Topic 1: Rationale in Studying Financial Markets and Institutions

The study of financial markets and institutions will enable you to understand how funds
are transferred from people who have an excess of available funds to people who have a
shortage.

In a market system, businesses of all types face risks, and many businesses fail.
Economists and policy makers are particularly concerned about the risk and potential failure
that financial institutions face because they play a vital role in the financial system.

Financial markets and institutions involve huge flows of funds throughout the world
economy which in turn affect business profits, the production of goods and services, and the
economic well-being of the countries around the world.

 Well-functioning financial markets are a key-factor in producing high economic growth;

 Poorly performing financial markets are one reason that many countries in the world
remain poor;
 Activities in financial markets also have direct effects on personal wealth, the behavior of
business and consumers and the cyclical performance of the economy;
 Direct fund transfers are common among individuals, small businesses and in economies
with less developed financial markets and institutions;
 Large business in developed economies find it more efficient to enlist the services of a
financial institution when the time comes to raise capital.
 Financial markets are the meeting place for people, corporations and institutions that
either need money or have money to lend or invest;
 Financial institutions are financial intermediaries that acquire funds by issuing liabilities
and in turn, use those funds to acquire assets by purchasing securities or making loan;
 Financial institutions are what make financial market work. Without them, financial
markets would not be able to move funds from people who save to people who have
productive investment opportunities.

Topic 2: Money and Interest Rates

Money is any item or commodity that is generally accepted as a means of payment for goods
and services or for repayment of debt.

Money serves as an asset to its holder — includes printed bills and minted coins by the National
Government (known as currency), and funds stored as electronic entries in checking and
savings account;

The financial system works on an entirely fiduciary basis, relying on the public’s confidence in
the established forms of monetary exchange because money is not directly backed by intrinsic
value.

 Before the invention of money, people bartered by swapping goods they produced for
things they needed from others. Barter is sufficient for simple transactions, but not
when things traded are of different values, or unavailable at the same time.
 By contrast, money has a recognized uniform value and is widely accepted.
 At the start of the modern age, individuals and governments began to establish banks,
and other financial institutions were formed.
 Eventually, ordinary people could deposit their money in bank accounts and earn
interest, borrow money for purchasing of properties, invest their wages in business, or
start business themselves.
 Banks could also insure against calamities that might devastate families or traders,
encouraging them to risk in the pursuit of profit.

Today it is the nation’s government and central bank that control a country’s economy. The
Federal Reserve is the central bank in the US. Tasked to issue their currency and regulates its
supply, and supervise member banks like deciding how much interest to charge from them to
borrow its reserve.

The central bank of the Philippines is the “Bangko Sentral ng Pilipinas”. While our
government still print and guarantee money, physical coins and notes are not as necessary
today.

Money must have the following characteristics for it to be considered the official currency used:
 must have value
 durable
 portable
 uniform
 divisible
 in limited supply
 usable as a means of exchange
 trusted by the people

Evolution of money:

Barter (10,000 - 3000BCE)

- the direct exchange of goods

Evidence of trade records (7000BCE)

- ledgers from these times read like narratives, with dates and descriptions of trades
made or terms for services rendered.
- pictures of items traded were also used to record exchanges.

Coinage (600BCE - 1100CE)

- Coins were introduced as a method of payment minting precious metals (e.g. gold, silver
and copper) in defined weights.

Bank notes (1100 - 2000)

- promissory notes or IOUs that were traded as currency and could be exchanged for
coins at any time. It was first introduced in order to avoid the heavy bulk of copper
coinage in large commercial transactions.

Digital money (2000 onward)

- virtual money

Highlights in the History of Money in the Philippines

Pre-Spanish Regime
- Barter and some coins were in used to trade with China, Java and Macau, among
others.
- The inconvenience of the barter system led to the adoption of a specific medium of
exchange – the cowry shells. Cowries produced in gold, jade, quartz and wood became
the most common and acceptable form of money through many centuries.
- The Philippines is naturally rich in gold, making possible the availability of local gold
coinage called piloncitos.
- Piloncitos are tiny engraved bead-like gold bits unearthed in the Philippines.
- The original silver currency unit was the rupee or rupiah (known locally as salapi),
brought over by trade with India and Indonesia.

