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CHAPTER 1 - FINANCIAL SYSTEMS AND THEFINANCIAL MARKETSources of Wealth Labor - will allow them to earn a salary/wage Land - generate wealth in the form of rent Capital - will earn interest when the venture is realizing good returns Entrepreneurship - generate more profit Finance - Key player in ensu...

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CHAPTER 1 - FINANCIAL SYSTEMS AND THE FINANCIAL MARKET

Borrowers - parties who are willing to pay the required return to obtain additional funds

Sources of Wealth 1. 2. 3. 4.

Labor - will allow them to earn a salary/wage Land - generate wealth in the form of rent Capital - will earn interest when the venture is realizing good returns Entrepreneurship - generate more profit

2.

Financial Intermediaries (How will the change occur?) Acts as a third party to facilitate the borrowing activity between lenders and borrowers.

3.

Financial Instruments (What will be used?) Medium of exchange of contractual obligation of a party, where such contract can be traded.

Finance - Key player in ensuring continuity of operations - The application of economic principles to decisionmaking that involves the allocation of money under conditions of uncertainty. - Came from the french word “finer” which means “to end and settle a debt”. Financial System - Allows households, companies and the government who have available funds to invest these funds in more potentially productive vehicles that can result in faster growth in the economy. - Composed of interrelated systems of financial markets, intermediaries and services. - Enhances the welfare of individual consumers as they have immediate access to funds allowing them to purchase things as they prefer Fund Providers - Households(primary fund provider), companies and government agencies who have available funds Fund Demanders - Households, companies and government agencies(main fund demanders) who have shortage of funds Direct Financing - Borrower-spenders borrow and deal directly with lenders through selling financial instruments - Ex. Buying stocks Indirect Financing - The borrowing activity between both parties still happens through the intervention of a financial intermediary. Elements of the Financial System 1. Lenders and borrowers (Who are the players?) The most essential stakeholders that make up the foundation of a transaction in the financial system. Lenders - parties that have excess funds that they can lend out to other entities for a required return

Represent claims on future income or assets of the borrower Borrowers - Liabilities Lenders - Asset 2 types of Financial Instruments a. Cash b. Derivative Financial Instruments 4.

Financial Markets (Where will it be traded?) Where suppliers and buyers of financial instruments meet. Money Market - Cash Financial Instruments Capital Market - Derivative Financial Instruments

5.

Regulatory Environment (How is it controlled?) The governance body to ensure that the transactions that occur within the financial systems comply with the laws and regulations. They are normally regulated by Central Banks

6.

Money Creation (What is the value it creates?) Money is used to either be reinvested or earned out from the system flows

7.

Price discovery (How much is created?) The process of determining or valuing the financial instrument in the market.

Financial Markets - Help in creating a more efficient allocation of capital which results in higher production and efficient that ultimately leads to economic growth.

Main economic function: Serve as a channel transfer excess funds from fund providers to fund demanders.

Participants: household, government and businesses, financial intermediaries, brokers and dealers, regulators, fund managers and financial exchanges.

Types of Financial Markets 1.

“Trading” - Exchanging of Financial Instruments Major economic functions of Financial Market: 1. Price discovery Interaction between buyers and sellers in the financial market in order to come up with price of the traded financial instrument.

For long term investors: they invest in money market to meet their short-term liquidity needs. Importance to fund demanders: They need it since immediate cash requirements of individuals, government and corporations do not necessarily coincide in the timing of their cash receipts.

Price is set at the level wherein the buyers are willing to buy, and sellers are willing to sell. Determines how the available funds from providers are allocated towards the demanders based on the demanders' willingness to accept the return required by the fund. 2.

Importance to fund providers: They need it because excessive holdings of cash also generates opportunity cost in the form of foregone interest.

Liquidity Through Financial Markets, holders can sell their own financial instruments to other investors to earn cash.

Money market instruments Offer an investment opportunity that yields a higher return than just mere holding of cash(which generates zero interest) Are very liquid and has very little default risk because of the associated short maturity term.

Easy access to a venue where investors can sell financial instruments for cash in an appealing feature when circumstances may occur that push investors to sell a financial instrument.

Ex. Treasury bills, Commercial papers, Certificate of deposits, Repurchase agreement, Banker’s acceptances.

Without liquidity, an investor is forced to hold to financial instrument up until… Debt instrument: Maturity date Equity instrument: Voluntary or involuntary liquidation 3.

Based on Instruments Traded Money Market Where Financial Instruments that will mature or be redeemed in one year or less(short-term) from issuance date are traded.

Capital Market Where Financial Instruments issued by governments and corporations that will mature one year from issuance date (long-term) are traded.

Reduction in transaction costs

The foundation of the capital market is made up by the dealers and brokers market which creates a venue for bond and stock transactions.

Types of Transaction Costs: Search Costs - costs incurred to look for financial instruments that can be purchased or sold by a party.

Capital Market Securities: a. Equity Instruments b. Debt Instruments

Explicit Search Costs Expenses needed to advertise intent to purchase or sell a financial instrument. Implicit Search Costs Include value of time consumed to look for a counterparty

2.

