FM 02- Financial Markets and Institutions

The Process of Capital Allocation

1. Direct transfers: Direct transfers occur when a business sells its securities directly to the savers in
exchange for money. This procedure does not involve any financial institution. Direct transfers are used
generally by small firms and relatively little capital is raised in this process.
2. Indirect transfers through Investment Banks: In this process money flows from savers to borrowers
through an investment bank that underwrites the issue. An underwriter acts as a facilitator for the
issuance of securities. A corporation sells its stocks, bonds, etc more generally referred to as
“securities”, to an underwriter and the underwriters then sell the “same securities” to the savers.
3. Transfers through a Financial Intermediary: Under such transfers the financial intermediary obtains
funds from savers in exchange for its own securities. Unlike the underwriting process, here the
financial intermediary, such as a bank, a mutual fund, an insurance company etc. issue their “own
securities” and in turn invest this money to buy different kinds of securities in anticipation of generating
a return higher than that offered to the savers.

Financial Markets

1. Physical asset market versus financial asset market. Physical asset markets (also called tangible or
real asset markets) are for products that are tangible assets and can be seen and touched. Financial
asset markets, on the other hand, deals with stocks, bonds, notes, and mortgages.
2. Spot markets versus future markets. Spot markets are markets in which assets are bought or sold
for “on-the-delivery. Future markets are markets in which participants agree today to buy or sell an
asset at some future date.
3. Money markets versus capital markets. Money markets are financial markets in which funds are
borrowed or loaned for short periods (less than one year). Capital markets are financial markets for
stocks and for intermediate or long-term debt (one year or longer).
4. Primary markets versus secondary markets. Primary markets are markets in which corporations
raise capital by issuing new securities. Secondary markets are the markets in which securities and
other financial assets are traded among investors after they have been issued by corporations.
5. Private markets versus public markets. Private markets are markets in which transactions are
worked out directly between two parties. Public markets are markets in which standardized contracts
are traded in organized exchanges.

Financial Institutions

1. Investment banks. Organization that underwrites and distributes new investment securities and helps
business obtain financing.
2. Commercial banks. The traditional department store of finance serving a variety of savers and
borrowers.
3. Financial services corporations. A firm that offers a wide range of financial services, including
investment banking, brokerage operations, insurance and commercial banking.
4. Credit unions. Cooperative associations whose members are supposed to have a common bond, such
as being employees of the same firm.
5. Pension funds. Retirement plans funded by corporations or government agencies for their workers
and administered primarily by the trust departments of commercial banks.
6. Life insurance companies. 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.
7. Mutual funds. Organizations that group investor funds to purchase financial instruments and thus
reduce risks through diversification.
 8. Exchange trade funds (ETF). Similar to regular mutual funds and are often operated by mutual fund
companies. ETF buy a portfolio of stocks of a certain type and then sell their own shares to the public.
9. Hedge Funds. Similar to mutual funds because they accept money and use the funds to buy various
securities, but there are some important differences.

Stock Market
A stock market is a place where stocks are bought and sold.
The Philippine Stock Exchange (PSE) is the only stock exchange in the Philippines.
PSE is one of the oldest stock exchanges in Asia.

The Market for Common Stock—Types of Stock Market Transactions

1. Initial Public Offering (IPO) - An initial public offering (IPO), or stock market launch, is a type of public
offering where shares of stock in a company are sold to the general public, on a securities exchange,
for the first time. Through this process, a private company transforms into a public company. Initial
public offerings are used by companies to raise expansion capital, monetize the investments of early
private investors, and become publicly traded enterprises.
2. Transactions on Secondary Market- After the initial issuance, investors can purchase from other
investors in the secondary market. In the secondary market, securities are sold by and transferred from
one investor or speculator to another. It is therefore important that the secondary market be highly
liquid. As a general rule, the greater the number of investors that participate in a given marketplace,
and the greater the centralization of that marketplace, the more liquid the market.
3. Stock repurchase- Stock repurchases (or share buyback) is the reacquisition by a company of its own
stock. A corporation can repurchase its own stock by distributing cash to existing shareholders in
exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction
in the number of shares outstanding. The company either retires the repurchased shares or keeps them
as treasury stock, available for re-issuance.
4. Secondary Market Offering-is a registered offering of a large block of a security that has been
previously issued to the public. The blocks being offered may have been held by large investors or
institutions, and proceeds of the sale go to those holders, not the issuing company. This is also
sometimes called secondary distribution.
5. Private Placement- Private Placement (or non-public offering) is a funding round of securities which
are sold not through a public offering, but rather through a private offering, mostly to a small number of
chosen investors. “Private placement” usually refers to the non-public offering of shares in a public
company (since, of course, any offering of shares in a private company is and can only be a private
offering).

Definitions to be considered

Market Price- is the current price of a stock.

Intrinsic Value- is the price at which stock would sell if all investors had all knowable information about a
stock.
Equilibrium Price- is the price that balances buy and sell orders at any given time. When a stock is in
equilibrium, the price remains relatively stable until new information becomes available and causes price to
change.
Efficient Market- is a market in which prices are close to intrinsic values and stocks seem to be in equilibrium.
Behavioral Finance Theory

Efficient Market HypothesisThe Efficient Market Hypothesis, or EMH, is an investment theory whereby share
prices reflect all information and consistent alpha generation is impossible. Theoretically, neither technical nor
fundamental analysis can produce risk-adjusted excess returns, or alpha, consistently and only inside
information can result in outsized risk-adjusted returns.