FUNDAMENTALS OF FINANCIAL MARKET a INANCIAL MARKET Chapter 2 FINANCIAL INTERMEDIARIES PNP Red tal aaa eee eSFUNDAMENTALS OF FINANCIAL Marge Financial intermediaries and Other participants It is common that income received by a parly or entity does not match requiray expenditures, hence, resulting in deficits. These deficits may be resolved through transferring funds from fund providers (with excess funds) to fund demanders (vith deficits). This can be done either through direct financing or indirect financing. Despite the presence of a financial market, its role to provide efficient allocation resources between fund providers and fund demanders may not work as expected. T, bridge the gap, a special type of financial entity called financial intermediaries were formeg to facilitate indirect financing. Financial intermediaries were formed during the time when market conditions make it hard for lenders of funds to transact directly with borrowers of funds. Financial intermediation is the process of indirect financing using financia| intermediaries as the main route to transfer funds from lenders to borrowers. Examples of financial intermediaries are depository institutions, insurance companies, asso management firms, regulated investment companies and investment banks. Most financial intermediaries provide services to suppliers and demanders of funds, The assets these financial intermediaries are not limited to the portfolio they are managing but the information they gain to facilitate and support their clients. Financial intermediaries generally provide the following services: * Enable trading of financial assets for the customers of the financial intermediary through brokering arrangements «Enable trading of financial assets through its own capital by buying a stake ina financial asset that its customers want to transact in * Assist in forming financial assets needed by its customers and distribute these to its customers and other market participants as well. * Provide investment advice and consultation services to customers * Manage financial assets of customers * Facilitate payment mechanism between merchants and customers. Benefits from Financial intermediaries The existence of financial intermediaries is also beneficial for the econom, ee sowie by financial intermedianes creates Opportunities to financial deat Peopl mention other economic benefits that this will \ sax cn ba pentt bo'tnease will help as well as managing the Acceleration of flow of funds between entities nee Fund ae use financial intermediaries to transfer funds to fund demanders car a ce cermecieres, Most savings of fund providers may not be plage deal — und providers may ‘opt to keep their money at home rather pling the flow of money. Financial intermediaries also serve 8 ‘Savings and wealth function, i i pon em sores mn showing Parties with excess funds to store their funds 37FUNDAMENTALS OF FINANCIAL MARKET eo _OoMnMVOOO IAL MARKET A” Efficient allocation of funds Financial intermediaries possess the expertise to make sure that funds will flow in the economy in the most efficient manner. To ensure efficient allocation, financial intermediaries manage asymmetric information to a certain degree in its operations. Asymmetric information occurs when potential borrowers have more information about the ffansaction compared to the bank. Asymmetric information may lead to two further problems: adverse selection and moral hazard. Adverse selection means that high risk borrowers that would tend to default is more likely to be more active in borrowing funds than low risk borrowers who Pay on time. Since high risk borrowers are more eager to look for loans, they have a higher chance of being chosen. Adverse selection usually occurs before a transaction takes place. Since adverse selection is a known fact, potential direct lenders may opt not to extend loans despite good payers in the market. of Information! New York Stock Exchange (NYSE) is the largest in the world. NYSE was established in 1792 and accounts for about 40% of the world market capitalization Moral hazard occurs when borrowers have the tendency to take undesirable or immoral risks (for the lender) with the money, once they receive it, not disclosed during the loan granting process. Engaging in these undesirable activities may lower the chance that the loan will be Paid back. Moral hazard happens after the loan is granted. As a result, lenders may also refrain from extending loans since moral hazards reduces the probability of the loan to be repaid. Through financial intermediaries, individuals and firms may put their money in trustworthy banks financial intermediaries rather than directly to borrowers. Financial intermediaries are also better equipped at screening out bad borrowers from good borrowers which may reduce risk of adverse selection. Financial intermediaries also have the mechanism to monitor action of their borrowers, potentially reducing losses related to moral hazard. Knowing this allows bank to put controls in place to ensure that these risks are consistently mitigated, ensuring efficient allocation of funds. Creation of money Through its depositary function, financial intermediaries, specifically banks, allow creation of money through its bank loan services. This allows existing and new funds to be allocated efficiently. Banks acts as the conduit that lessen the constraint of limited income over spending, permitting consumers to spend while expecting future income and businesses to get physical capital. This results in more output for the economy and ‘employment growth. Through the financial intermediaries the state may recognize whether the need to create stronger monetary policy is imperative. Support in price discovery Price Discovery is @ process of setting a price which is acceptable for the buyer and the seller. Since financial intermediaries actively engage in trading financial securities, they play a significant role in price discovery. They play the role as experts and facilitators to enable to assign values to financial instruments based on different factors. The financial system, specifically the banking sector, also significantly influences discovery of interest rates. Consequently, this interest rates are factored in fair market valuation of financial instruments. 