I.

Introduction to Financial System

The Financial System give support to our economy by helping in economic development
and raising the standard of living people and it's also provides effective financial as well as
advisory services. Financial system has three elements:

1. Financial instruments, answers the question ‘what’, we say, they buy and sell financial
instrument, in finance we call this trade and in financial economic it means to buy and
sell financial instruments. The other name of financial instruments are Financial Asset or
Financial Claims, that it is a claim on an entities future earnings and asset. Example,
stock, bonds and so on.
2. Financial markets, answers the question ‘where’. It is a market where Financial
Instruments are traded. It also gives strength to economy by making finance available at
the right place. Financial Markets has economic function:
a) Mobilisation of Savings and their Channelization into more Productive Uses: this
market takes the uselessly lying finance in the form of cash where it is really needed.
Many financial instruments are made available for transferring finance from one side
to the other side.
b) Facilitates Price Discovery: the financial markets is helpful to investors in giving the
proper price. Like goods and services, the investors also try to discover the price of
their security or to determine of it.
c) Provides Liquidity to Financial Assets: this is a market where the buyer and seller of
all securities are available all the times. The investors can invest their money
whenever they desire and they can also convert their investment into money.
d) Reduces the Cost of Transactions: in this way financial markets reduces the cost of
transaction to makes every type of information available without spending any
money.
 Transaction cost is the cost incurred during trading or any cost involved in making an
economic transaction. Transaction cost classified into:
- Cost of search and information: Search cost is the time, energy and money expended by
consumer who is researching a product or service for purchase. Search cost divided into
two, Explicit cost such as advertising. Implicit cost such as value of time. Information
cost include everything an individual or company spends when investigating whether a
particular investment or activity is likely to be profitable.
- Cost of contracting and monitoring: when the two parties entering into transaction you
need to show some information to each other and make sure that you do the obligation or
must fulfill the obligation.
 - Cost of incentive problem: an incentive problem arises from the person's ability and
desire to influence the learning process, therefore wage process, it is taking unobserved
actions that affect performance.

3. Financial institutions, answers the question ‘who’. It is an institution which invest in

Financial Instrument and issues Financial Instruments of its own. It is also known as
financial intermediaries. The main function of intermediaries is called intermediation.
Intermediation is the process of channeling funds or transferring funds from savers to
users. Saves refer to the lender, they are suppliers of funds to borrowers in return with
promises of repayment of even more in the future. User refer to the borrower, they are the
demanders of funds.

Financial System ensures efficient functioning of the payment mechanism in an

economy. So all the transactions between the buyers and sellers of goods and services are
effected smoothly because of financial system. There are also financial regulators, they are the
police that monitor and regulate the financial system.

II. Financial Markets

2.1. Financial Market and Structure

2.1.1. Debt Vs. Equity

A financial instrument can be classified by the type of claims that the investor has on
the issuer. A financial instrument in which the issuer agrees to pay the investor interest plus
repay the amount borrowed is a debt instrument. A debt instrument also referred to as an
instrument of indebtedness, can be in the form of a note, bond, or loan. The interest payments
that must be made by the issuer are fixed contractually. The investor in a debt instrument can
realize no more than the contractual amount. For this reason, debt instruments are often called
fixed income instruments.

In contrast to a debt obligation, an equity instrument specifies that the issuer pays the
investor an amount based on earnings, if any, after the obligations that the issuer is required to
make to investors of the firm’s debt instruments have been paid. The classification of debt and
equity is especially important for two legal reasons. First, in the case of a bankruptcy of the
issuer, investor in debt instruments has a priority on the claim on the issuer’s assets over equity
investors. Second, the tax treatment of the payments by the issuer can differ depending on the
type of financial instrument class.
 2.1.2. How to Classify Financial Markets

There are different ways to classify financial markets. They are classified according to
the financial instruments they are trading, features of services they provide, trading procedures,
key market participants, as well as the origin of the markets.
 2.2. Types of Financial Markets
A. Physical Asset Markets vs. Financial Asset Markets
Physical Asset Markets are tangible assets and can be seen and touch with a very identifiable
physical presence. For products such as wheat, autos, real estate, computers and machinery.
Financial Asset Markets are intangible assets, meaning that they cannot be seen or felt and may
not have a physical presence, except for the existence of a document that represents the
ownership held in the asset. Financial Asset deals with stocks, bonds, notes and mortgages.

