Financial Markets 2.

Capital Markets
• Markets that trade debt (bonds) and
• Any marketplace where the trading of
equity (stocks) instruments with
securities occurs
maturities of more than one year
• It includes the stock market, bond market,
forex market, and derivatives market, among
others Foreign Exchange Markets
• It is a market where buyers and sellers trade
• “FX” markets deal in trading one
commodities, financial securities, foreign
currency for another (e.g dollar in
exchange, and other freely exchangeable
exchange for yen)
items (fungible items) and derivatives of
• The “spot” FX transaction involves the
value at low transaction costs and at prices
immediate exchange of currencies at the
that are determined by market forces
current exchange rate
• The “forward” FX transaction involves
Tradable commodities: the exchange of currencies at a specified
date in the future and at a specified
1. Metals (gold, silver, platinum, and copper)
exchange rate
2. Energy (crude oil, heating oil, natural gas,
and gasoline)
3. Livestock and Meat (lean hogs, pork bellies, Derivative Security Markets
live cattle, and feeder cattle)
• The markets in which derivative securities
4. Agricultural (corn, soybeans, wheat, rice,
trade
cocoa, coffee, cotton, and sugar)

Derivative Security
Primary Markets vs. Secondary Markets
1. Primary Markets • An agreement between two parties to
exchange a standard quantity of an asset at a
• Markets in which users of funds (e.g
predetermined price on a specified date in the
corporations & governments) raise funds
future
by issuing financial instruments (e.g
stocks and bonds)

Financial Institutions
2. Secondary Markets
• Markets where financial instruments are • Institutions that perform the essential
traded among investors function of channeling funds from those with
surplus funds to those with shortages of funds
(e.g banks, thrifts, insurance companies,
Money Markets vs. Capital Markets
securities firms and investment banks,
1. Money Markets finance companies, mutual funds, and
• Markets that trade debt securities with pension funds)
maturities of one year or less (e.g
Treasury bills)
Money Key Measures for the Money Supply

• It is an economic unit that functions as a M1: Narrow Measure

generally recognized medium of exchange
• It includes all currency (i.e cash) in
for transactional purposes in an economy
circulation, traveler’s checks, demand
• It is a means of payment for goods and
deposits at commercial banks (or other
services or repayments of debts – it serves as
depository institutions) held by the public,
an asset to the holder
and other checkable deposits
• It is often referred to as the narrowest
Role or Function of Money in the Economy measure of money supply or narrow money
• It refers primarily to money used as a medium
1. Medium of exchange
of exchange
• It is accepted freely in exchange for all other
goods
• It is a barter system which is very M2: Intermediate Measure
inconvenient so the introduction of money
• It includes everything in M1 as well as saving
has got over the difficulty of barter
deposits and balances in retail money market
funds
2. Measure of value
• It refers primarily to money used as a store of
• Money acts as a common measure of value;
value
it is a unit of account and a standard of
measurement
• When we buy a good in the market, we pay a
M3: Broad Measure
price for it in money; and price is nothing but
value expressed in terms of money • It includes everything in M2 as well as large
time deposits, balances in institutional money
3. Store of value market funds, and term repurchase
• Money is a convenient form to store wealth agreements
-TRA is a contract in which the vendor of
4. Standard of deferred payments a security agrees to repurchase it from the
• It forms the basis for credit transactions buyer at an agreed price
• If credit transactions were to be carried on the
basis of commodities, there would be a lot of
difficulties and it will affect trade M4 (L): Broadest Measure

• In addition to everything in M3, this includes

liquid and near liquid assets such as: short
Money Supply (Money Stock)
term treasury bills, high grade commercial
• The total value of money available in an paper, and bank acceptance notes.
economy at a point of time
• It consists mostly of currency and demand
deposits Treasury bills, notes, and bonds
• Currency includes all coins and paper money • Marketable government debt securities
issued by the government and the banks 1. Treasury bills have maturities of a year or
less
 2. Treasury notes are issued with maturities 3. Speculative Demand
from two to ten years • The demand to take advantage of future
3. Treasury bonds are long-term investments changes in the interest rate or bond prices
that have maturities of 10 to 30 years from • The higher the rate of interest, the lower the
their issue date speculative demand for money
• The lower the rate of interest, the higher the
speculative demand for money
High grade commercial papers

