CHAPTER 2: FINANCIAL MARKETS

Financial markets are structures through which the fund flows. They are 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 bonds they hold. Financial markets are
the meeting place for those with excess funds (investors or lenders referred to as
surplus/savings units) and those who need funds (borrowers or issuers of securities referred to
as deficits units).savings from households and businesses are channelled to those individuals
and businesses which needs the funds. The needs of deficit units and surplus units gave rise to
financial markets. Financial markets are at the heart of financial system determining the volume
of credit available, attracting savings, and setting interest rates and security prices.

Financial markets are classified as either (1) primary or secondary market or (2) money
or capital markets. Although we have other classifications of financial markets, these two are
the basic classifications of financial markets.

PRIMARY MARKETS

Financial claims are initially sold by deficit units in primary markets. Primary markets are
markets in which users of funds, raise funds, through new issues of financial instruments such
as stocks and bonds. They consist of underwriters, issuers, and instruments involved in buying
and selling original or new issues of securities referred to as primary securities. In other words,
primary markets are markets for primary securities (new issues of financial instruments like
stocks and bonds). They raise cash for the issuing company, which acts as borrower by
increasing its current capital stock when it issues stock, or outstanding liabilities when it issues
bond. The government also acts as a borrower when it issues bond or Treasury bills. The
primary market transaction involves either equity security (stock) or debt security (bond). These
new issues are issued to initial suppliers of funds or investors.

The following figures depict primary market transactions. The corporation needing
funds issues new or original issues of either stocks or bonds directly to the investors or to
underwriters/financial intermediaries who in turn sell them to the investors. Financial
intermediary acts as a middleman or bridge that will satisfy the needs of the deficit units and
the surplus units.
 jgj
Deficit Units Surplus Units

Borrowers/Users of Initial supplier of

funds; Corporations funds; Households and
issuing new/original businesses
issues of stocks or
bonds

Primary Markets Involving Direct Selling (Without an Intermediary)

Deficit Units
Underwriters Surplus Units
Borrowers/Users of
funds; Corporations Investment/ Merchant Initial supplier of
issuing new/original banks intermediary funds; Households and
issues of stocks or businesses
bonds

Primary Markets Involving an Intermediary

Most primary market transactions are done through investment banks, also called
merchant banks, which help the corporations issuing the stocks or bonds sell these stocks or
bonds to interested investors. Investment or merchant banks purchase shares issued by the
issuing company in an underwriting transaction and then sell these issues to the public. An
underwriter guarantees the sale of the issues, but does not intend to hold the shares or bonds
in his own account. However, if the issue is unsuccessful and public investors refuse to purchase
the issues, the underwriting carries the issues as its own investment, while waiting for morale
favourable 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 analysis and advisor to the issuing company
5. Absorb the risk and cost of creating a market for the securities
 Primary market issues are generally for public offerings or publicly traded securities like
stocks of companies already selling stocks in the 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
needs for the funds. First time issues for the public are called initial public offerings (IPO).

SECONDARY MARKETS

Once financial instruments are issued in primary markets, they are then traded in
secondary markets. Secondary markets are like used car markets. Secondary markets are
markets for currently outstanding securities, referred to as secondary securities. These
securities were previously bought and owned and now being resold either by the initial
investors or those who have purchased securities in the secondary market. Secondary markets
provide liquidity for investors as they sell their financial securities when they need cash.

All transactions after the initial issue in the primary market are done in the secondary
markets. For instance, X owns stocks initially issued by METF Company and later on sells these
METF Company stocks to Y; the sale of X to Y or anyone else is done in the secondary market.
Transactions in the stock and bond market exchanges are secondary market transactions.
Shares held by the public are termed outstanding shares or securities. They do not increase the
capital stock of the original issuing company or its outstanding liabilities unlike in primary
market transactions. Secondary markets only transfer ownership, but do not affect the total
outstanding shares or securities in the market. Only when the issuing corporations redeem
bonds or retire stocks will outstanding shares or securities be reduced. Redemption of bonds
decreases total outstanding debt securities in the market and at the same time reduces the
outstanding liabilities of the issuing company. Retirement of stocks reduces the total
outstanding equity securities in the market and the outstanding capital of the issuing
corporation.