B. Spot Markets vs. Future Markets

Spot Markets also known as cash market is where the assets are sold immediately. Usually,
the deal between the parties is settled within trade date plus 2 or 3 days. Markets in which assets
are bought or sold for on-the-spot delivery. Future Markets are financial contracts giving the
buyer an obligation to purchase an asset at a set price at a future point in time. Are markets in
which participants agree today to buy and sell an asset at some future date.

C. Money Market vs. Capital Market

Money Market are short-term debt instrument such as T-bills, trade bills reports, commercial
paper and certificate of deposit. Financial market in which funds are borrowed or loaned for
short periods (Less than or one (1) year). Capital Market deals in long term securities such as
equity share, debentures, bonds and preference shares. Financial market for stocks and for
intermediate or long-term debt (One (1) year or longer).

D. Primary Market vs. Secondary Market

Primary Market is Markets in which corporations raise capital by issuing new securities.
Secondary Market is Markets in which securities and other financial assets are traded among
investors after they have been issued by corporation.

E. Private Markets vs. Public Markets

Private Markets is Markets in which transactions are worked out directly between two
parties. Public Markets are Markets in which standardized contracts are traded on organized
exchanges.
 2.3. Money Markets Purpose and Structure

2.3.1. The Role of Money Markets

The purpose of money markets is to facilitate the transfer of short-term funds from agents
with funds (corporations, financial institutions, individuals, government) to those market
participants who lack funds for short-term needs. For financial institutions and to some extent to
other non-financial company money markets allow for executing such functions as: Fund raising;
Cash management; Risk management; Speculation or position financing; Signaling; Providing
access to information on prices.

2.3.2. Money Market Segments

In a broad sense, money market consists of the market for short term funds, usually with
maturity up to one year. It can be divided into several major segments:

 Interbank market is where banks and non-deposit financial institutions settle contracts
with each other and with central bank involving temporary liquidity surpluses and deficits.
Interbank market is defined mainly in terms of participants, while other markets are defined
in terms of instruments issued and traded.
 Primary market is absorbing the issues and enabling borrowers to raise new funds.
 Secondary market for different short-term securities, which redistributes the ownership,
ensures liquidity, and as a result, increases the supply of lending and reduces its price.
 Derivatives market, market for financial contracts whose values are derived from the
underlying money market instruments.

2.3.3. Money Market Participants

Money market participants include mainly credit institutions and other financial
intermediaries, governments, as well as individuals (households).

 Ultimate lenders in the money markets are households and companies with a financial
surplus which they want to lend, while ultimate borrowers are companies and government
with a financial deficit which need to borrow. Ultimate lenders and borrowers usually do
not participate directly in the markets. As a rule they deal through an intermediary, who
performs functions of broker, dealer or investment banker.
 Central bank employs money markets to execute monetary policy. Through monetary
intervention means and by fixing the terms at which banks are provided with money,
central banks ensure economy’s supply with liquidity.
  Credit institution (banks) account for the largest share of the money market. They issue
money market securities to finance loans to households and corporations, thus supporting
household purchases and investments of corporations. Besides, these institutions rely on
the money market for the management of their short-term liquidity positions and for the
fulfillment of their minimum reserve requirements.

Other important market participants are other financial intermediaries, such as money market
funds, investment funds other than money-market funds, insurance companies and pension funds.

Large non-financial corporations issue money market securities and use the proceeds to
support their current operations or to expand their activities through investments. In general
issuance of money market securities allow market participants to increase their expenditures and
finance economic growth.

