FINANCIAL MARKETS: DEFINITION
These new issues are issued to
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 or securities referred to as
deficit units). Savings from households and businesses are
channeled to those individuals which need the funds. The need
for 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)
Financial markets are classified as either (1) primary market or
secondary market or (2) money market or capital market.
Although there are other classifications of financial markets,
these two are the basic classification 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 new 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 a borrower by
increasing its capital stock when it issues stocks or
outstanding liabilities when it issues bonds or Treasury bills.
The primary market transaction involves either equity security
(stock) or debt security (bond).
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 1) or to
underwriters/financial intermediaries (Figure 2) who in turn sell
them to the investors. Financial intermediary acts as the
middlemen or bridge that will satisfy the needs of the deficit
units and the surplus units.
Most primary market transactions are done through investment
banks, also called merchant banks, which help the corporation
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).
2. Give advice to issuing corporations as to the price and
number of securities to issue.
3. Attract the initial public purchasers of the securities.
4. Act as a market analyst and advisor to the issuing company.
5. Absorb the risk and cost of creating a market for the
securities.
Primary market issuers 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. 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 place, 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 the 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 are 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 be 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 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 payment,
respectively.
Figure 3 depicts the secondary market transaction.
Secondary markets exist for the purpose of marketability or
easy selling/transfer of ownership and liquidity or easy
convertibility to cash of securities. Marketable securities are
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.
Commercial banks have trust departments and treasury
departments that are major players in the secondary market.
Trust departments recommend money market and capital
market securities for their clients. Treasury departments
recommend money market and capital 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
accounts. 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 at 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 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 borrowing, lending,
or investing for short periods of time (Kidwell et al. 2013). The
government treasury uses money markets to finance its day-to-
day operations. Businesses and households also 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 organized 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 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, banker's 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 other are met in the money
market. 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 documents 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 a 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. Interbank call loans are credits of one bank to
another for a period not exceeding 4days. 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
deposits, that is, the bank is in trouble. Interbank call loans are
treated as deposit substitues. 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 requirement.
In financial crisis situations, it is the duty of the country's
central bank to provide liquidity to stabilize markets. This is
because risk may trade at premium to a bank's target rates,
called money rates that central bankers cannot control. These
are called repo rates. Repo rate is the rate at which the central
bank of a country lends money to commercial banks in the
event of any shortfall of funds. Repo rate is used by monetary
authorities to control inflation. Pero markets allow participants
to undertake rapid financing in the interbank market
independent of credit limits to stabilize the system. A
repurchase agreement is a sale of securities for cash with a
commitment to repurchase them at a specified future date. A
borrower pledges securitized assets such as stocks in
exchange for cash to allow its operations to continue.
In the Philippine money market, trading of government
securities is regularly observed. the following discussion
relative to government securities is from the Bureau of
Treasury's official website.
The Philippine government issues two kinds of government
securities (GS) : Treasury bills (T-bills) and Treasury bonds (T-
bonds), so-called because it is the Bureau of Treasury which
originates their sale to the investing public though a network of
licensed dealers.
T-bills are government securities which mature in less than a
year. There are three tenors of T-bills: (a) 91-day, (b) 182-day,
and (c) 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.
T-bonds are government securities which mature beyond one
year. At present, there are five maturities of bonds: (a) 2-year,
(b) 5-year, (c) 7-year, (d) 10-year, and (e) 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.
T-bills are sold at a discount (less than the principal); hence,
the yield to the investor is the difference between the purchase
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 payment on
interest payment dates.
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 corporations and government for bonds. Long-term
securities have maturities of more than a year. These
instruments often carry greater default and market risks than
money market instrument generally because they are long-
term. In return, they carry a higher return yield. They suffer
wider price fluctuations than money market instruments.
Capital markets are composed of stock market for equity or
stock securities, bond markets for debt securities, mortgage
markets for mortgages, foreign exchange markets, derivative
securities markets, direct loan market, and lease markets
among others.
The need for long-term assets or capital goods as purchase of
land or building or plant expansion will resort to the capital
market as a source of funds. Capital goods are used to produce
goods and services to generate revenues. It is in the capital
market that long-term users of funds and those with long-term
excess funds meet. These long-term securities include long-
term loans, mortgages, and financial leases; corporate stocks
and bonds; and government long-term Treasury notes and
bonds. Security exchanges, over-the-counter markets,
investment banks, mortgage banks, insurance companies, and
other financial institutions deal with the capital markets. Over-
the-counter transactions are done through a 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.
A. 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 or
delivery is negotiable. 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 ofL
1. stock market for equity or stock securities;
2. bond market for debt securities; and
3. derivative securities market for securities deriving value
from another security.
Stock Market
Stock market serves as the medium or agent of exchange in
transactions dealing with equity securities. It involves
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 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 six indices: Financials, Industrial, Holding Firms,
Services, Property, and Mining and Oil. The overall index, which
is called the Philippine stock exchange index (PSEi), is a
composite of the six 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.
