Chapter 1: FINANCIAL SYSTEMS AND THE FINANCIAL MARKET

The Financial System

Finance
 In the world of commerce, finance is a key player in ensuring continuity of operations in the world of
commerce
 Is the life-blood of the company
 the management must ensure that its continuous flow is maximize

Financial Management
 an important process to ensure that profit and wealth is maximized

Sources of Wealth (Origin of wealth)

1. Entrepreneurship (requires entrepreneurial skills) - profit

2. Capital (either financial or industrial) - Interest
3. Land (can be used in business or leased) - Rent
4. Labor - Salaries, Wages

 Investor - already has capital

 From investor to entrepreneur

 Point of information
• Wages - daily or weekly
• Salary - more than that

Finance
 plays in the system called business
 application of economic principles to decision-making that involves the allocation of money under conditions
of uncertainty

 in the field of commerce, investors allocate their funds among financial assets to accomplish their objectives
i.e. to maximize profit and wealth in the long run while businesses and govt raise funds by issuing claims
against themselves that are invested

Finance
 provides the framework for making decisions as to how those funds should be obtained and invested
Financial system
 provides the platform by which funds are transferred from those entities that have funds to invest to those
entities that need funds to invest

Finance
 reffered to as financial economics

Tools used in financial decision-making

 drawn from areas of economics; outside economics: mathematics, statistics, psychology and accountancy

Accountancy
 requires in depth analysis of the transaction and even financial results to enable them to provide reasonable
opinion which among the courses of action should be considered

Three key areas of the study of capital markets

1. The financial system
2. Structure of interest rates
3. Pricing of assets

Financial system
 allows households, companies, and the government who have available funds to invest these funds in more
potentially productive vehicles that can result in faster growth in the economy
 encourages fund savings from its stakeholders and transform these savings efficiently into investment
vehicles that help the economy grow faster
 is a set of arrangements or conventions embracing the leading and borrowing of funds by non-financial
economic units and the intermediation of this function by financial intermediaries in order to facilitate the
transfer of funds , to create additional money when required, and to create markets in debt and equity
instruments (and their derivatives) so that the price and allocation of funds are determined efficiently- Faure-
AP
 composed of network of inter-related systems of financial markets, intermediaries and services
 carries out the essential economic function that transfers funds from parties that have available funds to
parties that need funds

Point of information
 Finance- came from the french word "finer" which means "to end and settle a debt"
 Fund providers- households, companies and government agencies who have available funds because they
spend less than their income
 Fund demanders- households, companies and government agencies that have fund shortage because of
deciding to spend more than their income
 Main reason for the existence of a financial system - matching the difference in spending (excess funds from
one party to the fund gap of another party)

Financial system
 permits an efficient method to move funds between entities who have funds and entities who need funds
 serves as a regular, time-efficient and cost-effective link between fund providers and fund demanders
 within the financial system, funds are efficiently transferred from one party to another through innovative
schemes on savings and investments that investors are willing to partake in
How a financial system works as illustrated by Mishkin,2004

 Primary fund provider/lender-savers in the financial system – households

 Main fund demanders or borrower-spenders- business firms and govts

Two routes of flow of funds from lender-savers to the borrower-spenders

1. Direct financing
 borrower-spenders borrow and deal directly with lenders through selling financial instruments (or securities)
 financial instruments represent claims on the future income or assets of the borrower
 borrowers recognize financial instruments as liabilities
 lenders recognize financial instruments as asset
 ex. Buying stocks directly from a company

2. Indirect financing
 borrowing activity between both parties still happen through indirectly, with the intervention of a financial
intermediary

 People who save frequently are not the same people who have access to profitable investment opportunities
(i.e. entrepreneurs)
 Both providers and demanders gain returns from the transfer of funds
 Fund providers can charge interest on the fund they are willing to loan out while fund demanders can earn
from the investment they are going to pursue using the funds obtained from the provider

Financial system
 important for the growth of the economy

 Financial Markets - help in creating more efficient allocation of capital which results in higher production and
efficient that ultimately leads to economic growth.
 Capital - can be physical or financial
 Efficient allocation of capital- occurs when funds are invested in productive investments that yield return for
the fund providers and fund demanders
Properly functioning financial system
 enhances welfare of individual consumers as they have immediate access to funds
 Funds are made available to young people to purchase what they want without making them wait to save for
the entire purchase price thus funds flow back much faster to business enterprises (through profit),
government (taxes), investors (interests or dividends)

 Efficient financial markets- enhance the economic well-being of all members of society
 Financial system- addresses the problem of information asymmetry

information asymmetry
 one stakeholder to a transaction holds superior information than the other party
 causes inefficient allocation of financial resources as one party may be in a better negotiating position
because of the lacking of information of the other party

Elements of the Financial System

1. Lenders and borrowers (who are the players?)

 also known as fund providers and fund demanders
 most essential stakeholders that make up the foundation of a transaction in the financial system
 without these, the financial system will not exist
 Lenders are parties that have excess funds that they can lend out to other entities for a required return
 Borrowers are parties who are willing to pay the required return to obtain additional funds to finance their
investment initiatives

2. Financial Intermediaries (how will the exhange occur?)

 special type of financial entity that acts as a third party to facilitate the borrowing activity between lenders and
borrowers
 gather funds from lenders and redistribute it to borrowers through an investment vehicle like loans
 lenders and borrowers do not even know who the ultimate individual or firm is who provided or demanded for
the funds

3. Financial Instruments (What will be used?)

 medium of exchange of contractual obligation of a party, where such contract can be traded
 can be tangible or intangible
 two types of financial instruments:
 cash
 derivative
 IFRS defined instruments as a contract where a party recognize it as an asset and another is a liability

4. Financial Markets (Where will it be traded?)

 where suppliers and buyers of financial instruments meet
 two types of financial markets depending on the instrument that were being traded
 money market - exchange cash financial instruments
 Capital market - trade derivative financial instrument

5. Regulatory environment (How it is controlled?)

 risk is inherent in every business operation
 government should intervene in the system
 regulatory environment is a governance body to ensure that it complies with the laws and regulations
imposed to the actors as well as the elements that plays within the system
  financial systems are normally regulated by Central Banks

6. Money creation (what is the value it creates?)

 with the flow of financial instruments, money is created
 money is used either be reinvested or earned out from the system flows
 money as it was given value out of the financial transactions because of the exchange that occurred in the
system may be converted in another form

7. Price discovery (how much is created?)

 as the financial systems continuously flows and operates, the financial instruments create value
 process of determining or valuing the financial instrument in the market
 price is normally driven by the level of risk on how the issuer of the financial instruments

The financial markets

 the channels or places where funds and financial instruments such as stocks, bonds and other securities are
exchanged between willing individuals and/or entities
 also includes the existing mechanisms and conventions to facilitate transfer of funds and or financial
instruments between market participants
 intend to establish a consistent, efficient and cost-effective bridge between fund providers and fund
demanders
 participants in the financial markets: lenders and borrowers such as household, government and business,
financial intermediaries, brokers and dealers, regulators, fund managers and financial exchanges
 main economic function of financial market is to serve as a channel to transfer excess funds from fund
providers to fund demanders
 financial market is the mechanism that bridges surplus and deficit economic units through providing ways to
fund deficit units directly or indirectly via financial intermediaries
 financial market also provide additional options to lenders and borrowers on which form they want their
transaction to be in
 ex. fund providers may deposit funds in banks, buy primary or secondary securities or lessen their debt
through purchasing existing securities. On the other hand, fund demanders may issue new securities or sell
currently-owned financial instruments in the financial market to obtain funds.
 a functioning financial market allows market participants to avail different options that suit their needs

 Trading - exchanging of financial instrument

 Popular examples of financial market

 New York Stock Exchange
 Philippine Stock Exchange or PSE

3 Major Economic Functions of Financial Market

1. Price discovery
 interaction between buyers and sellers in the financial market in order to come up with price of the traded
financial instrument
 price is set at the level wherein the buyers are willing to buy and sellers are willing to sell
 agreement between the two parties is important in determining the price of the financial instrument
 usually the providers of fund in the financial market determines the required return for a financial instrument
(minimum rate of return that they are willing to accept to purchase a financial instrument)
  this function of the financial market determines how the available funds from the fund providers are
allocated towards the fund demanders based on the fund demanders' willingness to accept the return
required by the fund providers

2. Liquidity
 financial markets serve as a forum where buyers and sellers can meet to facilitate transactions
 holders can sell their own financial instrument to other investors to earn cash
 investors can sell financial instruments for cash
 easy access to a venue where investors can sell financial instruments for cash is an appealing feature when
circumstances may occur to push investors to sell a financial instrument (offers liquidity to investors)
 without liquidity, an investor is forced to hold to financial instrument up until such time that conditions in the
agreement happen that will permit the disposal of the instrument (e.g. conversion) or the issuer is
contractually obligated to pay for the instrument
 for debt instruments, this pertains to maturity date; for equity instruments, this refers to voluntary or
involuntary liquidation
 all types of financial markets offer different degrees of liquidity

3. Reduction in transaction costs

 transaction costs are costs incurred of parties’ transaction to trade a financial instrument
 2 types or classification of transaction costs
 search costs- incurred to look for financial instruments that can be purchased or sold by a party
o explicit search costs are expenses needed to advertise intent to purchase or sell a financial
instrument
o implicit search costs include value of time consumed to look for a counterparty for the transaction
 information costs
o information costs are costs related in evaluating investment characteristics of a financial instrument;
investors often spend information costs to gather information about profitability, liquidity, stability,
and market value of a financial instrument to justify worthiness of the investment
 in a price efficient market, prices of the financial instrument properly reflect the combined information
gathered by the market participants

Types of financial markets

 classified depending on the transactions that is being observed or the exchange that is done, to whom it is
traded or the market where it is traded, the manner how it is traded and the perspective of the country

• Based on Instruments Traded

1. Money market
 trade short-term security
 money market is the sector of the financial system that trade financial instruments that will mature or be
redeemed in one year or less from issuance date
 cater to fund demanders who need short-term funds from fund providers who have excess short-term funds
 short term is defined as one year or less
 once money market securities are issued, they are traded in the secondary market
 money markets are not exclusive for short-term investors
 long term investors also need the money market as they tend to invest in this market to meet their short-term
liquidity needs
 money market is very important for fund demanders since immediate cash requirements of individuals,
government and corporations do not necessarily coincide on the timing of their cash receipts
  seasonal or temporary financing requirements like peak seasons also creates the necessity for short-term
fund requirements
 excessive holdings of cash by fund providers also generates opportunity cost in the form or forgone interest
 fund providers with excess cash tend to maintain only minimum cash requirements as needed for its day-to-
day operations and invest the excess cash in financial instruments that can be quickly and cheaply converted
to cash when needed with minimal risk of loss in value involved
 money markets serve as a conduit to efficiently transfer large amounts of money from fund providers to fund
demanders for short maturity term quickly and at a cheap cost from the parties involved.
 money market instruments offer an investment opportunity that yields a higher return than just mere holding
of cash (which generates zero interest)
 money market instruments are very liquid and easily convertible to cash and has a very little default risk
because of the short maturity term
 ex. of financial instruments traded in the money market: treasury bills, commercial papers, certificates of
deposits, repurchase agreement, bankers' acceptances

2. Capital market
 trade long-term security
 capital market is a sector of the financial markets where financial instruments issued by governments and
corporations that will mature beyond one year from issuance date (long term) are traded
 long-term financial instruments encompass financial instruments that have maturity dates longer than one
year and perpetual securities (with no maturity)
 the foundation of the capital market is made up by dealers and brokers market which creates a venue for
bond and stock transactions
 two classifications of capital market securities
 equity (represent ownership interest)
 debt
 capital markets are expected to be a liquid market where fund demanders can interact with potential
investors to acquire external financing resources
 capital market should be an efficient market to ensure that available funds are allocated to its most
productive use
 efficient allocation stems from competition between wealth-maximizing investors who determine prices of
securities believed to be close to their real value
 in an efficient market, the price of securities, which is a product of interaction between buyers and sellers in
the market is believed to be a fair estimate of its real value and any new info that investors will learn will
eventually move its price upwards or downwards

• Based on market type

 in primary market, the supplier of funds is called lenders while they are buyers in the secondary market
  borrowers are the demanders of fund in primary market while sellers are what we call for those demanders in
the secondary market

1. Primary market
 type of financial market wherein fund demanders such as corporation or government agency raise funds
through new issuances of financial instruments e.g. bonds and stocks
 when internally generated funds (e.g. retained earnings) are not enough, demanders need to raise additional
funds in primary markets to fully finance new projects or production expansion requirements
 new issuances of financial instruments are sold to original fund providers are (usually households) in
exchange for money that the fund demander needs
 primary market securities also include issuance of additional debt or equity securities of an already publicly
traded company
 non-negotiable instruments like mortgage loans, savings deposits and life policies are issued only in primary
markets and are not traded in secondary markets
 usually, primary market transactions are coursed through investment banks which are financial institutions
that act as intermediaries between issuing companies (fund demanders) and potential investors (fund
providers)
 investment bank provides advice to issuers on matters related to prices of the securities, transaction costs
and number of securities to be issued based on their fund needs; they also provide advice on how to present
information to attract potential investors to the securities issuance; once securities issuance is settled with
the issuer, the investment banks markets the securities to the initial purchasers for the issuer; through the
assistance of an investment bank, the issuer reduces the risk and cost of establishing a market for the
securities on its own; investment banks is responsible to all aspects to ensure proper execution of the
issuance: legal and financial exchange requirements, appointments of lawyers and editors, due diligence
etc.;
 investment banks also underwrite securities
 underwriting means that investment banks guarantee the price for the securities of the issuing company and
then sells these to the general public

 Transactions in the primary market can be classified based on the intended purchasers of the securities

Four types of issue methods that can be done in the primary markets:

1. Public offering
 occurs when securities offered for sale in the general public is done through issuing a prospectus
or placing document which contains an offer to the general public to subscribe or purchase
securities at a stated price
 private companies who will sell shares to the general public for the very first time is said to undergo
an initial public offering or IPO which are done through the help of investment banks
 public offering
 offer for subscription
o the general public is invited to subscribe to unissued shares of the company
o proceeds received from an offer of subscription are enjoyed by the company and
can be used to finance their investment objectives
 offer for sale
o existing shareholders invites potential subscribers to buy portion of the shares
they own
o proceeds are enjoyed by the existing shareholders and not by the company
 most of the time, an underwriter is appointed for public offerings
  underwriter provides an undertaking to purchase the remaining securities if the offer will not be fully
subscribed by the public
 fee is paid by the issuing company to the underwriters in exchange of the undertaking
 securities coursed through underwriters gives comfort to potential investors since they are willing to
take the risk of guaranteeing these securities

2. Private placement (also called as limited public offer)

 occurs when an issuer looks for a single investor, an institutional buyer or group of buyers to
purchase the whole securities issuance instead of offering it to the general public
 securities sold through private placements tend to be illiquid and not easily converted to cash
because of the very limited parties it was sold to.
 only established institutions or firms are able to buy and hold on to them
 one variation of a private placement is that an underwriter subscribes to all securities at a certain
price and consequently, sells these same securities to a group of investors at a higher price and
the difference bet these two prices is termed as underwriting spread