III. Financial Instruments

Financial Instruments are often called Financial Assets, are intangible assets, which are
expected to provide future benefits in the form of a claim to future cash.

Any transaction related to financial instrument includes at least two parties:

 the party that has agreed to make future cash payments and is called the issuer;
 the party that owns the financial instrument, and therefore the right to receive the
payments made by the issuer, is called the investor.

2 Classifications of Financial Instruments

 Debt instrument - the issuer agrees to pay the investor interest plus the amount
borrowed.
 Equity instrument - the issuer pays the investor an amount based on earnings.

3.1. Money Market Instruments

These are debt instruments that have a maturity of one year or less. Major characteristics of
money market instruments are:

 short-term nature
 low risk
 high liquidity
Types of Money Market Instruments

1. Treasury Bills (Government Securities)

Treasury bills are short-term money market instruments issued by government and
backed by it. Therefore market participant view these government securities as the safest
instruments for having little or even no risk.

2. Interbank Market Loan (FED Funds)

It is a loan of one commercial bank to another commercial bank for the purpose of
satisfying minimum reserve requirements to the central bank. Banks with reserves in excess of
required reserves can lend these funds to other banks.

3. Commercial Papers

These are short-term debt instrument issued only by large, well known, creditworthy
companies and is typically unsecured. The aim of its issuance is to provide liquidity or finance
company’s investments, e.g. in inventory and accounts receivable.

4. Certificate of Deposits (CD)

A CD is a piece of paper or certificate that states that a deposit has been made with a
bank for a fixed period of time, at the end of which it will be repaid with interest.

5. Repurchase Agreement (REPO)

A repurchase agreement (REPO) is an agreement to buy any securities from a seller with
the agreement that they will be repurchased at some specified date and price in the future. It can
also be defined as a secured loan because it represents a loan backed by securities. If the
borrower defaults on the loan, the lender has a claim on the securities.

6. Eurocurrency Instruments (International money market securities)

Apart from variety of money market instruments which enable short-term lending and
borrowing to take place in the domestic currency, in recent years some of the fastest growing
markets have been the so-called eurocurrency markets. These are markets in which the
borrowing and lending denominated in a currency of some other country takes place. In general,
eurocurrency market instruments are the same as other money market instruments. When such
instruments are denominated in some other currency, they are identified as ‘euro-’, though it can
be any currency (e.g. US dollars, or Japanese yen).
 3.2. Capital Market Instruments

Capital Market is also known as the financial market or place where debt and equity
instrument are traded. It enables suppliers and demanders of long-term funds to make transactions.
The transfer of funds from entities with surplus funds to deficit unit or to those who require it.
While, Capital Market Instruments are used to finance the purchase of capital asset and it can
be the combination of debt and equity instrument.

1. Bonds are long term debt securities issued by the treasury, government agencies and
corporations to finance their operations. It provides return to investors in the form of interest
income and usually matures between 10-20 years.

 Treasury Bonds are debt securities issued by the US treasury to finance

government spending activities and perceived to be free from default risk because
they are issued by the US treasury.
 Corporate Bonds are debt securities issued by corporation and sold to investors
and subject to default risk because the issuer could default on its obligation to repay
the debt especially when corporation experience low profitability, bankruptcy etc.
 Municipal Bonds are debt securities issued by a state, municipality or county to
finance its capital expenditures, including the construction of highways, bridges or
schools. And it is exempt from federal taxes and most state and local taxes, making
them especially attractive to people in high income tax brackets.

