THE FINANCIAL MARKETS

What is Financial Market?

 The financial markets are financial institutions and systems that facilitate transactions in all types of
financial claims. They are the heart of the financial institution. They are usually classified into money
market and the capital market.

 A financial market is a market in which people and entities can trade financial securities such as stocks
and bonds.

 The financial markets are the venues for buying and selling financial instruments.

The Role of Financial Market in the economy

A financial market helps the economy in the following manner:

1. Saving Mobilization
2. Investment
3. National Growth
4. Entrepreneurship growth
5. Industrial development

Classification of Financial Market

1. As to term or maturity
a. Money Market
b. Capital Market

2. As to type of issue
a. Primary Market
b. Secondary Market

MONEY MARKET

The money market is where short-term funds are raised through the buying and selling of short term,
marketable and low risk debt securities which are known as money market instruments—have maturities
ranging from one day to one year and are extremely liquid. The suppliers of funds for money market
instruments are institutions and individuals with a preference for the highest liquidity and the lowest risk.

The money market is important for businesses because it allows companies with a temporary cash
surplus to invest in short-term securities, and it also allows companies with a temporary cash shortfall to sell
securities or borrow funds on a short-term basis. In essence, it acts as a repository for short-term funds. The
money market is not a physical place, but an informal network of banks and traders linked by telephones, fax
machines, and computers. Money markets exist both in the Philippines and abroad.
Examples of Money Market Instruments

1. TREASURY BILLS Treasury bills (T-bills) are short-term notes issued by the governments. They come
in three different lengths to maturity: 90, 180, and 365 days. The two shorter types are auctioned
on a weekly basis, while the annual types are auctioned monthly. T-bills can be purchased directly
through the auctions or indirectly through the secondary market.

2. AGENCY NOTES. These obligations are not generally backed by the government, so they offer a
slightly higher yield than T-bills, but the risk of default is still very small. Agency securities are
actively traded, but are not quite as marketable as T-bills. Corporations are major purchasers of this
type of money market instrument.
3. SHORT-TERM TAX EXEMPTS These instruments are short-term notes issued by state and municipal
governments. Although they carry somewhat more risk than T-bills and tend to be less negotiable,
they feature the added benefit that the interest is not subject to income tax. For this reason,
corporations find that the lower yield is worthwhile on this type of short-term investment.

4. NEGOTIABLE CERTIFICATES OF DEPOSIT. Certificates of deposit (CDs) are certificates issued by a

bank against deposited funds that earn a specified return for a definite period of time. They are
one of several types of interest-bearing "time deposits" offered by banks. An individual or company
lends the bank a certain amount of money for a fixed period of time, and in exchange the bank
agrees to repay the money with specified interest at the end of the time period. The certificate
constitutes the bank's agreement to repay the loan. The maturity rates on CDs range from 30 days
to six months or longer, and the amount of the face value can vary greatly as well. There is usually a
penalty for early withdrawal of funds, but some types of CDs can be sold to another investor if the
original purchaser needs access to the money before the maturity date.

5. COMMERCIAL PAPER Commercial paper refers to unsecured short-term promissory notes issued
by corporations. Commercial paper has maturities of up to 270 days (the maximum allowed
without SEC registration requirement). It is typically issued by large, credit-worthy corporations
with unused lines of bank credit and therefore carries low default risk.

6. BANKERS' ACCEPTANCES "A banker's acceptance begins life as a written demand for the bank to
pay a given sum at a future date. The bank then agrees to this demand by writing 'accepted' on it.
Once accepted, the draft becomes the bank's IOU and is a negotiable security. This security can
then be bought or sold at a discount slightly greater than the discount on Treasury bills of the same
maturity." Bankers' acceptances are generally used to finance foreign trade, although they also
arise when companies purchase goods on credit or need to finance inventory. The maturity of
acceptances ranges from one to six months.

