Topic 2: Financial Markets and Institutions

Prayer

Come, Holy Spirit, Divine Creator, true source of light and fountain of wisdom! Pour forth your
brilliance upon my dense intellect, dissipate the darkness which covers me, that of sin and of
ignorance. Grant me a penetrating mind to understand, a retentive memory, method and ease in
learning, the lucidity to comprehend, and abundant grace in expressing myself. Guide the
beginning of my work, direct its progress, and bring it to successful completion. This I ask through
Jesus Christ, true God and true man, living and reigning with You and the Father, forever and ever.
Amen.

Learning Objectives

At the end of this topic, students will be able to:

 Identify the different types of financial markets and financial institutions and explain how these
markets and institutions enhance capital allocation.
 Explain how the stock market operates and list the distinctions between the different types of
stock markets.
 Explain how the stock market has performed in recent years.
 Discuss the importance of market efficiency and explain why some markets are more efficient
than others.

Activating Prior Learning

In our first topic you had good grasped on the overview of financial management. You have
learned that management’s primary goal should be to maximize the long-run value of the stock,
which means the intrinsic value as measured by the stock’s price over time. And to maximize
value, firms must develop products that consumers want, produce the products efficiently, sell
them at competitive prices, and observe laws relating to corporate behaviour. As discussed, if firms
are successful at maximizing the stock’s value, they will also be contributing to social welfare and
citizens’ well-being.

Further, in our past topic, it was also highlighted that the primary task of financial management
through the CFO, and the financial managers are (1) to make sure the accounting system provides
“good” numbers for internal decision making and for investors, (2) to ensure that the firm is
financed in the proper manner, (3) to evaluate the operating units to make sure they are performing
in an optimal manner, and (4) to evaluate all proposed capital expenditures to make sure they will
increase the firm’s value.
Also, you have learned that businesses can be organized as proprietorships, partnerships, or
corporations. In addition, it was also discussed with you the four important business trends that
changes the way business is done: (1) the focus on business ethics that resulted from a series of
scandals in the late 1990s, (2) the trend toward globalization, (3) the ever-improving information
technology, and (4) the changes in corporate governance.

In our next topic, we will go deeper on the premise that the firm’s primary goal is to maximize the
price of its stock. As to be elaborated in this topic, stock prices are determined in the financial
markets; so if financial managers are to make good decisions, they must understand how these
markets operate. In this topic, it is also to be discussed that individuals make personal investment
decisions; so they too need to know something about financial markets and the institutions that
operate in those markets. Therefore, in this topic, we will discuss the markets where capital is
raised, securities are traded, and stock prices are established and the institutions that operate in
these markets.

Presentation of Contents

FINANCIAL ENVIRONMENT
 It is a part of an economy that affects the diverse functions of the economy on the fiscal
outcomes of a nation, with the key players being investors, firms, and markets.
o Investors are individuals or businesses that expect returns from the already placed capital
into companies.
o Any business that offers goods or services to consumers is recognized as a firm, while
markets signify the economic environment that makes all this possible.
 The financial sector (or system) is vital for the smooth functioning of the economy since it
helps money to be channeled efficiently from savers (or surplus units) to prospective
borrowers (or deficit units).

FINANCIAL SYSTEM
 Definitions of Financial System
 It is a network of financial institutions, financial markets, financial instruments, and
financial services that facilitate money transfer.
 It is the set of interrelated and interconnected components consisting of financial
institutions, markets, and securities.” (Dhanilal)
 It is the integrated form of financial institutions, financial markets, financial securities, and
financial services which aim is to circulate the funds in an economy for economic growth. (Amit
Chaudhary)
 Its aim is to facilitate the circulation of funds in an economy. In this way, the financial
system makes it easier:
 o for firms to obtain financing for profitable investments opportunities (investments in
new technology, capital equipment, or for acquisition of other companies), and
o for individuals to borrow against future income (e.g., to pay for university, to buy a
house or car, etc).

Source: https://ssavvides.files.wordpress.com/2015/10/financial-environment-chapter-1-introduction.pdf

o Without financial markets and institutions, borrowers would have to borrow directly
from savers. In such a case it is easy to imagine that not much borrowing would take
place since it would be very difficult for people in need to borrow to find other people
able and willing to lend the same amounts and with exactly the same terms (time,
interest rate, collateral, etc).
o In other words, we need to have “a double coincidence of wants”. Therefore, we can
easily conclude that a well-functioning financial system is necessary for a well-
functioning economy.

 CAPITAL FORMATION PROCESS

People and organizations with surplus funds are saving today in order to accumulate funds for
some future use. Members of a household might save to pay for their children’s education and the
parents’ retirement, while a business might save to fund future investments. Those with surplus
funds expect to earn a return on their investments, while people and organizations that need capital
understand that they must pay interest to those who provide that capital.

