FINANCIAL MARKETS  Secondary Markets – markets in which existing, already outstanding
securities are traded among investors.
 Financial markets are where traders buy and sell assets. These include
stocks, bonds, derivatives, foreign exchanges and commodities. The
markets are where businesses go to raise cash. It is also where
companies reduce risks and where investors make money.
This is where people and organizations who want to borrow money
and those who have surplus funds are brought together.
Types of Financial Markets
 Physical Asset Markets – also called tangible or real asset markets are
for products such as wheat, autos, real estate, computers and
machinery
 Financial Asset Markets – deal with stocks, bonds, notes, and
mortgages. It also deals with derivative securities whose values are
derived from changes in the prices of other assets.
 Spot Markets – markets in which assets are brought or sold for “on-
the-spot” delivery.
 Future Markets – where participants agree today to buy or sell an
asset at some future date
 Money Markets – these are markets for short-term, highly liquid debt
securities.
 Capital Markets – are markets for intermediate (1-10 years) or long-
term (more than 10 years) debt and corporate stocks
 Primary Markets – markets in which corporations raise new capital
 Private Markets – transactions are negotiated directly between two
parties. (e.g. bank loans and private debt placements with insurance)
 Public Markets – where standardize contracts are traded on organized
exchanges. (e.g. common stock and corporate bonds)
 Derivatives – any financial asset whose value is derived from the value
of some underlying asset. It can be used to reduce risks or to speculate.
 Hedging operations – its purpose is to reduce risk exposure.
(Suppose a wheat processor’s costs rise and its net income falls
when the price of wheat rises. The processor could reduce its
risk by purchasing derivatives – wheat futures – whose value
increases when the price of wheat rises.
 Speculation – done in hopes of higher returns but raises higher
risk exposure.
To illustrate the growing importance of derivatives;
Credit default swaps are contracts that offer protection against the
default of a particular security. Suppose a bank wants to protect itself
against a default of one of its borrowers. The bank could enter into a
credit default swaps where it agrees to make regular payments to
another financial institution. In return that financial institution agrees to
insure the bank against losses that would occur if the borrower
defaulted.
A healthy economy is dependent on efficient fund transfers from
people who are net savers to firm and individuals who need capital

High – frequency trading (HFT) – helps reduce transaction’s costs and
makes it easier for other investors to get in and out of the market.
 Bitcoin – a virtual currency that involves no intermediate and has no
fees.
 Crowdfunding - changing technology has allowed some individuals
and firms to bypass intermediates and directly raise money from
investors to help fund various projects.
FINACIAL INSTITUONS
i. Investment banks – traditionally help companies raise capital. It is
organizations that underwrites and distribute new investment
securities and helps businesses obtain financing.
 Help corporations design securities with features that are
currently attractive to investors
 Buy these securities from the corporation
 Resell them to rise the needed capital
ii. Commercial banks – these are the traditional “department stores of
finance” because they serve a variety of savers and borrowers.
iii. Financial services corporations – are large conglomerates that
combine many different financial institutions within a single
corporation.
iv. Credit unions – are cooperative associations whose members are
supposed to have a common bond such as being employees of the
same firm. Credit unions are often the cheapest source of funds
available to individual borrowers (US).
v. Pension funds – are retirement plans funded by corporations or
government agencies for their workers and administered primarily
by the trust departments. This invests primarily in bonds, stocks,
mortgages, and real estate.
vi. Life insurance companies – take savings in the form of annual
premiums
vii. Mutual funds – corporations that accept money from savers and
then use these funds to buy stocks, long-term bonds, or short-term
debt instruments issued by businesses or government units;
Organizations that pool investor funds to purchase financial
instruments and thus reduce risks through diversification.
 Risks are high but the rewards are also high
 Money market funds – mutual funds that invest in short-
term, low-risk securities and allow investors to write checks
against their accounts.
 Actively managed funds – try to outperform the markets
 Indexed funds – are designed to simply replicate the
performance of a specific market index.
