Week 1-2 Introduction to Financial Markets and Financial Systems.pptx

finmar

1. WEEK 1: INTRODUCTION TO FINANCIAL SYSTEMS AND FINANCIAL MARKET

2. OBJECTIVES: To Describe the elements of financial systems, particularly the financial market. To Describe the importance of financial market in maximizing firms profit and wealth. To Differentiate the different types of financial markets.

3. I. Nature and Importance of Financial System The Financial System The term "finance" refers to the management of money and the process of generating sufficient finances. This refers to how money is generated and then invested in order to make money. It is essential for the sustained operations of the firm. In making decisions involving the funding distribution in the face of uncertainty, finance is the application of economic concepts.

4. ➢ Indirect Financing In this route, the borrowing activity between both parties still happens though indirectly through the intervention of a financial intermediary. ➢ Direct Financing In this route, the borrower-spenders borrow and deal directly with lenders through selling financial instruments (or securities). Financial instruments represent claims on the future income or assets of the borrower. Borrowers recognize financial instruments as liabilities while lenders recognize these as an asset. Buying stocks directly from a company is also considered direct financing.

5. Sources of Wealth 1. Labor -Through hard work, expertise and time, people will earn their salaries/wages. 2. Land - May be used in business or be leased by somebody else which either way generates wealth in the form of rent. 3. Capital - Realizing good returns in venture, the capital earns interest 4. Entrepreneurial Skills - Managing the commercial affairs and ensuring that the company continuously grow and generate more profit

6. I. Elements of Financial System 1. Lenders and Borrowers (Who are the players?) Lenders (Fund Providers) are parties that have excess funds that they can lend out to other entities for a required return. Households are the primary fund providers or lender-savers. Borrowers (Fund Demanders) are parties who are willing to pay the required return to obtain additional funds to finance their investment initiatives. Business Firms & Governments is the primary fund demanders or borrower-spenders. 2. Financial Intermediaries (How will the exchange occur?) Financial Intermediaries are a special type of financial entity that acts as a third party to facilitate the borrowing activity between lenders and borrowers. Often, potential borrowers do not have an idea which parties or entities are willing to lend out money to them and vice-versa. This gap in awareness makes it difficult for financial transactions to occur. This is where financial intermediaries come into the picture. 3. Financial Instruments (What will be used?) Financial Instruments are medium of exchange of contractual obligations of a party, where such contracts can be traded. These can be tangible or intangible. There are two types of financial instruments, it could be cash or derivative financial instruments. International Financial Reporting Standards defined Financial Instruments as a contract where a party recognizes it as an asset and another is a liability. 4. Financial Markets (Where will it be traded?) Financial Markets are the same with the other economic markets where suppliers and buyers of financial instruments meet. There are two types of financial markets depending on the instruments that were being traded. For cash financial instruments, these are exchanged in the money market. For derivative financial instruments, it will be traded in the capital markets.

7. 5. Regulatory Environment (How it is controlled?) Risk is inherent in every business operation. Moreover, for financial systems since it involves different business and financial risks, the government should intervene in the system. Regulatory Environment is the governance body to ensure that the transactions that occur within the financial systems complies with the laws and regulations imposed on the actors as well as the elements that plays within the system. Financial systems are normally regulated by Central banks. 6. Money Creation (What is the value it creates?) With the flow of financial instruments, money is created. Money is used to either be reinvested or earned out from the system flows. In economics, the money as it was given value out of the financial transactions because of the exchange that occurred in the system may be converted into another form. 7. Price Discovery (How much is created?) As the financial systems continuously flow and operate, the financial instruments create value. Price discovery is the process of determining or valuing the financial instrument in the market. The price is normally driven by the level of risk on the issuer of the financial instrument.

8. III. Nature and Importance of Financial Market Financial Markets Refers to channels or places where funds and financial instruments such as stocks, bonds and other securities are exchanged between willing individuals and/or entities. This also includes the existing mechanisms and conventions to facilitate transfer of funds and/or financial instruments between market participants. Financial markets intend to establish a consistent, efficient, and cost-effective bridge between fund providers and fund demanders. Participants in the financial markets include households, government and businesses, financial intermediaries, brokers and dealers, regulators, fund managers and financial exchanges.

9. Three Major Economic Functions of Financial Market 1.Price Discovery Refers to the interaction between buyers and sellers in the financial market in order to come up with the price of the traded financial instrument. Price is set at the level wherein the buyers are willing to buy, and sellers are willing to sell. 2.Liquidity Financial markets serve as a forum where buyers and sellers can meet to facilitate transactions. As a result, holders can sell their own financial instruments to other investors to earn cash. Easy access to a venue where investors can sell financial instruments for cash is an appealing feature when circumstances may occur that push investors to sell a financial instrument. This reality offers liquidity to investors. 3. Reduction in Transaction Cost This is the last function of a financial market. Transaction costs are the costs incurred of parties’ transactions to trade a financial instrument. Transaction costs can be classified into two types: search costs and information costs. Search costs are costs incurred to look for financial instruments that can be purchased or sold by a party. Explicit search costs are expenses needed to advertise intent to purchase or sell a financial instrument. Implicit search costs include the value of time consumed to look for a counterparty for the transaction.

