CHAPTER 4 : FINANCIAL MARKETS

WHAT ARE FINANCIAL MARKETS? These markets provide a permanent venue for savers and borrowers, and which render financial services whenever required by their customers.

BENEFITS OF FINANCIAL MARKETS 1. Funds are directed to DSUs which can use them most efficiently 2. Liquidity is provided to savers WHY FIRMS INVEST AND BORROW? Firms, at one time or another are confronted by capital deficiency. This happens when opportunities for investment come by. Additional investment may bring additional income or economies in operation. When the owners of the firm cannot provide additional capital, they will resort to borrowing. This situation happens not only to small firms but to big firms as well. A system must be able to address that particular economic need. The answer lies in the operation and maintenance of a financial system which includes financial markets.

METHOD BY WHICH FINANCIAL MARKETS TRANSFER FUNDS DIRECT FINANCE Refers to lending by ultimate borrowers with no intermediary. Under this method the SSUs gives money to the DSU in exchange for financial claims on the DSU. The claims issued by the DSU are called direct claims and are typically sold in direct credit markets such as the money or capital markets. Direct financing provides SSUs with a venue for savings with expected returns. The DSUs as a result are provided with a source of funds for consumption or investment. This arrangement increases the efficiency of the financial market. ADVANTAGES OF DIRECT FINANCING: 1. These are few DSUs which can transact in the direct market because the denominations of securities sold are very large (usually millions of pesos). 2. It is difficult to match the requirements of SSUs and DSUs in terms of denomination, maturity, and other factors.

METHODS OF DIRECT FINANCING: Private placements Brokers and dealers Investment brokers

Private placement refers to the selling of securities by private negotiation directly to insurance companies, commercial banks, pension funds, large-scale corporate investors, and wealthy individual investors. Brokers is one who acts as an intermediary between buyers and sellers but does not take title to the securities traded. Dealer is one who is in the security business acting as a principal rather than an agent. The dealer buys for his account and sells to customers from inventory. He makes profits by selling his inventory of securities at a price higher than the acquisition cost. Investment broker is a person who provides financial advice and who underwrites and distributes new investment securities.

INDIRECT FINANCE (also called financial intermediary) Refers to lending by an ultimate lender to a financial intermediary that then relends to ultimate borrowers. Financial intermediaries include commercial; banks, mutual savings bank, credit unions, life insurance companies and pension funds.

CLASSIFICATION OF FINANCIAL MARKETS Financial markets may be classified as follows : 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Primary market Secondary market Money market Capital market Bond market Stock market Mortgage market Consumer credit market Auction market Negotiation market Organized market Over the counter market Spot market Futures market

15. Options market 16. Foreign exchange market

PRIMARY MARKET a financial market in which newly issued primary and securities are traded for the first time. Investors who buy these new issues are supplying funds to DSUs which issue the securities. Large corporations needing large amount of funds usually tap the primary market through bond issuance. SECONDARY MARKET- is that financial market through which existing financial securities are traded. SSUs which bought new securities from the primary market may sell the same to the secondary market anytime they wish to change their portfolios before maturity dates. The secondary market provides liquidity to the SSUs with securities held. MONEY MARKET- is that financial market on which debt securities with an original maturity of one year or less are traded. Long term securities are traded in the money market if they have six months or less left to maturity. CAPITAL MARKET- is that portion of the financial market where trading is under taken for securities with maturity of more than one year. The capital market is subdivided into three parts; 1. The bond market; 2. The stock market and; 3. The mortgage market. BOND MARKET- the market for debt instruments of any kind. It operates through a system of dealers using a telecommunications network, rather than in a single physical location for trading. Dealers include giant banking firms located around the world. STOCK MARKET- is that financial market where the common and preferred stocks issued by corporations are traded. It has two components: (1) the organized exchanges: and (2) the less formal overthe-counter markets. The Philippine Stock Exchange is classified into the ff categories; 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Banks Financial services Communication Power and energy Transportation services Construction and other related products Food, beverages, and tobacco Holding firms Manufacturing, distribution, and trading Hotel, recreation, and other services

11. Bonds, preferred stocks, and warrants 12. Others MORTGAGE MARKET- is that portion of the financial market which deals with loans on residential, commercial, and industrial real estate and on farmland. Various financial institutions comprise the mortgage market. CONSUMER CREDIT MARKET- the market involved in loans on autos, appliances, education, travel is referred to as the consumer credit market. As there are millions of consumers tapping the credit market, it is expected that there will be a number of financing institutions extending auto, salary, and various personal loans to consumers. AUCTION MARKET- is one where trading is conducted by an independent third party according to a matching of prices on orders received to buy and sell a particular security. Stocks are sold to the highest bidder on the trading floor. NEGOTIATION MARKET- when buyers and sellers of securities negotiate with each other regarding price and volume, either directly or through a broker or dealer, they are engage in the financial market called negotiation market. ORGANIZED MARKET- is that financial market with fixed trading rules. It is situated at a central location in the financial district in which trading is generally conducted by auction. Another name for organized markets are exchanges like the Philippine Stock Exchange, and the Australian Stock Exchange. OVER-THE-COUNTER MARKET- is that market consisting of large collection of brokers and dealers, connected electronically by telephones and computers that provide for trading in unlisted securities. All securities not traded in the stock exchange for one reason or another are traded over the counter. The over-the-counter market consists of facilities namely: 1. Relatively few dealers who hold inventories or over the-counter securities and act as a securities market; 2. The many brokers who act as agents in bringing these dealers together with investors and 3. The computers, terminals, and electronic networks that provide a communications link between dealers and brokers.

SPOT MARKET- when securities are traded for immediate delivery and payment, the market type referred to is the spot market. The spot price is the feature of the spot market and which is actually the price paid for a security that will be delivered on the spot immediately. The term immediately may actually mean one or two days to one week depending on the facilities used or the tradition in the area. The spot market is an alternative to the future market. FUTURE MARKET- is that market where contracts are originated and traded that gives the holder the right to buy something in the future at a price specified by the contract.

OPTION MARKET- is one where stock options are traded. A stock option is a contract giving the owner the right to either buy or sell a fixed number of shares of a stock (usually 100) at any time before the expiration date at a price specified in the option. Option contracts may cover items like gold and Treasury bonds. Option are traded in organized securities exchanges like the Philippine Stock Exchange. One purpose of the options market is to make possible for investors who wish to reduce the risk of losing money due to price changes in the future. FOREIGN EXCHANGE MARKET - is the market where people buy and sell currencies. This market is composed of the ff: 1. Banks located throughout the world buying and selling foreign moneys, in the form of foreign currencies in foreign banks 2. Foreign exchange dealers and 3. Currency exchanges catering mostly to tourist and are found in the downtown areas, airports, and railroad stations in major tourist center.