Chapter 1: Rationale in Studying Financial Markets and Institutions

Financial markets and institutions not only influence your everyday life but also Chapter 2: Introducing Money and Interest Rates
involve huge flows of funds (trillions) throughout the world economy which in
affect business profits, production of goods and services and economic well- Money – any item or commodity that is generally accepted as a means of
being of the countries. payments for goods and services or for repayment of debt, and that serves as an
asset to its holder. It is composed of bills and coins.
Activities in financial markets also have direct effects on personal wealth,
behavior of business and consumers and the cyclical performance of the The financial system works on an entirely fiduciary basis, relying on the public’s
economy. confidence in the established forms of monetary exchange

Financial markets have been around since mankind settled down to growing The federal reserve is the central bank in the US while in the Philippines it is the
crops and trading them with others. Bangko Sentral ng Pilipinas or BSP

Financial markets

1. Stocks Characteristics and Key Functions of Money

2. Bonds
1. Store of Value - People can store their wealth for future use.
3. Foreign Currency Exchange
2. Item of Worth - Money has an intrinsic value, such as that of the precious
metal that was used to make the coin.
Financial Institutions
3. Means of Exchange - Exchange money freely and widely for goods and its
1. Banks value should be as stable as possible.
2. Insurance Companies
4. Unit of Account - Money can be used to record wealth possessed, traded or
3. Mutual Funds
spent personally and nationally.
Direct Fund Transfer – Are common among individuals and small businesses
5. Standard of Deferred Payment - Money is useful because of its ability to
and in economies where financial markets and institutions are less developed.
serve as a standard of deferred payment. Money can facilitate exchange at a
Financial institutions – Financial intermediaries that acquire funds by issuing given point by providing a medium of exchange and unit of account.
liabilities and in turn use those funds to acquire assets by purchasing securities
or making loans.
The Evolution of Money
They reduce transaction costs, allow sharing and solve problems created by
adverse relation and moral hazard. 1. Barter (10000 – 3000 BCE) - Specific items were exchanged for others
agreed by the negotiating parties to be of similar value. The direct exchange of
Framework Underlying All Discussions
goods formed the basis of trade for thousands of years. Adam Smith, 18 th
1. Understanding century author of the Wealth of Nations, was one of the first to identify it as a
2. Evaluating precursor to money.
3. Predicting
2. Evidence of Trade Records (7000 BCE) - Pictures of items were used to
record trade exchanges, becoming more complex as values were established
and documented.

3. Coinage (600 BCE – 1100 CE) - Defined weights of precious metals used by
some merchants were later formalized as coins that were usually issued by
states.
4. Bank Notes (1100-2000) - States began to use bank notes, issuing paper - By the early 20th century, money became separated from its direct relationship
IOU’s that were traded as currency, and could be exchanged for coins at any to precious metal. By mid-20th century, new ways of money appeared such as
time. credit cards, digital transactions, and even forms of money such as
cryptocurrency. The gold standard collapsed altogether in the 1930s.
5. Digital Money (2000 onwards) - Money can now exist virtually on
computers, and large transactions can take place without any physical cash 1. Potosi Inflation (1540-1640) - The Spanish discovered silver in Potosi,
changing hands. Bolivia, and caused a century of inflation by shipping 350 tons of the metal back
to Europe annually.

2. The Great Debasement (1542-1551) - England’s Henry VIII debased the

Artifacts of Money silver penny, making it three-quarters copper. Inflation increased as trust
dropped.
1. Barter (5000 BCE) - Early trade involved directly exchanged items
3. Early Joint-Stock companies (1553) - Merchants in England began to form
2. Sumerian Cuneiform Tablets (4000 BCE) - Scribes recorded transactions
companies in which investors bought shares and shared its rewards.
on clay tablets, which could also act as receipts.
4. Bank of England (1694) - The bank of England was created as a body that
3. Cowrie Shells (1000 BCE) - Used as currency across India and the South
could raise funds at a low interest rate and manage national debt.
Pacific, they appeared in many colors and sizes.
5. The Royal Mint (1696) - Issac Newton became warden and argued that
4. Lydian Gold Coins (600 BCE) - In Lydia, a mixture of gold and silver was
debasing undermined confidence. All coins were recalled, and new silver ones
formed into disks, or coins, stamped with inscriptions
were minted.
5. Athenian Drachma (600 BCE) - The Athenians used silver from Laurion to
6. US Dollar (1775) - The Continental Congress authorized the issue of United
mint a currency used right across the Greek world
States dollars in 1775, but the first national currency was not minted by the US
6. Han Dynasty Coin (200 BCE) - Often made of bronze or copper, early Treasury until 1794.
Chinese coins had holes punched in their center.
7. Gold Standard (From 1844) - The British pound was tied to a defined
7. Roman Coin (27 BCE) - Bearing the head of the emperor, these coins equivalent amount of gold; other countries adopted a similar gold standard.
circulated throughout the Roman Empire
8. Credit Cards (1970s) - The creation credit cards enabled consumers to
8. Byzantine Coin (700 CE) - Early Byzantine coins were pure gold, later ones access short-term credit to make smaller purchases. This resulted in the growth
also contained metals such as copper. of personal debt.

9. Anglo-Saxon Coin (900 CE) - This 10th century silver penny has an 9. Digital Money (1990s) - The easy transfer of funds and convenience of
inscription stating that Offa is King of Mercia electronic payments became increasingly popular as internet use increased.

10. Arabic Dirham (900 CE) - Many silver coins from the Islamic empire were 10. Euro (1999) - Twelve EU countries joined together and replaced their
carried to Scandinavia by Vikings national currencies with the Euro. Bank notes and coins were issued three years
later.

