Chapter 2: FINANACIAL MARKETS AND without going through a type of financial institution.
The business delivers its securities to savers, who in
INSTITUTIONS
The Capital Allocation Process
Financial Markets
Financial Institutions
Stock Market and Returns
Stock Market Efficiency
Shareholder value – is ultimately determined in the
financial markets.
Financial Markets – are where traders buy and sells
assets. This includes: stocks, bonds, derivatives, foreign
exchange, and commodities.
Markets – are where businesses go to raise cash to
grow. It’s where companies reduce risks and make
money.
Capital Allocation – is the process of distributing a
company’s financial resources with a purpose of
enhancing the firm’s long-term financial stability and
value creation – and providing fair returns to providers
of risk capital.
Capital Allocation Decisions – are made by the
company’s board and management.
Capital – is the money or wealth needed to produce
goods and services.
Such transfers make take place directly. Meaning that a
business sells its stocks or bonds directly to savers who
provide the businesses with capital in exchange.
Transfers or capital takes place indirectly through:
An investment banking house (financial intermediary)
such as banks, mutual fund, or insurance company.
THE CAPITAL ALLOCATION PROCESS
 In a well-functioning economy, capital flows
efficiently from those who supply capital to
those who demand it.
 Supplies of capital: individuals and institutions
with “excess funds”. These groups are saving
money and looking for a rate of return on their
investment.
 Demanders or users of capital: individuals and
their institutions who need to raise funds to
finance their investment opportunities. These
groups are willing to pay a rate of return on the
capital they borrow
How is capital transferred between savers
and borrowers? – Direct transfers of money
and securities
Direct transfers of money and securities – occurs when
a business sells its stock or bonds directly to savers,
turn, give the firm the money it needs. It is used mainly
by small firms and relatively little capital is raised by
direct transfers.
 Direct transfers
 Investment banks
 Financial intermediaries
( insert photo: DIAGRAM OF THE CAPITAL FORMATION
PROCESS )
Investment banks – ibank – Ex. Morgan Stanley which
underwrites the issue. And underwriter facilitates the
issuance of securities. The company sells its stocks or
bonds to the investment banks, which then sells these
same securities to savers.
The business securities and savers money merely pass
through the investment bank. However, because the
investment bank buys and hold the securities for a
period of time, it is taking a risk, it may not be able to
resell the securities to savers for as much as it paid.
Because anew securities are involved and the
corporation receives the sale proceeds, this transaction
is called a primary market transaction.
Financial Intermediaries – Ex. Banks, insurance
company or mutual fund.
The intermediaries – obtains funds from savers in
exchange for its securities. The intermediary uses this
money to buy and hold businesses’ securities, and
savers hold the intermediary’s securities.
 Largest full-service investment banks
 JPMorgan Chase
 Goldman Sachs
 BofA Securities
 Morgan Stanley
 Citigroup
 Credit Suisse
 Barclays Investment bank
 Deutsche Bank
A saver – deposits dollars in a bank. Receiving a
certificates of deposit. Then, the bank lends the money
to a business in the form of a mortgage loan. Thus,
intermediate literally create new forms of capital. In this
case, certificates of deposit, which are safer and more
liquid than mortgages and thus better for most savers
to hold
In the US, SECURITIES – are defined as contracts in
which one party invests money with another and
expects to make a return.
Certificates of deposit – fall under the broad terms of
the definition, and bank-issued brokerage CDS are
traded as securities. Regular bank CDS are not regulated
as securities
CDs – are time-deposit agreement between individuals
and banks that involves a depositor committing funds to
the bank for a predetermined period of time in
exchange for a specified rate of interest.