  Index – where the users can check the value of derivatives
 As per 2019 there are 250 corporations included in the Philippine
Stock Index.
viii. Exchange traded funds (ETFs) – generally traded in the public
market so an investor who wants to invest in the Chinese market for
example, can buy shares in an ETF that holds stocks in that
particular market.
ix. Hedge funds – typically have large minimum investments (often
exceeding $1 million) and are marketed primarily to institutions and
individuals with high net worth; reduces risk so they choose the
most competing corporations
x. Private equity companies – are organizations that operate much
like hedge funds but rather than purchasing some of the stock of a
firm, private equity player buy and the mange entire firms. Most of
the money used to buy the target companies is borrowed
 UK has the heaviest regulations
 Regulations hurt the efficiency of financial institutions but is
necessary so that financial institutions won’t run amok
 It also avoid market rushes and financial crisis
 China has the biggest bank in the world (Industrial & Commercial
Bank of China Ltd)
 Stock Market – most common and unique
 Most active secondary market and the most important one
to financial managers. It is where the price of firm’s stocks is
established because the primary goal of financial managers
is to maximize their firm’s stock prices.
 Physical location stock exchanges – formal organizations having
tangible physical locations that conduct auction markets in
designated securities.
 Tangible entities
 Has its own building for exchanges
 Has an elected governing body (board of governors)
 Electronic communications networks (ECN) – use electronic
technology to bring buyers and sellers together
 Over-the-counter (OTC) market (dealer market) – a large collection
of brokers and dealers connected electronically by telephones and
computers that provides for trading in unlisted securities. It is for
stocks infrequently traded and the inventory is with the broker or
firm.
 Dealer market – includes all facilities that are needed to conduct
security transactions not conducted on the physical location
exchanges.
DEALER’S QUOTE/PROFIT: = bid price – ask spread
  National Association of Securities Dealers Automated Quotation  Efficient market – prices are close to intrinsic values and stocks
(NASDAQ) – the computerized network used by Financial Industry seem to be in equilibrium
Regulatory Authority (FINRA)
EFFICIENCY CONTINUUM
Highly Inefficient Highly Efficient
Closely held corporations Publicly owned corporations
Small companies not followed Large companies followed by
Small companies Large companies
Owned by few (privately owned) Owned by thousands of investors by many analysts. Not much many analysts. Good
Closely held stocks Publicly held stock contact with investors communications with investors

 Secondary market – Outstanding shares/used shares of established  The factor is the size of the company – the larger the firm, the more
publicly owned companies that are traded. analysts tend to follow it and thus the faster new information is
 Primary market – additional shares sold by established publicly likely to be reflected in the stock’s price.
owned companies
Efficient markets hypothesis (EHM) – one of the cornerstones of modern
 Initial Public Offerings (IPO) market – made by privately held firms.
finance theory. If a stock’s price is “too low”, rational traders will quickly
It is the market for stock that is just being offered to the public.
take advantage of this opportunity and buy the stock, pushing prices up to
 Going public – when closely held corporations is offered for
the proper level. Likewise, if prices are “too high”, rational traders will sell
the public the first time
the stock, pushing the price down to its equilibrium level.
 When the market is strong, many companies go public to
bring in new capital and to give their founders an Overconfidence may in part stem from two other biases;
opportunity to cash out some of their shares.
 Self-attribution bias – people’s tendency to ascribe any success
Stock market efficiency: they have in some activity to their own talents, while blaming
failure on bad luck rather than on their ineptitude
 Market price – the current price of a stock
 Hindsight bias – the tendency of people to believe, after an event
 Intrinsic value – price which a stock would sell if all investors had all
has occurred, that they predicted it before it happened
knowable information about a stock. It is based on expected future
cash flow and its risk Time line – an important tool used in time value analysis; it is a graphical
 Equilibrium price – price that balances buy and sell orders at any representation used to show the timing of cash flow
given time
Future value – cash flow will grow over a given period of time when
compounded at a given interest rate
Present value – value of today of a future cash flow
Compounding – arithmetic process of determining the final value of a cash
flow when compounded interest is applied
Compound interest – occurs when interest is earned on prior period’s
interest
Simple interest – occurs when interest is not earned on interest.
