OVERVIEW OF FINANCIAL MARKETS

Financial System FINANCIAL MARKETS

● A financial system means the The arenas through which funds flow / are
structure is available in an economy. structures through which funds flow.
● It mobilizes capital from various
surplus sectors of the economy and Financial market may be defined as a
allocate / distribute to various needy transmission mechanism between investors
sectors (or lenders) and the borrowers (or users)
● Transformation of saving into through which transfer of funds is
investments and consumption / facilitated’.
spending (financial assets) by the
active role played by the financial It consists of individual investors, financial
system – financial intermediaries institutions and other intermediaries who are
● The place where these activities linked by a formal trading rules and
take place could be taken to connote communication network for trading the
the financial market. various financial assets and credit
● Financial system comprises a instruments.
mixture of intermediaries, markets
and instruments that are related to The financial markets act as a link between
each other. these two different groups.

Components of Financial System It facilitates this function by acting as an

intermediary between the borrowers and
According to the structural approach, the lenders of money.
financial system of an economy consists of
three main components:
FUNCTION OF FINANCIAL MARKETS
1) Financial markets: according to the Financial market gives strength to the
functional approach, financial markets economy by making finance available at the
facilitate the flow of funds in order to finance right place.
investments by corporations, governments
and individuals. ● Mobilization of savings and their
2) Financial intermediaries (institutions): Channelization into more Productive
are the key players in the financial markets Uses: Financial market gives
as they perform the function of impetus to the savings of the people.
intermediation and thus determine the flow This market takes the uselessly lying
of funds. finance in the form of cash to places
3) Financial regulators: perform the role of where it is really needed. Many
monitoring and regulating the participants in financial instruments are made
the financial system. available for transferring finance
from one side to the other side. The
Each of the components plays a specific investors can invest in any of these
role in the economy. instruments according to their wish.
 ● Price discovery: The price of any through new issues of financial instruments,
goods or services is determined by such as stocks and bonds.
the forces of demand and supply.
Like goods and services, the e.g., the sale of new corporate stock or new
investors also try to discover the Treasury securities
price of their securities. The financial
market is helpful to the investors in Secondary markets facilitate the trading of
giving them proper prices. financial instruments once they are issued.
e.g., the sale of existing stock
● Liquidity to Financial Assets: This
is a market where the buyers and 2. Money vs. Capital Markets
the sellers of all the securities are
available all the time. This is the Money markets — markets that trade debt
reason that it provides liquidity to securities or instruments with maturities of
securities. It means that the less than one year (flow of short-term funds)
investors can invest their money,
whenever they desire, in securities Capital markets —markets that trade debt
through the medium of financial and equity instruments with maturities of
markets. They can also convert their more than one year (flow of long-term
investment into money whenever funds)
they so desire.

● Reduction of transaction cost:

Various types of information are
needed while buying and selling
securities. Much time and money is
spent in obtaining the same. The
financial market makes available
every type of information without
spending any money. In this way,
the financial market reduces the cost
of transactions.

TYPES OF FINANCIAL MARKETS

Financial markets can be distinguished by 3. Foreign Exchange Markets (Forex
the trading structure and maturity structure Market) — markets in which cash
of its securities (two major dimensions): flows from the sale of products or
assets denominated in a foreign
1. Primary vs. Secondary Markets currency are transacted and traded.

