COURSE CODE AND TITLE : FINP 6 – CAPITAL MARKETS

LESSON NUMBER : MODULE 4

TOPIC 4 : THE FINANCIAL MARKET 2 ( Capital Markets)

LEARNING OBJECTIVES:
At the end of this lesson, the student should be able to:

1. Discuss capital market

2. Explain the differences of stock market, bond market and derivative markets
3. Differentiate securities market and non-securities market

PRE-ASSESSMENT:
In a yellow sheet of paper, answer the following questions

1. What is the difference between money and capital market?

2. What is the difference between stock market and bond market?
3. What is the difference between securities market and non-securities market?

LESSON PRESENTATION:

CAPITAL MARKETS
Capital markets are markets for long-term securities. Long-term securities are either debt securities (notes,
bonds, mortgages, leases) or equity securities (stocks). Major suppliers of capital market securities are
corporations for stocks and corporation and government for bonds. Long-term securities have maturities of
more than a year. These instruments often carry greater default and market risks than money market
instruments generally because they are long-term. In return, they carry a higher return yield. They suffer
wider price fluctuations than money market instruments

Capital markets are composed of stock market for equity or stock securities; bond markets for debt
securities, mortgage market for mortgages, foreign exchange markets, derivative securities markets, direct
loan market, and lease market, among others.

The need for long-term assets or capital goods as purchase of land or building or expansion will resort to the
capital market as a source of funds. Capital goods are used to produce goods and services to generate
revenues. It is in the capital market that long-term users of funds and those with long-term excess funds
meet. These long-term securities include long-term loans, mortgages, and financial leases; corporate stocks
and bonds and government long-term Treasury notes and bonds. Security exchanges, over-the counter
markets, investment banks, mortgage banks, insurance companies, and other financial institutions deal with
the capital markets. Over-the-counter transactions are done through a loose network of security traders
known as broker-dealer, dealers and brokers.

The capital market consists of :

1. Securities market; and
2. Negotiated (or non-securities ) market

1. Securities market

Securities market is where companies issue common stocks or bonds which are marketable/negotiable to
obtain long-term funds. An instrument which is transferable by endorsement or delivery is negotiable.
Negotiability allows securities to be traded anonymously. The identity of the seller need not be known.
Negotiability improves liquidity because anyone who holds the security can immediately sell the security
when the holder needs cash. The holder can even sell the security prior to maturity.

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Securities market is composed of :

1. Stock market for equity or stock securities

2. Bond market for debt securities, and
3 Derivative securities market for securities deriving their value from another security

1)STOCK MARKET
Stock market serves as the medium or agent of exchange transactions dealing with equity securities. It
involves institutions and analysts who review the performance of listed companies. When companies are
successful in their operations and investments, analysts recommend buying of their stocks creating demand
and increasing share prices and shareholders wealth. Shareholders can penalize poor management of
companies by seling off their holdings driving share prices down. All markets follow the basic economic law
of supply and demand. If there a lot of shares of any one company in the market, its prices go down. The
scarcity of the shares drives the share prices up. If many are buying the stocks, it creates demand and
raises prices up.

Classifying stocks into boards enabled PSE to calculate stock indexes (indices) for each group. A stock
index is a measure of the price level of the shares listed in the exchange by the indicated category. Index
reflects the prices of selected stocks. It is useful as a track record of changes in stock prices over time. PSE
tracks four indices: commercial and industrial, property, mining, and oil. The overall index, which is called
the Philippine stock index (Phisix),is a composite of the four indices. (Saldana 1997)

Saldana (1997) listed the following prices in a trading day:

1. Open- the stock price for the first transaction at the start of trading day
2. Low - the lowest stock price for transactions during the day
3. High- the highest stock price for transactions during the day
4. Close - the stock price for the last transaction of the day

Index also reports price movements of groups and the entire market. Other indicators of the market are
changes in averages and prices movements of stocks according to the number of stocks that increased in
price( advances) or decreased in price (declines)