• An unsecured, short-term debt instrument

The Impact of Money
issued by a corporation, typically for the
financing of accounts payable and • Higher interest rates will decrease
inventories or meeting short-term liabilities. investments
Maturities on commercial paper rarely range • It becomes more expensive to borrow money
longer than 270 days. • Consumption will decrease because
consumers will tend to save
• Higher peso will decrease exports resulting in
Bank acceptance notes slower GDP growth
• An instrument representing a promised future
payment by a bank
• The payment is accepted and guaranteed by The Quantity Theory of Money
the bank as a time draft to be drawn on a • Quantity theory of money states that money
deposit. The draft specifies the amount of supply and price level in an economy are in
funds, the date of the payment, and the entity direct proportion to one another
to which the payment is owed • When there is a change in the supply of
money, there is a proportional change in the
price level and vice-versa
Three Motives for Demanding Money (Sources of
Demand)
1. Transaction Demand The Equation of Exchange
• People prefer to be liquid for a day-to-day
expense. The amount of liquidity desired • It is the mathematical expression of the
depends on the level of income, the higher the quantity theory of money. In its basic form,
income, the more money is required for the equation says that:
increased spending. • The total amount of money that changes
hands in an economy equals the total
2. Precautionary Demand money value of goods that change hands,
• It is the demand for liquidity to cover or that nominal spending equals nominal
unforeseen expenditure such as an accident income
or health emergency. The demand for this
type of money increases as the income level
increases. MxV=PxY
Whereas:
M= money supply Present 133 144 174 451
Value
V= velocity of money
P= price level
Capital Charge
Y= volume of the transactions (real GDP)
ALL ARE INVESTED CAPITAL:
Fixed Assets
The velocity of money is a measure of the
Land and Building
number of times that the average unit of currency is
used to purchase goods and services within a given Plant and Equipment
time period.
Distribution Channel Assets

The Time Value of Money

Net Current Assets
• The value of money changes over time.
Cash
• Money invested in a bank today will be worth
much more in 10 years’ time Amounts owed by customers
• Money can be invested and will grow
-Credit from suppliers
• The future value of Php1 increases by the
yield % each year Raw Materials and Packaging
Work in Progress

Present Value of Php 1.00 discounted by 12% Stocks of Finished Goods

each year Net Assets x WACC = Capital Charge
1/1.12 1/1.25 1/1.40 1/1.57
0.89 0.80 0.71 0.63
Weighted Average Cost of Capital
The weighted average of cost of the equity (capital
from the shareholders) and cost of the loans
Which business is better? (borrowings – banks or other sources)
Year 1 Year 2 Year 3 Total
Business 50 180 345 575
A Equity Borrowings Total
Factor 0.89 0.80 0.71 Amounts 600 400 1,000
Present 44 144 245 433 Net Rate 15% 7%
Value Charge 90 28 118

Year 1 Year 2 Year 3 Total WACC = 188/1,000= 11.8%

Business 150 180 245 575
B
Factor 0.89 0.80 0.71 *Higher risks, higher returns
Cost of Share Funds (Equity) • It is also the cost of debt for the borrower and
the rate of return for the lender
= Expectation of the shareholders

Interest
Shareholders Expect Return:
• Money paid regularly at a particular rate for
• Dividends
the use of money lent, or for delaying the
• Share Price Appreciation
repayment of a debt
• It is distinct from a fee which the
borrower may pay the lender or some
Cost of Capital
third party
• The cost of a company’s funds: either debt, • Typically expressed as Annual
equity, or both Percentage Rate (APR)
• It is the minimum return that investors expect • The cost of using money
for providing capital to the company, thus • When you borrow, you pay interest
setting a benchmark that a business has to • When you lend or deposit funds in bank
meet accounts, you can earn interest
• If expectations are not met, they should have
placed their money in another venture
How interest rates are determined

There are two main sources of funds: • The interest rate is determined by a number
of factors such as the state of the economy,
1. Cost of the Equity – capital from the demand and supply of loanable funds, and
shareholders inflation.
2. Cost of the Loans – capital from the banks • A country’s central bank sets the interest rate.
or other sources (borrowings) • When the central bank sets interest rates
Interest Rates at a high level, the cost of the debts rises.
When the cost of debt is high, people are
• While interest rates represent interest income discouraged from borrowing and slows
to the lender, they constitute a cost of debt to consumer demand.
the borrower • A loan is considered low risk by the lender
• Companies weigh the cost of borrowing when it will have a lower interest rate. A loan
against the cost of equity, such as dividend that is considered high risk will have higher
payments, to determine which source of interest rate.
funding will be the least expensive, hence, • Higher interest rates will induce people to
the cost of capital is evaluated to achieve an save more, so loanable funds will increase.
optimal capital structure • Interest rate functions as the price in the
• It is also the amount a lender charges for the money market.
use of assets expressed as a percentage of the
principal
• The assets borrowed could include cash, Keynesian Theory
consumer goods, or large assets such as a
vehicle or building The rate of interest is determined as a price in two
markets:
 1. Investment Funds The Payment System
• The rate balances the demand for funds
Commodity Money
(required for investment) and the supply
of funds (from savings) • It is a money whose value comes from a
2. Liquid Assets commodity of which it is made
• Holding assets as readily available money • It consists of objects having value or use in
themselves (intrinsic value) as well as their
value in buying goods
Equilibrium Interest Rates

• The rate at which the quantity of money

Fiat Money
demanded is equal to the quantity of
money supplied • It is a currency without intrinsic value that
• This results to Money Market has been established as money, often by
Equilibrium government regulation
• The Central Bank can alter the • It does not have intrinsic value, and has value
equilibrium interest rate by adjusting the only because a government designed it as a
supply of money legal tender

