FM 9 – CAPITAL MARKETS

Introduction

• The Financial System

I. INDIRECT FINANCE (Financial Intermediaries)

Financial Intermediation
❖ purchasing direct claims with one set of characteristics (e.g. maturity,
denomination) from borrowers
❖ transform purchased claims with a different set of characteristics, then sells
them to the lenders
 Types of Financial Intermediaries

a. Depository Institutions
- commercial banks, savings and loan associations, savings banks, and
credit unions.
- They derive the bulk of their loanable funds from deposit accounts sold to
the public.

b. Contractual Savings Institutions

- insurance companies and pension funds.
- They attract funds by offering financial contracts to protect the saver
against risk.

c. Investment Intermediaries
- finance companies, mutual funds, venture capitalist, and money market
mutual funds (MMMFs).
- They sell shares to the public and invest the proceeds in stocks, bonds,
and other securities.

II. DIRECT FINANCE (Financial Markets)

Financial Markets – determines the cost of capital

Financial Markets can be classified by:

a. Debt Market vs. Equity Market

Debt Market Equity Market

✓ a.k.a. Bond Market ✓ a.k.a Stock Market
✓ transactions are made between ✓ transactions are made thru PSE
brokers, large institutions, or by (Philippine Stock Exchange)
individual investors
 ✓ less risky; even if a company is ✓ more risky; investor may lose
liquidated, bondholders are first to money (even lose their entire
be paid investment) in case of bankruptcy
✓ lower potential return on ✓ higher potential return on
investment investment
✓ fluctuates less in price than stocks ✓ equity market is volatile by nature;
social, political, governmental, or
economic events
✓ bonds carry a fixed interest rate ✓ equity holders may profit from
dividends
✓ they may also profit from sale of
stocks if their market prices
increase
✓ most are unsecured, but are issued ✓ equity market is viewed as
a rating by several agencies to inherently risky; substantial price
indicate the integrity of the issuer swings may have little to do with
the stability and good name of the
corporation that issued them

KEY TAKEAWAYS

• In the equity market, investors and traders buy and sell shares of stock.
• Stocks are stakes in a company, purchased to profit from company dividends or the resale of the
stock.
• In the debt market, investors and traders buy and sell bonds.
• Debt instruments are essentially loans that yield payments of interest to their owners.
• Equities are inherently riskier than debt and have a greater potential for big gains or big losses.

(investopedia.com)
 b. Primary Market vs. Secondary Market

Primary Market Secondary Market

✓ market where securities are ✓ market where created securities
created are traded among investors
✓ IPO (Initial Public Offering) – ✓ PSE (Philippine Stock Exchange)
companies sell new stocks/bonds to
the public for the first time
✓ Underwriters ✓ investors trade previously issued
o financial specialists who securities without the issuing
determine initial offering companies’ involvement
price of the securities

❖ Types of Primary Offering

▪ Rights Offering

- permits companies to raise additional equity through the primary market after
already having securities enter the secondary market
- current investors are offered prorated rights based on the shares they currently
own, and others can invest anew in newly minted shares.

▪ Private Placement

- allows companies to sell directly to more significant investors such as hedge

funds and banks without making shares publicly available.

▪ Preferential Allotment

- offers shares to select investors (usually hedge funds, banks, and mutual funds)
at a special price not available to the general public.

Similarly, businesses and governments that want to generate debt capital can choose to issue new short-
and long-term bonds on the primary market.
Specialized Categories of Secondary Market

▪ Auction Markets

- All individuals and institutions that want to trade securities congregate in one
area and announce the prices at which they are willing to buy and sell.
- These are referred to as bid and ask prices.
- The idea is that an efficient market should prevail by bringing together all
parties and having them publicly declare their prices.
- Thus, theoretically, the best price of a good need not be sought out because the
convergence of buyers and sellers will cause mutually agreeable prices to
emerge.

▪ Dealer Markets

- Does not require parties to converge in a central location.

- Rather, participants in the market are joined through electronic networks.
- The dealers hold an inventory of security, then stand ready to buy or sell with
market participants.
- These dealers earn profits through the spread between the prices at which they
buy and sell securities.
- Dealers, who are known as market makers, provide firm bid and ask prices at
which they are willing to buy and sell a security.
- The theory is that competition between dealers will provide the best possible
price for investors.

(investopedia.com)
c. Money Market vs. Capital Market

Money Market Capital Market

✓ trade of short-term debt; as short ✓ trade of long-term stocks and
as overnight and no longer than a bonds
year
✓ borrowers tap it for cash they need ✓ companies issue stocks and bonds
to operate from day to day to raise money to grow their
businesses – long-term purposes
✓ lenders use it to put spare cash to ✓ investors buy them to share in that
work growth
✓ money market is less risky than ✓ capital market is potentially more
capital market rewarding than money market
✓ returns are modest but risks are ✓ market movement is constantly
low monitored from hour to hour and
analyzed for clues as to the health
of the economy at large
✓ a company/government usually
issues short-term debt to cover
routine expenses/supply working
capital – not for capital
improvements/large-scale projects
✓ helps ensure that institutions
maintain appropriate level of
liquidity on a daily basis
✓ prevents institutions from falling
short and needing more expensive
loans
✓ prevents hoarding of excess cash
that isn’t earning interest
 ❖ Capital Market Instruments

▪ Government Bonds
▪ Corporate Bonds
▪ Mortgages
- Long-term loans to households or businesses to purchase buildings or land, with
the underlying asset (house, land, or plant) serving as collateral.
▪ Commercial Bank Loans
▪ Bank Debentures
- A debt instrument issued by financial institutions to borrow long-term funds
from capital market.
- There is no reserve requirement for bank debentures.
- Also, the amount of bank debentures is considered as the part of bank capital
because it is a stable source of funds for financial institutions.
▪ Stocks: no specified maturity date.

