MODULE 1 PACKET

FM 312 – FINANCIAL MARKETS & INSTITUTIONS

MODULE 1 OVERVIEW:

Welcome to Module 1 – Introduction and Overview of Financial Markets

In Module 1, we will discuss the reasons behind studying Financial Markets and Institutions. The module
will introduce us to different types of financial markets namely, primary markets versus secondary
markets, money markets versus capital markets, foreign exchange markets and derivative security
markets. The need for financial market regulation will also be discussed. This module will also give us the
overview of Financial Institutions (FIs), the unique economic functions performed by Financial
Institutions, additional benefits FIs provide to suppliers of funds and economic functions FIs provide to
the financial system as a whole. Finally, we will identify the risks incurred by financial institutions and
discuss globalization of financial markets and institutions. This module contains in-lesson exercises, quiz
and assignment.

CONSULTATION HOURS:

Phone or Messenger: 3-4 PM Monday-Thursday

sdadivas@usa.edu.ph 09503308693

MODULE 1 LEARNING OBJECTIVES:

By the end of this module, the students will be able to:

Differentiate between primary and secondary markets.

Differentiate between money and capital markets.

Distinguish between the different types of financial institutions.

Know the services financial institutions perform.

LECTURE DISCUSSIONS

Module 1 – Introduction and Overview of Financial Markets

Why Study Financial Markets and Institutions?

For an economy to achieve its potential growth rate, mechanisms must exist to effectively allocate
capital (a scarce resource) to the best possible uses while accounting for the riskiness of the
opportunities available. Markets and institutions have been created to facilitate transfers of funds from
economic agents with surplus funds to economic agents in need of funds. For an economy to maximize
its growth potential it must create methods that attract savers’ excess funds and then put those funds to
the best uses possible, otherwise idle cash is not used as productively as possible. The funds transfer
should occur at as low a cost as possible to ensure maximum economic growth.

Overview of Financial Markets

What are the primary and secondary markets?

Basically, it is in the capital market, called the stock market, where an investor can buy and sell stocks.
This market consists of the primary market or secondary market, depending on whether the securities
were sold by the company itself or by an existing shareholder(s).

Primary market

In the primary market, new shares are issued and sold to the investing public for the first time. It is
where capital is actually raised by the company selling stock directly to investors typically through an
initial public offering. For instance, if San Miguel Corporation decides to sell a new stock to raise equity
funds, it will be a primary market transaction. Since it is the first time the company has sold stock to the
public, it is called an initial public offering (IPO). The proceeds of the sale go to San Miguel Corporation,
the issuing company. Investors who have subscribed to the IPO have provided the company with the
necessary funds to continue its operation and expansion, and become part owners of the company.

An underwriter or investment banker assists the issuer of a new security in setting the offering price and
in marketing the securities to the public. The investment bankers serves as a middleman in the transfer
of funds between the company in need of capital and the public, and facilitates the issuance of shares.

There is occasionally a secondary offering in the primary market. This means that the shares of stock
being offered were previously issued but is being offered to the public for the first time by a large or
controlling shareholder. As such, the selling stockholder gets the proceeds of the sale.

Secondary market

The secondary market is where securities can be bought and sold after they have been issued to the
public in the primary market. Thus, if you decide to buy existing shares of San Miguel Corporation, you
cannot buy them directly from the issuing company anymore since they have all been sold to the
investing public during the initial public offering.
So, how can you avail of San Miguel shares when the IPO has been completed? Investors can only buy
these shares from existing shareholders who are willing to sell their shares. When they do so, it is a
secondary market transaction. The proceeds from this transaction don not go to the issuing corporation;
instead they go to the investor who sold his shares.

The secondary market is where the original shareholders sell their shares to other investors. An investor
can only make a profit when he can sell his shares at a price higher that the purchase price. This market
gives a continuous reflection of the value of securities (prices) at some point in time according to the
best available information.

Secondary markets include the stock exchange and the over-the-counter (OTC) market.

The two alternative mechanisms of fund raising are direct financing, where the saver directly purchases
a claim from the ultimate funds user in the primary market, or indirect financing where savers place
their money in a FI and the FI lends money to the ultimate borrower. In the cases where savers desire to
place their money directly in the markets, institutions such as investment bankers (asset brokers) have
evolved to assist in this process. The first time a firm issues securities to the public is referred to as its
initial public offering (IPO). Issuing additional stock of a firm that already has stock publicly traded is
referred to as a seasoned offering (or sometimes called a ‘follow on’ offering). In some cases firms offer
the issue to one or only a few institutional buyers. The primary markets are the markets where firms
(and other borrowers) create and sell new securities in order to raise cash to fund positive NPV projects
(or to meet some other social goals in the case of non-profit fund raisers).

The secondary markets exist to provide liquidity and price information to investors. These functions
make the primary market more attractive. Investors would be far less likely to invest in risky long term
primary securities unless they believe they can obtain updates of the current value of their claims and
have the ability to sell these claims quickly at low cost. Hence the efficiency of operations of the
secondary markets affects the growth rate in the overall economy through their effect on the primary
markets.

What are the money and capital markets?

