eee ea ee CC te ee ee ee ee FUNDAMENTALS OF FINANCIAL MARKET Chapter 1 FINANCIAL SYSTEMS AND THE FINANCIAL MARKETFUNDAMENTALS OF FINANCIAL tre» _— AN The Financial System In the world of commerce, finance Is @ key player in ensuring continuty cy Sperations. As they say, i is the life-blood of the company. Being the lite ioc y management must ensure that its continuous flow is maximize Hence, tinaned management is an important process to ensure that profit and wealth is mavimizag Sources of Wealth Money or wealth can be generated in different ways. In economics, these arg Aifferent sources of wealth. Figure 1 illustrates the sources of wealth and the type of oss, that can be generated. Let's call this as the Origin of Wealth. Every person always started with their own baby steps. Of course, we can't discount the fact that we are heavily dependent on our families, parents in Particular, vie Provide us with our needs. Normally, a person completes his education then after @ vile they will either work or do their own business but the basic of it is primarily labor since what they acquired from their education are the fundamentals. Labor through hard work will allow them to earn si lary or wage As the person — ) Continuously earns, they can save and eventually acquire | Point of Information! their own land which mi 'ybe used in their business or be leased by somebody else. Either way, it will generate | Wages are earned on a wealth in the form of rent. Moving on, as their land and | ally or weekly basis more labor become profitable, people starts venturing to higher | than that is called Salary | risk thus aiming for higher returns, ——— They start infusing capital either financial or industrial. Now the person is an investor. AS the venture is realizing good returns the capital will eam interest in later chapters, we will discuss how to manage the interest earned in capital markets Optimistically, businesses that matures and grow need more focus. The invesiors eventually take active participation in the business/venture. Thus, from investors they become the entrepreneur of their own which requires entrepreneurial skills, managing the commercial affairs and ensuring that their company continuously grow and generate more profit. Profit will eventually be accumulated, and investment will be diversified as it Grows employing new breed of Individuals and labor force and the cycle goes on Here you will see how finance plays in the system called business. The word finance is well known and defined in different ways. Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty, In the field of commerce, investors allocate their funds among financial assets to accomplish their objectives i.e. to maximize profit and wealth in the long run. Businesses and governments, on the other hand, raise funds by issuing laims against themselves that are invested. Finance provides the framework for making decisions as to how those funds Should be obtained and then invested, It is the financial system that provides the platform by which funds are transterred from those entities that have funds to invest to those entities that need funds to invest. 7FUNDAMENTALS OF FINANCIAL MARKET Entrepreurship Capital Land Labor Figure 1.1. Sources of Wealth The theoretical foundations for finance draw from the field of economics and, for this reason, finance is often referred to as financial economics. The tools used in financial decision-making, however, draw from many areas outside of economics: mathematics, Statistics, psychology, and accountancy. Since accountancy deals in providing quantitative information, primarily financial in nature, it is a necessity for these disciplines will have an integration. Accountancy requires in depth analysis of the transaction and even financial results to enable them to provide reasonable opinion which among the courses of action should be considered The study of capital markets focuses on three kay areas: the financial system, Structure of interest rates and pricing of assets. These will be further discussed in the later chapters. Financial system allows households, companies and the government who have available funds to invest these funds in more potentially productive vehicles that can result in faster growth in the economy. The financial system encourages fund savings from its ‘stakeholders and transform these savings efficiently into investment vehicles that help the economy grow faster. To cite another good definition of financial system: “Financial system is a set of arrangements.or conventions embracing the lending and borrowing of funds by non ~ financial economic units and the intermediation of this function by financial intermedianes in order to facilitate the transfer of funds, to create additional money when required, ‘and to create markets in debi and equity instruments (and their derivatives) so that AP. Financial system is composed of network of inter-related systems of financial markets intermediaries and services. The financial system of a country cares out the essential economic function that transfers funds from parties that have available funds to parties that need funds 1@ price and allocation of funds are determined efficiently *— Faure, 8]INDAMENTALS OF. FINANCIAL MARKET In a country, there are households, companies and government agencies who have available funds income. Essentially, because they spend less than their these are the fund providers. On the other hand, there are also households, companies ‘and government agencies that have fund shortage because ‘of deciding to spend more than their income. These are the fund demanders. Matching the difference in spending (excess funds from one party to the fund gap of another party) is the main reason for the existence of a financial system. The financial system permits an efficient method to move funds between entities who have funde and evtities who need funds, Financial systems #2142 Er a regular, time- Siders and fund