TYPES of CDS
 Standard bank CDs - pay account holders a set
rate of return over a period of time. Clients who
withdraw funds during the CD term incur a
penalty that depletes the interest earned and
may reduce the principal.
 Liquid CDs – are a cross between a savings 2. SPOT MARKETS VS. FUTURE MARKETS
account and a traditional CD. They are also
called risk-free CDs or no penalty CDs. Penalty- Spot Markets
free CDs allow customers to withdraw funds at - Are markets in which assets are brought or sold
any time without penalty. for “on-the-spot” delivery (literally within a few
 Brokerage CDs – are sold by banks directly to days)
investment companies, which market them as
securities to customers. Future Markets
- Are markets which participants agree today to
WHAT IS MARKET? buy or sell an asset at some future date.
Market – is a venue where goods and services are - Farmer agrees to sell 5,000 bushels of soybeans
exchanged. 6 months from now at a price of $12.28
- Food processor may enter into a contract
Financial market – is a place where individuals and - Such transaction can hedge or reduce the risks
organizations wanting to borrow funds are brought faced by both the farmer and the processor
together with those having a surplus of funds.

TYPES OF MARKETS
1. PHYSICAL ASSET MARKET VS. FINANCIAL ASSET
MARKETS
2. SPOT MARKETS VS. FUTURE MARKETS
3. MONEY MARKETS VS. CAPITAL MARKTES
4. PRIMARY MARKETS VS. SECONDARY MARKETS
5. PRIVATE MARKETS VS. PUBLIC MARKETS

1. PHYSICAL VS FINANCIAL MARKETS

Physical Asset Market

US
- also called tangible or real asset markets
A measure of capacity equal to 64 US pints (equivalent
- are for products as wheat, autos, real estate,
to 35.2 liters), use for dry goods.
computers and machinery.
British
Financial Asset Market
A measure of capacity equal to 8 imperial gallons
- deals with stocks, bonds, notes, and mortgages,
(equivalent to 36.4 liters), use for dry goods and liquids.
derivative securities
- Also deals with derivatives securities whose
3. MONEY MARKETS VS. CAPITAL MARKTES
values are derived from the changes in the
prices of other assets.
Money Markets
- A share of Ford Stock is a pure financial Asset
- Are the markets for short- term, highly liquid
while an option to buy Ford shares is a
debt securities. The New York, London, and
Derivative security whose value depends on the
Tokyo money markets are among the world’s
price of the Ford Stock.
largest.
In Finance, an OPTION – is a contract which gives the
Capital Markets
buyer (the owner or holder of the option) the right, but
- Are the markets for intermediate-or long-term
not the obligation, to buy or to sell an underlying asset
debt and corporate stocks.
or instrument at a specified stock price prior to or on a
specified date, depending on the form of the option.
Ex. The New York Stock Exchange
Short-term – less than 1 year TYPES OF FINANCIAL INSTITUTIONS
Intermediate – 1 to 10 years  Investment banks
More than 10 years – long term  Commercial banks
 Financial service corporations
 Credit unions
 Pension funds
 Life insurance companies
 Mutual funds
 Exchange traded funds
 Hedge funds
 Private equity companies

1. Investment Banks As Underwriters

4. PRIMARY MARKETS VS. SECONDARY
MARKETS Investment banks – generally guarantees that the firm
will raise the needed capital, thus called underwriters.
Primary Markets
- Are the markets in which corporations raise a Bear Stearns – collapsed and was later acquired by J.P.
Morgan,
new capital.
GE – sell a new issue of common stock to raise capital, a
Lehman Brothers – went bankrupt, and Merril Lynch
primary market transaction would take place
GE – receives the proceeds was forced to sell out to Bank of America.
IPO – Initial Public Offering
NIM – New Issue Market 2 surviving major investment banks – Morgan Stanley
and Goldman Sachs received Federal Reserve Approval
FPO – Follow on Public Officer
to become commercial bank holding companies.
Secondary Markets
- Are markets in which existing, already Investment banks in the Philippines
outstanding securities are traded among
investors According to Bangko Sentral – there are 21 universal
banks in 2018
- Jane Doe decided to buy 1,000 shares of GE
stock, the purchase would occur in secondary Ex:
o Land Bank of the Philippines
market
- NEW YORK STOCK EXHANGE, is secondary o Australia and New Zealand Banking Group
market Limited
o Deutsche Bank AG
o Ing Bank N.V.
o Standard Chartered
o The Hongkong & Shanghai Banking Corporation
o RCBC
o Security Bank Corporation
o Union Bank of the Philippines
o DP
o BPI, BDO, Inc., UCPB, China Banking
Corporation, PNB, Metropolitan Bank and Trust
Company

