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Chapter 2 - Financial Markets: Learning Outcomes

1. The document discusses financial markets, which facilitate transactions between those with excess funds (surplus units) and those who need funds (deficit units). 2. It differentiates between primary and secondary markets, as well as money and capital markets. Primary markets involve the initial sale of securities from deficit units to surplus units. Secondary markets allow for the resale of existing securities. 3. Money markets involve short-term debt instruments up to one year, while capital markets trade long-term debt and equity securities with maturities over one year that generally provide higher returns due to greater risk.
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0% found this document useful (0 votes)
846 views9 pages

Chapter 2 - Financial Markets: Learning Outcomes

1. The document discusses financial markets, which facilitate transactions between those with excess funds (surplus units) and those who need funds (deficit units). 2. It differentiates between primary and secondary markets, as well as money and capital markets. Primary markets involve the initial sale of securities from deficit units to surplus units. Secondary markets allow for the resale of existing securities. 3. Money markets involve short-term debt instruments up to one year, while capital markets trade long-term debt and equity securities with maturities over one year that generally provide higher returns due to greater risk.
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER 2 – FINANCIAL MARKETS

Learning Outcomes:
At the end of this chapter: the students should be able to:

1. Explain the meaning of financial markets;


2. Differentiate primary market from secondary markets; primary security from secondary security
3. Discuss fully the difference between money market and capital market;
4. Explain the difference between the different types of investors;
5. Elaborate on the role of securities exchange in financial markets;
6. Discuss fully the different government-issued securities (GS) and how the markets for GS work;
7. Explain the difference between stock market, bond market, and derivative securities; and
8. Discuss the other markets as participant in the financial market.

FINANCIAL MARKETS: DEFINITION

Financial Markets - are structure through which funds flow. They are the institutions and systems that
facilitate transactions in all types of financial claim.

A financial Claim - entitles a creditor to receive payment from a debtor in circumstances specified in a
contract between them, oral or written.

Depositors → Banks

Bondholders → Bond issuer

Financial markets are the meeting place for those with excess funds (surplus/saving units) and those
who need funds (deficit units).

Surplus/ Deficit Units


Saving Units
Borrowers;
Investors; Issuers of
lenders securities

The needs of deficit units and surplus units gave rise to financial markets.

Basic classification of financial markets:

(1) Primary or Secondary


(2) Money Market or Capital Market
PRIMARY MARKETS

Financial claims are initially sold by deficit units in primary markets. 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 (Saunders and Cornett 2011). They consist of underwriters, issuers, and instruments
involved in buying and selling original or new issues of securities referred to as primary securities.

Deficit Units Surplus Units


Funds
Borrowers/Users of Initial supplier
funds; Corporations of funds;
issuing new/original
Households
issues of stocks or Securities
and businesses
bonds

The corporation needing funds issues new or original


issues of either stocks or bonds directly to the investors

Deficit Units Surplus Units


Underwriters
Borrowers/Users of Initial supplier
Investments/ of funds;
funds; Corporations
Merchant banks
issuing new/original
intermediary Households
issues of stocks or
and businesses
bonds

The corporation needing funds issues new or original


issues of either stocks or bonds to underwriters/financial
intermediaries who in turn sell them to the investors.

Most primary markets transactions are done through investment banks, also called as merchant banks,
which help the corporations issuing the stocks or bonds sell these stocks or bonds to interest investors.
Investment or merchant banks purchase shares issued by the issuing company in an underwriting
transaction and then sell these securities to the public.

