Learning Objectives
After the session (offline and/or online distance learning), the student is expected to:
1. Describe the elements of financial systems, particularly the financial market
2. Describe the importance of financial market
3. Differentiate the different types of financial markets
4. Describe the role of Bangko Sentral ng Pilipinas in the Financial Market
5. Describe the evolution of currency and instruments used in financial markets
To my students,
I know we are in a tough situation now, and we do not when it will end. But remember, learning must never
stop. Amidst the situation, I will try my very best and exert all the efforts to deliver to you quality education. Despite
constraints on time, technical ability, unavailability of resources, and the mere fact that we are far from each other, we will
try to normalize the teaching – learning process. Bear with me and always do your best, future CPAs!!!
To guide you in the learning process, I will be sending you modules for your offline distant learning. This module
will help you study in advance. However, I know the learning from modules alone isn’t sufficient. Therefore, all my
modules will be accompanied by video lectures which will be available to you online and offline. For online videos, you
can access such through the link I will be sending to our group chat. In case your problem is connection, I will try my best
to send to you, door-to-door, in a CD, flashdrive, or any possible means, the videos so you can watch in even offline.
Keep safe always. To God be the Glory!
Your teacher,
Mr. RONEL E. CAAGBAY, CPA
THE FINANCIAL SYSTEM
A financial system is a set of institutions in the economy that permit the exchange of funds. Financial
systems exist on firm, regional, and global levels. Borrowers, lenders, and investors exchange current funds to
finance projects, either for consumption or productive investments, and to pursue a return on their financial
assets. The financial system also includes sets of rules and practices that borrowers and lenders use to decide
which projects get financed, who finances projects, and terms of financial deals .
Therefore, everyone in the in the economy involve on how the funds flow is part of the financial system.
It is so called a system because it is organized, and there’re is policies and practices to follow.
Financial system has six (6) elements:
The financial system has six essential elements:
- First: the ultimate lenders/fund
suppliers (= surplus economic
units) and borrowers/fund
demanders (= deficit economic
units. They undertake the
lending and borrowing process.
The ultimate lenders lend to
borrowers either directly or
indirectly via different financial
intermediaries in the economy.
- Second: the financial
intermediaries which
intermediate the lending and
borrowing process. They connect lenders and borrowers, and earn a margin as payment for the intermediation
(including lower risk for the lender). They buy the securities of the borrowers and issue their own to fund these
(and thereby become intermediaries).
- Third: financial instruments (or assets), which are created/issued by the ultimate borrowers and financial
intermediaries to satisfy the financial requirements of the various participants. These instruments may be
marketable (e.g. treasury bills) or non-marketable (e.g. retirement annuities).
- Fourth: the creation of money (= bank deposits) by banks when they satisfy the demand for new bank credit.
This is a unique feature of banks. Central banks have the tools to curb money growth.
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COLLEGE OF ACCOUNTANCY
FINANCIAL MARKETS
MODULE
- Fifth: financial markets, i.e. the institutional arrangements for the issue and trading (dealing) of the financial
instruments. It is like a simple market, but the products are not goods for basic human consumption and needs.
This specific element of financial system is the focus of our subject.
- Sixth: price discovery, i.e. the establishment in the financial markets of the price of money, i.e. the rates of
interest on debt (and deposit) instruments and the prices of share instruments.
The flow of funds in the financial system is repetitive in nature. Stopping the flow of funds in the financial
system means the economy is failing. Imagine an economy6 without someone who wants to lend money, no
one wants to invest, and no one wants to borrow. It is like living in a world without money.
THE FINANCIAL MARKET
A financial market is a market where buyers and sellers trade commodities, financial securities, foreign
exchange, and other freely exchangeable items (fungible items) and derivatives of value at low transaction
costs and at prices that are determined by market forces.
The Philippine Stock Exchange (PSE) in Ortigas, an
example of financial market
The role of financial markets in the success and strength of an economy cannot be underestimated.
Here are four important functions of financial markets:
1. Puts savings into more productive use
Business firms must not let their excess funds sit in their vaults and earn nothing. Financial markets open
an avenue for firms to use it excess fund in a more productive way where they will earn a return.
2. Determines the price of securities
Investors aim to make profits from their securities. However, unlike goods and services whose price is
determined by the law of supply and demand, prices of securities are determined by financial markets.
3. Makes financial assets liquid
Buyers and sellers can decide to trade their securities anytime. They can use financial markets to sell
their securities or make investments as they desire
4. Lowers the cost of transactions
In financial markets, various types of information regarding securities can be acquired without the need
to spend.