11. Bitcoin (2008) - A form of electronic money that exists solely as encrypted
The Economics of Money data on servers is announced. The first transaction took place in January 2009
- Understanding of the nature of money became more sophisticated in the 16 th
century.
Highlights in the History of Money in the Philippines
- National banks were established in the late 17th century, with the duty of
regulating the country’s money supplies. Pre-Spanish Regime - The prevailing medium of exchange was barter; some
coins were circulating as early as the 8th century. Commodity money as gold,
gold dust, silver, wires, coffee, sugar rice, spices, carabao were used as money. 1. Transaction Demand - Money demanded for day-to-day payments through
Piloncitos and other commodities were in circulation. balances held by households and firms. Varies with GDP, it does not depend on
the rate of interest
Spanish Regime - Introduced coins in 1521. Silver coins minted in Mexico were
predominantly used in 1861, the first mint was established in order to 2. Precautionary Demand - Money demanded as a result of unanticipated
standardize coinage. payments. Varies with GDP

American Regime - First local currency, the Philippine Peso was introduced 3. Speculative Demand - Money demanded because of expectations about
replacing the Spanish Filipino Peso. The PNB was authorized to issue Bank Notes. interest rates in the future.
Later, the BPI was authorized to issue its own bank notes that were redeemable
but not made legal tender. Rate of Interest – The price paid in the money market for the use of money.

Japanese Regime - Issued Japanese War Notes. These bills had no reserves nor
backed up by any government asset and were called “mickey mouse” money.
The Quantity Theory of Money - Changes in the money supply directly
Post War Period - All Japanese currencies were declared illegal; all banks were influences the economy’s price level.
closed and all Philippine National Bank Notes were withdrawn from circulation.
M x V =P x Y
- The new treasury certificate called victory money were printed denominations
with the establishment of the Central Bank. In 1949 a new currency called Where:
Central Bank Notes was issued. M = Quantity of Money
- The Central Bank launched the New Generation Currency, which is uniform in V = Velocity of Money
size where significant events in history, buildings and heritage sites were
featured in 2010. In 2018, the New Generation Coin series were put in circulation P = Price Level

Y = Real GDP

The Supply and Demand for Money - The economy’s nominal GDP (P x Y) is equal to money actually used in the
economy (M x V)
M1 (Money used as a Medium of Exchange) – The narrowest measure of
the money supply. Includes currency in circulation held by the nonbank public, - Velocity (V) and potential real GDP (Y) is not affected by the quantity of money
demand deposits, other checkable deposits and travelers check. (M) and are constant

M2 (Money used as a store of value) – Includes money held in savings The Time Value of Money
deposits, money market deposit accounts, noninstitutional money market
mutual funds and other short-term money market assets Interest – The cost of using money over time

M3 (Money used as a Unit of Account) – Includes the financial institutions.

L – Includes liquid and near-liquid assets (short-term treasury notes, high-grade Present Value
commercial paper)
- Based on the commonsense notion that a peso of cash flow paid to you one
BSP – Responsible for determining the supply of money year from now is less valuable to you than a peso paid to you today.

Simple Loan – simplest kind of debt instrument

The Demand for Money

n
FV =PV x (1+i)
FV = Future Value

PV = Present Value

I = Interest

N = Number of Terms

According to Keynesian Theory, the rate of interest is determined as a price in Chapter 3: Payment System
two markets:
Money facilitates transactions in the economy. This mechanism is called a
1. Investment Funds payment system

2. Liquid Assets

Commodity Money - Good used as money that has value independent of its
use as money
Three Components of Money Interest
Fiat Money - Money such as paper currency that has no value apart from its
1. Risk Premium - Probability of default (risk imposed on the lender by the use as money.
possibility that the borrower may be unable to repay the loan)
Checks - Promises to pay on demand money deposited with a bank or other
2. Inflationary Premium - Expectation that the loan will be repaid with pesos financial institutions.
of less purchasing power as the result of inflation

3. Pure Interest - The real price one must pay for earlier availability
New Technology and the Payments System

The BSP supervises the payments system but doesn’t directly control it because
many payments are processed by banks and other private firms.

Five most desirable outcomes for a payment system

1. Security - Better security increases consumers and businesses confidence

that funds will not be stolen electronically

2. Efficiency - Increasing the efficiency of the payments system allows it to

function using fewer workers and computer or other capital, which benefits the
economy.

3. Speed - Fast settlement of payments facilitates transactions by both

households and businesses
4. Smooth International Transactions - Increasing amount of business that
takes place across borders can be facilitated if payments can be made quickly
and conveniently

5. Effective Collaboration among participants in the system. - Payment’s

system needs to efficiently involve government, financial firms such as banks,
and other business around the world.

Automated Clearing House (ACH) - Direct deposits of payroll checks into the
checking accounts of workers and electronic payments on car loans and
mortgages.

Automated Teller Machine (ATM)

E-Money - Digital cash people use to buy goods and services. The central bank
does not control e-money and is essentially a private payments system. Chapter 4: Financial Instruments

Bitcoin - The product of decentralized system of linked computers. Produced by Financial Instruments – Any contract that gives rise to a financial asset of one
people performing the complicated calculations necessary to ensure that online entity and a financial liability or equity instrument of another entity. These
purchases made with bitcoins are legitimate (25). 21 million bitcoins before include primary instruments and derivative financial instruments.
mining; expected to be reached in 2030
Contract – An agreement between two or more parties that has clear economic
Blockchain - A distributed ledger or an online network that registers ownership consequences that the parties have little, if any, discretion to avoid, usually
of funds, securities, or any other good, including movies and songs. because the agreement is enforceable by law.

Cashless Society - Electronic payments make up more than two-thirds of all Financial Instruments
noncash payments.
1. Financial Assets
Cashless Society may be difficult to attain because: 2. Financial Liabilities
3. Equity Instruments
- The infrastructure for an e-payments system is expensive to build. 4. Derivatives
- Many households and firms worry about protecting their privacy in an
electronic system that is subject to computer hackers, although
supporters of blockchain believe its encryption technology can overcome
Financial Asset
this problem.
1. Any asset that is

- Cash
- Petty Cash
- Demand, Savings and Time Deposit
- Undeposited Checks
- Foreign Currencies
 - Money Orders - Obligations to deliver own shares worth a fixed amount of cash
- Bank Drafts - Some derivatives on own equity instruments

2. Equity instrument of another entity (investment in ordinary shares) Equity Instruments - An equity instrument is any contract that evidence a
residual interest in the assets of an entity after deducting all of its liabilities.
- Stock Certificate
- Publicly Listed Securities Examples:

3. Receivables (Accounts, notes, loans and investment in bonds and other debt - Ordinary Shares
instrument issued by other entities) - Preference Shares

- Trade-Receivables - Warrants or written call option that allow the holder to subscribe or purchase
- Promissory Notes ordinary shares in exchange for a fixed amount of each or another financial
- Bond Certificates asset.