Primary markets facilitate in which users of 4. Derivative Markets —markets in

funds (e.g., corporations) raise funds which derivative securities trade.
 Secondary Markets
Purpose: This is where financial
instruments, once issued, are traded among
Primary Markets investors. Think of this like a stock market
Purpose: This is where new financial where people buy and sell shares with each
instruments are created and sold for the first other.
time, like when a company sells shares to
Key Players:
raise money.
● Financial Markets (Investors):
Key Players: These are people or institutions that
already own financial instruments
● Users of Funds: Companies or
and want to sell them.
governments that need money and
● Securities Brokers: Middlemen
issue debt (like bonds) or equity (like
who help connect buyers and sellers
stocks).
in the market.
● Investment Bank: A middleman that
● Other Suppliers of Funds: New
helps the company sell its financial
investors who want to buy these
instruments to investors. This
financial instruments.
process is called "underwriting."
● Initial Suppliers of Funds: These Flow:
are the investors (like you, me, or
big institutions) who buy these new ● Financial instruments move from
instruments, providing money to the sellers to buyers.
companies. ● Money moves from buyers to
sellers.
Flow: ●
● Financial instruments (like stocks)
go from the company to the
investors.
● Money (funds) goes from the PRIMARY MARKETS
investors to the company.
Primary markets are markets in which users
of funds (e.g., corporations) raise funds
through new issues of financial instruments,
such as stocks and bonds. ● Primary market financial instruments
include issues of equity by firms
Most primary market transactions are initially going public (e.g., allowing
arranged through financial institutions called their equity shares to be publicly
investment banks — for example, Morgan traded on stock markets for the first
Stanley or Bank of America Merril Lynch — time). These first-time issues are
that serve as intermediaries between the usually referred to as initial public
issuing corporations (fund users) and offerings (IPOs). Primary market
investors (fund suppliers). securities also include the issue of
additional equity or debt instruments
● For these public offerings, the of an already publicly traded firm.
investment bank provides the
securities issuer (the funds user) SECONDARY MARKETS
with advice on the securities issue
(such as the offer price and number Once financial instruments such as stocks
of securities to issue) and attracts are issued in primary markets, they are then
the initial public purchasers of the traded, that is, rebought and resold — in
securities for the funds user. secondary markets.

By issuing primary market securities ● Buyers of secondary market

with the help of an investment bank, securities are economic agents
the funds user saves the risk and (consumers, businesses, and
cost of creating a market for its governments) with excess funds.
securities on its own. ● Sellers of secondary market
financial instruments are
● Rather than a public offering (i.e., an economic agents in need of
offer of sale to the investing public at funds.
large), a primary market sale can
take the form of a private Secondary markets provide a centralized
placement. marketplace where economic agents know
they can transact quickly and efficiently.
With a private placement, the These markets therefore save economic
securities issuer (user of funds) agents the search and other costs of
seeks to find an institutional buyer seeking buyers or sellers on their own.
such as a pension fund or group of
buyers (suppliers of funds) to In addition to stocks and bonds, secondary
purchase the whole issue. Privately markets also exist for financial instruments
placed securities have traditionally backed by mortgages and other assets,
been among the most illiquid foreign exchange, and futures and options
securities, with only the very largest (i.e., derivative securities — financial
financial institutions or institutional securities whose payoffs are linked to other,
investors being able or willing to buy previously issued [or underlying] primary
and hold them. securities).
 secondary market. However, the
Derivative securities have existed for issuer does obtain information about
centuries, but the growth in derivative the current market value of its
securities markets occurred mainly in the financial instruments, and thus the
1980s through 2000s. As major markets, value of the corporation as
therefore, the derivative securities markets perceived by investors such as its
are among the newest of the financial stockholders, through tracking the
security markets. However, the financial prices at which its financial
crisis clearly illustrates the magnitude of the instruments are being traded on
risk that derivatives can impose on a secondary markets.
Financial Institution and even the world’s
financial system. This price information allows issuers to
evaluate how well they are using the funds
Indeed, at the very heart of the financial generated from the financial instruments
crisis were losses associated with off- they have already issued and provide
balance-sheet derivative securities information on how well any subsequent
created and held by Financial offerings of debt or equity might do in terms
Institutions. of raising additional money (and at what
cost).
Losses resulted in the failure, acquisition, or
bailout of some of the largest Financial Secondary markets offer buyers and
Institutions (e.g., the investment banks Lehman sellers liquidity—the ability to turn an
Brothers, Bears Stearns, and Merrill Lynch; the asset into cash quickly—as well as
savings institution Washington Mutual; the information about the prices or the value of
insurance company AIG; the commercial bank their investments.
Citigroup; the finance company Countrywide
Financial; and the government sponsored
● Increased liquidity makes it more
agencies Fannie Mae and Freddie Mac) and a
desirable and easier for the issuing
near meltdown of the world’s financial and
firm to sell a security initially in the
economic systems.
primary market.
● Further, the existence of centralized
Secondary markets offer benefits to both
markets for buying and selling
investors (suppliers of funds) and issuing
financial instruments allows
corporations (users of funds).
investors to trade these instruments
at low transaction costs.
● For investors, secondary markets
provide the opportunity to trade
Figure 1–1 illustrates a timeline for the
securities at their market values
primary market exchange of funds for a new
quickly as well as to purchase
issue of corporate bonds or equity and a
securities with varying risk-return
secondary market transfer of funds.
characteristics.
MONEY MARKETS
Money markets are markets that trade debt
● Corporate security issuers are not
securities or instruments with maturities of
directly involved in the transfer of
one year or less.
funds or instruments in the
In the money markets, economic agents CAPITAL MARKETS
with short-term excess supplies of funds Capital markets are markets that trade
can lend funds (i.e., buy money market equity (stocks) and debt (bonds)
instruments) to economic agents who instruments with maturities of more than
have short-term needs or shortages of one year. The major suppliers of capital
funds (i.e., they sell money market market securities (or users of funds) are
instruments). corporations and governments.