After realizing the role of financial markets in the economy and in the lives of people, it is now the time
to know the importance of financial market. These are the following:
1. Help economic growth of the country.
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FINANCIAL MARKETS
MODULE
The economy of a country largely depends on different transactions happening inside it. The more the
transactions taking place, the better for the economy. Since financial markets are the same as the “usual
market”, more transactions means there are more funds circulating in the economy.
2. Help savers become investors
Excess funds usually go to savings. But this is not a good practice because the money will not earn a
return. Financial markets are good place to put excess funds because there is a higher change of earning a
higher return.
3. Helps businesses to raise money for expansion
Selling financial instruments like stocks and bonds in a financial market is a good way of obtaining large
amount of funds. Even the government is sourcing some of its fund from financial instruments.
There are various types of financial markets, as there are also numerous types of financial instruments.
Think of usual markets in the Philippine. When we say dry goods market, we cannot buy seafood
products there. When we are talking about supermarket, expect that there are varied items there. When we
say wet market, we can buy fish and other water-based products there.
Same goes with financial markets. In general, financial instruments are the products sold in financial
markets. However, each financial instrument has its own financial market. These markets are enumerated and
explained below:
According to Nature of Assets
1. Stock market: This is the market where shares of the company are listed and traded after their IPO.
2. Bond market: This market allows companies and the government to raise money for a project or
investment. Investors buy bonds from a company, which later returns the amount of bond with agreed
interest.
3. Commodities market: In this market, investors buy and sell natural resources or commodities, like corn,
oil, meat, and gold.
4. Derivatives market: This market deals in derivatives or contracts, whose value is based on the underlying
asset being traded.
According to Nature of Claim
1. Equity Market: It is a market where investors deal in stocks or other equity instruments. It is basically the
market for residual claims.
2. Debt Market: In this market, investors buy and sell fixed claims or debt instruments, like debentures or
bonds.
According to Maturity of Claim
1. Money Market: The markets where investors buy and sell securities that mature within a year are the
money market. Assets that investors buy and sell in this market are commercial paper, certificate of
deposits, treasury bills, and more.
2. Capital Market: Markets, where investors buy and sell medium and long term financial assets, is a
capital market. There are two types of capital market: Primary Market (where a company issues its
shares for the first time (IPO), or already listed company issues fresh shares) and Secondary Market or
Stock Market (where buyers and sellers trade already issued securities in the primary market).
According to Time of Delivery
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HIGHER EDUCATION DEPARTMENT
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FINANCIAL MARKETS
MODULE
1. Cash Market: It is the market where transactions are settled in real time.
2. Futures Market: In this market, settlement and delivery take place at a future specified date.
According to Organizational Structure
1. Exchange Traded Market: A market with centralized authority and set regulations are Exchange Traded
Market, like NYSE, NASDAQ, and PSE.
2. Over-the-Counter Market (OTC): Markets with customized procedures and decentralized organization is
an OTC market. It is a type of secondary market. Smaller organizations prefer this market as it has fewer
regulations and is less expensive.
Financial Market in a Nutshell
Responsibilities of BSP
The BSP provides policy directions in the areas of money, banking and credit. It supervises operations of banks
and exercises regulatory powers over non-bank financial institutions with quasi-banking functions.
Under the New Central Bank Act, the BSP performs the following functions, all of which relate to its status as the
Republic’s central monetary authority.
Liquidity Management. The BSP formulates and implements monetary policy aimed at influencing money
supply consistent with its primary objective to maintain price stability.
Currency issue. The BSP has the exclusive power to issue the national currency. All notes and coins issued by the
BSP are fully guaranteed by the Government and are considered legal tender for all private and public debts.
Lender of last resort. The BSP extends discounts, loans and advances to banking institutions for liquidity
purposes.
Financial Supervision. The BSP supervises banks and exercises regulatory powers over non-bank institutions
performing quasi-banking functions.
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HIGHER EDUCATION DEPARTMENT
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FINANCIAL MARKETS
MODULE
Management of foreign currency reserves. The BSP seeks to maintain sufficient international reserves to meet
any foreseeable net demands for foreign currencies in order to preserve the international stability and
convertibility of the Philippine peso.
Determination of exchange rate policy. The BSP determines the exchange rate policy of the Philippines.
Currently, the BSP adheres to a market-oriented foreign exchange rate policy such that the role of Bangko
Sentral is principally to ensure orderly conditions in the market.
Other activities. The BSP functions as the banker, financial advisor and official depository of the Government, its
political subdivisions and instrumentalities and government-owned and -controlled corporations.
The Evolution of Currency
Ancient Origins
Historians note that ancient societies discovered over time that it was often easier, and safer, to
exchange goods with one another than to go to battle for them. Scholars trace such exchange back into
human prehistory, 10,000 years or more ago.
