DON HONORIO VENTURA STATE UNIVERSITY

COLLEGE OF BUSINESS STUDIES-

BAFIN 101B - Financial Market

CHAPTER 1 OVERVIEW OF THE FINANCIAL SYSTEM

Learning Objectives:
At the end of the discussion, the student will able to:
1. Explain the concept and importance of Financial Markets
2. Discuss the different financial market and its structure
3. Explain the function of financial markets
4. Identify who are the financial intermediaries and its importance

Why Study Financial Markets?

This chapter focus on financial markets, markets in which funds are
transferred from people who have an excess of available funds to people who have a
shortage. Financial markets such as bonds and stock markets are important in
channelling funds from people who do not have productive use for them to those who
do, resulting in greater economic efficiency. Activities in financial markets also have
direct effects on personal wealth the behaviour of businesses and customers, and the
overall performance of the economy.
Debt Markets & Interests Rates
A security (also called a financial instrument) is a claim on the issuer’s future
income or assets (any financial claim or piece of property that is subject to ownership).
A bond is a debt security that promises to make payments periodically for a specified
period of time. Debt markets, also often referred to generically as the bond market,
are especially important to economic activity because they enable corporations and
governments to borrow in order to finance their activities; the bond market is also
where interest rates are determined. An interest rate is the cost of borrowing or the
price paid for the rental of funds. There are many interest rates in the economy—
mortgage interest rates, car loan rates, and interest rates on many different types of
bonds.

Interest rates are important on a number of levels. On a personal level, high

interest rates could deter you from buying a house or a car because the cost of
financing it would be high. Conversely, high interest rates could encourage you to save
because you can earn more interest income by putting aside some of your earnings as
savings. On a more general level, interest rates have an impact on the overall health of
the economy because they affect not only consumers’ willingness to spend or save but
also businesses’ investment decisions. High interest rates, for example, might cause a
corporation to postpone building a new plant that would provide more jobs.
The Stock Market
A stock is a security that is claim on the earnings and assets of a corporation.
Issuing stocks and selling it to the public is a way for corporations to raise funds to
finance their activities. The stock market, in which claims on the earnings of
corporations are traded, in the most widely followed financial market in the country

The stock market is also an important factor in business investment decisions

because the price of shares affects the amount of funds that can be raised by selling
new issued stock to finance investment spending. A higher price of the firm’s shares
means that it can raise a higher amount of funds, which can be used to use
production facilities and equipment’s
The Foreign Exchange Market
For funds to be transferred from one country to another country, they have to
be converted from the currency in the country of origin into the currency of the
country they are going to. The foreign exchange market is where this conversion
takes place, and so it is instrumental in moving funds between countries. It is also
important because it is where the foreign exchange rate, the price of the country’s
currency in terms of another’s is determined.
A. FUNCTIONS OF FINANCIAL MARKETS
Financial markets perform the essential economic function of channelling funds
from who have saved surplus by spending less than their income to people who have a
shortage of funds because they wish to spend more than their income. The function is
shown schematically in Figure 1. Those who have saved and are lending funds to
finance their spending, the borrower-spenders, are at the right. The principal lender-
savers are households, but business enterprises and government as well as foreigners
and their governments, sometimes also find themselves with excess funds and to send
them out. The most important borrower-spenders are business and the government,
but households and foreigners also borrow to finance their purchases of cars,
furniture, and houses. The arrow show that funds flow from lender-savers to
borrower-spenders via two routes.
In direct finance, the borrowers borrow funds directly from lenders in financial
markets by selling their financial instruments, which are claims on the borrower’s
future income or assets. Financial markets are assets for the person who buy the out
liabilitie

Why is this channelling of funds from savers to spenders so important to the

economy? The answer is that the people who save are frequently not the same people
who have profitable investment opportunities available to them, the entrepreneurs.
Without financial markets it is hard to transfer funds from a person who has no
investment opportunities to one who has them.
The existence of financial markets is also beneficial even if someone borrows for
a purpose other than increasing a production a business. Financial markets have
such as important function in the economy. They allow funds to move from people
who lack productive investment opportunities to people who have such opportunities.
By so doing, financial markets contribute to higher production and efficiency in
the overall economy. They also directly improve the well-being of consumers by
allowing them to time their purchases better. They provide funds to young people to
buy what they need and can eventually afford without forcing them to wait until they
have saved he entire purchase price.
B. STRUCTURE OF FINANCIAL MARKETS
1. Debit and Equity Markets
A firm or an individual can obtain funds in a financial market in two ways. The
most common method is to issue debt instrument, such as a bond or mortgage,
which is a contractual agreement by the borrower to pay the holder of the instrument.
The maturity of a debt instrument is the time (term) to the instrument’s expiration
date. A debt instrument is short term if its maturity is less than a year and long
term if its maturity is ten years longer. Debt instruments with a maturity between one
and ten years are said to be intermediate term.
The second method of raising funds is by issuing equities such as common
stocks, which are claims to share in the net income and the assets of a business.
Equities usually make periodic payments (dividends) to their holders and are
considered long term securities because they have no maturity date.
The main disadvantage of owing a corporations equities rather than its debt is
that an equity holder is a residual claimant that is the corporation must pay all its
debt holders before it pays its equity holders. The advantage of holding equities is that
the equity holder benefit directly from any increases in the corporation profitability or
asset value because equities confer ownership rights on the equity holders. Debt
holders do not share in this benefit because payments are fixed.
2. Primary and Secondary Markets
A primary market is a financial market in which issues of a security, such as a
bond or a stock are sold to initial buyer by the corporation or government agency
borrowing the funds. A secondary market is a financial market in which securities
that have been previously issued can be resold.

3. Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity
of the securities traded in each market. The money market is a financial market in
which only short term debt instruments; the capital market is the market in which
longer term debt and equity instruments are traded. Money market securities are
usually more widely traded than longer term securities and so tend to be more liquid.
Capital market securities, such as stocks and long term bonds, are often held by
financial intermediaries such as insurance companies and pension funds, which have
little uncertainty about the amount of funds they will have available in the future.
C. FINANCIAL MARKET INSTRUMENTS
1. Stocks are equity claims on the net income and asset of a corporation.
2. Mortgages are loans to households or firms to purchase housing, land, and
other real structures, where the structure or land itself serves as collateral for
the loans.
3. Corporate bonds are long term bonds issued by corporations with very strong
credit savings. The typical corporate bonds sends the holder an interest
payment twice a year and pays off the face value when the bond matures. Some
corporate bonds are convertible bonds have the additional feature of allowing
the holder to converts them into a specified number of shares of stock at any
time up to the maturity date.
 D. FUNCTIONS OF FINANCIAL INTERMEDIARIES
As shown in Figure 1 (p. 3), funds also can move from lenders to borrowers by
a second route called indirect finance because it involves a financial intermediary
that stands between the lender-savers and the borrower-spenders and helps
transfer funds from one to the other. A financial intermediary does this by
borrowing funds from the lender-savers and then using these funds to make loans to
borrower spenders. For example, a bank might acquire funds by issuing a liability to
the public (an asset for the public) in the form of savings deposits.
The process of indirect finance using financial intermediaries, called financial
intermediation, is the primary route for moving funds from lenders to borrowers.
Indeed, although the media focus much of their attention on securities markets,
particularly the stock market, financial intermediaries are a far more important source
of financing for corporations than securities markets are.
Transaction Costs
Transaction costs, the time and money spent in carrying out financial
transactions, are a major problem for people who have excess funds to lend. Financial
intermediaries can substantially reduce transaction costs because they have
developed expertise in lowering them and because their large size allows them to
take advantage of economies of scale, the reduction in transaction costs of
transactions as the size (scale) of transactions increases.
Because financial intermediaries are able to reduce transaction costs
substantially, they make it possible for you to provide funds indirectly to people. In
addition, a financial intermediary’s low transaction costs mean that it can provide its
customers with liquidity services, services that make it easier for customers to
conduct transactions. For example, banks provide depositors with checking accounts
that enable them to pay their bills easily. In addition, depositors can earn interest on
checking and savings accounts and yet still convert them into goods and services
whenever necessary.
Risk Sharing
Another benefit made possible by the low transaction costs of financial
institutions is that they can help reduce the exposure of investors to risk—that is,
uncertainty about the returns investors will earn on assets. Financial intermediaries
do this through the process known as risk sharing: They create and sell assets with
risk characteristics that people are comfortable with, and the intermediaries then use
the funds they acquire by selling these assets to purchase other assets that may have
far more risk. Low transaction costs allow financial intermediaries to share risk at low
cost, enabling them to earn a profit on the spread between the returns they earn on
risky assets and the payments they make on the assets they have sold. This process of
risk sharing is also sometimes referred to as asset transformation, because in a
sense, risky assets are turned into safer assets for investors
 Financial intermediaries also promote risk sharing by helping individuals to
diversify and thereby lower the amount of risk to which they are exposed.
Diversification entails investing in a collection (portfolio) of assets whose returns do
not always move together, with the result that overall risk is lower than for individual
assets. (Diversification is just another name for the old adage, “You shouldn’t put all
your eggs in one basket.”) Low transaction costs allow financial intermediaries to do
this by pooling a collection of assets into a new asset and then selling it to individuals.
TYPES OF FINANCIAL INTERMEDIARIES
1. Depository Institutions
Depository institutions (for simplicity, we refer to these as banks throughout
this text) are financial intermediaries that accept deposits from individuals and
institutions and make loans. These institutions include commercial banks and the so-
called thrift institutions (thrifts): savings and loan associations, mutual savings
banks, and credit unions.
a. Commercial Banks. These financial intermediaries raise funds primarily by
issuing checkable deposits (deposits on which checks can be written), savings
deposits (deposits that are payable on demand but do not allow their owner to
write checks), and time deposits (deposits with fixed terms to maturity).
b. Savings and Loan Associations (S&Ls) and Mutual Savings Banks. These
depository institutions, obtain funds primarily through savings deposits (often
called shares) and time and checkable deposits. In the past, these institutions
were constrained in their activities and mostly made mortgage loans for
residential housing. Over time, these restrictions have been loosened so that
the distinction between these depository institutions and commercial banks has
blurred. These intermediaries have become more alike and are now more
competitive with each other.
c. Credit Unions. These financial institutions, are typically very small
cooperative lending institutions organized around a particular group: union
members, employees of a particular firm, and so forth. They acquire funds from
deposits called shares and primarily make consumer loans.
2. Contractual Savings Institutions
Contractual savings institutions, such as insurance companies and pension
funds, are financial intermediaries that acquire funds at periodic intervals on a
contractual basis. Because they can predict with reasonable accuracy how much they
will have to pay out in benefits in the coming years, they do not have to worry as much
as depository institutions about losing funds quickly. As a result, the liquidity of
assets is not as important a consideration for them as it is for depository institutions,
and they tend to invest their funds primarily in long-term securities such as corporate
bonds, stocks, and mortgages.
a. Life Insurance Company. Life insurance companies insure people against
financial hazards following a death and sell annuities (annual income
payments upon retirement). They acquire funds from the premiums that people
 pay to keep their policies in force and use them mainly to buy corporate bonds
and mortgages. They also purchase stocks, but are restricted in the amount
that they can hold.
b. Fire and Casualty Insurance Companies. These companies insure their
policyholders against loss from theft, fire, and accidents. They are very
much like life insurance companies, receiving funds through premiums for their
policies, but they have a greater possibility of loss of funds if major disasters
occur. For this reason, they use their funds to buy more liquid assets than life
insurance companies do.
c. Pension Funds and Government Retirement Funds. Private pension funds
and state and local retirement funds provide retirement income in the form of
annuities to employees who are covered by a pension plan. Funds are acquired
by contributions from employers and from employees, who either have a
contribution automatically deducted from their paychecks or contribute
voluntarily. The largest asset holdings of pension funds are corporate bonds
and stocks