Derivative Financial Instruments - Derivatives are financial instruments that

“derive” their value on contractually required cash flows from some other
security or index.
4. Derivatives - A contract allowing a company to purchase a particular asset a designated
future date, at a predetermined price is a financial instrument that derives its
- Future Contracts
value from expected and actual changes in the price of the underlying asset.
- Forward Contracts
- Call Options Examples of Derivatives:
- Foreign Currency Futures
- Interest Rate Swaps 1. Future Contracts - An agreement between a seller and a buyer that requires
that seller to deliver a particular commodity at a designated future date, at a
predetermined price. Generally referred to as commodity future contract.
Purchased either as an investment or as a hedge against the risks of future price
Financial Liabilities - A financial liability is any liability that is:
changes
(a.) A contractual obligation:
2. Forward Contracts - Like a future contract but differs in three ways:
i. To deliver cash or another financial asset to another entity
I. Calls for delivery on a specific date
ii. To exchange financial assets or financial liabilities with another entity
II. Usually not traded on a market exchange
under conditions that are potentially unfavorable to the entity.
III. Does not call for a daily cash settlement for price changes in the
(b.) A contract that will of may be settled in the entity’s own equity instruments underlying contracts.
and is:
Gains and losses on forward contracts are paid only when they are closed out
i. A non-derivative for which the entity is or may be obliged to deliver a
3. Call Options - Options give its holder the right either to buy or sell an
variable number of the entity’s own equity instruments
instrument at a specified price and within a given time period. Frequently are
ii. A derivative that will or may be settled other than by the exchange of a
purchased to hedge exposure to the effects of changing interest rates. An option
fixed amount of cash or another financial asset for a fixed number of the
holder has no obligation to exercise the option. The holder of a future contract
entity’s own equity instruments.
must buy or sell within a specified period unless the contract is closed out before
Examples: delivery comes due.

- Accounts, Notes, and Loans Payable from other entities and bonds and 4. Foreign Currency Futures - Foreign loans frequently are denominated in
other debt instruments issued by the entity. the currency of the lender (Japanese Yen, Swiss Franc, German mark). If
- Derivative financial liabilities
exchange rates change, the peso equivalent of the foreign currency that must be 2. Financial Markets and Financial Institutions
repaid differs from the peso equivalent of the foreign currency borrowed. 3. The Central Bank and Other Financial Regulators.

5. Interest Rate Swaps - Exchange cash flows as of a specified date or a series

of specified dates based on a notional amount and fixed and floating rates.
Functions of the Financial System

- The main task of the financial system is to channel funds from sectors that
have a surplus to sectors that have a shortage of funds.

- Banks, insurance companies, mutual funds, stockbrokers and other financial

services firms compete to provide financial services to households and
businesses

Three key services that the financial system provides to savers and borrowers

1. Risk Sharing - Risk is the chance that the value of financial assets will
change relative to what one expects to. Splitting wealth into many assets to
reduce risk is known as diversification. The financial system provides risk sharing
Chapter 5: Overview of the Financial System by allowing savers to hold many assets.

The financial system consists of all financial intermediaries and financial markets
and their relations with respect to the flow of funds to and from households,
2. Liquidity - The ease with which an asset can be exchanged for money which
governments, business firms and foreigners, as well as the financial
savers view as a benefit. Assets created by financial system are more liquid
infrastructure.
than physical assets. The financial system has increased the liquidity of many
assets through the process of securitization

3. Information - Collection and communication of information, or facts about

borrowers and expectations of returns on financial assets. Financial markets
convey information to both savers and borrowers by determining the prices of
stocks, bonds and other securities.

Asymmetric Information – The situation in which one party to an economic

transaction has better information than does the other party. The borrower has
more information than does the lender.

Two problems arising from asymmetric information:

1. Adverse Selection – The problem investors experience in

distinguishing low-risk borrowers from high-risk borrowers before making
an investment
2. Moral Hazard – The problem investors experience in verifying that
Key Components of Financial System borrowers are using their funds as intended.

1. Financial Instruments
Transaction Costs – Cost of a trade or a financial transaction e.g. the 4. Financial intermediaries also increasingly rely on sophisticated software
brokerage commission charged for buying or selling a financial asset. to evaluate the creditworthiness of loan applicants.

Information Costs – Cost that savers incur to determine the creditworthiness

of borrowers and to monitor how they use the funds acquired.

How Financial Intermediaries Reduce “Adverse Selection”

The problem of adverse selection can be minimized if not totally avoided using
the following approaches:

1. Requiring borrowers to disclose material information on their financial

performance and financial position
2. Collecting information on firms and selling that information to investors
3. Convincing lenders to require borrowers to pledge some of their assets
as collateral which the lender can claim of the borrower defaults.

How Financial Intermediaries Reduce Moral Hazard Problems

Financial Intermediaries can reduce moral hazard problems by adopting more

stringent procedures in monitoring the borrowers use of funds. This will include: Chapter 6: The Philippine Financial System

1. Specializing in monitoring borrowers and developing effective Structure of the Philippine Financial System
techniques to ensure that the funds they loan are actually used for their
I. Banko Sentral ng Pilipinas (BSP)
intended purpose.
II. Banking Institutions
2. Imposing Restrictive Covenants
A. Private Banking Institutions