If the 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 volatility and therefore, risk in
investment in the stock, that is, the more volatile a stock is,
the riskier 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 volumes 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 particular stock. The higher they are, the more
enticing the stocks will be to current and potentual
stockholders. Howerver, a company's stock price does not
represent the value of the stock as an investment. The value of
the stock is determined by various methods, but generally
based on the return on equity or 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 increase in the 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 earning (PE) ratio
is the ratio of stock price to earning 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
1. 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.
2. Municipal bond (LGU) us 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 gaovernment in implementing their development
programs, and most importantly, encourages and rewards
transparent good governance among local government
exceutives. LGU bond does all these while attracting private
institutional capital and providing the investing public with an
alternative long-term investment.
3. 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 dayes. It may include such term as the ability
of the isser 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 desribe a type of
security which market value is directly related to or derived
from another traded security. Derivative securities markets
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 fo the
underlying security to be exchanged chages, the value of the
derivative security changes. Options, futures, and forward
contracts are examples of derivatives as well as stock
warrants, swap agreements, mortgage-backed securities, and
other more exotic variation. 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' stock. The most important determinanat 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
uncertaintly 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
specualtion. It was the need for this type of transaction that
spawned the fist derivative securities markets. Another
example would be the mortgage-backed securities, which are
instruments that are secured/guaranteed by mortgages.
Capital markets and money money markets include the
exchanges where securities or financial instruments are traded
or sold. These exchanges can be formally o rganized or
informally organized (OTC). Organized security exchanges
are like the PSE and other international stocks exchanges,
including National Stock Exchange of India (NSE), New York
Stock Exchange (NYSE), and Nasdaq Stock Market of the
United States.
B. Negotiated/Non-securities Market
Negotiated or non-securities market does not involve
securities, thus called nonsecurities market. This is so-called
negotiated because it results from negotiatio between a
borrower and a lender. Itincludes 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 relative is a
negotiated loan occuring in a negotiated market. A negotitated
market is where the buyer and the seller deal with each other,
either idirectly or indirectly through a broker or dealer, with
regard to both price and volume. Buyers and sellers are given
sufficient time to locate one 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 a company needs P3M 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 with big individual depositors, lines of credit up to a
certain limit, for example P5M or P10M, depending on te
average amount of deposits they have with the bank. The
larger the average amount of deposi a depositor has with a
bank, the higher the line of credit is granted.
Suppose the company needing the P3M has a line of credit with
its bank. It can borrow P3M from that bank if the amount is
within its line of credit. If its line of credit is only P2M, then it
can only borrow P2M maximum. The loan agreement is called
term loan agreement. A term loan agreement is an agreement
between a borrower and a lender for a definited period of time,
hence, the word "term". Term of the loan is the lenght 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 that canpital issues like shares and bonds
that can be merely endorsed and transferred because they are
negotiable. The loan is negotiated loan, but non-negotiated.
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 the banks is part of the capital market and
still the predominant means of financing, especailly 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 bank 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 P1B loan from a bank
syndicate heded 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 it is not
limited to the following:
1. Loan market
2. Mortgage market
1. 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.
2. Mortage market is where a real property (property with more
or less permanent life), like land (residential, agricultural, or
industrial) building (commercial, residential, etc.), and big
machineries, among others are used to guarantee or secure big
loans. It is also a type of loan, bit 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 mortage company and get the loan
to buy the property the use the property as the collateral for
the loan, that is, the company mortgages the property. The
mortgage market also includes the market for forecolsed
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 take over by the lender.
Other than the banks and other financial institutions,
governmet agencies like the National Home Mortgage Finance
Corporation (NHMFC), Government Service Insurance System
(GSIS), Social Security System (SSS), 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 of a capital lease.
Other Markets
Other markets are a combination of the money and capital
markets because they deal with both short-term 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 loans, car
loans, appliance loans, educational loans, and among others.
They can be short-term, like character loans, or long-term like
car loans (usually five years), or appliance loans (usually three
years). These can also include pawnshops, SSS pension lending
companies, and other small consumer loan companies.
When the loans involved are short-term, they belong to the
money market. If long, they belong to the capital market.
Mortgage loans, leases, real estate loans could extend up to
five or ten years or even up to 15 or 30 years, thus belonging to
the capital market.
These loans are usually granted by banks, credit unions,
savings and loans associations, and even lending agencies like
the SSS lending agencies, which lend out 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 SSS 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.
2. 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 include NYSE which was formed in 1972.
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.
3. 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 one or more dealers. Dealers
act as market makers by quoting prices at which they will sell
or buy to other dealers and to their clients or customers. It
does not mean the dealers may quote the same prices to other
dealers as they post to customers, and they do not necessarily
quote the same prices to all customers. Moreover, dealers in an
OTC security can withdraw from market making at any time,
which can cause liquidity to dry up, disrupting the ability of the
market participants to buy or sell. Exchanges are far more
liquid because all buy and sell orders as well as execution
prices are exposed to one another.