3. Auction
 usually used for issuance of treasury bills, bonds and other securities issued by the government and
are commonly executed exclusively with market makers

Three methods of auction

 Dutch auction- seller begins the sale at a high price and then lowered down at specific intervals until the
potential buyer agrees to purchase at that price
 English auction- the prospective buyers commence the auction by submitting an initial bid price and
other buyers submit a new bid to top the previous one. The process continues as price of the securities
increases as more interested buyers bid on it. The bidding stop when no other bidders want to top the
last bid. The last highest bid price becomes the price of the securities that the highest bidder should pay
 Descending price sealed auction (first-price sealed auction)- bidders submit sealed bids to sellers and
ranked from highest to lowest; the number of securities is allocated first to highest-priced bid and
follows a descending order; highest- priced bids receive full allocation while lower bids receive
allocations distributed pro rata

4. Tap issue
 issuers are open to receive bids for their securities at all times
 issuers maintain the right to accept or reject the bid prices based on their how much fund they need,
when they need the fund and what is their outlook of the market

2. Secondary Market
 refers to the market wherein securities issued in primary market are subsequently traded i.e resold and
repurchased (secondhand)
 buyers in secondary market include households, businesses, and governments who have excess funds while
the sellers are the household, business and governments who are need funds
 secondary market become a centralized marketplace wherein buyers and sellers can quickly and efficiently
transact with each other.
 allows the buyers to save on search and information costs as they do not need look for transactions on their
own
 when the buyer purchases a financial instrument in the secondary market, funds are transferred to the seller
 transactions in the secondary market usually occurs through the help of security brokers which acts as the
facilitator between seller and buyer of security
 original issuer of financial instrument is not involved in subsequent transactions in the secondary market
 ex. Foreign exchanges market, futures market and options market

Economic functions of secondary market

1. Price discovery
 provides information about prices of the securities traded which can influence economic decisions like
choosing between financing through long-term borrowing or issuance of new share
 the higher the price of the security in the secondary market, the higher the price that issuing companies
can set on new securities that they will issue
 higher prices suggest that issuing companies may raise higher amount of financial capital when they
sell new securities in the primary market

2. Liquidity and reduction in borrowing cost

 allows active trading which improves the liquidity and marketability of the securities
 liquid market means that parties who want to buy and sell are equally matched, thus price of securities
becomes stable
 liquid market reduces interest rates as liquidity premium can be removed
 increased liquidity of a security also improves its desirability in the eyes of the investors helping issuing
firms to sell new instruments in the primary market

3. Support to the primary market

 price discovery helps in giving information that can be helpful in
 setting prices for new issuances executed in the primary market and
 assessing receptiveness of the market for new issuances

4. Implementation of monetary policy

 allows regulators such as the BSP to trade securities to influence liquidity and interest rates set in the
financial system

 secondary markets are beneficial as it gives investors the opportunity to sell securities at fair market
value if they need cash or purchase additional securities that have differing risk and return
characteristics to diversify the portfolio
 secondary markets provide liquidity to investors who hold the securities as they are able to convert
the securities to cash quickly by selling to other participants in the secondary market
 secondary market also provides information to investors on the market value of the investments
 transaction costs are also kept at a low level since the securities are traded in a centralized market
 although issuers are not involved, they also benefit from the transactions in the secondary market
 securities traded in the secondary market gives the issuing company an idea how much is the fair
market value of their financial instruments
 the value of the company can be determined as perceived by investors based on the market prices of
the financial instruments traded in the secondary market
 the market price of the securities also gives the issuers an idea how well they are using the funds
obtained from the securities issuance and gives information as well on how much funds (and
associated costs) can subsequent debt or equity issuances raise for the firm
 securities that are easily tradeable in the secondary market are also perceived to be more liquid,
hence, issuing firms can easily sell more securities in the future as investors will find it to be more
desirable
 conditions existing in the secondary market is very important for corporations that regularly issue
securities
 Classification of secondary market based on market structure
 market structure refers to the mechanisms how buyers and seller interact to arrive at the price and
quantity of the securities to be traded

1. Order-driven market structure (auction market)

 buyers and seller propose their price through their brokers who conveys the bid in a centralized
location
 the price is then matched (securities will be awarded to the buyer with same offer price as the selling
price of the seller) and the transaction is consummated

Types of orders that go into an order-driven market structure

 Market orders (or at-best orders)
o orders placed with broker-dealers with the instruction to execute transaction at the
prevailing best market price
o client relies on the expertise and integrity of the broker-dealer to execute deals when
the latter perceives that the current price is considered best
 Limit orders
o Orders placed where clients set a price or price range that may be below/above
existing price
o sell (higher than the limit price or range)
o buy (lower than the limit price or range)
 Day orders
o Orders placed only valid until the end of the business day or
o All orders not executed at the end of the day will be cancelled and removed from the
system
 Good-until-cancelled orders
o Order placed remains valid for a sustained period up until the client voluntarily cancels
and remove these from the system

2. Quote-driven market structure ( primary dealer markets, professional markets or market-made markets)
 market makers establish price quote at which the market participants should trade with
 market makers set a bid quote (to buy) and offer quote (to sell)
 bid quote lower than offer quote
 difference between bid quote and offer quote is called a spread, inures to the benefit of the market
makers as profit
 spread represents transactional costs of trading and reflects liquidity
 narrow spread signals liquidity while a wide spread indicates that securities are illiquid
 the higher turnover of securities sold, the better profit earned by market makers
 trading of bonds and currency are usually done in a quote-driven structure

Classification of primary and secondary markets based on where the financial instruments are traded

1. Exchange (or formalized)

 centralized trading locations
 in order to be traded, all financial instruments should be listed by the organized exchange and comply
with regulations set forth by the exchange prior to being listed
 most exchanges are order-driven
  most popular exchanges are the new york stock exchange, philippine stock exchange and chicago
board of trade for commodities (wheat, corn, silver, and other raw materials)

2. Over- the- counter market (informal)

 unlisted financial instruments are allowed to be traded in addition to listed financial instruments
 dealers stationed at various locations who have securities on hand are approached by those who are
willing to accept their price
 can also be done through computers
 very competitive since all parties are aware of how prices are set for each available security
 ex. Labor market, fish market and vegetable market
 do not have formalized mechanisms unlike exchanges
 bonds, loans, spot money, and foreign exchange markets are unlisted and traded in OTC
 all markets start as an informal market and progress into formalized markets depending on need to
maintain a liquid and safe market for participants
 instruments traded in OTC includes negotiable certificates of deposit, banker's acceptances and
foreign exchange

Based on country's perspective

 categorized depending on the interest or perspective of the country

1. Internal or national market

 financial market operating in a certain country

Two parts
 Domestic market
o issuers of securities which are traded afterwards are residents in a country
 Foreign market
o issuers who are not residents of a country can sell or issue securities and traded subsequently
o rules of regulatory authority where the security is issued will prevail regarding issuance of foreign
securities
o ex. US company issuing financial instruments in the Philippines shall comply with Philippine
securities law
2. External market
Two unique characteristics of securities being traded:
 Upon issuance, these securities are offered simultaneously to investors in different countries
 Securities are issued outside the regulatory jurisdiction of any single country

Based on manner of financial intermediaries

1. Broker market
 buyer and seller brought together by a broker and trade occurs at that point
 ownership of securities effectively changes on the floor of exchange through the help of a broker
 broker market is usually composed of national and regional securities exchanges
 Philippine Stock Exchange is the sole broker market in the Philippines

2. Dealer market
 buyer and seller not brought directly together by a third party
 market makers (dealers who create market by offering to sell/buy securities at stated ask/bid prices,
respectively) execute the sell or buy orders

Two distinct trades that occur

 Seller sells his securities to a dealer
 Buyer buys his securities from a dealer (can be the same dealer of seller A)

 ask price refers to the lowest price of a security offered for sale
 bid price is the highest proposed price in order for investors to buy a security
 investors pay the ask price when purchasing securities and receives the bid price when selling them
 dealers earn profit through the spread between bid and ask prices
 dealer markets do not have centralized trading floors as compared with exchanges
 dealer markets consist of many market makers that are connected through a mass telecommunication
network
Chapter 2: FINANCIAL INTERMEDIARIES AND OTHER PARTICIPANTS

Financial Intermediaries and Other Participants

Deficits
 common that income received does not match required expenditures
 resolved through transferring funds from fund providers (wtith excess funds) to fund demanders (with deficits)
either through direct financing or indirect financing

Financial Market- role is to provide efficient allocation of resources between fund providers and fund demanders may
not work as expected

Financial intermediaries- special type of financial entity that bridge the gap and facilitates indirect financing

Financial intermediation- process of indirect financing using financial intermediaries as the main route to transfer
funds from lenders to borrowers

Ex. of financial intermediaries

 depository institutions, insurance companies, asset management firms, regulated investment companies and
investment banks

 the assets of financial intermediaries are not limited to the portfolio they are managing but the information they
gain to facilitate and support their clients

Financial intermediaries provide the following services

 Enable trading of financial assets for the customers of the financial intermediary through brokering
arrangements
 Enable trading of financial assets through its own capital by buying a stake in a financial asset that its
customers want to transact in
 Assist in forming financial assets needed by its customers and distribute these to its customers and other
market participants as well.
 Provide investment advice and consultation services to customers
 Manage financial assets of customers
 Facilitate payment mechanism between merchants and customers.

Benefits from financial intermediaries

 beneficial for the economy
 creates opportunities to financial savvy people
 other economic benefits that will help managing the risk on the part of investors

1. Acceleration of flow of funds between entities

 financial intermediaries serve a savings and wealth storage function allowing parties with excess funds to
store their funds in risk-free/low-risk financial instruments

2. Efficient allocation of funds

  to ensure efficient allocation, financial intermediaries manage asymmetric information to a certain degree in
its operations
 assymetric information occurs when potential borrowers have more information about the transaction
compared to the bank
 assymetric information may lead to 2 further problems
 Adverse selection
o high risk borrowers that would tend to default is more likely active in borrowing funds than low risk
borrowers who pay in time
o since high risk borrowers are more eager to look for loans, they have a higher chance of being
chosen
o usually occurs before a transaction takes place
o potential direct lenders may opt not to extend loans despite good payers in the market

 Moral hazard
o Occurs when borrowers tend to take undesirable or immoral risks (for the lender) with the money,
once they received it, not disclosed during the loan granting process
o lower the chance that the loan will be paid back
o happens after the loan is granted
o lenders may also refrain from extending loans since moral hazards reduces the probability of the
loan to be repaid

 through financial intermediaries, they may put their money in trustworthy banks rather than directly to
borrowers
 Financial intermediaries are better equipped at screening bad and good borrowers which may reduce risk of
adverse selection
 Financial intermediaries also have the mechanism to monitor action of their borrowers, potentially reducing
losses related to moral hazard
 this allows banks to put controls in place to ensure that these risks are consistently mitigated, ensuring
efficient allocation of funds

3. Creation of money
 Financial intermediaries, through its depositary function, specifically banks, allow creation of money through
bank loan services
 this allows existing and new funds to be allocated efficiently
 banks acts as the conduit that lessen the constraint of limited income over spending, permitting consumers to
spend while expecting future income and businesses to get physical capital
 results in more output for the economy and employment growth
 through financial intermediaries, the state may recognize whether the need to create stronger monetary
policy is imperative

4. Support in price discovery

 price discovery is the process of setting price which is acceptable for the buyer and seller
 since financial intermediaries actively engage in trading financial securities, they play a significant role in
price discovery
 Financial intermediaries play the role as experts and facilitators that assign values to financial instruments
based on different factors
 financial system specifically the banking sector influences discovery of interest rates which are factored in fair
market valuation of financial instruments

 Improved liquidity for lenders

 o lender's liquidity is zero up until the loan matures and the lender receives the payment
o Financial intermediaries can manage cash from different lenders (i.e. depositors) through
immediately encashable products such as current and savings deposit accounts and at the same
time offer non-marketable financial products such as mortgages, leases and credit contracts
o ultimate lenders have better liquidity compared to direct lending funds to providers

 Reduced price risk for lenders

o price risk means prices of financial instruments vary over time
o Financial intermediaries offer
 low risk financial products: deposits to ultimate lenders
 high price risk: shares, bonds and property financing to borrowers
o risk sharing is when lenders enjoy mitigated price risks as they course the transfer of funds with
very low risk to financial intermediaries which in turn bear the bigger risk when lending to other
entities
o risk sharing happens when financial intermediaries create and sell financial assets with risk
profile that their clients are comfortable to invest on
o through the proceeds they can collect, financial intermediaries may then sell these financial
assets to purchase other assets that may have higher risk and return
o risk sharing can also be called as asset transformation, since in essence, risky assets are
converted into safer assets for the investors

 Diversification of lenders
o typically, members of household only have smaller wealth compared to financial intermediaries and
do not have as much investment opportunities for their funds
o lenders may not be able to efficiently maximize returns from their funds because of the limited
investment opportunities
o put their funds through financial intermediaries which have wider access to investment possibilities,
allows these household members to diversify their portfolio better
o diversification is the process of investing funds in a portfolio of assets that have individual returns
that do not move at the same direction together
o if one return asset goes up, another goes down
o diversification usually results in overall portfolio risk that may be lower than risk of each individual
asset
o diversifications allows lenders to share risk from their investments
o risk is the uncertainty regarding the return an investor will earn on their invested assets
o low transactions costs allow financial intermediaries to offer diversification opportunities by
organizing a collection of assets into a new product and then selling it to interested investor

 Economies of scale
o occurs when fixed costs are optimized per unit as a result of sheer volume of transactions
o cost per transaction reduced as the number of transactions increases
o since financial intermediaries are experts in executing financial transactions, they can get and
perform large numbers of transactions
o two main economies of scale optimized by financial intermediaries
 Transaction costs - costs associated with trading or managing funds and investment
transactions
 Research costs - incurred to monitor performance of potential companies to be invested
in through economic, industry, and financial analysis and look for other investment
opportunities that will pay off in the long run
 o financial intermediaries allow funds to be concentrated to them and they will incur transaction and
research costs in behalf of all of its depositors
o transaction and research costs are spread over all depositors of the bank, enabling economies of
scale

 Payments System
o financial system serves as the main structure for making payments for any goods, service or
securities that are purchased
o financial assets become the medium of payment and are settled efficiently (assuming efficient
clearing and settlement system)
o most common financial assets accepted as payment: bank notes, coins and bank deposits
(through checks, straight credit card purchases, debit cards)

 Risk mitigation
o risk may also pertain to the uncertainty that something untoward or damaging may occur to a
person or entity
o financial system allows people and companies to protect and build their wealth through having
insurance against threats to life, income and properties