1. Universal Bank (UB) or Expanded Commercial Bank (EKB) - Any

How Financial Intermediaries Reduce Transaction Costs
commercial bank, which performs the investment house function in addition to
Transaction Costs may be reduced by adopting the following techniques: its commercial banking authority. It may invest in equities of allied and non-
allied enterprises which may either be financial or non-financial
1. Financial intermediaries take advantage of economies of scale –
reduction in average costs that results from an increase in the volume of 2. Commercial Bank or Domestic Bank (KB) - Any commercial bank that is
a good or service produced confined only to commercial bank functions such as accepting drafts and issuing
2. Financial Intermediaries can also take advantage of economies of scale letters of credit, discounting and negotiating promissory notes.
in other ways.
3. Thrift Banks (TB) - Includes savings and mortgage banks, stock savings and
3. Financial Intermediaries also take advantage of technology to provide
loan associations and private development banks. Their function is to
financial services such as those that atm networks provide.
accumulate the savings of depositors and invest them together with their
capital, loans secured by bonds, mortgages in real estate and insured
improvements thereon.
III. Non-Bank Financial Institutions
a. Stock Savings and Mortgage Bank (SSMB) - Any corporation
organized for the purpose of accumulating the savings of depositors and A. Private Non-Bank Financial Institutions
investing them, together with its capital, in readily marketable bonds
1. Investment House - Any enterprise which engages in underwriting securities
and debt securities: checks, bills of exchange and acceptance or notes
of other corporations. It also generates income from sale of investment in
arising out of commercial transactions.
securities.
b. Private Development Bank (PDB) - A bank that exercises all the
2. Investment Banks - Do not take in deposits and until very recently rarely
powers and assumes all the obligations of the savings and mortgage
lent directly to households. - Engaged in underwriting – guarantee a price to a
bank as provided in the General Banking Act except other stated. The
firm issuing stocks or bonds and then make a profit by selling the stocks or
Development Bank of the Philippines is the government counterpart of
bonds at a higher price.
the PDB and helps the PDB augment their capitalization as provide under
R.A. 4093 3. Financing Company - Primary purpose is to extend credit facilities to
consumers and to industrial, commercial or agricultural entities by discounting,
c. Stock Savings and Loan Association (SLA) - Any corporation
factoring, leasing etc.
engaged in the business of accumulating the savings of its member or
stockholders and using such accumulated funds, together with its capital 4. Securities Dealer - Any person or entity engaged in the business of buying
for loans and investment insecurities of productive enterprises. and selling securities for his own or its client’s account.
4. Rural Banks (RB) - Any bank authorized by the Central Bank to accept 5. Savings and Loan Associations (S&Ls) - Accumulate the funds of many
deposits and make credit available to farmers, businessmen and cottage small savers and then lend this money to home buyers and other types of
industries in the rural areas. borrowers. The most significant economic function of the S&Ls is to “create
liquidity”
5. Cooperative Banks - Banks established to assist the various cooperatives by
lending those funds at reasonable interest rates. 6. Mutual Funds - Corporations which accept money from savers and then use
these funds to buy stocks, bonds or short-term debt instruments issued by
business or government units.

7. Pawnshops - Persons or entities engaged in the business of lending money

B. Government Banks or Specialized Government Banking Institutions with personal property, jewelry, and other durable goods as collateral for the
loans given.
1. Development Bank of the Philippines (DBP) - Provides loans for
developmental purposes, gives loans to the agricultural sector, commercial 8. Lending Investor - Any person or entity engaged in the business of effecting
sector and the industrial sector. securities transactions, giving loans and earns interest from them.

2. Land Bank of the Philippines (LBP) - A government bank which provides 9. Pension Funds - Retirement plans funded by corporations or government
financial support in the implementation of the Agrarian Reform Program (CARP) agencies for their workers and administered primarily by the trust departments
of the government. of commercial banks.

3. Al-Amanah Islamic Investment Bank (R.A. No. 6048) - Authorizes the 10. Insurance Companies - Take savings in the form of annual premiums, then
bank to promote and accelerate the socio-economic development of the invest these funds in stocks, bonds, or real estate and finally make payments to
Autonomous Region of Muslim Mindanao (ARMM) by performing banking, the beneficiaries of the insured parties.
financing and investment operations, and to establish and participate in
11. Credit Unions - Cooperative association whose members have a common
agriculture, commercial and industrial ventures based on the Islamic concept of
bond, such as being employees of the same firm. They are the cheapest source
banking.
of funds available to individual borrowers.
B. Government Non-Bank Financial Institutions

1. Government Service Insurance System - Provides retirement benefits,

housing loans, personal loans, emergency and calamity loans to government
employees.

2. Social Security System (SSS) - Provides retirement benefits, funeral

benefits, housing loans, personal loans and calamity loans to employees who are
working in private companies and offers.

3. Pag-Ibig - Provides housing loans to both government and private

employees.

The Evolving Philippine Financial System

To counteract the downside risks and smooth functioning of the Philippine

financial system, more stringent initiatives are being pursued by the four
regulatory agencies namely:

1. Bangko Sentral ng Pilipinas (BSP)

2. Securities and Exchange Commission
3. Insurance Commission (IC)
4. Philippine Deposit Insurance Commission (PDIC)
5.
Chapter 7: Financial Markets: An Overview 6. Investing - The stock, bond and money markets provide an opportunity to
earn a return on funds that are not needed immediately, and to accumulate
Financial Markets – The meeting place for people, corporations and assets that will provide an income in future.
institutions that either need money or have money to lend or invest.
7. Risk Management - They also enable the markets to attach a price to risk,
Function of Financial Markets - Financial markets and financial intermediaries allowing firms and individuals to trade risks so they can reduce their exposure to
have the basic function of getting people together by moving funds from those some while retaining exposure to others.
who have a surplus of funds to those who have a shortage of funds.

Debt and Equity Markets

Funds in a financial market can be obtained by a firm or an individual in two

ways:

1. Debt Instrument - Most common method to issue such as bond or

mortgage. A contractual agreement by the borrower to pay the holder of the
instrument fixed peso amounts at regular intervals until a specified date.

Maturity – The number of years until that instrument’s expiration date.

< 1 year = Short term,

> 1 year < 10years = Intermediate term

>10 years = Long term

2. Equity Instruments - Examples are common or ordinary stocks. Claims to

share in the net income and the assets of a business. Equities often make
periodic payments (dividends) to their holders. Long term because they have no
What Financial Markets Do maturity date.

