2. TOPIC 1: Financial and Capital Markets Defined
WHAT ARE THE FINANCIAL MARKETS
There are lots of individuals and firms with surplus funds. This actually means that their
current expenditures are smaller than their current incomes. To many of them, the surplus
funds need to be invested.
At the same time, there are people and firm whose needs for funds are greater than their
current incomes. They need a reliable source of loanable funds.
Individuals and firms who want to borrow money are brought together with those who want
to lend in the financial markets. These markets provide a permanent venue for savers and
borrowers, and which render financial services whenever required by their customers. These
services are made possible by the financial markets through expediting the creation and
trading of financial instruments.
3. TOPIC 2: Benefits and Components of
Financial and Capital Markets
BENEFITS OF FINANCIAL MARKETS The operation
of financial markets offer advantages which covers
the following:
1.Funds are directed to DSUs which can use them
most efficiently; and
2. Liquidity is provided to savers.
4. Figure 4 shows
an illustration
of how funds
and financial
instruments
are channeled
to and from
the surplus
spending units
(SSUs) and the
deficit
spending units
(DSUs) in the
financial
markets
5. Financial markets, just like any market, operate under the influence of the demand
and supply of funds. DSUs that can use borrowed funds in the most productive
manner can afford to pay higher interest rates. Because of this, they have an edge in
the bidding for loanable funds. As such, business firms, big and small, compete for the
use of the funds made available by the financial market. The competition will push
interest rates higher and this will motivate savers to save more so they will have more
funds for lending.
An additional benefit provided by financial markets is liquidity. Without the
intervention of financial markets, savers will directly lend to borrowers. This
arrangement forces the lender to wait for the maturity date of the loan before he gets
his money back. The lender will be at a great disadvantage if he finds out later that he
needs the loaned amount before maturity. This problem is eliminated when financial
markets are tapped. This happens because financial instruments are issued to lenders,
which in turn, can be converted to cash even before maturity, by endorsement or sale.
8. • Primary Market A financial market in which newly issued primary and secondary securities
are traded for the first time is called primary market. Investors who buy these new issues
are supplying funds to DSUs which issue the securities.
• Secondary Market A secondary market is that financial market through which existing
financial securities are traded. SSUs which bought new securities from the primary market
may sell the same to the secondary market anytime they wish to change their portfolios
before maturity dates. As such, the secondary market provides liquidity to the SSUs with
securities held.
When banks buy Treasury bills (T-bills) from the Bangko Sentral, they do so in
consideration of their clients who buy the T-bills from them and which forms a solid
secondary market.
• Money Market The money market is that financial Market on which debt securities with an
original maturity of one year or less are traded. Long-term securities may also be traded in
the money market if they have six months or less left to maturity
9.
10. Capital Market
The capital market is that portion of the financial market where trading is undertaken for securities
with maturity of more than one year. Banks that bid for two year Treasury bonds are considered
part of the capital market.
The capital market is subdivided into three parts:
1. The bond market;
2. The stock market; and
3. The mortgage market.
Bond Market
The market for debt instruments of any kind is called the bond market. It operates through a
system of dealers using a telecommunications network, rather than in a single physical location for
trading. Dealers include giant banking firms located around the world.
Stock Market
The stock market is that financial market where the common and preferred stocks issued by
corporations are traded. It has two components: (1) the organized exchanges; and (2) the less
formal over-the-counter markets
11. There are many organized exchanges throughout the world like the New York and London Stock Exchanges. In
the Philippines, stocks are openly traded in the Philippine Stock Exchange. The companies whose stocks are
traded in the Philippines Stock Exchange are classified into the following categories:
1. Banks
2. Financial service
3. Communication
4. Power and energy
5. Transportation services
6. Construction and other related products
7. Food, beverages, and tobacco
8. Holding firms
9. Manufacturing, distribution, and trading
10. Hotel, recreation, and other services
11. Bonds, preferred stocks, and warrants
12. Others
12. The mortgage market is that portion of the financial market which deals with loans on
residential, commercial, and industrial real estate, and on farmland.
