Module Capital Markets 2023

MANUEL V GALLEGO FOUNDATION COLLEGES, INC.
INSTITUTE OF ACCOUNTANCY AND BUSINESS
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CAPITAL MARKETS (FM317)
Vision:
:
MVGFCI is the only professional institution in the region committed to uphold the vision of its founder
to achieve a better life by providing full opportunities where every graduate and member of the
MVGFCI community are transformed into competent and morally upright professionals dedicated
towards the development of a better society.
Mission:
:
In pursuit of its vision, MVGFCI shall provide full opportunities and support to ensure and sustain
quality instruction, research, community extension, student affairs and support services.
VISION AND MISSION OF THE INSTITUTE OF BUSINESS AND MANAGEMENT
VISION
The Institute of Business and Management is known for producing business professionals and
entrepreneurs and educators who are creative, technologically savvy and professionally competent
with values and virtues of a Gallegan.
MISSION
The Institute of Business and Management is committed to providing the support needed to develop
business professionals and future entrepreneurs through quality instruction, research, community
engagement, student affairs and support services.
Desired Students’ Learning Outcomes
The Graduates Manifest the Attributes of A “Gallegan” Which Are as Follows:

1. Professionally Competent
2. Effective Communicator
3. Critical Thinker
4. Strong Interpersonal and Collaborative Skills
5. Responsible and Accountable
6. Ethical
7. Lifelong Learner Course
Course Title : CAPITAL MARKETS

Course Code : FM317
Pre-requisite : None
Credit : 3 units
Instructor : Macky C. Herezo, PHD. BA.
Contact Info : 0997-243-3133 / herezo24@gmail.com
Course Description:
This course focuses on Capital Market Theory, its efficiency and implications. It establishes a
coherence with the rest of the financial institutions within the environment. The course also deals with
the relationship of the financial market with the government and how the latter stands a powerful
influential tool. The course likewise attempts to develop the analytical ability of the students through
various financial case presentations.
COURSE LEARNING OUTCOMES:
Students at the end of the course are expected to:
1. Invest using financial intermediaries such as online or traditional brokers in the financial
markets.
2. Analyze different case studies in relation to making financial investment decisions.
3. Analyze the risks and returns of different investment vehicles and portfolios.
4. Provide solutions on current financial system issues our country is experiencing.
Prepared by: Macky C. Herezo, PHD. BA. Page 1 of 71

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Course Content:
No. of Module Topic Sub Topic
Meetings
 Getting to know
Week 1  Levelling of expectations
 Brief journey to the:
One (1) Virtual PART 1.  VMG of MVGFCI
Meetings via ORIENTATION  VMG of the BSBA Program
Google Meet  Understanding the Policies, Guidelines
Module 1
and Requirements of the Course (to
include the Grading Systems and House
rules during the online meetings)
Week 2-3  Financial System: Definition
 Financial System Participants
Two (2) Virtual THE FINANCIAL  Bangko Sentral ng Pilipinas and the
Meetings via Module 1 SYSTEM Philippine Financial System
Google Meet  Monetary Policy and Financial System
WEEK. 4 1st PRELIMINARY PERIOD

Week 5  Financial markets: Definition
Module 2 FINANCIAL  Primary Markets
One (1) Virtual MARKETS  Secondary Markets
Meeting via  Money Markets
Google Meet  Capital Markets
 Other Markets
 Types of investors
Week 6-7 Module 3 FINANCIAL  Money market instruments
INSTRUMENTS  Capital market instruments
One (1) Virtual
Meeting via
Google Meet
WEEK 8. 2nd PRELIMINARY PERIOD
 Financial intermediaries: Definition
Week 9 - 10  Direct and Indirect finance
 Changing the Nature of Financial
One (1) Virtual intermediaries
Meetings via Module 4  Classification of Financial
Google Meet Intermediaries
FINANCIAL
 Depository Institutions
INTERMEDIATION
 Non – depository institutions
 Risks of Financial Intermediation
 Role of Financial Intermediaries in
Socio – Economic Development
 Economic Bases for Financial
Intermediation
Week 11 - 12  Concept Risk
One (1) Virtual  Measurement of Risk
Meetings via  Concept of Returns
Google Meet OVERVIEW OF  Risk and Return
Module 5
RISK AND RETURN  Structure of Rates of Return
 Term Structure of Interest Rates
 Theories of Term Structure
 Risk Structure of Interest Rates
WEEK 13. MIDTERM PERIOD
Week 14-15 Module 6 INTEREST RATES  Concept of Interest Rates
One (1) Virtual AND THEIR ROLE  Demand for and Velocity of Money
Meetings via IN FINANCE  Interest Rate, Prices, Demand For
Google Meet Money, and Velocity of Money
 Types of Interest
 Difference between interest rates and
rates of return
 Interest Rates and Their Role in
Finance