1. Raising Capital - Financial markets are also an important source of capital Residual Claimant – The corporation must pay all its debt holders before it
for individuals who wish to buy homes or cars, or even to make credit-card pays its equity holders.
purchases.
Financial Market – Functions both as primary and secondary markets for debt
2. Commercial Transactions - Financial markets provide the grease that and equity securities.
makes many commercial transactions possible.

3. Price Selling - Financial Markets provide price discovery, a way to determine

Primary Market - Original sale of securities by governments and corporations.
the relative values of different items, based upon the prices at which individuals
are willing to buy and sell them. There are two types of primary market transactions:
4. Asset Valuation - Market prices offer the best way to determine the value of Public Offerings – Selling securities to the general public. It must be registered
a firm or of the firm’s assets, or property. with the SEC
5. Arbitrage - Currencies may trade at very different prices in different Public Placement – Negotiated sale involving a specific buyer.
locations. As traders in financial markets attempt to profit from these
divergences, prices move towards a uniform level, making the entire economy
more efficient.
 Listing – Admission of securities to dealings on a recognized stock exchange of
any incorporated company, central and stage governments.
Secondary Market - After securities are sold to the public, they can be traded
in the secondary market between investors. It is known as Stock Market or - Objective is to provide liquidity and marketability to listed securities and ensure
Exchange effective monitoring of trading for the benefits of all participants of the market.

Brokers – Agents of investors who match buyers with sellers of securities - Recognized stock exchange – Stock exchange being recognized by the
national government through the SEC.
Dealers – Link buyers and sellers by buying and selling securities and stated
prices. - Brokers – Securities bought and sold in recognized stock exchange through
members

- Official Quotation – Price at which the securities are bought and sold on a
Two broad segments of the stock market: recognized stock exchange.
1. The Organized Stock Exchange - Have a physical location where stocks
buying and selling transactions take place in the stock exchange floor (e.g. PSE,
New York Stock Exchange) The securities of an entity may be listed at any of the following stages:

2. The Over the Counter (OTC) Exchange - Shares, bonds and money market  At the time of public issue of shares or debentures
instruments are traded using a system of computer screens and telephones.  At the time of rights issue of shares or debentures
Example is NASDAQ  At the time of bonus issue of shares
 Shares issued on amalgamation or merger

Secondary Markets serve two important functions:

The Philippine Stock Exchange - National stock exchanged of the Philippines.
1. The make it easier to sell these financial instruments to raise cash and make it
more liquid. Created in 1992 from the merger of the Manila Stock Exchange and Makati Stock
Exchange. The main index for PSE is the PSE composite Index (PSEi) composed
2. They determine the price of the security that the issuing firm sells in the of thirty listed companies. Overseen by a 15-member BOD chaired by Jose T.
primary market. Pardo. It was Formed on December 23, 1992 and MSE is established on August
12, 1927, on Muelle de la industria, Binondo Manila, MkSE is established on May
15, 1963 based in the Makati Central Business District.
Stock Exchange - An organized market where securities like shares,
Day Trading – Buying and selling of shares, currency, or other financial
debentures of public companies, government securities and bonds issued by
instruments in a single day. The intention is to profit from small price
municipalities, public corporations, and other local authorities are purchased and
fluctuations.
sold.

- Purpose is to facilitate the exchange of securities between buyers and sellers,

thus providing a market place, virtual or real. Potential Day Traders Should Be Knowledgeable of the Following:
Listing Agreement – Ensures that the company provides all the information 1. Market Data - Current trading information for each day-trading market.
pertaining to its working from time to time.
2. Scalping - Strategy in which traders hold their share or financial asset for just
- Known as barometer of the company’s economy a few minutes or even seconds.

3. Margin Trading - Buying shares that involves the day trader borrowing a part
of the sum needed from the broker who is executing the transaction.
Listing of Securities on Stock Exchange
4. Bid-Offer Spread - The difference between a price at which a share is sold, 2. Deregulation - Individual investors need substantial protection, but that
and that at which it is bought. dealing involving institutional investors requires little regulation.

3. Liberalization - Reduction of regulations has been accompanied by a general

liberalization of rules governing participation in the markets.

4. Consolidation - Liberalization has led to consolidation, as firms merge to

Potential Day Traders Should Be Aware That take advantage of economies of scale or to enter other areas of finance.
1. Day Trading is a High-Risk Occupation - Day traders suffer severe losses 5. Globalization - Most of the important financial firms are now highly
in their first months to trading, and many never graduate to profit-making international, with operations in all the major financial centers.
status.
Chapter 8: Money Markets and Capital Markets
2. Day trading is Stressful - Day traders must watch the market nonstop
during the day, concentrating on dozens of fluctuating indicators in the hope of Money Market – Network of corporations, financial institutions, investors and
spotting market trends. governments which deal with the flow of short-term capital. They exist to
provide the loans that financial institutions and governments need to carry out
3. Day Trading is Expensive - Day traders pay large sums in commissions, for their day-to-day operations. Primary function is for banks and other investors
training and for computers. with liquid assets to gain a return on their cash or loans.

Rise of Formal Markets Who Uses the Money Market?

Important attributes that smaller markets often lack: Companies Banks Investors
Commercial paper, Certificate of deposit Financial instruments in
1. Liquidity - The ease with which trading can be conducted.
unsecured loans for with a set interest rate which sums of less than
2. Transparency - Availability of prompt and complete information about trades P100,000 or more that and fixed-term maturity P50,000 can be invested
and prices. mature within 1-9 of up to five year. in money market funds.
months
3. Reliability - Ensuring that trades are completed quickly according to the
terms agreed.
Types of Money-Market Instruments
4. Legal Procedures - Adequate to settle disputes and enforce contracts.
Money Market Securities – Short-term instruments with an original maturity of
5. Suitable Investor Protection and Regulation - Trading will be deterred if less than one year.
investors lack confidence in the available information about the securities they
1. Commercial paper - Short-term debt obligation of a private sector firm or a
wish to trade, the procedures for trading, the ability of trading partners.
government sponsored corporation.
6. Low Transaction Costs - Participants will strive to complete them in places
2. Bankers Acceptances - Promissory note issued by a non-financial firm to a
where trading costs, regulatory costs and taxes are reasonable
bank in return for a loan. The bank resells the note in the money market at a
discount and guarantees payment.