In a well-functioning economy, capital flows efficiently from those with surplus capital to those
who need it. This transfer can take place in the three ways:
1. Direct transfers of money and securities, as shown in the top section, occur when a business
sells its stocks or bonds directly to savers, without going through any type of financial
institution. The business delivers its securities to savers, who, in turn, give the firm the money
it needs. This procedure is used mainly by small firms, and relatively little capital is raised by
direct transfers.
2. Indirect transfers through Investment Bankers - transfers may also go through an investment
bank which underwrites the issue. An underwriter serves as a middleman and facilitates the
issuance of securities. The company sells its stocks or bonds to the investment bank, which
then sells these same securities to savers. The businesses’ securities and the savers’ money
merely “pass through” the investment bank. However, because the investment bank buys and
holds the securities for a period of time, it is taking a risk—it may not be able to resell the
securities to savers for as much as it paid. Because new securities are involved and the
corporation receives the proceeds of the sale, this transaction is called a primary market
transaction.
3. Indirect transfers through a Financial Intermediary - Transfers can also be made through a
financial intermediary such as a bank, an insurance company, or a mutual fund. Here the
intermediary obtains funds from savers in exchange for its securities. The intermediary uses
this money to buy and hold businesses’ securities, while the savers hold the intermediary’s
securities.

 SERVICES PROVIDED BY THE FINANCIAL SYSTEM

 Risk Sharing: The Financial System provides risk sharing by allowing savers to hold
many assets and enables individuals to transfer risk. Financial markets can create
instruments to transfer risk from savers to borrowers who do not like uncertainty in returns
or payments to savers or investors who are willing to bear the risk.
 Liquidity: It provides for savers and borrowers liquidity. If an individual needs their assets
for their own consumption and investment, they can just exchange it. Bonds, stocks, or
checking accounts are created by financial assets, which have more liquid than cars,
machinery, and real estate.
 Information: The first informational role the financial system plays is to gather
information which includes finding out about prospective borrowers and what they will
do with borrowed funds. The second informational role that financial system plays is
communication of information. Financial markets do that job by incorporating
information into the prices of stocks, bonds, and other financial assets. Savers and
borrowers receive the benefits of information from the financial system by looking at
asset returns.
 FUNCTIONS OF FINANCIAL SYSTEM
 Pooling of Funds: In a financial system, the savings of people are transferred from
households to business organizations. With these, production increases and better goods
are manufactured, which increases the standard of living of people.
 Capital Formation: Business requires finance. These are made available through banks,
households and different financial institutions. They mobilize savings which leads to
Capital Formation.
 Facilitates Payment: The financial system offers convenient modes of payment for goods
and services. New methods of payments like credit cards, debit cards, cheques, etc.
facilitate quick and easy transactions.
 Provides Liquidity: The financial market provides the investors the opportunity to
liquidate their investments, which are in instruments like shares, debentures, bonds.
 Short and Long-Term Needs: The financial market takes into account the various needs
of different individuals and organizations. This facilitates optimum use of finances for
productive purposes.
 Risk Function: The financial markets provide protection against life, health, and income
risks. Risk Management is an essential component of a growing economy.
 Better Decisions: Financial Markets provide information about the market and various
financial assets. This helps the investors to compare different investment options and
choose the best one. It helps in decision making in choosing portfolio allocations of their
wealth.
 Finances Government Needs: The government needs a huge amount of money for the
development of defense infrastructure. It also requires finance for social welfare
activities, public health, education, etc. This is supplied to them by financial markets.
 Economic Development: If the Government intervenes in the financial system to influence
macroeconomic variables like interest rate or inflation, credits can be made available to
corporate at a cheaper rate. This leads to the economic development of the nation.

FINANCIAL MARKET
 Definitions of Financial Market
 It is a market where buyers and sellers trade
commodities, financial securities, foreign
exchange, and other freely exchangeable
items (fungible items) and derivatives of value
at low transaction costs and at prices that are
determined by market forces.