The short-term nature of these instruments Households are the major suppliers of funds
means that fluctuations in their prices in the for these securities. Given their longer
secondary markets in which they trade are maturity, these instruments experience
usually quite small. Money markets do not wider price fluctuations in the secondary
operate in a specific location—rather, markets in which they trade than do money
transactions occur via telephones, wire market instruments. 4 For example, all else
transfers, and computer trading. constant, long-term maturity debt
instruments experience wider price
Money Market Instruments. A variety of fluctuations for a given change in interest
money market securities are issued by rates than short-term maturity debt
corporations and government units to obtain instruments.
short-term funds.
Treasury bills — short-term obligations Capital Market Instruments.
issued by the government.
Federal funds — short-term funds Corporate stock — the fundamental
transferred between financial institutions ownership claim in a public corporation.
usually for no more Mortgages — loans to individuals or
than one day. businesses to purchase a home, land, or
Repurchase agreements — agreements other real property.
involving the sale of securities by one party Corporate bonds — long-term bonds
to another with a promise by the seller to issued by corporations.
repurchase the same securities from the Treasury bonds — long-term bonds issued
buyer at a specified date and price. by the U.S. Treasury.
Commercial paper — short-term State and local government bonds —
unsecured promissory notes issued by a long-term bonds issued by state and local
company to raise short-term cash. governments.
Negotiable certificate of deposit — bank- U.S. government agencies — long-term
issued time deposit that specifies an interest bonds collateralized by a pool of assets and
rate and maturity date and is negotiable, issued by agencies of the government.
(i.e., can be sold by the holder to another Bank and consumer loans — loans to
party). commercial banks and individuals.
Banker’s acceptance — time draft payable FOREIGN EXCHANGE MARKETS
to a seller of goods, with payment
guaranteed by a bank. In addition to understanding the operations
of domestic financial markets, a financial
manager must also understand the Major participants
operations of foreign exchange markets and
foreign capital markets. ● Individuals
● Firms
While foreign currency exchange rates are ● Banks
often flexible—they vary day to day with ● Governments
demand and supply of foreign currency for ● International Agencies
dollars—central governments sometimes
intervene in foreign exchange markets There are two tier system in the foreign
directly or affect foreign exchange rates exchange market:
indirectly by altering interest rates . ● One involves the transactions
between the ultimate customer and
The sensitivity of the value of cash flows on bank.
foreign investments to changes in the ● Other consists of the transaction
foreign currency’s price in terms of dollars is between the banks
referred to as foreign exchange risk.

