FINANCIAL MARKET AND THE FINANCIAL SYSTEM Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trend is — The Financial System In the field of commerce, finance is a key player in ensuring continuity of operations. As they say, it is the life-blood of the company, Financial management is an important process to ensure that profit and wealth is maximized. It is important to understand how money revolves around in a system to enable development of strategies and plan on how to keep the profit in the short run and wealth growing in the longrun. Sources of Wealth Money or wealth can be generated in different ways. In economics, there are different sources of wealth. Figure 1 illustrates the sources of wealth and the type of wealth that can be generated. Let's call this the Origin of Wealth. Every person always starts with baby steps. Of course, we can't discount the fact that we are heavily dependent on our families, parents in particular, who provide us with our needs. Normally, a person completes education then he/she will either work or start a business. Labor through hard work will allow them to earn a salary or wage. As a person continuously eams, he/she can save and eventually acquire properties. Land is a form of property which can be used in their a. business or be leased fo somebody else. | _ 7@ minimum wage is Either way, it will generate wealth in the | 2/80 used as an indicator form of rent. Moving on, as property and | for the purchasing power labor continuously earn, people start of a locality venturing to other form of vehicles with higher risk with the intention of aiming for higher returns. Point of Information! As people accumulate funds or save more sufficient enough to start infusing capital either financial or industrial. Now, that person can be considered as an investor. As the venture realizes good returns, the capital will earn interest. In succeeding chapters, we will discuss how to manage the interest earned in capital markets. Optimistically, businesses that mature and grow need more focus. The investors 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 grows and generates more profit. Profit will eventually be accumulated, and investment will be diversified as it grows employing 4 new breed of individuals and labor force and the cycle goes on. Here you will see how finance plays in the system called business. al Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends ____ 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 tun. Businesses and governments, on the other hand, raise funds by issuing claims 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 transferred from those entities that have funds to invest to those entities that need funds to invest. Entrepreneurship Profit Capital cissi4 Land Rent SCI Ti Labor ree 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 to have an integration. Accountancy requires in-depth analysis of financial results and underlying transactions to provide reasonable recommendations which among the courses of action should be considered. Financial system allows households, companies and the ernment 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 al Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Treng stakeholders and transforms these savings effi ntly 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 intermediaries in order to facilitate the transfer of funds, to create additional money when required, and to create markets in debt and equity instruments (and their derivatives) so that the price and allocation of funds are determined efficiently.” — Faure, AP. Financial system is composed of network of inter-related systems of financial markets, intermediaries and services. The financial system of a country carries out the essential economic function that transfers funds from parties that have available funds to parties that need funds. In a country, there are households, companies and government . agencies who have available funds pares cone fom hie because they spend less than their income. Essentially, these are the fund means “to end and settle | providers. On the other hand, there are a debt" also households, companies and government agencies that experience fund shortage because they decide to spend more than their income. These are 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. Point of Information! The financial system permits an efficient method to move funds between entities who have funds and entities who need funds. Financial systems serve as a regular, time-efficient and cost-effective link between fund providers and fund demanders. Within the financial system, funds are efficiently transferred from one party to another through innovative schemes on savings and investments that investors are willing to partake in. Figure 1.2 illustrate the financial system, the players in the system and More importantly how the funds flow in the system. Funds can flow . in two routes: via direct financing or indirect financing: Direct financing, In this route, the borrower-spenders borrow and deal directly with suppliers or lenders through selling finand instruments (or securities). Financial instruments represent claims on the future income or assets of the borrower. Borrower 101 Scanned with CamScannerREGULATORS = FINANCIAL DEMANDERS INTERMEDIARIES (Borrowers) syolvinoay n [4 2 be Fe) o ul a FINANCIAL MARKETS SUPPLIERS (Lenders) ry: (oY hale be }- | Figure 1.2. Financial Systems Elements of the Financial System There are five essential elements that make up a country’s financia system. These elements are the following: 1. Demanders and Suppliers of Fund (Who are the players?) Demanders of Fund are individuals or cor orati Fi ion needing financial support for them to start their tases fund forthe . ei 11 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Treng, is d expansion. Because of this intent, the tis known to be the borrower because tre ise to return them in the future in working capital, or planne the party in the system thal will be asking for funds with a promi the form of interest or dividends. Fund are individuals or corporation who are j uinthat are wiling to provide andlor has excess wealth and are looking for opportunity to keep it growing. These arg people or investors that are willing to extend financial support with interest. These players are also considered as the lenders in the system. Lenders are parties that have excess funds that they can leng d return. Borrowers are parties who cout to other entities for a require 0 ar are willing to pay the required return to obtain additional funds to finance their investment initiatives. Suppliers of other side of the syste! ies (How will the exchange occur?) Financial Intermediaries are special types of financial entities that act as a third party to facilitate the borrowing activity between lenders and borrowers. Often, potential borrowers do not have an idea which parties or entities are willing to lend out money to them and vice-versa. This gap in awareness makes it difficult for financial transactions to occur. This is where financial intermediaries come 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 visit a financial intermediary to participate in the financial transaction. The lenders and borrowers do not even know who the ultimate individual or firm is who provided or demanded for the funds. They only need to have access to the financial intermediary to enjoy the benefits of the financial transaction. Financial instruments (What will be used? ge of contractual ‘ded. These ca" ial instruments, Financial instruments are medium of exchan: obligation of a party, where such contract can be trat be tangible or intangible. There are two types of financi iil it could be cash or derivative financial instruments. Internation@! Financial Reporting Standards defined financial instruments a5 @ contract where a party recognizes it as an asset while the party treals it as a liability. Financial markets (Where will it be traded? Financial Markets is the venue where su! i ppliers al financial instruments meet. There are two types of financ! f buyers! "A markels wi Scanned with CamScanner\ FINANCIAL MARKETS: Fundamentals and Trends depending on the instruments that are being traded. For cash financial instruments, these are exchanged in the money market. For derivative financial instruments, it will be traded in capital markets. 