 Implementation of monetary policy function

o financial system provides the best mechanism to allow the government to implement monetary
policies to manage economic growth, steady employment rate, equilibrium of balance of payments
and inflation
o through the regulatory authorities, government greatly influence interest rates affecting
consumption and investments and demand for loans

o Financial intermediaries exist to foster a more favorable transaction terms between fund providers
and fund demanders compared if the two parties directly deal with each other. Figure 2.1 presents
the two-step process observed by financial intermediaries

o funds that financial intermediaries obtain can be a liability of the financial intermediary or equity
owners of the financial intermediary
o funds that they invest or lend out to other market players are assets of financial intermediary
o financial intermediaries receive a fee as cost of providing the service of facilitating indirect financing
o fees of financial intermediaries is the difference between the cost of issuing financial securities
(dividends, interest, capital gains) and revenues earned from primary securities (dividends,
interest, capital gains) bought
o Let's take a look at a universal bank, a depositary institution, as an example. Universal banks
accept cash deposits from persons, companies and the government. Bank depositors are the fund
providers. Funds received from the depositors are treated as liability of the bank. Consequently;
the same funds are used by the bank either to lend to parties who need funds through a loan
agreement or buy securities for capital appreciation. The loan receivables and securities acquired
becomes assets of the universal bank.
o Financial intermediaries convert financial assets that are not attractive to most investors (money of
an individual) into another financial asset- as a liability of the financial intermediary-that are more
favored by the general public

This transformation has 3 economic functions:

 Maturity intermediation
- Money deposited in banks are payable on demand or at a specific maturity date (e.g.
time deposits)
- usually banks can only hold deposits that cannot be withdrawn for a maximum of 3
years
- maturity of deposits made by fund providers are usually short term
- banks usually extend loans to its borrowers for more than 3 years
- this mismatch between fund providers and fund demanders can become a problem if
financial intermediaries did not exist
- if financial intermediaries did not exist, long-borrowers would have to borrow money
for shorter term to match short duration at which fund providers are willing to lend
funds
- this may also result in difficulties for borrowers in looking for lenders who are willing to
provide funds for the length of time it is needed
- maturity intermediation is an economic function of financial intermediaries whereby by
using its own liabilities, banks convert long term assets into short terms assets by
extending loans to borrowers based on the time they need it and giving financial
assets to depositors for their desired investment prospect
- maturity intermediation gives fund providers/investors more alternatives in terms of
how long they want to invest in financial instruments and borrowers have more
choices on the length of maturity of their debts
- maturity intermediation also allows financial intermediaries to charge lower interest
rate for borrowers
- Since financial intermediaries can depend on successive fund sources over a long
period of time, they can offer lower interest on long term loans compared to individual
investors
- individual investors require higher interest rate from borrowers for long term loans
compared to short term loans
- cost of long-term borrowing can be lessened in an economy that has financial
intermediaries

 Risk reduction through diversification

- diversification is the economic function exercised by financial intermediaries which
converts more risky assets to lower risky assets through sharing of risks
- ex. Mutual funds
 - Mutual funds normally solicit and accept fund from investors in exchange for shares in
the mutual fund. Consequently, the mutual funds then invest the funds obtained in
portfolio of financial instruments. The shares in the mutual fund represent the
ownership in the portfolio of financial instruments while the financial instruments are
considered as assets of the mutual fund.
- Investing in many companies (and not only in one or two firms) allows the mutual fund
to diversify and reduce the overall risk of the investment. This is advantageous for
individuals who have limited capital as they will face difficulty in buying shares in
many companies on their own because of the high cost involved. Investing in mutual
funds help these individuals to enjoy the same level of diversification even at a limited
capital
- Even though individuals may diversify their portfolio on their own, they may not be
able to lower down the risk as cost-effective as financial intermediaries.
- The cost-effective diversification that financial intermediaries can do is an essential
advantage of financial systems to the economy.

 Cost reduction for contracting and information processing

- information processing cost is the cost of acquiring and processing information
needed to evaluate purchase or subsequent sale of a financial instrument
- information processing cost also include opportunity cost of time associated with
information processing
- in order to maximize their return from their available funds, investors should be able to
develop skills essential to assess risk and return characteristics of their financial
instrument alternatives to evaluate whether to buy or sell a financial instrument
- contracting costs are usually incurred by investors for writing loan agreements and
enforcing terms of agreements to the concerned parties with regards to the
willingness to extend loans to a consumer or business
- in order to protect their self-interest, investors should develop skills to draft a legally
enforceable contract to be signed by both parties
- one loan agreement is signed, investors should also devote time to monitor financial
status of the borrower and pursue legal actions for any violation in the legal
agreement
- both information processing cost and contracting costs require time before they can
be done
- however most investors do not have the luxury of time to do both activities and are
willing to pay compensation to other parties to do these for them
- Financial intermediaries employ personnel that possess both information processing
and contracting skills that can act in behalf of investors ex. Banking staffs and
investment professionals are knowledgeable in analyzing and managing financial
assets
- standardized loan agreements are available in banks that can be easily used
- for more complex transactions, the legal counsel of banks can also help in
customizing the agreement
- investment professionals can also monitor compliance to loan stipulations and initiate
actions for any violations noted
- it is cost-effective for financial intermediaries to employ people since their main
business is managing and investing funds
- financial intermediaries enjoy economies of scale associated with information
processing and contracting costs due to large sum of funds that they manager
 - the reduced cost of financial intermediaries compared to cost of each individual
investor if incurred separately,ultimately benefit the investors who has financial claim
on the financial intermediary and the issuers (reduction in funding costs)
- most financial intermediaries are exposed to high levels of liquidity risk
- liquidity risk is when liability holders (e.g. depositor for banks) may require cash in
exchange of financial claims they have from the financial institution
- as a result financial intermediaries always maintain high level of cash and marketable
securities to make sure that they can meet the demand from depositors when the
latter requires them to pay

Classification of Financial intermediaries

 commonly financial intermediaries may opt to be a financial institution which is primarily extending financial
support to demanders, while most are going into the exchange of this instruments
 with the emergence of technology and innovative ways on how the funds were channeled, financial
intermediaries can already make combination to mitigate the risk and generate greater returns
 the three classifications of intermediaries find ways on how the suppliers of fund will be able to maximize the
funds they put into the financial system and at the same time address the needs of the demander of the
fund

1. Depository Institutions
o firms that accept cash deposits from individuals, companies and entities
o once deposit is received, it becomes liability of the depositary institution to the depositor
o through the funds accumulated through deposit and non-deposit sources (obtained via issuance of debt
instruments), depository institutions extend loans to different entities
o interest earned from loans are the main source of revenue for depositary institutions

o a simple illustration to distinguish the difference on how depository institutions and nonfinancial companies
recognize assets and liabilities as shown in Figure 2.2

o loan is the biggest portion of the asset base of depository institution

 Four categories of loans
- Business
 - Commercial or industrial
- Commercial or residential real estate
- Individual loans for vehicle or credit card purchases and all other loans

o loans are the main revenue-generating assets for banks

o depository institutions also keep a significant investment on securities such as interest-bearing
deposits purchased from other financial institutions, repurchase agreements, treasury bills, mortgage-
backed securities and other equity and debt instruments which they trade to manage liquidity and
earn interest from these
o bank usually invest on securities that are highly liquid, can be traded into secondary markets and
have low default risk
o investment on securities offers liquidity to banks
o deposits comprise the biggest portion of bank's liabilities
o deposits may be transaction accounts (checkable deposits that may bear interest or not), household
savings, large time deposits and passbook saving accounts

Subdivision of depository institutions

 Commercial banks
- These banks are authorized to accept drafts/checks and issue letters of credit; discount
and negotiate promissory notes, drafts, bills of exchange, and other evidences of debts;
receive deposits; buy and sell foreign exchange and gold or silver bullion; and lend
money against securities consisting of personal property or first mortgages on improved
real estates and the insured improvement thereon.
- raise their funds through offering
 checking deposit accounts (deposits on which drafts/checks can be written
against)
 savings deposit accounts (deposits that are payable on demand, but checks
cannot be written against)
 time deposits ( deposits that have maturity in fixed terms)
- commercial banks use these funds to extend consumer, mortgage, and commercial
loans to borrowers and purchase government securities and corporate bonds
- universal banks are banks who operate as a commercial bank and offer investment
banking services

Point of information: top 5 commercial banks in the philippines as of dec 31, 2018
 BDO Unibank inc.
 Metropolitan Bank and Trust Company
 Land Bank of the Philippines
 Bank of the Philippine Islands
 Philippine National Bank

 Thrift banks
- mobilized small savings and provide loans at generally longer and easier terms than do
commercial banks as they cater to lower income groups
- loans are usually for basic economic needs such as housing
- small producers such as farmers, cottage industry entrepreneurs and consumers rely on
these banks
 Savings banks
- Organized for the purpose of accumulating savings deposits and investing them for
specified purposes such as readily marketable bonds and securities, commercial papers
 and accounts receivables, drafts, bills of exchange, acceptance or notes arising from
loans, whether secured or unsecured, mortgages on real financing for home building or
home development., such other investments and loans as allowed by the monetary board
of the BSP in pursuit of national economic objectives

Blank classification according to services they offer

 Individual banking
- focuses on financial requirements of individuals and included services such as consumer
lending, consumer installment loans, automobile financing, brokerage services, mortgage
lending, credit card financing, individual-oriented financial investment services

 Institutional banking
- caters to needs of financial and non-financial corporations and government entities in
activities such as commercial real estate financing and leasing

 Global banking
- sector wherein commercial banks contend with investment banks by offering broad range
of service offerings revolving around corporate financing (sourcing of funds that goes
beyond traditional bank loans to include letters of credit and underwriting of securities),
providing financial advice on strategic initiatives such as financing sources, corporate
restructuring, acquisitions and divestitures, and facilitating transactions involving the
capital market and foreign exchange products/services

- Banks play a significant role in transmitting the impact of monetary policy set by a
country's central bank to the rest of the economy.
- Banks also contributes to the efficiency of the financial system by offering payment
services that directly benefits the economy and by offering maturity intermediation
services.
- Because of the crucial nature of the services offered by banks, the government closely
regulates its operation to prevent any huge disruption in providing financial services that
may eventually result in massive losses for the economy.

Four types of deposit accounts (liabilities in the point of view of banks)

- Depositors are insured by the Philippine Deposit Insurance Corporation up to maximum
amount of Php 500,OOO.

 Demand deposits or checking accounts

- deposits can be withdrawn upon demand through checks and offer very minimal interest
since can be withdrawn easily

 Savings deposits
- deposits earn interest at a level below market interest rates, can be withrawn upon
demand and do not have specific maturity
  Money market demand account
- deposits placed on money markets that have slightly higher interest rates (money market
rates) compared to savings deposits but can be withdrawn only after a short period of time

 Time deposits (certificates of deposits)

- deposits that have fixed maturity date and depositors may earn interest at a fixed or
floating interest rate

- aside from deposits, banks can produce funds from non-depository sources which includes
borrowing through issuing financial instrument in the money and/or bond market and borrowing
reserves from the BSP
- Rediscounting is a standing credit facility offered by BSP to aid banks to meet temporary liquidity
needs through refinancing the loans that banks extend to their clients
-Through this facility, the BSP enables timely delivery of credit to all productive sectors of the
economy.
- rediscounting is one of the monetary tools used by BSP to regulate liquidity level in the Philippine
financial system
- BSP's rediscounting is administered by the department of loans and credit
- overdraft credit line (OCL) is offered by BSP to banks participating in clearing operations of the
Philippine clearing house corporation to cover for any shortfall demand deposit accounts of the
banks with the BSP resulting from clearing operations
- overdraft is a deficit in deposit account resulting from withdrawing wore money than what is
deposited in the account
- BSP sets a ceiling on the overdraft amount that a bank may incur to cover for clearing losses from
interbank borrowings and repurchase agreements with BSP
- BSP offers full secured emergency loans to serve as financial assistance for banks with liquidity
problems from causes beyond their control to help in resolving liquidity woes
- emergency loan is pursuant to section 84 of RA No. 7653 , the loan shall be up to the amount
needed by the bank to resolve the liquidity predicament but shall not exceed 50 percent of its
deposits and provided that any emergency advance should be collateralized by government
securities and uncumbered first-class collateral (primarily real estate).
- contractual saving institutions are financial intermediaries that obtain funds at periodic intervals
based on existing contract
-unlike depository institutions, contractual saving institutions can project more accurately how much
money they need to pay in the future (in the form of benefits promised)
- contractual saving institutions need to pay their contractual obligations after several years
- contractual saving institutions does not consider asset liquidity as prime importance but focus
more on investing long-term securities like stocks, mortgages, and corporate bonds
-ex. of contractual savings institutions Insurance companies and pension funds

 Insurance companies
- offer a unique service to assume risk or become underwriters of the risk associated with
various insurable occurrences
- insurance companies role as risk bearers and they also invest on financial markets
- contract of insurance is an agreement whereby one undertakes for a consideration to
indemnify another against loss, damage or liability arising from an unknown or contingent
event
- insurance company is an example of a contractual savings institutions
- insurance companies collect premiums (payment made by parties who wants to be insured) in
exchange for selling protection against potential future risks
- premiums can be paid lump sum prior to the contract or during the life of the insurance policy
- if the risk materializes in the future, the insurance company shall pay the insured amount to the
beneficiary of the policy
- benefits can be paid via lump sum (one-time payment) or annuity( yearly)
- the beneficiary can be the one who paid the premiums or other party who the payor assigned
- since insurance companies do not know if the insured event will happen or not, they can take
advantage of the premiums received by earning return from it by investing the money in the
financial market
Insurance products offered by insurance companies
2. Investment Intermediaries
o organizations whose primary objective is to maximize return from investments in various financial
instruments to add value for the investor

 Asset management firms

- are companies that manage funds owned by individuals, companies or the government through
buying and selling of financial instruments
- asset management firms are compensated through fees
- mostly, the fee charged is based on the amount of fund being managed
- in some cases, fee charged can be based on the performance of assets being managed
- asset management firms are usually subsidiaries of commercial banks, investment banks, and
insurance companies

Types of accounts/funds usually handled by asset management firms

 Regulated investment companies (RIC)

- Financial intermediaries that sells shares to the general public in exchange of cash and
- once they received the proceeds, they invest it in a diversified portfolio of financial
instruments
- normally asset management firms are contracted to manage the investment portfolio of
regulated investment companies
- different RICs have varying investment objectives and can engage in trading in different
asset classes
 money market funds
 stock funds
 bond funds
- asset management strategies in portfolios can be further subdivided into two
 Passive funds (indexed funds) - managed to mimic movements in the market
index such as PSE index
 Active funds - managed by the asset management firms with the intention to
outperform the index fund via actively trading securities in the fund portfolio

Each share stands for proportional interest in the portfolio of financial instruments managed by the
RIC. Each share in the portfolio is valued at Net Asset Value (or NAV). NAV is interpreted to be a
per share metric. Eq. 2.1 presents the NAV computation.
Two types of RICs
 Open-end funds (mutual funds)
- no fixed number of shares as long as investors are willing to invest,
it can offer additional shares
- in the point of view of the investors, new investments to the fund are
purchased at net asset value at time of purchase while redemptions
or sale of shares are also priced at net asset value
- Total number of shares of the fund increases if there more
investments made to the fund than withdrawals and vice-versa.
- For example, at the beginning of the trading day, the mutual fund
portfolio has 10 million shares and is valued at Php150 million
without any liabilities. The NAV at the beginning of the trading day is
P15. During the trading day, investors paid Php2.5 million to the
fund and redeemed Php l million from the fund. Assume that prices
of the securities remain constant. The net investment of Php l .5
million signifies that 100,000 shares (Php l .5 million/P15) were
issued to investors. At the end of the day, the fund has 10.1 million
shares valued at Php 151.5 million
- market value of the portfolio and the number of shares changes
which leads to a change in NAV
- once trading day ends, NAV will be the same for all regardless of
the net shares added to or deducted from the fund because new
investments and withdrawals on the fund are valued at the end-of-
day NAV
 Closed-end funds
- have a fixed number of shares upon its inception and do not issue
additional or redeem shares
- investors who intend to buy or sell shares should bring it to the
secondary market for trading
- prices of shares in closed-end funds are associates with demand
and supply in the secondary market where the funds are being
traded
- unlike open-end funds, market price of the fund's shares may be
higher or lower than NAV
- trading at a premium are shares priced higher than NAV
- trading at a discount are shares priced lower than NAV
- brokerage commission fee is paid by investors in closed-end funds
to brokers who will transact the purchase or sale on their behalf

