TOPIC 1: OVERVIEW OF FINANCIAL MARKETS AND INVESTMENT PRODUCTS

Topic Learning Outcomes

After this topic, you should be able to:
1. Enumerate and understand the functions and roles of financial markets and its participants
2. Enumerate, differentiate, and discuss the operation of different types of financial intermediaries and institutions
3. Discuss the role and function of Central Bank in the financial environment
4. Enumerate the different types of investment products and their characteristics
5. Discuss how stock market works and generate returns

Be Engaged
Look:

Think:
1. Are you familiar with the institutions on the pictures above? What are their roles in our economy?
2. Have you availed any of their product? If yes, why?
3. Are you considering a career in relation with these institutions? Why or why not?
Let’s Discuss
1. Functions and participants of the Financial Markets
2. Overview of the operations of financial intermediaries and financial institution such as banks, investment
houses, insurance companies and others.
3. Role and function of the Central Bank
4. Types of Banks and other financial intermediaries
5. Types of investment products and their characteristics.
6. The stock markets
7. The market for common stocks
8. Stock market returns and stock market efficiency.

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 investors’ perspective, individuals 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. Figure 1.1 below,
show different ways how the capital flows from capital providers (savers) to those who need funds or capital (business).

Figure 1: Diagram of the Capital Formation Process for business

1. Direct transfers - occur when a business sells its stocks 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 (IB) - 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
much as it paid, and they hold the securities for a period of time. This transaction is called a primary market
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 investors 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 investors to
firms, corporations, 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 capital from savers.
2. Transfer resources across 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
vast array of options to grown your money in.
4. Markets 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

let us look at who are the main market participants. We have four main participants. Here are they, the key roles they
play, and their relationship with one another:

1. Firms – these are the business who needs capital to fund their operation, planned expansion, and other business
related necessities. Business firms also deposit some of their funds in financial institutions, primarily in checking
accounts with various commercial banks. Like individuals, firms borrow funds from these institutions, but firms
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. Individuals
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 suppliers for financial institutions: They save more money than they borrow.
3. Government – is in place to ensure Market integrity, to protect the investors, and to make sure that prices
correctly reflect the fair value of securities 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,
governments indirectly borrow from them.
4. Financial Intermediaries – all the chain of brokers, market makers, banks, and institutions that make the
interface between investors or between the investors and the firms. They are key suppliers of funds and the key
demanders of funds are individuals, businesses, and governments

Types of Markets
It is useful to classify markets along the following dimensions:

1. Physical asset markets 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, notes, mortgages and derivative securities.

2. Spot markets versus futures markets.

• Spot markets are markets in which assets are bought or sold for “on-the-spot” delivery
 • Futures markets are markets in which participants agree today to buy or sell an asset at some future date.
Such a transaction can reduce, or hedge, the risks faced 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 institutions have temporarily idle funds
that they wish to invest in a relatively safe, interest-bearing asset.
• 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 stock transactions. International capital markets also
exist.

4. Primary markets versus secondary markets.

• Primary markets are 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 is 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. Examples are
Bank loans and private debt placements with insurance companies.
• Public markets are where standardized contracts are traded on organized 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 loans
or investments. Financial institutions are governed by regulatory guidelines of the government. The following are types
of financial institutions:

1. Investment banks – which are also called underwriters, help companies raise capital by helping corporations
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 influence the money supply.
3. Financial services corporations – large conglomerates that combine many different financial institutions within a
single corporation. Example of which is Citigroup who owns Citibank (a commercial bank), an investment bank,
a securities brokerage organization, insurance companies, and leasing companies.
4. Credit unions – cooperative 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 individual borrowers.
Members’ 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
primarily by the trust departments of commercial banks or life 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 – corporations that accept money from individual or corporate business savers or investors and
then 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 funds – tries to outperform the overall markets

• Indexed funds – designed to replicate the performance of a specific market 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.

Role and function of the Central Bank

The Republic Act No. 7653 or “The New Central Bank Act” mandates that the State shall maintain a central monetary
authority that shall function and operate as an independent and accountable body corporate in the discharge of its
mandated responsibilities concerning money, banking and credit. This law pave way for the establishment of an
independent central monetary authority which is a body corporate known as the Bangko Sentral ng Pilipinas or simply
Bangko Sentral.