5. Regulatory environment (How it is controlled?) Risk is inherent in every business operation. Moreover, for financial systems since it involves different business and financial risks, the government should intervene in the system. Regulatory environment is the governance body to ensure that the transactions that occur within the financial systems comply with the laws and regulations imposed on the entities as well as the elements that play within the system. Financial systems are normally regulated by central banks. 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. Participants in the financial markets include ultimate lenders and borrowers such as households, governments and businesses, financial intermediaries, brokers and dealers, regulators, fund managers and financial exchanges. The main economic function of financial markets is to serve as a channel to transfer excess funds from fund providers to fund demanders. Asa result, financial markets become the mechanism that bridge surplus and deficit economic 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 existence of a functioning financial market allows market participants to avail of different options that suit their needs. 23] Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trend “There are three major economic functions of the financial market price discovery, liquidity and reduced transaction costs. e Price Discovery Price discovery refers to the interaction between buyers. and sellers in the financial market in order to come up with the price, of traded financial instrument. Price is set at the level wherein the buyers are willing to buy, and sellers are willing to sell. The agreement between the two parties is important in determining the price of the financial instrument. Usually, the providers of funds in the financial market determine the required return for a financial instrument. This is the minimum rate of return that they are willing to accept to purchase a financial instrument. This function of the financial market determines how the available funds from the fund providers are allocated towards the fund demanders based on the fund demanders’ willingness to accept the return required by the fund providers. Liquidity The second function of the financial market is liquidity. Financial markets serve as a forum where buyers and sellers can meet to execute transactions. As a result, holders can sell their own financial instruments to other investors to earn cash. Easy access to a venue where investors can sell financial instruments for cash is an important feature especially when there are circumstances that push investors to sell a financial instrument. This reality offers liquidity to the investors. Without liquidity, an investor is forced to hold onto a 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 aan All types of financial markets offer different degrees of liquidity. ¢ Reduction in transaction costs _ Reduction in transaction costs is the last function of @ financial market. Transaction costs are the costs incurred when tet Parties trade a financial instrument. Transaction costs can Classified into two types: search costs and information costs. wi Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends a Search costs are costs incurred to look for financial instruments that can be purchased or sold by a party. Explicit search costs are expenses needed to advertise intent to purchase or sell a financial instrument. Implicit search costs include the value of time consumed to look for a counterparty for the transaction. Information costs are costs related to 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 the” worthiness of the investment. In a price efficient market, prices of the financial instrument properly reflect the combined information gathered by the market Participants. Types of Financial Markets The subsequent discussion will classify the financial markets as to the instruments traded, the parties in the exchange, where the market took place, how itis traded and based on the origin or perspective of the traders. Based on Instruments Traded Financial markets may be classified whether the instrument is a short-term security or long term. Short term securities are normally traded in the money market, while long term securities are classified under the 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 from 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 are 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 use this market to meet their short-term liquidity needs. Money market is very important for fund demanders since immediate cash requirements of individuals, government and corporations do not necessarily coincide with the timing of their cash receipts. For example, cash receipts from sales of a corporation do not take place at the same pattern of their expenses (e.g. wages, supplies and other expenses). Seasonal or temporary financing requirements like peak seasons also creates the necessity for short-term fund requirements. 15 | Scanned with CamScanneree fund providers holdings of cash by f At the same time, excessive holdings of cash Py fe Rev acrs tunity cost in the for poor ei an repre onan na eet quirements as needed for its day-to-day operations and it fF cash requirements a: ts that can be quickly and cheaply jal instrument a [ ee Ae Me aran needed with minimal risk of loss in value involved, converte he conduit to efficiently transfer large Se Soe Te vidars to fund demanders for short from ae Se gems cuckly and at a cheap cost from the parties involved, Money market instruments offer an re eee, that yields a higher return than just mere holding of rey ihe generat les Zero interest). Also, money market instruments are very liquid and can be easily convertible to cash and have very little default risk because of the associated short maturity term. Common examples of financial instruments that are traded in the money market are the following: Treasury Bills, Commercial Papers, Certificates of Deposits, Repurchase Agreement and Bankers’ Acceptances. Capital market is the sector of financial markets where financial instruments issued by governments and corporations that will mature beyond one year from issuance date (long-term) are traded. Long-term financial instruments encompass financial instruments that have maturity dates longer than one year and perpetual securities (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. Capital market securities are classified into two: debt and equity (which Fepresent ownership interest) . Capital markets are expected to be a liquid market where fund demanders can interact with potential investors to acquire external financing resources. Investors believe that the capital market should be an efficient market to ensure that available funds are allocated to its most productive use. The efficient allocation stems from competition between wealth-maximizing investors who determine prices of Sscurities believed to be close to their real value. In an efficient market, the Price of securities, which is a product of interaction between buyers and Revers in the market, is believed to be a fair estimate of its real value, ANY New information that investors will | will ever its price learn will move its pri Upwards or downwards. ventually Based on Market Type Anoth ik 5 Market the instr gerization Of the financial market is to what type of : uments are being t i ized into Prima 1g traded. This may be categoriz "y and secondary markets. Figure 1.3 illustrates the difference of the 16 | Scanned with CamScannerFINANCIAL MARKET: ‘undamentals and Trends a two types of financial market in terms of the market type. In the primary market, the supplier of funds is called lenders while they are called buyers in the secondary market. Borrowers are the demanders of funds in the primary market while they are called sellers in the secondary market. Primary Market Figure 1.3. Primary vs Secondary Markets Primary market is a type of financial market wherein fund demanders such as corporations or government agencies raise funds through new issuances of financial instruments e.g. bonds and stocks. Normally, when internally generated funds (e.g. retained earnings) are not enough, demanders need to raise additional funds in primary markets to fully finance new projects or production expansion requirements. 