It's been found that humans relied on barter as money, or the direct exchange of goods and services.
Examples of items bartered include anything considered of value, be it food, tools, weapons, materials,
property, clothing, adornments or household wares.
The barter system evolved, and certain items, such as livestock, grains and metals, gained broader
acceptance as a standard means of exchange, most likely for their easy measurability. Historical records show
that as early as the 10th millennium B.C. onward, certain domestic animals such as cattle and goats were
frequently traded among individuals and societies.
With the development of farming and later writing in Mesopotamia from the 8th millennium BC onward,
the use of grains for trade became commonplace. The Sumerian rulers in cities such as Uruk and Ur built large
granaries and developed sophisticated accounting systems to assure that fair exchanges were made to
farmers and especially to local authorities. Initially, in some societies, transactions were been made with tokens
that resembled coins. The purpose of the tokens, which were marked with an image of the item being traded,
was to serve as a reminder that an item had exchanged hands.
The Evolution of Coin
Around the 7th millennium BC in western and central Asia, societies developed a means of trade
centered on that region's rich mineral deposits, extracting metals such as gold, copper and tin. By the 3rd
millennium BC, the use of gold bars with standardized weights and value was common in cities in Egypt and
Mesopotamia. At the time these "commodity currencies" came into existence, other societies around the globe
also started experimenting with standardized forms of currency. Among some items used for trade were cowrie
shells, common in East Asia and Africa, as well as stones, beads, animal skins and weapons like knives and
spearheads. These forms of currency trade persisted and were refined over the next millennia, until the
appearance of the first standardized unit of currency, the coin.
According to historians, coins were first crafted in the 7th century BC, in the ancient kingdom of Lydia,
on the western coast of the region now known as Turkey. These first coins were made of a mixture of gold and
silver known as electrum. The coins were not always round, as commonly seen today, but they often had
irregular sizes and shapes, and were inscribed on only one side. They did come in standardized weights,
however, ranging from about 0.15 grams to around 14 grams. Some of the earliest found had the names of two
individuals inscribed in ancient Lydian script, Walwel and Kalil, which were thought to possibly refer to the
Lydian ruler at the time, King Alyattes, and his father Sadyattes.
From Lydia, the use of electrum coins spread to Greek cities on the coast of Asia Minor, and then to the
mainland of ancient Greece. Almost as early as rulers and nations began to produce coin currencies, the
practice of counterfeiting followed suit. One early practice was to shave the edges of coins to gain material to
produce new coins through forgery.
China and Paper Currency
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HIGHER EDUCATION DEPARTMENT
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FINANCIAL MARKETS
MODULE
Independently from Lydia and Greece, kingdoms and individuals in China also disseminated the use of
their own form of coins, based on miniaturized metallic representations of tools such as knives, agricultural
implements and axes. Later, the Chinese adopted rounded coins with inscriptions of Chinese characters.
The Chinese also innovated as they were the first to use paper currency. As the first to manufacture
paper around the year 100 by using materials such as linen, hemp, bamboo and mulberry bark, the Chinese
had already developed the practice of writing credit notes on paper and deer skins as guarantees for long-
distance trade. The paper bills first appeared during China's Tang dynasty around the 7th century in the Valley
of the Yellow River.
The practice evolved into the development of paper currency, which was found to be a lighter weight
substitute for the thousands of coins that needed to be transported between regions to carry out increasingly
larger transactions from growing trade. Local Chinese authorities at that time suggested that merchants
exchange their metallic coins at the government treasury for paper notes. It came to be known as "fei qian," or
flying money, likely for its tendency to carried away in a strong wind. The use of paper currency later became
fully institutionalized in China during the Song dynasty, which began around 960.
The Emergence of the Banknote in Europe
Paper currency didn't gain widespread usage in Europe until later. It was first brought to the region by
travelers like Marco Polo and William of Rubruck. Europe, however, didn't have the necessary material for
paper currency. The first paper mill in Europe was only established by the Moors in the region that is now Spain
in around 1150.
But in the tumultuous environment of the early Renaissance period in Europe, where transporting
increasingly large sums of metallic coins was risky, merchants and governments around Europe began to adopt
the practice of making transactions with the handwritten promissory notes.
By the 1500s, banking institutions had emerged that gave receipts in exchange for currency deposits.
The receipts were made in the name of the depositors and were payable upon demand. Many of the receipts
also had the words "or the bearer" after the name of the depositor, meaning they could be redeemed later by
anyone presenting them.