Costs associated with investing in RICs include

 Shareholder fee or sales charge
 - one-time charges imposed to investors
 Annual fund operating expense known as expense ratio
- covers operating expense of the fund
- large component of expense ratio is management fees paid to asset
management firms in exchange of its services

- RICs allow individual shareholders to combine their resources to take advantage of lower
transaction cost when purchasing larger number of stocks or bonds
- These funds let investors to have access on more diversified portfolios than they
otherwise would invest individually.
- investment in mutual funds can be regarded as risky because it is traded in the market

 Exchange Traded funds (ETF)

- like mutual funds but the shares of the portfolio funds trade in an exchange like a regular
share offered by a company
- possess characteristics of both open-ended and closed-ended
- they are open-end funds but the share pricing has small premiums or discounts from the
NAV, like a closed-end fund
- Investment advisors assume responsibility for managing the portfolio that it moves as the
same way as the index
- pricing might be slightly different from NAV as the pricing is influenced by supply and
demand in secondary market
- ETFs are also allowed to place limit orders, stop orders and orders to sell short or at a
margin since its shares are directly traded in the secondary market like open-end funds

 funds
- developed to cater to sophisticated investors and are usually not subject to the same
regulation covering mutual funds
- investor base usually consists of affluent individuals and organizations with a relatively
high minimum investment limit
- hedge funds are usually organized as a private investment partnership or offshore
investment corporation which uses various trading strategies to gain better position in
different markets

Strategies employed by hedge in executing investments

 Leverage- use of borrowed money to invest
 Short selling- selling of a security not owned with the expectation that the price of
the security will eventually decline
 Derivatives and simultaneous selling and buying of securities to take advantage of
profit from temporary mismatching of prices

- investors of hedge funds evaluate performance of the asset manager through absolute
return (peso amount realized from the investment) rather than relative return (difference
between realized return and the return shown in a benchmark index)
- compensation for the services of a hedge fund managers are a mix of fixed fee computed
based on the value of portfolio being managed plus an incentive fee (performance based
compensation that is computed through a percent share in the positive return realized
from the investment)
  Seperately managed accounts (individually managed accounts)
- distinct funds solely dedicated to an individual or institutional investor
- instead of investing in a shared fund like a mutual fund, a fund can be made that will be
based on specific necessities and suit the specific objectives required by a sole investor
- specialized funds
- fees charged are higher than RICs

 Investment banks
- highly leveraged institutions that have significant influence on how primary and secondary markets
work
- assist entities (individual, corporate, government) to raise money to fund their initiatives
- assist potential investors by serving as dealer or broker of transaction in secondary market
- may be affiliated with leading financial services holding companies such as Bank of America
Securities and JPMorgan Securities or be an independent investment bank without any affiliation
such as Goldman Sachs and Merrill Lynch

Classification of investment banks based on activities that they can offer to investors
 Full service investment banks- offer wide range of activities
 Botique investment banks- only specialize in one or two activities

Activities that an investment bank can offer

 Public offering of securities

- Investment banks often assist firms to offer securities to the general public in order to raise
funds for varying business objectives.
- Investment banks give recommendation to the issuing company on what securities are
attractive to investors to allow easier raising of funds.
- Investment banks also take into consideration how the issuing company want to treat the
securities (whether equity, debt or mix of both) when advising.
- Investment banks possess information regarding the current willingness of investors to
buy various kinds of securities and on the prices, investors are willing to pay.
- investment banks participate in initial public offering and subsequent public offerings
(secondary or seasoned offering)
- Initial public offering refers to the first time that a corporation offers stock to the general
public.
- Once the issuing company chose the investment bank that would underwrite its securities,
investment bank performs a due diligence process to look at the value of the firm and the
results will be documented via prospectus which is a requirement of the SEC for public
offerings
- prospectus contains all info regarding the firm that a potential investor finds relevant in
deciding whether to buy the firm's securities or not including the firm’s profitability, net
worth and risks the firm is facing such as pending lawsuits and competition
- a red herring is a preliminary prospectus shared to potential investors because of the
notice printed in red included in front cover signifying the tentative nature of information in
the document
- Once the SEC approves the registration statement, the investment banks conducts a road
show to visit institutional investors like pension funds and mutual funds that might be
interested in the securities
- The investors then check the prospectus and the securities offer.
- quiet time is observed which restricts what the company officials can say regarding the
company
- The quiet time is important to ensure that all potential investors will have access to the
same information and no unpublished data will give them an unfair advantage.
- Once all available information is shared with the investors, the investment banks then
assign price for the security based on its estimate on how many securities will the
investors demand.
- Next, the investment bank underwrites the shares.
- underwriting is when an investment bank purchases the securities from the issuing
company and then offers these securities in the market in behalf of the issuing company
- gross spread is how investment bank earns in underwriting
- gross spread is the difference between the price paid by investment bank to the issuing
company and the price of security when reoffered to the general public (reoffering price)
- In exchange of the spread, the investment bank assumes the risk that it may not profitably
resell the securities being underwritten.
- To expound, if the investment bank has misjudged condition of the market, it may sell the
securities at a lower price than what was guaranteed to the issuing company.

Two types of underwriting arrangement

 Firm commitment
- the investment bank buys the securities from the issuer based on a fixed price
and resells it to the general public at a higher price
- a single investment bank may perform underwriting for small issues
- however, for large issues, a single investment bank may face problems in
exhausting all securities to be sold.
- Since this type of arrangement entails a high level of risk, the primary
investment bank often form a group of investment banks, called as an
underwriting syndicate, to buy and sell the securities.
- Once the securities are reoffered to the public, the gross spread will be shared
between all investment banks in the Underwriting syndicate.
- Distributing the securities to the general public is critical to ensure realization of
the gross spread.
- All the securities should be sold to the public based on the reoffering price and
usually entails a huge marketing effort especially if the issue size is huge.
- each member of the underwriting syndicate will offer the securities to their own
client base.
- if the member investment banks included in the syndicate is not able to
exhaust and sell all securities, the lead investment bank can also engage other
institutions not included in the underwriting syndicate to form a selling group to
extend their investor reach.
- Once sold, the gross spread shall be distributed between the lead underwriter
(which serves as the manager), members of the underwriting syndicate and
members of the selling group

 Best effort arrangement

- investment banks do not buy the securities from the issuing company
 - In its place, investment banks only use their connections and expertise to offer
the securities to the general public and earn based on the gross spread of the
securities it can sell.
- underwriting help reduce information costs between borrowers and lenders
since investment banks place their reputation on the line for the firms that they
underwrite for
- investors have greater confidence if securities are underwritten by investment
banks as they believe that the investment banks has performed due diligence
on the issuing firm to ensure that investors can buy the securities without
incurring excessive risk.

 Private placement of securities

- securities are offered only to a selected number of firms like insurance companies,
pension funds and investment companies

 Trading of securities
- Investment banks can also trade securities on behalf of their clients.
- investment banks earn through commissions when they act as a broker or dealer for a
transaction
- When they act as a broker or dealer, investment banks do not take any position in the
trade, thus, not putting their own capital at risk.
- in some instances, investment banks can become market makers in behalf of clients,
using their own capital to trade the securities
- When investment banks are market makers,they earn through the difference between
selling price of the security and price paid by investment bank for the security (i.e. bid-ask
spread) and through price appreciation of any security still on hand
- proprietary or prop trading is when investment banks use their capital on their own volition
to trade securities based on how they forecast potential movements in prices, interest
rates and foreign currency

Two major risks of proprietary trading in which investment banks are exposed
 Interest rate risk- pertains to the risk if market interest rates went up, the prices of
their long term securities will go down
 Credit risk- borrower may not pay or default on their loans

 Advisory services for mergers, acquisitions and financial restructuring

- Investment banks perform advisory engagements for mergers and acquisitions, leveraged
buyouts, capital restructuring and reorganization for financially distressed corporations.
- investment banks usually help in looking for potential M&A candidates based on the
requirements of the client, perform due diligence and give recommendation to acquiring or
target companies regarding valuation and non-valuation related aspects of the
transaction, provide support to firms that are in danger of a hostile takeover, assist
companies to raise funds for an acquisition and give a fair opinion regarding a potential
transaction to the board of directors.
- Investment banks can provide advice for both buyers (buy side) and sellers (sell side).
- Since they have access to their client information, investment banks may initiate
contacting companies regarding potential sales, purchases or mergers.
- For firms who wish to be acquired, investment banks may look for companies that are
willing to pay significantly higher than the book value of the firm.
 - investment banks can estimate the value of firms, lead negotiations and prepare
acquisition bids
- investment banks also provide advices on financial restructuring of problematic
companies.
- financial restructuring occurs when a corporation undergoes a significant modification of
its capital structure, operating structure, corporate strategy and corporate tactical plans to
prevent bankruptcy, avoid potential problems with creditors or undergo reorganization as
permitted by the law.
- Investment banks earn from providing advisory services through a fee based on the size
of the transaction.
- This service is particularly profitable as investment banks do not need invest sizeable
portion of its capital to perform.
- The only significant costs are the salaries of personnel working on the engagement.

 Merchant banking
- investment bank use its own money to lend money as a creditor or buy shares as an
investor
- Investment banks directly assume the risk on the capital it provides to the invested
company.
- Investment banks course their money through private equity funds when they aim to
invest in equity.

 Securities, finance and prime brokerage service

- The investment strategy of some investors require them to borrow money to buy a
security or borrow securities to sell a security short or cover a short sale
- these investors usually enter in a repurchase agreement which is the borrowing of funds
in the securities market rather than a bank borrowing
- repurchase agreement is like a collateralized loan whose collateral is the security bought
- Investment banks can usually lend the securities for the repurchase agreement and earn
a fee for such service.
- securities finance is the borrowing of securities or borrowing funds
- prime brokerage is also offered by investment banks to hedge fund and large institutional
investors
- prime brokerage is considered as priority servicing for very important clients
- services offered under prime brokerage include securities finance, global custody, risk
management system and prioritized operational support

 Asset management
- Investment banks also have division that perform asset management services to clients
such as endowments, insurance companies, pension funds, foundations and high net
worth individuals.
- these asset management departments can be mutual or hedge funds
- Same with asset management firms, investment banks earn through a percentage of the
managed assets in this service.

 Research
- Investment banks also conduct research on different industries or large market players.
- Investment banks assign analysts that collect publicly available information about the
subject, visit the firm to do interview and inspect the facilities.
 - investment banks uses the results of the compile research as inputs to identify potential
candidates as acquirer or acquiree
- Some research information is made public as research notes and can be used to provide
advice to investors whether to buy, sell or hold stocks.
- Opinions from large investment banks sometime may affect market price of shares as
they can influence perception of investors.
- Analysts may also engage in giving opinions regarding present state of the financial
markets, do economic researches, write reports on economic trends and provide forecast
macroeconomic variables like GDP, inflation, employment and interest rates.

 Finance companies
- raise funds through issuing stocks and bonds or selling commercial papers
- lend out funds to individual consumers (to buy furniture, vehicles, home improvements) and small
businesses
- Some non-financial corporations open their own finance companies to assist the selling of their main
product ex. Toyota financial services philippines of toyota motor Philippines that offer car financing
solutions for automobiles sold by Toyota

Other participants (5 sectors)

 interact with each other to buy or sell different kinds of financial instruments.
 Depending on the circumstances, below market participants can either be a lender (fund provider) or
borrower (fund demander).

1. Household sector
 composed of individuals and families, including families serving charitable, religuous and non-profit
organizations
 include unincorporated businesses such as retailers, farmers and professional partnerships since the
business transactions cannot be specifically segregated from the owner's personal transactions

2. Government
 Government role is focused more on regulating all participants and the market in general.
 NGA national govt agencies
 LGU
 GOCC government-owned and controlled corporations
 national government raises funds through the bureau of treasury

3. Corporate sector/ non- financial corporation

Two big segments of corporation

 Financial corporations (depository institutions, investment banks, asset management companies and
insurance companies)
o Most act as financial intermediaries
o All other companies not classified as financial are known to be non-financial corporations.
 Non-financial corporations
o issue financial instruments to raise fund for their business requirements and trade financial
instruments in the money market (short term) or capital market (long term) as investment in case
they have excess funds
 o non-financial corporations that offer pension plans for their employees invest the funds associated
with the defined benefit plan to earn some return in preparation for payout in the future.
o captive finance companies are subsidiaries of non-financial corporations that engage in activities
same as financial corporations
o Ex. Toyota Financial Services (subsidiary of Toyota Motor Corporation) and Puregold Finance, Inc.

4. Foreign sector
 consists of all entities, individuals, assets and organizations that are situated outside the jurisdiction of a
certain country
 foreign central banks (monetary authorities of a foreign country) and foreign companies invest in other
countries/markets in order to
o stabilize their local currency compared to foreign currencies
o gain return from investing excess funds in attractive countries/markets with huge growth potential
 supranational institutions refer to an international entity formed by two or more central government via
international treaties ex. Multilateral development banks
 multilateral development banks are mandated to give financial assistance to developing countries using
funds gathered from member countries
 Through this activity, regional integration is pursued in specific geographic territories.
 multilateral development banks ex. European Investment Bank, World Bank or (International Bank for
Reconstruction and Development), Inter-American Development bank and Asian Development Bank

Point of information
World bank group- one of the world's largest sources of funding for developing countries
Members of the group
 International Bank for Reconstruction and Development. (IBRD)
 International Development Association (IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency (MIGA)
 International Center for Settlement of Investment Disputes

5. Non- profit organizations

 businesses that exist to respond to specific causes like humanitarian aid, socio-civic causes, environment,
arts and many more
 These do not necessarily operate to generate profit or monetary for its investors.
 include foundations and endowments
Chapter 3: FINANCIAL REGULATION AND THE CENTRAL BANK

Financial Regulation
 Every country must implement its regulatory system to ensure controls and governance.
 Regulation was designed to set rules and guidelines to be followed that is designed to ensure balance
among the individuals, firms and/or citizens as the case maybe.
 Regulation is also designed to reconcile conflicting interests.
 Public utility Research Center in the University of Florida defined regulation is a process whereby the
designated government authority provides oversight and establishes rules for firms in an industry.
 regulatory agency is identified by law or by order to execute the regulatory framework and be an oversight of
a certain industry or particular firm
 Its presence sets the boundaries to manage or control the behavior of the individuals, firms and/or citizens.
 world bank sets regulatory measures to address certain risk and social factors (system risk, consumer
protection, efficiency enhancement and social objectives)
 Systemic risk is the probability of a firm to fail its objective that will result to ripple effect.
 Consumer protection on the other hand is a factor to consider that policies enforced assumes the effect to
the consumers' welfare.
 Efficiency enhancement is a factor that is considered to ensure the dynamism and agility of the policy to
adopt in a fast-changing environment.
 the policy should take into consideration the alignment in the objectives of the society or what is factored as
social objectives.