38 |FUNDAMENTALS OF FINANCIAL Maj, | 1 Improved liquidity for lenders Liquidity of ultimate lenders is enhanced through the presence of financ,, intermediaries. For example, a borrower receives money from an ultimate long, through a vehicle lke loan, the lender's liquidity is zero up unt the loan matures and the lender receives the payment. Financial intermediaries cer! manage eas, from different londers (ie. depositors) through immediately encashable produc, such as current and savings deposit accounts and at he same time and offer nop, marketable financial products such as mortgages, leases and credit contracts a result, the ultimate lenders have better liquidity compared to directly lending funds to providers. Reduced price risk for lenders Price risk means that prices of financial instruments may vary over time. Financial intermediaries offer very low-risk financial products such as deposits to ultimate lenders and at the same time offer financial products with high price risk such as shares, bonds and property financing to borrowers. As a result, lenders enjoy mitigated price risks as they course the transfer of funds with very low tisk to financial intermediaries which in turn bear the bigger risk when lending to other entities. This process can be called as risk sharing. Risk sharing happens when financial intermediaries create and sell financial assets with tisk profile that their clients are comfortable to invest on. Through the proceeds they can collect, financial intermediaries may then sell these financial assets to purchase other assets that may have higher risk and return. Risk sharing can also be called as. ‘asset transformation, since in essence, risky assets are converted into safer asses for the investors. Diversification of lenders Typically, members of household only have smaller wealth compared to financia! intermediaries. As 2 result, they do not have as much investment opportunities for their funds. This becomes a problem as lenders may not be able to efficient'y maximize returns from their funds because of the limited investment opportunities. Putting their funds through financial intermediaries, which have wider access !° investment possibilities, allows these household members to diversify thet portfolio better. Diversification is the process of investing funds in a portfolio assets that have individual returns that do not move at the same direction togethe’. For example, if return of Asset A goes up, return of Asset B usually goes down Diversification usually results in an overalll portfolio risk that may be lower than "is of each individual asset. Diversification also allows lenders to share risk from tne! investments. Looking at a finance perspective, tisk refers to the uncertainty regarding the return an investor will earn on their invested assets. Low transaction costs allow financial intermediaries to offer diversification ‘opportunities bY organizing a collection of assets into a new product and then selling it to interested investors. Economies of scale Economies of scale occurs when fixed costs are optimized per unit as a result of sheer volume of transactions. Cost per transaction is reduced as the number 0 transactions increases. Since financial intermediaries are experts in executi"? 3a ay is) eleC ”mClUlUltlttw””OOCOCO FUNOAMENTALS OF FINANCIAL MARKET financial transactions, they can get and perform large numbers of transactions. There are two main economies of scale that are optimized by financial intermediaries: transaction costs and research costs. Transaction costs pertain to cost associated with trading or managing funds and investment transactions. Research costs refer to costs incurred to monitor performance of potential companies to be invested in through economic, industry and financial analysis and look for other investment opportunities that will pay off in the long run. Financial intermediaries allow funds to be concentrated to them and they will incur transaction and research costs in behalf of all of its depositors. As @ result, transaction and research costs are spread over all depositors of the bank, thus, enabling economies of scale. "Payments System ‘The financial system serves as the main structure for making payments for any goods, service or securities that are purchased. Certain financial assets become the medium of payment and are settled efficiently (assuming efficient clearing and settlement system). Most common financial assets that are accepted as payment are bank notes, coins and bank deposits (through checks, straight credit card purchases, debit cards). * Risk mitigation On a general perspective, risk may also pertain to the uncertainty that something untoward or damaging may occur to a person or entity. Some types of financial intermediaries offer protection to individuals and organizations against adverse incidents that may occur. Consequently, the financial system allows people and companies to protect and build their wealth through having