CHAPTER 1 - Help in creating more efficient allocation of capital
Financial Systems and The Financial Market (physical/financial)
Financial Management – an important process to ensure
maximization of profit and wealth.
Sources of Wealth (Origin)
1. Labor – salary/wage
2. Land – rent
3. Capital (financial/industrial) – interest
4. Entrepreneurial skills – profit
Self-sacrifice - delayed gratification
Finance – also known as financial economics
- Application of economic principles to decision-making
that involves the allocation of money under conditions of
uncertainty.
- Provides the framework for making decisions as to how
those funds should be obtained and then invested
- Life-blood of the company
- “finer” (French): to end and settle a debt
Study of Capital Markets (key areas)
1. Financial system
2. Structure of interest rates
3. Pricing of assets
FINANCIAL SYSTEM
- Provides the platform by which funds are transferred from
those entities that have funds to invest to those entities
that need funds to invest.
- Composed of network of inter-related systems of
financial markets, intermediaries and services.
- Main reason for existence: matching the difference
between the spending of fund providers and fund
demanders.
- Regular, time-efficient and cost-effective link between
fund demanders and fund providers.
- Households: primary fund provider
- Business Firms & Government: main fund demander
Faure’s definition of financial system:
Set of arrangements/conventions embracing the lending and
borrowing of funds by non-financial economic units and the
intermediation of this function by financial intermediaries in
order to facilitate the transfer of funds, to create additional
money when required, and to create markets in debt and
equity instruments (and their derivatives) so that the price
and allocation of funds are determined efficiently.
Flow of Funds (two routes)
1. Direct Financing – borrower-spenders borrow and
deal directly with lenders through selling financial
instruments
o Financial Instruments – claims on the future
income or assets of the borrower
o Borrowers – liabilities; Lenders- assets
o Ex: buying stocks directly from a company
2. Indirect Financing – happens through the
intervention of a financial intermediary
FINANCIAL MARKETS
- Enhances welfare of individual consumers as they have
immediate access to funds.
Information Asymmetry – one stakeholder to a transaction
holds superior information than the other party which causes
inefficient allocation of financial resources as one party may
be in a better negotiating position
ELEMENTS OF FINANCIAL SYSTEM
1) Lenders and Borrowers
- Who are the players?
- Most essential stakeholders that make up the
foundation of a transaction
- Lenders: have excess funds that they lend for a return
- Borrowers: willing to pay the return for additional
funds
2) Financial Intermediaries
- How will the exchange occur?
- Special type of financial entity that acts as a third
party to facilitate the borrowing activity
- Gathers funds from lenders and redistribute it to
borrowers through an investment vehicle like loans
3) Financial Instruments
- What will be used?
- Medium of exchange of contractual obligation of a
party, where such contract can be traded (tangible or
intangible)
- A contract where a party recognize it as an asset and
another is as liability (IFRS 32)
- Types: cash/derivatives
4) Financial Markets
- Where will it be traded?
- Where suppliers and buyers of financial instruments
meet
- money market – cash; capital markets – derivative
5) Regulatory Environment
- How is it controlled?
- Governance body to ensure that the transactions that
occur within the financial systems complies with the
laws and regulations imposed to the actors as well as
the elements that plays within the system
- Financial systems are normally regulated by Central
Banks
6) Money Creation
- What is the value it creates?
- Money is used to either be reinvested or earned out
from the system flows
- May be converted into another form
7) Price Discovery
- How much is created?
- Process of determining or valuing the financial
instrument in the market
- Price is normally driven by the level of risk on how
the issuer of the financial instruments
THE FINANCIAL MARKETS
- Channels or places where funds and financial instruments
are exchanged. (e.g. NYSE, PSE)
- Intend to establish a consistent, efficient, and cost-
effective bridge between lenders and borrowers.
Financial Markets | Chapter 1 | M.J.R.
- Participants (e.g. household, gov’t, businesses, financial
intermediaries, broker and dealers, regulators, fund
managers and financial exchanges)
- Main economic function: serve as a channel to transfer
funds from fund providers to fund demanders.
- Trading: exchanging of financial instruments.
Major Economic Functions of Financial Markets
1. Price Discovery - determines how the available funds
from the fund providers are allocated towards the
fund demanders based on fund demanders’
willingness to accept the return required by the fund
providers. Undergoes negotiation.
2. Liquidity – easy access to a venue where investors
can sell financial instruments for cash
o Debt instruments – maturity date
o Equity instruments – voluntary/involuntary
liquidation
3. Reduction in transaction cost
o Transaction Cost – costs incurred of parties’
transaction to trade a financial instrument
o Search Cost: incurred to look for financial
instruments.
 Explicit Search Cost - needed to
advertise.
 Implicit Search Cost - value of time.
o Information Cost: evaluating investment
characteristics to justify worthiness.
TYPES OF FINANCIAL MARKETS
Based on Instruments Traded
1) MONEY MARKET – short-term securities are traded
- Cash financial instruments
- Financial instruments that will mature or be
redeemed in one year or less from issuance date
- Traded in secondary market
- Long-term investors for short-term liquidity needs
- Conduit to efficiently transfer large amounts of
money from fund providers to fund demanders for
short maturity term quickly and at a cheap cost.
- Instruments are very liquid, easily convertible to
cash and have very little default risk.
EX: T-bills, Commercial papers, Certificates of Deposit,
Repurchase agreement, Bakers’ acceptances,
Redeemable preference shares
2) CAPITAL MARKET – long-term securities are traded
- Derivative financial instrument
- Financial instruments that will mature beyond one
year from issuance date and perpetual securities (no
maturity)
- Foundation is made up by the dealers and brokers
market.
- Classifications:
o Equity (ownership interest)
o Debt
EX: Stocks (no maturity)
Based on Market Type
1) PRIMARY MARKET – lenders and borrowers
- fund demanders such as corporation or a government
agency raise funds through new issuances of
financial instruments e.g. bonds and stocks
- sold to original fund providers
- issuance of additional debt or equity securities of an
already publicly traded company
- non-negotiable instruments: mortgage loan,
savings deposits and life policies (issued only in
primary market)
- transactions are coursed through investment banks
o Investment banks - provides advice to issuers
(price, transaction costs, number to be issued)
based on their fund needs.
 Responsible in all aspects to ensure proper
execution of the issuance.
 Underwrite securities
 underwriting – investment banks
guarantee the price for the securities of the
issuing company and then sells these to the
general public
TYPES OF ISSUE METHODS
a) Public Offering
- securities are offered for sale to the general
public through issuing a prospectus or placing
an offer document
- Private companies who will sell shares to the
general public for the first time shall undergo
an Initial Public Offering (IPO) through the
help of investment banks.
- Can either be:
o Offer for subscription – IPO
- General public is invited to subscribe to
unissued shares.
- Proceeds: company
o Offer for sale
- Secondary offering but first time to be
issued to the public.
- Existing shareholders invite the public
to but portion of their shares.
- Proceeds: existing shareholders.
- Underwriter provides an undertaking to
purchase the remaining securities if the offer
will not be fully subscribed to the public (fee
is paid in exchange).
b) Private Placement (Limited Public Offer)
- Issuer looks for a single investor, an
institutional buyer or group of buyers to
purchase the whole securities issuance instead
of offering it to the general public
- Securities are illiquid and are not easily
converted into cash
- Only firms/financial institution are able to
buy.
- Underwriter subscribes to all securities and
sells it at a higher price (difference of prices
is underwriting spread).
c) Auction
- usually used for issuance for treasury bills,
bonds and other securities issued by the
government
- executed EXCLUSIVELY with market
makers
Financial Markets | Chapter 1 | M.J.R.
 - Three Methods:
o Dutch Auction
- Seller begins sale at a high price,
lowered down until buyer agrees to
purchase
o English Auction
- Prospective buyers submit an initial bid
price
- Other buyers submit new bid to top the
previous one, the bidding stops when
no other bidders want to top the last bid
o Descending Price Sealed Auction (First-
price sealed auction)
- Bidders submit sealed bids to sellers.
- Sealed bids are ranked
- Highest bids receive full allocation
while lower bids receive allocation pro
rata.
d) Tap Issue
- issuers are open to receive bids for their
securities at all times
- maintain the right to accept or reject the bid
prices
2) SECONDARY MARKET
- Where securities issued in the primary market are
subsequently traded, resold and repurchased.
- Centralized market wherein buyers and sellers can
transact
- Transactions occur through help of securities brokers
(facilitator)
- The original issuer of the financial instrument is not
involved
- allows the buyers and sellers to save on search and
information costs
EX: foreign exchanges market, futures market, and
options market
- Economic Functions of secondary market:
 Price Discovery
- provides information about prices of the
securities traded which can influence
economic decisions
- the higher the price of the security in the
secondary market, the higher the price on
issuing companies
 Liquidity and reduction in borrowing cost
- allows active trading which improves
liquidity and marketability of the securities
- reduces interest rates
- liquid market – parties who want to buy
and sell are equally matched, thus, price
of securities becomes stable
 Support to the primary market
- setting prices for new issuances
- assessing receptiveness of the market
 Implementation of monetary policy
- Influence liquidity and interest rates
- Investors can sell securities at fair market value if
they need cash (liquidity)
- Provides information to investors on the market
value of the investments.
- Minimized transaction costs because it is a
centralized market
- Issuers can have an idea of how much is the fair
market value of their financial instruments
- Value of the company can be determined based on
the prices of the financial instruments
- Market price > how well they are using the funds
- Market structure: how buyers and sellers interact
to arrive at the price and quantity of the securities to
be traded
- Classification based on market structure:
 ORDER-DRIVEN MARKET STRUCTURE
- buyers and sellers propose their price
through their brokers who conveys the bid
in a centralized location. (auction market)
- Types of orders:
a. Market Orders (at-best orders)
 orders placed with broker
 no price set
 executed immediately at the
prevailing best market price
b. Limit Orders
 Price/price range that may be
below/above the existing price is
set
 Broker executes the transaction
when prices go higher (sell) or
lower (buy) than the limit price or
range.
c. Day Orders
 Only valid until the end of the
business day.
d. Good-until-cancelled orders
 Remains valid for a sustained
period (60 days) up until the client
voluntarily cancel and remove
these from the system
 QUOTE-DRIVEN MARKET STRUCTURE
- Also called as primary dealer markets,
professional markets, market-made markets
- Seller dictates price
- Market makers set a bid quote (to buy) and
offer quote (to sell), the difference of
which is a spread.
- Spread represents transactional costs of
trading and reflects liquidity.
- Narrow spread – liquid; Wide spread –
illiquid
- EX: Trading of bonds and currency
Classification of Primary and Secondary markets based on
where financial instruments are traded:
1. EXCHANGE (Formalized)
- Centralized trading locations
- All financial instruments are listed and must
be complied with regulations set forth
- Most exchanges are Order-driven
- e.g. NYSE, PSE, Chicago Board of Trade for
commodities
2. OVER-THE-COUNTER MARKET (Informal)
- Where unlisted financial instruments are
traded
- Can be done through computers
- Do not have formalized mechanisms
- Bonds, loans, spot money and foreign
exchange markets
Financial Markets | Chapter 1 | M.J.R.
 - Negotiable certificates of deposit, banker’s
acceptances