Various financial institution comprise the mortgage market. This may be derived from a
review of advertisements in newspapers where financial institutions are inviting
interested parties to buy foreclosed properties. Aside from banks, the National Home
Mortgage Finance Corporation, the Government Service Insurance System, and the Social
Security System grant mortgage loans, secure by house and lot as collateral.
Consumer Credit Market
The market involved in loans of autos, appliances, education, and travel is referred to as
consumer credit market. As there are millions of consumers tapping the credit market, it is
expected that there will be a number of financing institutions extending auto, salary, and
various personal loans to consumers.
13. Auction Market
The auction market is one where trading is conducted by an independent
third party according to a matching of prices on orders received to buy and
sell particular security. Stocks are sold to the highest bidder on the trading
floors. At the Philippine Stock Exchange, buyers of securities make their bids
and prospective sellers make their offer. Bids and offers stipulate both price
and volume and are handled by the trader, an agent of the auction market.
Offers are ranked from the lowest price up; bids from the highest price
down. Bids and offers are matched with one another. If there is a match,
Trade is consummated. Buyers and sellers do not directly trade with one
another, but though the trader. The Philippine Stock Exchange is an example
of an auction market
14. Negotiation Market
When buyers and sellers of securities negotiate with each other regarding price
and volume, either directly or through a broker or dealer, they are engaged in
the financial market called negotiation market.
Securities that are not frequently traded and which are in large volume may not
be readily accommodated in the auction market for lack of time to receive
sufficient orders. This situation is remedied by the negotiation market where
the buyers and sellers are given sufficient time to locate one another and to
revise either price or volume in order to clear the market.
Once in a while, the Philippine government negotiates with institutions like the
World Bank for loans intended for various projects.
15. Organized Market
The organized market is that financial market with fixed trading rules. It is situated at a
central location in the financial district in which trading is generally conducted by auction.
Another name for organized markets are exchanges like the Philippines Stock Exchange and
the Australian Stock Exchange. Common and preferred stocks, bonds, and warrants are sold
at the Philippine Stock Exchange. Stock exchanges have specifically designated members,
and have an elected governing body – the board. Members have seats in the exchange,
which are bought and sold. The seat gives the holder Philippine Stock Exchange is composed
of 15 members
Over-the-Counter
Market The over-the-counter market is that market consisting of large collection of brokers
and dealers, connected to electronically by telephones and computers that provide for
trading in unlisted securities. All securities not traded in the stock exchange, for one reason
or another, are traded over the counter.
16. The over-the-counter market consists of facilities, namely:
1. Relatively few dealers who hold inventories or over-the-counter securities and act as a
securities market;
2. The many brokers who act as agents in bringing these dealers together with investors;
3. The computers, terminals, and electronic networks that provide a communications link
between dealers and brokers.
Spot Market
When securities are traded for immediate delivery and payment, the market type referred
to is spot market. The spot price is the feature of the spot market and which is actually the
price paid for a security that will be delivered on the spot immediately. The term
immediately may actually mean one or two days to one week depending on the facilities
used or the tradition in the area.
The spot market is an alternative to the future market
17. Futures Market
The futures market is that market where contracts are originated and traded that give the holder the right
to buy something in the future at a price specified by the contract.
For some time in the past, there was a futures market operating in the Philippines, but I was dissolved
because of some difficulties. As its importance cannot be discounted, The Bankers Association of the
Philippines has recommended key reforms in government regulations that will pave the way for the
resumption of futures trading in the country.
Options Market
The options market is one where stock options are traded. A stock option is a contract giving the owner the
right to either buy or sell a fixed number of shares of a stock (usually 100) at any time before the expiration
date at a price specified in the option.
Options contract may cover items like gold and Treasury bonds. Options are traded in organized securities
exchanges like the Philippine Stock Exchange.
One purpose of the option market is to make possible investors who wish to reduce the risk of losing
money due to price changes in the future. For instance, an importer purchasing goods to be paid in foreign
currency may avoid the risk of a sharp rise in the foreign exchange rate by buying an options contract.
18. Foreign Exchange Market The foreign exchange market is the
market where people buy and sell foreign currencies. This market
is composed of the following:
1. Banks located throughout the world buying and selling
monies, in the form of foreign currencies and deposits in
foreign banks;
2. Foreign exchange dealers; and
3. Currency exchanges catering mostly to tourists and are found
in the downtown areas, airports, and railroad stations in
major tourist centers.