Table 3.1 presents what regulatory measures address the risks identified.
 financial regulation is a type of regulation whereby rules and standards were set to oversight the ability of
the companies to establish and maintain appropriate level of capital to sustain its operation
 financial regulation also includes setting controls over the market factors that will affect the financial
sustainability of the firms and players in the industry
Market Drivers Regulated
 in financial markets, some players or firms failed to survive even if they comply with regulation set because
these firms respond to the ff. market drivers

1. Competitiveness
 Government are duty bound to regulate competition in the financial sector
 Financial sector has an important role in shaping the overall economy of a country hence it is a must that
this must be regulated.
 market forln the financial market the following are regulated: access to capital, credit and loan term
offerings, support to providers of financing, management of business risks, transactions cost and tariffs
 main determinant of competition are the main forces that drives the market i.e. buyers and sellers
 Normally, investors explore for those which can offer with the less risk with favorable returns.
 The question is, how favorable is favorable?
 The challenge is for the firm on the degree of risk it can assume to enable them to compete in the market.
 connivance in the market may be probable and impose a high collaborative rate among them, in this
scenario government regulation will take place.
 To illustrate, Company A, a brokerage company, imposes 1% brokerage fee to its clients. Company B as a
new player imposes a brokerage fee of 0.75% for every transaction it closes. Company C another player
enters the market offering brokerage fee of 0.70% for every transaction. Company A kept its price policy.
 In this case, assuming the provide same level of service, Company A is facing a high risk of sustainability in
the future if they will not adjust to the competition. In the given scenario, probability that their clients will shift
to the new players that offer a lower rate.
 Government in this case may provide support to Company A to enable the company to compete should
there are internal consideration or risk that they assume that can be passed on in other means.
 pricing for services may be affected with the risks assumed by a firm

2. Market behavior
 behavior of the firms in the industry can be regulated by their behavior
 their behavior in the market can be demonstrated on their
 integrity on their activities
 integrity on their representation

 Regulation will come into play to address failures in the market by setting parameters to ensure that firms
will comply with certain standards to ensure integrity of the firms and level the playing field.
  the government normally sets:
 full disclosure of information
 prohibition of insider trading
 control of new players
 setting minimum capital requirement
 minimum governance rules

3. Consistency
 Consistency, same with the field of Accountancy, is considered as an important principle in the business.
 Consistency in the market is normally demonstrated to their information disclosure and policies.
 The firm must enable themselves to ensure that they provide sufficient information to their customers.
 Given that financial market is heavily a service providing industry, information symmetry is a plus to all
customers/clients that enable them to make sound decision.
 Information is a vital asset in financial markets.
 government role is to set standards to regulate and ensure that information provided in the market are fair,
consistent, and conservative.
 this will allow the investors to make decision.
 In most of the times, degree of risks assumed were based on the information made available
 The issue is that the company's ability to provide a fair and consistent information.
 trust of the clients is dictated on how the firms was able to maintain its rapport in terms of the information
shared.
 in accounting parlance, information can be treated as an intangible asset hence value should be tested
overtime
 principle of prudential regulation whereby the government impose rules or standards that will govern the
behavior of the financial institutions and financial markets that grants commitments to minimize the risk of
uncertainty and strengthen the integrity of the firms

4. Stability
 Market stability is an external and fatal factor to be considered by the firms in the financial market.
 Given that market behavior is dependent on a lot of factors, the risk is very high.
 most of the players failed to survive because their ability to forecast and to mitigate the market risk.
 In the financial market, the impact of financial risk is something that the regulatory environment should
consider.
 The regulation must be able to protect the interest of the clients as well as the companies to enable their
corporate sustainability.
 systematic instability is a challenge or threat whereby it arises where a segment or firm was not able to meet
its commitment because of their failure to address the risks of the market
 the risk arises is the default risk of the company to ascertain repayments thereby disrupting the continuous
flow of finances in industry

Regulators of financial activities

 Financial Activities has been referred to activities that deals on funding certain transaction or expenditures.
 in the financial market, the financial activities are focused on the trading of securities and financial instruments.
 financial activity regulation is the process of setting rules to set standards, control and order on the financial activities,
regardless of the source
1. BSP
 created under the New Central Bank Act or Republic Act 7653 and attached agency of department of
finance
 Under the Philippine law, this will act as central monetary authority which will act as a corporate body that is
responsible concerning money, banking and credit
 BSP shall provide policy directions in these areas.
 It is also responsible for the supervision of financial institutions and exercise regulatory powers.

The functions of BSP

 Liquidity management
o The BSP formulates and issues monetary policy aimed at influencing money supply in order to maintain
price stability

 Currency issue
o The sole responsibility to issue notes and coins representing the national currency of the Philippines
o all issuance made by BSP are with sovereign guarantee and shall be considered legal tender in
exchange for private and public debts

 Lender of last resort (rediscounting)

o BSP acts as the provider of discounts, advances and financial support to financial institution for them to
maintain their liquidity

 Financial supervision
o BSP regularly supervises financial institutions and is empowered to exercise regulatory powers over
non-bank institutions conducting quasi-banking functions

 Management of foreign currency reserves

o manages the financial foreign currency requirement of the Republic by ensuring sufficient international
reserves wil be made available on time
o this is to preserve the international stability and position of philippine peso
  Determination of exchange rate policy
o BSP sets the policy that will determine the rate of exchange of Philippine peso over different currency
o Currently, BSP subscribes to a market-oriented foreign rate policy hence the rates are dependent in the
behavior of the market

 Other activities as banker, financial advisor, and official depository of the government and its
instrumentalities

Monetary Board
o BSP shall be governed by the monetary board
o Monetary board composed of 7 members
o Monetary board is chaired by the governor of BSP and composed of 6 other members coming
from:
 1 member-member of the cabinet designated by the president of the republic (that cabinet
member can designate an undesecretary of his dept to attend on his behalf),
 5 members: from the private sector (3 members shall serve for a term of 6 months while 2 will
serve for 3 months),
o all members can only be re- appointed once
o governor acts as the Chief Executive Officer of BSP
o BSP is supported by four sectors/functions:
 Financial supervision sector- responsible mainly for the supervision and regulation of banks
and other financial institutions under the scope of BSP
 Monetary and Economics sector- aims to conduct the formulation of monetary policy, ensure
its implementation and assess its effectiveness
 Currency management sector- responsible in the production, distribution, disposal or
retirement of currencies in the Philippines including security documents, commemorative
medals and medallions
 Corporate services group- the support group of the BSP that conducts the human capital
management, financial services, information technology support and other corporate resource
management
o More specific information is available on the Organization Primer of the BSP.

Point of information!
 BSP has its money museum within their complex which was constructed since january 3, 1999 and
serves as the repository of all currencies and other historical financial resources
 museo ng bangko sentral ng Pilipinas is open from monday- Friday 9:00am to 4:00 pm, visiting the
museum subject for appointment

2. Insurance Commission (IC)^3

 Mandated by virtue of Executive Order No. 192 s. 2015 to ensure enforcement of the provisions of the
Insurance Code or Republic Act 10607 i.e. to Regulate and supervise the insurance, pre-need, and health
maintenance organization industry
 Governed by Depatment of Finance that supervises and regulates the operations of life and non-life
companies, mutual benefit associations, and trusts for charitable uses.
 Issues licenses to insurance agents, general agents, resident agents, underwriters, brokers, adjusters and
actuaries
 Has the authority to suspend or revoke such licenses

The functions of IC are as follows:

  Promulgation and implementation of policies, rules and regulations governing the operations of
entities engaged in insurance, pre-need, and HMO activities as well as benevolent features.
 Licensing of insurance, reinsurance companies, its intermediaries, mutual benefit associations,
trusts for charitable uses, pre-need companies, pre-need intermediaries, and HMO companies
 Conducting insurance agent's examinations, as well as processing of reinsurance treaties and
request for investments of insurance companies
 Examination/verification of the financial condition and methods of doing business of entities
engaged in insurance business, pre-need, mutual benefit associations, trusts for charitable uses,
and HMO companies
 Evaluation and preparation of statistical reports, studies, researches, annual reports, and position
papers relative to insurance, pre-need matters, and HMO maters
 Review of premium rates imposed by life and non-life companies, mutual benefit associations;
statistical reports of adjusters to determine compliance with established standards.
 Adjudication of claims and complaints involving loss, damage or liability incurred by an insurer under
any kind of policy or contract of insurance or suretyship;
 Review and approval of all life and non-life policies, pre-need, and HMO plans before sale to
prospective clients.

3. Philippine Securities and Exchange Commission (SEC)

 national government regulatory agency to administer oversight on the corporate sector, capital market
participants and securities and investment instrument and promote corporate governance over these.
 created on October 26, 1936 under the commonwealth act no. 83

In the Republic Act 8799 or the Securities Regulation Code, widens the responsibility and scope of the SEC
to include the following:

 Have jurisdiction and supervision over all corporations, partnerships or associations who are the
grantees of primary franchises and/or a license or permit issued by the Government;
 Formulate policies and recommendations on issues conceming the securities market, advise Congress
and other government agencies on all aspects of the securities market and propose legislation and
amendments thereto;
 Approve, reject, suspend, revoke or require amendments to registration statements, and registration
and licensing applications;
 Regulate, investigate or supervise the activities of persons to ensure compliance;
 Supervise, monitor, suspend or take over the activities of exchanges, clearing agencies and other
SROs;
 Impose sanctions for the violation of laws and the rules, regulations and orders issued pursuant thereto;
 Prepare, approve, amend or repeal rules, regulations and orders, and issue opinions and provide
guidance on and supervise compliance with such rules, regulations and orders;
 Enlist the aid and support of and/or deputize any and all enforcement agencies of the Govemment, civil
or military as well as any private institution, corporation, firm, association or person in the
implementation of its powers and functions under this Code;
 Issue cease and desist orders to prevent fraud or injury to the investing public;
  Punish for contempt of the SEC, both direct and indirect, in accordance with the pertinent provisions of
and penalties prescribed by the Rules of Court;
 Compel the officers of any registered corporation or association to call meetings of stockholders or
members thereof under its supervision;
 Issue subpoena duces tecum and summon witnesses to appear in any proceedings of the Commission
and in appropriate cases, order the examination, search and seizure of all documents, papers, files and
records, tax retums, and books of accounts of any entity or person under investigation as may be
necessary for the proper disposition of the cases before it, subject to the provisions of existing laws;
 Suspend, or revoke, after proper notice and hearing the franchise or certificate of registration of
corporations, partnerships or associations, upon any of the grounds provided by law; and
 Exercise such other powers as may be provided by law as well as those which may be implied from, or
which are necessary or incidental to the carrying out of, the express powers granted the SEC to
achieve the objectives and purposes of these laws.

4. Board of Investments (BOI)

 Lead agency to promote investment in country and thereby generate local and foreign investment
investment in the country
 An attached agency of Department of Trade and Industry.
 Board of Investments provides advisory, actualization and post services to the investors

BOI Provides the following services to encourage new investments:

 Provide information for knowledge-based research
 Incentivize the investors through the provision of tax holidays, tax and duty exemption of imported
equipment etc.
 Participate through policy advocacy initiatives to ensure that the laws and regulation are
investment friendly

Money Supply and Payment System

 The financial system is an interrelated financial process which is fueled by money.
 Money supply is the availability of financial resources for deployment in the financial system
 It is making the money available for use or for trade or investment balanced with monetary demand of the
market managed by the central bank or the BSP
 This is, of course, balanced with the monetary demand of the market.
 This balance is managed by the central bank. For the case of the Philippines, it is the Bangko Sentral ng
Pilipinas.

Money will take the form of the following

 Cash (coins and bills)
 demand deposits
 other financial instruments

 Money is expected to be regulated somehow to enable the sovereign to have control to its economy
 money is an essential factor in the financial system.
 In order to do this, Monetary policies must be enforced with the objective of promoting sustainable output
and employment at its peak and stabilize prices

Requirements for a monetary policy to be appropriate or effective by BSP

 Alignment to the target roles
 Access to information
 Responsiveness of variable set

Regulation of circulation of notes

 The central bank or BSP for the case of the Philippines is authorized by the republic under R.A.
7653 have the sole power to issue currency within the territory of the Philippines
 Given it is a sole authority, No one is allowed to issue or reproduce any document or object for
general monetary circulation
 Violators will be facing with imprisonment of not less than 5 years but not more than 10 years,
greater penalty might be imposed depending on the gravity pursuant to the Revised Penal Code of
the Philippines
 Different manner of regulation imposed in other countries

According to Chapter 4 of the BSP Circular No. 829 series 2014 amending the consolidated rules and
regulations on currency notes and coins issued in the Philippines, for the banks, including their
branches, if applicable, must observe the following for the deposit of their notes:

 Banks shall classify their cash deposits and sorted by series and by denomination. They should
classify it according to:
- clean or fit notes
- dirty or unfit notes

 Banks shall provide securely seated bags or containers separately for the clean or fit notes, and
for the dirty or unfit notes accompanied by a deposit slip for each type/category. It must be
labeled "UNFIT".

 Handling of deposits, banks' deposits shall be packed in sealed bags or containers in standard
quantity of twenty (20) full bundles per denomination. Each bundle containing 1,OOO notes in 10
equal straps. Each strap containing 100 notes.

 Banks located in the provinces may make direct deposits of currency notes, duly identified and
sorted, with the nearest BSP regional office/branch. For those without regional offices available,
they may arrange it with their respective head offices to be shipped to BSP in Quezon City. The
cost shall be borne by the bank concerned.

 Banks shall incorporate measures on the implementation thereof in their compliance program.

 For the deposit of their coins the following were observed:

- Coins shall be free from adhesive tapes
- Coins shall be sorted into fit, unfit or mutilated per denomination and per series Each bag of
coins shall contain the following standard number of pieces and amount per denomination:
 - Personnel in charge for setting up the controls for financial institutions e.g. Accountants,
Internal Auditors, controllers, comptrollers etc. must ensure that these guidelines were
properly observed
- Auditors may consider as part of their procedures to validate the authenticity of the
currencies as described by the BSP in its circulars

a currency note shall be considered unfit for circulation when:

 It contains heavy crinkles which break the fiber of the paper and indicate that disintegration of the
note has begun; or
 It is badly soiled/contaminated and/or with writings even if it has proper life or sizing; or
 It presents a limp or rag-like appearance and/or it cannot sustain its upright position when held at
the mid-portion of one of the shorter borders.

For currency coin shall be considered unfit for circulation when:

 it is bent or twisted out of shape or defaced or show signs of corrosion, but its genuineness and/or
denomination can still be readily and clearly determined/identified; or
 It has been considerably reduced in weight by natural abrasions/wear and tear.

