Fundamentals of Financial Markets

FIN 107
Intended Learning Outcomes
• Understand what a financial asset is and its properties and economic functions
• Understand what a financial market is and the principal economic functions it
performs
• Understand the types of financial markets that facilitate the flow of funds
• Understand the types of securities traded within financial markets
• Understand the participants in the financial markets and the business of financial
institutions
• Understand what a financial intermediary is

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Financial Assets
• An ASSET is any possession that has value in
ASSET
an exchange.
• Assets can be classified as:
• Tangible
• Intangible Tangible Intangible
• The value of a TANGIBLE ASSET depends on
particular physical properties.
• INTANGIBLE ASSET represents legal claims
to some future benefits. Reproducible

• FINANCIAL ASSETS are intangible assets. The

typical future benefit comes in the form of a
claim to future cash.
Nonreproducible

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Financial Assets
• ISSUER – the entity that agrees to make future cash payments
• INVESTOR – the owner of the financial asset

Examples of financial assets:

• Common stock issued by Ayala Land, Inc.
• A bond issued by the Philippine Bureau of Treasury
• An automobile loan from BDO

Debt versus Equity Claims

• DEBT CLAIM – debt instruments requiring fixed dollar payments to borrow the funds
• EQUITY CLAIM – obligates the issuer of the financial asset to pay the holder an
amount based on earnings
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Role of Financial Assets
Two Principal Economic Functions

• Transfer funds from those parties who have surplus funds to invest to those who
need funds to invest in tangible assets

• Surplus units: participants who receive more money than they spend, such as investors
• Deficit units: participants who spend more money than they receive, such as borrowers

• Transfer funds in such a way as to redistribute the unavoidable risk associated with
the cash flow generated by tangible assets among those seeking and those providing
the funds

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Role of Financial Assets
Example:
Billy has a license to manufacture FINEX calculators. He estimates that he needs P5
million to purchase plant and equipment to manufacture the calculators. Unfortunately,
he has only P2 million to invest, his life savings, which he does not want to invest even
though he feels confident a receptive market exists for the watches. On the other hand,
Vivien and Anthony both have P3 million and P1 million available money for investments,
respectively.

By accident, Billy, Vivien and Anthony meet and discuss their financial plans. By end of
the day, they agree to a deal. Billy will invest P1 million of his savings and sell 50%
interest to Vivien for P3 million. Anthony agrees to lend Billy P1 million for 5 years. Billy
will be responsible for operating the business without the assistance of Vivien and
Anthony. Billy now has his P2 million to manufacture the calculators.

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Value of a Financial Asset
• VALUATION is the process of
determining the fair value or price Determine
of a financial asset. the Value of
Estimate the
appropriate financial asset
• The fundamental principle of cash flow
interest rate
valuation is that the value of any
financial asset is the present value Cash flow = Present
Minimum
of the cash flow expected. interest, value of
interest rate
• Factors affecting valuation: principal expected
Plus
• Impact of information repayment, cash flow
premium
• Impact of the internet dividends,
required for
• Impact of behavioral finance expected
perceived
sale price of
risk
asset

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Properties of Financial Assets
• Moneyness
• Divisibility and Denomination
• Reversibility
• Term to Maturity
• Liquidity
• Convertibility
• Currency
• Cash Flow and Return Predictability
• Complexity
• Tax Status

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Financial Markets
• A FINANCIAL MARKET is a market in which financial assets (such as stocks and bonds)
can be purchased or sold. Funds are transferred in financial markets when one party
purchases financial assets previously held by another party.

• The existence of a financial market is not necessary condition for the creation and
exchange of a financial asset. Though, in most economies, financial assets are created
and subsequently traded in some type of organized financial market structure.

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Role of Financial Markets
Primary economic functions of financial markets
• Interaction of buyers and sellers in a financial market determine the price of the
traded asset or equivalently, the required return on a financial asset is determined

• Financial markets provide a mechanism for an investor to sell a financial asset

• Financial markets reduce the search and information costs of transacting

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Role of Financial Markets

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Classification of Financial Markets
• PRIMARY MARKETS – facilitate the issuance of new securities

• SECONDARY MARKETS – facilitate the trading of existing securities, which allows for
a change in the ownership of the securities

• Liquidity is the degree to which securities can easily be liquidated (sold) without a loss of
value

• If a security is illiquid, investors may not be able to find a willing buyer for it in the
secondary market and may have to sell the security at a large discount just to attract a
buyer

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Classification of Financial Markets
PRIMARY MARKETS

BONDS or SHARES

Sell side

contacts contacts Buy side

CORPORATES Fund
Manager

Investment Investors
Banks Institutions

CAPITAL
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Classification of Financial Markets
SECONDARY MARKETS

