Chapter 1

Rationale in Studying Financial Markets and Institutions

THE NEED TO STUDY FINANCIAL MARKETS

In a market system, businesses of all types face risks, and many businesses fail. Economists and
policy makers are particularly concerned about the risk and potential failure that financial institutions
(bank and non-bank) face because they play a vital role in the financial system.

Financial markets and institutions not only influence your everyday life but also involve huge
flows of funds trillions of dollars throughout the world economy which is turn affect business profits, the
production of goods and services and the economic well-being of the countries around the world.

The study of financial markets and institutions will reward you with an understanding of many
exciting issues such as how funds are transferred from people who have an excess of available funds to
people who have a shortage. Indeed, well-functioning financial markets are a key factor in producing
high economic growth and poorly performing financial markets are one reason that many countries in
the world remain desperately poor. Activities in financial markets also have direct effects on personal
wealth, the behavior of business and consumers and the cyclical performance of the economy.

On the evening television news, you have just heard that the bond market has been booming. In
the business section of a local newspaper, you read that the Euro is slightly higher against the yen. A
European airline loses millions of dollars with derivatives. The Dow Jones Industrial Average is off 18
points in active trading. Another local newspaper reported that "with inflation slowing again in June,
2019, the Bangko Sentral ng Pilipinas (BSP) Governor has sounded off on potential rate cuts in the near
term. There was even a hint that the overnight borrowing rate cut will likely come before the last
installment of the latest reserve requirement reduction scheduled at the end of July, 2019 which was
implemented by the BSP in early May, 2019, will occur.

Does this mean that interest rates will fall so that it is easier for you to finance the purchase of a
new computer system for your small retail business? Will the economy improve in the future so that it is
a good time to build a new factory building or add to the one you are in? Should you try to raise funds by
issuing stocks or bonds or instead go to the bank for a loan? If you import goods from abroad, should
you be worried that they will become more expensive?

All these events are examples of Financial Markets at work. That markets exercise enormous
influence over modern life comes is not news. But although people around the word speak glibly of
"Wall Street", the "stock market" and the "currency marks", the meanings they attach to these time-
worn phrases are often unclear and out-of-date.

This book explains the purposes that different financial markets serve and clarifies the way they
work. It cannot tell you whether your investment portfolio is likely to rise or fall in value. But it may help
you understand how its value is determined and how the different securities or financial instruments in it
are created and traded.
 This book provides answers to the businessmen's questions by examining how financial markets
(such as those for stocks, bond and foreign currency exchange) and financial institutions (such as banks,
insurance companies, mutual funds and other institution) work.

The word "market" usually conjures up an image of the bustling, paper-strewn floor of the New
York Stock Exchange and of Philippine Stock Exchange and of traders motioning frantically in the
"futures" cubicles of Chicago. These images are out-of-date as almost all the dealings are now handled
computer to computer, often with minimal human intervention.

Financial Markets have been around ever since mankind settled down to growing crops and
trading them with others. The independent decisions of all those farmers constituted a basic financial
market, and that market fulfilled may be the same purposes as financial markets do today.

Financial Markets are comprehensively discussed in Unit III.

THE NEED TO STUDY FINANCIAL INSTITUTIONS

Direct funds transfers are common among individuals and small businesses and in economies
where financial markets and institutions are less developed. But large businesses in developed
economies generally find it more efficient to enlist the services of a financial institution when the time
comes to raise capital.

Financial institutions are what make financial market work. Without them, financial markets
would not be able to move funds from people who save to people who have productive investment
opportunities. Thus, they also have important effects on the performance of the economy as a whole.

Financial institutions are financial intermediaries that acquire funds by issuing liabilities and in
turn use those funds to acquire assets by purchasing securities or making loans.

They play an important role in the financial system because they reduce transaction costs, allow
sharing and solve problems created by adverse relations and moral hazard. As a result, financial
institutions allow small savers and borrowers to benefit from the existence of financial markets thereby
increasing the efficiency of the economy.

The field of financial markets and institutions is indeed an exciting one. Not only will one learn
materials that affect the life of the individual directly but also gain a clearer understanding of events in
financial markets and institutions that we hear about in the news media. Understanding how financial
institutions are managed is important because there will be many times in one's life, as an individual, an
employee, or the owner of a business, when you will interact with them. Cases provided in this textbook
which provide specific analytic tools are useful if one makes his/her career at a financial institution and
also give him/her a feel of what a job as a manager of a financial institution is all about.

Another reason for studying financial institutions is that they are among the largest employers in
the country and frequently pay very high salaries. Hence some of you have a very practical reason for
studying financial institutions: It may help you get a good job in the financial sector. Even if your interests
lie elsewhere, you should still care about how financial institutions are run because there will be many
times in your life, as an individual, an employee, or the owner of a business, when you will interact with
these institutions. Knowing how financial institutions are managed may help you get a better deal when
you need to borrow from them or if you decide to supply them with funds.

APPROACH IN STUDYING FINANCIAL MARKETS AND INSTITUTIONS

The framework underlying all discussions in this text has three levels, namely,

a) Understanding

Students learn to understand economic analysis, that is, students develop the economic intuition
they need to organize concepts and facts.

b) Evaluating

Students learn to evaluate current developments and the financial news. Students learn to use
financial data and economic analysis to think critically about how they interpret current events.

c) Predicting

Students learn to use economic analysis to predict likely changes in the economy and the
financial system.