5. PRIVATE MARKETS VS. PUBLIC MARKETS
Private Markets
- Markets in which transactions are worked out
directly between two points
Public Market
- Markets in which standardized contracts are
traded on organized exchanges
2. Commercial Bank
- The traditional department store to finance
serving a variety of savers and borrowers.
Historically, commercial banks were the major
institutions that handled checking accounts
Philippines – are smaller than Universal Banks in terms
of scope of business
Commercial banks – offer various banking services, but
they cannot engage in the activities of investment
houses or investment banks such as underwriting of
securities
Ex of Commercial banks:
o Bank of Commerce
o Bank of China Limited – Manila Branch
 o BDO Private Bank, Inc.
o Citibank N.A
3. Financial Services Corporations
- Large conglomerates that combine many
different financial institutions within a single
corporation.
Ex. Citigroup owns Citibank (a commercial bank), an
investment bank, a securities brokerage organization,
insurance companies and leasing companies.
Bancnet, The Philippine Dealing and Exchange Corp
4. Credit Unions
- Cooperative associations whose members are
supposed to have a common bond, such as
being employees of the same firm.
- Members savings are loaned only to other
members, generally, for auto purchases, home
improvement loans, and home mortgages.
- Are often the cheapest source of funds available
to individual borrowers
5. Pension Funds
- Are retirement plans funded by corporations or
government agencies for their workers and
administered primarily by the trust
departments of commercial banks or by life
insurance companies.
- Invest primarily in bonds, stocks, mortgages and
real estate.
6. Life Insurance Companies
- take savings in the form of annual premiums,
invest these funds in stocks, bonds, real estate
and mortgages, and make payments to the
beneficiaries of the insured parties.
7. Mutual Funds
- are 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.
- These organizations pool funds and thus
reduce risks by diversification. They also
achieved economies of scale in analyzing
securities, managing portfolios and buying and
selling securities.
- Different funds designed to meet the objectives
of different types of savers
Bond funds – prefer safety
Stock Funds – for savers who are willing to accept
significant risks in the hope of higher returns
Money Market Funds – used as interest- bearing
checking accounts
MUTUAL FUNDS IN THE PHILIPPINES
 ATRAM Alpha Opportunity Fund
 MBG Equity Investment Fund
 Soldivo Strategic Growth Fund
 Sun Life Prosperity Dynamic Fund
 Sun Life Prosperity Philippine Equity Fund
 Philequity PSE Index Fund
8. Exchange Traded Funds
- Similar to regular mutual funds and are often
operated by mutual fund companies.
- ETFs shares generally traded in the public
markets, 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.
- The S&P 500, or just the S&P – is a stock
market index that measures the stock
performance of 500 large companies listed on
stock exchanges in the United States. It is one of
the most commonly followed equity indices,
and may consider it to be one of the best
representations of the US stock market.
9. Hedge Funds
- Similar to mutual funds because they accept
money from savers and use the funds to buy
various securities.
- While mutual funds and ETFs are registered and
regulated by SEC, hedge funds are largely
unregulated.
- Hedge funds typically have large minimum
investments and are marketed primarily to
institutions and individuals with high net worth.
- Hedge funds received their name because they
traditionally were used when an individual was
trying to hedge risks.
10. Private Equity Companies
- Organizations that operate muck like hedge
funds but rather than purchasing some of the
stock of a firm, private equity players buy and
then manage entire firms.
STOCK MARKET
 NYSE Euronext – formed in 2007 merger of the
New York Stock Exchange and Euronext.
 NASDAQ
 2 Basic Types of how stocks are traded
A. Physical location exchanges which include the
NYSE
B. Electronic dealer- based markets, which include
the NASDAQ, the less formal over-the counter
market and the recently developed electronic
Communications networks (ECNs)
- It is where the prices of firms stocks are
established
- It is a place where shares of public listed
companies are traded
OVER THE COUNTER
 Some brokerage firms maintain an inventory of
