For the Investor:
Common
Interest Rates – 0.88 percent  Over the long run, common stock has outperformed debt-based financial assets
Stock
 Along with the increased expected return comes increased risk
For the Borrower:
 Interest rates are locked in over the entire life of the debt Major Original
Market Riskiness Interest Rates
Participants Maturity
 Has a tax advantage over common stock in that interest payments are tax
Long-Term deductible, whereas dividend payments are not Issued by
Debt and corporations to Risky, with
For the Investor: individuals, other dividends only Do not pay
Fixed Capital Equity No maturity date
 Can be used to generate dependable current income corporations, and paid when they interest
Income institutional are declared
Securities  Some bonds produce tax-free income
investors
Market  Long-term debt tends to produce higher returns than short-term debt
 Less risky than common stock Ensuring the Soundness of Financial Intermediaries
 Investor can lock in an interest rate and know the future returns (assuming the
issuer does not default on its payment) a. Restrictions on Entry
Long-Term Negotiable Certificates of Deposits (LTNCD’s) Government Regulatory Agency created tight regulations governing who is allowed to
Minimum Investments – PHP50,000 and increment of PHP10,000 set up a financial intermediary.
Riskiness – Default risk depends on the strength of the issuing banks
Maturity – 1 – 5 Year
Disclosure
Interest Rates – 3 – 4 percent – strict reporting requirements for financial intermediaries: their bookkeeping must follow
certain strict principles, their books are subject to periodic inspection, and they must
PHP Government Bond and Notes make certain information available to the public
- represents debt that is issued by a government and sold to investors to support government
spending b. Restrictions on Assets and Activities
- issued by the Philippines to mutual fund, businesses individual and foreign countries There are restrictions on what financial intermediaries are allowed to do and what assets
Minimum Investments – PHP100,000 and increment of PHP10,000 they can hold.
Riskiness – no default risk but price will decline if interest rates rise ex: Commercial banks and other depository institutions are not allowed to hold common stock
Maturity – 2 - 10 Year because stock prices experience substantial fluctuations.
Interest Rates – 0.77 – 4 percent
Insurance companies are allowed to hold common stock, but their holdings cannot exceed a
Corporate Bond certain fraction of their total assets
- represents debt that is issued by a government and sold to investors to support companies Deposit Insurance
spending - the government can insure people’s deposits so that they do not suffer great financial
- issued by the corporation to mutual fund, businesses individual and foreign countries loss if the financial intermediary that holds these deposits should fail
 FINANCIAL MARKETS
 Mutual Funds
c. Restrictions on Interest Rates - based on pooling of funds from different investors
Competition has also been inhibited by regulations that impose restrictions on interest - invested into different financial products such as securities, stocks, and bonds
rates that can be paid on deposits. - managed by a fund manager employed by the mutual fund company

Most Common Financial Products Measuring Interest Rates

 Savings Different debt instruments have very different streams of cash payments to the holder (known as
- low risk cash flows), with very different timing.
- offers relative liquidity Present Value or Present Discounted Value: PV= [CF/(1+i)^n]
- an investor earns very minimal interest on this type of investment PV – Present Value
Savings Account in a Bank CF – Cash Flow or Interest Income
- most common type of financial product that is offered to customers i - interest rates
n - maturity period
Regular Account
- the depositor is issued a passbook Example: What is the present value of $250 to be paid in two years if the interest rate is 15%?

Time Deposit
- a more long-term basis where the depositor is issued a time deposit certificate

 Loans
Short Term Loans - payable within one year

Long Term Loans - due beyond one year or more

- collateralized and non-collateralized

Four Types of Credit Market Instruments
Collateral
1. Simple Loan
- an asset, like a piece of real estate property or a vehicle, that is attached to a loan
- the lender provides the borrower with an amount of funds, which must be repaid to the
- in case of a default in payment, the lending institution may take ownership of this in lieu
lender at the maturity date along with an additional payment for the interest
of money
- many money market instruments are of this type (ex: commercial loans to businesses)
 Bonds
2. Fixed-Payment Loan
- a loan granted to organizations by individuals and organizations who have excess funds
- also called a fully amortized loan
With reference to our previous discussion on the suppliers and demanders of funds, - the lender provides the borrower with an amount of funds, which must be repaid by making
organizations also get to the point where they need additional funds to support their the same payment every period, consisting of part of the principal and interest for a set
operations. Short- and long-term loans are available through commercial banks. Some number of years (ex: housing and auto loan)
organizations may also resort to the issuance of bonds to the public.
3. Coupon Bond
 Security - pays the owner of the bond a fixed interest payment (coupon payment) every year until the
- when an investor has a security, this means that he has a financial instrument signifying maturity date, when a specified final amount (face value or par value) is repaid
ownership of stocks of a publicly traded company, or a bond issued by a government - three pieces information:
agency  Issuer
 Maturity Date
Publicly Traded Company  Coupon Rate
- a stock corporation that has opened the selling of shares of stocks to the general
* The face value of a bond is usually in $1,000 increments.
investing public
4. Discount Bond
 Treasury Bills
- also called a zero-coupon bond
- securities issued by the government
- bought at a price below its face value (at a discount), and the face value is repaid at the
- often referred to as T-bills
maturity date
- yield no interest but are sold at a discount ex: a discount bond with a face value of $1,000 might be bought for $900; in a year’s time the owner
- the earnings are very minimal as the risk level is very low would be repaid the face value of $1,000

