San Mateo Municipal College Prepared by: Jesica O.

Maningas, CPA, CMA

Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

CCFMAR_FINANCIAL MARKETS
Asymmetric information in the financial system

It occurs when one party has more or superior information about a transaction than the other party. This lack of
transparency can lead to unfair advantages or poor decisions due to insufficient or misleading information.

Here are some examples of asymmetric information in various aspects of the financial system:

1. Banking Sector: A bank has more information on the borrower's credit history and repayment ability, which
is not available to the borrower. On the other hand, a borrower may have more information about their
personal financial situation and prospects than their lender.
2. Insurance: An individual applying for insurance knows more about their health conditions and habits than
the insurance company (also known as adverse selection). After the insurance is taken, the individual might
behave in a riskier way, assuming the insurer will bear the loss (also known as moral hazard).
3. Stock Market: Company insiders often have more information about the firm's financial health, growth
prospects, potential risks, etc., than outsiders such as investors or analysts. This allows them to exploit this
asymmetric information for financial gain.
4. Financial advisors: Sometimes, advisors have incentives to recommend products or services that earn them
the most commission, rather than what's best for the client.

To mitigate the effects of asymmetric information, financial institutions will instill information disclosure requirements,
create regulations to punish deceptive practices, or use statistical models to predict behavior. Despite these efforts,
asymmetric information cannot be eliminated and thus remains a crucial aspect to consider in financial analysis and
policymaking.

Asymmetric information in financial systems typically falls into two main types:
1. Adverse Selection: Adverse selection occurs before a transaction is carried out. For example, in the
insurance industry, those more likely to buy health insurance are those who know they have health
problems. Since the insurer is less informed about the person's health than the person themselves, they
can't accurately assess the risk and charge an appropriate premium. This concept also applies in financial
markets, where borrowers who are most likely to default on loans are also the ones who seek loans the
most.
2. Moral Hazard: Moral hazard occurs after a transaction is completed. It means that one party behaves
differently from how it agreed to behave because it no longer bears the full consequences of its actions.
For instance, after obtaining an insurance policy, a person might take more risks because they know the
costs of an accident will be borne by the insurance company. Similarly, in the financial system, a company
might engage in riskier business ventures after securing a loan, knowing that if their venture fails, the
financial burden falls to the lender.

Both adverse selection and moral hazard are significant issues in finance since they can lead to market failures and
require institutions to develop mechanisms to counter or minimize their effects. Some measures include screening
and monitoring the activities of the other party involved in a transaction, regulations to enforce transparency, and
incentives to promote good behavior.

Managing Credit Risk and the Asymmetric Information

1. Screen and Monitoring

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

• Screening – to accomplish effective screening, lenders must collect reliable information from
prospective borrowers. Effective screening and information collection form an important principle of
credit risk management.
Credit score: a statistical measure derived from the information collected from borrower that predicts
a possible trouble in loan repayments
• Monitoring and Enforcement of Restrictive Covenants – by monitoring borrowers’ activities to see
whether they are complying with the restrictive covenants and by enforcing the covenants if they are
not, lenders can make sure that borrowers are not taking on risks at the lenders’ expense

2. Long-term Customer Relationships – lender with previous relationship to its borrower will find it easier to
obtain a loan at a low interest rate because the financial institution has an easier time determining if the
prospective borrower is a good credit risk and incurs fewer costs in monitoring the borrower
3. Loan Commitments – it is a special vehicle for institutionalizing a long-term customer relationship. It is a
bank’s commitment to provide a firm with loans up to a given amount at an interest rate that is tied to some
market interest rate
4. Collateral – it is a property promise to the lender as compensation if the borrower defaults, lessens the
consequence of adverse selection because it reduces the lender’s losses in the case of a loan default. It
also reduces moral hazard because the borrower has more to lose from a loan default
5. Compensating Balances – it is a particular form of collateral required when a bank makes commercial loans.
It is the minimum required amount of funds to keep by the borrowing in a checking account at the bank. It
helps increase the likelihood that a loan will be paid off thus reducing moral hazard
6. Credit Rationing – refusing to make loans even though borrowers are willing to pay the stated interest rate
or even a higher rate
2 Forms of Credit Rationing:
• Lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a
higher interest rate
• Lender is willing to make a loan but restricts the size of the loan to less than the borrower would like

Credit Ratings
In the context of financial markets, credit ratings are used by investors when deciding whether to invest in a
particular security, such as a bond.