The capital of the Bangko Sentral

• Fifty billion pesos (P50,000,000,000), to be fully subscribed by the Government
• Ten billion pesos (P10,000,000,000) of which shall be fully paid for by the Government upon the effectivity of
this Act and the balance to be paid for within a period of two (2) years from the effectivity of The New Central
Bank Act.

Responsibility of Bangko 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 institutions
performing quasi-banking functions.

Primary Objective of Bangko Sentral

• The primary objective of the Bangko Sentral is to maintain price stability conducive to a balanced and
sustainable growth of the economy.
• It shall also promote and maintain monetary stability and the convertibility of the peso.

The Monetary Board

• The powers and functions of the Bangko Sentral shall be exercised by the Bangko Sentral Monetary 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 (7) members are:
the Governor of the Bangko Sentral (1), who shall be the Chairman of the Monetary Board. The
Governor of the Bangko Sentral 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" recognizes 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 integrity 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 engage in banking operations or quasi-banking functions without authority from the
Bangko Sentral
• Entity authorized by the Bangko Sentral to perform universal or commercial banking functions shall likewise
have the authority to engage in quasi-banking functions. The determination of whether a person or entity is
performing banking or quasi-banking functions without Bangko Sentral authority shall be decided by the
Monetary Board.
• Organization of banks
o The Monetary Board may authorize 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 shall mean twenty (20) or more persons; and
That the minimum capital requirements prescribed by the Monetary Board for each category of
banks are satisfied.
• The Bangko Sentral shall, when examining a bank, have the authority to examine an enterprise which is wholly
or majority-owned or controlled by the bank.

CLASSIFICATION OF BANKS
"The General Banking Law of 2000" enumerates various bank classification. Here are they and their function based on
the respective laws that govern them:

• Universal banks – A universal bank shall have the authority to exercise, in addition to the powers authorized for
a commercial bank in Section 29 of "The General Banking Law of 2000", the powers of an investment house as
provided in existing laws and the power to invest in non-allied enterprises.
• Commercial banks – A commercial bank shall have, in addition to the general powers incident to corporations,
all such powers as may be necessary to carry on the business of commercial banking, such as accepting drafts
and issuing letters of credit; discounting and negotiating promissory notes, drafts, bills of exchange, and other
evidences of debt; accepting or creating demand deposits; receiving other types of deposits and deposit
substitutes; buying and selling foreign exchange and gold or silver bullion; acquiring marketable bonds and other
debt securities; and extending credit, subject to such rules as the Monetary Board may promulgate. These rules
may include the determination of bonds and other debt securities eligible for investment, the maturities and
aggregate amount of such investment.
• Thrift banks – organized for the following purposes: (1) Accumulating the savings of depositors and investing
them; (2) Providing short-term working capital, medium- and long-term financing, to businesses engaged in
agriculture, services, industry and housing; and (3) Providing diversified financial and allied services for its
chosen market and constituencies specially for small and medium enterprises and individuals.
• Rural banks – as defined in Republic Act No. 7353 (hereafter the "Rural Banks Act"); the State hereby encourages
and assists in the establishment of rural banking system designed to make needed credit available and readily
accessible in the rural areas on reasonable terms. Loans or advances extended by rural banks organized and
operated under this Act shall be primarily for the purpose of meeting the normal credit needs of farmers,
fishermen or farm families owning or cultivating land dedicated to agricultural production as well as the normal
credit needs of cooperatives and merchants.
• Cooperative banks – as defined in Republic Act No. 6938 (hereafter the "Cooperative Code"); A cooperative bank
is one organized by, the majority shares of which is owned and controlled by, cooperatives primarily to provide
financial and credit services to cooperatives. The term “cooperative bank” shall include cooperative rural banks.
• Islamic banks – as defined in Republic Act No. 6848, otherwise known as the "Charter of Al Amanah Islamic
Investment Bank of the Philippines", these are subject to the basic principles and rulings of Islamic Shari’a.
• Other classifications of banks as determined by the Monetary Board of the Bangko Sentral ng Pilipinas.
The Market for Common Stock
Let’s Define:

a. Closely Held Corporation – A corporation that is owned by a few individuals who are typically associated with
the firm’s management.
b. Publicly Owned Corporation – A corporation that is owned by a relatively large number of individuals who are
not actively involved in the firm’s management.
Types of Stock Market Transactions
We can classify stock market transactions into three categories as stated below in the order in which a company open its
shares or ownership in public.