7. REPURCHASE AGREEMENTS Repurchase agreements—also known as repos or buybacks—are

Treasury securities that are purchased from a dealer with the agreement that they will be sold back
at a future date for a higher price. These agreements are the most liquid of all money market
investments, ranging from 24 hours to several months. In fact, they are very similar to bank deposit
accounts, and many corporations arrange for their banks to transfer excess cash to such funds
automatically.
 8. MONEY MARKET DEPOSIT ACCOUNTS (MMDAs). MMDAs are usually refer to a liquid funds
account placed in the form of savings accounts that is held with a retail financial institution, usually
a bank that offer a higher rate of interest that ordinary. It is a type of hybrid account combining
some elements of a savings account and a checking account.
9. MONEY MARKET MUTUAL FUNDs (MMMF). These are offered by investment companies. They are
investment pools that buy safe, short-term securities.
10. Exchange-Traded Fund (ETF). These are investment funds that are traded on stock exchange. It
combines the feature of mutual funds and stocks.
11. Certificates of Assignment. An agreement that transfer the rights of the seller over a security in
favor of the buyer.

CAPITAL MARKET

The capital market is where long-term funds are raised through the bond market and stock market.
Bond market deals with longer and riskier debt securities such as bonds, while the stock market deals with
equity securities or stocks. Basically, it is in the capital market, called the stock market, where an investor can
buy and sell stocks.

The Capital Market Instruments

Financial instrument traded in the capital market consist of debt and equity instrument with maturities
greater than one year. These instruments are as follows:

1. Stocks/ Corporate Stocks

2. Corporate, Treasury, Municipal Bonds
3. Mortgage-backed securities

A. Stocks/ Corporate Stocks

Stocks are ownership equity in a corporation allowing the holders to enjoy some of the profits in the
form of dividends and share some of the risks. These are traded on exchange and their prices may vary
from day to day, depending on their desirability and economic conditions.

Classifications of stocks. Stocks may be classified based on the rights of stockholders, nature of
business, risk and potential for earning, marketability, market capitalization, and citizen of investors.

1. As to rights of stockholders

Based on the rights of stockholders, stocks may be classified as common stock and preferred stocks.
Each type of corporate stock offers a shareholder certain rights and limitations.

Common Stock. The holders of common stock can reap two main benefits from the issuing
company: capital appreciation and dividends. Capital appreciation occurs when a stock's value
increases over the amount initially paid for it. The stockholder makes a profit when he or she
 sells the stock at its current market value after capital appreciation. Dividends, which are
taxable payments, are paid to a company's shareholders from its retained or current earnings.

Typically, dividends are paid out to stockholders on a quarterly basis. These payments are
usually made in the form of cash, but other property or stock can also be given as dividends.

Preferred Stock. Preferred stock refers to that portion of owners’ equity that enjoys
preferences over common stocks. It doesn't offer the same potential for profit as common
stock, but it's a more stable investment vehicle because it guarantees a regular dividend that
isn't directly tied to the market like the price of common stock. The other advantage of
preferred stock is that preferred stockholders get priority when it comes to the payment of
dividends. In the event of a company's liquidation, preferred stockholders get paid before those
who own common stock. In addition, if a company goes bankrupt, preferred stockholders enjoy
priority distribution of the company's assets, while holders of common stock don't receive
corporate assets unless all preferred stockholders have been compensated (bond investors take
priority over both common and preferred stockholders). Like common stock, preferred stock
represents ownership in a company. However, owners of preferred stock do not get voting
rights in the business.

The different types of preferred stock include:

1. Participating preferred stock, which entitles holders to dividend increases if, during a given
year, common stock dividends exceed those of preferred stock dividends.

2. Adjustable-rate preferred stock, which is tied to Treasury bill or other rates. The dividend is
augmented based on the shifts in interest rates, determined by an established formula.

3. Convertible preferred stock, which has a conversion price named at its issuance so that it can
be converted to a company's common stock at the set rate.

4. Straight or fixed-rate perpetual stocks, which have no maturity, because the dividend rate is
set for the life of the issue.

2. As to nature of business
Stock are classified as bank and financial services, industrial and commercial, mining and oil.
These classifications are modified to separate banks from financial services and to subdivided industrial
and commercial into communications, power and energy, transportation services, holding firms, hotel
and recreation and other services.

3. As to Risk and Earning Potentials

Considering the risk and potentials for earnings, stocks may be classified as blue chips, growth, cyclical,
defensive and speculative.

 BLUE CHIPS. These belong to large companies which have a long record of earnings and
dividends payments. They are also known as value stocks. Although returns are moderate, they
are low-risk and are dependable. Investment in this kind of stocks is called value investment.

 GROWTH STOCKS. These belong to corporations with growth rate faster than that of the
general economy. The growth may be in terms of revenue, net income and productive assets.
  CYCLICAL STOCKS. Their earnings and prices move with the changes in the national economy.