2. Bond Market

Bond Market is the market where bonds are issued and traded. It is generally classified into:

1. Treasury notes and bonds market;

2. Municipal bonds market; and
3. Corporate bonds market

Treasury Notes and bonds – these are issued by the government’s treasury. Like T-bills, T-notes and T-
bonds are backed by the full faith and credit of the government and are therefore free from risks. As a result,
they pay relatively low rates of interest (yields to maturity) to investors. However, because of longer
maturity, they are subject to wider price fluctuation than money market instruments and therefore subject to
interest rate risk. In contrast to T-bills that sell at a discount, T-notes and T-bonds pay coupons interest
semi-annually. They have maturities of over 1 to 10 years.

Municipal bond (LGU) is an important financial instrument for development. In the Philippines, LGU bonds
have only recently been acknowledged as a potential tool for development. LGU bond reduces the
dependence of LGUs on the national government in implementing their development programs, and most
importantly, encourages and rewards transparent good governance among local government executives.
LGU bond does all these while attracting private institutional capital and providing the investing public with
alternative long-term investment instrument.

Corporate bonds are long-term bonds isued by private corporations. Bond indenture is the legal contract
that specifies the rights and obligations of bond issuer and bondholders (investors), term of the bond,
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interest rate and interest payment dates. It may include such restrictions on the on the issuer's dividend
payments, among others.

3) Derivative Securities Market

The term "derivative" is commonly used to describe a type of security which market value is directly related
to or derived from another traded security. Derivative securities market refers to the market where derivative
securities are traded. Derivative securities are finaincial instruments which payoffs are linked to another,
previously issued securities. They represent agreements between two parties to exchange a standard
quantity of an asset or cash flow at a predetermined price at a specified date in the future. As the value of
the underlying security to be exchanged changes, the value of the derivative security changes. Option,
futurès, forward contracts are examples of derivatives as well as stock warrants, swap agreements,
mortgage-backed securities, and other more exotic variations. While derivative securities have been in
existence for centuries, the growth in derivative security markets occurred mainly the 1990s and 2000s
(Saunders and Cornett 2011).

An example of a derivative would be a call option on a company's stock. The most important determinant of
the price of the option is the current price of the company's shares (the underlying asset) in the open
market. Futures contracts would also allow a farmer to keep his product (e.g., rice) until some time in the
future, yet remain in the current price at the time of harvest. The contract would, in effect, sell off the price
uncertainty to someone in the market who is willing to hold it, in this case, the farmer has hedged his risk of
a price drop. The person who accepts the risk is engaged in the practice of speculation. It was need for this
type of transaction that spawned the first derivative securities markets. Another example would be the
mortgage-backed securities, which are instruments that are secured /guaranteed by mortgages.

Capital markets and money markets include the exchanges where securities or financial instruments are
traded or sold. These exchanges can be formally organized or informally organized (OTC). Organized
security exchanges are like the PSE and other international exchanges, including ASX, SZSE, National
Stock Exchange of India (NSE), OSE, American Stock Exchange (AMEX), and Nasdaq Stock Market of the
United States. There are also electronic exchanges like the US Futures Exchange (USFE), Bats, and
Boston Equities Exchange.

Negotiated/Non-Securities Market

Negotiated or non-securities market does not involve securities, thus called non-securities market. This is
so-called negotiated because it results from negotiation between a borrower and a lender. It includes a
direct loan by a company or a person from lending institution, like a bank. Also, a personal loan that
someone asks from a parent or a relative is a negotiated loan occurring in a negotiated market. A negotiated
market is where the buyer and the seller deal with each other, either directly or indirectly through a broker
or dealer with regard to both price and volume. Buyers and sellers are given sufficient time to locate one
another to do the trade. Borrowing transactions that are large in volume may not be easily traded in the
auction market, instead these are done in the negotiated market.