Based on Market Type In primary market: Lenders - suppliers or fund Borrowers - demanders of funds

Information Costs - costs related in evaluating investment characteristics of a financial instrument.

Secondary market: Buyers - suppliers of fund

Sellers - demanders of funds Primary Market Where fund demanders raise funds through new issuance of financial instruments e.g. bonds and stocks.

same securities at a higher price 3.

Transactions are coursed through Investment Banks that act as intermediaries between issuing companies (demanders) and potential investors (providers).

Dutch Auction Seller begins the sale at a high price. The price of securities is continuously lowered down at specific intervals until the potential buyer agrees

Investment Banks - provide advice to issuers about prices of the securities, transaction costs and number of securities to be issued based on their fund needs. - Responsible to legal and financial exchange requirements, appointments of lawyers and auditors, due diligence, etc. - They underwrite securities

English Auction Prospective buyers commerce the auction by submitting an initial bid price. The bidding stops when no other bidders wants to top the last bid. Descending price sealed Auction(First-price sealed auction) Bidders submit sealed bids to the sellers that will be ranked from highest to lowest price. Highest priced bids receive full allocation while lower bids receive allocation distributed pro rata.

Underwriting Investment banks guarantee the price for the securities of the issuing company and then sells to the public. Types of issue methods that can be done in the primary markets: 1. Public Offering Securities are offered for sale to the general public through issuing a prospectus or placing document Private companies who will sell shares to the general public for the very first time is said to undergo an Initial Public Offering (IPO) through the help in investment banks Can either be an offer for subscription or an offer for sale An underwriter is appointed for public offerings. It provides an undertaking to purchase the remaining securities if the offer will not be fully subscribed to the public.

2.

Private Placement(Limited Public Offer) Issuers look for a single investor, an institutional buyer or group of buyers to purchase the securities issuance An underwriter subscribes to all securities at a certain price and consequently, sell the

Auction Used for issuance of treasury bills, bonds and other securities issued by the government and are commonly executed exclusively with market makers.

4.

Tap Issue Issuers are open to receive bids for their securities at all times, and they maintain the right to accept or reject the bid prices.

Secondary Market Securities issued in the primary market are subsequently traded i.e. resold and repurchased. Buyers are the ones who have excess funds while the sellers are tho who need funds. Transactions usually occur through the help of securities broker which acts as a facilitator between the seller and the buyer of the security. Ex. Foreign exchange market, futures market and options market Economic functions: ● Price discovery The higher the price of the security in the secondary market, the higher the price that issuing companies can set on new securities that they will issue. ●

Liquidity and reduction in borrowing costs

reflects liquidity

Allows active trading which improves liquidity and marketability of the securities. ● ●

Narrow Spread - Signals liquidity Wide Spread - Indicates illiquidity

Support to the primary market Implementation of monetary policy

Secondary Markets provide liquidity to the investors who hold the securities as they are able to convert the securities to cash quickly by selling to other participants.

Primary and Secondary Market can also be classified based on where the financial instruments are traded: Exchange (or Formalized) Centralized trading locations where financial instruments are purchased or sold between market participants.

Classifications based on Market Structure: Order-Driven Market Structure Buyers and sellers propose their price through their brokers who conveys the bid in a centralized location. Also called as Auction Market. Types of orders: ➢ Market Orders (At-best orders) - orders placed with broker-dealers with the instruction to execute transactions at the prevailing best market price.

In order to be traded, all Financial Instruments should be listed by the organized exchange. Over-theCounter Market (or Informal) A place where unlisted financial instruments are allowed to be traded, in addition to listed financial instruments. Ex. Labor market, Fish market, Vegetable market 3.

➢ Limit orders Orders placed where clients set a price or price range that may be below/above the existing price.

Based on Country’s Perspective Internal or National Market Refers to the financial market operating in a certain country. Domestic Market - issuers who are considered residents in a country issue the securities Foreign Market - issuers who are not residents of a country can sell or issue securities subsequently traded. The rules of the regulatory authority where the security is issued will prevail.

➢ Day orders Orders placed that only valid until the end of the business day. ➢ Good-until-cancelled orders Orders placed that remains valid for a sustained period up until the client voluntarily cancels and remove these from the system.

External Market Refers to the Financial market where securities that have two unique characteristics are being traded: a.

Quote-Driven Market Structure Also called as primary dealer markets, professional markets or market-made markets.

b.

Market makers establish a price quote at which the market participants should trade with. Market makers set a bid quote(to buy) and offer quote(to sell). Spread - difference bet the bid and offer quote - Inures to the benefit of the market makers as profit - Represents the transactional costs and

Upon issuance, these securities offered simultaneously to investors in different countries Securities are issued outside the regulatory jurisdiction of any single country

Ex. International Market, Offshore market and Euromarkets 4.

Based on the manner of Financial Intermediaries Broker Market Buyers and sellers are brought together by a broker and the trade occurs at that point. Dealer Market

High risk borrowers that would tend to default is more likely to be more active in borrowing funds than low risk borrowers who pay on time.