insurance against threats to their life, income and properties. = Implementation of monetary policy function The financial system provides the best mechanism to allow the goverment to implement its monetary policies to manage economic growth, steady employment rate, equilibrium of balance of payments and inflation. Through the regulatory authorities, the government is also able to greatly influence interest rates which consequently affect consumption and investments and the demiand for loans. Financial intermediaries exist to foster a more favorable transaction terms between fund providers and fund demanders compared if the two parties directly deal with each other, Figure 2.1 presents the two-step process observed by financial intermediaries. olFUNDAMENTALS OF FINANCIAL Manip, ARK Lending or Investing fund obtained to the fund demanders Obtaining of funds from fund providers (lenders or Investors) Figure 2.1 Two Step Process Funds that the financial intermediaries obtain can become either a liability of the financial intermediary or equity owners of the financial intermediary. The funds that they invest or lend out to other market players are recognized as assets of the financial intermediary. In exchange facilitating indirect financing, financial intermediaries receive a fee as cost of providing the service. Fees of financial intermediaries usually pertains to the difference between cost of issuing financial securities (dividends, interest, capital gains) and revenues earned from primary ‘securities (dividends, interest, capital gains) bought. Let's take a look at a universal bank, a depositary institution, as an example. Universal banks accept cash deposits from persons, companies and the government. Bank depositors are the fund providers. Funds received from the depositors are trested as liability of the bank. Consequently, the same funds are used by the bank either to lend to parties who need funds through a loan agreement or buy securities for capital appreciation. The loan receivables and securities acquired becomes assets of the universal bank The process mentioned above permits financial intermediaries to convert financial assets that are not attractive to most investors (money of an individual) into another financial asset — as a liability of the financial intermediary — that are more favored by the general public. This transformation has three economic functions: Maturity intermediation Normally, money deposited in banks are payable on demand or at a specific matunty date (e.g. time deposits). Usually, banks can only hold deposits that Cannot be withdrawn by depositors for a maximum term of three years. Based on this premise, maturity of deposits made by fund providers are usually short-term. Gntie tar hari, bani usualy ‘extend loans to its borrowers for more than three yen fund provi Problem if financial intermediaries did moe Masons eon Baers If financial intermediaries did not exis Ist, long-borrowers would have to borrow money for shorter term to match short duration at which fund providers are willing ailSe ee ea FUNDAMENTALS OF FINANCIAL MARKET a a TRY, to lend funds. This may also result in difficulties for borrowers in looking for lenders ‘who are willing to provide funds for the length of time it is needed. By using its own liabilities, banks essentially convert long-term assets into short- term assets by extending loans to borrowers based on the time they need it and giving financial assets to depositors for their desired investment prospect. This economic function of financial intermediaries is called maturity intermediation. Maturity intermediation gives fund providers / investors more alternatives in terms of how long they want to invest in financial instruments and borrowers have more choices on the length of maturity of their debts. Maturity intermediation also allows financial intermediaries to charge lower interest rate for borrowers. Normally, individual investors require higher interest rate from borrowers for long-term loans compared to short-term loans. Since financial intermediaries can depend on successive fund sources over a long period of time, they can offer lower interest rates on long-term loans compared to individual investors. Thus, cost of long-term borrowing can be lessened in an economy that has financial intermediaries + Risk reduction through diversification Diversification is the economic function exercised by financial intermediaries which converts more risky assets to less risky assets through sharing of risks. One good ‘example of diversification is the activities performed by mutual funds. Mutual funds normally solicit and accept fund from investors in exchange for shares in the mutual fund, Consequently, the mutual funds then invest the funds ‘obtained in portfolio of financial instruments. The shares in the mutual fund represent the ownership in the portfolio of financial instruments while the financial instruments are considered as assets of the mutual fund. Investing in many companies (and not only in one or two firms) allows the mutual fund to diversify and reduce the overall risk of the investment. This is advantageous or individuals who have limited capital as they will face difficulty in buying shares in many companies on their own because of the high cost involved Investing in mutual funds help these individuals to enjoy the same level of diversification even at a limited capital. Even though individuals may diversify their portfolio on their own, they may not be able to lower down the risk as cost-effective as financial intermediaries. The cost- effective diversification that financial intermediaries can do is