An underwriter guarantees the sale of the issues, but does not intend to hold the shares or bonds in his
own account. However, if the issue is unsuccessful and public investors refuse to purchase the issues, the
underwriter carries the issues as its own investment, while waiting for more favorable market conditions.
Investment banks provide the following services:

1. Provide funds in advance (giving cash to the issuer based on the agreed price of the security,
usually a certain percentage of the total agreed price.)
2. Give advice to issuing corporations as to the price and number of securities to issue
3. Attract the initial public purchasers of the securities
4. Act as a market analyst and advisor to the issuing company
5. Absorb the risk and cost of creating a market for the securities

Primary market issues are generally for public offerings or publicly traded securities like stocks of
companies already selling stocks in the stock market or stock exchanges. First-time issues for the public
are called initial public offerings or IPOs

Rather than a public offering, primary market sales can take the form of a private placement, particularly
for closed corporations, that is, corporations whose stocks are only sold to family or a few close friends,
relatives, and some other private individuals.

SECONDARY MARKETS

Once financial instruments are issued in primary markets, they are then traded in secondary markets.
Secondary markets are like used car (second-hand) markets. Secondary markets are markets for currently
outstanding securities, referred to as secondary securities. These securities were previously bought and
owned and now being resold either by the initial investors or those who have purchased securities in the
secondary market. Secondary markets provide liquidity for investors as they sell their financial securities
when they need cash.

All transactions after the initial issue in the primary market are done in the secondary markets.

A owns stocks initially issued by Co. X and later on sells these Co. X stocks to B; the sale of A to
B or anyone else is done in the secondary market.

Secondary markets only transfer ownership, but do not affect the total outstanding shares or securities in
the market. Secondary markets transfer shares, but do not raise funds for companies which issued the
securities. They do not affect the issuing company, except to transfer ownership of the stocks or bonds in
its books for purposes of dividend or interest payments, respectively.

MONEY MARKETS

Money markets cover markets for short-term debt instruments, usually issued by companies with high
credit standing. They consist of a network of institutions and facilities for trading debt securities with a
maturity of one year or less (Saldana 1997).

The Philippine money market started in 1965 primarily as a facility for trading excess funds among
commercial banks (Saldana 1997). The Bangko Sentral ng Pilipinas (BSP) requires banks to maintain a daily
minimum cash reserve with them set as a percentage of deposit liabilities. Other than the level of cash
reserves, BSP has certain strict requirements on banks. Banks with temporary cash surpluses led
commercial banks to set up the money market as an auction house for excess reserves. It is called the
interbank call market, a money market.

In the Philippine money market, trading government securities is regularly observed. The following
discussion relative to government securities is from the Bureau of Treasury’s official website.

Treasury bills (T-bills) – are government securities which mature in less than a year. There are three tenors
of T-bills: 91-day, 182-day, and 364-day bills. The number of days is based on the universal practice around
the world of ensuring that the bills mature on a business day. T-bills are quoted either by their yield rate,
which is the discount, or by their price based on points per unit.

T-bonds - are government securities which mature beyond one year. At present, there are five maturities
of bonds: 2-year, 5-year, 7-year, 10-year, 20-year. These are sold at its face value of on origination. The
yield is represented by the coupons, expressed as a percentage of the face value on per annum basis,
payable semi-annually. T-bills are sold at a discount (less than the principal); hence, the yield to the
investors is the difference between the purchase price and the principal. On the other hand, T-bonds are
sold at face value (the amount of principal) and are coupon bonds; that is, they bear coupons, which
represent the interest on the principal and are presented when claiming interest payments on interest
payment dates.

Please go to https://www.treasury.gov.ph/ for additional reading. At the least, know more about the
National Registry of Scripless Securities and GSEDs
CAPITAL MARKETS

Capital Markets are markets for long-term securities. Long-term securities are either debt securities
(notes, bonds, mortgages, leases) or equity securities (stocks). Major suppliers of capital market securities
are corporations for stocks and corporation and governments for bonds. Long-term securities have
maturities of more than a year. These instruments often carry greater default and market risks than
money market instruments generally because they are long-term. In return, they carry a higher return
yield. They suffer wider price fluctuations than money market instruments.

Capital markets are composed of stock market for equity or stock securities, bond markets for debt
securities, mortgage market for mortgages, foreign exchange markets, derivative securities markets,
direct loan market, and lease market, among others.