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 Interest Rates and the Economy
 Interest Rate Theories
 Determinants of Interest Rates
 Measurement of Interest Rate
 Concept of Time Value of Money
Week 15-16 Module 7  Simple and Compound Interest
TIME VALUE OF  Future Value and Compounding
Two (2) Virtual MONEY  Present Value and Discounting
Meetings via  Net Present Value
Google Meet  Ordinary Annuity and Annuity Due
Week 17 Module 8  Markowitz Portfolio Theory
One (1) Virtual CAPITAL MARKET  Capital Market Theory Assumptions
Meeting via THEORY  Capital Asset Pricing Model
Google Meet  Mean – Variance Analysis
WEEK 18. FINAL PERIOD
Expectations from Students
Students are held responsible for meeting the standards of performance established for the course
by the faculty. Their performance and compliance with the course requirements are the bases for
passing or failing in each course, subject to the rules of the MVGFCI. The students are expected to
take all examinations on the date scheduled, read the assigned topics prior to class, submit and
comply with all the requirements of the subject as scheduled, attend each class on time and
participate actively in the discussions.
Furthermore, assignments such as reports, reaction papers and the like shall be submitted on the set
deadline as scheduled by the faculty via email. Extension of submission is approved for students with
valid reasons like death in the family, hospitalization, and other unforeseen events. Hence,
certificates are needed for official documentation. Likewise, special major examination is given to
students with the same reasons above. Attendance shall be checked every Class meeting will be
done face to face and on-line to be advised by the faculty in charge.
In the case of face to face meeting, students are expected to strictly follow the health protocols
issued by the IATF/Department of Health. For the online meeting using the facilities of MVGFCI, strict
observance of the safety and security protocols of MVGFCI IS HIGHLY EXPECTED. Students shall
be expected to be punctual in their virtual and face to face classes. Observance of classroom
decorum is required as prescribed by latest MVGFCI Student Handbook.
General Rule:
1. Assignment and reports will be given throughout the semester. Such requirement will be
announced a week before the scheduled virtual meeting.
2. Academic honesty should always be practiced. Any evidence of copying or plagiarism in any
course work will result in a failing grade for all parties involved
3. Reporter should be ready to orally present their assignments’ on scheduled date of
presentation. No show or no report means a grade of 5.0 in that area.
4. Withdrawal and dropping of subject should be done in accordance with existing MVGFCI
policies and guidelines.
5. As student, everyone is expected to be resourceful enough in looking for additional reading
materials and references to be able to come up with scholarly assignments’ and papers.
6. Students are expected to attend 90% of the virtual class meeting and should be able to
complete the whole session the following house rules for virtual class meeting.
Observance of Academic Honesty and Professionalism
It is the mission of MVGFCI to train its students in the highest levels of professionalism and moral
value. In support of this, academic integrity is highly valued, and violations are considered serious
offenses. Examples of violations of academic integrity include, but are not limited to the following:
1. Plagiarism – using ideas, data, or language of another without specific or proper

acknowledgment. Example: Copying text from the Web site without quoting or properly citing the
page URL, using crib sheet during examination. For a clear description of what constitutes plagiarism
as well as strategies for avoiding it, students may refer to the Writing Tutorial Services web site at
Indiana University using the following link: http://www.indiana.edu/~wts/pamhlets.shtml. For citation
styles, students may refer to http://www.uwsp.edu/psych/apa4b.htm.

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2. Cheating – using or attempting to use unauthorized assistance, materials, or study aids during
examination or other academic work. Examples: using a cheat sheet in a quiz or exam, altering a
grade exam, and resubmitting it for a better grade.
3. Fabrication – submitting contrived or improperly altered information in any academic

requirements. Examples: making up data for a research project, changing data to bias its
interpretation, citing non-existent articles, contriving sources. (Reference: Code of Academic Integrity
and Charter of the Student Disciplinary System of the University of Pennsylvania at
http://www.vpul.upenn.edu/osl/acadint.html).
Policy on Absences
1. A student who incurs two (2) unexcused absences in any scheduled meetings shall be given a
mark of “FA” or “failure due to absences” as his/her final rating for the semester, regardless of his
performance in the class. Students are expected to be present during the entire duration of the virtual
class or present at least 75% of the virtual class time, otherwise he/she will be marked absent for that
class meeting.
2. Attendance is counted from the first official day of regular classes regardless of the date of
enrolment. Students who miss a test or assignment for reasons entirely beyond their control (e.g.
illness) may submit a request for special consideration. Provided that notification and documentation
are provided in a timely manner, and that the request is subsequently approved, no academic
penalty will be applied.
3. In such cases, students who miss a test or assignment for reasons entirely beyond their control
(e.g. illness) may submit a request for special consideration. Provided that notification and
documentation are provided in a timely manner, and that the request is subsequently approved, no
academic penalty will be applied in such cases.
Required Readings
The main readings are the guide questions and suggested references indicated in the different
modules. Lecture notes, short cases, and power point presentations may be provided by the faculty
in charge However, as college students, they are expected to be resourceful enough to look for
additional related materials to guide them in their assignments and research works. Journals and
most recent reading materials are suggested. News clippings and video clips may also be
considered. Getting references from internet may also be done PROVIDED students get their
references from RELIABLE sources only and an article and photos/ clipart’s copied MUST be
properly cited including the date when the material was accessed.
Evaluation and Grades
Performance of students will be assessed based on how well he or she has good understanding and
application of the course materials.
1. Class participation/ recitation (no separate grade for attendance as active class participation
already means your attendance) 15%
2. Seatworks/Activities 20%
3. Quizzes 25%
4. Average Long Exams/Final Paper 40%
100%
HOUSE RULES DURING THE ONLINE CLASS MEETINGS
1. Be prepared
 Check your internet connection, your audio and video 30 minutes before the start of the class.
 Run the zoom test: https://zoom.us/test to check that your system is set up adequately for
participating in the event.
 Have your course design and module and other related materials for the class within your reach.
 Check your area in a room almost similar to a classroom, with enough ventilation and light, free
from any form of disturbance during the entire class session.
 Wear decent tops (like when you go to school. If you used to go to school in uniform- then wear
your uniform with your ID. Remember this is a class meeting
 Have proper lighting so that your face is recognizable and can be seen clearly.
 Microphones must be turned on during the entire class.