The purpose of FOREX is to help Structure of the Philippine FOREX

international trade and investment. A Market
FOREX market helps businesses convert
The Philippine FOREX market is a
one currency to another.
decentralized market where currencies are
traded over the counter (OTC), meaning
In a typical foreign exchange transaction a there is no central exchange. The Bangko
party purchases a quantity of one currency Sentral ng Pilipinas (BSP) plays a
by paying a quantity of another currency. regulatory and supervisory role to ensure
stability and smooth functioning.
The FOREX is unique because of:
Key Segments:
● Its trading volumes
● The extremely liquidity of the market 1. Interbank Market: The core of the forex
● Its geographical dispersion market where banks trade currencies
● Its long trading hours 24 hours a day among themselves.
● The low margins of profit compared 2. Retail Market: Smaller trades involving
with other market or fixed income individuals, businesses, and institutions,
often facilitated by banks and money
but profits can be high due to very
service businesses (MSBs).
large trading volumes. 3. Parallel Market: Informal forex trading
channels, which are smaller in scale and
Exchange rates fluctuations are usually less regulated.
caused by actual monetary flows as well as
by expectations of change in monetary Participants in the Philippine
FOREX Market
flows caused by changes in GDP growth,
Inflation, interest rates, budget and trade Participants in the market can be divided
deficits or surpluses and other into the following categories:
macroeconomic conditions.
A. Regulators:
 ● Bangko Sentral ng Pilipinas ○ Engage in currency hedging
(BSP): and forex transactions to
○ Oversee forex transactions in manage exchange rate risk.
the country. ● Travelers and Overseas Filipino
○ Implements exchange rate Workers (OFWs):
policies, regulates forex ○ Travelers exchange pesos
dealers, and ensures for foreign currency, and
compliance with foreign OFWs remit their earnings to
exchange laws. the Philippines.
○ Sets the rules for authorized
agents (like banks) to E. Speculators and Investors:
conduct foreign exchange
transactions. ● Individuals or institutions who buy
and sell currencies for profit, based
B. Market Makers: on expected exchange rate
movements.
● Commercial Banks:
○ Major participants in the
forex market.
○ Facilitate large forex Key Features of the Philippine FOREX
transactions for businesses Market
and retail customers.
○ Provide quotes for buying
● Floating Exchange Rate System:
and selling foreign
○ The Philippine peso (PHP)
currencies.
operates under a managed
floating exchange rate
C. Brokers and Dealers:
system. The BSP allows the
● Foreign Exchange Dealers (FX peso’s value to be
Dealers): determined by market forces
○ Licensed by the BSP to but intervenes to avoid
provide forex services. excessive volatility.
○ Operate as intermediaries in ● Remittance-Driven:
the forex market for ○ A significant portion of forex
individuals and businesses. transactions in the
Philippines is driven by
remittances from overseas
Filipino workers (OFWs),
D. End Users: contributing to a steady
inflow of foreign currencies.
● Importers and Exporters: ● Import and Export Trade:
○ Use the forex market to pay ○ The demand for forex is
for international trade. heavily influenced by
○ Importers need foreign international trade activities,
currency to pay for goods, with importers demanding
while exporters exchange foreign currencies and
foreign currency earnings exporters supplying them.
into pesos. ● Authorized Agent Banks (AABs):
● Multinational Corporations: ○ These are banks and other
financial institutions
 authorized by the BSP to
deal in foreign exchange.
● Money Service Businesses FINANCIAL MARKET REGULATION
(MSBs):
○ Includes forex dealers,
money changers, and Financial instruments are subject to
remittance agents that regulations imposed by regulatory agencies
facilitate forex transactions such as the Securities and Exchange
on a smaller scale. Commission (SEC)—the main regulator of
securities markets since the passage of the
Securities Act of 1934—as well as the
exchanges (if any) on which the instruments
DERIVATIVE SECURITY MARKETS are traded.

Derivative security markets are the markets For example, the main emphasis of SEC
in which derivative securities trade. A regulations (as stated in the Securities Act
derivative security is a financial security of 1933) is on full and fair disclosure of
(such as a futures contract, option contract, information on securities issues to actual
swap contract, or mortgage-backed and potential investors. Those firms
security) whose payoff is linked to another, planning to issue new stocks or bonds to be
previously issued security such as a sold to the public at large (public issues) are
security traded in the capital or foreign required by the SEC to regis- ter their
exchange markets. securities with the SEC and to fully describe
the issue, and any risks associated with the
Derivative securities generally involve an issue, in a legal document called a
agreement between two parties to prospectus.
exchange a standard quantity of an asset or
cash flow at a predetermined price and at a The SEC also monitors trading on the major
specified date in the future. As the value of exchanges (along with the exchanges
the underlying security to be exchanged themselves) to ensure that stockholders and
changes, the value of the derivative security managers do not trade on the basis of
changes. While derivative securities have inside information about their own firms (i.e.,
been in existence for centuries, the growth information prior to its public release).
in derivative security markets occurred
mainly in the 1990s and 2000s. SEC regulations are not intended to protect
investors against poor investment choices,
As major markets, the derivative security but rather to ensure that investors have full
markets are the newest of the financial and accurate information available about
security markets. Derivative securities, corporate issuers when making their
however, are also potentially the riskiest of investment decisions. The SEC has also
the financial securities. Indeed, at the center imposed regulations on financial markets in
of the recent financial crisis were losses an effort to reduce excessive price
associated with off-balance-sheet fluctuations.
mortgage-backed (derivative) securities
created and held by Financial Institutions.