The Basic Structure of Financial Markets

A financial market is any place where money and credit are exchanged. When you take out a
home loan from your bank, you participate in the financial markets. Within the financial
markets, the following principal sets of players that interact:

1. Borrowers. Those who need money to finance their purchases. These include businesses
that need money to finance their investments or to expand their inventories as well as
individuals who borrow money to purchase a new automobile or a new home.
2. Savers (Investors). Those who have money to invest. These are principally individuals
who save money for a variety of reasons, such as accumulating a down payment for a home
or saving for education. Firms also save when they have excess cash.
3. Traders and Speculators. Those who borrow and invest with the sole purpose of making
profits from the market. They act as both borrowers and savers in the market but their
borrowing is not intended to fund a business and neither is their investment based on savings
tapped out of a commercial activity. Just like regular borrowers and savers, traders and
speculators bring liquidity and efficiency in the market.
4. Financial Institutions (Intermediaries). The financial institutions and markets that help
bring borrowers and savers together. They are companies in the financial sector that provide
a broad range of business and services including banking, insurance, and investment
management.

Through these principal agents, financial markets deliver the function of financial
intermediation, the process through which a financial instrument is exchanged for funds. For
example, banks extend loans in exchange for a loan contract signed by the recipient. In
essence, financial intermediation involves one party to transfer funds while the other party
signs (or agrees) to a contract to repay through cash payments in future. The future cash
payments, in turn, may be subject to various types of risks.

The Financial Marketplace: Financial Institutions

1. Commercial Banks - Individuals deposit funds at commercial banks, which use the
deposited funds to provide commercial loans to firms and personal loans to individuals, and
purchase debt securities issued by firms or government agencies. are the traditional
“department stores of finance” because they serve a variety of savers and borrowers.
Historically, commercial banks were the major institutions that handled checking accounts
and through which the Federal Reserve System expanded or contracted the money supply.
2. Investment Banks - Traditionally help companies raise capital. They (1) help corporations
design securities with features that are currently attractive to investors, (2) buy these
securities from the corporation, and (3) resell them to savers. An organization that
underwrites and distributes new investment securities and helps businesses obtain financing.
Underwriting is the process through which an individual or institution takes on financial risk
for a fee. This risk most typically involves loans, insurance, or investments.

3. Insurance Companies - Individuals purchase insurance (life, property and casualty, and
health) protection with insurance premiums. The insurance companies pool these payments
and invest the proceeds in various securities until the funds needed to pay off claims by
policyholders.

4. Mutual Funds - Mutual funds owned by investment companies that enable small investors
to enjoy the benefits of investing in a diversified portfolio of securities purchased on their
behalf by professional investment managers.
Different funds are designed to meet the objectives of different types of savers. Hence, there
are bond funds for those who prefer safety, stock funds for savers who are willing to accept
significant risks in the hope of higher returns, and money market funds that are used as
interest-bearing checking accounts.

5. Pension Funds - are retirement plans funded by corporations or government agencies for
their workers and administered primarily by the trust departments of commercial banks or by
life insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and
real estate.

6. Credit Unions - are cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm.
Members’ savings are loaned only to other members, generally for auto purchases, home
improvement loans, and home mortgages.
7. Exchange Traded Funds (ETF) - are similar to regular mutual funds and are often
operated by mutual fund companies.
ETFs buy a portfolio of stocks of a certain type—for example, media companies or Chinese
companies—and then sell their own shares to the public. ETF shares are generally traded in
the public markets, so an investor who wants to invest in the Chinese market, for example,
can buy shares in an ETF that holds stocks in that particular market.
8. Hedge Funds - are also similar to mutual funds because they accept money from savers
and use the funds to buy various securities, but there are some important differences. While
mutual funds (and ETFs) are registered and regulated by the Securities and Exchange
Commission (SEC), hedge funds are largely unregulated. They also tend to more actively
influence the managers of the corporations that they invest in. Because of the higher risk,
hedge funds are open to a limited range of investors who are deemed to be sufficiently savvy.
Only an accredited investor, which means an individual with a net worth that exceeds $1
million, can invest in a hedge fund.

9. Private Equity Firms - a financial intermediary that invests in equities that are not traded
on the public capital markets.
The first category is the Venture capital firms raise money from investors (wealthy people
and other financial institutions), which they then use to provide the initial financing for
private start-up companies.
The second major category of private equity firms is the leveraged buyout firm. These firms
acquire established companies that typically have not been performing very well with the
objective of making them profitable again and then selling them.
With the exception of hedge funds and private equity companies, financial institutions are
regulated to ensure the safety of these institutions and to protect investors.

The Financial Marketplace: Securities Markets

A security is a negotiable instrument that represents a financial claim. It can take the form of
ownership (stock) or a debt agreement (bond). Businesses and individual investors can trade
the securities issued by public corporations—that is, those whose debt and equity are traded
in the public securities markets
 Financial Instruments - -is a real or a virtual document representing a legal agreement
involving some sort of monetary value. These can be debt securities like corporate
bonds or equity like shares of stock.
Debt Securities
 Firms borrow money by selling debt securities in the debt market. If the debt must be
repaid in less than a year, these securities are sold in the short-term debt market, also
called the money market.
 If the debt has a maturity (the length of time until the debt is due) of between 1 and
10 years, it is often referred to as a note, and if the maturity is longer than 10 years, it
is called a bond; both are sold in the capital market, which is the market for long-term
financial instruments.
Equity Securities
 represent ownership of the corporation. There are two major types of equity
securities: common stock and preferred stock.
 When you buy equity securities, you are making an investment that you expect will
generate a return. However, unlike a bond, which provides a promised set of interest
payments and a schedule for the repayment of principal, an equity security provides
returns that are less certain.
Financial Markets
 A market is a venue where goods and services are exchanged.
 A financial market is a place where individuals and organizations wanting to borrow
funds are brought together with those having a surplus of funds.
Types of Financial Markets
 Physical assets vs. financial assets
 Money vs. Capital
 Primary vs. Secondary
 Spot vs. Futures
 Public vs. Private

Physical assets vs. Financial assets

 Physical Market is also known as real asset or tangible markets because of the
products involved that are not qualified as financial assets.
 Examples are real estate, PPE, inventories.
 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.
 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.