For guidance, these currencies which are no longer allowed to be used for circulation but may be presented
for exchange to or deposited with any bank. The reason that the BSP will not accept these currencies are as
follows:

 The notes and coins can no longer be identified; or

 The coins have indications of filing, clipping or perforation; or
 Notes which have lost more than 2/5 of their surface or all of the signatures inscribed thereon; or
 Notes which are split edgewise resulting in the loss of the whole of or part of, either the face or
back portion of the banknote paper; or
 Notes where the Embedded Security Thread or Windowed Security Thread placed thereon is
completely lost except when the damage appears to be caused by wear and tear, accidental
burning, action of water or chemical or bites of insects etc.

Purchasing power
 based on the consumer price index
 In economics, CPI is the weighted average value of the basket prices of all commodities representing the
market
 commodity group in consumer price index: food and non-alcoholic beverages; alcoholic beverages and
tobacco; clothing and footwear; housing, utilities and other fuels; furnishings and maintenance costs; health;
transport; communication; recreation and culture; education; restaurant and miscellaneous
 inflation rate is the degree of movement of CPI from a period to another
 inflation is derived in EQ 3.1
 This means that the prices went up by 3.57%. In terms of the purchasing power this signifies that PI .00 can
buy lesser than the previous year to about 3.57%.
 Inflation is an indication of the market risk. Hence, this also affects the ability of the people to make new
purchases or settle their obligation.
 in finance, inflation is a driver of the financing costs.
 For regulatory purposes, BSP finds its way to control inflation and enable continuous flow of funds in the
market. Thus, BSP is one of the credible agencies that targets the inflation.
 Philippine Statistics Authority, for the case of the Philippines, is the body that determines the current inflation
based on the current movement of the commodities set as index in the market.
 inflation go up, purchasing power goes down

Two types of inflation

 Core inflation- per BSP, core inflation is used for most of the economic estimates where it excludes in the
equation the movement of the commodities or incidents with very volatiles movement or outliers
 Headline inflation – captures changes of the cost of living based on the movement of the basket of
commodities as a whole

 In figure 3.1 , you may note the trajectory of the headline and core inflation for the years 2013 to 2018. You
may observe that the relationship of the headline to core is not consistent over the years where the headline
is not always higher than the core inflation. This is because the excluded incident or commodity may
overstate or understate the basket of prices, but that effect will not last for long term. It is important in those
 engaging in financial markets to know which movement should be considered for their long-term decision.
For those in the capital market for example, this is a good input whether to buy, sell or hold their securities.
Strategies on how manage these securities and even the financial instruments will be discussed in the later
chapter of this book.

Payment System
 The business is not a business if without any trade or exchange
 In civil law of the Philippines, there are different way to settle an obligation after the delivery of products or
render of service.
 one of the modes of settlement of an obligation is through payment of the products or services through the
payment system
 Payment system is a set of interrelated processes of settlement of goods or services rendered in exchange
for a set of instruments that will undergo either a banking or non-banking procedures

Characteristics for an effective payment system

 No ideal or best methodology to administer a payment system
 The system is dependent on the best amenable, convenient and acceptable solution for both parties i.e.
the payee and the payor
 The payment system will work on a certain network or sub-systems that will link the parties grounded by
certain rules and procedures
 According to the BSP, a payment system normally requires the ff.
o Standard methods of transmitting payment messages within the system
o Agreed means of settlement

o Common operating procedures and rules e.g. admission, fees and operating hours.

Standard methods of transmitting payment

 Conventional (manual) way of transmitting payment is the literal arm’s length exchange of
transaction whereby the seller or the obligor deliver the goods or render service while the
other party will deliver in the instance
 This became a challenge became a challenge especially for those located in a remote
location or for those who are far from each other
 Nowadays, this is no longer a challenge.
 Banking system already provides different ways to settle obligation or may payments.
 With the electronic banking or e-banking system, it enables the settlement to be made
through fund transfer, online payment or special requests from the bank made virtually.

Figure 3.2 presents an interface of a personal e-banking service.

  The e-banking with the other features allows payment and money transfers.
 This shows that payment system works within an infrastructure providing efficient solution
and real-time processing of payment with reduce risk.

Agreed means of settlement

 Given that the exchange is a contract between the parties, it is essential that they also
agree on the manner on how the payment is to be rendered.
 Even there is an available online infrastructure to make payments, some people are still
confident on doing it manual or the conventional way.
 Although the payment, made through cheques is not that warranted, except if it is a
manager cheque, some people still preferred this type of payment
 What is important in the payment system is that parties will agree on the manner of
payment
 In accounts payable processing, all transactions for purposes of controls are charged to
accounts payable account
 the settlement of these transactions varies depending on the manner on how it is agreed
for settlement
 No matter what is the manner of settlement, it all boils down to a credit to cash
 The normal means of settlement are as follows:
- Cash or cheque Payment
- Online payment (if the supplier of goods or service is an accredited merchant of a
bank)
- Automated Teller Machine
- Fund transfer
- Credit Cards
- Debt Cards and Stored Value Cards
- Electronic Money
- Manual Money transfer
- Paybox System
- Cash deposit
- Assignment

Common operating procedures and rules

 Other than the agreement on the manner on how it will be settled, another key
requirement for an effective payment system is the operating procedures and rules.
 information or guidelines Must mutually accepted by both parties
 Agreements are normally provided by the payment system facility to provide guidelines
and protection for both parties in case of breach as well protection of the system that the
transactions are cleared from the settling party
 In an online banking system, these agreements are provided as a template to all clients or
users of the system and provides a formal authority to the facility to use information and
the users agreed to subscribed to the banking policies
  Policies sent by the banks or financial institutions were regulated by the BSP

Importance of Payment System

 Payment System is an essential facility to enable the complete course of the transaction

Based on the characteristics and features of payment system, BSP identified the following
importance of the system

 Safe and real time transactions

- The payment systems are designed to safeguard the identity and transaction as a whole
especially on electronic payment system facilities.
- Payment systems are deemed safe given that the characteristics are mutually agreed by
the parties including the manner of payment which is convenient for both.
- Real time are normally applicable for electronic/internet-based system and can be
applicable to manual payment system
- The transaction when the exchange is made and settlement is rendered completes the
transaction already in that point in time
- For e-banking payment system facilities, it is debited to the account of the payor real-time
however most of the systems requires 3 banking days before it is credited to the account of
the payee
- The payor should not worry for the potential interest it will be incurred for these because
the reference should be the date of transaction of the payor and not the posting date to the
payee
- The 3 banking day rules is required as part of the clearing process, but most of the time,
particularly for fund transfer it is credited real time
- The Philippine Bureau of Internal Revenue adopts the use of electronic filing and payment
system that allows you to file and pay the tax due of both personal and corporate
- Payment system is a hybrid that is primarily design to encourage compliance in tax filing
and facilitates the payment to provide convenience to the taxpayers.

Effective risk management

 Since the payment system facility, nowadays, involve well defined parties and rules.
 payment system facilities have verification process to allow the users to validate the transaction before
completing the authority to make payments
 one advantage for established payment system is the Absence of physical cash or financial instrument,
everything can be made virtually or electronically which minimizes the risk of loss, theft and
misappropriation
 Although it is an effective risk mitigation methodology, there are still risk that needs to be recognize upon
using payment systems. These risks are enumerated in Table 3.2

Table 3.2 Risks of Payment Systems

 Credit Risk- Ability of the payor to meet the full value of its obligation due to unforeseen
charges.
 Liquidity Risk- Timing difference on posting may affect the visibility of the user or a party
to determine that full amount due and end up its ability to calculate currently maturing
obligation
 Default Risk- Risk that payment will be made on time.
 Technological Risk- System downtime and system "bugs" may occur.
  Legal Risk- Changes in rules and regulations affecting the payment system

Facilitates financial market transactions

 In the emergence of the e-banking system that serves as the platform of the payment system
facilities.
 The payment system may facilitate the settlement of the financial market transaction
 The database may also be used to make future analysis or projections of the investors
 The system can also be used to validate the personality or credit rating of certain instruments
before completed the trade

Certain platforms are integrated with online brokerage companies to

- facilitate opening an account
- facilitate purchase or sale of the transactions; and
- reduce human intervention provides objective approach to manage financial market
transactions

Chapter 4: MONEY MARKET AND RELATED FINANICIAL INSTRUMENTS

Financial Instruments

 According to conceptual framework for financial reporting (2018)

 An asset is a resource controlled by the entity as a result of past events from which future economic
benefits are expected to flow to the entity
 Asset can be classified in terms of physically tangible and intangible assets
o Tangible assets has physical properties and can be easily seen, touched or perceived by
the five senses
o Value of tangible assets are based on its physical properties
o Ex of tangible assets: buildings, equipment, machinery, land and supplies
o Intangible assets are identifiable assets that do not have physical substance and usually
represents a legal claim to some future economic benefit
o Financial instruments also called financial assets or securities are intangible as future
economic benefit takes form of a claim to cash that will be received in the future
o Financial instruments are the main vehicle used for transactions in the financial market
o For the purposes of presentation in financial statements, financial instruments may be
presented under cash equivalents or investments
o Securities that are maturing within 90 days or less are classified under cash equivalents
otherwise, they are classified under investments.
o There is a minimum of two parties involved in a financial instrument:
 Issuer
- is the party that issues the financial instrument and agrees to make future
cash payments to the investor
 - issuing party usually needs additional funds for investment to further grow
their business
 investor
- the party that receives and owns the financial instrument and bears the right
to receive payments to be made by the issuer
- usually have surplus funds that are not earning anything and are willing to
bear some risk to earn something from their surplus funds
o At the point of issuance of the financial instrument, the issuer usually receives something of
value (usually cash) from the investor
o The financial instrument then becomes the proof (hence, called as security) of the future
claim of the investor from the issuer
o two main economic purposes of Financial instruments:
 Allows transfer of fund from entities with excess funds (investors) to entities who
needs funds (issuer) for business purposes (e.g. to pay for tangible assets).
 Permit transfer of fund that allows sharing of inherent risk associated with the cash
flows coming from tangible asset investment between the issuer and investor.
o the initial investor does not hold on to the instrument up until the time the issuer can make
the payment and trade their financial securities to other individuals or institutions who are
willing to pay for their claim to future payment
o Financial intermediaries also operate in the financial system demand funds from "investors"
and convert these to various financial assets that the general public is willing to buy
o claims of the final wealth holders generally differ from the liabilities recognized by the
issuers (final demanders of funds).

Money Market

 One primary misconception is that money or currency is the security being traded in a money market.
 financial instruments are the primary subject of trading in a money market.
 the financial instruments traded in the money market are short-term and highly liquid, that it can be
considered close to being money.
 three fundamental characteristics of Money market securities:
 Usually sold in large denominations
 Low default risk
 Mature in one year or less from original issue date. Most money markets instruments mature in less
than 4 months.
 Transactions in the money market are not confined to one singular location
 the traders organize the purchasing and selling of the securities among participants and closes the
transactions electronically
 money market securities commonly have an active secondary market
 An active secondary market enables individuals / organizations to trade money market instruments to cater
to short-term financial needs
 Money market instruments become a flexible tool as individuals / organizations may invest in these for
short-term gains and convert it back to cash quickly once liquidity need arises.
 On an accounting perspective, most money market instruments are considered as cash equivalents due to
the fact that they mature (i.e. cash can be redeemed) within three months or less from the date of purchase.
 Most transactions in the money market are very large, hence, they are considered as wholesale markets.
 The required size of the transaction usually averts individual investors in directly participating in the money
market
 dealers and brokers execute transactions in the trading rooms of brokerage houses and large banks to
match customers (buyers to sellers) with each other
 Despite this limitation, individual investors nowadays can invest in the money market by joining funds that
trade mostly using money market instruments.
 A mature secondary market for money market instruments allows the money market to be the preferred
place for firms to temporarily store excess funds up until such time they are needed again by the
organization. Investors who place funds in the money market do not intend earn high returns for their
money. Instead, investors look at the money market as a temporary investment that will provide a slightly
higher return than holding on the money or depositing it in banks.
 If investors believe that the Prevailing market conditions do not justify a stock purchase or there might be a
possible interest hikes impacting bonds, then they can choose to invest on money market instruments in the
meantime.
 Holding on to cash is a very expensive option for investors as this does not generate any return.
 Any idle cash becomes an opportunity cost to investors by means the interest income not earned by holding
on to the cash.
 To reduce opportunity costs, money markets become a viable option to temporarily invest idle funds.
 Investors also plan their strategy to incur the lowest opportunity costs.
 Investors invest on money market securities because of the objectives that they want to have an easy
source of cash to be able to act quickly if there are available investment opportunities that come but at the
same time do not want to let go of potential interest income.
 Financial intermediaries also use money market instruments to attain investment requirements or deposit
outflows.
 money markets offer a least expensive alternative for fund demanders such as the government and financial
intermediaries when they have short-term fund requirements.
 Fund demanders need to have funds quickly because the timing of cash inflows and outflows does not
synchronize with each other.
 For businesses, timing of cash collections from revenue may not match when the business needs to pay its
operating expenses.
 For government, collection of revenue only comes at certain points of the year (tax payment deadlines) but
expenses are incurred throughout the year.
 To resolve the need for funds as a result of the mismatch, these entities turn to money markets to obtain
funds.
 Participants in the money market
 Bureau of Treasury.
o sells government securities to raise funds.
o Short-term issuances of government securities allow the government to obtain cash until tax
revenues are collected.
 Commercial banks.
o Issues treasury securities; sell certificates of deposits and extends loans;
o offers individual investor accounts that can be used to invest in money market
o Banks are the primary issuer negotiable certificates of deposits, banker’s acceptances and
repurchase agreements.
 Private Individual.
o made their investment through money market mutual funds
 Commercia/ Non-Financial Institutions.
o buy and sells money market securities to manage their cash i.e. to temporarily store excess funds
in exchange of somewhat higher return and obtain short-term funds
 Investment companies.
o Trade securities in behalf of their clients.
 o Makes a market for money market securities through maintaining an inventory of financial
instruments that can be bought or sold.
o help maintain liquidity of money market since they make sure that sellers can easily sell their
securities when the need arises.
 Finance / commercial leasing companies.
o raise money market instruments i.e. commercial paper to lend funds to individual borrowers
 Insurance companies.
o invest on money market to maintain liquidity level in case of unexpected demands most especially
for property and casualty insurance companies.

 Pension funds.
o Maintain funds in money market as preparation for long-term investing in stocks and bonds market
o Need to maintain liquidity to meet obligations but since future obligations are likely expected, huge
money market investments are not necessary.
 Money market mutual funds.
o permit small investors (e.g. individuals) to invest in the money market by accumulating funds from
numerous small investors to buy large-denomination money market securities.
 Point of Information! No exact account when first currency is used. But as early as 5,000 B.C. metals were
believed to be the first form of currency in the West Hemisphere. While shells for the East.

Types of Money Market Financial Instruments

 Money market instruments took the form of short-term deposits, government securities, commercial papers
and certificates of deposit which form part of the Philippine interest rate market.
 Money market instruments are governed by Philippine regulations and are influenced by market
movements.