A credit rating evaluates the credit worthiness of a debtor, especially a business (company) or a government, but
also of financial instruments such as bonds. It affects the interest rate paid by the issuers to investors. The lower the
credit rating, the riskier the investment and therefore, the higher the interest rate the issuer has to pay to attract
investors.

Credit ratings can also influence the price and demand for certain securities, as some institutional investors are
required to hold a certain amount of high-rated bonds.
It is also worth noting that credit rating agencies (CRAs), companies that assign these ratings, play a critical role in
financial markets. Top CRAs include the following:
• Standard & Poor's (S&P)
• Moody's
• Fitch Ratings

Credit ratings are not guarantees of credit quality or solvency. They are opinions about credit risk made by private
companies based on thorough analyses. Discrepancies in the evaluations provided by different rating agencies are
common.

Ratings are not static. They may be upgraded if the financial health of the subject improves or downgraded if it
worsens. Sudden changes in ratings can impact financial markets negatively. For example, a downgrade of a
country's public debt can trigger a fall in its bond prices and respective market.

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

Credit Information System

A credit information system, also known as a credit reporting system, in the context of financial markets, is a system
that collects and distributes information about borrowers' credit history. This includes both individuals and
organizations and covers both positive and negative information.

The information typically comes from a variety of sources such as banks, credit card companies, lenders, and other
financial institutions. These systems are typically managed by Credit Bureaus or Credit Reporting Agencies. In some
countries, there can also be public credit registries run by central banks or other regulatory institutions.

This information is typically used by lenders to make decisions about providing credit to individual entities. It gives
lenders a detailed picture of how an entity has handled credit in the past, helping them gauge the risk of lending to
it. This can affect whether a loan is granted and what interest rates are offered.

In financial markets, a well-developed and effective credit information system can contribute to market stability and
efficiency by improving lenders' ability to evaluate risk, reducing default rates, and facilitating access to credit.
Investors also use this information to assess a company's creditworthiness or a country's risk profile when deciding
whether to invest in bonds or other debt instruments. This, in turn, influences the cost of borrowing and the overall
performance of the financial markets.

While they are necessary and beneficial, credit information systems also need to carefully manage privacy concerns
and ensure information is accurate and up to date for them to function optimally.

Key Risks In Money Markets

Participants in money markets are exposed to the following types of risk:

1. Interest Rate Risk

2. Credit Risk
3. Credit Spread Risk
4. Counterparty Risk
5. Liquidity Risk

Interest Rate Risk

Where assets are funded using a financing arrangement with interest cost fixed for a different term than is earned
from the asset. The purchase of a 12-month fixed rate certificate of deposit (CD) funded using the overnight
interbank market presents the holder with interest rate risk.

A parallel shift higher in the yield curve would bring losses from two sources: a cash flow cost from the increase in
(overnight) funding cost, as well as a negative mark-to-market cost from the reduced secondary market value of
the CD as its (fixed) cash flows get discounted using an increased rate.

The purchase of a 12-month CD could be funded by the issuance of a 6-month CD. This would leave the bank
Treasury with a fixed rate asset for 12 months and a fixed rate liability for 6 months.

A parallel shift in the yield curve would have no immediate impact from a cash flow perspective. However, the two
exposures imply a forward commitment – to issue a six-month CD in six months’ time.

This forward commitment brings an exposure on a mark-to-market basis that can only be hedged by a forward CD
transaction or with the use of a derivative such as futures contracts that provide a fixed rate commitment for the
same period.

Credit Risk

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

This is the risk of loss from a counterparty being unable or unwilling to make the payments required under that
agreement.

The only money market instruments that present almost no credit risk to their holders are treasury bills or reverse
repos. A reverse repo is effectively a loan of cash but where the borrower provides government securities as
collateral.

Bank treasurers do invest in these very low credit risk instruments, largely because of the minimal regulatory
capital requirements and preferred treatment in the calculation of Basel III ratios (such as the liquidity coverage
ratio (LCR) and net stable funding ratio (NSFR).