Securities
Financial Markets Other Suppliers of Funds
Brokers (Buyers of outstanding
(Owners of outstanding
securities: Investors) securities: Investors)
Dealers

Secondary Market with Secondary Securities Offered for Sale

 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.

The securities exchange serves the following purposes:

1. Provides marketability by allowing savers to sell their securities immediately

2. Provides liquidity by raising cash any time
3. Provides valuation by serving as a means for determining current values of shares and
ultimately of companies

MONEY MARKETS

Money markets cover markets for short – term debt instruments, usually issued by
companies with high credit standing. They consist of a network of institutions and facilities for
trading debt securities with a maturity of one year or less. They are markets in which
commercial banks and other businesses adjust their liquidity by borrowing, lending, or investing
for short periods of time. The government treasury uses money markets to finance its day to
day operations. Business 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 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/brokers and their major
customers.

Only debt securities are short term. Stocks or equity securities are long term and
therefore dealt with in the capital market. 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. Being short term, these securities are at low risk of
interest rate changes. Money market securities are traded in massive quantities. Most money
market transactions are referred to as open market transactions due to their impersonal and
competitive nature. Open market transactions is an order placed by an insider after all
appropriate documentation has been filled, to buy or sell restricted securities openly in an
exchange.

In the Philippine money market, trading of government securities is regularly observed.

The Philippine Government issues two kinds of government securities: Treasury bills and
Treasury bonds, so called because it is the Bureau of the Treasury which originates their sale to
the investing public through a network of licenced dealers. Government agencies, local
governments, and government-owned and controlled corporations may float securities but
these are not labelled as treasuries. Government securities are no longer certificated; they are
known as “scripless”.

Treasury bills are government securities which mature in less than a year. There are
three tenors of T-bills (1) 91-day, (2) 182-day, and (3) 364-day bills. The number of days is based
on the universal practice around the world of ensuring that the bills mature on a business day.
T-bills are quoted either by their yield rate, which is the discount, or by their based on 100
points per unit. T-biils are sold at a discount (less than the principal0; hence, the yield to the
investor is the difference between the purchase price and the principal.

Treasury bonds are government securities which mature beyond one year. At present, there are
five maturities of bonds (1) 2 year, (2) 5-year, (3) 7-year, (4) 10-year, and (5) 20-year. These are
sold at its face value on origination. The yield is represented by the coupons, expressed as a
percentage of the face value on per annum basis, payable semi-annually.

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 governments for bonds. Long term
securities have maturities for more than a year. These instruments often carry greater default
and market risks than money market instruments 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 market for mortgages, foreign exchange markets.
Derivative securities markets, direct loan market, and lease market, 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 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.

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 allows securities to be traded
anonymously. The identity of the seller need not be known. Negotiability improves liquidity
because anyone who holds the security can immediately sell the security when the holder
needs cash. The holder can even sell the security prior to maturity.

Securities market is composed of:

1. Stock market for equity or stock securities;

2. Bond market for debt securities; and
3. Derivative securities market for securities deriving their value from another security.

Stock Market

Stock market serves as the medium or agent of exchange transactions dealing with
equity securities. 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
shareholder`s 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, it 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.

Bond Market
 Bond market is the market where bonds are issued and traded. It is generally classified
into:

a. Treasury notes and bonds – are issued by the government`s treasury. Like T-bills, T-
notes and T-bonds are backed up 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 (yield to
maturity) to investors.
b. Municipal bonds – is an important financial instruments for development. In the
Philippines, LGU bonds have only recently been acknowledged as a potential tool for
development. LGU bonds reduces the dependence of LGU`s on the national government
in implementing their development programs, and most importantly, encourages and
rewards transparent good governance among local government executives.
c. 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, term of the bond, interest rate, and interest payment dates.

Derivative Securities Market

The term derivative is commonly used to describe a type of security which market value
is directly related to or derived from another traded security. Derivative securities are financial
instruments which pay-offs are linked to another, previously issued securities. They represent
agreements between two parties to exchange a standard quantity of an asset or cash flow at a
predetermined price at a specified date in the future. As the value of the underlying security to
be exchanged changes, the value of the derivative security changes. Option, futures and
forward contracts are examples of derivatives.