The need for long-term assets or capital goods as purchase of land or building or plant expansion will
resort to the capital market as a source of funds. Capital goods are used to produce goods and services to
generate revenues. It is in the capital market that long-term users of funds and those with long-term
excess funds meet. These long-term securities include long-term loans, mortgages, and financial leases;
corporate stocks and bonds; and government long-term treasury notes and bonds. Security exchanges,
over-the-counter markets, investment banks, mortgage banks, insurance companies, and other financial
institutions deal with the capital markets. Over-the-counter transactions are done through a loose
network of security traders known as broker-dealer, dealers, and brokers.

The capital market consists of:

1. Securities market; and


2. Negotiated (or non-securities) market.

Securities Market
In securities market, companies issue common stocks or bonds, which are marketable/negotiable,
to obtain long-term funds. An instrument that is transferable by endorsement or delivery is negotiable.
Negotiability allows securities to be traded anonymously. The identity of the seller need not be known.
Negotiability improves liquidity because anyone who holds the security can immediately sell the security
when the holder needs cash. The holder can even sell the security prior to maturity:

Securities market is composed of:

1. Stock market for equity or stock securities;


2. Bond market for debt securities; and
3. Derivative securities market for securities deriving their value from another security.
Stock Market

Stock market serves as the medium or agent of exchange transactions dealing with equity
securities. It involves institutions and analysts who review the performance of listed companies. When
the companies are successful in their operations and investments, analysts recommend buying of their
stocks creating demand and increasing share prices and shareholder’s wealth. Shareholders can penalize
poor management of companies by selling off their holdings driving share prices down. All markets follow
the basic economic law of supply and demand. If there are a lot of shares of any one company in the
market, its prices go down. The scarcity of the shares drives the share prices up. If many are buying the
stocks, it creates demand and raises prices up.

Please go to https://www.pse.com.ph/ for additional reading related to Philippine Stock Exchange.


At the least, know more about the Investing Procedures and Indices.

Bond Market

Bond Market is the market where bonds are issued and traded. It is generally classified into:

1. Treasury notes and bonds market.


2. Municipal bonds market; and
3. Corporate bonds market

Treasury notes and bonds are issued by the government’s treasury. Like T-bills, T-notes and T-
bonds are backed by the full faith and credit of the government and are therefore free from risks. As a
result, they pay relatively low rates of interest (yields to maturity) to investors. However, because longer
maturity, they are subject to wider price fluctuation than money market instruments and therefore
subject to interest rate risk. In contrast to T-bills that sell at a discount, T-notes and T-bonds pay coupon
interest semi-annually. They have maturities of over 1 to 10 years.

Municipal bond (LGU) is an important financial instrument for development. In the Philippines,
LGU bonds have only recently been acknowledged as a potential tool for development. LGU bond reduces
the dependence of LGUs on the national government in implementing their development programs, and
most importantly, encourages and rewards transparent good governance among local government
executives. LGU bond does all these while attracting private institutional capital and providing the
investing public with an alternative long-term instrument.

Corporate bonds are long-term bonds issued by private corporations. Bond indenture is the legal
contract that specifies the rights and obligations of bond issuer and bondholders (investors), in term of
the bond, interest rate and interest payment dates. It may include such term as the ability of the issuer to
call the bond or redeem bonds prior to maturity, and restrictions on the issuer’s dividend payments,
among others.

Derivative Securities Market

The term “derivative” is commonly used to describe a type of security which market value is
directly related to or derived from another traded security. Derivative securities market refers to the
market where derivatives securities are traded. Derivative securities are financial instruments which
payoffs are linked to another, previously issued securities. They represent agreements between two
parties to exchange a standard quantity of an asset or cash flow at a predetermined price at a specified
date in the future. As the value of the underlying security to be exchanged changes, the value of the
derivative security changes. Options, futures, and forward contracts are examples of derivatives as well
as stock warrants, swap agreements, mortgaged backed securities, and other more exotic variations.
While derivative securities have been in existence for centuries, the growth in derivative security markets
occurred mainly in the 1990s and 2000s (Saunders and Cornett 2011).