an essential advantage of financial systems to the economy. Cost reduction for contracting and information processing Information processing costs refers to the cost of acquiring and processing information needed to evaluate purchase or subsequent sale of a financial instrument. Information processing costs also include opportunity cost of time associated with information processing. In order to maximize return from their available funds, investors should be able to develop skills essential to assess risk and retum characteristics of their financial instrument alternatives. Once they develop these skills, investors can use these to evaluate whether to buy or sell a financial instrument, 424Ligemmnalinats oo’ ee FUNDAMENTALS OF FINANCIAL M449, CG ‘Sntracting costs refers to the cost | wing roomerts incurred for joan tena terms of agreements to the concerned parties Conwactng cons, 2 pee lly incurred by investors wha are wiling to extend loans to consumer Oral a ec jotet to protect their selt-interest, investors should develop sing : & legally enforceable contract to be signed by both parties Once iioe agreement is signed, investors should also devote time to monitor financial stan. Sf the borrower and pursue legal actions for any violation in the legal agreerray Both information Processing and contracting costs require time before they can t done. However, most investors do not have the luxury of time to do both activites ‘and are willing to pay compensation to other parties to do thase for them With these points, financial intermediaries employ personnel that possess bop, skills that they can act in behalf of investors, Banking staffs and invests, Professionals are knowedgeable in analyzing and managing financial assets Standardized loan agreements are available in banks that can be easily used Fe, More complex transactions, the legal counsel of banks can also help i, Customizing the agreement investment professionals can also moniter Compliance to loan stipulations and initiate actions for any violations noted As a result, it is Cost-effective for financial intermediaries to employ these people since their main business is managing and investing funds. Financai intermediaries enjoy economies of scale associated with information processing and contracting costs due to the large sum of funds that they manager. The reduced costs of financial intermediaries, compared to costs of each individual investor if incurred separately, ultimately benefit the investors who has financiai claim on the financial intermediary and the issuers (reduction in funding costs) Most financial intermediaries are exposed to high levels of liquidity risk. Liquidity risk refers to the risk that liability holders (e.9. depositors for banks) may requis cash in exchange of the fir | claims they have from the institution. As a result financial intermediaries always maintain high level of cash and marketable Securities to make sure that they can meet the demand from depositors when the latter requires them to pay. Classification of Financial Intermediaries Given the diverse role of the financial intermediaries in the financial system. Commonly, financial intermediaries may opt to be a financial institution which is primarity extending financial support to demanders, while most are going into the exchange of this instruments, With the emergence of technology and innovative ways on how the funds wera channeled, financial intermediaries can already make combination to mitigate the risk and generate greater returns. There are three classifications of Financial Intermediaries: Depository Institutions and Investment Intermediaries, These three intermediaries find ways on how the Suppliers of fund will be able to maximize the funds they put into the financial system and at the same time address the needs of the demander of fund. aiiFUNDAMENTALS OF FINANCIAL MARKET Depository institutions Depository institutions are firms that accept cash deposits from individuals, companies and entities. Once the deposit is received, this becomes liability of the Gepositary institution to the depositor. Through the funds accumulated through deposit and non-deposit sources (obtained via issuance of debt instruments), depository institutions extend loans to different entities. Interest earned from these loans are the main source of revenue for depository institutions, A simple illustration to distinguish the difference on how depository institutions and nonfinancial companies recognize assets and liabilities is shown in Figure 2.2. Commercial Banks Nonfinancial Firms Aaa — abn and Renee, Deposts | Loan ‘omer nancial oocts. ‘Other ‘omer nontnanctel | fatities manvts ‘and equity Figure 2.2 Commercial Bank vs Nonfinancial Firms The biggest portion of the asset base of a depositary institution is loans. Loans can be divided into four categories: business, commercial or industrial loan; commercial or residential real estate loans; individual loans for vehicle or credit card purchases and all other loans. Loans are the main revenue-generating assets for banks. Depositary institutions also keep a significant investment on securities such as interest-bearing deposits purchased from other financial institutions, repurchase agreements, treasury bills, mortgage-backed securities and other equity and debt instruments. Banks eam interest income from these and trade these regularly to manage liquidity. Banks usually invest on securities that are highly liquid, can be traded in secondary markets and have low default risk. Investment on securities offers liquidity to banks. On the other hand, deposits comprise the biggest portion of a bank's liabilities. Deposits may be transaction accounts (checkable deposits that may bear interest or not), household savings, large time deposits and passbook savings accounts. In the Philippines, depository institutions are further subdivided to commercial banks, thrift banks and savings banks. 