Spot Market vs Future Market

 Spot Market – a market where assets or goods are sold for and delivered on the spot
or at present. The determination of the price and delivery is on the same day.
 Future Market – a market where future contracts are sold. A future contract is a
contract that gives the purchaser an obligation to buy an asset at a predetermined price
at a future date.
Money Market vs Capital Market
 Money Market - this is a market where short-term debts with maturities of one year or
less are used as a source of financing.
 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.
 Capital Market - this is a market where long-term debt and equity securities are
involved, for financing.
Pubic Market vs Private Market
 Private Market - this is a market where negotiation and agreement takes place
personally between two parties.
 Public Market - this is a market where a security or contracts with standardized
features are being traded and held by individuals.
How Securities Markets Bring Corporations and Investors Together
The figure shown below describes the role of the securities markets in bringing investors
together with businesses looking for financing. In this regard, the securities markets are just
another component of the financial marketplace. They are unique, however, in that investors
in the securities markets provide money directly to the firms that need it, as opposed to
making deposits in commercial banks that then loan money to those firms.
Step 1. The firm sells securities to investors. The firm raises money in the securities
markets by selling either debt or equity. When it initially sells the securities to the public, the
sale is considered to take place in the primary market. This is the only time the firm receives
money in return for its securities.
Step 2. The firm invests the funds it raises in its business. The firm invests the cash raised
in the securities markets in hopes that it will generate cash flows—for example, it may invest
in a new restaurant, a new hotel, a factory expansion, or a new product line.
Step 3. The firm distributes the cash earned from its investments. The cash flow from the
firm’s investments is reinvested in the firm, paid to the government in taxes, or distributed to
the investors who own the securities issued in step 1. In the last case, the cash is distributed to
the investors who loaned the firm money (that is, bought the firm’s debt securities) through
the payment of interest and principal. Cash is distributed to the investors who bought equity
(stock) through the payment of cash dividends or the repurchase of shares of the firm’s
previously issued stock.
Step 4. The firm’s securities are traded in the secondary market. Immediately after the
firm’s securities are sold to the public, the investors who purchased them are free to resell
them to other investors. These subsequent transactions take place in the secondary market.

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 directly to the investors.
In turn, these investors pay directly to the issuing company.
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.
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.
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.
The Financial Marketplace: Stock Market
 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

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.

Stock Market Transactions

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.
 Whenever stock in a closely held corporation is offered to the public for the first time,
the company is said to be going public. The market for stock that is just being offered
to the public is called the initial public offering (IPO) market.
 Going Public - The act of selling stock to the public at large by a closely held
corporation or its principal stockholders. Closely Held Corporation - A corporation
that is owned by a few individuals who are typically associated with the firm’s
management.

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.

 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.

 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.
As the heading shows, META is traded on the NasdaqGS. The information right below the
company name and ticker symbol shows the real-time quote at 3:19 p.m. EST. META stock
closed on Feb 12 at $460.12 per share and it opened for trading on February 13 at $467.93
per share. As of mid-afternoon, META’s stock had traded from a low of $466.12 to a high of
$471.88 and the price range during the past 52 weeks was between $167.66 and $485.96. As
of mid-afternoon February 13, 12,017,345 shares of stock had traded hands. META’s average
daily trading volume (based on the past 3 months) was 18,325,186 shares, so trading on this
day looks to be below the average daily trading volume. The total value of all of META’s
stock, called its market cap, was $1.201 trillion. The 1-year target estimate represents the
median 1-year target price as forecasted by analysts covering the stock. It is estimated at
$503.80.

Stock Market Efficacy

 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.
 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.
 Market price: The current price of a stock. also known as perceived value, is the price
of the stock which is currently traded in the market.
 Intrinsic value: The price at which the stock would sell if all investors had all
knowable information about a stock. this is the true value of the stock. This is the
price that the willing buyer will bid and willing seller will ask.
 Equilibrium price: The price that balances buy and sell orders at any given time.

 When markets are efficient, investors can buy and sell stocks and be confident that
they are getting good prices. When markets are inefficient, investors may be afraid to
invest and may put their money “under the pillow.
 If the stock market is efficient, it is a waste of time for most people to seek bargains
by analyzing published data on stocks. That follows because if stock prices already
reflect all publicly available information, they will be fairly priced, and a person can
beat the market only with luck or inside information. So rather than spending time and
money trying to find undervalued stocks, it would be better to buy an index fund
designed to match the overall market. Also, markets are more efficient for individual
stocks than for entire companies; so, for investors with enough capital, it does make
sense to seek out badly managed companies that can be acquired and improved. Note,
though, that a number of private equity players are doing exactly that; so, the market
for entire companies may soon be as efficient as that for individual stocks.