Understanding the Role of Financial Markets and Institutions

Module 5 - Understanding the Role of Financial

Markets and Institutions
LEARNING OBJECTIVES
After studying this module, you should be able to:
1. Define financial markets.
2. Identify the participants in the financial markets.
3. Appreciate the importance of financial markets as providers of funds to business
establishments.
4. Enumerate and distinguish the types of markets.
5. Familiar with the categories of financial institutions.
6. Understand the role of the stock market.
7. Know the kinds of stock market.
8. Explain the reasons for transactions in stock market.
9. Discuss the role and operation of a stock exchange
10. Know how securities are listed on the stock exchange.

UNDERSTANDING THE ROLE OF THE FINANCIAL MARKETS AND

INSTITUTIONS

INTRODUCTION
One may wonder how a financial manager knows whether he or she is maximizing shareholder
value and ethical (unethical) behavior may affect the value of the company. This information is
provided daily to financial managers through price changes determined in the financial markets.
But what are the financial markets?
Financial markets are the meeting place for people, corporations and institutions that either need
money or have money to lend or invest. In a broad context, the financial markets exist as a vast
global network of individuals and financial institutions that may be lenders, borrowers or owners
of public companies worldwide. Participants in the financial markets also include national, state
and local governments that are primarily borrowers of funds for highways, education, welfare and
other public activities; their markets are referred to as public financial markets. Large corporations
raise funds in the corporate financial markets.
Corporations rely on the financial markets to provide funds for short-term operations and for new
plant and equipment. A firm may go to the markets and raise financial capital by either borrowing
money through a debt offering of corporate bonds or short-term notes, or by selling ownership in
Understanding the Role of Financial Markets and Institutions

the company through an issue of common stock. When a corporation uses the financial markets to
raise new funds, the sale of securities is said to be made in the primary market by way of a new
issue. After the securities are sold to the public (institutions and individuals), they are traded in the
secondary market between investors. It is in the secondary market that prices are continually
changing as investors buy and sell securities based on their expectations of a corporation's
prospects. It is also in the secondary market that financial managers are given feedback about their
firm's performance. Those companies that perform well and are rewarded by the market with high
priced securities have an easier time raising new funds in the money and capital markets than their
competitors. They are also able to raise funds at a lower cost.

STRUCTURE AND FUNCTION OF THE FINANCIAL MARKETS

Different financial markets serve different types of customers or different parts of the country.
Financial markets also vary depending on the maturity of the securities being traded and the types
of assets used to back the securities.

TYPES OF MARKETS
1. Physical asset markets versus financial asset markets. Physical asset markets (also
called tangible or real asset markets) are for products such as wheat, autos, real estate,
computers and machinery. Financial asset markets, on the other hand. deal with stocks.
bonds, notes and mortgages. Financial markets also deal with derivative securities whose
values are derived from changes in the prices of other assets. A share of Meralco stock is
a pure financial asset. while an option to buy Meralco shares is a derivative security whose
value depends on the price of stock. Bonds backed by subprime mortgages are another type
of derivative, as the values of these bonds are derk ed from the values of the underlying
mortgages.

2. Spot markets versus future markets. Spot markets are markets in which assets are bought
or sold for "on-the-spot- delivery. Future markets are markets in which participants agree
today to buy or sell an asset at some future date.

3. Money markets versus capital markets. Money markets are financial markets in which
funds are borrowed or loaned for short periods (less than one year). Capital markets are
financial markets for stocks and for intermediate or long-term debt (one year or longer).

4. Primary markets versus secondary markets. Primary markets are the markets in which
corporations raise capital by issuing new securities. Secondary markets are the markets in
which securities and other financial assets are traded among investors after they have been
issued by corporations.
Understanding the Role of Financial Markets and Institutions

5. Private markets versus public markets. Private markets are markets in which
transactions are worked out directly between two parties. Public markets are markets in
which standardized contracts are traded on organized exchanges.

FINANCIAL INSTITUTIONS
Direct funds transfers are common among individuals and small businesses and in economies
where financial markets and institutions arc less developed. large businesses in developed
economies generally find it more efficient to enlist the services of a financial institution when it
comes time to raise capital.

CATEGORIES OF FINANCIAL INSTITUTIONS

1. Investment banks. An organization that underwrites and distributes new investment
securities and helps business obtain financing.