 DEFENSIVE STOCKS. Their earnings are not affected so much by changes in the economy. They
belong to corporations engaged in foods and public utilities.

 SPECULATIVE STOCKS. These belong to companies that are not yet operating profitably but are
expected to do so in the future.

4. As to their marketability

In relation to marketability of stocks, they are classified as listed or unlisted depending on whether
they are listed in the stock exchange or not. Marketability of stocks. A stocks investor prefers to buy
shares that he can easily dispose.

5. As to Market Capitalization
Market capitalization refers to the total market value of shares of stocks listed in the stock exchanges.
Accordingly, stocks are classified as first liners, second liners and third liners. Market capitalization
refers to the market value of the total number of shares outstanding of a corporation.

6. As to Citizenship of Investors
Stocks are classified into Class A and Class B. Class A may be bought by Filipinos only. Foreign investors
are allowed to buy Class B only due to the prohibitions for foreigners to own more than 40% equity in
Philippine corporations.

B. BONDS

Bond is a certificate of indebtedness with fixed interest rate and maturity date. It is a formal and
unconditional promise, made under seal, to pay a specified sum of money at a determinable future date and
to make periodic payments at a stated rate until the principal amount is paid. The written agreement on bonds
issues between the issuing party and the bondholder is called bond indenture. Bonds may be short-terms
investment when they are listed in the stock exchanges so that a bondholder can sell his holdings anytime he
wants to.

Classification of Bonds. Bonds may be classified as follows:

A. As to the issuing party:

1. Government bonds—issued by a government unit.
2. Commercial bonds—issued by a private corporations.

B. As to security:
1. Mortgage bonds—secured by lien on real property.
2. Equipment trust bonds—secured by equipment of the company.
3. Collateral trust bond—secured by securities invested in by the issuing company.
4. Debenture bonds—secured by all of the free assets of the issuing company so that in
effect they are not secured by any specific.

C. As to maturity of principal:
1. Straight bonds—the entire principal will mature at one time.
2. Serial bonds—the principal matures installment.
3. Convertible bonds—they can be exchanged for other securities of the company at the
option of the bondholder.
4. Callable bonds—they can be called or redeemed by the issuing company before
maturity.
5. Noncallable—they are not subject to redemption before maturity date.
 D. As to transferability
1. Bearer bonds—they can be transferred to other parties by mere delivery because
bondholders are not registered in the books of the issuing entity.
2. Coupon bonds—interest coupons are attached to the bond certificates and interest is
paid to the holder of said coupons.
3. Registered bonds—they are registered in the books of the issuing company so that they
can be transferred to other parties only upon surrender of the bond certificate to the
issuing company.

a. Registered as to principal only. Interest is paid to any party who presents interest
coupon.

b. Registered as to both principal and interest. Interest is paid only to the party whose
name appears as bondholder in the books of the issuing entity.

C. Municipal Bonds

Municipal bond also known as “Munis” is a bond issued by a city or other local government, or their
agencies. Municipal bonds are the next progression in terms of risk. Cities don't go bankrupt that often, but it
can happen. The major advantage to municipal bond is that the returns are free from tax. Furthermore, local
governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds
completely tax free. Because of these tax savings, the yield on a municipal bond is usually lower than that of a
taxable bond.

TYPES OF TAX-EXEMPT MUNICIPAL BONDS

1. General obligation bonds. Principal and interest are secured by the full faith and credit of the
issuer and usually supported by either the issuer’s unlimited or limited taxing power. In many
cases, general obligation bonds are voter-approved.

2. Revenue bonds. Principal and interest are secured by revenues derived from tolls, charges or
rents from the facility built with the proceeds of the bond issue. Public projects financed by
revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities,
hospitals and subsidized housing. Many of these bonds are issued by special authorities created
for that particular purpose.

D. Treasury Notes and Treasury Bonds

Treasury notes are securities issued by the government with maturities greater than one year but less
than 10 years. These notes are issued in either fixed or floating rates and will be used to refinance debt while
Treasury bonds are long-term bond financial instruments issued by the government to finance deficits of the
national government.

E. Mortgage-Backed Security (MBS)

MBS is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These
securities must also be grouped in one of the top two ratings as determined by an accredited credit rating
agency, and usually pay periodic payments that are similar to coupon payments.