However, banks are motivated to maximize earnings for their shareholders and treasurers will therefore take
incremental credit risk from other relatively lower quality assets in exchange for a higher interest return than can
be achieved from T-Bills or reverse repos.

Credit Spread Risk

Just as with bonds, it should always be recognized that money can be gained or lost from market perceptions of
credit riskiness without the borrower in question defaulting. A perceived deterioration in the credit quality of the
borrower will cause credit instruments issued by that borrower to adjust to lower secondary market prices.

The rates of return available to new buyers of such instruments will increase to bring an expected return equal to
the risk-free rate once the probability of reduced repayment following default is incorporated into the calculation.

Counterparty Risk
This is the risk that another bank, dealer firm, or client fails to meet its commitments. Even though money market
transactions are usually quite short in tenor, the counterparty risks are typically of longer duration. For some
money market instruments counterparty risk is combined with credit and credit spread risk, such as with bank
deposits, primary (newly issued) commercial deposits (CDs).

Derivatives such as swaps, swaptions, caps, and floors are widely cleared through central counterparties, indeed
for an increasingly broad range of products and in most of the "developed" markets this use of clearing is
mandatory. This reflects the fact that central clearing can greatly reduce – if not entirely eliminate – counterparty
risk in respect of these products.

Liquidity Risk
Liquidity risk is the risk that assets in a given size over a given period cannot be bought or sold without adversely
affecting the price of the asset. Liquidity is a vital consideration in money markets. In fact, for some money market
participants, liquidity is the most important consideration.

Corporate investors invest excess cash into money markets as part of a strategy to limit exposure to banks.
However, these investors will seek instruments that can be sold very quickly and easily. The corporate treasurer of
any nonfinancial sector business will usually regard the risk of loss from deterioration in the liquidity of a short-term
investment asset as being extraneous to the expectations of shareholders and therefore in direct conflict with high
standards of corporate governance.

Investors in Treasury bills (discussed shortly) mostly forgo the higher yields that would be available from equivalent-
tenor instruments from nongovernment issuers favoring the safety of treasury instruments. The safety they expect
to enjoy is very low credit risk and very high market liquidity.

While the use of some instruments by certain investors comes with expectations of liquidity, there are other
circumstances where liquidity can be considered less important. The secondary market for commercial deposits
(CDs) and commercial paper (CP) can be quite illiquid but that inconvenience is often mitigated by their relatively

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

short terms to maturity. Where investors have the prospect of getting repaid quite soon illiquidity can become less
of a concern.

Transactional Markets Overview

Transactional finance covers areas where money is needed to facilitate immediate business, such as foreign
exchange (FX/forex), trade finance, and commodities markets.

In practice, there is no clear distinction between funding and transactional finance. A lot of short-term debt – such
as overdrafts – could be regarded as transactional finance, while commodities and FX markets include
considerable numbers of "non transactional" market participants such as institutional investors and speculators.

• Foreign Exchange
The FX market has a long history and can be considered transactional finance because it facilitates cross-border
transactions, such as trade or tourism. In terms of volume and activity, it is the largest financial market in the world.

Although it originally developed on the back of transactional requirements, financial market professionals now
dominate the FX market. It attracts a substantial number of investors and speculators, and there are many
transactions between dealers – it is estimated that less than 10% of market turnover involves nonfinancial
institutions.

Most FX transactions involve USD, and more than half are concentrated in just three currency pairs (EUR/USD,
USD/JPY, and GBP/USD).

• Trade Finance
Trade finance evolved to address a simple issue: importers wish to pay for goods only when they arrive – and then
preferably as late as possible – while exporters want to be sure they will receive payment.

Although much international trade takes place between trusted counterparties on an open account basis (see
below), many trade participants require more certainty concerning delivery or payment.

To facilitate this, banks may act as transactional intermediaries, collecting and vetting documents, negotiating
with counterparty banks, and transmitting payments. Banks may also take a more direct role. For example, they
may facilitate trade by lending directly to exporters or by providing guarantees to either of the trading parties.