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 provide 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 17 | Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends ial investors to the securities issuance, Tact Potent th the Issuer, the investment bi rkets the Socurtties to the initial purchasers for the ssouer anks marks tence of an investment bank, the issuer reduces the risk er ot sstabishing & market for the securities on its own. Investment and cost of estan nie for all aspects to ensure proper execution of the banks are Trioand financial exchange requirements, appointments of issuance: Joga" iors, due diligence, etc. Investment banks also underwrite lawyers ani aderwriting means that investment banks guarantee the price Sete curies of the issuing company and then sell hese to the general public. present information to atti Once the securities issu: Transactions in the primary market can be classified based on the intended purchasers of the securities. There are four types of issue methods that can be done in the primary markets: ¢ Public Offering. This occurs when securities are | offered for sale to the general public. Offering to the general public is done through issuing a prospectus (document which contains an offer to the general public to subscribe or purchase securities at a stated price). Private companies who sell shares to the general public for the very first time are deemed to be conducting an initial public offering or IPO. IPOs are usually done through the help of investment banks Public offering can either be an offer for subscription or an offer for sale. In an offer for subscription, the general public is invited to subscribe to unissued shares of the company. Proceeds received from this offer are enjoyed by the company and can be used to finance their investment objectives. In an offer for sale, existing Shareholders invite potential subscribers to buy a portion of the shares they own. Proceeds from this offer are enjoyed by the existing shareholders, not by the company. 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 for 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. whens Blacomant (also called as limited public offer). This occurs group of aoe looks for a single investor, an institutional buyer Of Of offerin ers to purchase the whole securities issuance instead 1g it to the general Public. Traditionally, securities sold 181 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends through private placements tend to be illiquid and are not easily converted into cash because of the very limited parties it was sold to. As a result, it is common that only established financial institutions or firms are able to buy and hold on to them. One variation of a private placement is that an underwriter subscribes to all securities at a certain price and consequently, sells these same securities to a group of investors at a higher price. The diference between these two prices is termed as underwriting spread. * 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 the seller begins the sale at a high Price. From that point, the price of the securities is continuously lowered down at specific intervals until the potential buyer agrees to purchase at that price. o English auction. Type of auction where the prospective buyers commence 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 continues as the 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. o 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 the highest priced bid and follows a descending order. Highest priced bids receive full allocation while lower bids receive allocations distributed pro rata. 19} Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trengy ; hen issuers are open to rece; ue. This method occurs wl @ op ceive ¥ i . Issuers maintain the right their securities at all times. Ight to bi] ra + reject the bid prices based on how much fund they neeq, a Ferine need the fund and what is their outlook of the market, ” refers to the market wherein the securit net are sueeuer waded ie. on af nd). Buyers in the secondary market includ; eeeae eee a governments who have excess funds whie, the sellers are the household, businesses and {governments vo wae funds, The secondary market becomes a centralized marketplace where buyers and sellers can quickly and efficiently transact with each other. As b ipsult, the secondary market allows the buyers and sellers to save on Search and information costs as they do not need look for transactions on their own. © Tap Issi Secondary issued in primary When the buyer purchases a financial instrument ‘in the secondary market, funds are transferred to the seller. Transactions in the secondary market usually occur through the help of securities brokers which acts as the facilitator between the seller and the buyer of the security. The original issuer of the financial instrument is not involved in the subsequent transactions in the secondary market. Examples of the secondary market include foreign exchanges market, futures market and options market. Economic functions of secondary market include: © Price discovery The secondary market provides information about prices of the securities traded which can influence economic decisions like choosing between financing through long-term borrowing or issuance of new shares. The higher the price of the security in the secondary market, the higher the price that issuing companies can set on new securities that they will issue. Higher prices suggest that issuing companies may raise a higher amount of financial capital when they sell new securities in the primary market. * Liquidity and reduction in borrowing costs Secondary market allows active trading which improves liquidity and marketability of the securities. A liquid market means that partes who want to buy and sell are equally matched, thus, the literest aos becomes Stable. A liquid market also reduces liquidity of gs, (9uidity premium can be removed. Increased Y of @ Security also improves its desirability in the eyes investors hel i b primary manear'® Suing firms to sell new instruments in the 20! Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends ee Support to the primary market Price discovery helps in giving information that can be helpful in (a) setting prices for new issuances executed in the primary market and (b) assessing receptiveness of the market for new issuances. ‘Implementation of monetary policy — Secondary market allows regulators such as the BSP to trade securities to influence liquidity and interest rates set in the financial system. For investors, secondary markets are beneficial as it gives them the opportunity to sell securities at fair market value if they need cash or purchase additional securities that have differing risk and return characteristics to diversify their portfolio. Secondary markets provide liquidity to the investors who hold the securities as they are able to convert the securities to cash quickly by selling to other participants in the secondary market. Secondary market also provides information to investors on the market value of the investments. Transactions costs are also kept at a low level since the securities are traded in a centralized market. Although issuers are not involved, they also benefit from the transactions in the secondary market. Securities traded in the secondary market gives the issuing company an idea how much is the fair market value of their financial instruments. Consequently, the value of the company can be determined as perceived by investors based on the market prices of the financial instruments traded in the secondary market. The market price of the securities also gives the issuers an idea how well they are using the funds obtained from the securities issuance and gives information as well on how much funds (and associated costs) can subsequent debt or equity issuances raise for the firm. Securities that are easily tradable in the secondary market are also perceived to be more liquid, hence, issuing firms can easily sell more securities in the future as investors will find it to be more desirable. Conditions existing in the secondary market are very important for corporations that regularly issue securities. Secondary markets can be classified based on the market structure. Market structure refers to the mechanisms how buyers and sellers interact to arrive at the price and quantity of the securities to be traded. There are two classifications based on market structure: order — driven and quote-driven. 21| Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trengg 7 Order-Driven Market Structure In an order-driven market structure, the buyers and sellers propose their price through their brokers who conveys the bid in centralized location. The price is then matched (securities will be awarded to the buyer with the same offer price as the selling pricg of the seller) and the transaction is consummated. This is algo called the auction market. Types of orders that go into an order-driven market structure include the following: Market orders (or at-best orders) orders placed with broker Dealers with the instruction to execute transactions at the prevailing best market price. Client relies on the expertise and the integrity of the broker-dealer to execute deals when the latter perceives that the current price is considered best. Limit orders Orders placed where clients set a price or price range that may be below/above the existing price. Depending whether it is a sale or purchase transaction, the broker executes the transaction when prices go higher (sell) or lower (buy) than the limit price or range. Day orders Orders placed that are only valid until the end of the business day. All orders not executed at the end of day are cancelled and removed from the system. Good-until-cancelled orders Orders placed that remain valid for a sustained period up until the client voluntarily cancels and removes these from the system. © Quote-Driven Market Structure This is also called primary dealer markets, professional markets oF market-made markets. In a quote-driven market structure, the market makers establish a price quote at which the market Participants should trade with. The market makers set a bid quote zi Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends (to buy) and offer quote (to sell). Bid quote is generally | the offer quote. The difference between the bid quole and offer quote, called a spread, represents profit for market makers. Spread is important as it represents the transactional costs of trading and reflects liquidity. Narrow spread signals liquidity while a wide spread indicates that securities are illiquid. The higher turnover of securities sold, the better profit earned by market makers. Trading of bonds and currency are usually done in a quote-driven structure. Primary and secondary markets can also be classified based on where the financial instruments are traded. There are two classifications: exchange and over-the-counter market. Figure 1.4 illustrates how financial instruments in primary and secondary markets are traded. Exchange (or formalized) Exchanges are centralized trading locations where financial instruments are purchased or sold between market participants. In order to be traded, all financial instruments should be listed by the organized exchange. All financial instruments should comply with the regulations set forth by the exchange prior to being listed. Most exchanges are order-driven. Most popular exchanges are the New York Stock Exchange, Philippine Stock Exchange and Chicago Board of Trade for commodities (wheat, corn, silver and other raw materials). Over-the-Counter market (or informal) Over-the-counter (OTC) market is the place where unlisted financial instruments are allowed to be traded, in addition to listed financial instruments. Dealers stationed at various locations who have securities on hand stay ready to sell and buy securities “over the counter” to any party who approaches them and is willing to accept their price. Because of technological advancements, transactions in OTC markets can now be done through computers. OTC markets are very competitive since all parties are aware of how prices are set for each available security. To give perspective, the labor market, fish market and vegetable market is considered as an OTC market. Over-the-counter markets do not have formalized mechanisms to regulate transactions unlike exchanges. Bonds, loans, spot ad and foreign exchange markets are unlisted, hence, are aged e an OTC market. All markets start out as an informal ay sie prior to progressing into formalized markets depending a her to maintain a liquid and safe market for participants. 23| Scanned with CamScanner; FINANCIAL MARKETS: Fundamentals and Treng is instruments traded ove! unter include negotiable certiicajes of deposit, banker's acceptances and foreign exchange. Based on Country’s Perspective Financial markets can be also categorized depending on the interest or perspective of the country. It can be internal or national ang external. Internal or National market refers to the financial Market operating in a certain country. It is made up of two parts: domestic Market and foreign market. Domestic Market — refers to the market where issuers who are considered residents in a country issue the securities and where these securities are traded afterwards. ¢ Foreign Market - refers to the market where issuers who are not residents of a country can sell or issue securities and subsequently trade. The rules of the regulatory authority where the security is issued will prevail regarding issuance of foreign securities. For example, a US company wanting to issue financial instruments in the Philippines shall comply with Philippine securities law. External market refers to the financial market where securities that have two unique characteristics are being traded: a. Upon issuance, these securities are offered simultaneously to investors in different countries b. Securities are issued outside the regulatory jurisdiction of any single country. Examples of external markets include international market and offshore market. Based on Trading Modality In a broker market, the buyer and the seller of the securities are brought together by a broker and the trade occurs at that point. Ownership of the securities effectively changes on the floor of the exchange through the help of a broker. Broker market is usually composed of national and fegional securities exchanges. The Philippine Stock Exchange is the sole broker market in the Philippines. In a dealer market, the buyer and seller are not brought directly together by a third party. Instead, market makers (dealers who create markets by offering to sell/buy securities at stated ask/bid prices, respectively) execute the sell or buy orders. In a dealer market, there ar 24 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends two distinct trades that occur: Seller sells his securities to a dealer and Buyer buys his securities from a dealer (can be the same dealer of Seller A). The ask price refers to the lowest price that the seller of a security offered for sale is willing to take while the bid price is the highest proposed rice that investors are willing to shell out to buy a security. In essence, investors pay the ask price when purchasing securities and receive the bid ice when selling them. Dealers earn profit from these transactions though the spread between bid and ask prices. Dealer markets do not have centralized trading floors as compared with exchanges. Instead, dealer markets consist of many market makers that are connected through a mass telecommunications network. Financial Intermediaries and Other Participants It is common that income received by a party or entity does not match required expenditures, hence, resulting in deficits. These deficits may be resolved through transferring funds from fund providers (with excess funds) to fund demanders (with 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 of resources between fund providers and fund demanders may not work as expected. To bridge the gap, a special type of financial entity called financial intermediaries were formed to facilitate indirect financing. Financial intermediaries were formed during the time when market conditions made it hard for lenders of funds to transact directly with borrowers of funds. Financial intermediation is the process of indirect financing using finar: intermediaries as the main route to transfer funds from lenders to borrowers. Examples of financial intermediaries are depository institutions, insurance companies, pension companies, asset management firms, regulated investment companies and investment banks. Most financial intermediaries provide services to suppliers and demanders of funds. The assets of these financial intermediaries are not limited to the portfolio they are managing but also include information they gain to facilitate and support their clients. Financial