2. Commercial banks. The traditional department store of finance serving a variety of savers
and borrowers.

3. Financial services corporations. A firm that offers a wide range of financial services,
including investment banking, brokerage operations, insurance and commercial banking.

4. Credit unions. Cooperative associations whose members are supposed to have a common
bond, such as being employees of the same firm. Credit unions are often the cheapest
source of funds available to individual borrowers.

5. Pension funds. Retirement plans funded by corporations or government agencies for their
workers and administered primarily by the trust departments of commercial banks or by
life insurance companies.

6. Life insurance companies. Savings in the form of annual premiums; invest these funds in
stocks, bonds, real estate and mortgages; and make payments to the beneficiaries of the
insured parties.

7. Mutual funds. Organizations that pool investor funds to purchase financial. instruments
and thus reduce risks through diversification. Money market funds are mutual funds that
invest in short-term, low-risk securities and allow investors to write checks against their
accounts.

8. Exchange trade funds (ETF). Similar to regular mutual funds and are often operated by
mutual fund companies. ETF buy a portfolio of stocks of a certain type and then sell their
own shares to the public.
Understanding the Role of Financial Markets and Institutions

9. Hedge funds. Similar to mutual funds because they accept money and use the funds to buy
various securities, but there are some important differences.

10. Private equity companies. Organizations that operate much like hedge funds, but rather
than purchasing some of the stock of firm, private equity players buy and then manage
entire firms.

THE STOCK MARKETS

Business finance is concerned with the provision of funds for investment in business enterprise,
whatever is invested in this way must be provided by an investor and this means that the investor
must forgo consumption and save to provide the funds. Savers and the users of their funds come
together in the market for finance, where the normal rules of supply and demand apply unless there
is government interference with interest rates. The price of money is the rate of interest paid for
the use. If the demand for investment funds is greater than the funds offered for investment by
savers, then the rate of interest will rise until people in the economy are induced to forgo
consumption and make their savings available for investment. The new issues of securities are
made available in the primary market. The securities that are already outstanding and owned by
the investors are usually bought and sold through the secondary market, which is popularly known
as stock market.
In a stock market, purchases and sales of securities whether of government or semi-government
bodies or other public bodies and also shares and debentures issued by joint stock companies are
affected. The securities of government are traded in the stock market as a separate component
called gilt edged market. Government securities are traded outside the trading wing in the form of
over the counter sales or purchases. Another component of stock market deals with trading in
shares and debentures of limited companies.
In the stock market, the outstanding issues are permitted to trade. In this market, a stock or bond
issue has already been sold to the public and it is traded between current and potential owners. The
proceeds from sale in the stock market do not go to the issuing organization but to the current
owner of the security. Once new issues have been purchased by investors, they change hands in
the stock market. The primary middlemen in the stock market are brokers and dealers. The
distinction between them is the broker acts as an agent, whereas the dealer acts as a principal in
the transaction. Stock markets are said to reflect the health of the country's economy. On the other
hand, major economic indicators' stock market movements to a large extent. From a thorough
analysis of the various economic indicators and its implications on the stock markets, it is known
that stock market movements are largely influenced by broad money supply, inflation,
credit/deposit ratio and fiscal deficit apart from political instability. Besides, fundamental factors
like corporate performance, industrial growth and so forth always exert a certain amount of
influence on the stock markets. The derivatives are most modern financial instruments in hedging
the risk. The individuals and firms who wish to avoid or reduce risk can deal with others who are
Understanding the Role of Financial Markets and Institutions

willing to accept the risk for a price. The common place where such transactions take place is
called the derivative market. Forwards, futures, options, swaps, caps and floor are some of the
commonly traded derivatives in the derivatives market.

KINDS OF STOCK MARKET

There are two broad segments of the stock markets:
1. The Organized Stock Exchange. The stock exchanges will have a physical location where
stocks buying and selling transactions take place in the stock exchange floor (e.g., New
York Stock Exchange, Japan Nikkei, Shanghai Components, NASDAQ, Philippine Stock
Exchange, etc.).

2. The Over-the-Counter (OTC) Exchange. Where shares, bonds and money market
instruments are traded using a system of computer screens and telephones.