Financial markets are classified into the money market and the capital market. The money market is
where short-term funds are raised through the buying and selling of short term debt securities such as
commercial papers. The capital market is where long-term funds are raised through the bond market,
which deals with long-term debt securities such as bonds, the stock market which deals with equity
securities or stocks.
Money markets evolved to meet the short term investment needs (1 year or less) of corporations and
institutions desiring to earn a small positive rate of return on cash that would be needed shortly, hence
they have evolved with high denomination safe securities that have little risk of principle loss. Capital
markets are markets where borrowers raise cash for long term investment needs. These are generally
riskier than money markets and hence, capital market securities must promise to pay a higher rate of
return to attract funds. Savers willing to take the associated risk are attracted to these markets.

What is a stock market and stock exchange?

There are differences in their definition but real concept of a stock exchange and stock market remains
constant. Simply defined, a stock market is an organized activity involving the buying and/or selling of
securities done within a stock exchange.

In a fundamental sense, a stock exchange brings buyers and sellers together. It is an organization whose
function is to facilitate the purchase and sale of stocks and other securities. It is a market where
investors can buy and sell securities after they have been offered in the primary market.

Remember that the stock exchange is not a capital raising mechanism. As part of the secondary market,
it is only adjunct to the capital raising market or primary market. It is merely a place or means where
existing shareholders can sell their shares to those who are ready to buy.

The stock exchange and the stock market facilitate the flow of savings into investments by providing a
ready market for the resale of securities. The inflow of funds in the stock market is one efficient way of
directing a needed resource (in this case, money) into a growing economy. As such, the stock exchange
plays a key role in economic development by providing a centralized environment that brings together
the demanders and suppliers of funds to make secure and fast transactions.

What is the over-the-counter market?

Stocks of corporations not listed and therefore not traded in the stock exchange but registered and
licensed by the Securities and Exchange Commission for sale to the public are only available in the so-
called over-the-counter (OTC) market. This market is not a specific organization but another way of
trading securities. OTC transactions are carried out by direct inquiries and negotiations among the
buyers and sellers through the use of mail, telephone, telegraph, Teletype, or other forms of
communications.
What are the advantages of the stock market?

The stock market is a better market for the trading of securities as opposed to the OTC because of the
following:

 Most accessible market

Through the offices of member firms located everywhere, even in the provinces, stocks are available to
millions of people.

 Ready market

With a simple phone call, an investor can buy and sell stock, virtually within minutes. Market
transactions are done swiftly, conveniently and at a fair price.

 Liquidity of the market

Hundreds of different stocks are available to thousands of buyers and sellers and can readily be turned
into cash due to the large number of market players. The OTC market is generally much thinner or less
liquid which makes it more difficult to sell at a certain time in a failing market due to lack of buyers.

 Operates in full public view

Transactions and price data are readily available through newspapers, radio, television, and information
networks. Unlike the stock exchange, the over-the-counter stock prices are not published daily in the
newspapers, which makes it more difficult for an investor to keep track of his investment.

Who are the players in the stock market?

Investors are the ones who buy and sell securities in the hope of receiving dividend income and making
a profit through capital appreciation. These buyers and sellers are not the only players in the stock
market. Other persons or institutions ensure that the stock market is a readily accessible, efficient,
orderly and transparent market. These are:

 Stockbroker

Anyone who wishes to buy shares of stocks or bonds must have a stockbroker. He acts as an agent or
middleman between the investor and other buyers/sellers. As an intermediary, the stockbroker
executes orders for clients, purchasing or selling the stocks on the stock exchange. He is the only person
or corporation authorized and licensed by the Securities and Exchange Commission to trade in
securities. They are commonly known as members, member-brokers, or member-firms of the Philippine
Stock Exchange.

 Stock exchange
This is the organization that oversees the transactions of the buyers and sellers placed through the
member-brokers. Its professional management ensures that the market is efficient, fair, transparent and
orderly by enforcing its rules and regulations.

 Transfer agent

When shares are purchased and transferred from the seller to the buyer, the transaction should be
recorded in the stock books of every listed company which record the complete shareholdings of each
stockholder of the company. But most companies have his record keeping done by a separate agency,
called the transfer agent. Thus, when a transaction has been done, the details are kept in a ledger or
record book by the company’s transfer agent. As such, the transfer agents maintains the ledgers for
each issuer company showing the name and address of, and the number of shares held by each
registered stockholder. Another function of a transfer agent, which is either a commercial bank or trust
company, is to cancel old certificates, issue new certificates and change the name of the certificates into
the buyer’s name when the shares have been sold.

 Clearing House

When a transaction has been made, the seller – through his stockbroker – has to deliver the stock
certificate to the buyer who in turn orders his stockbroker to pay for the shares purchased. This seems
to be an easy process. But considering the thousands of transactions executed everyday, and the nearly
200 stockbrokers involved, broker-to-broker payments and delivery of certificates would become
complicated. To facilitate transactions and make the market more orderly, all payments by all
stockbrokers are done to a centralized institution, called the clearinghouse. Thus, all stockbrokers will
make payments to and receive payments from the clearinghouse for purchases and sales they have
made for their clients. At the same time, all stock certificates will be delivered to and obtained from this
central institution.

 Listed company

A corporation that offers and lists its shares in the stock exchange is called a listed company or issuer. A
listed company is also known as a publicly owned company in view of the fact that its shares were sold
to the investing public. These are the companies that raised their required funds through such issuance
of securities to the public. The capital raised provides the company with the necessary funds to be
invested in business facilities and equipment. An issuing company becomes a listed company, whose
shares are traded in the stock market, after it has met the strict listing requirements imposed by the
stock exchange.