 It is a place where the savings from several

sources are mobilized towards those who need
Source: https://marketbusinessnews.com/financial-
funds. glossary/financial-
market/#:~:text=A%20financial%20market%20is%20a,are%20de
termined%20by%20market%20forces.
 Types of Markets
1. Physical asset market versus financial asset markets
 Physical asset markets – (also called “tangible” or “real” assets markets) are for
products such as wheat, autos, real estate, computers and machinery.
 Financial asset markets – deal with stocks, bonds, notes and mortgages. They also
deal with derivative securities whose values are derived from changes in the prices of
other assets. (A share of Ford stock is a “pure financial asset” while an option to buy
Ford shares is a derivative security whose value depends on the price of Ford stock.)
2. Spot markets versus futures markets
 Spot markets – are markets in which assets are bought or sold for “on-the-spot”
delivery (literally, within a few days).
 Futures markets – are markets in which participants agree today to buy or sell an
asset at some future date. (A farmer may enter into a futures contract in which he
agrees today to sell 5,000 loads of corn 6 months from now at a price of Php130,000
a load.)
3. Money markets versus capital markets
 Money markets – the financial markets in which funds are borrowed or loaned for
short periods (less than one year). (The New York, London and Tokyo money markets
are among the world’s largest.)
 Capital markets – the financial markets for stocks and for intermediate or long-term
debt (one year or longer). (The New York Stock Exchange, where the stocks of the
largest U.S. Corporations are traded, is a prime example of a capital market.)
4. Primary markets versus secondary markets
 Primary markets – are the markets in which corporations raise new capital. (If GE
were to sell a new issue of common stock to raise capital, a primary market transaction
would take place. The corporation selling the newly created stock, GE, receives the
proceeds from the sale in a primary market transaction.)
 Secondary markets – are markets in which existing, already outstanding securities
are traded among investors. (If Juan Dela Cruz decided to buy 1,000 shares of GE
stock, the purchase would occur in the secondary market.)
5. Private markets versus public markets
 Private markets – markets in which transactions are worked out directly between
two parties. (Examples are bank loans and private debt placements with insurance
companies.)
 Public markets – markets in which standardized contracts are traded on organized
exchanges. (For example, common stocks and corporate bonds)
FINANCIAL INSTITUTION
 Definitions of Financial Institution
 It is a company engaged in the business of dealing with financial and monetary
transactions such as deposits, loans, investments, and currency exchange.
 It encompasses a broad range of business operations within the financial services sector
including banks, trust companies, insurance companies, brokerage firms, and investment
dealers.
 It is a firm that provides access to financial markets, both to savers who want to place
their savings in financial instruments and to borrowers who want to borrow from banks
or issue debt securities.
 It is called financial intermediary (businesses that connect savers with borrowers) since it
serves as middlemen between individuals, firms, and financial markets.

 Types of Financial Institutions

a. Investment Bank – an organization that underwrites and distributes new investment
securities and helps businesses obtain financing.
 Traditionally, they help companies raise capital by: (a) designing securities with
features that are currently attractive to investors; (b) buy these securities from the
corporation, and (c) resell them to savers.
b. Commercial Bank – the traditional department store of finance serving a variety of
savers and borrowers.
c. Financial Services Corporation – a firm that offers a wide range of financial services,
including investment banking, brokerage operations, insurance and commercial
banking.
d. Credit Unions – are cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm.
e. Pension Funds – are retirement plans funded by corporations or government agencies
for their workers and administered primarily by the trust departments of commercial
banks or by life insurance companies.
f. Life Insurance Companies – take savings in the form of annual premiums; invest these
funds in stocks, bonds, real estate and mortgages; and make payments to the
beneficiaries of the insured parties.
g. Mutual Funds – organizations that pool investor funds to purchase financial
instruments and thus reduce risks through diversification.
h. Money Market Funds – mutual funds that invest in short-term, low-risk securities and
allow investors to write checks against their accounts.
i. Exchange Traded Funds (ETFs) – are similar to regular mutual funds and are often
operated by mutual fund companies. They buy a portfolio of stocks of a certain type and
then sell their own shares to the public.
 j. Hedge Funds – are also similar to mutual funds because they accept money from savers
and use the funds to buy various securities but there are some important differences.
While mutual funds (and ETFs) are registered and regulated by the SEC, hedge funds
are largely unregulated.
k. Private Equity Companies – are organizations that operate much like hedge funds; but
rather than buying some of the stock of a firm, private equity players buy and then
manage entire firms.

Self Test
1. Distinguish the difference of the following:
a. Physical asset markets vs. financial asset markets
b. Spot market vs. futures market
c. Money market vs. capital market
d. Private market vs. public market
e. Commercial bank vs. investment bank
f. Mutual fund vs. hedge fund

Application
CRITICAL-THINKING EXERCISE
1. What are the economic advantages of a financial intermediary?
2. Why are financial markets essential for a healthy economy and economic growth?
3. List three (3) financial institutions found in your locality and answer the following:
a. Classify as to type of financial intermediary
b. Describe their primary functions
c. Explain how they contribute to economic growth

Feedback
Direction: Write 3 questions related to any part of this week’s topic that you don’t understand.
Look for a classmate you could chat with in the FB messenger. Send him/her your questions and
let him/her answer it (vice versa). Print screen your communication and paste it in your study
notebook.