10. IV. Types of Financial Markets Based on Instruments Traded 1. Money Market This is the sector of the financial system where financial instruments that will mature or be redeemed in one year or less from issuance date are traded. Specifically, money markets cater to fund demanders who need short-term funds from fund providers who have excess short-term funds. Short-term is defined as one year or less. Once money market securities are issued, they are traded in the secondary market. Money markets are not exclusive for short-term investors. Long-term investors also need the money market as they tend to invest in this market to meet their short-term liquidity needs. 2. Capital Market This is the sector of the financial market where financial instruments issued by governments and corporations that will mature beyond one year from issuance date (long-term) are traded. Long-term financial instruments encompasses financial instruments that have maturity dates longer than one year and perpetual securities (with no maturity). The foundation of the capital market is made up by the dealers and brokers market which creates a venue for bond and stock transactions.

11. Based on Market Type 1. Primary Market This is a type of financial market wherein fund demanders such as corporations or a government agency raise funds through new issuances of financial instruments e.g. bonds and stocks. Normally, when internally generated funds (e.g. retained earnings) are not enough, demanders need to raise additional funds in primary markets to fully finance new projects or production expansion requirements. 2. Secondary Market Refers to the market wherein the securities issued in primary market are subsequently traded i.e., resold and repurchased (secondhand). Secondary markets become a centralized marketplace where buyers and sellers can quickly and efficiently transact with each other. As a result, the secondary market allows the buyers and sellers to save on search and information costs as they do not need look for transactions on their own.

12. Based on Market Type: Primary Market Four Types of Issue Methods in Primary Markets 1. Public Offering - This occurs when securities are offered for sale to the general public. Private companies who will sell shares to the general public for the very first time are said to undergo an initial public offering or IPO. IPOs are usually done through the help of investment banks. 2. Private Placement (Limited Public Offer) - This occurs when the issuer looks for a single investor, an institutional buyer or group of buyers to purchase the whole securities issuance instead of offering it to the general public.

13. Based on Market Type: Primary Market 3. Auction - This is usually used for issuance of treasury bills, bonds and other securities issued by the government and are commonly executed exclusively with market makers. Auction can be done in three methods: ● Dutch Auction - Type of auction where the seller begins the sale at a high price. From that point, the price of the securities is continuously lowered down at specific intervals until the potential buyer agrees to purchase at that price. ● English Auction - Type of auction where the prospective buyers commerce the auction by submitting an initial bid price. Other buyers interested to purchase the securities submit a new bid to top the previous one. The process continues as the price of the securities increases as more interested buyers bid on it. The bidding stops when no other bidders want to top the last bid. Lastly, the highest bid price becomes the price of the securities that the highest bidder should pay. ● Descending price sealed auction (first-price sealed auction) - Type of auction where bidders submit sealed bids to the sellers. The sealed bids are ranked from highest to lowest price. The number of securities is allocated first to the highest price bid and follows a descending order. Highest priced bids receive full allocation while lower bids receive allocations distributed pro rata.

14. Based on Market Type: Primary Market 4. Tap Issue - This method occurs when issuers are open to always receive bids for their securities. Issuers maintain the right to accept or reject the bid prices based on their how much fund they need, when they need the fund and what is their outlook of the market.

15. Based on Market Type: Secondary Market Economic Functions of Secondary Markets 1. Price Discovery - secondary market provides information about prices of the securities traded which can influence economic decisions like choosing between financing through long-term borrowing or issuance of new shares. 2. Liquidity and reduction in borrowing costs - secondary market allows active trading which improves liquidity and marketability of the securities. 3. Support to the primary market - Price discovery helps in giving information that can be helpful in (a) setting price for new issuances executed in the primary market and (b) assessing receptiveness of the market for new issuances. 4. Implementation of monetary policy - Secondary market allows regulators such as the BSP to trade securities to influence liquidity and interest rates set in the financial system.