demanders. Within the efficient and co: i 2 st-effective link between fund to another through financial system, funds are efficiently Transferred from one party | o innovative schemes on savings and investments that investors are willing to partake in. A basic overview of how a financial system works as illustrated by (Mishkin, 2004) in Figure 2. As Mischkin illustrated, the primary fund provider / lender-savers in the financial system are households but business firms, government and foreigners with spare funds can also lend out. On the other end, the main fund demanders or borrower-spenders he borrowed fund to support growth are business firms and government. Businesses use tI and expansion projects while government use the money to finance infrastructure and other community welfare projects. Households also become borrower-spenders when they borrow money to buy their cars and houses. Market participants will be further discussed in the later chapters. Funds can flow from lender-savers to the borrower-spenders in two routes: via direct financing or indirect financing: * Direct Financing. In this route, the borrower-spenders borrow and deal directly with lenders through selling financial instruments (or securities). Financial instruments represent claims on the future income or assets of the borrower coweer eee financial instruments as liabilities while lenders recognize these | asset. Buying stocks directly from a company is also considered 4s Point of Information! Finance came from the French word ‘finer’ which means “to end and settle a debt” * Indirect financing. in this route, the borrowi ivi , the b ing activity between both parties still happens though indirectly through the intervention of a financial intermediary.FUNDAMENTALS OF FINANCIAL MARKET Tea ea es re Lenaers~ Savers . SS 1. Household Borrowert-Spenders| Financial Business UNDS >| Government = Notes: f 1, Business . FUNDS || 2. Government ‘ 3. Households . Foreigners \ 4, Foreigners DIRECT FINANCE Figure 1.2. Financial Systems People who save frequently are not the same people who have access to profitable investment opportunities (i.e. entrepreneurs). The transfer of funds from providers to demanders allows both parties to gain some return. For example, fund providers can charge interest on the fund they are willing to loan out while fund demanders can earn from the investment they are going to pursue using the funds obtained from the provider Without the financial system, fund providers will not eam interest and fund demanders cannot pursue their investment because of lack of funds: The existence of financial system is important for the growth of the economy because of this reason. Financial markets help in creating more efficient allocation of capital which results in higher production and efficient that ultimately leads to economic growth. Capital can be physical or financial, either of which are used to produce more wealth. Efficient allocation of capital occurs when funds are invested in productive investments that yield return for the fund providers and fund demanders. A properly functioning financial system also enhances welfare of individual consumers as they have immediate access to funds allowing them to purchase things as they prefer. Funds are made available to young people to purchase what they want without making them wait to save for the entire purchase price. As a result, funds flow back much faster to business enterprises (through profit), government (through taxes) and investors (through interest or dividends). Efficient financial markets enhance the economic well- being of all members of the society. To become more efficient, the financial system of a country commonly addresses the problem of information asymmetry. Information asymmetry occurs when one stakeholder to a transaction holds superior information than the other party. Information “asymmetry causes inefficient allocation of financial resources as one party may be in a better negotiating position because of the lacking information of the other party. 10|eae A a erm Elements of the Financial Syste™ itry’s | ‘There are seven essential elements that make UP a country’ than yy, ‘These seven elements are the following: the players?) rrawe known as fund providers an oi seer, Lenders and Borrowers ar6 sn cesartial stakeholders that make uti the mos! ‘. arate’ ‘ial system, Without these Wo partig,, th | 4. Lenders and borrowers (Who are \ | ort ov Cu" Gemanders, respectively. The: ‘ent foundation of a transaction in the I | {fereoe financial system will not exist. funds that they can lend out to 94, parties who are willing to pa their investment initiatives, | Lenders are parties that have excess entities for @ required return. Borrowers are Pe required return to obtain additional funds to final occur?) the , 2. Financial intermediaries (How will the exchange yore re special type of financial entity that acts as , | +" © third party to facilitate the borrowing activity between lenders and borrowers. Ott, i err potential borrowers do not have an idea which parties or entities are willing to jeny “ac cout money to them and vice-versa. This gap in awareness makes it Gifficult for financial transactions to occur. This is where financial intermediaries coms into the “= picture. They gather funds from lenders and redistribute it to borrowers through an } ‘ investment vehicle like loans. Potential lenders and borrowers then Just need to visi tcoave nomen &3"Fihancial intermediary to participate in the financial transaction. The lenders ang EST borrowers do not even know who the ultimate individual or firm is who provided or vorormmce ™" demanded for the funds. They only need to have access to the financial intermediary . ines to enjoy the benefits of the financial transaction. tot cre Financial Intermedia aga4 oor find of es 3 Financial instruments (What will be used?) Financial instruments are medium of exchange of contractual obligation of a_party, where