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 There should be no profanity or anything of the sort displayed in the background.
2. Be punctual.
 The class will start on time. Log in at least 20 minutes before the time. The faculty in charge will
start admitting students 15 minutes before the time.
3. Be an active participant in class activities.

 Provide inputs and reactions and express your views during the discussion.
4. Be respectful.
 Respect by listening to the discussion. If you want to share your thoughts or ask question or
engage in the discussion, use the chatbox or raise your hands by putting on the video. Wait for
the teacher in charge to acknowledge you.
5. Be interested in the class.

 Your punctual and complete attendance is one good indication of your interest in the class.
 Don’t leave the meeting room unless with permission from the faculty in charge or unless he/she
advised you to leave as classes has already ended.
 Class photo will be taken as indication of your attendance. Take interest by participating in this.
ASSESSMENT TOOLS/RUBRICS
Essays 2 - Approaching
% 3-At Standard 4- Exceeds Standard 1-Below Standard
Standard
 Some knowledge of
 Limited knowledge of
 Knowledgeable; substantive, the subject;
the subject; minimal
thorough development of the adequate range of
substance, analysis
essay, including appropriate analysis and
and synthesis;
 Knowledge of the subject; examples; literary devices synthesis;
 Poor thematic
 Adequate range of analysis and noted and analyzed;  Limited thematic
development, use of
synthesis;  Good use of comparison development and
Content, Coherence examples and critical
50%  Appropriate thematic and contrast, critical inquiry use of examples;
and Rationality interpretation of the
development and use of and interpretation.  Mostly relevant to
material;
examples relevant to the topic.  Follows logically from the the topic, but lacks
 Inadequate use of
 Interpretation shows originality. analysis presented, logical detail in critical
quotations.
and cohesive sequencing interpretation of the
 Interpretation is
both between and within material;
predictable and/or
paragraphs.  Interpretation shows
unfocused.
some originality.
 Main ideas clear  Ideas are not well

but loosely connected;
 Clear statement of ideas; organized or
 Title too general;
clear organization connected;
 Main ideas clear and organized  Poor organization
(beginning, middle, and end)  Title pertinent to the
or connected; and transitions;
Organization and and smooth transitions; essay;
Format
30%  Title pertinent to the essay;
 Introduction leads reader  Sequencing logical  Lacks logical
 Sequencing logical and but incomplete;
into topic; sequencing and
complete.
 conclusion effectively  Bibliographical development;
summarizes main findings; material and  Formatting
formatting
adequate. inadequate.
 Low fluency;
 Fluent expression; accurate  Tolerable fluency;  Significant mistakes
 Adequate fluency; use of relatively complex
 some problems in in the use of complex
 Simple constructions used structures;
Grammar, use of complex constructions;
Vocabulary and 20%
effectively;  Complex range of constructions;  Frequent grammar
Fluency  Minimal problems in use of vocabulary;
 Some grammar and spelling errors,
complex constructions; no accurate word/idiom choice;
and spelling lack of accuracy
grammar and spelling errors. mastery of word forms and
errors. interferes with
expressions; appropriate
meaning.
level of usage.
2 – Approaching
%
Case Analysis 3 – At Standard 4 – Exceeds Standard Standard 1 – Below Standard
Presents information
Existing Synthesizes in depth information Presents information from
Presents in depth information from from relevant sources
knowledge, from relevant sources irrelevant sources
30% relevant sources representing various representing limited
research, and/ or representing various points of representing limited points
points of view/approaches. points of
views view/approaches. of view/approaches.
view/approaches.
Organizes evidence but
Organizes and synthesizes the organization Lists evidence but it is not
Organizes evidence to reveal
evidence to reveal insightful is not effective in organized
Analysis 40% important patterns, differences, or
patterns, differences, or revealing important and/or is unrelated to
similarities related to focus.
similarities related to focus. patterns, differences or focus.
similarities.