44|oy FUNDAMENTALS OF FINANCIAL MARk¢y i drafts/checks Commercial Banks. These banks authorized to accept ang issue letters of credit: discount and negotiate promissory notes, drafts, bills of exchange, and other evidences of debts; receive deposits, Duy and sq or silver bullion; and lend money agains, ‘securities consisting of personal property or first mortgages on improveg are payable on demand, but checks cannot be | Top S Commercial Banks in the | mitten against) and time deposits (deposits that | have maturity in fixed terms). Based on how much | is raised from these deposits, commercial banks use these funds to extend consumer, mortgage and commercial loans to borrowers and purchase government securities and corporate bonds Banks who operate as a commercial bank and also offer investment banking services are known as universal banks. Thrift Banks. These banks are primarily mobilized small savings and provide loans at generally longer and easier terms than do commercial banks as they cater to the lower income groups. Loans are usually for basic ‘economic needs, such as housing. Small producers such as farmers, cottage industry entrepreneurs, and consumers rely on these banks for the financing of their production and consumption requirements. © Savings Banks. organized for the purpose of accumulating savings deposits, and investing them for specified purposes, such as readily marketable bonds and securities, commercial papers and accounis receivables, drafts, bills of exchange, acceptance or notes arising from loans, whether secured or unsecured, mortgages on real financing for home building or home development, such other investments and loans as allowed by the Monetary Board of the BSP in pursuit of national economic objectives. Banks offer variety of services to their clientele which can be grouped into individual banking, institutional banking and global banking. Individual banking primarily focuses on financial requirements of individuals and included services such as consumer lending, consumer installment loans, automobile financing, brokerage services, mortgage lending, credit card financing, individual-oriented financial investment. services Institutional banking often caters to needs of financial and nori-financial corporations and government entities in activities such as commercial real estate financing and leasing Lastly, global banking is the sector wherein commercial banks contend with investment banks by offering broad range of service offerings revolving around corporate financing (sourcing of funds that goes beyond traditional bank loans to include letters of credit and underwriting of securities), providing financial advice on strategic initiatives such 6s financing sources, corporate restructuring, acquisitions and divestitures, and facilitating transactions Involving the capital market and foreign exchange products / services. Banks play a significant role in transmitting the impact of monetary policy set by # country’s central bank to the rest of the economy. Banks also contributes to the efficiency 45TONE Se Be EE of the financial system by offering payment services thal directly benefits the economy and by offering maturity intermediation services. Because of the crucial nature of the services offered by banks, the government closely regulates its operation to prevent any huge disruption in providing financial services that may eventually result in massive losses for the economy. Banks often issue four types of deposit accounts (liabilities in their point of view) demand deposits, savings deposits, money market demand accounts and time deposits. Depositors are insured by the Philippine Deposit Insurance Corporation up to maximum amount of Php500,000, * Demand deposits or checking accounts - Deposits that can be withdrawn upon demand through checks and offer very minimal interest since this can be withdrawn easily. * Savings deposits - Deposits that earn interest at a level below market interest be withdrawn upon demand and do not have a specific maturity * Money market demand account - Deposits that are placed on money markets that have slightly higher interest rates (money market rates) compared to savings deposits but can be withdrawn only after a short period of time * Time deposits (or certificates of deposits) — Deposits that have a fixed maturity date and depositors may earn interest at a fixed or floating interest rate. Aside from deposits, banks can procure funds from non-depository sources Non- depository sources include borrowing through issuing financial instrument in the money and/or bond market and borrowing reserves from the BSP. Rediscounting is a standing credit facility offered by the BSP to aid banks to meet temporary liquidity needs through refinancing the loans that banks extend to their clients. Through this facility, the BSP enables timely delivery of credit to all productive sectors of the economy. Rediscounting is one of the various monetary tools use by the BSP to regulate the liquidity level in the Philippine financial system. The BSP’s rediscounting is administered by the Department of Loans and Credit For banks participating in the clearing operations of the Philippine Clearing House Corporation, BSP offers an overdraft credit line (OCL) facility to cover for any shortfall demand deposit accounts of the banks with the