such contract can be traded. These can be tangible or intangible There are two types of financial instruments, it could be cash or derivative financial instruments. International Financial Reporting Standards defined Financia Instruments as a contract where a party recognize it as an asset and another is 2 liability. This will be extensively discussed in later chapters - i 4. Financial markets (Where will it be traded?) } 5 Financial Markets is same with the other economi sunelee and ase be! ee instruments meet. There aaiwonpae et financial ment that were being traded. For cash financial instruments, these are exchanged in th 1e ‘ instrument, it will be traded in the capital ee, ark For derivative financial uiFUNDAMENTALS OF FINANCIAL MARKET 5. Regulatory environment (How it is controlled?) Risk is inherent in every business oj since It involves different busi eration. Moreover, for financial ‘systems in the id financial ‘isks, government should intervene gulatory environment is the governance body to ensure that the that occur within the financial systems complies with the laws ne posed to the actors as well as the elements that plays within the systen lems are normally regulated by Central banks ar Money creation (What is the value it creates?) With the flow of financi either be reinvested or earned as it was given value out of th occurred in the system may bi al instruments, (money is created Money is used to out from the system flows. In economics, the money @ financial transactions because of the exchange that @ converted into another form.. - Price discovery (How much is created?) As the financial systems continuously flows and operates, the financial instruments create value. Price discovery Is the process of determining or valuing the financial instrument in the market, The price is normally driven by the leval of risk ‘on how the issuer of the financlal instruments. The Financial markets Financial market refers to channels or places where funds and financial instruments such as stocks, bonds and other securities are exchanged between willing individuals and/or entities. This also includes the existing mechanisms and conventions to facilitate transfer of funds and/or financial instruments between market participants. Financial markets intend to establish a consistent, efficient and cost-effective bridge between fund providers and fund demanders. F Participants in the financial markets include ultimate \enders and borrowers such as household, gavernment and businesses. financial intermediaries, broker and dealers, regulators, fund managers and financial exchanges. = The main economic function of the financial markets is to serve as a channel to transfer excess funds from fund providers to fund demanders. As a result, financial markets become the mechanism that bridges surplus and deficiteconomic units through providing ways to fund deficit units directly or indirectly via financial intermediaries. Financial markets also provide additional options to lenders and borrowers on which form they want their transaction to be in. For example, fund providers may deposit funds in banks, buy primary or secondary securities or lessen their debt through purchasing existing securities, On the other hand, fund demanders may issue new Securities or sell currently-owned financial instruments in the financial market to obtain funds. The existing of a functioning financial market allows market participants to avail of different options that suit their needs. 12|_Ss.,?-s i FUNDAMENTALS OF FINANCIAL MaRkey Exchanging of financial instruments is also more commonly known as “trading® Popular ejamPles of financial markets are the New York Stocx Exchange and Philipping Steck Exchange or PSE. There are three Major economic functions of the financial market: price discovery liquidity and reduced transaction costs, Ble Price Discovery Price discovery refers to the interaction between buyers and sellers in the financial market in order to come up wilh pice of te waded financial instumerr fs Setat the level wherein the buyers are willing to buy, and sell mare alng (0 Sell. The agreement between the two parties is important re nine the rice of the financial instrument. Usually, the providers of fun A ec Market determines the required retum for a financial_instrument. ie 's the minimum rate of retum that they are willing to accept to purchase a nancial instrument. This function of the financial market determines how the available funds from the fund Providers are allocated towards the fund Sores faved ‘on the fund demanders’ wilingness to accept the return required by the fung providers. Liquidity The second function of the financial market is liquidity) Financial markets Serve as a forum where buyers and sellers can Meet to facilitate transactions. As ‘e sell financial instument. This realty offers liquidity to the investors. Without liquidity, an investor is forced to hold to financial instrument up until Such time that conditions in the agreement happen that will permit the disposal of the instrument (e.g. Conversion) or the issuer is contractually obligated to Pay for the instrument. For debt instruments, this Pertains to the.maturity date: for equity instruments, this refers to voluntary or involuntary liquidation. All types of financial markets offer different degrees of liquidity. = 78 Reduction in transaction cosis Reduction in transaction Costs is the last func Transaction costs are the costs incurred of Parties’ tran: ramen. Transaction costs can be Classified into tw. formation costs ion of a financial market 'saction to trade a financial © types: Search costs and Search costs are costs incu i 2g Purchased or sold by a party capt : l00k for financial instruments that can advertise intent to Purchase or sell a finanes) , ant, pAPeNSSS needed to : cial instrument. im, include value of time consumeq $o.look for 2 cou niger ee Dict Search costsEE a, FUNDAMENTALS OF FINANCIAL