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FINANCIAL MARKETS:

Financial environments are factors and situations that primarily affect the financial aspects
of the corporation. The principal factors are the sources of financing through A) Financial
Markets and B) Financial Intermediaries.

The main source of funds used for investments and operations come from the savings of the
investors. The financial managers acquire these funds through equity financing and debt
financing. These financing transactions take place in the so called financial markets and with
the intervention of the different financial intermediaries and institution.

On the other hand, there are other markets not classified as financial markets but can affect
the operating and investing activities of the firm.

I. Different types of markets

A. Financial Markets are the place where financial assets such as Equity Securities (shares
of Stock) and Debt Securities (Bond certificates) are issued and traded.

1. Stock Market – this is a market where equity securities are being issued and traded.
In this market, the stockholders may sell their stock investments or the firm may issue
additional stocks if the stock price is overvalued or may purchase stocks if
undervalued.

For example, if the firm has to raise funds but wants to avoid high interest rate, the
firm may issue equity securities in this market.

2. Bond Market – this is a market where debt securities are being issued and traded.
This is also referred as the fixed-income market because the investors or so called
bondholders receive fixed interest payments from their investments assuming they
will hold the bond until maturity or on a longer period of time.

For example, if the firm has to raise funds but the stock price is undervalued, the firm
may issue debt securities rather equity securities in this market.

3. Money Market – this is a market where short-term debts with maturities of one year
or less are used as a source of financing.

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An example of this short-term debt security is a Treasury bill which is issued by the
government with maturity of one year or less.

4. Capital Market – this is a market where long-term debt and equity securities are
involved, for financing.

The examples of the long-term debt security are Treasury note and Treasury bond
wherein the former is a debt security issued by the government usually with maturity
of more than one year but not more than 10 years while the latter is a debt security
issued by the government with maturity of more than 10 years.

B. Other markets:
1. Physical Market is also known as real asset or tangible markets because the products
involved are real estate, property plant and equipment, inventories, etc. Hence, those
assets not qualified as financial assets are sold in this market.

Say for example, the acquisition of raw materials to be used for the manufacture of
products takes place in this market. In addition, if the firm has to expand its
operations and increase its production, the firm has to purchase machineries in this
market.

2. Spot Market – this is a market where assets or goods are sold for and delivered on the
spot or today. Thus, the determination of price and delivery of goods is on the same
date.

An example is when a rice dealer went to the farm during harvest to purchase all the
harvest at an agreed price and to be delivered on the same day; this takes place in
spot market.

Another example is when a Philippine based corporation purchased inventories on
February 14, 2017 from a US based corporation to be imported and paid on March 3,
2018, the Philippine corporation has to pay in US dollars. This is an example of an
exposed liability position (ELP) where the amount of accounts payable changes as the
exchange rate changes. Therefore, there is a need to purchase foreign currency to
settle the accounts payable. The purchase of foreign currency will be on the
settlement date, March 3, 2018. Thus, the determination of exchange rate (price) and
delivery of investment in foreign currency (US dollars) is on the spot.

3. Future Market – this is a market where future contracts are sold. A future contract is
a contract that gives the purchaser an obligation to buy an asset (and the seller an

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obligation to trade an asset) at a predetermined price at a future date. Thus, the price
is agreed today but the delivery of goods is in the future.

An example is when a rice dealer went to the farm a month before harvest to purchase
all the future harvest at an agreed price today and to be delivered on the day of
harvest; this takes place in future market.

Another example, is investing in a 1.) forward contract or 2.) option contract (both
hedge instruments) to hedge foreign currency transaction (hedge item).

In a forward contract, the exchange rate used to value the purchase or sale of foreign
currency is a forward rate. Hence, the forward rate (price) is already determined
today but the delivery of the investment in foreign currency (ex. US Dollars -$) is in
the future.

An option contract is an example of a derivative whose value is derived from the price
of an “underlying” asset. Option contracts are classified as call option (option to buy)
or put option (option to sell). This contract has an option price set at the inception of
the transaction which is exercisable by the investor in the future, hence making the
transaction under future market.

4. Private Market – this is a market where negotiation and agreement takes place
personally between two parties. Hence, making the contract unique or tailor-made.

Say for example, investing in a life insurance is personal between the insured and
insurer. The policy holder being the insured while insurance company being the
insurer. Another example of transaction that takes place in a private market is when
a depositor opens a savings or checking account in a bank.

5. Public Market – this is a market where a security or contracts with standardized
features are being traded and held by individuals.

For example, in stock markets and bond markets, the securities (stock certificates and
bond certificates) issued by the corporation have standard features. Hence, making
them available for trading or exchange unlike the life insurance policy discussed
above.

II. Financial Intermediaries:

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Financial Intermediaries are the organizations that provide financing to the

individuals, corporation or other organizations by raising funds or money from
investors.