intermediaries generally provide the following services: inancial Trading of financial assets for the customers of the fi . intermediary through brokering arrangements 25 | Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Treng, sets through its own capital by buying © Trading of financial as: : a stake in a financial asset that its customers want ig transact in | s _ Formation of financial assets needed by its customers ang distribute these to its customers and other mara, articipants as well. ‘ . investment consultation services to customers it i ent Financial assets managem' . Payment mechanism between merchants and customers. intermediaries are exposed to high levels of iquicty to the risk that liability holders (e.g. depositors for banks) may require cash in exchange of the financial claims they have from the institution. As a result, financial intermediaries always maintain a 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. Most financial i risk. Liquidity risk refers The existence of financial intermediaries is also beneficial for the economy. Services provided by financial intermediaries create opportunities for financial savvy people, spur economic gains and aid in managing the risk on the part of the investors. The notable benefits of Financial Intermediaries are: 1. Acceleration of flow of funds between entities Fund providers use financial intermediaries to transfer funds to fund demanders. In the absence of financial intermediaries, most savings of fund providers may not be easily available to fund demanders. Fund providers may opt to keep their money at home rather than in banks disrupting the flow of money. Financial intermediaries also serve a savings and wealth storage function, allowing parties with excess funds to store their funds in risk-free/low-risk financial instruments. Nn 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 transaction compared to the bank. Asymmetric information may lead to two further problems: adverse selection and moral hazard. 61 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends a 3. 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 act as the conduit that lessens 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. 4. Support in price discovery Price discovery is a 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 assign values to financial instruments based on different factors. The financial system, specifically the banking sector, also significantly influences discovery of interest rates. Consequently, these interest rates are factored in fair market valuation of financial instruments. 5. Improved liquidity for lenders Liquidity of ultimate lenders is enhanced through the presence of financial intermediaries. For example, a borrower Feceives money from an ultimate lender through a vehicle like loan, the lender's liquidity is zero up until the loan matures and the lender receives the payment. Financial intermediaries can manage cash from different lenders (i.e. depositors) through immediately products which can be converted to cash fast such as current and Savings deposit accounts and at the same time offer non- fmarketable financial products such as mortgages, leases and credit contracts. As a result, the ultimate lenders have better liquidity compared to directly lending funds to providers. a 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 27| Scanned with CamScannerFINANCIAL MARKETS: Fundamentals i 4 Ind Tr offer financial products with high price risk such as Share: # @ and property financing to borrowers. As a result, lenders om iti ice risks as they course the transfer of fy a ran ak toancial intermediaries which in tum bear thepall ve wien fending t0 other entities. This process can be eA@ertk sharing. Risk sharing happens when financial intermediaries pa and sell financial assets with a risk profile that their Clients comfortable to invest on. Through the proceeds they can ogy financial intermediaries may then sell these financial Assets, a purchase other assets that may have higher risk and return Rigs sharing can also be called asset transformation, since in essence risky assets are converted into safer assets for the investors,’ Diversification Diversification is the economic function exercised by financial intermediaries which converts more risky assets to less risky assets through sharing of risks. It is the process of investing funds in a portfolio of assets that have individual returns that do not move in the same direction together. For example, if the retum of ‘Asset A goes up, the return of Asset B usually goes down Diversification usually results in an overall portfolio risk that may be lower than the risk of each individual asset. Diversification also allows lenders to share risk from their investments. Looking at a finance perspective, risk 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 2 collection of assets into a new product and then selling it to interested investors. Economies of scale Economies of scale occur when fixed costs are optimized Per unit as a result of large volume of transactions. Cost pet transaction is reduced as the number of transactions increases. Since financial intermediaries are experts in executing financial transactions, they can get and perform large numbers a transactions. There are two main economies of scale that are optimized by financial intermediaries: information processing and transaction costs. Information processing costs refers to the cost of acquiring and processing information needed to evaluate purchase © 21 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends ma ee 10. Reeve ee hd a financial instrument. This also refers to costs invested int nitor Performance of potential companies to be igca fi rough economic, industry and financial analysis and 0k for other investment opportunities that will pay off in the long Tun. 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 return 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. On the other hand, transaction costs pertain to costs associated with trading or managing funds and investment transactions. This includes contracting costs which refer to the cost incurred for writing loan agreements and enforcing terms of agreements to the concerned parties. Contracting costs are usually incurred by investors who are willing to extend loans to a consumer or business. In order to protect their self-interest, investors should develop skills to draft a legally enforceable contract to be signed by both parties. Once a loan agreement is signed, investors should also devote time to monitor financial status of the borrower and pursue legal actions for any violation in the legal agreement. . 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 government 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 demand for loans. Financial intermediaries exist to foster more favorable transaction terms between fund providers and fund demanders compared if the two parties directly deal with each other. Figure 2.1 29| Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Treng, a is presents the two-step process observed by finangia intermediaries. Lending or investing fund obtained to the fund demanders Obtaining of funds from fund providers (lenders or investors) Figure 2.1 Two Step Process Classification of Financial Intermediaries Given the diverse role of the financial intermediaries in the financial system. Financial intermediaries can be a financial institution which is primarily extending financial support to demanders, while most are going into the exchange of these instruments. With the emergence of technology and innovative ways on how the funds were channeled, financial intermediaries can already make combinations to mitigate the risk and generate greater returns. There are three classifications of financial intermediaries: depository institutions, contractual savings institutions and investment intermediaries. These three intermediaries find ways on how the supplies of funds can maximize return from funds they put into the financial system and at the same time address the needs of the fund demanders. Depository Institutions ____. Depository institutions are firms that accept cash deposits fo" individuals, companies and entities. Once the deposit is received, i becomes liability of the depositary institution to the depositor. Through "7 funds accumulated through deposit and non-deposit sources (obtained “ issuance of