In 1661, the government of Sweden became the first European government to issue its own state-
sponsored banknote as legal tender. By 1694, the Bank of England, as part of King William III's effort to finance a
war against France, became the first government bank to make permanent issuance of paper currency.
Like earlier banknotes, these were also payable "to the bearer," allowing for their circulation among the
population. The notes were denominated in "pounds," which was a currency unit that had been in existence in
England since reign of Anglo-Saxon King Offa of Mercia in the middle ages. Initially, the Bank of England issued
notes in larger quantities of 50 pounds, far higher than the average annual earnings of most individuals, so most
people continued to use coins and few actually did business with paper currency.
Technology to Foil Counterfeiting
With the growing issuance of paper currency, the problem of counterfeiting also increased. Among the
successful early technologies used to foil counterfeiters was watermarking, a technique to make a physical
impression on bills that first appeared in Italy around 1282. The technique was later advanced in 1826 by John
Marshall with his invention of a rolling impression device called the "dandy roll."
Forex Trading and Currency Guarantees
Although the pound, the dollar and other currencies of major industrialized nations have been in
existence in some form for hundreds of years, the regulation and breadth of currency markets has undergone
marked transformation since their beginnings. With the creation of standardized currencies by governments
and their increased international trade, the first foreign exchange market, or forex market, appeared in
Amsterdam in the 17th century. While currency began as a means of trade to obtain other items, it has evolved
over time to where it is considered an asset itself, and now represents the world's largest market, with
approximately US$5 trillion traded around the globe on a daily basis. Of principle importance for currency
holders have been changes in the types of guarantees backing the value of currencies.
Early forms of money, including coins, were based on the intrinsic value of the materials they were
made from, but paper currencies historically required the backing of some other asset. Since early on, the most
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FINANCIAL MARKETS
MODULE
common asset to guarantee currencies were gold, which was coveted both for its versatility of use and
aesthetic appeal. Britain was the first to formally adopt a "gold standard" for its currency in 1821 based on the
production of gold coins at its royal mint.
The relative value of currencies was not only important to individuals holding them, but was also a key
factor for the prosperity of entire nations and economies, and it was frequently part of the circumstances
leading to international conflicts over the years. In 1946, after the conflicts of WWI and WWII, countries around
the world entered into the Bretton Woods agreement, which helped formalize the use of gold and also the U.S.
dollar to back currency values around the world.
As in the past, the value of currencies under the system necessarily corresponded to the amount of gold
held by governments. As the production and reserves of gold failed to keep pace with the demand for
creation of money, the U.S. in 1973 decided to go off the gold standard, and other countries followed suit.[
Since then, the relative value of currencies has been backed not by one particular asset, but by
governments' creditworthiness and the faith of the public in their abilities to pay back any debts owed by them.
The abandonment of the gold standard helped alleviate the need for some governments to amass and
stockpile large supplies of gold, but it also forced countries to seek new means to guarantee stability for their
currencies as they "floated" freely against one another.
The global currency market fluctuations that occurred from that time were among the factors that
helped encourage the nations of continental Europe in 1999 to follow through with their long-held plans to
consolidate their national currencies into a single unit called the Euro.
For investors, trading has grown ever more sophisticated since formal exchanges first appeared. And in
the 20th century, with the emergence of electronic trading, large volumes of currencies began to be traded
among banks, businesses and individuals around the globe nearly instantaneously.
Further, investors have also adopted new financial instruments known as derivatives to gain financial
advantage in carrying out their currency trading. These instruments, such as futures, options and swaps, allow
traders to time their exchange of currencies according to their wishes and hedge against large unpredictable
fluctuations in the value of currencies caused by global political and economic events.
Continued Evolution
The concept of currency both as a physical and now digital means of trade continues to evolve.
Recognizing the steadfast popularity of physical currencies, governments have sought ways to make currency
cheaper to produce, more durable and more difficult to counterfeit. The government of Australia was a recent
innovator in that effort, introducing banknotes made from plastic polymers in the 1980s that have since gained
popularity around the globe.[20] The last century has also seen the rise in the popularity of credit, debit and
electronic money transfer services. In some cases, this has reduced or eliminated the need for physical
currency altogether.
Meanwhile, individual traders, seeking to circumvent the volatility and unpredictability of national
currencies that are tied to political decision-making by governments, have experimented with new "digital"
currencies such as the bitcoin that are traded entirely in an online electronic environments. History shows that
it's unlikely that more traditional physical forms of currency will disappear as humans have shown a
fundamental desire for a physical means of trade. But at the same time, developments have shown that
individuals and societies will seek ever-widening definitions for the concept of "currency" to increase the
economic efficiency and advantages obtained from trading.
