CHAPTER 2 FINANCIAL MARKETS Believe you can and you've halfway there. Theodore Roosevelt <% . Bs ollie = aalll A om oe Ah iepS Manners INTRODUCTION At the forefront of secondary securities transactions in the Philippines is the Philippine Stock Exchange (PSE). PSE was formed from the country’s two former stock exchanges, the Manila Stock Exchange (MSE), established on August 8, 1927 and the Makati Stock Exchange (MkSE), established on May 27, 1963. Although both MSE and MKSE traded the same stocks of the same companies, the bourses were separate stock exchanges for nearly 30 years until December 23, 1992 when both exchanges were unified to become the present-day PSE. In June 1998, SEC granted PSE a self-regulatory organization (SRO) status, which means that the bourse can implement its own rules and establish penalties on erring trading Participants (TPs) and listed companies. In 2001, one year after the enactment of the Securities Regulation Code, PSE was transformed from a non-profit, non-stock, member. Boverned organization into a shareholder-based, revenue-earning corporation headed by a President and a Board of Directors. (PSE.com.ph 2016) In the advent of increased trade and globalization, the need for facilities, like PSE, and Systems that will enhance availability of funds are of utmost importance. Individuals and business institutions need funds to finance their needs. These needs Bive rise to the clamor for sources to fund financial activities. On the other hand, those with excess funds need to find ways and means to make their savings earn. Money in one’s hand does not earn anything. This need required the facilities and system that will help them make profitable investments. tis in this light that financial markets evolved. In this chapter, students will learn about financial markets, primary markets, secondary | __ Markets, money markets, and capital markets. They will be acquainted with the different money markets and the different capital markets. In addition, market for government securities (GS) will be discussed. Market offerings and private placements will be differentiated. The students will also have a preview of the different money market and capital market instruments dealt with in these markets, which will be discussed fully in the next chapter. FINANCIAL MARKETS: DEFINITION Financial markets are structures through which funds flow. They are the institutions and systems that facilitate transactions in all types of financial claim. A financial claim entitles a Creditor to receive payment from a debtor in circumstances specified in a contract between them, oral or written. Depositors have financial claims on banks where they hold their deposits; bondholders have financial claims on companies issuing the bonds they hold, Financial markets are the meeting place for those with excess funds (investors or lenders referred to as surplus/ Savings units) and those who need funds (borrowers or issuers of securities referred to as deficit units). Savings from households and businesses are channeled to those individuals and businesses which need the funds. The needs of deficit units and surplus units gave rise . to financial markets. Financial markets are at the heart of financial system determining the volume of credit available, attracting savings, and setting interest rates and security prices (Rose 1994),Cuaprer 2: FINANCIAL MARKETS Financial markets are classified as either (1) primary or secondary market or (2) money or capital market. Although we have other classifications of financial markets, these two are the basic classifications of financial markets. PRIMARY MARKETS Financial claims are initially sold by deficit units in primary markets. Primary markets are markets in which users of funds (e.g., corporations) raise funds, through mew issues of financial instruments such as stocks and bonds (Saunders and Cornett 2011). They consist of underwriters, issuers, and instruments involved in buying and selling original or new issues of securities referred to as primary securities. In other words, primary markets are markets for primary securities (new issues of financial instruments like stocks and bonds). They raise cash for the issuing company, which acts as borrower by increasing its current capital stock when it issues stocks, or outstanding liabilities when it issues bonds. The government also acts as a borrower when it issues bonds or Treasury bills. The primary market transaction involves either equity security (stock) or debt security (bond). These new issues are issued to initial suppliers of funds or investors. The following figures depict primary market transactions. The corporation needing funds issues new or original issues of either stocks or bonds directly to the investors (Figure 8) or to underwriters/financial intermediaries (Figure 9) who in turn sell them to the investors. Financial intermediary acts as the middleman or bridge that will satisfy the needs of the deficit units and the surplus units. Deficit Units Borrowers/Users of Funds flow pera ae funds; Corporations oranges issuing peviorers) Households and issues of stocks or eri meses bonds Figure 8: Primary Markets Involving Direct Selling (Without an Intermediary) Deficit Units : Borrowers/Users of Surplus Units funds; Corporations Underwriters Initial supplier of Investment/ funds; Households Merchant banks and businesses intermediary (investors) Issuing new/original issues of stocks or bonds Legend: Funds flow <——— Securities flow = ———__________» Figure 9: Primary Markets Involving an IntermediaryMost primary market transactions are done through investment banks, also called ‘merchant banks, which help the corporations issuing the stocks or bonds sell these stocks or bonds to interested investors. Investment or merchant banks purchase shares issued by the issuing company in an underwriting transaction and then sell these issues to the public. ‘An underwriter guarantees the sale of the issues, but does not intend to hold the shares or bonds in his own account. However, if the issue is unsuccessful and public investors refuse to purchase the issues, the underwriter carries the issues as its own investment, while waiting for more favorable market conditions. Investment banks provide the following services: 1. Provide funds in advance (giving cash to the issuer based on the agreed price of the security, usually a certain percentage of the total agreed price) Give advice to issuing corporations as to the price and number of securities to issue Attract the 2y 3. ial public purchasers of the securities 4. Act asa market analyst and advisor to the issuing company 5. Absorb the risk and cost of creating a market for the securities Primary market issues are generally for public offerings or publicly traded securities like stocks of companies already selling stocks in the stock market or stock exchanges. If these companies need additional funds, they create new issues to raise the firm’s capitalization or create new issues of bonds or debt instruments, thereby increasing its outstanding liabilities to meet the need for the funds. First-time issues for the public are called initial public offerings (IPOs). At times, it takes several investment banks to undertake such issues. Primary market securities also include the issue of additional equity or debt instruments of an already publicly traded firm. SEC requires corporate borrowers in the money market to register their issues unless they are specifically exempted from doing so (Chapter III, Sections 9 and 10 of the Securities Regulation Code). Prior to registering with the SEC, a company seeks a credit rating from the Credit Information Bureau. Rather than public offering, primary market sale can also take the form of private placement, particularly for closed corporations, that is, corporations whose stocks are only sold to family or a few close friends, relatives, and other private individuals. In addition, in private placement, the corporation issuing the stocks or bonds may seek to find an institutional buyer—such as a pension fund or group of buyers to purchase the whole issue. Merchant banks conduct private sale of shares to a few individuals or institutions but a vigorous and broad-based secondary market requires an efficiently operating securities exchange. Stocks | of closed companies are not publicly traded. These banks remain under the management and control of private companies and individuals. Larger companies, on the other hand, like the San Miguel Corporation, PLDT, Petron, Yahoo, and Google are publicly traded in large volumes.