BSP resulting from clearing operations. Overdraft refers to the deficit in a deposit account resulting from withdrawing more maney than what is deposited in the account. Usually, the BSP sets a ceiling on the overdraft amount that a bank may incur to cover for clearing losses from interbank borrowings and repurchase agreements with BSP. For solvent banks experiencing liquidity problems resulting from causes beyond their control, BSP offers fully secured emergency loans to serve as financial assistance to help in resolving liquidity woes. This is pursuant to Section 84 of RA No. 7653. The emergency loan shall be only up to the amount of needed-by the bank to resolve the liquidity predicament but shall not exceed 50% of its deposits and provided that any emergency advance should be collateralized by government securities and unencumbered first-class collateral (primarily real estate). 46 |FUNDAMENTALS OF FINANCIAL MARK Contractual savings institutions are financial intermediaries that obtain funds periodic intervals based on an existing contract, Unlike depository institutions, contractuyay savings institutions can project more accurately how much money they need to pay in thy future (in the form of benefits promised). Usually, contractual savings institutions need t pay their contractual obligations after several years. As such, asset liquidity is not the prime importance and they focus more in investing in long-term securities like stocks. mortgages and corporate bonds. Examples of contractual savings institutions arg insurance companies and pension funds. Insurance Companies Insurance companies offer a unique service to the individuals, corporations ang other entities in a country. Insurance companies offer services to assume risk or become undenwriters of the risk associated with various insurable occurrences. In addition to thei; role as risk bearers, insurance companies also invest in the financial markets. A contract of insurance is an agreement whereby one undertakes for a consideration to indemnity another against loss, damage or liability arising from an unknown or contingent event Insurance companies is an example of a contractual savings institutions. ‘The business of insurance companies works like this. Insurance companies collect premiums (payment made by parties who want to be insured) in exchange for selling protection against potential future risks. Premiums can be paid lump sum prior to the contract or during the life of the insurance policy. If the risk materializes in the future, the insurance company shall pay the insured amount to the beneficiary of the policy. Benefits can be paid via lump sum (one-time payment) or annuity (yearly payments). The beneficiary can be the one who paid the premiums or other party who the payor assigned. ‘Since insurance companies do not know if the insured event will happen or not, they can take advantage of the premiums received by earning return from it by investing the money in the financial market. Insurance products that are offered by insurance companies include: Proceeds will be paid to beneficiary if... Life insurance ‘The insured person dies * Pure life insurance coverage — premium is cheaper vs VUL; insured amount is guaranteed * Variable unit linked (VUL) insurance — insurance with investment component; portion of the premiums is invested, and any return will be in added to the insured amount. Insured amount in the contract is the minimum guaranteed amount. 47|FUNDAMENTALS OF FINANCIAL MARKET P Proceeds will be paid to beneficiary if... tired person 3 E spina a Insurance hospitalized or undergoes 3 to these firms covered medical treatment Property and Financial losses occur resulting * Commonly covers residential Casualty from damage, destruction or houses and vehicles insurance loss of insured property properly attributable to a sudden event Liability The insured party gets involved « Some companies also call this Insurance Ina Mitigation resulting from his as Directors’ Action Insurance of other's actions Disability The insured party becomes » Same with health insurance Insurance unable to earn income due to a however this will be for partial disability oF full disability Long-term care The insured party requires Insurance long-term care coverage if they are no longer able to take care of themselves, Structured The insured event occurs. settlements Fixed guaranteed periodic payments are given over a long period of time. Financial Issuer of an insured bond fails» Used to manage credit risks guarantee to pay principal and interest insurance timely. Investment intermediaries Investment intermediaries are organizations whose primary objective is to maximize return from investments in various financial instruments to add value for the investors, + Asset Management Firms ‘Asset management firms are companies that manage funds owned by individuals, companies or the government through buying and selling of financial instruments. Asset management firms are compensated for the management service through fees that they their clients. Mostly, the fee charged is based on the ‘amount of fund being managed. In some cases, fee charged cans be based on the performance of assets being managed. Looking at the trend nowadays, asset management firms are usually subsidiaries of commercial banks, investment 481Se ee eo ae lle ee i Se ol banks and insurance companies. The types of accounts / funds usually handieg by asset management firms are: * Regulated investment companies (RIC) Financial intermediaries that sells shares to the general public , exchange of cash. Once they receive the proceeds, they then invest the mong, in a