STOCK MARKET – previously issued securities traded in secondary markets
 Most active secondary market
Why financial managers are interested in stock market?
 Primary goal is to maximize their firm’s stock prices
Physical location stock exchange
 Tangible entities
 Has its own building
 Has an elected governing body (board of governors)
 Governors of PSE are elected every 3 years
 The old Philippine Stock Exchange located in Makati City (Aug. 8, 1827)
 The new Philippine Stock Exchange located in Bonifacio Global City
 Index – PSEi
Based on PSE rules, sanctioned by the SEC, the board must be made up of 8
non-broker governors:
 1 president (Hans B. Sicat)
The PSE consist of 15
 3 independent governors
governors (non-broker)
 1 governor to represent issuers
 3 market participants
 The New York Stock Exchange located in Wall Street, NYC, NY, USA
(May 17, 1792)
 Often referred to as “the Big Board”
 It is by far the largest stock exchange by market capitalization
 “The Pits” are circular areas where trading occurs
 It trades in a continuous auction format (open outcry)
 Specialist broker serves as the auctioneer who is not an employee
 Automation was used in 1955 using hand held computers (HHC)
 Euronext located in La Defense, Greater Paris, France (1602
Amsterdam Stock Exchange)
 Considered as the “oldest/modern” securities market in the world
 Combines 5 national markets in Europe
 Over the counter market – often referred to as “dealer markets”
today for stocks infrequently traded. Inventory is with dealer firms
The system consists of;
 Relatively few dealers who hold inventory
 Brokers acting as agents to bring dealer and investor together
 Computers, terminals and ECN’s that provide the communication
link (dealer & broker)
 Bid price – how much they are willing to pay the stock
 Ask price – how much they will sell the stock
 Bid-ask spread – representing dealer’s profit
 Brokers and dealers who participate in the OTC market are members
of a self-regulated private corporation as the Financial Industry
Regulatory Authority, Inc. (FINRA)
 Licenses brokers and oversees trading practices
 NASDAQ – the computerized network used by FINRA
Expected prices & returns vs Realized prices & returns
 The name of the game is to “pick the winners”. Financial managers
attempt to do this, but don’t always succeed.
RISK MANAGEMENT
 Risk can be measured by impacts x probability
Two types of events:
i. Negative event – can be classified as risk
ii. Positive event – classified as opportunities
Financial risk – any of various types of risk associated with financing
including financial transactions that include company loans in risk of default
 Credit risk – occurs when there is a potential that a borrower may
default or miss on an obligation as stated in a contract
 Concentration risk – a banking term describing the level of risk in a
bank’s portfolio arising from concentration to a single counterparty,
sector or country
 Market risk – risk of losses arising from movements in market prices
 Interest Rate risk – risk that arises for bond owners from fluctuating
interest rates
 Foreign exchange risk – a financial risk that exists when a financial
transaction is denominated in a currency other than the domestic
currency of the company. The exchange risk arises when there is a
significant appreciation of the domestic currency in relation to the
denominated currency before the date when the transaction is
completed
 Equity risk – the financial risk involved in holding equity in a particular
investment through purchase of stock
 Commodity risk – the uncertainties of future market values and the
size of the future income caused by the fluctuation in the prices of
commodities
 Price risk – arising out from adverse movements in the world prices,
exchange rates, basis between local and world prices. Price area risk
usually has a rather minor impact
 Quantity / volume risk
 Cost risk – input price risk
 Political risk
 Liquidity risk – a risk that for a certain period of time given financial
asset, security or commodity cannot be traded quickly enough in the
market without impacting the market price
 Refinancing risk – the possibility that a borrower cannot refinance by
borrowing to repay existing debt
 Operational risk – the risk of a change in value caused by the fact that
actual losses, incurred for inadequate or failed internal processes,
people and systems, or from external events
 Country risk – risk of investing or lending in a country, arising from
possible change in business environment that may adversely affect
operating profit or value of assets in the country (E.g. devaluation,
war etc.)
