Week 1: Overview of Financial Markets and Investment Products

Topic Learning Outcomes

1. Enumerate and understand the functions and roles of financial markets and its participants
2. Discuss the operation of different types of financial intermediaries and institutions
3. Discuss the role and function of the Central Bank in the financial environment

Be engaged:

Are you familiar with the institutions on the picture above? What are their roles in our economy? Are
you considering a career in relation with these institutions? Why or why not? (Assignment)

Introduction

The firm’s primary financial goal is to maximize shareholders’ wealth or value which is ultimately
determined in the financial markets. Hence, financial managers should make sound decisions keeping in
mind how financial markets work and operate. In investor’s perspective, indivduals or entities make
investment decisions, that should be anchored to the knowledge and understanding about financial
institutions that operate within the financial market.
The Capital Allocation Process

In an efficient economy, capital flows efficiently from those with excess capital to those who need it.
Below shows how the capital flows from providers (savers) to those who need funds or capital
(business)

Diagram of the Capital Formation Process for business

1. Direct transfers occur when a business sells its sticks or bonds directly to savers. The business
delivers the securities to savers in exchange for the capital. This process is mainly seen used by
small firms and relatively little capital is acquired through these processes.
2. Indirect transfers through an investment Bank- an underwriter facilitates the issuance of
securities. The business sells its stocks or bonds to the investment bank, which further sells
these to savers or investors. This entails risk on the part of investment bank since they may not
be able to resell the securities to savers for as transaction since new securities are involved and
the corporation receives the sale proceeds.
3. Indirect transfers through a Financial Intermediary- transfers made through a bank, an
insurance company, or a mutual fund are examples of these. The existence of intermediaries
greatly increases the efficiency of money and capital markets. The intermediary obtains funds
from savers or investor in exchange for its own securities. The intermediary uses this money to
buy and hold businesses’ securities, and the savers hold the intermediary’s securities. Therefore,
 intermediaries literally create new forms of capital such as certificates of deposit, which are
safer and more liquid than mortgages and thus better for most savers to hold.

Functions of the financial system

The core function is being the fact that a financial market acts to transfer resources from ivestor to
firms, corporation, that need to make investments. Merton & Bodie (1995) state that “ the primary
function of any financial system is to facilitate the allocation and deployment of economic resources,
both across borders and across time, in an uncertain environment”.

Four other functional functions

1. The first function is the pooling of resources and subdivision of shares- they collect the capital
from th savers
2. Transfer resources accorss time and across space-they are “platforms” that aid the transfer of
capital and resources
3. Help us manage risks-“ do not put all your eggs in one basket” This connotes that financial
markets provides vas arrat of options to gorwn your money in
4. Makrets provide information-mainly the transaction price of the security agreed by the buyer
and seller informs you on the value of a firm

Participants in financial markets

Four main particpants and their key roles they play and their relationship with one another

1. Firms-these are the business who needs capita; to fund their operations, planned expansion, and
other business related necessities. Business firms also deposit some of their funds in financial
institutions, primarily in checking are net demanders of funds. They borrow more money than
they save.
2. Investors- these are the people who allocate their savings to productive investment
opportunities. Individual s not only supply funds to financial institutions but also demand funds
from them in the form of loans. However, individuals as a group are the net suppiers for financial
institutions. They save more money that they borrow.
3. Government-is in place to ensure Makrte intergirtity, to protect the investors and to make sure
that prices correctly reflect their fair value of securoties and protect investors against abuse.
They maintain deposits of temporarily idle funds, certain tax payments, and Social Security
payments in commercial banks. They do not borrow funds directly from financial institutions,
although by selling their debt securities to various institutions, government indirectly borrow
from them.
 4. Financial intermediaries- all the chain of broker, market makers, banks and institutions that
make the interface between investors and the firms. They are key suppliers of funds and the key
demanders of funds are individuals, business and governments.

Financial markets take many different forms and operate in diverse ways. But all of them, whether
highly organized, , or highly informal, like the money changers on the street corners, serve the same
basic functions.

1. 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.
2. 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.
3. Arbitrage. In countries with poorly developed financial markets, commodities and currencies
may trade at very different prices in different locations. As traders in financial markets
attempt to profit from these divergences, prices move towards a uniform level, making the
entire economy more efficient.
4. 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.
5. Commercial transactions. As well as long-term capital, the financial markets provide the
grease that makes many commercial transactions possible. This includes such things as
arranging payment for the sale of a product abroad, and providing working capital so that a
firm can pay employees if payments from customers run late.
6. Investing. The stock, bond and money markets provide an opportunity to earn a return on
funds that are not needed immediately, and to accumulate assets that will provide an income
in future.
7. 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.