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States a conclusion focused solely on States a general
States an ambiguous,
the States a conclusion that is a conclusion that, because
illogical or
inquiry findings. The conclusion logical it is so general,
Conclusions 20% unsupportable conclusion
arises extrapolation from the inquiry also applies beyond the
from inquiry
specifically from and responds findings. scope
findings.
specifically to the inquiry findings. of the inquiry findings.
Presents limitations and
Insightfully discusses in detail Presents relevant and
implications,
Limitations and Discusses relevant and supported relevant supported
10% but they are possibly
implications limitations and implications and supported limitations and limitations and
irrelevant and
implications implications
unsupported
NARRATIVE %
REPORT –
INVESTING IN 2 – Approaching
STOCK MARKET 3 – At Standard 4 – Exceeds Standard Standard 1 – Below Standard
Provides a description of
An outstanding assessment that
the target market and its
clearly identifies the target
characteristics and Little or no detail provided
Target Audience/ Assessment clearly identifies the market, its characteristics and
10% needs, but is limited in on target market and its
Segment target market. needs, and utilizes secondary
depth and use of characteristics and needs.
sources to support this
secondary data to
assessment.
support the assessment.
Narrative report is done
excellently with clear explanation Narrative report is done i
Narrative report – of experiences of the students but not described in Narrative report is
Narrative report is done appropriately
Investing in stock 30% also the details were clearly enough detail to convey missing, or, if identified, is
stating the details and experience of
market stated with additional a strong and clear weak in detail.
the students with the activity.
recommendations to improve the strategy.
current stock market system.
Some information on Information not provided
Control operations are proactive
Implementation, Information on implementation and implementation and on implementation and
and evaluation methods have a
Evaluation & 30% evaluation thoroughly and clearly evaluation identified, but evaluation of marketing
clear criterion which thoroughly
Control identified limited in scope and plan or very little detail
and clearly identified.
detail provided.
These issues fit with the analysis
A clear statement of the
Correctly identifies the key issues, that the learner has performed Identifies key issues,
key issues, problems,
problems, and/or challenges facing (i.e,, they do not stand apart from problems, and/or
Key Issues 30% and/or challenges facing
the firm before offering a the rest of the paper, the key challenges facing the
the firm is lacking
recommendation issues emerge from the student’s firm
own analysis)
Inaccurate assessment
Equivalent
50% passing 60% passing Equivalent Percentage
Percentage
1 94.45 – 100 1 95.57 – 100
1.25 88.90-94.44 1.25 91.12 – 95.56
1.5 83.34-88.89 1.5 86.68 – 91.11
1.75 77.79-83.33 1.75 82.23 – 86.67
2 72.23-77.78 2 77.79 – 82.22
2.25 66.68-72.22 2.25 73.34 – 77.78
2.5 61.12-66.67 2.5 68.90 – 73.33
2.75 55.57-61.11 2.75 64.45 – 68.89
3 50.00-55.56 3 60.00 – 64.44
5 Below 50% 5 Below 60%
Grading Table – 60% Passing
MODULE 1. PART I. ORIENTATION
This part discusses the vision, mission and desired students learning outcome of MVGFCI.
A. Vision
MVGFCI is the only professional institution in the region committed to uphold the vision of its
founder to achieve a better life by providing full opportunities where every graduate and
member of the MVGFCI community are transformed into competent and morally upright
professionals dedicated towards the development of a better society.
B. Mission

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In pursuit of its vision, MVGFCI shall provide full opportunities and support to ensure and
sustain quality instruction, research, community extension, student affairs and support services.
C. Desired Students’ Learning Outcomes

The Graduates Manifest the Attributes of A “Gallegan” Which Are as Follows:
1. Professionally Competent
2. Effective Communicator
3. Critical Thinker
4. Strong Interpersonal and Collaborative Skills
5. Responsible and Accountable
6. Ethical
7. Lifelong Learner Course
MODULE 1: Part II. THE FINANCIAL SYSTEM
INTRODUCTION
This module will tackle the different topics in relation to financial system such as the concept
of the financial system, the financial system participants, the Bangko Sentral ng Pilipinas, the
Philippine financial system and the monetary policy.
The topics stated above will broaden the knowledge of the students regarding the
interrelationship of different financial system participants. Furthermore, the relationship of the Bangko
Sentral ng Pilipinas and the monetary policy will also be explained which will help the students
assess the current financial situation of our country.
INTENDED LEARNING OUTCOME

At the end of the module, the learners are expected to:
1. Analyze a financial system’s role in the economy.