 Legal risk – it is recognized as the most significant category of
operational loss events and considered to be a legal issue
 Model risk – a risk of loss resulting from using insufficiently accurate
models to make decisions
STEPS IN RISK MANAGEMENT
 Political risk – risk faced by investors, corporations, and governments
that political decisions, events or conditions will significantly affect the
profitability of a business actor or the expected value of a given
economic action
 Valuation risk – the financial risk that an asset is overvalued and is
worth less than expected when it matures or is sold
 Reputational risk – the potential loss to financial capital, social
capital, and/or market share resulting from damages to a firm’s
reputation
 Volatility risk – a change of price of a portfolio as a result of changes
in the volatility of a risk factor
 Settlement risk – a counterparty (or intermediary agent) fails to
deliver a security or its value in cash as per agreement when the
security was traded after the counterparty have already delivered
security or cash value as per the trade agreement
 Profit risk – the concentration of the structure of the company’s
income statement where the income statement lacks income
diversification and income variability
 Systemic risk – the risk of collapse of an entire financial system or
entire market imposed by interlinkages ad independencies in a system
or market, where the failure of a single entity or cluster of entities can
cause cascading failure, which could potentially bankrupt or bring
down the entire system or market
i. Establishing context – defining a framework for the activity and an
agenda for developing an analysis of risks involved in the process
 The social scope of risk management
 Identity and objectives of stakeholders
 The basis upon which risk will be evaluated
ii. Identifying the problem
  Source analysis – risk sources which can either be internal or
external (uses mitigation instead or management)
(E.g. stakeholders of a project, employees of a company or
the weather over an airport)
 Problem analysis (root-cause analysis) – risks are related to
METHODS OF MITIGATION
identified threats.
(E.g. threat of losing money, threat of human errors, accidents
and casualties)
Common risk identification methods are:
 Objectives-based risk identification – organizations and
project teams have objectives. Any event that may endanger
achieving an objective partly or completely is identified as risk
 Scenario-based risk identification – scenarios may be created
as alternative ways to achieve an objective, or an analysis of
the interaction of forces in (E.g. a market or battle). Any event
that triggers an undesired scenario is identified as risk
 Taxonomy-based risk identification – a breakdown of
Financial Risk Management – a specialization of risk management
possible risk sources. Based on taxonomy and knowledge of
best practices, a questionnaire is compiled. The answers to
the question reveal risks
 Common-risk checking – lists with known risks. Each risk in
the list can be checked for application to a particular situation
 Risk charting – combines the above approaches by listing
resources at risk, threats to those resources, modifying
Hedge – and investment made to limit loss
factors which may increase or decrease the risk and
consequences it wished to avoid
iii. Assessment – once a risk is identified, they must be assessed as to
their potential severity of impact (generally a negative impact, such as
damage or loss) and to the probability of occurrence.
 Avoidance – not performing an activity that could carry risk. It may
seem the answer to all risk. It also means losing out on the potential
gain that accepting (retaining) the risk may have allowed
 Reduction / Optimization – reducing the severity of the loss or the
likelihood of the loss from occurring. Finding a balance between
negative risk and the benefit of the operation. (E.g. Outsourcing)
 Sharing – sharing with another party the burden of loss or the
benefit of gain.
 Retention – accepting the loss or benefit of gain from a risk when
the incident occurs. Setting up an allowance account or insurance is
a viable strategy.