The Forces of Change 3. Treasury Bills - Securities with a maturity of one year or less issued by
national government.
1. Technology - Abundant computing power and cheap telecommunications
have encouraged the growth of entirely new types of financial instruments. 4. Government Agency Notes - National government agencies and
government-sponsored corporation are heavy borrowers in the money market
5. Local Government Notes - Issued by provincial or local governments, and Trading Process for Corporate Bonds
by agencies of these governments such as school’s authorities and transport
commissions.

6. Interbank Loans - Loans extended from one bank to another with which it
has no affiliation.

7. Time Deposit - Interest bearing bank deposits that cannot be withdrawn

without penalty before a specified date.

8. Repos - Repurchase agreement known as repos, serve to keep markets highly

liquid, which in turn ensures that there will be a constant supply of buyers for
new-money market instruments.

Other arrangements can be as follows:

Capital Markets - A financial market in which longer-term debt and equity
instruments are traded. Securities include bonds, stocks and mortgages. Often 1. Competitive Sale – The investment bank can purchase the bonds through
held by financial intermediaries such as insurance companies and pension funds. competitive bidding against other investment banks or by directly negotiating
with the issuer.

2. Negotiated Sale – A single investment bank obtains the exclusive right to

Capital Market Participants originate, underwrite and distribute the new bonds through a one-on-one
negotiation process. The investment bank provides the origination and advising
- National and local government
services to the issuer.
- Corporations
3. Best Efforts Underwriting Basis - In their arrangement, the underwriter
National Government – Issues long-term notes and bonds to fund the national
does not guarantee a firm price to the issuer. The investment bank incurs no risk
while local governments issue notes and bonds to finance capital projects.
of mispricing the security since it simply seeks to sell the securities at the best
Corporations – Issues long-term and bonds and stock to finance capital market price it can get for the issuing firm.
investment expenditure and fund other investment opportunities.
Advantages and Disadvantages of Using Bonds

Advantages Disadvantages
Capital Market Trading - Occurs in either primary or secondary market. When 1. Long-term debt is generally less 1. Debt (other than income bonds)
firms sell securities for the very first time, the issue is an initial public offering expensive than other forms of results in interest payments that, if
(IPO), Subsequent sales of a firm’s new stocks or bonds to the public are simply financing because (a) investors view not met, can force the firm into
primary market transactions. debt as a relatively safe investment bankruptcy.
alternative and demand a lower rate
A. Bonds – Long term promissory note issued by the firm. Bond Certificate – the of return, and (b) interest expenses 2. Debt (other than income bonds)
tangible evidence of debt issued by a corporation and represents a loan made by are tax deductible. produces fixed charges, increasing
investors to the issuer. Investors are to receive exactly he same two sets of cash the firm's financial leverage Although
2. Bondholders do not participate in this may not be a disadvantage to all
flows:
extraordinary profits, the payments firms, it certainly is for some firms
I. The periodic interest payments are limited to interest. with unstable earnings streams.
II. The principal (par value or face value)
3. Bondholders do not have voting 3. Debt must be repaid at maturity
rights. and thus at some point involves a
 major cash outflow C. A Low Variability of Past Earnings
4. Flotation costs of bonds are D. Large Firm Size
generally lower than those of ordinary 4. The typically restrictive nature of E. Little Use of Subordinated Debt
(common) equity shares indenture covenants may limit the
firm's future financial flexibility. The poorer the bond rating, the higher the rate of return demanded in the
capital markets.

Credit Rating – Provide an indicator of default risk that in turn affects the rate
of return that must be paid on borrowed funds. An example and description of
Bonds Features and Prices these ratings follows:

1. Par Value – The face value of the bond that is returned to the bondholder at Credit Risk Credit Description
maturity. Rating
Investment Grade
2. Coupon Interest Rate – The percentage of the par value of the bond that Highest Quality AAA The obligor's (issuer's) capacity to
will be paid out annually in the form of interest. Formula: Stated Interest meet its financial commitment on
Payment / Par Value the obligation is extremely strong.
High Quality AA The obligor's capacity to meet its
3. Maturity – The length of time until the bond issuer returns the par value to financial commitment on the
the bondholder and terminates the bond. obligation is very strong
Upper Medium Grade A The obligor's capacity to meet its
4, Indenture – The agreement between the firm issuing the bonds and the bond
financial commitment on the
trustee who represents the bondholders.
obligation is still strong, though
5. Current Yield – Refers to the ratio of the annual interest payment to the somewhat susceptible to the
adverse effects of changes and
bond’s market price.
economic conditions.
6. Yield to Maturity – Refers to the bond’s internal rate of return. It is the Medium Grade BBB The obligor exhibits adequate
discount rate that equates the present value of the interest and principal protection. However, adverse
payments with the current market price of the bond. economic conditions or changing
circumstances are more likely to
Formula: lead a weakened capacity to meet
its financial commitment.
Below Investment Grade
Somewhat Speculative BB Faces major ongoing uncertainties
Principal Payment −Price of the Bond ¿
Approxiamte Yield=Annual Interest Payment + Maturity or exposure to adverse business,
Number of Years ¿ .6 ( Price of Bond )+.4 (Principal Payment
financial, or)economic conditions
which could lead to the obligor's
inadequate capacity to meet its
financial commitment.
Credit Quality Risk – The chance that the bond issuer will not be able to make Speculative B Adverse business, financial, or
timely payments economic conditions will likely
impair the obligor's capacity or
Bond ratings involve a judgment about the future risk potential of the bond the willingness to meet its
provided by rating agencies such as Moody's, Standard and Poor's and Fitch financial commitment.
IBCA, Inc. Dominion Bond Rating Services. Bond ratings are favorably affected Highly Speculative CCC Currently vulnerable to
by: nonpayment, and is dependent
upon favorable business, financial,
A. A Low Utilization of Financial Leverage and economic conditions for the
B. Profitable Operations obligor to meet its financial
 commitment. e. Open-end Mortgage Bonds - Allow the issuance of additional
Most Speculative CC Currently highly vulnerable to mortgage bonds using the same secured assets as security.
nonpayment. However, a restriction may be placed upon the borrower, requiring
Imminent Default C Used to cover a situation where a that additional assets should be added to the secured property if
bankruptcy petition has been filed new debt is issued.
or similar action taken, but f. Limited Open-end Mortgage Bonds - These bonds allow the
payments on this obligation are issuance of additional bonds up to a limited amount at the same
being continued priority level using the already mortgaged assets as security.
Default D Obligations are in default, or the
filing of a bankruptcy petition has Other Types of Bonds
occurred, and payments are
jeopardized. 1. Floating Rate or Variable Rate Bonds - The interest payment changes
with market conditions. In periods of unstable interest rates this type of debt
offering becomes appealing to issuers and investors. To the issuer, this type of
Types of Bonds debt eliminates some of the risk and variability in earnings that accompany
1. Unsecured Long-Term Bonds interest rate swings. To the investor, it eliminates major swings in the market
value of the debt that would otherwise have occurred if interest rates had
A. Debenture - These are unsecured long-term debt and backed only by changed.
the reputation and financial stability of the corporation.
B. Subordinated Debenture - Claims of bondholders of subordinated 2. Junk or Low-Rated Bonds - Bonds rated BB or below. The major participants
debentures are honored only after the claims of secured debt and of this market are new firms that do not have an established record of
unsubordinated debentures have been satisfied performance. although in recent years junk bonds have been increasingly issued
C. Income Bonds - An income bond requires interest payments only if to finance corporate buyouts. Since junk bonds are of speculative grade, they
earned and nonpayment of interest does not lead to bankruptcy. Usually carry a coupon rate of between 3 to 5 percent more than AAA grade long-term
issued during the reorganization of a firm facing financial difficulties. debt. As a result, there is now an active market for these new debt instruments.