MARKET. —_— —arvmnv——rere—rrr—rrvrrvreveeet Information costs are costs related in evaluating investment characteristics of a financial instrument. Investors often spend information costs to gather information about profitability, liquidity, stability and market value of a financial instrument to justify worthiness of tI stment. In a price efficient markel, prices: of the financial instrument properly reflect the combined information gathered by the market participants. Types of Financial Markets As it is known that financial markets are classified depending on the transactions that is being observed or the exchange that is done, to whom t is traded or the market where it is traded, the manner how it is traded, and the perspective of the country. Based on Instruments Traded Financial Markets may be classified according to the type of financial instrument it traded. Whether the instrument is a short-term security or long term. Short term securities are normally traded in money market, while long term securities were Classified under capital market. Money market is the sector of the financial system where financial instruments that will mature or be redeemed in One year or less trom issuance date are traded. Specifically, money markets cater to fund demanders who need short-term funds from fund providers who have excess short-term funds. Short-term is defined as one year or less. Once money market securities are issued, they ate traded in the secondary market. Money markets are Not exclusive for short-term investors. Long-term investors also need the money market as they tend to inyest in this market to meet their short-term liquidity needs._ Money market is very important for fund demanders since immediate cash requirements cof individuals, government and corporations do not necessarily coincide on the timing of their cash receipts. For example, cash receipts from sales of a corporation do not take pace at the same pattem of their expenses (€.9. wages, supplies and other expenses). easonal or temporary financing requirements like peak seasons also creates the necessity for short-term fund requirements. At the same time, excessive holdings of cash by fund providers also generates opportunity cost in the 2regone interest. As a result, fund providers with excess cash tend to maintain only minimum cash requirements as needed for its day-to-day operations and invest the excess cash in-financial-instruments that can be quickly and cheaply converted to‘cash when needed with minimal risk of loss in value involved. Money markets serve as the conduit to efficiently transfer large amounts of money from fund providers to fund demanders for short maturity term quickly and at a cheap cost from the parties involved. Money market instruments offer an investment opportunity that yields a higher retum than just mere holding of cash (which generates zero ir interest). Also, money market instruments are very liquid and easily convertible to cash and has very little default ris e naturity term, Common examples of financial instruments that are traded \ey Market are the following: Treasury Bills, Commercial Papers, Certificates of Deposits, Repurchase agreement, Bankers’ acceptances, 14}FUNDAMENTALS OF FINANCIAL Maney Capital market is the sector of the financial rarely sero fare err Lie i ill mature be) , te by governments and corporations that will m: ay 28 ee pnancel Rear long-term) are traded. Long-term financial instrume n ane Say ‘dates longer than one year and perpetual securties (with no maturity), The foundation of the capital market is made up by the dealers and brokers market which creates a venue for bond and stock transactions. fied into two: equity (which represent ownership Capital market securities are classi chapters. interest) and debt. Further discussion in the late ed to be a liquid market where fund demanders can interact Ne ing resources. Investors believe that with potential investors to-acquire external financi apitel market should be an efficent market to ensure that avaliable funds are allocated to its most productive use. The efficient allocation stems from competition between wealth. i i of securities believed to be close to their rea) maximizing investors who determine prices 0 Oe acct ot nterecinn value. In an efficient market, the price of securities, P between buyers and sellers in the market, is believed to be 2 fair estimate of its real value, ‘Any new information that investors will learn will eventually move its price upwards or downwards. Based on Market Type Another categorization of financial market is to what type of market it is being traded. This may be categorized into primary and secondary market. Figure 1.3 illustrates the difference of the two types of financial market in terms of the market type. It can be noted that in primary market the supplier of funds is called lenders while they are buyers in the secondary market. Borrowers are the demanders of fund in primary market while sellers are what we call for those demanders in the secondary market. primary markt — . + theditterence secondary markat the diference Ea —__, Ea Figure 1.3. Primary vs Secondary Markets Primary market is : ora a type of financial market wherein fund demanders such as corporation bonds and stocks. Normally, whi fu 3 fen internal an on ly generate i enough, emenders nee to Tae vane af nds (€.9. retained earnings) are ‘ew projec or production expansion requirements, P=" Markets to fully finance 15 |FUNDAMENTALS OF FINANCIAL MARKET New issuances of financial instruments are sold to original fund providers (usually households) in exchange for money that the fund demander needs. Primary market securities also include issuance of additional debt or equity securities of an already Publicly traded company. Non-negotiable instruments like mortgage loans, savings deposits and life policies are issued only in primary markets and are not traded in secondary markets. Usually, primary markets transactions are coursed