Open Account Basis

Trading on an open account basis occurs when an exporter ships goods to an importer without receiving cash or
any other legally binding undertaking at or before the time of delivery. According to the agreed terms of the sales
contract, the importer will then pay the exporter on receipt of an invoice.

Open account trading is therefore a form of “buy now, pay later” agreement – it requires exporters to assume
significant credit risk.

In practice, open account trading is more akin to regular payments for a continuous flow of goods rather than
once-off payments for specific transactions.

Commodities
Commodities are raw or partly-refined materials that are used to make the products we use every day. Large
markets facilitate trading in a wide range of commodities, from agricultural goods to energy and metals. Most
agricultural commodities can be divided into three broad groups or “complexes.”

1. The grains complex includes commodities such as corn, wheat, rice, oats, and soybeans.
2. The livestock and meat complex includes live cattle, feeder cattle, and lean hogs.

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

3. The soft commodities complex includes sugar, cocoa, coffee, orange juice, and cotton.

New commodities markets are emerging all the time.

Commodities markets can be seen as transactional as they allow end-users, such as manufacturers or
distributors, to purchase the materials they need from a market featuring the offerings of numerous
producers. However, as with foreign exchange markets, commodities markets also serve investors and
speculators.

Risk Management Markets Overview

Risk management products have their origins in the concept of hedging. A hedging instrument aims to reduce
overall risk by generating an offsetting gain if there is a loss elsewhere.

In practice, there is no such thing as a "perfect hedge" because hedging transactions vary greatly as to how far
they can offset losses. Although risk can be reduced, it cannot be eliminated.

Risk management products can be subdivided broadly into insurance-type products and derivatives.

• Insurance
Insurance is perhaps the most recognizable form of risk management. As well as familiar consumer/retail products
such as life insurance and home insurance, there are also financial insurance products. Some companies specialize
in insuring bond payments – if the issuer is incapable of making repayments, the insurance company pays instead.

There are also bank guarantee products where a bank promises to repay a lender if the borrower is incapable of
doing so. Together with export guarantee schemes – where a government entity promises that exporters will be
paid – these instruments play a significant role in trade finance.

• Derivatives
Derivatives are financial instruments whose value is based on or derived from the value of some other instrument
known as the underlying. Derivatives facilitate risk management by giving certainty as to future costs or revenues
and setting maximum or minimum values for key variables.

Derivatives reference nearly every possible underlying in finance. Although commodity and agricultural derivatives
markets remain significant, they are dwarfed by the markets for derivatives covering key financial variables such
as interest rates, exchange rates, equities, and credit.

With most derivatives, there is little or no requirement to use cash upfront, and most derivative contracts can be
liquidated or closed out before the need for an actual purchase. This allows traders and speculators to benefit
from leverage – they can generate returns based on the performance of the underlying with no cash outlay.

An important caveat, however, is that most derivatives transactions require some form of collateral payment to
cover the credit risk associated with the future transaction. Because derivatives mimic the price movements of
other assets, they are widely used as speculative instruments as well as for risk management purposes

Financial Market Participants

Key Market Players

Numerous players contribute to the day-to-day functioning of financial markets, and each individual financial
market is shaped by the unique mix of its participants.

The key players include:

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

1. Banks
2. Nonbank financial firms
3. Institutional investors
4. Corporates
5. Individuals
6. Governments/sovereigns
7. Regulators

Banks
Banks play multiple roles in different markets. Within a single country, there may be many types of banks.
Likewise, within a single bank, there may be many different business lines.

In the simplest case, banks take deposits from individuals or institutions and make loans. This is known as
commercial banking.

Alternatively – or additionally – banks distribute debt and equity securities in both primary and secondary markets.
This is known as investment banking.

An investment bank may act as:

• An underwriter – guaranteeing proceeds for an issuer

• A broker – serving as an agent between buyer and seller
• A market-maker, buying or selling securities from customers and holding inventory

The difference between a broker and a market-maker is that, while a broker acts as an intermediary between
buyers and sellers, transferring securities between them in exchange for a fee, a market-maker purchases or sells
securities as a principal on its own account.

Banks are also significant borrowers in their own right.