This book stresses a unifying, analytic framework to study financial markets and institutions. This
framework uses a few basic concepts to keep organize your thinking about the determination of asset
prices, the structure of financial markets, bank management and the role of monetary policy in the
economy. The basic concepts are equilibrium, basic supply and demand analysis to explain behavior in
the financial markets, the search for profits, and an approach to financial structure based on transaction
costs and asymmetric information.

The framework also provides the tools needed to understand trends in the financial market
place and in variables such as interest rates and exchange rates. This text also emphasizes the interaction
of theoretical analysis and empirical data in order to expose the reader to real-life events and data.

And to function better in the real world outside the classroom, it is recommended that one must
get into the lifelong habit of regularly following the financial news that appears in leading financial
publications or read the financial / business section of the newspapers.

Lastly, the World Wide Web has become an extremely valuable and convenient resource for
financial research. These sites contain additional information and are updated frequently. Visit these
sites to further explore topics that one finds of particular interest.

This chapter offers a preliminary overview of the fascinating study of financial markets and
institutions. We will return to a more detailed treatment of the regulation, structure and evaluation of
financial markets and institutions in the succeeding chapters.
REVIEW QUESTIONS

Questions

1. Why is there a need to understand how monetary policy is conducted by central banks worldwide?

2. What crucial role do banks and other financial institutions play?

3. Why is understanding how financial institutions are managed important to your life?

4. Give three important reasons why is there a need to study Financial Markets.

5. What is the most significant role that financial markets play?

6. Explain briefly the three levels of the framework that underlie the study of financial markets and
institutions.
Chapter 2 - INTRODUCING MONEY AND INTEREST RATES

Expected Learning Outcomes

After studying the chapter, you should be able to...

1. Explain the role of money in a nation's economy

2. Enumerate and describe the characteristics and key functions of money

CHAPTER 2

INTRODUCING MONEY AND INTEREST RATES

ROLE OF MONEY IN THE ECONOMY

Money is any item or commodity that is generally accepted as a means of payment for goods
and services or for repayment of debt, and that serves as an asset to its holder. On the simplest level,
money is composed of the bills and coins which have been printed or minted by the National
Government (these are called currency). But money also includes the funds stored as electronic entries
in one's checking account and savings account.

Because money in a modern economy is not directly backed by intrinsic value (e.g., the coin's
weight in gold or silver), the financial system works on an entirely fiduciary basis, relying on the public's
confidence in the established forms of monetary exchange.

Money is the oil that keeps the machinery of our world turning. By giving goods and services an
easily measured value, money facilitates the billions of transactions that take place every day. Without it,
the industry and trade that form the basis of modern economies would grind to a halt and the flow of
wealth around the world would cease.

Money has fulfilled this vital role for thousands of years. Before its invention, people bartered,
swapping goods they produced themselves for things they needed from others. Barter is sufficient for
simple transactions, but not when the things traded are of differing values, or not available at the same
time. Money, by contrast, has a recognized uniform value and is widely accepted. At heart a simple
concept, over many thousands of years, it has become very complex indeed.

At the start of the modern age, individuals and governments began to establish banks, and other
financial institutions were formed. Eventually, ordinary people could deposit their money in a bank
account and earn interest, borrow money and buy property, invest their wages in business, or start
companies themselves." Banks could also insure against the sorts of calamities that might devastate
families or traders, encouraging risk in the pursuit of profit.
 Today it is the nation's government and central bank that control a country's economy. The
Federal Reserve (known as "The Fed") is the central bank in the US. The Fed issues currency, determines
how much of it is in circulation, and decides how much interest it will charge banks to borrow its money.

In the Philippines, the central bank that controls the country's economy is the "Bangko Sentral
ng Pilipinas". While government still print and guarantee money, in today's world it no longer needs to
exist as physical coins or notes, but can be found solely in digital form...

CHARACTERISTICS AND KEY FUNCTIONS OF MONEY

Money is not money unless it has all of the following defining characteristics: Money must have
value, be durable, portable, uniform, divisible, in limited supply, and be usable as a means of exchange.
Underlying all of these characteristics is trust - people must be confident that if they accept money, they
can use it to pay for goods.

Store of Value

Money acts as a means by which people can store their wealth for future use. It must not,
therefore, be perishable, and it helps if it is of a practical size that can be stored and transported easily.

Item of Worth

Most money originally has an intrinsic value, such as that of the precious metal that was used to
make the coin. This in itself acted as some guarantee the coin would be accepted.

Means of exchange

It must be possible to exchange money freely and widely for goods, and its value should be as
stable as possible. It helps if that value is easily divisible and if there are sufficient denominations so
change can be given.

Unit of Account

Money can be used to record wealth possessed, traded or spent- personally and nationally. It
helps if only one recognized authority issues money. If anybody could issue it, then trust in its value
would disappear.

Standard of Deferred Payment

Money is also useful because of its ability to serve as a standard of deferred payment.

Money can facilitate exchange at a given point by providing a medium of exchange and unit of
account.