CHAPTER 1

Financial Markets (its definition, use, and importance)

Financial markets - are structures through which funds flow. It refer to a place or
system where trading of financial instruments occurs.

Financial markets can be distinguished along two major dimensions:

• Primary versus secondary markets

• Money versus capital markets

Why Study Financial Markets and Institutions?

• Markets and institutions are primary channels through which capital is allocated in our
society

• Investment and financing decisions require managers and individual investors to

understand the flow of funds throughout the economy

• Managers and individuals must also understand the operation and structure of
domestic and international financial markets

Primary Markets vs Secondary Markets

Primary markets - Markets in which users of funds (e.g., corporations) raise funds
through new issues of financial instruments, such as stocks and bonds

Include issues of equity by firms initially going public, referred to as initial public
offerings (IPOs)

fund users issue securities in the external primary markets to raise additional funds

are arranged through financial institutions called investment banks, which serves as
intermediaries or underwriter between the issuing corporations (fund users) and
investors (fund suppliers).
Primary market financial instruments include issues of equity by firms initially going
public (e.g., allowing their equity—shares—to be publicly traded on stock markets for
the first time).

These first-time issues are usually referred to as initial public offerings (IPOs).

Primary market securities also include the issue of additional equity or debt instruments
of an already publicly traded firm.

Initial Public Offerings (IPOs)

Secondary markets - Markets that trade financial instruments once they are issued in
primary markets, they are then traded—that is, rebought and resold

 Sellers of secondary market financial instruments are economic agents in need

of funds.

 Secondary markets provide a centralized marketplace where economic

agents know they can transact quickly and efficiently.

 These markets therefore save economic agents the search and other
costs of seeking buyers or sellers on their own.

 Secondary markets offer buyers and sellers liquidity—the ability to turn an asset
into cash quickly—as well as information about the prices or the value of their
investments.

 It also offers Information about the prices or the value of investments and
trading with low transaction costs

Money versus Capital Markets

Money markets - trade debt securities or instruments with maturities of one year or
less

Economic agents with short-term excess supplies of funds can lend funds (i.e., buy
money market instruments) to economic agents who have short- term needs or
shortages of funds (i.e., they sell money market instruments).

Fluctuations in their prices in the secondary markets in which they trade are usually
quite small (the shorter the duration, the lesser impact to prices)

Duration ≠ tenor
 Money Market Instruments - issued by corporations and government units to
obtain short-term funds

• Treasury bills —short-term obligations issued by the U.S. government.

• Commercial paper —short-term unsecured promissory notes issued by a company to
raise short-term cash.

• Negotiable certificate of deposit —bank-issued time deposit that specifies an interest

rate and maturity date and is negotiable, (i.e., can be sold by the holder to another
party).

• Banker’s acceptance —time draft payable to a seller of goods, with payment

guaranteed by a bank.

Capital markets - trade debt (bonds) and equity (stocks) instruments with maturities of
more than one year

• Given their longer maturity, these instruments experience wider price fluctuations in
the secondary markets in which they trade than do money market instruments (the
longer the duration, the bigger impact to prices)

Capital Market Instruments - issued by corporations and government units to obtain

medium to long- term funds

 Corporate stock —the fundamental ownership claim in a public corporation.

 Corporate bonds —long-term bonds issued by corporations.
 Treasury bonds —long-term bonds issued by the U.S. Treasury.
 Government securities —long-term bonds collateralized by a pool of assets and
issued by agencies of the government.
 Bank and consumer loans —loans to commercial banks and individuals.
Foreign Exchange Markets

Gold standard as the basis of FX rate determination from 1880 – 1933

Bretton Woods Agreement - Value at which currencies were pegged to the USD is
called the parity or par value and this new system of fixed parities were officially set by
the government or the central bank

Foreign exchange risk - is the sensitivity of the value of cash flows on foreign
investments to changes in the foreign currency’s price in terms of dollars

• U.S. dollars received on a foreign investment depends on the exchange rate between
the U.S. dollar and the foreign currency when the non-dollar cash flow is converted into
U.S. dollars.

• While foreign currency exchange rates are often flexible—they vary day to day with
demand and supply of foreign currency for dollars—central governments sometimes
intervene in foreign exchange markets directly or affect foreign exchange rates indirectly
by altering interest rates.

• The sensitivity of the value of cash flows on foreign investments to changes in the
foreign currency’s price in terms of dollars is referred to as foreign exchange risk

Derivative Security Markets

derivative security- is a financial security (e.g., future, option, swap, or mortgage-

backed security) whose payoff is linked to another, previously issued security, such as a
security traded in capital or foreign exchange markets

• Derivative securities generally involve an agreement between two parties to exchange

a standard quantity of an asset or cash flow at a predetermined price and at a specified
date in the future.

• Derivatives are traded in derivative security markets

 Generally involves agreement between two parties to exchange a standard

quantity of an asset or cash flow at a predetermined price and at a specified
future date

 Derivative markets are the newest of financial security markets and are also
potentially the riskiest security
Derivative activity:

 Tremendous growth between 1992-2013

 Large drop from 2013 to 2019, due largely to the 2014 implementation of the
Volcker Rule

Volcker Rule

 The Volcker rule generally prohibits banking entities from engaging in proprietary
trading or investing in or sponsoring hedge funds or private equity funds.

 The regulations have been developed by five federal financial regulatory

agencies, including the Federal Reserve Board, the Commodity Futures Trading
Commission, the Federal Deposit Insurance Corporation, the Office of the
Comptroller of the Currency, and the Securities and Exchange Commission.