If customer deposits are insufficient to support their lending businesses, banks will borrow from bond or money
markets. Banking concentration varies from country to country. For instance, there are many banks in the
Philippines but far fewer in Thailand. Some banks operate internationally, with huge volumes of cross-border
business. And, in some countries, the most important banks may be foreign-owned.

Non-Bank Financial Firms

Nonbank financial firms such as asset managers are important participants in financial markets, involved in
trading, investment, and other activities.

In addition, various nonbank entities are increasingly offering traditional banking services.

For instance, some institutional investors may enter direct lending relationships with borrowers. Retail investors
may deposit cash in short-term investment funds rather than with conventional banks, and nonbank financial
technology (FinTech) firms that offer payment services have made significant inroads into the consumer
banking/payments space. Further, some FinTech firms offer other banking services, including loans and FX
facilities.

The system of intermediation that involves entities and activities outside the regular banking system is known as
"shadow banking."

Many economies now have significant shadow banking sectors. Shadow banking activities are a challenge for
regulators as rules that apply to traditional banks may not be easily transferable to shadow entities.

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

Thus, while shadow banking benefits consumers by providing additional funding and investment opportunities, the
growth of nonbank credit may create new risks in financial systems – risks that existing prudential regulation is not
equipped to address.

Institutional Investors
Institutional investors represent the most important "supply" of financing in securities markets. By aggregating
funds, they can sidestep the limitations of individual investors, buying/selling large quantities of securities, and
investing capital in otherwise inaccessible markets and assets.

Some institutional investors, such as pension funds and insurance companies, aim to generate returns on their
debt and equity investments sufficient to satisfy their obligations. Others, such as hedge funds, simply focus on
generating as much return as they can..

Corporates
Private sector companies are important players in debt markets. Rather than diluting ownership by issuing equity,
companies may prefer to fund themselves with debt. Further, while generally borrowers, some corporates may
have investable surpluses.

The term "corporates" covers a range of entities with different objectives and requirements.

Types of Corporate Entity

• Small & Medium Enterprises (Smes)
• Multinationals & Large Domestic Corporates

Individuals
Collectively, individuals represent the largest element of most financial markets, albeit with small individual
transaction sizes.

As well as providing deposits for the banking system, individual or retail investors are active in most bond and
equity markets, although their influence may be minor compared to institutional participants. Individuals also
borrow cash and use foreign exchange. Developments such as peer-to-peer lending and crowdfunding have
increased the importance of individuals in many funding markets.

Wealthier individual customers such as high net worth individuals (HNWIs) generally require different products and
pose different risks compared to less-wealthy individuals. As a result, they tend to be dealt with on a relationship
basis in specialist wealth management or private banking businesses.

Governments & Sovereigns

A sovereign is a self-governing state, usually a country. Sovereigns do not issue equity but are active in the debt
markets, where they dwarf the issuance from nonfinancial corporate bond issuers. Most governments run a deficit
between tax revenue and expenditure on public services, which they fund with debt. They may also tap the debt
markets when they need short-term funds.

Sovereign debt includes all forms of central government debt – such as treasury securities – as well as debt
securities issued by certain government agencies and obligations of the central bank or its equivalent. Some
governments also borrow on behalf of municipalities, local authorities, and other public bodies, although such
entities may also borrow on their own behalf. In addition to debt markets, governments may also be active in the
FX and gold markets in a bid to influence the value of their domestic currency.

Regulators & Regulation

Markets need rules and regulations to function efficiently.

Broadly speaking, financial regulators focus on three key areas:

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 San Mateo Municipal College Prepared by: Jesica O. Maningas, CPA, CMA
Institute of Business and Accountancy A.Y. 2023 – 2024, Second semester
Bachelor of Science in Accountancy FINANCIAL MARKETS

1. Stronger Financial Institutions - "Microprudential" regulators focus on the safety and soundness of
individual banks and other financial institutions.
2. Sound Markets - Market regulations focus on promoting fairness and transparency, eliminating potentially
distorting trading practices, and lowering credit and other risks.
3. Financial Stability - "Macroprudential" regulation looks at the broader health of the financial and economic
system. Regulators "fine-tune" other elements, such as credit policy, to reduce/remove systemic risks and
ensure overall stability.

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