2. Stocks are the right of ownership in a Company. The buyer of the shares is known as a
shareholder. Investors buy and sell shares over a stock exchange like NSE and BSE. Equity claims
on the net income and assets of a corporation. And it has no maturity therefore serve as a long-
term source of funds

 Common Stocks that allow the investors gain a sizable amount of profit through raising
prices of shares and dividend payments. It is equity ownership that allows the holders of
this stock to enjoy voting rights on corporate matters.
 Preferred Stock also represents owning a share of the company. Preferred stock pays a
predetermined dividend, whereas the dividends paid to common shareholders tend to vary
according to the company's fortunes. Holders of preferred stock do not get to vote on
company matters.
 3.3. Other Financial instruments

1. Mortgage is a debt obligation created to finance the purchase of real estate property that the
borrower is obliged to pay back with a predetermined set of payments. It is used by individuals
and businesses to make large real estate purchases without paying the entire purchase price up
front.

2. Leases a fixed term contract by which one party conveys land, property, services, etc. to another
for a specified time, usually in return for a periodic payment. Some examples of leases are
residential leases and commercial leases for the purpose of business.

IV. Financial Institutions

For financial transactions to happen, money must change hands. How do such exchanges
occur? At any given point in time, some individuals, businesses, and government agencies have
more money that they need for current activities; some have less than they need. Thus, we need a
mechanism to match up savers (those with surplus money they want to lend put) with
borrowers (those with deficits who wants to borrow money). We could just let borrowers search
out savers and negotiate loans, but the system would be both inefficient and risky. Even if you
had a few extra money, would you lend it to a total stranger? If you needed money, would you
want to walk around town looking for someone with a little to spare?

Now you know why we have financial institutions: they act as intermediaries between
savers and borrowers and they direct the flow of funds between them. With funds deposited by
savers in checking, savings, and money market accounts, they make loans to individual and
commercial borrowers. And to know which financial institution is most appropriate for serving a
specific need, it is important to understand the difference between the types of institutions and
the purposes they serve.

4.1. Types of Financial Institutions:

A. Depository Institutions are financial institutions that obtain funds through deposits from the
public. It takes savings from general public as demand or time deposits. These are more heavily
regulated than non-depository institutions.

Important services in the economy:

 provide safekeeping services and liquidity

 they provide payment system consisting checks and electronic fund transfer
 they pool the money of savers and lend it out to people or businesses
 they invest in securities
1. Commercial banks generate profit not only by charging borrowers higher interest rates than
they pay to savers but also by providing such services as check processing, trust and retirement
account management, and electronic banking. These are financial institutions, which help in
pooling the savings of surplus units and arrange their productive uses. They basically accepts the
deposits from individuals and institutions, which are repayable on demand. These deposits from
individuals and institutions are invested to satisfy the short-term financing requirement of
business and industry.

2. Savings banks or thrift institutions

 Credit unions are non-profit depository institutions that are financial

cooperatives owned by people belonging to a particular group, such as the
employees of a particular company, a union, a religious group or those who live in
a specific area, and they are governed by a board I f volunteers. Because they are
non-profits and owned by their customers, they charge lower loan rates and pay
higher interest rates on savings, and they offer a wide variety of financial services
for their owners.
 Savings & Loan Association are primary resources of homebuyers today created
to accept savings by private investors. They have been private entities and
mutually owned by their customer and some are publicly traded.
 Mutual Savings Banks are designed to serve low-income individuals. They make
non-commercial loans like mortgage loans and consumer loans. Mutual Savings
Banks allows customers to maintain accounts with low balances with low interest.

B. Non-Depository Institutions are government or private organizations that serve as

intermediaries between savers and borrowers. They are institutions that fund their lending
activities by selling their securities or insurance policies to the public. Sometimes they are
referred to as the Shadow Banking System because they resembles bank as financial
intermediaries but cannot legally accepts deposits. Their regulation is less stringent because such
as hedge funds, they are going to take greater risk for a chance to earn higher returns.

1. Finance companies are non-deposit institutions because they do not accept deposits from
individuals or provide traditional banking services, such as checking accounts. They do,
however, make loans to individuals and businesses, using funds acquired by selling securities or
borrowed money from commercial banks. They involve in leasing, project financing, housing
and other kind of real estate financing.