19. TOPIC 4: Methods of Fund Transfer
METHODS BY WHICH FINANCIAL MARKETS TRANSFER FUNDS
When firms need funds, the financial markets provide two methods by which funds could
be transferred to them. The methods consist of direct and indirect finance.
Direct Finance
Direct finance refers to lending by ultimate borrowers with no intermediary. Under this
method, the SSU gives money to the DSU in exchange for financial claims on the DSU. The
claims issued by the DSU are called direct claims and are typically sold in direct credit
markets such as the money or capital markets.
Direct financing provides SSUs with a venue for savings with expected returns. The DSUs as
a result, are provided with a source of funds for consumption or investment. This
arrangement increases the efficiency of the financial market
20. Direct financing, however, has some disadvantages. These are as follows:
1. There are few DSUs which can transact in the direct market because the denominations
of securities sold are very large (usually millions of pesos).
2. It is difficult to match the requirements of SSUs and DSUs in terms of denomination,
maturity, and other factors
Methods of Direct Financing.
There are various means used in direct financing.
These are as follows:
1. Private placements;
2. Brokers and dealers; and
3. Investment brokers.
Private placement refers to the selling of securities by private negotiation directly to insurance companies,
commercial banks, pension funds, large-scale corporate investors, and wealthy individual investors.
A broker is one who acts as an intermediary between buyers and sellers but does not take title to the
securities traded
21.
22. A dealer is one who is in the security business acting as a principal rather than an agent.
The dealer buys for his account and sells to customers from inventory. He makes profits by
selling his inventory of securities at a price higher than the acquisition cost.
The investment banker is a person who provides financial advice and who underwrites
and distributes new investment securities.
Indirect Finance
Indirect finance (also called financial intermediation) refers to lending by an ultimate
lender to a financial intermediary that then relends to ultimate borrowers. Financial
intermediaries includes commercial banks, mutual savings banks, credit unions, life
insurance companies, and pension funds.
The beneficiaries of direct financing brought to the fore the services of financial
intermediaries. Direct claims with one set of characteristics are purchased from
borrowers, then transformation into indirect claims with a different set of characteristics
and then sold to lenders
23. TOPIC 5: Under Writing and Selling the Firm’s
Securities in the Capital Market
The underwriting of securities may be done using any of the following methods:
1. negotiated underwriting;
2. competitive underwriting;
3. commission sales;
4. direct sales; and
5. firm commitment basis.
Negotiated Underwriting
When the issuing firm and the investment banker meet and agree on the terms and
conditions of the underwriting, this method is referred to as negotiated underwriting.
24. Several steps are required in the use of this method. These are the following:
1. The firm decides that additional funds are needed and a suitable investment banker is identified.
A pre-underwriting conference is made between the firm and the investment banker. The following
items are discussed:
a. The appropriate amount of funds to be raised;
b. The receptiveness of the capital market to different types of long-term securities;
c. The appropriate timing of such an issue; and d. The terms of the underwriting agreement
between the investment banker and the firm.
3. An underwriting syndicate is formed by the one who initiates the underwriting. The syndicate is a
temporary association of several investment bankers, with the number of participants varying from
one, when the initiating underwriter handles the whole issue, to a few dozens if the amount to be
raised is large. The initiating underwriter often becomes the manager of the syndicate and forms an
agreement with the other underwriters in the syndicate which defines the responsibilities, liabilities,
and fees of each and specifies the proportional amount of the issue each must purchase.
25. Competitive Underwriting
competitive underwriting is similar to the negotiated underwriting except that the
underwriting group bids against other underwriting groups for the initial purchase of the
securities at a public auction.
Commission-Best Efforts Basis When the investment banker acts as a selling agent for the
issuer and not as an underwriter, he is paid a commission. The investment banker agrees to
try his “best efforts" to sell the security is made on the successful sale of the entire amount.
Whatever is left over is returned to the issuing corporation.
Direct Sale There are instances when the issuer sells directly to the public, bypassing the
underwriter entirely.
Firm Commitment Basis The firm commitment basis is an underwriting agreement wherein
the investment house agrees to purchase the issue from the issuing corporation.