3. Investment Intermediaries
This category of financial intermediaries includes finance companies, mutual
funds, and money market mutual funds.
a. Finance Companies. Finance companies raise funds by selling commercial
paper (a short-term debt instrument) and by issuing stocks and bonds. They
lend these funds to consumers (who make purchases of such items as furniture,
automobiles, home improvements) and to small businesses. Some finance
companies are organized by a parent corporation to help sell its product.
b. Mutual Funds. These financial intermediaries acquire funds by selling shares
to many individuals and use the proceeds to purchase diversified portfolios
of stocks and bonds. Mutual funds allow shareholders to pool their
resources so that they can take advantage of lower transaction costs when
buying large blocks of stocks or bonds. In addition, mutual funds allow
shareholders to hold more diversified portfolios than they otherwise would.
Shareholders can sell (redeem) shares at any time, but the value of these shares
will be determined by the value of the mutual fund’s holdings of securities.
Because these fluctuate greatly, the value of mutual fund shares will, too;
therefore, investments in mutual funds can be risky.
c. Money Market Mutual Funds. These financial institutions have the
characteristics of a mutual fund but also function to some extent as a
depository institution because they offer deposit-type accounts. Like most
mutual funds, they sell shares to acquire funds that are then used to buy
money market instruments that are both safe and very liquid. The interest on
these assets is paid out to the shareholders. A key feature of these funds is
that shareholders can write checks against the value of their shareholdings. In
effect, shares in a money market mutual fund function like checking account
deposits that pay interest.
 d. Investment Banks. Despite its name, an investment bank is not a bank or a
financial intermediary in the ordinary sense; that is, it does not take in
deposits and then lend them out. Instead, an investment bank is a different
type of intermediary that helps a corporation issue securities. First it
advises the corporation on which type of securities to issue (stocks or bonds);
then it helps sell (underwrite) the securities by purchasing them from the
corporation at a predetermined price and reselling them in the market.
Investment banks also act as deal makers and earn enormous fees by helping
corporations acquire other companies through mergers or acquisitions.

Prepared by:

John Lee J. Mamaril, CFPP, LPT, MBA

Instructor - BA FIN 101B