debt instruments), depository institutions extend loans different entities. Interest earned from these loans are the main source revenue for depository institutions, aol Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends cal a ee A simple illustration to distinguish the difference on how depository institutions and nonfinanci i - eee Nees incial compani li is shown in Figure 22, panies recognize assets and liabilities i ae 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. __ Depository 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 earn 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 rural banks. o Commercial Banks. These banks are authorized to accept drafts/checks and issue letters of credit; discount and negotiate promissory notes, drafts, bills of exchange, and other evidences of debts; receive deposits; buy and sell foreign exchange and gold or silver bullion; and lend money against securities consisting of personal property or first mortgages on improved real estates and the insured improvement thereon. Basically, commercial banks raise their funds through offering checking deposit accounts (deposits on which draftsichecks can be written against), savings deposit accounts (deposits that are payable on demand, but checks cannot be written 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 31] Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Treng ir it banking services are kno 4 \d also offer investment b e wi universal banks, Commercial and universal banks Provige the widest array of services across depository institutions, o 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. Thrift banks are organized for the purpose of accumulating savings deposits, and investing them for specified purposes, such as readily marketable bonds ang securities, commercial papers and accounts receivables, o Rural Banks. These banks play a significant role in the development of the rural economy by offering basic financial services such as savings and credit facilities to farmers and small-scale merchants. 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. E-Wallets As old as mid 1990s, the digital wallets or e-wallets are being used as a tool to facilitate payment for online purchases. The first recorded transaction is a sale of compact disc using electronic payment via credit card. At the onset, the creditworthiness of the credit cards were used by the companies to accept payments for online transactions. It is later became more popular in the 2000s, when mobile phone technology emerges as a business tool more than personal communication device. Providers of this technology started being introduced as mobile or digit application where the funding is through electronic banking, credit ca Purchase of digital currencies etc. Contractual Savings institutions fan tog i : fan itr Savings institutions are financial intermediaries HS ot Periodic intervals based on an existing contract. Unl depository ji i cece) hentions, contractual savings institutions can project ™ uch money they need to pay in the future (in the form 32l Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends a et et benefits promised) their contractiat ah Usually, contractual savings institutions need to pay bligations after sev liquidity i not the: pritie i eral years. As such, asset liquidity is sacurticcsmereonen and they focus more on investing in long-term locks, mortgages and corporate bonds. Examples of contractual savings instituti . ions ar i : funds. re insurance companies and pension Insurance Companies ___ Insurance companies offer a unique service to the individuals, corporations and other entities in a country. Insurance companies offer services to assume risk or become underwriters of the risk associated with various insurable occurrences. In addition to their 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 indemnify another against loss, damage or liability arising from an unknown or contingent event. 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 pay the premiums. or another 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 ‘Other Notes paid to beneficiary if... "The insured person dies Pure life insurance coverage — premium is cheaper vs VUL; insured amount is guaranteed Life Insurance Variable unit linked (VUL) insurance — insurance with investment component; portion of the premiums is invested, 33 | Scanned with CamScannerProduct FINANCIAL MARKETS: Fundamentals ang, Proceeds will be paid to beneficiary Other Notes and any return will be in addition to the insured amount. Insured amount in contract is the minimum guaranteed amount. Health Insurance The insured person gets hospitalized or undergoes a covered medical treatment Hospitals will have receivabey from these firms Property and Casualty Insurance Financial ‘losses occur resulting from damage, destruction or loss of insured property properly attributable to a sudden event. ‘Commonly covers residential houses and vehicles Liability Insurance The insured party gets involved in a litigation resulting from his or other's actions ‘Some companies also call this as Directors’ Action Insurance Disability Insurance The insured party becomes unable to eam income due toa disability ‘Same with health insurance however this will be - for partial or full disability Long-term care insurance The insured party Fequires long-term care coverage if they are no longer able to take care of themselves Structured settlements The ‘insured event occurs, Fixed guaranteed periodic Payments are given over a long period of time. 34l Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends Proceeds will be Other Notes paid to beneficiary if... Financial Issuer of an insured | Used to manage credit risks guarantee bond fails to pay insurance —_| principal and interest timely. Pension Funds Pension fund (or retirement fund) is a type of financial intermediary which collects contributions from employees and uses the money collected to invest in various vehicles with the intention of growing these through the years to be able to pay benefits to the member employees upon their retirement. Contributions to pension funds are usually deducted immediately from the paycheck of employees and are remitted to pension funds directly by their employers. It is also a common practice that employers shoulder a portion of this contribution. In case contributions are not deducted from their paycheck automatically, employees can opt to pay voluntarily. Since retirement can be predicted, pension funds have the time to invest in long-term assets. As a result, a large percentage of pension funds’ investments are placed in stocks and corporate bonds. Pension benefits can only be received by employees once they are vested. Vesting refers to the number of years worked in order to qualify to receive retirement benefits. Vesting periods will be different among retirement plans. Pension funds can be private or state-run. In the Philippines, the state-run pension funds are Social Security System or SSS (for workers in the private sector) and Government Service Insurance System or GSIS (for government employees). Pension plans can be classified into two «Defined contribution plan The pension fund invests the contributions that they receive in various instruments. If the investments will be profitable, retirement benefits will be high or vice-versa. Ultimately, the retirement benefits will depend solely on the performance of the investment. 35 | Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Tyep, Defined benefit plan is type of plan, the employee will receive af, tourement benefit based on their years in pe regardless of the performance of the pension funge ifthe pension fund performs better and accumujaye: money greater than the benefit paid, the excg fund remains with the pension fund. However, ifthe ension fund underperforms and ecom, insufficient to pay out the benefits, the firm fa owns the plan becomes liable to pay for the difference. 