Spanish Regime
- Silver coins minted in Mexico were used and called the SpanishFilipino Peso.
- The local salapi continued under Spanish rule as a half-peso coin.

American Regime
 - The United States Congress passed the Philippine Coinage Act of 1903, established the
unit of currency to be a theoretical gold peso. Thus, the Philippine Peso was introduced
and replaced the Spanish-Filipino Peso.
- The Philippine National Bank and Bank of the Philippine Island was authorized to issue
Philippine Bank Notes.

Japanese Regime
- The Japanese issued Japanese War Notes that had no reserves nor backed up by any
government asset (known as “mickey mouse” money).

Post-War Period
- All Japanese currencies were declared illegal.
- Bangko Sentral ng Pilipinas was established and Victory Money were printed.
- In 2010, “New Generation Currency” was launched introducing a massive redesign for
current banknotes and coins. These features significant events in Philippine history,
iconic buildings, natural wonders and heritage sites in a uniform sized paper money and
coins.

Supply and Demand for Money - the Role of BSP on the Impact of Money

To stabilize the purchasing power of money and to support economic growth, the BSP’s
monetary policy is vital for the economy by monitoring the supply and demand for money.

Too much money in circulation can cause inflation, while not enough money will slow
down the economy.

Increase in withdrawn yet inactive money (i.e. piggybank money) will affect the bank’s
ability to extend loans and will influence the supply of money.

Changes in the supply of money will affect the interest rate and therefore the cost of
borrowing money.

Higher interest rates will decrease investments as it becomes more expensive to borrow
money and consumption may decrease because consumers will tend to save instead as interest
rate returns increase, making demand for goods and services low. And the opposite happens
when interest rates are lowered.

Key Measures for the Money Supply:

M1 - refers primarily to money used as a medium of exchange and is the narrowest measure of
money supply. It includes highly liquid kinds of money (e.g. currency in circulation by the
nonbank public, demand deposits and traveler’s check)

M2 - refers to money stored for future use (e.g. savings deposits, money market deposit
accounts and mutual funds).

M3 - refers to money used to record wealth possessed, traded or spent-personally and

nationally (unit of account). These are not highly liquid as it depends on availability of cash
by the financial institutions or on its date of maturity (e.g. large denomination time deposits
and Eurodollar deposits)

L - this measure includes liquid and nearly-liquid assets (e.g. short-term Treasury notes, high-
grade commercial paper and bank acceptance notes).

Types of Demand for Money

Transaction demand – the money we need to purchase goods and services in day to day life
– this is related to income.

Precautionary demand – money needed for financial emergencies.

Asset motive/speculative demand – states that people demand money as a way to hold
wealth. This may occur during periods of deflation or periods where investors expect bonds
to fall in value. Also, when people wish to hold money rather than buy assets/ bonds/risky
investment due to the prevailing interest rates.

Time Value of Money relative to Interest Rate and Inflation

Interest rate is cost of using money overtime. It is the premium paid by borrowers for earlier
availability and the reward received by lenders for delaying consumption.

Interest rates are determined by the demand and supply of loanable funds.

Inflation is the rise in prices of goods and services, which can be translated as the decline of
purchasing power over time.

The rate at which purchasing power drops can be reflected in the average price increase
of a basket of selected goods and services over some period of time.

Rising prices means that, when the borrower repays the principal loan in the future, it will
not purchase as much goods and services as it would have when the funds were initially
loaned.

An increase in the supply of money typically lowers interest rates, which in

turn, generates more investment and puts more money in the hands of consumers,
thereby stimulating spending. Businesses respond by ordering more raw materials and
increasing production. The increased business activity raises the demand for labor. The
opposite can occur if the money supply falls or when its growth rate declines.