Based on Country’s Perspective

1) Internal or National Market

- financial market operating in a certain country
- two parts:
a. Domestic Market - issuers who are considered
residents in a country issue the securities
b.Foreign Market – market where issuers who are
not residents of a country can sell or issue
securities
2) External Market
- financial market where securities that two unique
characteristics:
a. securities are offered simultaneously to investors
in different countries
b.securities are issued outside the regulatory
jurisdiction of any single country
EX: international market, offshore market, and
Euromarkets

Based on Manner of Financial Intermediaries

1) Broker Market
- buyer and seller of the securities are brought together
by a broker and the trade occurs at that point
- usually composed of national and regional securities
exchanges
- Philippine Stock Exchange – sole broker market in
the Philippines
2) Dealer Market
- buyer and seller are not brought directly together by
a third party
- market makers execute the sell or buy orders
- Two distinct trades: (a) seller sells his securities to a
dealer and (b) buyer buys his securities from a dealer
- ask price – lowest price of a security offered a sale
- bid price – highest proposed price in order for
investors to buy a security
- Investors pay the ask price when purchasing
securities and receives the bid price when selling
them
- Dealers earn profit through spread between bid and
ask prices
- Do not have centralized trading floors
- Consist of many market makers
- Market maker: dealers who create market by
offering to sell/buy securities at ask/bid prices)

Financial Markets | Chapter 1 | M.J.R.