REASONS FOR TRANSACTIONS IN STOCK MARKET

There are two main reasons why individuals transact in the secondary market or stock
market:
1. Information Motivated Reasons. Information motivated investors believe, that they have
superior information about a particular security than other market participants. This
information leads them to believe that the security is not being correctly priced by the
market. If the information is good, this suggests that the security is currently underpriced
and investors with access to such information will want to buy the security. On the other
hand, if the information is bad, the security will be currently overpriced and such investors
will want to sell their holdings of the security.

2. Liquidity Motivated Reasons. Liquidity motivated investors, on the other hand, transact
in the secondary market because they are currently in a position of either excess or
insufficient liquidity. Investors with surplus cash holdings (e.g. as a result of inheritance)
will buy securities, where as Investors with insufficient cash (e.g., to purchase a car will
sell) securities.

MEANING OF STOCK EXCHANGE

Stock exchange is an organized secondary market where securities like shares, debentures of public
companies, government securities and bonds issued by municipalities, public corporations, utility
undertakings, port trusts and such other local authorities are purchased and sold.' In order to bring
liquidity, the stock are traded systematically in a stock exchange.
Understanding the Role of Financial Markets and Institutions

The stock exchange is an entity (a corporation or mutual organization) which is in the business of
bringing buyers and sellers of stocks and securities together. The purpose of stock exchange is to
facilitate the exchange of securities between buyers and sellers, thus providing a market place,
virtual or real. The stock market does not have a physical presence; it is a virtual market. Gone are
the days when share brokers assembled in a place called the "trading ring" and bought and sold
shares, it was known as the outcry method. Technology has enabled the ring to be located on a
central computer, which has millions of buyers and sellers attached to it through a
telecommunication network. These buyers and sellers indicate their intentions through a computer
at home or the office, their own or their broker's. Buyers' and sellers' orders are matched by the
central computer, and if quantities and prices correspond, then a trade is set to be executed. The
entire process of sending the order to the stock exchange computer, confirmation of order and
execution, if any, is communicated within a fraction of a second.
The stock exchange supplies a platform from which to buy and sell shares in certain listed
companies. It regulates the company's behavior through requirements agreed upon by the company
in order to be listed. This is called a listing agreement which ensures that the company provides
all the information pertaining to its working from time to time, including events that affect its
valuation, such as mergers, amalgamations and such other sensitive matters. Large volumes are
possible in these markets because of two things. One is the ease of settlements. The shares that are
traded in are received and delivered 'through an electronic entry in the hooks of buyers and sellers.
The second reason is guarantee of trades. Sellers get their money, buyers get their shares. The
stock market is known as barometer of the company's economy. The companies listed on stock
exchanges collectively contribute to the country's GDP.

LISTING OF SECURITIES ON STOCK EXCHANGE

Listing means admission of securities to dealings on a recognized stock exchange of any
incorporated company, central and state governments, quasi-governmental and other financial
institutions/corporations, municipalities, electricity boards, housing boards and so forth. The
principal objective of listing is to provide liquidity and marketability to listed securities and ensure
effective monitoring of trading for the benefit of all participants in the market. A company desiring
to get listing has to enter into listing agreement with the concerned stock exchange and is required
to pay the specified listing fees. Thereafter, the company is required to comply with all clauses of
the listing agreement and to send details of book closure, record dates, copies of annual report,
quarterly and half-yearly reports and cash flow statements to the respective stock exchange where
the securities are listed. A recognized stock exchange means a stock exchange being recognized
by the national government through the Securities and Exchange Commission (SEC). Securities
are bought and sold in recognized stock exchanges through members who are known as brokers.
The price at which the securities are bought and sold on a recognized stock exchange is known as
official quotation.
Understanding the Role of Financial Markets and Institutions

The securities of an entity may be listed at any of the following stages:

 At the time of public issue of shares or debentures
 At the time of rights issue of shares or debentures
 At the time of bonus issue of shares
 Shares issued on amalgamation or merger
In a stock exchange, a person who wishes to sell his security is called a seller, and a person who
is willing to buy the particular stock is called the buyer. The rate of stock depends. on the simple
law of demand and supply.
Figure 8-1 shows a listing of the Top Companies classified according to Industries as of September
30, 2021 whose shares are traded in the Philippine Stock Exchange.
https://www.value.today/headquarters/philippines

References:
Cabrera, M. B. (2013). Financial Management: Principles and Applications
Comprehensive Volume