If a company needs Ps 1M to expand its manufacturing facilities, it can go to its bank where it maintains its
current or checking account, Generally, banks grant their depositors, especially companies and big
individual depositors lines of credit up to a certain limit for example Ps 5M or Ps 10M depending on the
average amount of deposit they have with the bank. The larger the average amount of deposit a depositor
has with a bank, the
line of credit the depositor is granted.

Suppose the company needing Ps3M has a line of credit vwith its bank. It can borrow Ps 3M from that bank
if the amount is within its line of credit. If its line of credit is only Ps 2M, then it can only borrow P2M
maximum. The loan agreement is called term loan agreenent. The term loan agreement is an agreement
between a borrower and a lender for a definite period of time, hence the word "term" Term of the loan is the
length of period from the date is taken to its maturity date, the date the loan is to be repaid.
The loan is non-negotiable therefore less liquid than capital issues like shares and bonds that can be merely
endorsed and transferred because they are negotiable. The loan is a negotiated loan, but non-negotiable.
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When the company needs more than its credit line, the resort it can have is to issue additional shares of
stocks or bonds in the capital market if the company is big and prominent and well known. While all
corporations are empowered to sell stocks and bonds in the open market, not all are able to do so. Only
corporations of high credit standing and are well known the business community can sell their stocks and
bonds in the open market. It would be very difficult for a small company to do this. A small company does
not have the capital, credit standing and connections that big companies have.

A direct loan from a bank is part of the capital market and still the predomninant means of of financing,
especially for a developing country like the Philippines. This is because only prominent and outstanding and
well-known cornpanies can issue securities. Srnall company individuals cannot issue these securities.

If the amount of financing or funds needed is large, instead of borrowing from a single bank, a syndicated
loan can be obtained from a group of banks called a syndicate. The SM Megamall was financed by a Ps
1B loan from a bank syndicate headed by PNB (Saldana, 1997)

The negotiated or non-securities market includes but not limited to, the following:
1. Loan market
2. Mortgage market
3. Lease market

1.Loan Market

Loan market is where a one-on-one transactíon takes place between a borrower and a lender. As in the
foregoing example, a loan by an individual or company from a bank is a direct loan transaction and an
example of a loan market. Even the government negotiates with the World Bank for certain types of loans.

2. Mortgage Market

Mortgage market is where a real property (property with more or less permanent life, like land (residential,
agricultural, or industrial), building (residential, commercial, etc) and big machineries, among others are
used to guarantee or secure big loans. It is also a type of loan, but a secured loan guaranteed by the
mortgage on the property. At times it is used as a means of buying properties. Those who want to own
properties go to a bank or mortgage company and get the loan to buy the property then use the property as
the collateral for the loan, that is, the company mortgages the property. The mortgage market also includes
the market for foreclosed properties. These are the properties taken by lenders because the borrowers
were unable to pay their loan and since the as the collateral for the loan, the property is taken over by the
lender.

Other than banks and other financial institutions, government agencies like the National Home Mortgage
Finance Corporation (NHMFC), Government Service Insurance System, Social Security System, and Pag-
IBIG HDMF grant mortgage loans that belong to the capital market.

3.Lease Market

Lease market is where equipment, building, or other property is being leased/rented out to another party.
The one who owns the property and who is renting the property out is the lessor and the party who is to use
the property in exchange of the rent or lease is the lessse. The lease could be an operating lease or a
capital lease.

OTHER MARKETS

Other markets are a combination of the money and capital markets, because they deal with both short and
long-term loans and securities. These may include the following:

1.Consumer Credit Market

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Consumer credit market involves parties and transactions related to loans granted to households who desire
to buy properties, such as cars or appliances, travel, obtain education for themselves or their loved ones, or
other similar needs. It is called consumer credit market because the borrowers are the consumers.

Consumer credit usually takes the form of character Ioan, car loan, appliance loan, educational loan, and
among others. They can be short-term, like character loans, or longer-term like car loans (usually five
years), or appliance loans (usually three years).These can also include pawnshops, SSS pension lending
companies, and other small consumer loan companies.