Financial Market Regulation

Financial instruments are subject to regulations imposed by regulatory agencies, such

as the Bangko Sentral ng Pilipinas (BSP), Philippine Deposit Insurance Corporation
(PDIC), Anti-Money Laundering Council (AMLC), and Securities and Exchange
Commission.

Bangko Sentral ng Pilipinas (BSP) - is the central monetary authority in charge of

regulating money, banking and credit in the Philippines.

- The BSP is governed by the Monetary Board, composed of seven

members appointed by the president of the Philippines, with the governor
as its chair.

- Through the Monetary Board, the BSP issues rules and regulations in the
exercise of its regulatory powers and directs the management, operations
and administration of the BSP.

Under the New Central Bank Act, the BSP performs the following functions, all of which
relate to its status as the Philippines’ central monetary authority:

• Liquidity management –formulates and implements monetary policy aimed at

influencing money supply consistent with its primary objective to maintain price stability
• Currency issue – exclusive power to issue the national currency. All notes and coins
issued by the BSP are fully guaranteed by the government and are considered legal
tender for all private and public debts

• Lender of last resort – extends discounts, loans and advances to banking institutions
for liquidity purposes

• Financial supervision –supervises banks and exercises regulatory powers over non-
bank institutions performing quasi-banking functions

• Management of foreign currency reserves seeks to maintain sufficient international

reserves to meet any foreseeable net demands for foreign currencies in order to
preserve the international stability and convertibility of the Philippine peso

• Determination of exchange rate policy –determines the exchange rate policy of the
Philippines. Currently, the BSP adheres to a market-oriented foreign exchange rate
policy, principally to ensure orderly conditions in the market

• Other activities - functions as the banker, financial advisor and official depository of
the government, its political subdivisions and instrumentalities, and of government-
owned and -controlled corporations

Philippine Deposit Insurance Corporation (PDIC) - has the power to conduct

examination of banks with the prior approval of the Monetary Board and within terms
and conditions determined by law. All banks are obligated to insure deposit liabilities
with the PDIC up to a maximum amount of PHP 500,000 or its foreign equivalent.

Anti-Money Laundering Council (AMLC) - has the power to conduct investigations of

money laundering and other violations of Republic Act No. 9160 or the Anti-Money
Laundering Act for the protection of the integrity and confidentiality of bank accounts
and to prevent the Philippines from being used as money laundering site for the
proceeds of any unlawful activity.

It monitors and receives covered or suspicious transaction reports from covered

institutions under the law, investigates suspicious transactions and covered transactions
deemed suspicious after an investigation.

CHAPTER 2

Financial Institutions – Institution that perform the essential function of channeling

funds from those with surplus funds to those with shortages of funds.
Provide money-related services like deposits, loans, investments, insurance, etc.

Flow of Funds Without Financial Institutions

The flow of funds in a world without financial institutions would be significantly different.
Financial institutions, such as banks and investment businesses, are essential in
connecting those needing finances with those who can lend or invest them.

Businesses cannot thrive in the absence of financial institutions

The result will be an inefficient use of funds, increased costs of doing business, and
greater risks for both depositors and borrowers. The flow of funding would be less
effective and more complicated.

Importance of Financial Institutions

Financial institutions play a crucial role in the economy, serving as the backbone of
financial activities that drive growth, stability, and innovation. These institutions
encompasses a wide range of entities, including banks, investment firms, insurance
companies, and more.

 Facilitate the efficient allocation of resources

  Promotes economic stability

 Fosters innovation

 Contributes to the personal financial well- being

Roles of Financial Institutions

Financial institutions have important roles to play within our economy, especially in
facilitating the flow of funds and the proper functioning of our financial system.

1. Regulation of Monetary Supply – Financial institutions help regulate the money

supply in the economy by maintaining stability and controlling inflation

2. Banking Services – Financial Institutions offer banking services

3. Insurance Services – Financial Institutions help to provide protection against

financial losses by providing insurances

4. Capital Formation – FI facilitate the process of raising capital for businesses

and governments

5. Investment Advice – FI provides investment advice that helps their customers

select the best investment option available in the market

6. Brokerage Services – Brokerage firms act as intermediaries between buyers

and sellers in financial markets, and they facilitate the buying and selling of
securities

7. Pension Fund Services – Through their various kinds of investment plans, FI

help individuals plan their retirement.

8. Trust Fund Services – some financial organizations provide trust fund services
to their clients, wherein they manage, invest, and safe-keep the client’s assets

9. Financing the SMEs – FI helps small and medium-scale enterprises setup

themselves by providing long-term as well as short-term funds

10. Government Agent for Growth – FI, especially central banks, can act as agents
of the government to implement economic policies.

TYPS OF FINANCIAL INSTITUTIONS

Financial institutions are essential because they provide a marketplace for money and
assets so that capital can be efficiently allocated to where it is most useful.
The financial institution is the one that helps capitalist economies in providing funds by
lending money or investing to it.

CENTRAL BANK - A central bank is a public institution that is responsible for

implementing monetary policy, managing the currency of a country, or group of
countries, and controlling the money supply.

RETAIL AND COMMERCIAL BANKS - A financial institution which accepts deposits

from the public and gives loans for the purposes of consumption and investment to
make profit.

INVESTMENT BANKING - Pertains to certain activities of a financial services company

or a corporate division that consist in advisory-based financial transactions on behalf of
individuals, corporations, and governments.

SAVINGS AND LOANS ASSOCIATES - A financial institution that specializes in

accepting savings deposits and making mortgage and other loans.

INTERNET BANKS - Online banking is also known as Internet banking or web banking.
Online banking offers customers almost every service traditionally available through a
local branch including deposits, transfers, and online bill payments.

INSURANCE COMPANIES - A company that creates insurance products to take on

risks in return for the payment of premiums.