Wants to sell Wants to buy

STOCK
EXCHANGE/
OTC
Fund Investment Investment Fund
manager Bank Bank manager

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Classification of Financial Markets
• MONEY MARKETS – financial market for short term financial assets
• Money market securities: have relatively high degree of liquidity
• Certificates of deposit
• Treasury bill
• Commercial paper
• Repurchase agreement
• Banker’s acceptances
• CAPITAL MARKETS – financial market for longer maturity financial assets
• Capital market securities: are commonly issued to finance the purchase of capital
assets such as buildings, equipment or machinery
• Bonds
• Mortgages
• Mortgage backed securities
• Stocks
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Classification of Financial Markets
Money market securities
• Certificates of deposit – certificates issued by a depository institution to a saver
depositing money for a specified length of time

• Treasury bill – safest short term security issued by the federal government

• Commercial paper – an unsecured short term note issued by a corporation as an

alternative to borrowing funds from commercial banks

• Repurchase agreement – a sale of security in which the seller agrees to buy back
the security at a specified price at a specified date

• Banker’s acceptances – short term promissory notes guaranteed by a bank

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Classification of Financial Markets
Capital market securities
• Bonds – long term debt securities issued by the Treasury, government agencies and
corporations to finance their operations

• Mortgages – long term debt obligations to finance the purchase of real estate
(prime mortgages and subprime mortgages)

• Mortgage backed securities – debt obligations representing claims on a package of

mortgages

• Stocks – represent partial ownership in the corporations that issued them

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Classification of Financial Markets
Money Markets
• Maturity: Takes place for short term up
to one year
• Instruments: certificate of deposits,
commercial paper, Treasury bills, etc.
• Institutions: financial banks, central
bank, commercial banks, financial
companies
• Liquidity: liquid
• Risk factor: risk involved is low
• Return: returns are usually low
Capital Markets
• Maturity: Takes place for longer
maturity
• Instruments: bonds, mortgages,
mortgage backed-securities, stocks
• Institutions: commercial banks, mutual
funds, underwriters, stockbrokers,
stock exchanges
• Liquidity: comparatively less liquid
• Risk factor: risk is comparatively higher
• Return: returns are usually high because
of higher duration
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Classification of Financial Markets
DERIVATIVE MARKETS
• Derivative Securities – financial contracts whose values are derived from the values of
underlying assets

• Speculation – allows an investor to speculate on movements in the value of the

underlying assets without having to purchase those assets

• Risk management and hedging – financial institutions and other firms can use
derivative securities to adjust the risk of their existing investments in securities

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Financial Institutions
• FINANCIAL INSTITUTIONS are needed to resolve the limitations caused by market
imperfections and are critical for the efficient operation of the capital markets.
• Provide one or more of the following services:
• Transform financial assets acquired through the market and constitute them into a
different and more widely preferable, type of asset, which becomes their liability.
• Exchange financial assets on behalf of customers
• Exchange financial assets for their own account
• Assist in the creation of financial assets for their customers and then sell those
financial assets to other market participants
• Provide investment advice to other market participants
• Manage the portfolios of other market participants
• Can be classified as depository and non-depository institutions

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Financial Institutions | Depository Institutions
Role of Depository Institutions – accept deposits from surplus units and provide credit
to deficit units through loans and purchases of securities
• Offer liquid deposit accounts to surplus units

• Provide loans of the size and maturity desired by deficit units

• Accept the risk on loans provided

• Have more expertise in evaluating creditworthiness

• Diversify their loans among numerous deficit units

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Financial Institutions | Depository Institutions
Depository institutions include:
• Commercial Banks
• Most dominant type of depository institution
• Transfer deposit funds to deficit units through loans or purchase of debt securities

• Savings Institutions
• Also called thrift institutions and include savings and loans (S&Ls) and savings banks
• Concentrate on residential mortgage loans

• Credit Unions
• Non-profit organizations

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Financial Institutions | Non-depository Institutions
Role of non-depository institutions
• Finance companies - obtain funds by issuing securities and lend the funds to
individuals and small businesses

• Mutual funds - sell shares to surplus units and use the funds received to purchase a
portfolio of securities.

• Securities firms - provide a wide variety of functions in financial markets (Broker,

Underwriter, Dealer, Advisory)

• Insurance companies - provide insurance policies that reduce the financial burden
associated with death, illness, and damage to property. Charge premiums and invest
in financial markets.

• Pension funds – manage funds until they are withdrawn for retirement FIN107 23
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Financial Institutions

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Financial Institutions
Relative importance of financial institutions

• Households with savings are served by depository institutions.

• Households with deficient funds are served by depository institutions and finance
companies.

• Several agencies regulate the various types of financial institutions, and the various
regulations may give some financial institutions a comparative advantage over
others.

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Financial Institutions
Summary of Institutional Sources and Uses of Funds

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Financial Institutions
Consolidation of Financial Institutions
• Typical Structure of a Financial Conglomerate - In recent years, the barriers to entry
have been reduced, allowing firms that had specialized in one service to expand more
easily into other financial services.

• Impact of Consolidation on Competition - provided more convenience. Individual

customers can rely on the financial conglomerate for convenient access to multiple
services.

• Global Consolidation of Financial Institutions - Many financial institutions have

expanded internationally to capitalize on their expertise.

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Financial Institutions
Organizational structure of a financial conglomerate

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End.
FIN 107

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