Capital markets and money markets include the exchanges where securities or financial
instruments are traded or sold. These exchanges can be formally organized or informally organized (OTC).
Organized security exchanges are like the PSE and other international stock exchanges, including ASX,
SZSE, National Stock Exchange of India (NSE), OSE, American Stock Exchange (AMEX), AND Nasdaq Stock
Market of the United States. There are also electronic exchanges like the US Futures Exchange (USFE),
Bats, and Boston Equities Exchange.
Negotiated/Non-Securities Market

Negotiated or non-securities market does not involve securities, thus called non-securities market.
This is so-called negotiated because it results from negotiation between a borrower and a lender. The
negotiated or non-securities market included, but is not limited to loan market, mortgage market, and
lease market. Loan market is where one-on-one transaction takes place between a borrower and a lender.
Mortgage market is where a real-property, building, and big machineries, are used to guarantee or secure
big loans. Lease market is where equipment, building, or other property is being leased/rented out to
another party.

OTHER MARKETS
Other Markets are a combination of the money and capital markets, because they deal with both
short and long-term loans and securities. These may include the following:

1. Consumer Credit Market


2. Organized Market
3. Over-the-Counter (OTC) Market
4. Auction Market
5. Foreign Exchange Market
6. Spot Market
7. Futures Market
8. Forward Market
9. Options Market
10. Swap Market
11. Third and Fourth Markets

TYPES OF INVESTORS
Investors are generally classified as bulls, bears, chickens, or pigs

1. Risk-averse investors (bulls and chicken). They are the type of investors who, when faced with
two investment alternatives with equal returns but one is riskier than the other, will choose the
les risky investment. They prefer risk-free assets than risky assets as long as the expected returns
on each asset are the same. In order for them to invest in a risk asset, they will require a higher
return.

2. Risk-taker investors (bears and pigs). They are the investors who are ready to pay a higher price
for an investment regardless of the risks involved.

3. Risk-neutral investors. They are investor who do not take into account the risks involved in the
investment and who are focused only on the expected returns.
In the stock market, there are what we call “bulls” and “bears”. When the market is showing
confidence, that is, stock prices are going up and market indices like the Nasdaq go up, we have a
bull market. The number of shares traded is also high and even the number of companies entering
the stock market rises showing that the market is confident. Bull markets are most common in an
expanding economy with low unemployment and inflation is somewhat constant. Technically, a bull
market is a rise in the value of the market of at least 20%. The huge rise of the Dow and Nasdaq
during the tech boom is a good example of a bull market.

A bear market is the opposite of a bull market. It is when the economy is bad, recession is
looming and stock prices are falling. If a person is pessimistic and believes that stocks are going to
drop, he is called a bear and said to have a “bearish outlook”. Bear markets make it tough for
investors to pick profitable stocks. However, this is the time to make money using a technique called
short selling. Short selling is a technique used by people who try to profit from the falling price of a
stock. Short selling is a very risky technique as it involves precise timing and goes contrary to the
overall direction of the market.

When people say you are a chicken, it means you are scared easily. For investors, chickens
are risk-averse investors whose fear overrides their need to make profits and so they turn only to
money market securities or get out of the markets entirely. While it is true that you should never
invest in something over which you lose sleep, avoiding the market completely and never taking
any risk will not give you any return.

Pigs are the opposite of risk-averse investors or chicken. They are high-risk investors looking
for the one big score in a short period of time. Pigs buy on hot tips and invest in companies without
doing their due diligence. They get impatient, greedy, and emotional about their investments, and
they are drawn to high-risk securities without putting in the proper time or money to learn about
these investment vehicles. Professional traders love the pigs, as they are often from their losses
that the bulls and bears reap their profits.

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Source: Capital Markets by Norma Dy Lopez-Mariano, PhD

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