Financial System

Financial Instruments, Financial Markets, and Financial Institutions

Financial Instruments

A financial instrument is a real or virtual document representing a legal agreement involving monetary value. These can be debt securities (e.g., corporate bonds) or equity (e.g., shares of stock). When a financial instrument is issued, it creates a financial asset on one side and a financial liability or equity instrument on the other.

A. Financial Assets

Definition: Rights to receive cash or another financial asset from another entity.

Examples:

• Cash
• An equity instrument of another entity
• A contractual right to receive cash or another financial asset

B. Financial Liabilities

Definition: Any liability that is a contractual obligation to:

• Deliver cash or other financial instruments to another entity.
• Exchange financial instruments under potentially unfavorable conditions (IAS 32).

Examples:

• Notes Payable
• Loans Payable
• Bonds Payable

C. Equity Instruments

Definition: Contracts that evidence a residual interest in the assets of an entity after deducting all liabilities (IAS 32).

Examples:

• Ordinary Share Capital
• Preference Share Capital

Debt Instruments

Definition: Generally have fixed returns due to fixed interest rates.

Examples:

• Treasury Bonds and Treasury Bills
• Corporate Bonds

Treasury Bonds and Bills

Issued by the Philippine government. These bonds and bills have usually low-interest rates and very low risk of default.

Corporate Bonds

Issued by publicly listed companies. Generally higher interest rates than Treasury bonds but not risk-free.

Equity Instruments

Definition: Have varied returns based on the performance of the issuing company, deriving returns from dividends or stock price appreciation.

Types:

1. Preferred Stock
   • Priority over common stock in asset claims.
   • Fixed dividend rate; no dividends to common stockholders until preferred dividends are paid.
2. Common Stock
   • Real owners of the company; benefit from growth.
   • Receive excess dividends after preferred stock dividends are paid.

Financial Markets

Financial markets refer to marketplaces where the creation and trading of financial assets, such as shares, debentures, bonds, derivatives, currencies, etc., take place.

Classifications of Financial Markets

1. Primary vs. Secondary Markets

Primary Market: Where new securities are issued through public offerings or private placements.

Secondary Market: Where previously owned securities are sold.

Example: The Philippine Stock Exchange (PSE) operates as both a primary and secondary market.

2. Money Markets vs. Capital Markets

Money Markets: Venue for securities with short-term maturities (1 year or less).

Created for individuals, businesses, and governments with temporarily idle funds.

Capital Markets: Securities with longer-term maturities are sold; includes bonds (long-term debt) and stocks (equity).

Financial Institutions

Financial institutions are companies in the financial sector that provide a range of business services, including banking, insurance, and investment management.

Types of Financial Institutions/Intermediaries

1. Commercial Banks

Accept deposits and provide loans to individuals and firms. Use deposited funds to purchase debt securities.

2. Insurance Companies

Individuals purchase insurance (life, property, casualty, health). Pool premiums and invest proceeds in securities until claims are needed.

3. Mutual Funds

Owned by investment companies; allow small investors to invest in a diversified portfolio. Invest in newly issued securities or transfer ownership among investors.

4. Pension Funds

Receive payments from employees and invest proceeds on their behalf. Include entities like the Government Service Insurance System (GSIS) and Social Security System (SSS).

Key Concepts

Holders of Financial Assets: Suppliers of funds.

Makers of Financial Liabilities and Equity Instruments: Users of funds.