1. Treasury Bills
 Treasury Bills are government securities issued by the Bureau of Treasury which mature jn less than a
year.
 three tenors of Treasury Bills: (1) 91 day (2) 182day (3) 364-day Bills.
 The number of days is based on the universal practice around the world of ensuring that the bills
mature on a business day.
 Treasury Bills are quoted either by their yield rate, which is the discount, or by their price based on 100
points per unit.
 Treasury Bills which mature in less than 91 -days are called Cash Management Bills (e.g. 35-day, 42-
day).
 Being government securities, these are no longer certificated (i.e. scripless) same with the practice in
other countries such as China, Canada and USA.
 Banks that compose majority of the Government Security Eligible Dealers (GSED) bid for T-bills in the
weekly auctions held by the Bureau of Treasury.
 The banks then resell the T-bills to investors.
 Treasury bills have virtually zero default risk since the government can always print more money that
they can use redeem these securities at maturity.
 Risk of inflationary Changes is also lower since the maturity term is shorter.
 Market for Treasury bills is both deep and liquid.
 Deep market means that the market has numerous different buyers and sellers while liquid market
means that securities can be quickly traded at low transactions costs.
 Investors prefer to go to a deep and liquid market such as Treasury bills since there is only little risk that
they will not be able to liquidate the securities when they prefer to.
 Government securities, particularly treasury bills,
 are the safest instrument in the market because they are backed by the full taxing power of
government, they are practically default risk-free.
 While there may be market risks owing to changes in interest rates, these are an attractive
investment vehicle since the safety of the investor's principal is assured.
 These are also marketable and highly liquid as they can be traded easily in the secondary market
anytime the market is open.
 Interest rate is not explicitly stated in the Treasury bill; hence, interest is not actually paid by the
government when they sell this security
 treasury bills are issued at a discount (meaning lower price than the par value at maturity).
 The return realized by investors come from the increase in the value of the securities (purchase price to
the price upon maturity).
 This means that for a PI,OOO Treasury bill sold at 990, the investor only needs to pay P990 as their
investment. Once they redeem the Treasury bill at maturity date, they will be able to collect the PI,OOO.
Simply put, they had a return of PIO from this investment.
 two methods of selling Treasury bills
 auctions or competitive bidding
o the Bureau of Treasury announces quantity and type of securities that they will sell.
o interested parties give bid offering and the Treasury accepts the highest bids.
o The Treasury accepts the bids in ascending order of yield until the accepted bids reach the
offering amount.
o Each accepted bid is awarded at the highest yield paid to any accepted bid.
 noncompetitive bidding.
o bidders only give the amount of securities that they want to buy.
o The Treasury accepts all noncompetitive bids.
o The price for all the securities under noncompetitive bids is set at the highest yield paid to
any accepted competitive bid.
o non-competitive bidders still pay the same price that are paid out by competitive bidders.
o The main difference between the two methods is that competitive bidders may or may not
receive allocation from the securities being sold while noncompetitive bidders are guaranteed
to receive the securities.
 When analyzing investments, investors often try to compare performance of financial instruments with
each other.
 To address this, most investors look at percentages to be able to compare returns better.
 At the point of view of investors, the discount rate indicates how much return, in %, they can get from a
particular security.
 The annualized discount rate for a non-interest-bearing security (like Treasury bill) is described in Eq
3.1.
  the investment rate
 Another variation of the annualized discount rate
 The investment rate address two weaknesses of the discount rate.
o The first one is the use of face amount as the denominator. Since the investor will pay less
than the face amount and the security is sold as a discount instrument, the computed return
is understated.
o The second weakness is the use of 360 days to annualize the return which also understates
the return. To be more specific, investment rate uses 365 days (366 days during leap year) to
annualize the return. The investment rate portrays a more accurate representation of how
much investor will earn from the security since it uses the actual number of days per year
and the true initial investment in the computation. Eq. 4.2 presents the formula for the
annualized investment rate.

 Treasury bills are also known to be very near to the definition of a risk-free asset.
 interest earned on Treasury bills are among the lowest in the market.
 Investors may find that earnings from Treasury bills may not be sufficient to cover for changes in purchasing
power brought by higher inflation.
 Treasury bills are mostly meant as an investment vehicle to temporarily store excess cash since it may
hardly catch up with inflation.

2. Repurchase Agreement
  A repurchase agreement (repo) is a financial contract involving two securities transactions, a sale/purchase
of a debt security on a near date and a reversing purchase/sale of the same or equivalent debt security on a
future date.
 Repurchase agreements enable short-term funds to be transferred between financial or non-financial
institutions, usually ranging from one-day to 3 to 14 days.
 Some repos can also range from one to three months.
 Repos are a key component of the debt securities market that produces short-term cash or securities
liquidity critical to price-making activity of income dealers.
 Dealers of government securities commonly use repos to manage liquidity and take advantage of expected
changes in interest rates.
 Dealers sell their securities to bank with an accompanying repo agreement promising to buy the securities
back at specified future date.
 repos are collateralized loans.
 In the Philippines, the government (through BSP) also uses repo to enforce monetary policy.
 The BSP purchases government securities from a bank commitment to sell it back at a specified future date
at a predetermined rate.
 repo transaction expands the level of money supply as it increases the bank's level of reserves.
 Under a reverse repo, the BSP acts as the seller of government’s securities thus the bank's payment
reduces its reserve account resulting in a contraction in system’s money supply.
 For both repos, the BSP can only affect the level of money supply temporarily, given that the parties
involved commit to reverse the transaction at an agreed future date.
 At present, the BSP enters into repo agreements for a day (overnight) for both repos and a maximum of 91
days and 364 days for repo and reverse repo agreements, respectively.
 Since repos are collateralized by the accompanying securities, these usually are treated as low-risk
investments with low interest rates.

3. Negotiable Certificates of Deposit

 Negotiable certificates of deposit are securities issued by banks which records a deposit made.
 The certificate indicates the interest rate and the deposit. Since maturity date is stated in the certificate,
negotiable certificates of deposit are treated as a term security with a specific maturity date.
 it cannot be easily withdrawn by the depositor since it is different from a demand deposit account wherein
money can be withdrawn upon demand of depositor.
 A certificate of deposit essentially restricts holders from withdrawing funds on demand.
 The concept behind CDs is that investors are willing to accept a higher return jn exchange of having no
access to liquidity.
 Negotiable certificate of deposit is also classified as a bearer instrument.
 As a bearer instrument, whoever person or entity which possesses the instrument upon maturity will
receive the principal and interest.
 This feature allows negotiable CDs to be purchased and sold between investors.
 Interest rates of CDs are based on the outcome of the negotiation between the depositor and the bank.
 Both parties should agree on the interest rate of the CD.
 The interest rates of CDs are usually at the same level with other money market securities since it carries a
low level of risk.
  Investors can buy or sell certificates of deposit up until the instrument's maturity.
 Negotiable CDs may have maturity period between one to four months up to six months.
 there are lesser demand for CDs with longer maturity
 Upon maturity, the bank shall pay the principal plus the interest to the investor who holds the CD.
 In the Philippines, the BSP allows and regulates the issuance of long-term negotiable certificates of
deposits (LTNCD).
 LTNCD refers to interest bearing negotiable certificates of deposit with a minimum maturity of five years.
 LTNCD offers a higher return compared to regular time deposit account because of the long period that
depositors will be unable to withdraw the money.

4. Commercial Paper
 Fundamentally, commercial papers are unsecured promissory notes.
 commercial paper may be short-term or long-term.
 Short term commercial paper means an evidence of indebtedness of any person with a maturity of three
hundred and sixty-five (365) days or less.
 Long term commercial paper is an evidence of indebtedness of any person with a maturity of more than
three hundred sixty-five (365) days.
 Since commercial papers are unsecured, only large and creditworthy corporations can issue this security.
 Lenders will not accept commercial papers from small companies since they are going to assume high level
of risk since this security is not secured.
 Commercial papers are issued directly to the buyer and usually, there is no secondary market for
commercial papers.
 Dealers may redeem commercial papers if the bearer needs cash, but this seldom happens.
 Nonbank corporations like financing companies usually issue commercial papers and use the proceeds to
fund loans that they extend to their clients.
 Issuers often maintain line of credits with banks to serve as backup for a commercial paper.
 The line of credit is primarily for the benefit of the issuer of the commercial paper. If the issuer is not able to
pay the maturing commercial paper, the bank will lend funds to the issuer to enable the latter to pay for the
commercial paper.
 The availability of line of credit reduces the risk associated with commercial papers, hence, this reduces the
interest rate.
 Banks usually extends the line of credit and agrees to provide the loan in advance in case there is a need
to pay off the commercial paper.
 In exchange, the issuer pays of a service charge in exchange of the line of credit.
 Issuers of commercial paper agrees to pay the line of credit fee because this is lower versus paying interest
on the commercial paper for an extended period of time.
 Commercial papers may either have a stated interest rate on its face or sold at a discounted basis.
 In the Philippines, commercial papers are not required to register with SEC if they meet the following
requirements:
 Issued to not more than 19 non-institutional lenders
 Payable to a specific person
 Neither negotiable nor assignable and held on to maturity
 Amount not exceeding P50 million.
 Otherwise, companies need to register with SEC first prior to issuing any commercial paper.

5. Banker's Acceptances
  Banker's acceptances refer to an order to pay a specified amount of money to the bearer on a specified
date.
 Banker's acceptances are often used to finance purchase of goods that have not yet been transferred from
the seller to the buyer.
 Banker's acceptance is usually offered to importers and exporters.
 An acceptance is formed when a draft or a promise to pay is made by the bank's client and the bank then
ultimately accepts, promising to pay in behalf of the client.
 The bank's acceptance of the draft translates to a promise to pay to whomever party presents it to the bank
for payment.
 The client then gives the draft (i.e. banker's acceptance) to the vendor to finance the purchase.
 For example, Company A wants to buy a large equipment from Company B for the first time. Since
Company B does not have any experience that will establish the creditworthiness of Company A, it may be
reluctant to ship the equipment immediately because they might experience difficulty in collection
afterwards. Company A may also be reluctant to send money to Company B for the same reason that they
may not receive the equipment as promised. To help consummate the transaction, banks may intervene
through the issuance of banker's acceptance wherein it will lend its name and creditworthiness to the paying
party, i.e. Company A.
 Banker's acceptances are usually payable to the bearer. Hence, this can be subsequently purchased end
sold until it matures.
 Banker's acceptances are usually sold at a discount, similar with Treasury bills.
 Market dealers also facilitate the trading of banker’s acceptances by matching prospective sellers and
buyers.
 Interest rates on banker's acceptances are usually low since default risk is very minimal.
Evaluating Money Market Securities
 As a finance person, you should be able to understand and evaluate which money market securities to
invest on depending on the purpose of the business.
 Money market securities may be evaluated based on the interest rates and liquidity.

 Interest rates are very relevant in deciding which money market securities to invest since this dictate the
potential return that can be received from the investment.
 Interest rates on money market tend to be relatively low as a result of the low risks associated with them
and the short maturity period.
 Money market securities have a very deep market;thus, they are competitively priced.
 most money market securities carry the same risk profile and attributes, thus, making each instrument a
close substitute for each other.
 if a particular security may have an interest rate that deviates from the average rate, supply and demand
forces in the market would ultimately correct it and force it back to the average rate
 Liquidity refers to how quick, efficient and cheap to convert a security into cash.
 Treasury bills, that have a ready secondary market, are considered to be more liquid than commercial
papers which do not have a developed secondary market.
 Holders of commercial papers tend to hold the security until it matures.
 For this reason, brokers may charge a higher fee for investors that would want to liquidate its commercial
paper since more effort shall be made to look for potential buyers compared to treasury bills that have
buyers willing to purchase at short notice.
 Since most money market securities are typically short-term, money market is often preferred by investors
who desire liquidity intervention — providing liquidity where it did not previously exist.
Valuation of Money Market Securities
 Valuation of money market securities is important to determine at what amount an investor is willing to pay
in exchange of a security.
 In some cases, investors need to give an amount as a bid to be able to buy securities.
 Money market securities can be valued using the present value approach.
 The interest rate used in the valuation shall reflect the required return from the instrument based on the
investor's perceived risk.
 Investors may also use the prevailing interest rate in the market for the type of security being purchased. Eq
4.3 presents the valuation formula which is practically present value formula.

 For example, face value of a one-year Treasury bill is at PI,000 with an annual interest rate of 3%. To
compute for the value of the Treasury bill, use the formula above. The face value which will be received
upon maturity is PI,OOO. The interest rate will be 3% and the number of periods is 1 (since it has a one-
year maturity term)

 This means that an investor is willing to pay P970.87 for a PI ,000 Treasury bill based on the risks
surrounding the instrument. In absolute terms, the investor will get return of P29.13 from this investment.
 Assume that another PI,OOO Treasury bill with maturity term of 90 days with an annual interest rate of 4%
is being evaluated. Assume 360 days. The value of said Treasury bill is computed as follows:

 The annual interest rate should be converted to match the 90-day maturity term. Hence, annual interest
term of 4% shall be multiplied with 90 / 360 to get how much is the interest rate for the tenor of the security.
In this case, the interest rate to be used is 1% which represents the interest cost associated with the 90
days that the money is held by the government.
 As a general rule, as the interest rate rises, the value of the security becomes lower.
 market risk is increases thus the impact on the value of the securities also reduces.
Chapter 5: MANAGING THE CREDIT RISK OF THE FINANCIAL INSTRUMENT
Credit Risk and Interest Rates
 Credit risk is one type of business risk.
 This is the risk that the borrower was not able to repay its obligation.
 Such risk is valuated as a factor to determine the cost of lending or financing using debt.
 Credit risk also affects the valuation of accounts
Theories related in Setting Interest Rates
 According to Fabozzi and Drake, there are two economic theories that drives the interest rates.
 loanable funds theory
o assumes that it is ideal to supply funds when the interests are high and vice versa.
o introduced by Knut Wicksell in 1900s.
 liquidity preference theory.
o introduced by John Maynard Keynes
o the interest rates are dependent on the preference of the household whether they hold or use it for
investment.
 o the longer the term the higher the rates because investors preferred the short-term investment
more.
 BSP defined interest rates to be a type of price.
 Interest are set to compensate the risk of allowing the finances to flow into the financial system.
 The interest as a price is different on the perspective of the lender or borrower.
 For lenders, interest rate is called as lending rate or return.
 For the borrowers, these will serve as cost of debt.
 Interest rates were classified depending on the type of instrument they derived and the tenor of the
investment.
 The tenor of the investment also defines the riskiness of the repayment of debt.
 The longer the life of the debt the riskier the repayment hence the interest rate is higher.
 two economic theories that affect the term structure of interest rate
 expectations theory
 market segmentation theory.
Expectation Theories
 Expectation theories is that the interest rates are driven by expectation of the lender or borrowers in the
risks of the market in the future.
 These maybe a pure expectation theory and biased expectation theory.
 Both theories understand how interest rate, or the term should be structured over time.