Capital markets and money markets include the exchanges where securities or financial
instruments are traded or sold. These exchanges can be formally organized or informally
organized (OTC). Organized security exchanges are like the PSE and other stock exchanges, like
ASX, SZSE, National Stock Exchange of India (NSE), OSE, American Stock Exchange (AMEX), and
Nasdaq Stock Market of the United States. There are also electronic exchanges like the US
Futures Exchange (USFE), Bats, and Boston Equities Exchange.

Negotiated/Non-Securities Market

Negotiated or non-securities market does not involve securities, thus called non-
securities market. This is so called negotiated because it results from negotiation between a
borrower and a lender. It includes a direct loan by a company or a person from a lending
institution like a bank. Also, a personal loan that someone asks from a parent or a relative is a
negotiated loan occurring in a negotiated market. A negotiated market is where the buyer and
the seller deal with each other, either directly or indirectly through a broker or dealer, with
regard to both price and volume.

The negotiated or non-securities market includes, but is not limited to, the following:

a. Loan market
b. Mortgage market
c. Lease market

Other Markets

1. Consumer Credit Market

2. Organized market
3. Over-the-Counter Market
4. Auction Market
5. Foreign Exchange Markets
6. Spot Market
7. Futures Market
8. Forward Market
9. Options Market
10. Swap Market
11. Third and Fourth Markets
This entitles a creditor to receive payment from a debtor in circumstances specified in a contract between
them, oral or written.

A. Financial markets C. Financial claims

B. Financial intermediaries D. Financial institutions

These are markets in which users of funds, raise funds, through new issues of financial instruments.

A. Primary market C. Money market

B. Secondary market D. Capital market

They act as a middleman or bridge that will satisfy the needs of the deficit units and the surplus units.

A. Financial markets C. Financial claims

B. Financial intermediaries D. Financial institutions

They guarantee the sale of the issues, but does not intend to hold the shares or bonds in his own account.

A. Hedger C. Arbitrageur
B. Speculator D. Underwriter

These are markets for currently outstanding securities

A. Primary market C. Money market

B. Secondary market D. Capital market

It is a financial markets where shares are issued and traded through exchanges representing a claim on the
assets and earnings of a corporation.

A. Debt market C. Equity market

B. Exchange traded market D. Over the counter market

These are short term debt securities having a maturity of up to one year.

These are markets for currently outstanding securities

A. Primary market C. Money market

B. Secondary market D. Capital market

It is a financial markets where participants’ trade standardized contracts for the future delivery of a
particular underlying assets.

A. Debt market C. Equity market

B. Cash market D. Futures market

Financial markets where buyers and sellers come together to trade securities through centralized
exchange.
 A. Debt market C. Equity market
B. Exchange traded market D. Over the counter market

It is decentralized financial markets where buyers and sellers trade securities directly with each other
through a broker-dealer.

A. Debt market C. Equity market

B. Exchange traded market D. Over the counter market

Financial markets provide the channel through which the new investors’ savings flow in the country. ( G)

The industries require the investors to raise funds, and the investors require the industries to invest their
money and earn the returns from them. (F)

Financial market provides an opportunity for the investors to sell their financial instruments at their fair
value prevailing in the market at any time during the working hours of the market. ©

A. Price Determination E. Risk sharing

B. Funds Mobilization F. Easy Access
C. Liquidity G. Capital Formation
D. Reduction in Transaction Costs and Provision of the Information

All transactions after the initial issue in the primary market are done in the secondary markets. T

Primary markets transfer ownership, but do not affect the total outstanding shares or securities in
the market. F

Secondary markets exist for the purpose of marketability or easy selling/transfer of ownership
and liquidity or easy convertibility to cash of securities. T

In the cash market, transactions take place in real time and settlement of trades occur within a few
days of transaction. T

Over-the-counter markets do not have a physical location as trades are conducted directly
between buyers and sellers. T

Stockholders do not have any ownership or claim to the future profits of the borrower and are
entitled to repayment of the loan with interest. F

Money market is a low-risk, low return market while Capital market is a high risk, high return
market T