2. Organized Market

Organized markets are the exchanges. Exchanges, whether stock markets or derivative exchanges, started
as physical places where trading took place. Some of the best-known organized markets are NYSE, which
was formed in 1792, and the Chicago Board of Trade (now part of the CME Group) which has been trading
future contracts since 1851.

3.Over-the-Counter (OTC) Market

Unlike exchanges, OTC markets have never been a "place." They are less formal, athough often well-
organized networks of trading relationships centered on or-more dealers. Dealers act as market makers by
quoting prices at which they will sell or buy to other dealers and to their clients or customers. It does not
mean the dealers may quote the same prices to other dealers as they post to customers, and they do not
necessarily quote the same prices to all customers. Moreover, dealers in an OTC security can withdraw
from market making at any time, which can cause liquidity to dry-up, disrupting the ability of market
partcipants to buy or sell. Exchanges are far more liquid because all buy and sell orders as well as
execution prices are exposed to one another

OTC markets are less transparent and operate with fewer rules than do exchanges. All of the securities and
derivatives involved in the financial turmoil that began with a 2007 /breakdown in the US mortgage market
were traded in OTC markets. (Dodd 2016)

There are a few dealers who hold inventories of OTC securities that act as a securities market. Included in
the OTCs are brokers who act as agents in bringing together dealers and investors. OTCs cannot function
without the computers, terminals, and electronic networks that facilitate transaction or trade between and
among dealers, brokers, and investors.

4. Auction Market

Auction market is where the trading is done by an independent third party matching prices on orders
received to buy and sell a particular security. Stocks are sold the highest bidder on the trading floors. The
highest bidder is the one who offered the highest price for a particular security. It is where buyers and
sellers are brought together directly, announcing the prices at which they are willing to buy or sell securities.

PSE is an example. At the PSE, buyers of securities make their bid and sellers make their offer. Each one
makes counter-offers. Bids and offers stipulate both prices and volume and are handled by the third party,
called the trader, an agent of the auction-market. Counter-offers are matched with one another. If there is a
match, the tradeor sale is consummated. Buyers and sellers do not directly trade with each other, but all
trades are done through the trader. The exchange is a noisy place as the offers are "shouted" by the
participants.

5.Foreign Exchange Markets

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Foreign exchange market provides the physical and institutional structure through which the money of one
country is exchanged for that of another country, the rate of exchange between currencies is determined,
and foreign exchange transactions are physically completed.

6. Spot Market

Spot markets are called such because buying and selling is done “on the spot”, that is for immediate
delivery and payment. The buyer pays immediately and the seller delivers immediately, if you pick up your
phone and ask your trader to buy you a certain stock, say PLDT stocks at today’s prices, that is spot market
transaction,you expect to acquire ownership of the PLDT stocks within minutes or hours (Rose 1984)

7. Futures Market

Unlike the spot market, futures market is where contracts are originated and traded that give the holder right
to buy something in the future at a price specified in the contract. It is an agreement to transact involving the
future exchange of a set amount of assets for a price that is settled daily.

8. Forward Market

Both the futures market and the forward market involve trading contracts calling fo the future delivery of
financial instruments, commoditites or currencies. If you call your broker today and ask him to purchase a
contract for you from another investor calling for delivery to you of Ps 500,000 T-bonds 6 montfs from today
that could either be a futures contract or a forward contract.

Forward markets ca be ether be in the commodity market (gold, copper, oil, copra, among others) ,the
foreigh currency market and even in the interest rate (forward rate agreements or FRA;s)

9. Options Market

Options Market is where stock options are traded. This is the formal market where the options are bought ad
sold and not when a stockholder is given the option or pre-emptive right to buy additional shares of stock to
maintain his proportionate share or ownership in a corporation. These options, given by the corporation to
the stockholders, can be sold by the stockholders if they do not want to exercise the same. This gives rise
to the options market.

