lOMoARcPSD|11088737
CHAPTER 1 - FINANCIAL SYSTEMS AND
THE FINANCIAL MARKET
The borrowing activity between both
parties still happens through the intervention
of a financial intermediary.
-
Sources of Wealth
Labor - will allow them to earn a
salary/wage
2. Land - generate wealth in the form of rent
3. Capital - will earn interest when the venture
is realizing good returns
4. Entrepreneurship - generate more profit
1.
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 Borrowers - parties who are
willing to pay the required return to
obtain additional funds
Finance
- Key
-
-
player in ensuring continuity of
operations
The application of economic principles to
decision making 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
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.
-
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?)
Downloaded by lalaland dalia (lalalanddalia08@gmail.com)
lOMoARcPSD|11088737
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
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.
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.
“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.
Price is set at the level wherein the
buyers are willing to buy, and sellers are
willing to sell.
Liquidity
Through Financial Markets, 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 in an appealing feature when
circumstances may occur that push investors
to sell a financial instrument.
Without liquidity, an investor is
forced to hold to financial instrument up
until…
Debt instrument: Maturity date
Equity instrument: Voluntary or
involuntary liquidation
-
3.
Reduction in transaction costs
Types of Transaction Costs:
Search Costs
- costs incurred to look for financial
instruments that can be purchased or sold by
a party.
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
Information Costs
costs related in evaluating investment
characteristics of a financial instrument.
TYPES OF FINANCIAL MARKETS
1.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.
Downloaded by lalaland dalia (lalalanddalia08@gmail.com)
lOMoARcPSD|11088737
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.
Importance to fund providers:
They need it because excessive holdings of
cash also generates opportunity cost in the
form of foregone interest.
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.
Ex. Treasury bills, Commercial papers,
Certificate of deposits, Repurchase
agreement, Banker’s acceptances.
Capital Market
Where Financial Instruments issued by
governments and corporations that will
mature one year from issuance date (longterm) are traded.
The foundation of the capital market is
made up by the dealers and brokers market
which creates a venue for bond and stock
transactions.
2.
Based on Market Type
In primary market:
fund Borrowers - demanders of
funds
Primary Market
Where fund demanders raise funds through
new issuance of financial instruments
e.g. bonds and stocks.
Transactions are coursed through
Investment Banks that act as intermediaries
between issuing companies (demanders)
and potential investors (providers).
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
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
Capital Market Securities:
a. Equity Instruments
b. Debt Instruments
Lenders - suppliers
Secondary market:
Buyers - suppliers of fund
Sellers - demanders of funds
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.
Downloaded by lalaland dalia (lalalanddalia08@gmail.com)
lOMoARcPSD|11088737
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 same
securities at a higher price
Auction
Used for issuance of treasury bills, bonds
and other securities issued by the
government and are commonly executed
exclusively with market makers.
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 Allows active trading which
improves liquidity and marketability of the
securities.
3.
●
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
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.
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.
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.
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.
➢
Limit orders
Orders placed where clients set a
price or price range that may be
below/above the existing price.
➢
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
Buyers are the ones who have excess funds while
the sellers are those 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.
Downloaded by lalaland dalia (lalalanddalia08@gmail.com)
lOMoARcPSD|11088737
voluntarily cancels and remove these
from the system.
Domestic Market - issuers who are
considered residents in a country issue the
securities
Quote-Driven Market Structure
Also called as primary dealer markets,
professional markets or market-made
markets.
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).
-
 External Market
Refers to the Financial market where
securities that have two unique
characteristics are being traded:
Upon issuance, these securities
offered simultaneously to investors
in different countries
b. Securities are issued outside the
regulatory jurisdiction of any single
country
a.
Spread
-
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.
difference bet the bid and offer quote
Inures to the benefit of the market
makers as profit
Represents the transactional costs
and
reflects liquidity
Narrow Spread - Signals liquidity
Wide Spread - Indicates illiquidity
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.
In order to be traded, all Financial Instruments
should be listed by the organized exchange.
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
Buyers and sellers are not brought directly
together by a third party. Market makers
execute the sell or buy orders.
Over-the Counter 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.Based on Country’s Perspective
Internal or National Market
Refers to the financial market operating in a
certain country.
Downloaded by lalaland dalia (lalalanddalia08@gmail.com)