1. Transaction: Initial public offerings made by privately held firms; The market: IPO market. Description:
The company that is a closely held corporation is said to be going public when its shares is offered to the
public for the first time. The market for stock that is just being offered to the public is called the initial public
offering (IPO) market.

2. Transaction: Outstanding shares of established publicly owned companies that are traded; The market:
secondary market.
Description:
The trade is said to have occurred in the secondary market whenever the owner of a certain number of
shares sells his or her stock. Therefore, the market for outstanding shares, or used shares, is the secondary
market. No new money was received by the originally stock issuing company when sales occur in this market.

3. Transaction: Additional shares sold by established publicly owned companies; The market: primary market.
Description:
A transaction is said to occur in the primary market if a publicly traded company decides to sell or issue
an additional number of shares to raise new equity capital.

Stock Market Efficiency

To begin analyzing stock market efficiency, consider the following definitions:

• Market price – The current price of a stock.

• Intrinsic value – The price at which the stock would sell if all investors had all knowable information about a
stock. A stock’s intrinsic value is based on its expected future cash flows and its risk.
• Equilibrium price – The price that balances buy and sell orders at any given time.
• Efficient market – A market in which prices are close to intrinsic values and stocks seem to be in equilibrium.

Well-functioning financial markets

A well-functioning or a well-efficient market should provide access to the following and to everybody:
• trading information
o These includes the price, volume, order book, beta spreads, in order to assess the aggregate risks in the
economy when they trade.
o Fundamentally, transparency, it's very important for all participants at any given point in time.
• trading technology
o higher speed access to the market
o Some people trade with older technology, some have high frequency trader who trade with modern,
very speedy technology. There might be risks of front running, so the high frequency trader may front
run the retail investor and this is unfair. So we want to avoid this type of front running behavior.
• company information
o information relevant to the company are well-known to everyone i.e. insider trading.
o Insider trading has existed ever since companies were quoted in exchanges. Basically, a CEO, a board of
director, may have privileged information and he's not supposed to trade on this privileged information
to make money before the public and the broader shareholders can make money from public
information.
• market opportunities
o when these are well published
o Every time institutions, banks collude to fix a price, it distorts the pricing discovery mechanism for
investors and for companies
Efficiency continuum (Figure 2) is a scale that goes from highly inefficient stocks to highly efficient stocks. The key factor
is the size of the company.
• Large companies tend to be highly efficient since the more analysts tend to follow it and thus the faster new
information is likely to be reflected in the stock’s price. These companies have better communication with
investors by constantly communicating through published regulatory reporting required by the government.
• Smaller companies are not followed by as many analysts as large companies. They don’t have much contact with
investors. Hence, they tend to be highly inefficient. In an inefficient market, it might be possible to purchase the
company’s stock at a low price and then be able to turn around and sell it at a higher price making a profit.

Figure 2: Market Efficiency Continuum

Different companies communicate better with analysts and investors, and the better the communications, the more
efficient the market for the stock. This is called arbitrage.

References
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
• Bagayao, I. Y., & et al. (n.d.). Financial Management Volume 1.
• The New Central Bank Act – Republic Act No. 7653
• The General Banking Law of 2000 – Republic Act No. 8791
• Thrift Banks Act – Republic Act No. 7906
• Rural Banks Act – Republic Act No. 7353
• Cooperative Code – Republic Act No. 6938
• Charter of Al Amanah Islamic Investment Bank of the Philippines – Republic Act No. 6848
• https://www.coursera.org/learn/understanding-financial-markets/lecture/1Pxk4/the-role-of-financial-
markets-part-1

Other online resources

https://www.coursehero.com/file/p7ahjfgm/2-9-Briefly-explain-what-is-meant-by-the-term-efficiency-
continuum-Efficiency/
https://www.youtube.com/watch?v=H8N4srb4Ops