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 charge their clients. Mostly, the fee charged is based on the amount of funds being managed. In some cases, fee charges can be based on the performance of assets being managed. Looking at the trend nowadays, asset management firms are usually subsidiaries of commercial banks, investment banks and insurance companies. The types of accounts / funds usually handled by asset management firms are: ¢ Regulated investment companies (RIC) Financial intermediaries that sell shares to the general Public in exchange for cash. Once they receive the proceeds, they then invest the money in a diversified portfolio of financial instruments. Normally, asset management firms are contracted to manage the investment portfolio of regulated investment companies. Different RICs have varying investment objectives and can engage in trading in different asset classes — whethet money market funds, stock funds or bond funds. Assél management strategies in portfolios can be further subdivid 361 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends into two: passive funds and active funds. Passive funds (or indexed 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. Equation below presents the NAV computation. Py L NAV = Sber of shares Pr Market Value of the Portfolio L Liability For example, a RIC currently has 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 a 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 fund are purchased at net asset value at time of purchase while redemptions (or sale of shares) are also priced at net asset value. Total number of shares of the fund increases if there are 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 Php150 million without any liabilities. The NAV at the beginning of the trading day is P15. During the trading day, investors paid Php2.5 million to the fund and redeemed Php! million from the 37] Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and re : — fund. Assume that prices of the securities remain constant, 7} net investment of Php1.5 million signifies that 100,000 shares (Php1.5 million / Php 15) were issued to investors. At the en of the day, the fund had 10.1 million shares valued at Php151.5 million. More commonly, the market value of the portfolio ang the number of shares changes. This ultimately leads to a change in NAV. However, once the trading day ends, NAV wij, be the same for all regardless of the net shares added to o, deducted from the fund. This is because new investments ang 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 intend to buy or sell shares should bring it to the secondary market for trading. Prices of the shares in closed-end funds are associated with demand and supply in the secondary market where the funds are being traded. Unlike open-end funds, the 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 valued lower than NAV are 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 for its services. RICs allow individual shareholders to combine thei Fesources to take advantage of lower transaction costs when Purchasing large numbers of stocks or bonds. These funds let investors have access to more diversified portfolios than theY otherwise would invest individually. 381 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends i 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 a company. Exchange traded funds possess characteristics of both open-ended and closed-ended funds. They are open-ended funds, but the share pricing has small premiums/discounts from the NAV, like a closed-end fund. Investment advisors assume responsibility for managing the Portfolio that it moves in 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. © Hedge Funds Hedge funds are developed to cater to sophisticated investors and are usually not subject to the same regulations covering mutual funds. The investor base of hedge funds usually consists of affluent individuals and organizations with a relatively high minimum investment limit. Hedge funds are usually organized as a private investment partnership or 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 money to invest), short selling (sale of a security not owned with the expectation that price of the security will eventually decline), derivatives and simultaneous 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 asset manager through absolute return rather than relative return. Absolute return refers to the peso amount realized from the investment while relative return refers to the difference between realized return and the return shown ina benchmark index. 39| Scanned with CamScanner? FINANCIAL MARKETS: Fundamentals and Trendg he services of hedge fund managers 2d on the value of portfoli ix of fixed fee computed base pong Peing managed plus an incentive fee, a performance- based compensation that is computed through a % share in the positive retum realized from the investment. Compensation for t «Separately managed accounts tely managed accounts or individually managed easel ‘unas solely dedicated to an individual of 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 with 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. 'nvestment banks can also be grouped based on_activilies that they can offer to investors. Full-service investment banks offer a wide range of activities while boutique investment banks only Specialize in one or two activities that they offer to their clients. Activities that an investment bank can offer are as follows: a. Public offering of securities the ene banks often assist firms to offer securities 10 objectives Pel in order to raise funds for varying business issuing company ment banks give recommendations to the tallow ease on What securities are attractive to investors consideration, hang Of funds. Investment banks also take into Securities (whether ene 8Suing company wants to treat the Investment banks «cul. debt or mix of both) when advising. Inks possess information regarding the curren! 401 Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends re tet ce ace 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). Once the issuing company chooses the investment bank that would underwrite its securities, the investment bank then performs a due diligence process to look 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 tegarding the firm that a potential investor finds relevant in deciding whether to buy the firm's securities or 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 conduct a roadshow 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 dnd no unpublished data will give them an unfair advantage. Once all available information is shared with the investors, the investment banks then assign a price for the security based on its estimate on how many securities the investors will 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 securities in the market on behalf of the latter. Investment banks earn in underwriting through the gross spread, i.e. the difference between the price paid by the investment bank to the issuing company and the price of security when reoffered to the general public (reoffering price). In exchange for 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 misiudged the condtion ofthe ruin may sell the securities at a low E Mretranteed to the issuing St a eweilprcs than what was a Scanned with CamScannerFINANCIAL MARKETS: Fundamentals ang Treng, oe iting arrangement can be firm commitme, best nats sim commitment, the investment bank ban the securities from the issuer based on a fixed price ang eats it to the general public at a higher price as discusseg in the last paragraph. A single investment bank may perfo underwriting for small issues. However, for large issues, single investment bank may face problems in exhausting ay securities to be sold. Since this type of arrangement entails g high level of risk, the primary investment bank often forms a group of investment banks, called as an underwriting ‘Syndicate, to buy and sell the securities. Once the securities are reoffered to the public, the Gross spread will be shared between all investment banks in the underwriting syndicate. Distributing the securities to the general Public is critical to ensure realization of the gross spread. Allthe securities should be sold to the public based on the Teoffering price and usually entails a huge marketing effort especially if the issue size is huge. Each member of the underwriting syndicate will offer the securities to their own client base. If the member investment banks included in the syndicate is not able to exhaust and sell all securities, the lead investment bank can also engage other institutions not included in the underwriting syndicate to form a selling group to extend In a best effort a buy the Securities fro, investment bank: Offer the Securitic STOSs spread of rangement, investment banks do not m the issuing company. In