Overview of Financial Markets & Capital Market Theory

What is a financial market and what is its primary function?

A financial market is any physical or electronic marketplace where buyers and sellers trade financial assets such as stocks, bonds, currencies, and derivatives. Its primary function is channeling funds from savers/investors (surplus units) to borrowers (deficit units) like businesses and governments to enable capital formation and economic growth.

What are the six classifications of financial markets presented in the lecture notes?

The six classifications are: By Maturity (Money Market vs. Capital Market), By Issuance Stage (Primary vs. Secondary Market), By Claim Type (Debt vs. Equity Market), By Delivery Timing (Spot vs. Derivatives Market), By Structure (Exchange-Traded vs. OTC Market), and By Geography (Domestic vs. International Market).

How do money market instruments differ from capital market instruments in terms of maturity and purpose?

Money market instruments mature in one year or less and exist mainly to manage short-term liquidity. Capital market instruments run longer than a year (or have no fixed maturity, like common stock) and fund long-term projects.

What specific Philippine and global examples are given for money market versus capital market instruments?

Philippine examples: 91/182/364-day Treasury bills (money market) vs. San Miguel Corporation's P60-billion, 6-to-10-year corporate bonds and PSE-listed shares (capital market). Global examples: U.S. Treasury bills and commercial paper (money market) vs. U.S. Treasury bonds and NYSE/Nasdaq-listed equities (capital market).

What is the key distinction between transactions in the primary market and the secondary market?

In the primary market, a security is sold for the first time and the issuer directly receives the proceeds. In the secondary market, existing securities change hands among investors, and the issuer receives no further proceeds.

How do the IPOs of Citicore Renewable Energy Corp. (CREC) and Rivian demonstrate primary and secondary market transactions?

CREC's June 2024 IPO raised P5.3 billion directly for the company (primary market) before shares traded daily on the PSE (secondary market). Rivian's $11.9-billion IPO on November 9, 2021 was a primary market transaction, followed by day-to-day trading on Nasdaq where the stock swung from $78 to over $170 within a week (secondary market).

How do investor claims and returns differ between debt and equity markets?

The debt market involves a creditor claim with fixed coupon or interest payments (e.g., SMC fixed-rate bonds, Apple corporate bonds). The equity market involves an ownership claim with variable dividends (e.g., Ayala Land common shares, Apple Inc. common stock).

How are Exchange-Traded and Over-The-Counter (OTC) structures exemplified in the Philippines and globally?

In the Philippines, the PSE operates a centralized equity board (Exchange-Traded), while most peso corporate bonds trade on the Philippine Dealing & Exchange Corp. (PDEX) over-the-counter. Globally, NYSE/Nasdaq represent centralized exchange trading, while the U.S. OTC Markets Group (Pink, OTCQX) caters to smaller or foreign issuers.

How do domestic and international markets differ in terms of target investors and currency denomination?

Domestic markets deal in peso-denominated local debt sold to local investors (e.g., local Peso Treasury bonds), while international markets deal in cross-border capital flows, such as Republic of the Philippines (ROP) U.S.-dollar global bonds sold to foreign investors.

How do financial markets facilitate capital formation, according to the examples of CREC and Rivian?

Capital formation converts idle savings into productive investment by connecting savers directly to businesses needing funds. CREC used its P5.3-billion IPO (2024) directly for solar and battery-storage capital expenditure, while Rivian used its $11.9-billion IPO (2021) to fund EV factory expansion in Illinois.

What is price discovery, and what recent examples illustrate how it functions?

Price discovery is continuous buying and selling that reveals the fair market value of a security in real time based on available information. Examples include the PSEi's aggregated daily close of 6,528.79 at end-2024 and GameStop's extreme price swing from $17 to $347.51 in January 2021.

What is liquidity provision in financial markets, and how do BDO and Apple shares illustrate it?

Liquidity provision lets investors convert securities into cash quickly without a large loss in value. BDO Unibank shares can be sold within seconds on the PSE during trading hours, while Apple shares trade with billions of dollars in daily volume on Nasdaq.

How do REITs and short-selling demonstrate risk transfer in capital markets?

PSE-listed REITs (AREIT, FILRT, MREIT, Citicore Energy REIT) let investors spread property risk across a diversified portfolio rather than a single building. Short-selling lets traders shift downside risk to parties willing to bear it, such as Melvin Capital's attempt to transfer downside risk on GameStop.

How does centralized electronic trading lower transaction costs for investors?

Electronic systems like PSE Trade XTS match orders in milliseconds at broker commissions of roughly 0.25% - 0.5% per trade, matching buyers and sellers instantly at a fraction of the cost of private negotiations.

How do market indices serve as economic growth signals?

Indices act as barometers of business confidence and economic performance. The PSEi's 1.2% gain in 2024 (its first yearly gain since 2019) signaled improving investor confidence, while the S&P 500 and Dow Jones Industrial Average are monitored by the U.S. Federal Reserve as gauges of financial conditions.

Who introduced Modern Portfolio Theory (MPT) in 1952, and what is its core premise?

Harry Markowitz introduced MPT in 1952. Its core premise is that investors are risk-averse, and because asset returns are not perfectly correlated, combining different assets into a portfolio can lower overall risk without lowering expected return, creating an 'efficient frontier'.

How can a Philippine investor apply MPT to reduce portfolio volatility?

An investor holding only mining stocks (e.g., Semirara Mining) can add a REIT (AREIT) and a consumer staple stock (Jollibee Foods)—assets that do not move in lockstep with mining—to reduce overall portfolio volatility for the same expected return.

Who proposed the Efficient Market Hypothesis (EMH) in 1970, and what are its three forms?

Eugene Fama proposed EMH in 1970. Its three forms are: weak form (prices reflect past prices), semi-strong form (prices reflect all public information), and strong form (prices reflect all private/insider information).

What real-world events are cited as supporting and challenging evidence for semi-strong EMH?

Supporting: A surprise Bangko Sentral ng Pilipinas (BSP) policy-rate cut causes bank stocks like BDO to reprice within minutes. Challenging: GameStop's 2021 run-up to $347.51 with unchanged company fundamentals demonstrated coordinated retail trading pushing prices far from fair value.

What is the Capital Asset Pricing Model (CAPM) formula and who introduced it in 1964?

Introduced by Sharpe (1964) and Lintner (1964), the CAPM formula is $$R_a = R_f + eta_a (R_m