through investment banks which are financial institutions that act as intermediaries between issuing companies (fund demanders) and potential investors (fund providers). Investment banks provides advice to issuers on matters related to prices of the securities, transaction costs and number of securities to be issued based on their fund needs. They ‘also provide advice on how to present information to attract potential investors to the securities issuance. Once the securities issuance is settled with the issuer, the investment banks markets the securities to the initial purchasers forthe issuer. Through the assistance of an investment bank, the issuer reduces the risk and cost of establishing a Market for the securities on its own. Investment banks is responsible to all aspects to ‘Snsure proper execution of the issuance: legal and financial exchange requirements, ‘appointments of lawyers_and. auditors, due diligence, etc. Investment banks also underwrite securities. Underwriting means that investment banks guarantee the pric® for the securities of the issuing company and then sells these to the general public. Transactions in the primary market can be classified based on the intended purchasers of the securities. There are four types of jssue methods that can be done in the primary markets: — nvtial Publier 5¢esing * Public Offering. This occurs when securities are offered for sale to the general Public. Offering to the general public is done through issuing-acprospectus) or placing document which contains an offer to the general public to subscribe or hase securities at a stated price. Private companies who will sell shares to the general Public for the very first time is said to undergo an initial public offering or IPOs are usually done through the help of investment banks. Public offering it Ir iption or an offer for sale In an offer for caer apaliacs public is pr subsctete scribe to unissued sheres of the company. Proceeds received from this offer are enjoyed by tha company and can be used to finance their investment objectives. In an offer for sale, existing shareholders invites potential subscribers to buy portion of the shares they own, ‘Proceeds from this offer is enjoyed by the existing shareholders, not by the Sompany . Most of the time, an_ underwriter is appointed for public-offerings. An underwriter provides an undertaking to purchase the remaining securities if the offer will not be fully subscribed by the public. In exchange of the undertaking, a fee is paid by the issuing company to the underwriters. Securities coursed through underwriters gives comfort to potential investors since underwriters are willing to take the risk of guaranteeing these securities. © Private placement limited public offer). This occurs when the 16 |———=—————_ FUNDAMENTALS OF FINANCIAL Many ey lase the whole securities issuance offering it to the general Public lonally, securities sol igh 0 cements tend to be illiquid and are not easily Converted into cash because of the very limited parties it was sold to. Ag @ result, it is common that only established financial institutions or firms are abie to buy and hold on to them. One variation of a private placement is that an underwriter subscribes to ai) securities at a certain price and consequently, sells these same securities to a Group of investors at a higher price. The difference between these two prices is termed as undenwriting * Auction. Another way to offer securities to the general public is through an auction process. Auction is usually used for issuance of treasury bills, bonds and other securities issued by the government and are commonly executed exclusively with market makers. Auction can be done in three methods Dutch auction — Type of auction where seller begins the sale at a high price ‘From that point, the price of the securities is continuously lowered dowm at specific intervals until the potential buyer agrees to purchase at that price f English auction - Type of auction where the prospective buyers cornmence ‘the auction by submitting an initial bid price. Other buyers interested to purchase the securities submit a new bid to top the previous one The process continuous as price of the securities increases as more interested buyers bid on it. The bidding stops when no other bidders want to top the last bid. The last, highest bid price becomes the price of the securities that the highest bidder should pay. Descending price sealed auction (or first-price sealed auction) ~ Type of auction where bidders submit sealed bids to the sellers. The sealed bids are ranked from highest to lowest price. The number of securities is allocated first to highest priced bid and follows a descending order. Highest priced bids receive full allocation while lower bids receive allocations distributed pro rata. ve «Tap Issue. This method occurs when issuers are open to receive bids for ther securities at all times. Issuers maintain the right to accept or reject the bid prices based on their how much fund they need, when they need the fund and what is ‘their outlook of the market. Secondary market refers to the market wherein the securities issued in primary market are subsequently traded ie. resold and repurchased (secondhand). Buyers in the ssconciay market include households, businesses and governments who have excess — while the sellers are the household, businesses and governments who are need tune deni samt market become a centralized marketplace wherein buyers and sellers - So tohrpeil transact with each other. As a result, the secondary market cree cs yers = eee On search and information costs as they do not need When the buyer purchases a fi transferred to the seller Unison cial instrument in the secondary market, funds are help of secunties brokers whieh sore aa tne secondary market usually occurs through the the security. The original issuer of ie ftalor between the seller and the buyer of the financial instrument is not involved in the 17