2. Secured Long-Term Bonds 3. Eurobonds - These are bonds payable or denominated in the borrower's
currency, but sold outside the country of the borrower, usually by an
A. Mortgage Bonds - a bond secured by a lien on real property. international syndicate of investment bankers. This market is denominated by
Typically, the market value of the real property is greater than that of the bonds stated in U.S. dollars. Eurobonds are also referred to as bonds issued in
mortgage bonds issued. This provides the mortgage bondholders with a Europe by an American company and pay interest and principal to the lender in
margin of safety in the event that the market value of the secured U.S. dollars. The use of Eurobonds by U.S. firms to raise funds has fluctuated
property declines. dramatically with the relative interest rates an abundance or lack of funds in the
European markets dictating the degree to which they are used.
Mortgage bonds can be subclassified as follows:

a. First Mortgage Bonds - The first mortgage bonds have the senior
claim on the secured assets if the same property has been pledged 4. Treasury Bonds - carry the "full-faith-and-credit" backing of the government
on more than one mortgage bond. and investors consider them among the safest fixed- income investments in the
b. Second Mortgage Bonds - These bonds have the second claim on world. The BSP sells Treasury securities through public auctions usually to
assets and are paid only after the claims of the first mortgage bonds finance the government's budget deficit. When the deficit is large, more bonds
have been satisfied. come to auction
c. Blanket or General Mortgage Bonds - All the assets of the firm
are used as security for this type of bond.
d. Closed-end Mortgage Bonds - The closed-end mortgage bonds
forbid the further use of the pledged assets security for other bonds. B. Ordinary (Common) Equity Shares
This protects the bondholders from dilution of their claims on the
assets by any future mortgage bonds.
A form of long-term equity that represents ownership of interest of the firm. votes it can elect all of the directors and prevent minority shareholders
Ordinary equity shareholders are called residual owners because their claim to from electing any directors.
earnings and assets is what remains after satisfying the prior claims of creditors b. Cumulative Voting - a voting system that permits the shareholder to
and shareholders. They are the true owner of the corporation and consequently cast multiple votes for a single director. Cumulative voting assessed
bear the unlimited risks and rewards of ownership. minority shareholders in electing at least one director. Community voting
is required in some jurisdiction for electing the board of directors.
Ordinary shareholders are considered to be residual domains. This means that
ordinary shareholders have the right to claim any cash flows or value after all 5. Book Value per Share – The accounting value of an ordinary share is equal
other claimants have received what they are owed to the ordinary share equity (ordinary share plus pain in capital plus retained
earnings) divided by the number of shares outstanding.
Features of Ordinary Equity Shares
6. Numerous Rights of Stockholders - collective and individual rights of
1. Par Value/No Par Value – Ordinary shares may be sold with or without par ordinary equity shareholders include among others:
value. Par value of ordinary equity share is the stated value attached to a single
share at issuance. If shares are sold more than its par value, the excess is A. Right to vote on specific issues as prescribed by the corporate charter
recorded as additional paid in capital, capital surplus or capital in excess of par. such as election of the board of directors, selecting the firms’
A firm issuing no par share may either assign a stated value or place it on the independent auditors, amending the articles of incorporation and bylaw,
books at the price at which the equity share is sold. increasing the amount of authorized stock and so forth.
B. Right to receive dividends if declared by the firm's board of directors.
2. Authorized, Issued and Outstanding – The number of issued shares may C. Right to share in the residual assets in the event of liquidation.
be greater than the number of outstanding shares because shares may be D. Right to transfer their ownership in the firms to another party.
repurchased by the issuing firm. E. Right to examine the corporate banks.
F. Right to share proportionally in the purchase of new issuance of equity
 Authorized Shares – The maximum number of shares that a
shares. This is known as a preemptive right.
corporation may issue without amending its charter.
 Issued Shares – The number of authorized shares that have been sold. C. Preferred Share
 Outstanding Shares – Those shares held by the public. (Issued shares
less treasury shares) - A class of equity shares which has preference over ordinary (common) equity
 Treasury Shares – Previously issued shares that are reacquired and shares in the payment of dividends and in the distribution of corporation assets
held by the firm in the event of liquidation. Preferred shares generally has no voting privileges
but it is a form of equity from a legal and tax stand point
3. No Maturity – Ordinary equity share has no maturity and is a permanent
form of long-term financing. Although it is neither callable nor convertible, the Preference - Holders of the preferred share must receive a dividend (in the case
firm can repurchase its shares in the secondary markets. Tender offer – A formal of a going concern firm) before holder of ordinary (common) equity shares are
offer to purchase shares of a corporation. entitled to anything