2. Insurance companies sell protection against losses incurred by illness, disability, death, and
property damage. To finance claims payments, they collect premiums from policyholders, which
they invest in stocks, bonds, and other assets. They also use a portion of their funds to make
loans to individuals, businesses, and government agencies.
3. A mutual fund invests money from a pool of investors in stocks, bonds, and other securities.
Investors become part owners of the fund. Mutual funds reduce risk by diversifying investment:
because assets are invested in dozens of companies in a variety of industries, poor performance
by some firms is usually offset by good performance by others. Mutual funds may be stock
funds, bond funds, and money market funds, which invest in safe, highly liquid securities.
(Liquidity is the speed with which an asset can be converted to cash.)

4. Pension/Provident funds manage contributions made by participating employees and

employers and provide members with retirement income. Pension funds are financial institutions
which accept saving to provide pension and other kinds of retirement benefits to the employees
of government units and other corporations. Pension funds are basically funded by the
corporation and government units for their employees, which make a periodic deposit to the
pension fund and the fund provides benefits to associated employees on the retirement. The
pension funds basically invest in stocks, bonds, and other type of long-term securities including
real estate.

5. Hedge Fund is a private investment fund that markets itself almost exclusively to wealthy
investors. Investors are less in number but occupy a very healthy base. It states a minimum
investment requirement, not less than $10 million.

Benefits of Hedge Fund:

- Protection from downfall

- Low correlation
- Performance consistency
- Cautions decision making

6. Exchange Traded Fund (ETF) contains types of investment like stocks, bonds and
commodities. These are marketable securities that has an associated price that allow it easily sell
or brought. It is a basket of securities that trade on an exchange.

Types of ETFs

a) Bonds – government bonds, corporate, state and local or municipal bonds

b) Industry – invest in technology, banking, or the oil or gas sector
c) Commodity – invest in crude oil or gold
d) Currency – foreign currencies like euro and Canadian
e) Inverse – attempt to earn gains from stock declines by shorting stocks

7. Securities facilitates financial market trade between buyers and sellers for a fee.

 Investment Banks – the issuance of financial securities that the main function is funding
on a primary market
  Brokerages - it is the secondary financial market that helps people to sell/buy their
existing securities

Categories of Securities:

a. Debt Securities – when a business borrows to grow first it will borrow using traditional
means; the banks. Banks don’t want to take too much risk, so they will only lend so much
to any one business. The business must then go to the capital market and issue debt
securities. When you buy a Bond, you are lending them your money and they owe it back
to you and they must also pay interest.
b. Equity Securities – when a business takes on additional owners to grow, it either find
private investors or it can go to the capital markets and issue securities in a form of
publicly traded. When you buy a Stock, you are buying an ownership to that company
and you will participate in that profit in one of two ways.
c. Derivative Securities – they give you the right to sell or buy you’re existing securities at
a specific price, by a specified date in the future. The price you pay is called “Premium”.
Think of it as an insurance premium.

4.2. Financial Regulatory Authorities in the Philippines

1. Bangko Sentral ng Pilipinas is the central bank of the Philippines. It functions by
supervising banks and exercising regulatory powers over non-bank institutions
performing quasi-banking functions. It also formulates and implements monetary policy
aimed at influencing money supply, consistent with its primary objective to maintain
price stability.
2. Securities and Exchange Commission is the agency of the Government of the
Philippines responsible for regulating the securities industry in the Philippines. In
addition to its regulatory functions, the SEC also maintains the country's company
register.
3. Philippine Deposit Insurance Corporation (PDIC) exist to protect depositors by
providing Maximum Deposit Insurance Coverage or MDIC that allows depositors to
deposit 500,000. If the bank closes and you have 700,000 deposits in that bank, you are
only get a 500,000 from the PDIC.
4. National Credit Union Administration (NCUA) is independent federal agency that
supervises and insures almost all credit union. It focuses on the greatest risks to the credit
union system or share insurance fund.