KEY TAKEAWAYS

• The money market is a short-term lending system. Borrowers tap it for the cash they need to
operate from day to day. Lenders use it to put spare cash to work.
• The capital market is geared toward long-term investing. Companies issue stocks and bonds to
raise money to grow their businesses. Investors buy them to share in that growth.
• The money market is less risky than the capital market while the capital market is potentially
more rewarding.

(investopedia.com)

Asset – is any possession that has value in an exchange

a. Tangible Asset – value depends on physical properties (buildings, land, machinery)

b. Intangible Asset
• represents legal claims to some future benefit
• value bears no relation to the form in which the claims are recorded
 • Financial Assets
➢ financial instruments/securities
➢ future benefit comes in the form of a claim to future cash

Parties in a Financial Asset

▪ Issuer – the entity that agrees to make future cash payments

▪ Investor – the owner/holder of the financial asset to whom future cash payments are to
be made

Claims of a Financial Asset

▪ Debt Instrument – claim is a fixed amount

▪ Equity Instrument (Residual Claim) – paid based on earnings or remaining interest after
holders of debt instruments are paid

Properties of Financial Assets

❖ Moneyness
• some financial assets act as a medium of exchange or as a settlement of transactions
• although not money itself, some financial assets are closely approximate money in that
they can be transformed into money at little cost, delay, or risk
• near money

❖ Divisibility & Denomination

• minimum size at which a financial asset can be liquidated
• the smaller the size, the more divisible

❖ Reversibility
• the cost of investing in a financial asset and then getting out of it and back into cash
again
• financial assets are traded in an organized market (market makers)
• bid-ask spread – the difference between the price at which a market maker is willing to
sell (ask price) and the price at which a market maker is willing to buy (bid price)

Example:
 A market maker is willing to sell some financial asset for Php 70.50 and is willing
to buy it for Php 70.00. The bid-ask spread is Php 0.50.

• Two main forces of market-making risk

a. Variability of the Price

- the greater the variability, the greater the probability of the market maker
incurring a loss in excess of a stated bound between the time of buying and
reselling the financial asset

b. Thickness of the Market

- the prevailing rate at which buying and selling orders reach the market maker
- frequency of transactions
➢ the greater the frequency of orders coming into the market for the
financial asset (order flow)
➢ the shorter the time that the financial asset must be held in the market
maker’s inventory
➢ the smaller the probability of an unfavorable price movement while
held
- Thin Market
➢ low number of buyers and seller
➢ fewer transactions, prices are often more volatile, assets are less liquid,
larger bid-ask spread

❖ Term to Maturity
• the length of time until the date when the instrument is scheduled to make its final
payment, or the owner is entitled to demand liquidation
• demand instruments – a creditor can ask for repayment at any time
• maturity may terminate before its stated maturity (bankruptcy, reorganization)
❖ Liquidity
• how much sellers stand to lose if they wish to sell immediately against engaging in a
costly and time-consuming search
• it may depend on suitable buyers (e.g., small stock corporation vs. speculators &
market-makers) – non-suitable buyers who are ready to purchase an instrument would
most likely ask for a discount price
• it may depend on contractual arrangement (e.g., ordinary deposits vs. pension funds) –
deposits are liquid since they can be cashed in any time while pension funds are
practically illiquid since they can only be cashed in upon retirement
• it may depend on the quantity to be sold – small quantities are more liquid than large
quantities
• Liquidity closely relates to whether a market is thick or thin.

❖ Convertibility
• a financial asset which can be transformed into another financial asset
• a bond which can be converted into another bond
• a bond which can be converted into equity shares (stocks)
• a stock which can be converted into another stock

❖ Currency
• financial assets are denominated in one currency
• foreign exchange risk – the risk of receiving less value from a financial asset due to the
fluctuations in exchange rates
• dual currency securities – issued to reduce foreign exchange risk

Example:

Paying interest in one currency but the paying the principal amount or redemption value
in a second currency.

• currency option – allows investors to specify that payments of either interest or

principal be made in either one of the two currencies
❖ Cash Flow and Return Predictability
• The return that an investor will realize from a financial asset will depend on the cash
flow expected to be received;
a. for equity instruments, the dividend payments on the stocks and their expected
sales price
b. for debt instruments, the interest payments and the repayment of the principal
amount
• The predictability of the expected return depends on the predictability of the cash flow.
• The riskiness of an asset can be equated with the uncertainty or unpredictability of its
return.
• Nominal Expected Return – considers the pesos expected to be received but does not
adjust those pesos to take into account the changes in their purchasing power (inflation)
• Real Expected Return – the nominal expected return is adjusted for the loss of
purchasing power of the financial asset as a result of inflation

❖ Complexity
• combining two or more simpler financial asset
• One must “decompose” complex assets into their component parts and price each
component separately.
• Most complex financial assets involve a choice/option granted to the issuer or investor
to do something to alter the cash flow.
• The value of such financial assets depends on the value of the choices/options granted
to the issuer or investor – it becomes essential to understand how to determine the
value of an option.

❖ Tax Status
• differ from year to year, country to country, financial asset to financial asset
• depends on the type of issuer, length of time the asset is held, the nature of the owner
and so on

Fabozzi, F.J. & Modigliani F. (2009). Capital Markets: Institutions and Instruments.
(Fourth Edition). Pearson.