 Insurance Yield to Maturity (YTM)

- bought by policyholders from insurance companies as protection of both life and properties - the interest rate that equates the present value of cash flows received from a debt instrument
* The policyholder is also referred to as the insured while the insurance company is the insurer. with its value today.
 FINANCIAL MARKETS
Example: Simple Loan Yields to Maturity on a 10% Coupon Rate Bond Maturing in 10 Years (Face Value = $1,000)
If Pete borrows $100 from his sister and next year she wants $110 back from him, what is the yield Price of Bond ($) Yield to Maturity (%)
to maturity on this loan? 1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81

Example: Discount Bond

i = (F-P) / P
F = face value of the discount bond
P = current price of the discount bond

Let us consider a discount bond such as a one-year U.S. Treasury bill, which pays a face value of
Example: Fixed Payment Loan $1,000 in one year’s time. If the current purchase price of this bill is $900, then equating this price
You decide to purchase a new home and need a $100,000 mortgage. You take out a loan from the to the present value of the $1,000 received in one Year.
bank that has an interest rate of 7%. What is the yearly payment to the bank to pay off the loan in
20 years?

Solution:
Distinction Between Nominal and Real Interest Rates
Nominal Interest Rates
- the interest rate makes no allowance for inflation

Real Interest Rates

- the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so
that it more accurately reflects the true cost of borrowing
“When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend”
Example: Coupon Bond
Rate of Return
- defined as the payments to the owner plus the change in its value, expressed as a fraction of its
purchase price

where: P = price of coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date

Find the price of a 10% coupon bond with a face value of $1,000, a 12.25% yield to maturity, and
eight years to maturity. = 889.20

Example: What would the rate of return be on a bond bought for $1,000 and sold one year later for
$800? The bond has a face value of $1,000 and a coupon rate of 8%.

Interesting Information:
When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. The price of a
coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the price of the
One-Year Returns on Different Maturity
bond falls. If the yield to maturity falls, the price of the bond rises. The yield to maturity is greater than the coupon
10% Coupon Rate Bonds When Interest Rates Rise from 10% to 20%
rate when the bond price is below its face value.
Years to Initial Current Initial Price Price Next Rate of Rate of
 FINANCIAL MARKETS
Maturity and probabilities?
Capital Gain
When Bond is Yield (%) ($) Year ($) Return (%)
(%)
Purchased Solution: Fly-by-Night Airlines
30 10 1,000 503 -49.7 -39.7
20 10 1,000 516 -48.4 -38.4
10 10 1,000 597 -40.3 -30.3
5 10 1,000 741 -25.9 -15.9
2 10 1,000 917 -8.3 +1.7
1 10 1,000 1,000 0.0 +10.0

Determinant of Asset Demand

Wealth
- the total resources owned by the individual, including all assets
“Holding everything else constant, an increase in wealth raises the quantity demanded of an asset”
Solution: Feet-on-the-Ground Bus Company
Expected Return
- the return expected over the next period on one asset relative to alternative assets
“An increase in an asset’s expected return relative to that of an alternative asset, holding everything else
unchanged, raises the quantity demanded of the asset”

Liquidity
- the ease and speed with which an asset can be turned into cash, relative to alternative assets
Example: What is the expected return on the Exxon-Mobil bond if the return is 12% two-thirds of “He more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable
the time and 8% one-third of the time it is, and the greater will be the quantity demanded”

Solution:

Risk
- the degree of uncertainty associated with the return on one asset relative to alternative assets

Standard Deviation - measure of risk

“Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity
demanded will fall” Shift in Demand for Bond
Example: Suppose that Fly-by-Night stock has a return of 15% half of the time and 5% the other
a. Wealth
half of the time, making its expected return 10%, while stock in Feet-on-the-Ground has
In a business cycle expansion with growing wealth, the demand for bonds rises and the
a fixed return of 10%. What is the standard deviation of the returns on the Fly-by-Night
demand curve for bonds shifts to the right. Using the same reasoning, in a recession, when
Airlines stock and Feet-on-the-Ground Bus Company, with the same return outcomes
 FINANCIAL MARKETS
income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the
left.

b. Expected Return on Bonds Relative to Other Alternative Assets

Higher expected interest rates in the future lower the expected return for long-term
bonds, decrease the demand, and shift the demand curve to the left. An increase in the
expected rate of inflation lowers the expected return for bonds, causing their demand to
decline and the demand curve to shift to the left.

c. Risk of Bonds Relative to Alternative Assets

An increase in the riskiness of alternative assets causes the demand for bonds to rise
and the demand curve to shift to the right.

d. Liquidity
An increased liquidity of alternative assets lowers the demand for bonds and shifts the
demand curve to the left.

Shift in Supply of Bond

a. Expected Profitability of Investment Opportunities
In a business cycle expansion with growing wealth, the supply of bonds rises and the
supply curve for bonds shifts to the right. Likewise, in a recession, when there are far fewer
expected profitable investment opportunities, the supply of bonds falls, and the supply curve
shifts to the left.

b. Expected Inflation
An increase in expected inflation causes the supply of bonds to increase and the supply
curve to shift to the right.

c. Government Budget
Higher government deficits increase the supply of bonds and shift the supply curve to the
right.