Elements of the Financial System
FUNDAMENTALS OF
FINANCIAL MARKETS
CHAPTER I
Financial Systems and the Financial Market
The Financial System
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.
Financial System is a set of arrangements or
conventions embracing the lending and borrowing
of funds by non-financial economic units and the
intermediation of this function by financial
intermediaries in order to facilitate the transfer of
funds, to create additional money when required,
and to create markets in debt and equity instruments
(and their derivatives) so that the price and
allocation of funds are determined efficiently.
- Faure, AP.
Sources of Wealth (Origin of Wealth)
 Labor – Wages/Salaries
 Land – Rent
 Capital – Interest
 Entrepreneurship – Profit
Finance – is the application of economic principles
to decision-making that involves that allocation of
money under conditions of uncertainty. Finance is a
key player in ensuring continuity of operations. It is
the life-blood of the company which the
management must ensure that its continuous flow is
maximized. Hence, financial management is an
important process to ensure that profit and wealth is
maximized.
Finance came from the French word “finer”which
means “to end and settle a debt
Key Areas of Capital Markets
 Financial System
 Structure of Interest Rates
 Pricing of Assets
Funds can flow from lender-savers to the borrower-
spenders in two routes:
Direct Financing – 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 as direct
financing.
Indirect Financing - the borrowing activity
between both parties still happens though indirectly
through the intervention of a financial intermediary.
Illustration by Mishkin, 2004
 Lenders and Borrowers
 Also known as fund providers and fund
demanders, respectively. The most essential
stakeholders that make up the foundation of a
transaction in the financial system.
 Lenders are parties that have excess funds that
they can lend out to other entities for a required
return while;
 Borrowers are parties who are willing to pay
the required return to obtain additional funds to
finance their investment initiatives.
 Financial Intermediaries
 These 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 is where financial
intermediaries come into picture.
 Financial Instruments
 These are a medium of exchange of contractual
obligation of a party, where such contract can
be traded. These can be tangible or intangible.
 There are two types of financial instruments:
Cash or Derivative Financial Innstruments.
 According to IFRS, a financial instrument is a
contract where a party recognize it as an asset
and another is a liability.
 Financial Markets
 It is the same with other economic markets
where suppliers and buyers of financial
instruments meet.
 There are two types of financial markets
depending on the instrument that is being
traded:
Money Market – Cash Financial
Instruments
Capital Markets – Derivative Financial
Instruments

 Regulatory Environment
 It is the governance body to ensure that the
transactions that occur within the financial
systems complies with the laws and regulations
imposed to the actors as well as the elements
that plays within the system.
 Financial systems are normally regulated by
Central Banks
 Money Creation
 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.
 Price Discovery
 It is the process of determining or valuing the
financial instrument in the market. As the
financial systems continuously flow and
operate, the financial instruments create value.
The Financial Markets
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.
Financial markets intend to establish a consistent,
efficient and cost-effective bridge between fund
providers and fund demanders.
Exchanging of financial instruments is also more
commonly known as “trading”. Popular examples
of financial markets are the New York Stock
Exchange and Philippine Stock Exchange or PSE.
There are three major economic functions of a
financial market:
Price Discover – refers to the interaction between
buyers and sellers in the financial market in order to
come up with a price for the traded financial
instrument. Price is set at the level where in the
buyers are willing to buy, and the sellers are willing
to sell.
Liquidity – the second function of the financial
market. 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.
Reduction in Transaction Costs – the last
function of a financial market. Transactions Costs
are the costs incurred of parties’ transaction to trade
a financial instrument. It can be classified into two
types:
 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 value time
consumed to look for a counterparty for the
transaction.
 Information Costs – are costs related in
evaluating investment characteristics of a
financial instrument. Investors often spend
information costs to gather information about
profitability, liquidity, stability and market value
of a financial instrument to justify worthiness of
the investment.
Types of Financial Markets Based on
Instruments Traded
Financial Markets may be classified according to
the type of financial instrument it traded whether the
instrument is a short-term security or long term.
Short-Term Securities are normally traded in the
Money Market, while Long-Term Securities are
classified under the Capital Market.
Money Market – 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.
Common examples of financial instruments traded
in the money market are: Certificates of Deposits,
Treasury Bills, Commercial Papers, Repurchase
Agreement, Bankers’ Acceptances, etc.
Capital Market – is the sector of the financial
markets 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 encompass
financial instruments that have maturity dates longer
than one year and perpetual securities (with no
maturity).
Long-Term is defined as longer than one year.
Capital market securities are classified into two:
Equity (which represent ownership interest) and
Debt.
Types of Financial Markets Based on Market
Type
Another categorization of financial market is to
what type of market it is being traded. This may be
categorized in primary and secondary market. It can
be noted that in primary market, the supplier of
funds is called lenders, while they are buyers in the
second market.
Primary Market – is a type of financial market
wherein fund demanders such as corporation or a
government agency raise funds through new
issuances of financial instruments e.g. bonds and
stocks. Primary market securities also include
issuance of additional debt or equity securities of an
already publicly traded company

Non-negotiable instruments like mortgage loans,

savings deposits and life policies are issued only in
primary markets.

Transactions in the primary market can be classified

based on the intended purchasers of the securities.
There are four types of issue methods that can be
done in the primary markets:
 Public Offering
 This occurs when securities are offered for sale
to the general public. Offering to the general
public is done through issuing a prospectus or
placing document which contains and offer to the
general public to subscribe or purchase securities
at a stated price.
 Private companies who will sell shares to the
general public for the very first time is said to
undergo an initial public offering or IPO.