diversified portfolio of financial instruments. Normally, asset managemen;, firms are contracted to manage the investment portfolio of reguiata, 4 investment companies. Different RICs have varying investment objectives and can engage jn, trading in different asset classes — whether money market funds, Stock funds or bond funds. Asset management strategies in portfolios can be further ‘subdivided into two: passive funds and active funds. Passive funds (or indexeq funds) are managed to mimic movements in the market index such as the PSE Index. Active funds are managed by asset management firms with the intention to outperform the index fund via actively trading securities in the fund portfolio, Each share stands for proportional interest in the portfolio of financial} instruments managed by the RIC. Each share in the portfolio is valued at Net Asset Value (or NAV). NAV is interpreted to be a per share metric. Eq. 2.1 presents the NAV computation. Bah: Eq2.1 NAV =~ aber of shares Pr Market Value of the Portfolio L Liability For example, a RIC has currently 10 million shares outstanding in its portfolio with market value of Php520 million and liabilities of Php20 million. The NAV is computed as follows: _ Php 520 — Php 20 NAV To = Php50 per share Asset management firms may manage two types of RICs: open-end funds and closed-end funds. Open-end funds, or more commonly known as mutual funds, do not have fixed number of shares. As long as investors are willing to invest, open-end funds can offer additional shares. Looking at the Point of view of investors, new investments to the ‘und are purchased at net ~ asset value at time of purchase while redemptions or sale of shares are als0 Priced at net asset value. Total number of shares of the fund increases if there more investments made to the fund than withdrawals and vice-versa. For example, at the beginning of the trading day, the mutual fund Portfolio has 10 million shares and is valued at PhptS0 ‘rilfon without any liabilities. The NAV at the beginning of the trading day is P15. During the \rading day, investors paid Php2.5 million to the fund and redeemed Pho! million from the fund. Assume that prices of the securities remain constant. The net investment of Php1.5 million signifies that 100,000 shares (Php1.5 million 49!FUNDAMENTALS OF FINANCIAL MARKET / P15) were issued to investors. At the end of the day, the fund has 10. shares valued at Php151.5 milion ae aoe More commonly, the market value of the portfolio and the number of shares changes. This ultimately leads to a change in NAV. However, once the trading day ends, NAV will be the same for all regardless of the net shares added to or deducted from the fund. This is because new investments and withdrawals on the fund are valued at the end-of-day NAV. _ On the other hand, closed-end funds have a fixed number of shares upon its inception and do not issue additional or redeem shares. Investors who intends to buy or sell shares should bring it to the secondary market for trading. Prices of the shares in closed-end funds are associates with demand and supply in the secondary market where the funds are being traded. Unlike open- end funds, market price of the fund's shares may be higher or lower than NAV. ‘Shares that are priced higher than NAV are dubbed as trading at a premium while shares value lower than NAV is known to be trading at a discount. A brokerage commission fee is paid by investors in closed-end funds to brokers who will transact the purchase or sale on their behalf. Costs associated with investing in RICs include: Shareholder fee or sales charge — one-time charges imposed to investors + Annual fund operating expense known as expense ratio — covers operating expenses of the fund. Large component of the expense ratio is management fee, the fees paid to asset management firms in exchange of its services. RICs allow individual shareholders to combine their resources to take advantage of lower transactions costs when purchasing large number of stocks or bonds. These funds let investors to have access on more diversified portfolios than they otherwise would invest individually. Since mutual fund shares are traded in the market, investments in mutual funds can be regarded as risky. Exchange Traded Funds (ETF) Exchange traded funds are like mutual funds, but the shares of the portfolio funds trade in an exchange like a regular share offered by @ company. Exchange traded funds possess characteristics of both open-ended and closed-ended funds. They are open-end funds, but the share pricing has small premiums/discounts from the NAV, like a closed-end fund. Investment advisors assume responsiblity for managing the portfolio that it moves at the same way as the index. Pricing might be slightly different from the NAV as the pricing is influenced by the interaction of the supply and demand in the secondary market. ETFs are also allowed to place limit orders, stop orders and orders to sell short or at a margin since its shares are directly traded in the secondary market unlike open-end funds. 