Buyers and sellers are not brought directly together by a third party. Market makers execute the sell or buy orders. CHAPTER 2- FINANCIAL INTERMEDIARIES AND OTHER PARTICIPANTS

Occurs before transaction happens

Financial Intermediaries - Were formed during the time when market conditions make it hard for lenders to transact directly with borrowers. - Ex. Depository institutions, insurance companies, asset management firms, regulated companies and investment banks

➢ Moral hazard Borrowers have a tendency to take undesirable or immoral risks with the money, once they receive it, not disclosed during the loan granting process.

Financial Intermediation The process of indirect financing using financial intermediaries as the main route to transfer funds from lenders to borrowers.

Financial Intermediaries are better equipped at screening out bad borrowers from good borrowers which may reduce the risk of adverse selection.

Financial Intermediaries provide the ff services: ● Enable trading of financial assets for the customers of the FI through brokering arrangements ● Enable trading of financial assets through its own capital by buying a stake in a financial asset that its customers want to transact in ● Assist in forming financial assets needed by its customers and distribute these to its customers and other market participants as well ● Provide investment advice and consultation services to customers ● Manage Financial assets of customers ● Facilitate payment mechanism between merchants and customers

Happens after the loan is granted

Financial Intermediaries have the mechanism to monitor action of their borrowers, potentially reducing losses related to moral hazard. 3.

Creation of money Financial Intermediaries, specifically banks, allow creation of money through its bank loan services, thus allowing existing and new funds to be allocated efficiently.

4.

Support in price discovery Financial Intermediaries play the role as experts and facilitators to enable to assign values to financial instruments based on different factors. ●

Improved liquidity for lenders FI can manage cash from different lenders through immediately encashable products such as current and savings deposit accounts

●

Reduced price risk for lenders Price risk means that prices of financial instruments may vary over time.

Benefits from Financial Intermediaries 1. Acceleration of flow funds between entities Fund providers use Financial Intermediaries to transfer funds to fund demanders. FI also serves a savings and wealth storage function, allowing parties with excess funds to store their funds in risk-free low-risk financial instruments. 2.

Efficient allocation of funds To ensure efficient allocation, Financial Intermediaries manage asymmetric information to a certain degree in its operations.

Financial Intermediaries offer low-risk financial products (deposits) to ultimate lenders and at the same time offer financial products with high price risk(shares, bonds, property financing) to borrowers.

Asymmetric Information Occurs when potential borrowers have more information about the transaction compared to the bank. It may lead to two further problems: ➢ Adverse selection

Risk Sharing Where lenders enjoy mitigated price risks as they course the transfer of funds with very low risk to FI which in turn bear the bigger risk when lending to other entities.

purchased. Can also be called as asset transformation ● ●

Diversification of lenders Household do not have as much investment opportunities for their funds, which is a problem as lenders may not be able to efficiently maximize returns from their funds because of limited investment opportunities. Through FI, which have wider access to investment possibilities, household can diversify their portfolio better. Diversification Process of investing funds in a portfolio of assets that have individual returns that do not move in the same direction together. Usually results in an overall portfolio risk that may be lower than rick of individual asset. Allows lenders to share risk from their investments. Risk Uncertainty regarding the return an investor will earn on their invested assets.

●

Financial system allows people and companies to protect and build their wealth through having insurance against threats to their life, income and properties.

●

Implementation of monetary policy function The Financial System provides the best mechanism to allow the government to implement its monetary policies to manage economic growth, steady employment rate, equilibrium of balance of payments and inflation. Financial Intermediaries are able to convert financial assets that are not attractive to most investors into another financial asset as a liability of the FI - that are more favored by the general public. This transformation has 3 econ functions:

Economies of scale Occur when fixed costs are optimized per unit as a result of sheer volume of transactions. Cost per transaction is reduced as the number of transactions increases.

Maturity intermediation If FI did not exist, long-borrowers would have to borrow money for shorter term to match the short duration at which fund providers are willing to lend funds.

Transaction Costs Cost associated with trading or managing funds and investment transactions

Maturity Intermediation gives fund providers/investors more alternatives in terms of how long they want to invest in financial instruments and borrowers have more choices on the length of maturity of their debts.

Research Costs Costs incurred in monitoring performance of potential companies to be invested in through economic. Industry and financial analysis Financial Intermediaries allow funds to be concentrated to them and they will incur transaction and research costs in behalf of all its depositors. ●

Risk Mitigation Risk may also pertain to the uncertainty that something untoward or damaging may occur to a person or entity.

Payments System Financial System serves as the main structure for making payments for any goods, services or securities that are

Risk reduction through diversification Diversification Economic function exercised by financial intermediaries which converts more risky assets to less risky assets through sharing of risks. Ex. Mutual Funds Cost reduction for contracting and information processing Information Processing Costs Refer to the cost of acquiring and processing

information needed to evaluate purchase or subsequent sale of a financial instrument.

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