its place only use their connections and expertise 9 les to the general Public and earn based on the the securities it can sell Underwritin, ig hel; borrowers and lenders Teputation on the line for t on PS reduce information costs bet since investment banks Pad Y. invest he firms that they are underwritin iad rts have Seater confidence if securities are underwfit@? performed, aig banks as they believe that the latter 7 Wee can pc ligence on the issuing firm to ensure i? ie ‘Wy the securities without incurring exce Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends ee b. Private Placement of Securities s Instead of selling securities to the general public, nen banks can also offer private placement of securities. in private placement, securities are offered only to a select number of firms like insurance companies, pension funds and investment companies. c. Trading of securities Investment banks can also trade securities on behalf of their clients. Investment banks earn from this service through commissions when they act as a broker or dealer for a transaction. When they act as a broker or dealer, investment banks do not take any position in the trade, thus, not putting their own capital at risk. In some instances, investment banks can become market makers on behalf of clients, thus, using their own capital to trade the securities. When investment banks are market makers, they ear through the difference between selling price of the security and the price paid by the investment bank for the security (ie. bid-ask spread) and through price appreciation of any security still on hand. Investment banks can also use their capital on their own volition to trade securities based on how they forecast potential movements in prices, interest rates and foreign currency. This is called proprietary or prop trading. However, proprietary trading exposes the investment banks to two major risks: interest rate risk and credit risk. Interest rate risk pertains to the risk that if investment banks hold long-term securities, they are exposed to the risk that if market interest rates went up, the prices of their long-term securities will go down. Credit risk refers to the risk that the borrower might not pay or default on their loans. d. Advisory services for mergers, acquisitions and financial restructuring Investment banks perform advisory engagements for mergers and acquisitions, leveraged buyouts, capital restructuring and reorganization for financially distressed corporations. Investment banks usually help in looking f potential M&A candidates based on the requirements : for client, perform due diligence and give recommendatio ie acquiring or target companies regarding valuation Sai Scanned with CamScannerFINANCIAL ian ee tion, provide support to i ited aspects of the transact i t fms that a in danger of a hostile takeover, assist companies es funds for an acquisition and give a fair opinion ‘agerding a potential transaction to the board of directors. INS ment banks can provide advice for both buyers oa in sellers (sell side). Since they have access to their client information, investment banks may initiate contacting companies regarding potential sales, purchases or mergers. For firms who wish to be acquired, investment banks may look for companies that are willing to pay significantly higher than the book value of the firm. Investment banks can estimate the value of firms, lead negotiations, and prepare acquisition bids. Investment banks also provide advice on financial restructuring of problematic companies. Financial restructuring occurs when a corporation undergoes a significant modification Of its capital structure, operating structure, corporate strategy and corporate tactical plans. Firms often resort to financial restructuring to prevent bankruptcy, avoid potential problems with creditors or undergo reorganization as permitted by the law. Investment banks earn from providing advisory services through a fee based on the size of the transaction. This service is particularly profitable as investment banks do not need to invest a sizable portion of its capital to perform. The only Significant costs are the salaries of Personnel working on the engagement. e. Merchant banking In merchant bankiniy, funds to lend money as a credi Investment banks directly a Provides to the invested comy ‘nvestment banks use their own itor or buy shares as an investor. ssume the risk on the capital it pany, f. Securities finance and prime brokerage service The investment strate i quires them to borrow ‘Gy of some investors req Money to buy a securit securities 0 Sell a security sh y ity or borrow al Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends St ence) ee C Sa ei or ben fee for such service. This activity of borrowing securities rowing funds is known as securities finance. Prime brokerage is also offered by investment banks to hedge funds and large institutional investors. Prime brokerage is considered as priority servicing for very important clients. Services offered under prime brokerage include securities finance, global custody, risk management system and Prioritized operational support. g. Asset management Investment banks also have divisions that perform asset management services to clients such as endowments, insurance companies, pension funds, foundations and high net worth individuals. These asset management departments can be mutual or hedge funds. Same with asset management firms, investment banks earn through a percentage of the managed assets in this service. h. Research Investment banks also conduct research on different industries or large market players. Investment banks assign analysts that collect publicly available information about the subject, visit the firm to do interviews and inspect the facilities. The investment bank then uses the results of the compiled research as inputs to identify potential candidates as acquirer or target. Some research information is made public as research notes and can be used to provide advice to investors whether to buy, sell or hold stocks. Opinions from large investment banks sometime may affect market price of shares as they can influence perception of investors. Analysts may also engage in giving opinions regarding the present state of the financial markets, do economic research Pete reports on economic trends and provide forecast on macroeconomic variables like GDP, inflation, employment and interest rates. Finance Companies Finance companies raise their funds through issuing stocks and bonds or selling commercial papers. Finance companies th es er funds to individual consumers (to buy furniture. Vehicles ae * . Ie 45 | Scanned with CamScanners FINANCIAL MARKETS: Fundamentals and 7, end improvements) and small businesses. Some non-financial co, rato, Open their own finance companies to assist in selling their main prog’ One example is Toyota Motor Philippines. Toyota Motor Philippines has 3 wholly owned finance company known as Toyota Financial Seng Philippines that offer car financing solutions for automobiles evi Toyota. y a6! Scanned with CamScannerFINANCIAL MARKETS: Fundamentals and Trends a Tacit oa on be generated from different sources. What ees iee finance managers to find ways on how to cea Systems is a network of interrelated. factors. The elements financial systems are: (1) lenders and borrowers; (2) financial intermediaries; (3) financial instruments; (4) financial markets; (5) regulatory environment; (6) money creation; and (7) price discovery. 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. The economic functions that affect the market are as follows: (1) price discovery; (2) liquidity and reduction in borrowing costs; (3) support to the primary market; and (4) implementation of monetary policy. Financial market are classified in terms of instruments traded — money market and capital market; or in terms of market types — primary and secondary market; in terms of country’s perspective — internal or national market and external market; in terms of trading modality — broker market and dealer market. In order to effect the exchange, Financial intermediaries were formed during the time when market conditions made it hard for lenders of funds to transact directly with borrowers of funds. Financial intermediation is the process of indirect financing using financial intermediaries as the main route to transfer funds from lenders to borrowers. 47\| Scanned with CamScanner