Conclusion: Money is the oil that keeps the machinery of our world turning. By giving goods
and services an easily measured value, money facilitates the billions of transaction that take
place every day

Topic 3: Financial Markets

A financial market is a market in which financial assets (securities) can be purchased or sold

Financial markets facilitate financing and investing by households, firms, and government
agencies

Surplus Units - Participants that provide funds. (e.g., households)

Deficit Units - Participants that enter markets to obtain funds. (e.g., the government)

A major participant in financial markets is the BSP, because it controls the money supply

Types of Financial Markets

Financial markets can be distinguished by the maturity structure and trading structure of its
securities

Money versus capital markets

- The flow of short-term funds is facilitated by money markets
- The flow of long-term funds is facilitated by capital markets

Primary versus secondary markets

- Primary markets facilitate the issuance of new securities
 e.g., the sale of new corporate stock or new Treasury securities
- Secondary markets facilitate the trading of existing securities
 e.g., the sale of existing stock
 Securities traded in secondary markets should be liquid
Organized versus over-the-counter markets
- A visible marketplace for secondary market transactions is an organized exchange Some
transactions occur in the over-the-counter (OTC) market (a telecommunications
network)

Knowledge of financial markets is power

- Decide which markets to use to achieve our investment goals or financing needs
- Decide which markets to use as part of your job Avoid common mistakes in investing
and borrowing

Securities Traded in Financial Markets

Money market Securities

- Money market securities are debt securities with a maturity of one year or less
- Characteristics: Liquid
Low expected return
Low degree of risk

Capital market Securities

- Capital market securities are those with a maturity of more than one year
- Capital market securities have a higher expected return and more risk than money
market securities
- Example: Bonds and mortgages
Stocks
 Bonds and Mortgages
 Bonds are long-term debt obligations issued by corporations and
government agencies
 Mortgages are long-term debt obligations created to finance the
purchase of real estate
 Bonds and mortgages specify the amount and timing of interest and
principal payments
 Stocks
 Stocks (equity) are certificates representing partial ownership in
corporations
 Investors may earn a return by receiving dividends and capital gains
 Stocks have a higher expected return and higher risk than long-term debt
securities

Derivatives Securities
- Derivative securities are financial contracts whose values are derived from the values of
underlying assets.
- Speculating with derivatives allow investors to benefit from increases or decreases
in the underlying asset.
- Risk management with derivatives generates gains if the value of the underlying
security declines.

Valuation of Securities in Financial Markets

Securities are valued as the present value of their expected cash flows, discounted at a rate
that reflects their uncertainty.

Market pricing of securities

- Different investors may value the same security differently based on their interpretation
of information

Impact of valuations on pricing

- Every security has an equilibrium market price at which demand and supply for the
security are equal
  Favorable information results in upward valuation revisions; unfavorable
information results in downward revisions
- Securities reach a new equilibrium price as new information becomes available

Impact of the Internet on the valuation process

- The valuation of securities is improved as a result of the internet because of:
 Online price quotations
 The availability of the actual sequence of transactions for some securities
 Increased information about firms issuing securities
 Online orders to buy or sell securities

Market Efficiency

Markets are efficient when security prices fully reflect all available information.

In an efficient market, different investors may still prefer different securities because of
differences in: Risk preference
Desired liquidity
Tax status

Impact of asymmetric information

- Asymmetric information is information a firm’s managers have that is not available to
investors
- The valuation process is influenced by the financial statements that are used to derive
cash flow estimates
- Securities may be mispriced because of: Flexibility in accounting guidelines
Overestimation of earnings
- The asymmetric information problem can be reduced if managers frequently disclose
financial data and information to the public or through increased regulation

Financial Market Regulation

Many regulations attempt to ensure that businesses disclose accurate information

Disclosure
- The Securities Act of 1933 intended to ensure complete disclosure of relevant financial
information on publicly offered securities
- The Securities Exchange Act of 1934 extended the disclosure requirements to secondary
market issues

Regulatory response to financial scandals

- Enron, WorldCom and other scandals involved:
 Exaggerated earnings
 Failure to disclose relevant information
 Auditors not meeting their responsibilities
- Existing regulations were not completely preventing fraud

Increased regulation is existing or emerging in these areas:

 Provision of more complete and accurate financial information
 More restrictions to ensure proper auditing by auditors
 Proper oversight by the firm’s board of directors