OTC markets are less transparent and operate with fewer rules
than exchanges do. 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 transactions or trade between and among dealers,
brokers, and investors.
4. 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 higher 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 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 rate
and are handled by their 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.
5. Foreign Exchange Markets
Foreign exchange market provides the physical and
institutional structure through which the money of one country
is to be delivered at a specific 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
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.
6. Spot Market
Spot markets are called such because buying and selling are
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 PLDT 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 exhange transactions
involve the exchange rate at the date of the transaction that is
why it is called spot exchange transactions. If the exchange
rate of dollar to peso is $1=47, the spot transaction will
compute it at the exchange rate. Therefore, if the transaction
is for $20,000, the one buying the exchange contract will need
P940,000 to consummate the contract. The spot market is the
exact opposite of the futures market and forward market.
7. Futures Market
Unlike the spot market, futures market is where contracts are
originated and traded that gives the holder the 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 there 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
if the 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
financial asset such as a T-bond may be purchased for future
delivery. A futures contract like this is a formal agreement
executed thorugh a commodity exchange for the delivery of
goods or securities in the future. One party agrees to accept a
specific commodity that meets a specified quality in a
specified month. The other party agrees to deliver the specified
commodity during the designated month. Each contract has a
standardized expiration and transaction 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 hiding, 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 the asset will be moving. Speculators make
bets or guesses that a stock is overpriced, he may short sell
the stock and wait for the price or the stock to decline, at
which point he will buy back the stock and receive a profit.
Unfavorable or adverse movement 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.
8. 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 P500,000 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 P500,000 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
P550,000 or down to P450,000, the buyer still pays P500,000.
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 nonstandardized
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
P1 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
P1 million starting 3 months from now. The seller of the FRA
agrees to lend P1 million to the buyer at the 6.5% indicated in
the contract starting 3 months from now. If interest rates rise
in the next 3 months, the FRA buyer gains from it. The FRA
buyer can still borrow the P1 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
6.5% interest rate instead the lower, say 5% or 5.5% interest
rate on the P1 million he is borrowing.
9. Options Market
Options market is where stock options are traded. This is the
formal market where the options are brought and sold, and not
when a stockholder is given the option or preemptive 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 and 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 obligations, 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 in a 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.
An option contract is defined by the following elements:
a. Type (put or call)
b. Underlying security
c. Unit of trade (number of shares)
d. Strike price
e. Expiration date
All option contracts are of the same type and style and cover
the same underlying security are referred to as 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 to
as an option series. (Nasdaq.com)
Options can be call options or put options. Call option gives the
buyer the right to buy an 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 buying
a call option. The buyer of the call option is the investor.
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 beofre October 10, 20xx. If he buys the shares, it will cost
him 100 shares x P100 = P10,000. However, the buyer has to
pay a call premium, say P1,000 to the agent immediately. His
cost for the shares will go up by P1,000. The total cost fir the
100 shares will then be (P10,000 + 1,000 = P11,000 or P110 per
share). In other words, the call premium becomes the price or
the option that is added to the cost of the shares at the strike
price.
If on or before the said date, the X crop shares are selling at
P120, the buyer of the call option already makes a profit of
P10/share (P120 current price and P110 cost) and should make
the buy.
If the price of the shares had gone down below the strike price
of P100 all the time until October 10 20xx, say P90, the buyer
of the call option has the right to refuse to buy and loses the
P1,000 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, 20xx, 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 P122 or P125. If he
buys at a time the price of the stocks is at P125, he makes a
profit of P15. Option buyers only buy when it is profitable to do
so.
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.
10. 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., 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
b. Currency swaps
c. Credit risk swaps
d. Commodity swaps
e. Equity swaps
The asset or instrument underlying the swap may change, but
the basic principle of a swap agreemnet 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 payment with
each other for a stipulated period of time. In effect, each party
helps to pay off all or a portion of the interest cost owed by the
other firm. The result is usually lower interst 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:
Interpretation:
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.
Types of Investors
The different types of investors in the different types of
markets are the following:
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 risk0free 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 when prices are low so your cost is low. Then, you wait until
expected returns. prices go up and that is the time for you to sell.

In the stock market, there are what we call "bulls" and "bears".
When the market is showing confidence, that is, the stock
prices are going up and market indices like the Nasdaq go up,
we have a bull market. The number of the 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 loooming, 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 tough for investors to pick
profitable stocks. However, this is the time to make money
using a technique called short-selling.
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 chickens. They
are high-risk investors looking for one big score in a short
period of time. They get impatient, greedy, and emotional about
their investment, 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 pigs,
as they are often their losses that the bulls and bears reap
their profits.

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 share
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