1. Mutual Funds (MF) – the investment company pools money from the investors then
invests these accumulated amount in a portfolio of securities whether equity (shares
of stock), debt (bonds) or money market (short term securities). In Mutual Fund, the
investors purchased shares of the investment company thereby giving the former the
right to receive dividends. The body that regulates these mutual funds is the
Securities and Exchange Commission. An example of mutual fund is Sun Life Balanced
Fund, Philequity Peso Bond Fund or ALFM Growth Fund. (philpad.com/best-mutual-
funds-in-the-philippines-2015)

2. Unit Investment Trust Fund (UITF) – the investment company sells units of investment
to the investors to accumulate a trust fund. The trust fund may be invested also in
equity, debt or balance of equity and debt. Hence, the investors own units of
investments not shares of stock. The regulatory body which supervises these unit
investment trust funds is the Banko Sentral ng Pilipinas. An example of investment in
UITF is the BPI Equity Index Fund of the Bank of the Philippine Island.
(philpad.com/mutual-fund-vs-uitf-similarities-and-differences-advantages-and-
disadvantages)

3. Pension Fund – these are pooled contribution from the employees or from the
employers that serves as the investment plans for the retirement benefits of the
employees. The accumulated funds may be invested in shares of stocks or in a mutual
fund in order to increase the amount of pensions received by the retirees.

4. Financial institution – this is a kind of financial intermediary that provide additional
financial services other than pooling and investing of funds. One type of financial
institution is a bank which may serve as debtor and creditor at the same time by
accepting cash deposits from savers (borrowing) and providing loans to individual or
to other firms (lending). Another type of financial institution is the insurance
company that sells protection against the losses from fortuitous events like fire,
accidents and death.

III. Transfer of Securities:

§ Direct Transfer
In a direct transfer of securities, the equity securities evidenced by stock
certificates and debt securities evidenced by bond certificates are issued

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directly to the investors. In turn, these investors pay directly to the issuing
company. Thus, the securities do not pass through the possession of any
financial intermediaries.


§ Indirect Transfer:
In an indirect transfer of securities, the issuing company seeks the aid of the
financial institution to easily issue their securities to the investors, thus there
is mediation between the issuer and the investor. Moreover, the investor may
acquire securities from the intermediary that are different from what have
been issued by the corporation. Therefore, indirect transfers of securities are
classified as:

o Indirect transfer through Investment Bank – the securities of the company
are bought by the investment bank or the so called underwriter with the
intention of reselling them to a prospective investor. The securities of the
issuing company will be in the hands of the investors. Thus, no new form
of capital is created.

o Indirect transfer through Financial Intermediary – the securities of the
company are bought by these financial intermediaries without the
intention of reselling the said securities; rather they will sell their own
securities to the new investors. The securities of the issuing company are
in the possession of the financial intermediaries while the new investors
will get the securities issued by the financial intermediaries e.g. Investors
will receive the insurance policies issued by the Insurance Companies.
Thus, new form of capital is created.

IV. Stock Market Transaction:

Stock Markets are markets where shares of stocks of corporation are sold to new
investors and or existing stockholders. The Philippines had two stock markets,
namely: 1.) Manila Stock Exchange (MSE) which was established on August 8,
1927, and 2.) Makati Stock Exchange (MkSE), which was established on May 27,
1963. However, these two markets were unified forming the Philippine Stock
Exchange on December 23, 1992 with eight (8) constituent indices such as:

• PSE Composite Index (PSEi)

• PSE All shares Index (ALL)
• PSE Holding Firms Index (HDG)

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• PSE Industrial Index (IND)

• PSE Financial Index (FIN)
• PSE Mining and Oil Index (M-O)
• PSE Property Index (PRO)
• PSE Services Index (SVC)

The figure below illustrates the stock position of portfolio investments with the
performance of the abovementioned indices.

Figure 2-1: The Stock Market Index and Stock Position of investments

(SOURCE: www.bpitrade.com)

This figure shows that the investor has invested in the stocks of the following company as
shown in the CODE column:
• Bank of the Philippine Island (BPI)
• East West Bank (EW)
• Petron Corporation (PCOR)
• Philippine National Bank (PNB)
• San Miguel Corporation (SMC)
• Philippine Long Distance and Telephone Company (TEL)

The LAST column shows the current stock price while the DIFF column is the peso value
increase or decrease in the said price of these stocks. The BID VOLUME column displays
the number of outstanding stocks that the willing buyers want to buy while the ASK
VOLUME column is the number of outstanding stocks that willing sellers want to sell. The
BID PRICE column illustrates the stock prices that buyers are willing to pay while the ASK
PRICE column is the stock prices that sellers are willing to accept. Say for example, in BPI
stock, the BID price is P 83.70 while the ASK price is P 85.75. There will be a bargain
between the willing buyer and seller until they meet at an agreed price. Now, if the BID
equals to ASK price, say for example at agreed price of P84.50, this will be new current
market price of the stock to be shown in the LAST column.

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The following are the stock market transaction:

1. Initial Public Offering (IPO) Markets – are markets where the stocks of a
closely held corporation, going public, are offered to the public for the first
time. The closely held corporations undergo IPO in order to raise additional
capital to finance their operating and investing activities. To aid these
corporations in going public, the investment banker may purchase all the new
offered shares at underwriter’s price then sell them to public at a retail price.
Hence, this is in the form of indirect transfer through investment bank.
However, the corporation may also undergo IPO through direct transfer where
individual investors may place their respective bid prices and the corporation
selling directly to them.