such stocks and stand prepared to make a
market for them. These dealers buy when
individual investors want to sell. And they sell
part of their inventory when investors want to
buy. At one time, the inventory of securities
 was kept in safe, and the stocks, when bought
and sold were literally passed over the counter.
 Today, these markets are often referred to as
dealer markets. The dealer market system
consists of
1. The relatively few dealers who hold inventories
of these securities and who are said to make a
market in these securities.
2. The thousands of brokers who act as agents in
bringing the dealers together with investors
3. The computers, terminals and electronic
networks that provide a communication link
between dealers and brokers.
The bid price – stock quote the price at which they will
pay for the stock
The ask price – the price at which they will sell the
shares
The bid-ask spread – which is the difference between
bids and ask prices represents the dealer’s mark-up or
profit.
PHYSICAL LOCATION STOCK EXCHANGES VS.
ELECTRONIC DELAER-BASED MARKETS
 Auction Market VS. Dealer Market (Exchanges
VS. OTC)
 NYSE vs. NASDAQ
 Differences are narrowing
PHILIPPINE STOCK EXCHANGE
The Philippine Stock Exchange, Inc., - is the national
stock exchange of the Philippines. The exchange was
created in 1992 from the merger of the Manila Stock
Exchange and the Makati Stock Exchange. Including
previous forms, the
- (PSE or Exchange) is a private non- profit and
non-stock organization created to provide and
maintain a fair, efficient, transparent and
orderly market for the purchase and sale of
securities such as stocks, warrants, bonds,
option, and others.
STOCK MARKET TRANSACTIONS
TYPES OF STOCK MARKET TRANSACTIONS
1. Outstanding shares established publicly-owned
companies. A market for outstanding shares or
used shares is the secondary market. The
company receives no new money when sales
occur in this market.
2. Additional shares sold by established publicly
owned companies: the primary market
3. Initial Public Offerings made by privately held
firms: the IPO market – whenever stocks in a
closely held corporation is offered to the public
for the first time, the company is said to be
going public.
WHAT IS AN IPO?
An Initial Public Offering (IPO) occurs when a company
issues stock in the public market for the first time.
“Going Public” enables a company’s owner to raise
capital from a wide variety pf outside investors. Once
issued, the stock trades in the secondary market.
Public Companies are subject to additional regulations
and reporting requirements.
MARTKET EFFECIENCY
Market Efficiency – refers to the degree to which
market prices reflect all available, relevant information.
If market are efficient, then all information is already
incorporated into prices, and so there is no way to
“beat” the market because there are no undervalued or
overvalued securities available.
 Securities are normally in equilibrium and are
“fairly priced.”
 Investors cannot “beat the market” except
through good luck or better information.
 Efficiency continuum
IMPLICATIONS OF MARKET EFFICIENCY
POSSIBLE REASONS MARKETS MAY NOT BE
EFFICIENT
 INDEX NUMBERS
Although there are different ways to calculate index
numbers, the numbers always represent a change from
an original base value.

The base value – represents the weighted-average

stock price of all the stocks that make up the index.

WHAT IS EFFICIENT MARKET HYPOTHESIS

(EMH)?
- The Efficient Market Hypothesis, or EMH, is an
investment theory whereby share prices reflect
all information and consistent alpha generation
is impossible. Theoretically, neither technical
nor fundamental analysis can produce risk-
adjusted excess returns, or alpha, consistently
and only inside information can result in
outsized risk-adjusted returns.

Alpha – is a measure of the active return on an

investment, the performance of that investment
compared with a suitable market index.

In modern financial markets, where index funds are

widely available for purchase, alpha is commonly used
to judge the performance of mutual funds and similar
investments.

CONCLUSION ABOUT MARKET EFFECIENCY

If the market is efficient, it is a waste of time for most
people to seek bargains by analyzing published data on
stocks.

Markets are more efficient for individual stock than for

the entire companies, so for investors with enough
capital, it does sense to seek out badly managed
companies that can be acquired and improved.