10. Swap Market

Swaps are agreement between the two parties ( counterparts) in exchanging specified periodic cash flows in
the future based on an underlying instrument or price (e.g. a fixed or floating rate on a bond or a note).
Like forward, futures and options, swaps allows firms to better manage their interest rate, foreign exchange
and credit risks
The swap market is where swaps are traded.

There are five general types of swaps:

a. Interest rate swaps

b. Currency swaps
c. Credit risk swaps
d. Commodity swaps
e. Equity swaps

SUMMARY :

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Capital markets are markets for long-term securities. Long-term securities are either debt securities (notes,
bonds, mortgages, or leases) or equity securities (stocks).

Securities market is where companies issue common stocks or bonds that are marketable/negotiable to
obtain long-term funds. An instrument which is transferable by endorsement or delivery is negotiable.

Stock market serves as the medium or agent of exchange transactions that deals with equity securities or
stocks.

Bond market is the market where bonds are issued and traded. Bond markets are generally classified into
Treasury notes and bonds market, municipal bonds market, and corporate bonds market.

Derivative Securities market refers to the market where derivative securities are traded.

Capital markets and money markets include the exchanges where the securities of financial instruments
are traded or sold. These exchanges can be formally of informally organized.

The negotiated or non-securities market includes, but is not limited to loan market, mortgage market, and
lease market. Loan market is where a one-on-one transaction takes place between a borrower and a lender.
Mortgage market is where a real propety, buildiing, and big machineries, are used to guarantee or secure
big loans. Lease marketIs where equipment, building, or other property is being leased/rented out to another
party.

Auction market is where the trading is done by an independent third party matching prices on orders
received to buy and sell a particular security.

Foreign exchange market provides the physical and institutional structure through which the money of one
country is exchanged to the money of another country, the rate of exchange between currencies is
determined, and foreign exchange transactions are physically completed.

Futures market is where contracts are originated and traded that give the holder right to buy something in
the future at a price specified in the contract.

Forward contracts are contractual agréements between a buyer and a seller at time to exchange a pre-
specified, non-standardized asset for cash at some later date.

Options market is where stock options, the right to buy stocks, are traded. Options are called warrants if
they are issued by corporations, and calls if they are issued by individuals.

Swaps are agreements between two parties in exchanging specified periodic cash flows in the future based
on an underlying instrument or price.

The third market comprises OTC transactions between broker-dealers and large institutions. The fourth
market is made up of transactions that take place between large institutions.

Investors are generally classified as bulls, bears, chickens, or pigs.

REINFORCEMENT/ ASSIGNMENT:
Write your answer clearly and neatly in clean sheet of paper

1)Go to the website of Bangko Sentral ng Pilipinas and read about the Financial Market operations
of BSP

ACTIVITY/ EVALUATION:

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IDENTIFICATION : Write your answer in one whole sheet of yellow paper.

_______________1.These are the market for long-term securities

_______________2.These are the long-term assets used to produce goods and services to generate
revenues
_______________3.It is the type of capital market where negotiable instruments like stocks and bonds are
traded
_______________4.It is the type of capital market where a borrower directly enters into a loan agreement
with the lender
_______________5. It is right granted to existing stockholders of a company to buy additional shares of
stock to maintain his proportionate share or ownership in a corporation

True or False – Write True if the statement is correct and False if incorrect

_______________6. The Philippine Stock Exchange belongs to the organized market

_______________7. Foreign exchange markets refer only to transactions froms banks
_______________8. Buying stocks for immediate delivery is done in the spot market
_______________9. In the futures and forward markets, delivery happens in the future
______________10. Speculations is the act of buying and selling of a commodity, security or currency to
protect against the risk of future price fluctuations.

Reference/resources:

1)Mariano, Norma Dy Lopez, PhD, Capital Market, Rex Book Store, 2017

2) Saunders, Anthony; Cornett, Marcia M, The Financial Markets and Institutions, Mc Graw Hill Education,
2011

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