1. Pure expectations theory

 based on the current data and statistical analysis to project the behavior of the market in the future.
 They all rely on the forward rates or the future interest rates based on their projection on the future
prices.
 expectation on the interest rates varies depending on the perspective and the maturity.
 For example, Company A needs to finance a project that will be operated in perpetuity. Company A
applied for a loan to Company B payable for 20 years. The prevailing interest rate at present is
7%.Based on the current environment, the market seems to worsen in the future. How will the
interest rate behave in the future? With the given information, Company B must assume a higher
rate than 7% since the probability that Company A may pay in the future is becoming low. The pure
expectations shall be based on the strong estimates based on the uncertainty of the future. The
rates to be agreed should be reasonable enough for both parties otherwise one will not be fully
compensated especially on the part of the lenders. Observed that the pure expectations theory only
relies on the term and not on other factors.
 Biased Expectation Theory
 includes that there are other factors that affect the term structure of the loans as well as the
interest to be perceived moving forward.
 The forward rates will be affected or will be adjusted if the liquidity of the borrower will be
weaker or stronger in the future.
 The adjustment or increase on the interest rate is called the liquidity premium.
 Liquidity premium increases as the maturity lengthens which is called the liquidity theory.
 Another theory under the Biased Expectation Theory is the preferred habitat theory which does
not only consider the liquidity but the risk premium as well but disregarding the consensus of
the market on the future interest rates.
 The habitat being referred here is the biased estimate over the market behavior in the future.
 2. Market Segmentation Theory
 This theory assumes that the driver of the interest rates are the savings and investment flows.
 The maturities are segmented depending on how the assets and liabilities were managed as well as
the lenders on how they extend financing.
 It is the same with preferred habitat theory however it does not assume that any of the players are
willing to shift sector should opportunity to arise for the asset or liabilities to be retired or lenders to
offer higher rates.
Determination of Interest Rate
 To determine the appropriate interest rate or rates the following factors should be considered assuming the
cash flows are already been established:
 Interest rates in the industry
 Risk exposure
 Compensation on the market expectation.
 In finance, interest can be determined by the function of the risk and the compensation of the investor on the
difference between the risk-free rate and the market fluctuations (Eq 5.1).

 The risk-free rate should the rate that assumes zero default in the market where this is more or less
equivalent to the rates offered by the sovereign.
 Normally, the risk-free rate is the Treasury bills issued by the republic.
 In the Philippines, this can also be referred in the Philippine Dealing Systems or PDS Group
 The PDS Group is an organized market that was formed out of the financial distress in 1997.
 Using the technology, the group provides full financial serviced from trading to clearing and to settlement.
 The group is composed of four corporation:
 Philippine Dealing and Exchange Corp. (PDEx) their trading services arm
 Philippine Depository and Trust Corp. (PDTC) for the securities services
 Philippine Securities Settlement Corp. (PSSC) for their payments and transfer services
 PDS Academy for Market Development Corp. (PDSA) as their training center.
 The risk free rate can be real or excludes the effect of inflation or the exclusion of the effect of the
purchasing power of Philippine Peso.
 Since the real risk free rate excludes the inflation, the nominal which is the risk free adjusted for inflation
may assume a compounding effect in the future.
 Since the BSP is the main supplier of the bank reserves, it cannot set the real interest rates because it
cannot set the inflation expectations.
 it is more appropriate to say the real risk free rate can be determined by deducting the prevailing inflation.
 Let's illustrate, Morgana Corp. would like to borrow funds from Oberon Financing.The risk free rate is 6%
and the current inflation is 2%. In the following year, the inflation is expected to grow to 3%. Oberon still
finds that the 4% margin remains to be relevant. How much is the interest rate that Oberon Financing should
impose to Morgan Corp.?
 We know that the risk free rate is nominal hence we have to recalculate to incorporate the forecasted risk of
purchasing power in the future. Hence, the real risk free rate should be recalculated.

 The real risk free rate is 4%, since the repayment will be made in the future, Oberon should consider the
forecasted inflation. Transposing the formula to determine the risk free rate nominal in the future and
incorporate the 3% inflation forecast:

 Now the nominal risk free rate applicable for the loan is 7%. We can calculate the applicable return that
Oberon Financing need in order to kept them whole by

 Therefore, the interest rate that Oberon Financing should charge Morgan is 11%. Now the question is will
this be acceptable to Morgana Corporation? The assessment then again will be different to the borrower.
Morgana should consider if their assessment in the future that the interest will go worse in the long term
then 11% is a good offer. Suppose, another financing company is offering 9% then Morgana should
reconsider. In addition, Morgana corporation in the long run should also consider that the interest cost on
their end would also result to tax benefits, if the interest cost is considered as a tax-deductible expense.

 Another way on how to calculate the interest rate is by the function of the market value, par value and the
interest expense paid by debt securities or bonds. Eq 5.2 presents the formula suggested to determine the
interest rate on debt securities.
 To illustrate, Merlin Corporation issued bonds with 10% nominal rate for a Php l,OOO par value bond
payable for 20 years. The bonds were sold for Php l ,200. How much is the interest rate of the Merlin bonds
in the market?
 Using the formula in Eq 5.2 the interest rate of Merlin bonds

 The interest rate in the market is 8.18% which is lower than the nominal 10% for the Merlin Bonds. This
means that the same bonds are perceived to be riskier in the market as compared to the nominal rate. But
what if the bonds were sold on premium? Note that the market value of the bond is Php l,200 hence there is
a Premium on the Php l,OOO par value of Php200. This is because the bonds are guaranteed by Merlin
Corporation to earn 10% interest while the market can only provide about 200 bps lower than market
 On the other hand, the bond sold at a discount expects that the nominal rate of the instrument or bond of the
same is lower than the market. Assume that Merlin Corporation issued Php l,OOO par value bonds paying
Php100 interest every year for 20 years where their bonds were sold at Php950. How much is the rate of
cost of debt in the market?
 It can be noted that the difference this time is that the interest is given at Php100 and the bonds market
value is Php950 lower than the par value of Php l,OOO, therefore there is a discount. The same problem
can be solve using Eq 5.2

 This time the interest rate is 10.51% higher than the nominal rate of 10%. Given that the difference is about
51 bps, the market value is discounted by about Php50 only (Phpl ,000 — Php950) You may observe that
 using this formula, interest rates can be determined depending on how the nominal or guaranteed interest
rate fairs with the market or effective cost of debt.
 In commerce, risk is a very important factor to consider that may drives the business up or down.
 Risk relates to the volatility of return patterns in the business.
 the challenge on quantifying the risk is imperative for the investors to be able to determine how much they
can keep themselves whole.
 There are risks that are inherent in every financing transaction.
 default risk
o risk arise on the inability to make payment consistently
o Most of the businesses was able to raise financing on their demands, however their cash flows
projected were not that guaranteed.
o Basically, the cash flows management principle is to allow the business to self-liquidate or self-
finance
o While, the company is made aware of their periodic obligation but there are still chances that they
may fail to make sure that the funds were available upon servicing of debt or paying the amortization
including interest
o This type of risk may be quantified by determining the probability of the borrower to default in their
payments in the duration of the loan.
 liquidity risk
o Liquidity Risk is identified by ensuring the business to be capable of meeting all its currently
maturing obligation.
o This is different in default risk
o . Liquidity risk is focusing on the entire liquidity of the company or its ability to service its current
portion of their debt as it comes due.
o In practice, this risk is quantified by determining the opportunity cost of the lender on the period
within which the borrowers were able to recoup or worst the value there cannot be salvage because
of the ability of the company to be liquid.
 legal risks
o Legal risk is dependent on the covenants set and agreed in between the lenders and the borrowers
o The legal risk will arise only upon the ability of any of the parties to comply with the covenants of the
contract.
o Normally, the burden is to the borrower to comply given that the party who is obliged to pay back is
them.
o The common defaults in the covenants are as follows:
 maintaining the financial ratios
 significant acquisition or disposal of assets
 repayment of other obligation
 declaration of dividends of any form without the consent of the lenders.
 market risks, among others.
o Market risk is the impact of the market drivers to the ability of the borrowers to settle the obligation.
o Market risk is classified as a systematic risk because it arises from external forces or based on the
movement of the industry.
o Among the risks that affects the interest, market risk is the most difficult to quantify.
o The experts and analysts can just only set certain parameters to measure it.
 Point of information! PDS provides rates for govt securities using the BVAL Methodology for Government,
Supranational, Agency and Investment-Grade Corporate Bonds
Mitigating the Interest Rate Risks
 Since there interest rate is dependent on the inflation, tenor and other market risks,companies should
consider and make reasonable estimates to mitigate these risks.
 Commercially, there are measures that the company may consider mitigating the impact of the interest
rates.
 The movement of the yield maybe normal or increasing,inverted or declining or flat or constant over time.
Figure 5.1 presents the trajectory or possible yield curves.

Spot rates
 The yield curves presented in Figure 5.1 was a set of points of rates on a particular maturity date.
 In a normal yield curve, most theories expect that interest rates increasing as the maturity lengthens.
 Although on the other hand, yield curve may change or move differently as expected especially when the
inflation is decreasing, or the purchasing power is improving.
 Spot rate is the interest rate or yield available/ applicable for a particular time.
 Spot rates are already actual rates and are not hedge.
 When the agreement is a spot rate the applicable interest rate is based on the prevailing market rate at the
particular time.
 It is important to know the spot rates to be used for establishing market expectation in the future.
 Spot rates will be used to mitigate the risk by referring to historical yield vis-a-vis the forces that occur in
those times.
 For example, a typhoon occurred in the Metro Manila that causes the prices of the resources to rise
because of the scarcity of resources resulting to increase in interest rates. Upon noting the effect on the
spot rates of the external forces, we will expect in the future that when such incident will recur the spot rates
will increase. Thus, it is incumbent to the supplier of funds to consider quantifying its effect so that the
variability of rates will be managed.

Forward Rates
 Given that spot rates are very hard to determine precisely, a way on how to mitigate the impact to the lender
of fund's return and on the other hand, the borrower’s cash flows to service the debt or loans in the future
should the interest go beyond their expectation, this is to have a forward rate or hedge rates.
 Forward rates are normally contracted rates that fixed the rates and allow a party to assume such risk on
the difference between the contracted rate and the spot rate.
 It is a challenge for the financial consultants and economic experts to determine that most probable rates in
the future.
  The clash will be that the lenders would like a more conservative rate while borrowers are aggressive or
lower as much as possible versus the expected spot rate in the future.
 To illustrate, Oberon Financing offers loans fixed for the first 5 Years at 8% and based on the market in the
future. Morgana corp. is capable of servicing the debt at only 9% for the next 10 years more than that they
will fail to maintain their debt covenant ratios. Morgana corp can enter into agreement with Oberon to have
the rates 8% for the first 5 years and 9% for years 6 to 10. The risk on the part of Morgana Corp. if the
interest rate remains to be 8% until year 10, the company will lose 1% per year. On the other hand, if the
rate results say around 10% then Morgana gain for the forward rate contract
Swap Rate
 Another way on how to mitigate the interest rate risk is enter into a swap rate.
 Swap rate is another contract rate where a fixed rate exchange for a certain market rate at a certain
maturity.
 Usually the one used as reference is the LIBOR.
 For the swap rate, it is normally the fixed portion of a currency swap.
 LIBOR or London Interbank Offered Rate is used to benchmark interest rates which is used as reference
for international banks to borrow. It is calculated using the Intercontinental Exchange or ICE. The rates
issued short term from 1 day up to 1 year and releasing more than 30 rates based on about five currencies.
This is the reason why this rate is used as the reference for consumer loans across the world.
 For better appreciation, with the illustration that Oberon Financing and Morgana Corp. borrowed at the rate
of 8% for years 1 to 5 and 9% for years 6 to 10 but with a clause that Morgana Corp and Oberon Financing
may use the prevailing LIBOR rate on years 9 to 10. Thus, the risk for Morgana Corp. is when the LIBOR
rate is higher than the rate at the maturity.
 The correlation of the swap rate and the maturity rate is called the swap rate yield curve.
 The curve is useful for countries as reference for the credit risks and for future decisions.
 Point of information! ICE or International Exchange was established in 2000 in Georgia, USA. Although it is
in US it is subject to European Union regulators watch.
Credit Ratings
 Aside from the purchasing power and factors initially identified, another driver of the interest rate or risk
consideration are the credit ratings.
 Credit rating affects the confidence level of the investors to countries or companies.
 The credit ratings are determined by companies that are recognized globally that objectively assigns or
evaluates countries and companies based on the riskiness of doing business with them.
 The riskiness is primarily driven by their ability to manage their liquidity and solvency in the long run.
 The higher the grade the lower the default risk associated to the country or company.
 These three major rating companies are:
 Standard & Poor's Corporation (S&P)
 Moody's Investors Service
 Fitch Ratings.
 Although, the credit ratings provided by these companies are just recommendatory opinion and will serve
as reference only and is not an absolutely provide default probability to the companies.
Standard & Poor's Corporation
 Standard and Poor's Corporation or S&P is an American financial services corporation was founded in
1941 by Henry Varnum Poor in New York, USA. The company uses data gathered from 128 countries
 using more than 1 ,500 credit analysts to assess the creditworthiness to the industry. The credit ratings
provided by S&P were categorized to Investment Grade and Non-Investment Grade and scaled from AAA
to D as presented in Table 5.1.

Moody's Investors Service

 Moody's Investors Services or Moody's is credit rating company particularly on debt securities established
in 1909 in New York, USA. The company gathers information from more than 130 countries, more than
4,000 non-financial corporate issues and more than 4,000 financial institutions. The company employs
more than 13,000 across the whole world.
 Moody's classify the credit standing into the ratings in Table 5.2 for the Moody’s Rating Scale4.
Fitch Ratings
 The third credit rating agency is Fitch Ratings. It was founded in 1914 in New York, USA. The company
was owned by Hearst. Hearst is a global information and services company. Fitch provides credit opinions
based on the credit expectations based on the certain quantitative and qualitative factors that drive a
company, they assess based on the credit analysis and intensive research. They conduct their assessment
over more than 8,000 entities around the globe with 25 different currencies.
 Fitch same with the other rating agencies publishes its opinion based on a Certain scale of ratings to
represents their opinion. Table 5.3 presents the rating definition of Fitch Ratings5.
  In 2019, Philippines was assessed by S&P at BBB with a stable outlook while Fitch fast evaluation was in
2017 at BBB also with stable outlook. Moody's on the other hand, rated the country in 2014 at Baa with
stable rating.
 United States were rated as AAA by Fitch in 2014 with stable outlook. Moody's rating is Aaa with stable
outlook in 2013, while S&P's latest rating in 2013 with stable rating at AA.
Other rating agencies
 There are other credit rating agencies other than the three major like DBRS and CARE Ratings. Unlike S&P,
Moody's and Fitch, these credit rating agencies were not located jn the United States.
 DBRS was established in 1976 in Toronto, Canada. The company was considered as the fourth largest
ratings agency. The company observe almost 50,000 securities worldwide. DBRS also has offices in New
York, Chicago, London, Frankfurt and Madrid in Spain6. The rating follows from AAA to C as the least.
 CARE Ratings started its operation in 1993 based in India. The company is based in Mumbai with partners
in Brazil, Portugal, Malaysia and South Africa. Other than Mumbai they also have about 10 regional officers
that aims to provide information to investors to serve as guide as they enter into new investment. They also
use AAA as the best instrument to D as the least.

COMPUTATIONS
Chapter 2 Net asset value
Chapter 3 Inflation
Chapter 4 Annualized discount rate and annualized investment rate
Market security value
Chapter 5 Risk fr