Types of markets

It is useful to classify markets along the following dimensions:

1. Physical assets makers versus financial asset markets

  Physical asset markets are also called “tangible” or “ real” asset markets since they sell
tangible commodities such as but not limited to wheat, autos, real estate, computers
and machinery.
 Financial asset markets deal with stocks, bonds, noted mortgages and derivative
securities.
2. Spot markets versus future markets
 Spot markets are markets in which assets are bought or sold for “on-the spot” delivery
 Future markets in which participants agree today to buy or sell an asset at some future
date. Such transaction can reduce, or hedge the risks by both the farmer and the food
processor.
3. Money markets versus capital markets
 Money markets are the markets for short-term highly liquid debt securities. The money
market exists because some individuals, businesses governments and financial
instituitions have temporarily idle funds
 Capital markets are the markets for intermediate or long term debt and corporate
stocks. Included are securities issues of business and government. The backbone of the
capital market is formed by the broker and dealer markets that provide a forum for
bond and stoc transactions. International capital markets also exist.
4. Primary markets versus secondary markets
 The markets in which corporations raise new capital. Financial market in which
securities are initially issued, the only market in which the issuer is directly involved in
the transaction/
 Secondary markets are markets in which existing already outstanding securities are
traded among investors. Financial market in which preowned securities (those that are
not new issues) are traded.The corporation whose securities are being traded in not
involved in a secondary market transaction and thus does not receive funds from such a
sale.
5. Private markets versus public markets
 Private markets are where transactions are negotiated directly between two or more
parties. Example are Bank loand and private debt placements with insurance companies.
 Public markets are where standardized contracts are traded on orgnanized exchanges.
Securities that are traded in public markets such as but not limited to common stock
and corporate bonds are held by a large number of individuals and are fairly
standardized.

Financial Institutions

Financial institutions serve as a “bridge” that channels the savings of individuals, businesses, and
governments into loand or investments. Financial institutions are governed by regulatory guidelines of
the government. The following are types of financial institutions.
1. Investment banks- whoch are also called underwriters, help companies raise capital by helpong
coprorations design securities with features that are currently attractive to investors. They buy
these securities from the corporation and resell them to savers
2. Commercial banks- serves a variety of services savers and borrowers such as checking services
that significantly inflience the money supply
3. Financial servicies corporations- large conglomerates that combine many different financial
instittuions witin a single corporation. Example of which is Citigroup who owns Citibank (a
commercial bank) an investment bank, a securities brokergae organization, insurance
companies and leasing companies.
4. Credit unions- copperative associations whose members are supposed to have a common bond,
such as being employees of the same firm. They are often the cheapest source of funds available
to indicvidual borrowers;. Member’s savings are loaned only to other members.
5. Pension funds- retirement plans funded by a corporations or government agencies for the
benefit of their employees. Pension funds, which are invested in bonds, stocks, mortgages and
real estate are administered primariliy by the trust departments of commercial banks or lifw
insurance companies.
6. Life insurance companies- take savings from annual premiums of clients and invest these funds
in stocks, bonds, real estate, and mortgages to make payments to the beneficiaries of the
parties insured.
7. Mutual funds-corporatins that accept money from individual or corporat ebusiness savers or
investor and the use these funds to buy stocks,long-term bonds, or short-term debt instruments
issued by businesses or government units. These organizations pool these funds and uses
diversification to mitigate risk. Different type of funds is designed to meet a particular objective
of different types of investors.
 Actively managed funds0 tries to outperform the overall markets
 Indexed funds- designed to replicate the performance of a specific maret index
 Exchange Traded Funds (ETFs)- similar to regular mutual funds and are often operated
by mutual fund companies. ETFs buy a portfolio of stocks of a certain type then sell their
own shares to the public.
8. Hedge funds- similar to mutual funds because they accept money from savers and use the funds
to buy various securities, but they are largely unregulated.
Responsibility of the Bagko Sentral

 Provide policy directions in the areas of money, banking and credit

 Supervision over the operations of banks and exercise regulatory powers as provided in the New
Central Bank Act and other pertinent laws over the operations of finance companies and non-
bank financial institutioons performing quasi –banking functions.

Primary Objective of Bangko Sentral

 The primary objective of the BSP is to maintain price stability conducive to a balanced and
sustainable growth of the economy
 It shall also promote and maintain monteray stability and the convertability of the peso

The Monetary Board

 The powers and funactions of the BSP shall be exercised by the Bangko Sentral Montery Board
 Composition of the Monetary Board
o Seven (7) members appointed by the President of the Philippines for a term of
six (6) years
o The seven members are:
- The Governor of the BSP (1) who shall be the Chairman of the Monetary
Board, shall be head of a department
- A member of the Cabinet (2) to be designated by the President of the
Philippines
- Five (5) members who shall come from the private sector, all of whom shall
serve full time

Banking

The state, as written in the Republic Act No. 8791 or the “The General Banking Law of 2000” recognized
the vital role of banks in providing an environment conducive to the sustained development of the
national economy and the fiduciary nature of banking that requires high standards of integirty and
performance.

Banks

 As defined by “The New Central Bank Act” shall refer to entities engaged in the lending of funds
obtained in the form of deposits
 No person or entity shall engaged in banking operations or quasi-banking funactions without
authority from the Bangko Sentral
 Entity authorized by the BSP to perform universal or commercial banking functions shall likewise
have the authority to engaged in quasi-banking functions. The determination of whether a
 person or entity is performing banking or quasi-banking funaction wiithout Bangko Sentral
authority shall be decided by the Monetary Board
 Organizations of the banks
o The Monetary Board may authorized the organization of a bank or quasi-bank subject to
the following conditions:
 That the entity is a stock corporation
 That its funds are obtained from the public which shalle mean twenty (20) or
more persons and
 That the minimum capital requirements prescrived by the Monetary Board for
each category of banks are satisifed.

The Bangko Sentral shall, when examinining a bank, have the authority to examine and enterprise which
is wholly or majority or controlled by the bank.

Classifications of Banks

“The General Banking law of 2000” enumartes various bank classificarion. Here are they and their
funaction based on the respective law that govern them.