4. Voting Rights – Each share of ordinary equity generally entitles the holder to The issuance of preferred shares is favored when the following conditions
vote on the selection of directors and in other matters. Shareholders unable to prevail:
attend the annual meeting to vote may vote by proxy. A proxy is a temporary
transfer of the right to vote of another party. 1. Control problems exist with the issuance of ordinary share
2. Profit margins are adequate to make of additional leverage attractive
Two common systems of Voting: 3. Additional debt poses substantial risk
4. Interest rates are low lowering the cost of preferred share
a. Majority Voting - a voting system that entitles each shareholder to has 5. The firm has a high debt ratio, suggesting infusion of equity financing is
one vote for each share owned. It is used to indicate the ordinary equity needed.
shareholders approval or disapproval of most proposed managerial
actions on which shareholders may vote. The directors receiving the Preferred Share Features
majority of the votes are elected. If a group controls over 50% of the
1. Par Value - Face value that appears on the stock certificate. In some cases, must be paid on preferred share before they can be paid on the ordinary
the liquidation value per share is provided for in the certificate (common) equity share, and in the event of bankruptcy, the claims of the
preferred shareholders must be satisfied before the ordinary (common) equity
2. Dividends - Percentage of the par value and are commonly fixed and paid shareholders receive anything. To reinforce these features, most preferred
quarterly but are not guaranteed by the issuing firm. Some recent preferred shares have coverage requirements similar to those on bonds
share issues called adjustable rate, variable rate, or floating rate preferred, do
not have a fixed dividend rate but peg dividends to an underlying index such as 9. Call Provision - A call provision gives the issuing corporation the right to call
one of the Treasury bill rate or other money market rates. in the preferred share for redemption. As in the case of bonds, call provisions
generally state that the company must pay an amount greater than the par
3. Cumulative and Noncumulative Dividends - Dividends payable to value of the preferred share, the additional sum being termed a call premium
preferred shares are either cumulative or noncumulative; most are cumulative. If
preferred dividends are cumulative are not paid in a particular year, they will be 10. Maturity - Three decades ago, most preferred shares were perpetual - it had
carried forward as an arrearage. Usually, both accumulated (past) preferred no maturity and never needed to be paid off However, today most new preferred
dividends and the current preferred dividends must be paid before the ordinary share has a sinking fund and thus an effective maturity date.
equity shareholders receive anything. If the preferred dividends are
noncumulative, dividends not declared in any particular year are lost forever and
the preferred shareholders cannot claim such anymore
Preference Share Valuation
4. No Define Maturity Date - Preferred share is usually intended to be a
Preferred share valuation is relatively simple if the firm pays fixed dividends at
permanent part of a firm's equity and has no definite maturity date. Sometimes
the end of each year. If this condition holds, then the stream of dividend
carries special retirement provisions. Almost all preferred shares have a call
payments can be treated in perpetuity and be discounted by the investor's
feature that gives the issuing firm the option of purchasing the share directly
required rate of return on a preferred share issue. A perpetuity is an annuity with
from its owners, usually at a premium above its par value. Some preferred
an infinite life span. If the preferred share has high risk, investors normally
shares have a sinking fund provision that requires the issuer to repurchase and
require a higher rate of return. This is because creditors have priority over
retire the share on a scheduled basis. Owners of convertible preferred share
preferred shareholders in their claims to both income and assets.
have the option of exchanging their preferred share for ordinary (common)
equity share based on specified terms and conditions. Thus, the intrinsic value of a share of preferred share (P.) is the sum of the
present values of future dividends discounted at the investor's required rate of
5. Convertible Preferred Share - Owners of convertible preferred share have
return. This also can be determined using the following valuation model.
the option of exchanging their preferred share for ordinary (common) equity
share based on specified terms and conditions.

6. Voting Rights - Preferred share does not ordinarily carry voting rights.
Special voting procedures may take effect if the issuing firm omits its preferred
dividends for a specific time period. Preferred shareholders are then permitted to
elect a certain number of members to the board of directors in order to
represent the preferred shareholder interests.

7. Participating Features - Participating preferred share entitles its holders to

share in profits above and beyond the declared dividend, along with ordinary
(common) equity shareholders. Most preferred share issues are non- In the Philippines, the following preferred shares are actively traded in the
participating. Without non-participated preferred, the return is limited to the Philippine Stock Exchange:
stipulated dividend.
 First Philippine Holding - Preferred
8. Protective Features - Preferred share issues often contain covenants to  San Miguel Purefoods - Preferred
assure the regular payment of preferred share dividends and to improve the  Petron Corporation Perpetual - Preferred
quality of preferred share. Preferred shareholders have priority over ordinary  Swift Foods, Inc. - Convertible Preferred
(common) equity shareholders with regard to earnings and assets. Dividends
COMPARATIVE FEATURES OF ORDINARY EQUITY SHARES, PREFERRED SHARES
AND BONDS

Ordinary Equity Preferred Bonds

Shares Shares
(a) Ownership Belongs to Limited rights Limited rights
and control of the ordinary equity when dividends under default in
firm shareholders are missed interest
through voting payments
rights and
residual claim to
income
(b) Obligation to None Must receive Contractual
provide payment before obligation
ordinary
shareholder
(c) Claim to Lowest claim of Bondholders and Highest claim
assets in any security creditors must be
bankruptcy holder satisfied first
(d) Cost of Highest Moderate Lowest
distribution
(e) Risk-return Highest risk Moderate risk Lowest risk
trade off highest return (at moderate return moderate return
least in theory)
(f) Tax status of Not deductible Not deductible Tax deductible
payment by cost = Interest
corporation payment x (1-Tax
rate)
(g) Tax status of A portion of Same as ordinary Government
payment to dividend paid to shares bond interest is
recipient another tax exempt
corporation is tax
exempt