2. Comprehend the different participants in the financial system and their roles.
3. Elaborate the role of BSP in the economic development of the Philippines.
4. Analyze the monetary policy and its role in the economic development of the country.
5. Analyze the relationship between monetary policy and financial system.
6. Illustrate how the tools of monetary policy are used to influence money supply and interest rates.
COURSE CONTENT
FINANCIAL SYSTEM: DEFINITION
Financial system describes collectively the financial markets, the financial system
participants, and the financial instruments and securities that are traded in the financial
markets. The functions of the financial system are:
- To channel the funds from the savings units (lenders) to the deficit units (borrowers)
- To provide a medium of exchange
- To provide a mechanism for risk sharing
- To provide a channel through which the central bank can influence the economy, in
general and the financial system, in particular.
With the advent of globalization, we have a multinational financial system. Multinational

financial system refers to the collective financial transfer mechanism that facilitate the
movement of money and profits between and among financial system participants
throughout the world. These mechanisms include transfer of prices on goods and services
traded internally and internationally; intercompany loans and leading (speeding up) and

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lagging (slowing down) payment, fees, and royalty charges wherever they are located in the
world; and dividend payments.
Kidwell et al. (2013) cited the inferences that we can draw about the financial system:
- If the financial system is competitive, the interest rate that the bank pays on
certificates of deposit (CDs) will bear at or near the highest rate that you can earn on
CDs of similar maturity and risk. At the same time, borrowers will have borrowed at or
near the lowest possible interest cost, given their risk class. Competition among
banks for deposits will drive CD rates up and loan rates down.
- Banks and other depository institutions, such as insurance companies, gather money
from consumers in small dollar amounts, aggregate it, and then make loans in much
larger dollar amounts.
- One important function of the financial system is to allocate money to the most
productive investment projects in the economy. If the financial system is working
properly, only projects with high – risk adjusted rates of return are funded, and those
with low rates are rejected.
- Finally, banks are profit – making organizations, and the bank and other lenders earn
much of their profits from the spread between lending and borrowing rates.
From the foregoing discussion, we can see that financial system performs four basic
functions, which are also the functions of finance and financial managers.
a. Fund acquisition – a way of getting deposits and necessary funds to finance projects
and investments
b. Fund allocation – determining to which uses, projects, or investments the acquired
funds will be used
c. Fund distribution – the process by which necessary funds are given to the uses,
projects, or investments that need funds
d. Fund utilization – using the funds for its intended purpose
FINANCIAL SYSTEM PARTICIPANTS
a. Households or consumers
b. Financial institutions / intermediaries
c. Non – financial institutions
d. Government
e. Central Bank
f. Foreign participants

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BANGKO SENTRAL NG PILIPINAS AND THE PHILIPPINE FINANCIAL SYSTEM
BSP VISION AND MISSION
Vision
- BSP aims to be a world – class monetary authority and a catalyst for a globally
competitive economy and financial system that delivers a high quality of life for all
Filipinos.
Mission
- BSP is committed to promote and maintain price stability and provide proactive
leadership in bringing about a string financial system conducive to a balanced and
sustainable growth of the economy. Towards this end, it shall conduct sound
monetary policy and effective supervision over financial institutions under its
jurisdiction.
OBJECTIVES OF BSP
BSP, as the central monetary authority of the country, is expected to provide the
country with a safer, more flexible, and more stable and healthy monetary and financial
system conducive to a balanced and sustainable growth of the economy. Towards this end,
it shall conduct sound monetary policy and effective supervision over financial institutions
under its jurisdiction.
1. Maintain monetary policies conducive to a balanced and sustainable growth of the

economy;
2. Maintain price stability in the country;
3. Promote and maintain monetary stability and the convertibility of the peso;
4. Maintain stability of the financial system
5. Provide payment and other financial services to the government, the public, financial
institutions, and foreign official institutions; and
6. Supervise and regulate depository institutions.

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To attain its objectives, the monetary and fiscal policies of the country need to be closely
and efficiently coordinated.
The different agencies of the government, both financial and fiscal, need to cooperate
with one another. Moreover, it is important that there would be coordination and cooperation
between the government and the private sectors. These sectors are partners in nation –
building.
FUNCTIONS OF BSP
Being the primary monetary authority, BSP performs the following functions:
1. Bank of Issue
- BSP has the monopoly of printing money bills and minting money coins. This
monopoly is designed to:
a. Ensure the uniformity of design and content of money;
b. Effect government supervision over money supply
c. Give prestige and honor to the central bank; and
d. Become a good source of income for the government.
2. Government’s banker, agent, and adviser

- BSP handles the banking accounts of government agencies and instrumentalities. All
government agencies deposit their funds with BSP. It provides foreign exchange to
the government for the importation of goods and services and for payment of foreign
loans. If funds are not sufficient for the needs of the country, BSP borrows from
international financial institution like the World Banka and International Monetary
Fund.
3. Custodian of the cash reserves of banks