16. Based on Market Structure 1. Order-Driven Market Structure In an order-driven market structure, the buyers and sellers propose their price through their brokers who conveys the bid in a centralized location. The price is then matched (securities will be awarded to the buyer with the same offer price as the selling price of the seller) and the transaction is consummated. Also called the auction market. 2. Quote-Driven Market Structure This is also called primary dealer markets, professional markets or market- made markets. In a quote-driven market structure, the market makers establish a price quote at which the market participants should trade with. The market makers set a bid quote (to buy) and offer quote (to sell). Bid quote is generally lower than the offer quote. The difference between the bid quote and offer quote, called a spread, inures to the benefit of the market makers as profit. Spread is important as it represents the transactional costs of trading and reflects liquidity. Narrow spread signals liquidity while a widespread indicates that securities are illiquid. The higher turnover of securities sold; the better profit earned by market makers. Trading of bonds and currency are usually done in a quote-driven structure.

17. Based on Market Structure: Order-Driven Market Structure Types of Orders in an Order-Driven Market Structure 1. Market Orders (at-best orders) - orders placed with brokers - dealers with the instruction to execute transactions at the prevailing best market price. Client relies on the expertise and the integrity of the broker-dealer to execute deals when the latter perceives that the current price is considered best. 2. Limit Orders - order places where clients set a price or price range that may be below/above the existing price. Depending on whether it is a sale or purchase transaction, the broker executes the transaction when price goes higher (sell) or lower (buy) than the limit price or range. 3. Day Orders - orders placed that are only valid until the end of the business day. All orders not executed at the end of the day are canceled and removed from the system. 4. Good-until-canceled Orders - orders placed that remain valid for a sustained period up until the client voluntarily cancels and removes these from the system.

18. Based on Financial Instruments Traded 1. Exchange (or formalized) Exchanges are centralized trading locations where financial instruments are purchased or sold between market participants. In order to be traded, all financial instruments should be listed by the organized exchange. All financial instruments should comply with the regulations set forth by the exchange prior to being listed. Most exchanges are order-driven. Most popular exchanges are the New York Stock Exchange, Philippines Stock Exchange, Philippines Stock Exchange and Chicago Board of Trade or commodities (wheat, corn, silver, and other raw materials). 2. Over-the-counter (OTC) OTC market is the place where unlisted financial instruments are allowed to be traded, in addition to listed financial instruments. Dealers stationed at various locations who have securities on hand stay ready to sell and buy securities “over the counter” to any party who approaches them and is willing to accept their price. Because of technological advancements, transactions in OTC markets can also be done through computers. OTC markets are very competitive since all parties are aware of how prices are set for each available security. To give perspective, the labor market, fish market and vegetable market is considered as an OTC market.

19. Based on Country’s Perspective 1.Internal or National Market Refers to the financial market operating in a certain country. it is made up of two parts: Domestic Market - refers to the market where issuers who are considered residents in a country issue the securities and where these securities are traded afterwards. Foreign Market - refers to the market where issuers who are not residents of a country can sell or issue securities and subsequently trade. The rules of the regulatory authority where the security is issued will prevail regarding issuance of foreign securities. For example, a US company wanting to issue financial instruments in the Philippines shall comply with Philippines securities law. 2. External Market Refers to the financial market where securities that have two unique characteristics are being traded: a. Upon issuance, these securities are offered simultaneously to investors in different countries b. Securities are issued outside the regulatory jurisdiction of any single country Examples of external markets include international market, offshore market and Euromarkets.

20. Based on Manner of Financial Intermediaries In a broker market , the buyer and the seller of the securities are brought together by a broker and the trade occurs at that point. Ownership of the securities effectively changes on the floor of the exchange through the help of a broker. Broker market is usually composed of national and regional securities exchanges. The Philippine Stock Exchange is the sole broker market in the Philippines. In a dealer market , the buyer and seller are not brought directly together by a third party. Instead, market makers (dealers who create markets by offering to sell/buy securities at stated ask/bid prices, respectively) execute the sell or buy orders. In a dealer market, there are two distinct trades that occur. Seller sells his securities to a dealer and Buyer buys his securities from a dealer (can be the same dealer of Seller A).

21. Types of Financial Markets A. Based on Instruments Traded Money Market Capital Market B. Based on Market Type Primary Market Issue Methods a. Public Offering b. Private Placement (Limited Public Offer) c. Auction (Dutch, English, Descending price sealed auctions d. Tap Issue 2. Secondary Market Economic Functions a. Price Discovery b. Liquidity and reduction in borrowing costs c. Support to the primary market d. Implementation of monetary policy

22. Types of Financial Markets C. Based on Market Structure Order-Driven Market Structure Types of Order-Driven Market Structure a. Market Orders b. Limit Orders c. Day Orders d. Good-until-canceled Orders 2. Quote-Driven Market Structure D. Financial Instruments Traded Exchange Over the Counter

23. Types of Financial Markets E. Based on Country’s Perspective Internal or National Market (Domestic, Foreign) External Market F. Based on Manner of Financial Intermediaries Broker Market Dealer Market

24. END OF PRESENTATION