Nominal rate vs. Real Rate Legal tender: It is recognized by law as means to
settle a public or private debt or meet a financial
1. Nominal Interest Rate
obligation.
• It refers to the interest rate before taking
inflation into account
2. Real Interest Rate
The Philippine Payment System
• It is the rate of interest an investor, saver, or
lender receives (or expects to receive) after • A fiat money system, wherein the BSP has
allowing for inflation the sole authority to issue paper currency.
Paper currency: It is valued because it is the legal
tender authorized to be used as a form of payment,
Components of Money Interest
hence, even if paper money does not have an intrinsic
1. Pure Interest or Real Interest value, people are willing to use it as a medium of
• The compensation, over, and above inflation exchange.
that a lender demands to lend his money
2. Inflation
• It is the change in the level of prices; higher What are Checks?
prices • A check is a negotiable instrument in the
3. Risk Premium form of bill of exchange.
- Liquidity Risk: The compensation that a
lender receives for investing funds in Bill of exchange: A bill of exchange is an
something that is difficult to sell unconditional order in writing addressed by one
- Credit Risk: The risk that the loan or bond person to another; signed by the person giving it;
won’t be repaid as scheduled, or not at all requiring the person whom it is addressed to pay on
demand or at a fixed determinable future time, a sum
certain in money, to order or to bearer.
Other forms of payment
1. Debit Card
Original Parties of a Bill of Exchange • A card issued by a bank allowing the holder
to transfer money electronically to another
1. Drawer
bank account when making a purchase
• The one who issues and draws the order bill.
• When used, the bank immediately credits the
• He does not pay directly.
seller’s account and debits the buyer’s
account
2. Drawee
2. Credit Card
• The party to whom the bill is addressed and
who is ordered and expected to pay.
*n case of a check, the drawee is a bank. Debit Card vs. Credit Card
Debit Cards are attached to a bank account and
allows you to spend existing funds.
3. Payee
• The one in whose favor the bill is originally Credit Cards allow you to spend on credit that you
issued or is payable. pay back at a later date.

The Importance of Checks 3. Proximity mobile payments

• Payments to a merchant that are initiated
Since checks are negotiable instruments,
from a mobile phone, using applications
Negotiable instrument: A formal document that is linked to a debit or credit card.
able to be transferred or assigned to the legal • These payments are made by simply waving
ownership of another person, thereby, facilitating a mobile phone that uses Near Field
trade. Communication (NFC) technology near a
merchant’s point-of-sale device.
1. They can be used as substitute for money
4. Automated Clearing House
2. Constitute the media of exchange for most
• The electronic clearing and settlement system
commercial transactions
used for financial transactions by commercial
- Increase the purchasing medium in
banks and other institutions.
circulation
• Example: Employers pay wages through
- Eliminate the need to count coins and bills
direct deposit to their accounts or consumers
physically remove the risk of dealing in cash
pay bills electronically out of checking
3. Serves as a medium of credit transactions
accounts.
- When cash is not available, a check can be
issued payable until a future date
Constraint on the use of checks 5. E-Money
• An electronic store of monetary value on
• It requires more trust on the part of the seller
a technical device that may be widely
as compared with accepting bills
used for making payments to entities
• The fundamental idea: The drawer has funds
other than the e-money issuer
in the hands of the drawee.
 • It can be accessed remotely via a device • Less money laundering because there is
like mobile phones or prepaid cards always a proper trail
• The device acts as a prepaid bearer • Less time and costs associated with handling
instrument which does not necessarily paper money as well as storing and
involve bank accounts in transactions depositing it
• It is essentially a private payment system • Easier currency exchange while traveling
6. Bitcoin internationally
• A digital currency (also called
cryptocurrency) that is not backed by any
country’s central bank or government DISADVANTAGES of Cashless Society
• It can be traded for goods and services
• Exposes your personal information to
with vendors who accept Bitcoins as
possible date breach
payment
• If hackers drain your bank account, you will
• The P2P network monitors and verifies
have no alternative source of money
the transfer of Bitcoins between users
• Technology problems can leave you with no
Blockchain is the underlying technology behind the access to your money
bitcoin. • The poor and those without bank accounts
will have difficulty paying and receiving
• It is technically the digital ledger in which
payments
transactions are recorded chronologically and
• Some may find it harder to control spending
publicly
when they do not see physical cash leaving
• It can allow individuals and companies to
their hands
make instantaneous transactions on a
• Banks may start charging fees to compensate
network without any middlemen if they are
for possible negative interest rates
decentralized
1 Bitcoin equals 2,492,794.04 Philippine Peso as
of February 25, 2021 On top of the expensive cost of building the
infrastructure, the disadvantages make it
difficult to attain an entirely cashless society in
Cashless Society the near future

• An economic state whereby financial

transactions are not conducted with money in
the form of physical banknotes or coins, but
rather through the transfer of digital
information, usually an electronic
representation of money between the
transacting parties

ADVANTAGES of Cashless Society

• Lower crime because there is no tangible

money to steal