- All banks are regulated to have adequate reserves in proportion to their deposit
liabilities with BSP to ensure availability of cash to depositors who wish to withdraw
deposits. These reserve requirements create the interbank call loans, that is, when
one bank lacks funds to comply with the reserve requirement of BSP, it borrows
money from other banks’ reserves with BSP for say, overnight. The interest rate on
these interbank call loans is called the reverse repo rate (RRP), which is the overnight
borrowing rate the official interest rate in the Philippines. In the Philippines, interest
rate decisions are taken by the Monetary Board of the BSP. In case of oversupply of
money creating inflation, the legal reserve requirement is made higher to cut down
liquidity or too much money in circulation. The reserve requirement, say 20%, means
that for every peso of deposit, the bank can only lend 80 centavos because the 20
centavos is deposited with BSP. The reserves deposited at BSP only earn minimal
interest, unlike the loans granted by the banks to borrowers. This is the reason the
banks do not like high reserve requirement, that is, they are unable to earn more
because the amount from regulating money supply, are able to help the government
in times of financial crises.
4. Custodian of the nation’s reserves of international currency

- The early years of central banking required central banks to maintain minimum
reserve of golds, and later international currency, as a guarantee for its issuance of
currency bills or notes and deposits liabilities (cash reserves of commercial banks).
This is designed to meet problems relevant to balance of payments and maintaining
the external value of the local currency. A central bank must meet its domestic and
international payments to create confidence in the people it serves and the countries
it deals with abroad.
5. Bank of rediscount and lender of last resort

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- The rediscounting function of the central bank means the central bank lends money to
banks in distress on the basis of their promissory notes or the promissory notes of the
bank borrowers. When banks grant loans to borrowers, borrowers execute a
promissory note, which the bank discounts. Interest is immediately deducted from the
proceeds of the loans, for example, if the interest is 200 on a 1,000 loan, the net
proceeds that the borrower gets is 1,000 – 200 = 800. The process is known as
discounting. These notes are presented by these banks to obtain a loan from the
central bank, that is why it is termed rediscounting, that is, the discounted notes are
again discounted.
6. Banks of central clearance and settlement
- The central bank acts as a sort of clearing house. This means that banks send
representatives to the clearing house at the central bank where claims are demanded by
one bank against another. Banks have their own boxes at the clearing house. All checks
placed in the boxes are payable to banks that cashed them. For example, a representative
of Bank A has the check of Bank B. The representative places the check of Bank B in the
box of Bank B. This means that Bank A demands payments from Bank B. Through the
process of bookkeeping (debits and credits), banks’ claims against other banks are settled
and cleared. These settlements are done through the reserves that all the banks have with
the central bank.
- For checks issued and cashed in Metro Manila, the clearing of checks is conducted by the
Philippine Clearing House Corporation (PCHC). Trusted as a neutral service bureau of
banks, PCHC extended its operating outfit by implementing several electronic – based
payment system services for the banking community such as the Electronic Peso Clearing
System (EPCS), Philippine Domestic Dollar Transfer System (PDDTS), and Project Abstract
Secure System (PASS). Sorting, processing and clearing of checks are done by computers.
Clearing of checks for provincial checks and Metro Manila checks is done manually at the
Manila Clearing / Regional Clearing units of BSP. Cebu, Davao, and Bacolod have their own
clearing units.
7. Controller of Credit
- Controlling money supply requires controlling credit. The higher the money supply in
circulation, the higher the prices of goods and services. Limited supply of money means
lower prices, which do not encourage production. Hence, it is imperative for the central bank
to limit, not only the money supply, but also credit. This is because credit is in addition to the
money supply in circulation. The more credit there is available, the more production is
encouraged because the consumers can also spend more if they are also able to obtain
credit.
BSP can control credit by:
a. Increasing or decreasing interest rates;

b. Increasing or decreasing the legal reserve requirement of banks
c. Regulating the margin requirements of stock exchange securities;
d. Open market operations (buying or selling government securities);
e. Imposing ceilings on total amounts bank can lend;
f. Rationing central bank credit;
g. Restricting imports;
h. Selecting projects for funding; and
i. Mora suasion (i.e., encouraging people and businesses to support and cooperate
with central bank policies and regulations).
MONETARY POLICY AND FINANCIAL SYSTEM

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- Monetary policy refers to the manipulation of money supply to affect the economy of a
country as a whole. It largely impacts interest rates. Increases in the money supply
lower short – term interest rates and will encourage investments and consumption.
On the long run, however, an abundance of money supply leads to increased prices
or inflation and is undesirable. This is where BSP plays its role as the balancer.
Generally speaking, expansionary monetary policies and contractionary monetary
policies involve changing the level of the money supply in a country. Expansionary
monetary policy is simply a policy which expands (increases) the supply of money,
whereas contractionary monetary policy contracts (decreases) the supply of a
country’s currency. Money supply is the total of currency and coins and demand
deposits in the economy.
LEARNING ACTIVITIES:
1. Lecture discussions via zoom meeting, Self-managed learning.
2. CASE STUDY: Due to the global crisis in terms of war between Ukraine and Russia, demand for oil from
US and China, and the weakening of the global economy, the oil prices in our country is currently reaching
high levels which translated to an increase as well of the general prices of the goods in the market or what
we call inflation. The inflation rate as of current date is at 9.2% according to the Bangko Sentral ng
Pilipinas, which is expected to continuously rise as most of the companies or industries will increase the
prices of their products due to high labor cost and other operating expenses.
If you were the BSP Governor, what type of monetary policy would you implement to ease the sudden
effects of inflation? Contractionary or expansionary? Illustrate the chain reaction of the measures you
would implement and explain why it will happen.
Guide questions:
1.1. Explain the flow of the financial system in the Philippines.
1.2. Describe each role of the financial participants in the financial system.
1.3. How does the BSP organize and manage the financial system in the Philippines?
1.4. What is the essence of monetary policy in controlling the money supply and the inflation of a
country?
References
 CAPITAL MARKETS author Norma Dy Lopez – Mariano, PHD. (2017)