50 |+ Hedge Funds @ funds are devi d to cater to sophisticated investors and are usyay, ia subject to the pg regulations covering mutual funds. Investor p; ¥ usually consists of affluent individuals and organizations with a relatively high minimum investment limit, Hedge funds are usually organized as a private investment partnership o, offshore investment corporation which uses various trading strategies to gain, better position in different markets. Hedge usually employ the following strategies when executing its investments: leverage (use of borrowed Toney to invest), short selling (sale of a security not owned with the expectation thay price of the security will eventually decline), derivatives and simulta Selling and buying of securities to take advantage of profit from temporary mismatching of prices Normally, investors of hedge funds are more inclined to evaluate performance of the t manager through absolute return rather than relative return, Absolute return refers to peso amount realized from the investment while relative return refers to the difference between realized return and the return shown in a benchmark index. Compensation for the services of hedge fund managers are a mix of fixed fee computed based on the value of portfolio being managed plus an incentive fee, a performance- based compensation that is computed through a % share in the positive return realized from the investment. Separately managed accounts Separately managed accounts or individually managed accounts are distinct funds solely dedicated to an individual or institutional investor. Instead of investing in a shared fund like a mutual fund, a fund can be made that will be based on the specific necessities of a sole investor. Investments done through the fund will suit the specific objectives required by the sole investor. Since these are like “specialized” funds, fees charged for separately managed accounts are typically higher than RICs. investment Banks Investment banks are highly leveraged institutions that have significant influence ‘on how primary and secondary markets work. Investment banks assist entities (individual, corporate, government) in raising money to fund their initiatives. Investment banks also assist potential investors by serving as the dealer or broker of transactions in the secondary market. Investment banks may be affiliated wit’ leading financial services holding companies such as Banc of America Securities and JPMorgan Securities or be an independent investment bank without any affiliation such as Goldman Sachs and Merrill Lynch. Investment banks can also be grouped based on activities that they can offer '0 investors. Full-service investment banks offer wide range of activities wrilé silFUNDAMENTALS OF FINANCIAL MARKET boutique investment banks only specialize in one or two activities that they offer to tneir clients. Activities that an investment bank can offer are as follows: ‘a. Public offering of securities Investment banks often assist firms to offer securities to the general public in ‘order to raise funds for varying business objectives. Investment banks give recommendation to the issuing company on what securities are attractive to investors to allow easier raising of funds. Investment banks also take into consideration how the issuing company want to treat the securities (whether equity, debt or mix of both) when advising. Investment banks possess information regarding the current willingness of investors to buy various kinds of securities and on the prices, investors are willing to pay. Investment banks participate in initial public offering and subsequent public offerings (also called secondary or seasoned offering). Initial public offering refers to the first time that a corporation offers stock to the general public. Once the issuing company chose the investment bank that would underwrite its securities, the investment bank then performs a due diligence process to ook at the value of the firm. The results of the due diligence process will be documented via prospectus which is a requirement of the SEC for public offerings. The prospectus contains all information regarding the firm that a potential investor finds relevant in deciding whether to buy the firm's securities ‘oF not. The prospectus also shows the firm's profitability, net worth and risks that the firm is facing such as pending lawsuits and competition. A preliminary prospectus shared to potential investors is called a red herring because of the notice printed in red included in the front cover signifying the tentative nature of the information in the document. Once the SEC approves the registration statement, the investment banks conducts a road show to visit institutional investors like pension funds and mutual funds that might be interested in the securities. The investors then check the prospectus and the securities offer. A quiet time is observed which restricts what the company officials can say regarding the company. The quiet time is important to ensure that all potential investors will have access to the same information and no unpublished data will give them an unfair advantage. Once all available information is shared with the investors, the investment banks then assign price for the security based on its estimate on how many securities will the investors demand. Next, the investment bank underwrites the shares. Underwriting occurs when an investment bank purchases the securities from the issuing company and then offers these secuntties in the market on behalf of the latter. Investment bank eams in underwriting through the gross spread, i.e. the difference between the price paid by investment bank to the issuing company and the price of security when reoffered to the general public (reotfering price). In exchange of the spread, the investment bank assumes the risk that it may not profitably resell the securities being underwritten. To expound, if the investment bank has misjudged condition of the market, it may sell the securities at a lower price than what was guaranteed to the issuing company. ‘The underwriting arrangement can be firm commitment or best efforts. In a firm ‘commitment, the investment bank buys the securities from the issuer based on 52]