Generally, the IPO transaction is classified as primary market transaction since
the new stocks were sold to the public, who are new shareholders. An
exception is when the outstanding stocks of the corporation owned by the
existing shareholders were sold to the public, the IPO transaction is under a
secondary market transaction.

2. Seasoned Offering – is the issuance of additional shares of stocks of the
company after its first time offering in order to finance the capital budget or
to improve its capital structure. This kind offering may be done by family
corporations or publicly listed corporations.

3. Primary Markets – are involved with the issuance or selling of new shares of
stocks to the investors through the aid of the investment bankers. The cash
proceed from primary market transaction goes to the corporation. Thus, the
transactions in this market change the size of the capital structure of the
company.

4. Secondary Market – are involved with the sale of the outstanding shares of
stocks to the existing shareholders or to new investors. The cash proceed from
secondary market transaction goes to the selling shareholders, not the
corporation. Thus, the capital structure of the company is not affected by the
secondary market transactions.

To illustrate the stock market transactions:

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In January 2, 2018, TRIPLE B CONSTRUCTION, a family corporation engaged

in construction business, wants to raise additional fund in order to finance
their additional capital expenditure. To address their financial needs, the
board of directors decided to have the corporation listed in the Philippine
Stock Exchange (PSE) so that they can sell new stocks to the public. On
February 1, 2018, TRIPLE B CONSTRUCTION sold its shares to the public for
the first time. The outstanding and authorized capital stocks of the corporation
are 500,000 and 1,000,000 shares respectively.

In June 30, 2018 the TRIPLE B CONSTRUCTION, now a publicly listed

company, sold additional 250,000 shares to fund their expansion projects.
Hence, the outstanding shares as of this date are 750,000.

One of the stockholders, named Don Bernabe, owned 200,000 shares. He sold
half of his ownership to his brother Mr. Jeffries on October 30, 2018. On the
other hand, TRIPLE B CONSTRUCTION repurchased the remaining 100,000
shares of Don Bernabe On November 30, 2018.

Analysis of the transactions:

§ The Initial Public Offering (IPO) was performed on February 1, 2018.

§ The Seasoned Offering (SO) was after the IPO, in this illustration, it was done on
June 30, 2018 when additional 250,000 shares were sold.

§ The IPO and SO are considered as sale of shares under primary market
transaction.

§ The sale of outstanding shares by Don Bernabe to Mr. Jeffries on October 30, 2018
is a secondary market transaction since the capital structure of the firm is not
affected.
§ The stock repurchase by TRIPLE B CONSTRUCTION from Don Bernabe on
November 30, 2018 is considered as primary market transaction because such
purchase affected the capital structure of the firm.

V. Stock Market Efficiency:
Stock market may be considered as efficient or inefficient market. If the stocks
market shows that the market prices of the stocks are about equal or close to
intrinsic values, there is market efficiency. In this situation, the stock price reflects
all publicly available information hence, are fairly priced. Thus, Investors returns
or losses under efficient market are relatively low.

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On the other hand, if the stock market is inefficient, the stock prices are considered
to be highly overvalued or undervalued. Hence, the investors are not confident to
invest unless they knew some information over the others.

There are three levels of efficiency in Efficient Market Hypothesis (EMH) namely:

§ Weak form – this level shows that the information regarding past or
historical prices of a particular stock is not conclusive in predicting stock
prices. Hence, an investor cannot beat the market by simply analyzing the
past performances of the stock.

§ Semi-strong form – this level shows that all the available public
information is already incorporated in the stock prices. Hence, the
investors cannot beat the market solely by analyzing the published
financial reports of the company unless they have information from
company insiders.

§ Strong form – this level show that investors cannot beat the market even
with insider information. Hence, the investors in this efficient market
cannot earn high returns.

The stock prices can be classified as:

a) Market value – also known as perceived value, is the price of the stock which
is currently traded in the market. In the Philippines, the market prices of the
stocks of publicly listed companies are readily available in the Philippine
Stock Exchange (PSE).

b) Intrinsic value – this is the true value of the stock. This is the price that the
willing buyer will bid and willing seller will ask provided that all necessary
information about the stock is available. The intrinsic value can be estimated
using either the a) Dividend Discount Model or b) Corporate Valuation Model.
(In depth discussion regarding these models will be on Chapter 7 – Stock Valuation.)


• If the so called market value (perceived value) is equal to the intrinsic value
(true value), the stock price is at equilibrium. Hence, the investor is neutral as
to selling or buying stocks.

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• If the market value of the stock is higher than the intrinsic value, the stock
price is deemed as overvalued. Thus, the stockholders are expected to sell than
to buy shares.

• If the market value is lower than the intrinsic value, the stock price is
undervalued. Hence, the investors are expected to purchase more shares to
take advantage of lower price. (Brigham-Houston, Fundamentals of FINANCIAL
MANAGEMENT, 13th ed., page 46-49)

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