 https://prepnuggets.com/glossary/financial-system/
 https://www.wallstreetmojo.com/monetary-policy/
 https://www.bsp.gov.ph/SitePages/PriceStability/VisualMPR/
MonetaryPolicyReport_May2022.aspx#:~:text=Baseline%20Inflation
%20Projections-,Inflation%20is%20expected%20to%20settle%20above%20the
%20target%20range%20of,the%20previous%20estimate%20of%203.7%25.

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MODULE 2: FINANCIAL MARKETS
INTRODUCTION
This module will explore the different topics in relation to financial markets which are the
concept and nature of financial markets, the primary markets, secondary markets, money markets,
capital markets, and also the different types of investors.
These topics will provide necessary information to the students regarding the different
markets which offer different investment vehicles. Moreover, the process on how to purchase these
investment products to these markets will also be discussed in this module.

1. Explain the meaning of financial markets.

2. Differentiate primary market from secondary market; primary security from secondary security.
3. Analyze the difference between money market from capital market.
4. Explain the difference between the different types of investors.
5. Elaborate the role of securities exchange in financial markets.
6. Comprehend the difference between stock market, bond market, and derivative securities.
COURSE CONTENT
FINANCIAL MARKETS : DEFINITION
Financial markets are structures through which funds flow. They are the institutions
and systems that facilitate transactions in all types of financial claim. A financial claim
entitles a creditor to receive payment from a debtor in circumstances specified in a contract
between them, oral or written. Depositors have financial claims on banks where they hold
their deposits; bondholders have financial claims on companies issuing the bonds they hold.
Financial markets are the meeting place for those with excess funds (investors or lenders
referred to as a surplus / savings units) and those who need funds (borrowers or issuers of
securities referred to as deficit units). Savings from households and businesses are
channeled to those individuals and businesses which need the funds. The needs of deficit
units and surplus units gave rise to financial markets. Financial markets are at the heart of
financial system determining the volume of credit available, attracting savings, and setting
interest rates and security prices.
Financial markets are classified as either (1) primary or secondary market or (2)
money or capital market. Although we have other classifications of financial markets, these
two are the basic classifications of financial markets.

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PRIMARY MARKETS
Financial claims are initially sold by deficit units in primary markets. Primary markets
are markets in which users of funds (e.g., corporations) raise funds, through new issues of
financial instruments such as stocks and bonds. They consist of underwriters, issuers, and
instruments involved in buying and selling original or new issues of securities referred to as
primary securities. In other words, primary markets are markets for primary securities. They
raise cash for the issuing company, which acts as borrower by increasing its current capital
stock when it issues stocks, or outstanding liabilities when it issues bonds. The government
also acts as a borrower when it issues treasury bills. The primary market transaction
involves either security or debt security. These new issues are issued to initial suppliers of
funds or investors.
SECONDARY MARKETS
Once financial instruments are issued in primary markets., they are then traded in
secondary markets. Secondary markets are like used car markets. Secondary markets are
markets for currently outstanding securities, referred to as secondary securities. These
securities were previously bought and owned and now being resold either by the initial
investors or those who have purchased securities in the secondary market. Secondary
markets provide liquidity for investors as they sell their financial securities when they need
cash.

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MONEY MARKETS
Money markets cover markets for short – term debt instruments, usually issued by
companies with high credit standing. They consist of a network of institutions and facilities
for trading debt securities with a maturity of one year or less. They are markets in which
commercial banks and other businesses adjust their liquidity position by borrowing, lending,
or investing for short periods of time. The government treasury uses money markets to
finance its day – to – day operations. Business and households also use money markets to
borrow and lend. Money market instruments that generally have short maturities are highly
liquid and low default risk. There is no formally organized exchange for money markets such
as PSE. Dealers and brokers are at the core of money market transactions. At the trading
room of dealers and brokers, when the market is open, these rooms are characterized by
tension and a frenzy of activities. Each trader sits in front of phones and computers that link
the dealer / broker to other dealers / brokers and their major customers.
CAPITAL MARKETS
Capital markets are markets for long – term securities. Long – term securities are
either debt securities (notes, bonds, mortgages, leases) or equity securities (stocks). Major
suppliers of capital market securities are corporations for stocks and corporation and
governments for bonds. Long – term securities have maturities of more than a year. These
instruments often carry greater default and market risks than money market instruments
generally because they are long – term. In return, they carry a higher return yield. They
suffer wider price fluctuations than money market instruments.