 The practice of economic value in a firm by using financial
instruments to manage exposure to risk
 Can be qualitative and quantitative
 Focuses on when and how to hedge using financial instruments to
manage costly exposures to risk
  The practice of taking a position in one market to offset and balance
against the risk adopted by assuming a position in a contrary or
opposing market or investment
CONTEXT MANAGEMENT OF INVESTMENTS
 Investors like returns and dislike risks
 Measurement of risk affect decisions
 The riskiness of an asset is based on its cash flows
 Same fundamental concept apply to all asset; differ in procedure
 The riskier the cash flow, the riskier the asset
Stand – Alone / Single stock – standalone risk is calculated in assuming that
the asset in question is the only risk and value that the investor has to lose
or gain. Standalone risk measures the dangers associated with a single facet
of a company's operations or by holding a specific asset
Portfolio – a number of stocks, are combined and their consolidated cash
flows are analyzed
Diversifiable risk – is a risk that can be diversified away and thus of little
concern to diversified investors. It is also known as company-specific or
unsystemic risk. (E.g. events like lawsuits, strikes, and events that are
unique to a particular firm)
Market risk – reflects the risk of a general stock market decline and cannot
be eliminated by diversification (hence, thus concern investors). Only
market risk is relevant to rational investors. It is the risk that remains in a
portfolio after diversification. (E.g. war, inflation, recessions, high interest
rates and other macro factors)
Probability distribution – listing of possible outcomes or events with a
probability (chance of occurrence) assigned to each outcome
Expected rate of return – rate of return expected to be realized from an
investment; the weighted average of the probability distribution of possible
results
Historical rates of return – actual rates of return based on past data. It is
often used as an estimate of future risk
Standard deviation (sigma) – a statistical measure of the variability of a set
of observations
Coefficient of variation – is the standardized measure of the risk per unit of
return; calculated as the standard deviation divided by the expected return.
It provides a more meaningful risk measure when the expected returns on
two alternatives are not the same
Continuous distribution shows risk – the tighter (or more peaked) the
probability distributions, the more likely the actual outcome will be close to
expected return also the tighter the distribution, the lower the risk
Between two investments that have the same expected returns but
different standard deviations, most people would choose the one with the
lower standard deviation and therefore the lower risk. If given the same
standard deviation (risk), but different expected return, most people would
choose the one with the higher expected return
Capital Asset Pricing Model (CAPM) – a theory of market equilibrium under
conditions of risk
Stock’s required rate = risk free rate + risk premium (reflects only the risk
remaining after diversification)
 The expected return on a portfolio is a weighted average of expected
returns on the stocks in the portfolio
 Actual return is the actual realized rates of return
 Portfolio’s risk is not the weighted average of the individual’s standard
deviations. The portfolio’s risk is generally smaller than the average of
the stock’s standard deviation because diversification lower’s the
portfolio’s risk
 Correlation – is the tendency of two variables to move together
 Correlation Coefficient – is a measure of the degree of relationship
between two variables
 Perfectly negatively correlated – all risk can be diversified away
 Independent – no correlation at all
 Perfectly positively correlated – diversification is completely useless
 Counter cyclically companies can be combined to form a riskless
portfolio. Combining stocks into portfolio reduces risk but does not
completely eliminate it
 A rational, risk-averse investor would be better off holding the portfolio
rather than just one of the individual stocks.
 Average portfolio risk declines as the number of stocks in a portfolio
increases but once 40 to 50 stocks are in the portfolio, additional stocks
do little to reduce risk
Reasons why investors hold one or few stocks:
i. High admin costs and commissions
ii. Index fund diversification
iii. Some think they can pick stocks that can “beat the market”
iv. Superior analysis can beat the market
Relevant risk – the risk that remains once a stock is in a diversified portfolio
Beta Coefficient – measures market risk; shows the extent to which a
stock’s return move up or down with the stock market. Average stock’s beta
is always 1.0. Stock’s beta reflects its contribution to the riskiness of a
portfolio; beta is theoretically the correct measure of the stock’s riskiness.
Excel’s =SLOPE () function can be used to calculate betas
Relative volatility of stocks – the steeper the line the larger the loss in a
down market
Modern Portfolio Theory / Markowitz model – a portfolio optimization
model that helps investor to choose securities that do not ‘move’ exactly
together, reducing risk
i. Determination the efficient set
  The portfolios that have the same return, the investor will prefer
the portfolio with higher rate of return
 If same risk level, an investor will prefer the portfolio with higher
rate of return

Capital market line (CML) – represents the risk-return trade off in the
capital market and the equilibrium condition. It means that the investor will
take higher risk if the return of the portfolio is also higher. It is always
upward sloping

Market portfolio – is the most diversified portfolio. It consists of all shares

and other securities in the capital market

Risk premium – is the product of the market price of risk and the quantity of
risk, and the risk is the standard deviation of the portfolio

Lending portfolio – the investor will lend a portion at risk-free rate

Borrowing portfolio – where investors borrows some funds at risk-free rate