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SECURITIES MARKET
In securities market, companies issue common stocks or bonds, which are

marketable / negotiable, to obtain long – term funds. An instrument that is transferable by
endorsement or delivery is negotiable. Negotiability allows securities to be traded
anonymously. The identity of the seller need not be known. Negotiability improvise liquidity
because anyone who holds the security can immediately sell the security when the holder
needs cash. The holder can even sell the security prior to maturity.
Securities market is composed of:
1. Stock market for equity or stock securities;

2. Bond market for debt securities; and
3. Derivative securities market for securities deriving their value from another security.
STOCK MARKET
Stock market serves as the medium or agent of exchange transactions dealing with
equity securities. It involves institutions and analysts who review the performance of listed
companies. When companies are successful in their operations and investments, analysts
recommend buying of their stocks creating demand and increasing share prices and
shareholders’ wealth. Shareholders can penalize poor management of companies by selling
off their holdings driving share prices down. All markets follow the basic economic law of
supply and demand. If there are a lot of shares of any one company in the market, its prices
go down. The scarcity of the shares drives the share prices up. If many are buying the
stocks, it creates demand and raises prices up.
Classifying stocks into boards enabled PSE to calculate stock indexes (indices) for
each group. A stock index is a measure of the price level of the shares listed in the
exchange by the indicated category. Index reflects the prices of selected stocks. It is useful
as a track record of changes in stock prices over time. PSE tracks four indices: commercial
and industrial, property, mining, and oil. The overall index, which is called the Philippine
Stock Index is a composite of the four indices.
Saldana (1997) listed the following prices in a trading day:

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1. Open – the stock price for the first transaction at the start of trading day
2. Low – the lowest stock price for transactions during the day
3. High – the highest stock price for transactions during the day
4. Close – the stock price for the last transaction of the day
BOND MARKET
Bond market is the market where bonds are issued and traded. It is generally
classified into:
a. Treasury notes and bonds market

b. Municipal bonds market; and
c. Corporate bonds market
Treasury notes and bonds are issued by the government’s treasury. Like T- bills, T –
notes and T – bonds are backed by the full faith and credit of the government and are
therefore free from risks. As a result, they pay relatively low rates of interest (yields to
maturity) to investors. However, because of longer maturity, they are subject to wider price
fluctuation than money market instruments and therefore subject to interest rate risk. In
contrast to T – bills that sell at a discount, T – notes and T – bonds pay coupon interest semi
– annually. They have maturities of over 1 to 10 years.
Municipal bond (LGU) is an important financial instrument for development. In the

Philippines, LGU bonds have only recently been acknowledged as a potential tool for
development. LGU bond reduces the dependence of LGUs on the national government in
implementing their development programs, and most importantly, encourages and rewards
transparent good governance among local government executives. LGU bonds does all
these while attracting private institutional capital and providing the investing public with an
alternative long – term investment instrument.
Corporate bonds are long – term bonds issued by private corporations. Bond indenture is
the legal contract that specifies the rights and obligations of bond issuer and bond holders,
term of the bond, interest rate, and interest payment dates. It may include such term as the
ability of the issuer to call the bond or redeem bonds prior to maturity, and restrictions on the
issuer’s dividend payments, among others.
DERIVATIVES SECURITIES MARKET
The term “derivative” is commonly used to describe a type of security which market
value is directly related to or derived from another traded security. Derivative securities
market refers to the market where derivatives securities are traded. Derivative securities are
financial instruments which pay offs are linked to another, previously issued securities. They
represent agreements between two parties to exchange a standard quantity of an asset or
cash flow at a predetermined price at a specified date in the future. As the value of the
underlying security to be exchanged changes, the value of the derivatives as well as stock
warrants, swap agreements, mortgage – backed securities, and other more exotic variations.
While derivative securities have been in existence for centuries, the growth in derivative
security markets occurred mainly in the 1990s and 2000s.
NEGOTIATED / NON SECURITIES MARKET
Negotiated or non – securities market does not involve securities, thus called non –
securities market. This is so – called negotiated because it results from negotiation between
a borrower and a lender. It includes a direct loan by a company or a person from a lending
institution, like a bank. Also, a personal loan that someone asks from a parent or a relative is
a negotiated loan occurring in a negotiated market. A negotiated market is where the buyer

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and the seller deal with each other, either directly or indirectly through a broker or dealer
with regard to both price and volume. Buyers and sellers are given sufficient time to locate
one another to do the trade. Borrowing transactions that are large in volume may not be
easily traded in the auction market, instead these are done in the negotiated market.
LOAN MARKET
Loan market is where a one – on – one transaction takes place between a borrower
and a lender. A loan by an individual or company from a bank is a direct loan transaction
and an example of a loan market. Even the government negotiates with the World Bank for
certain types of loans.
MORTGAGE MARKET
Mortgage market is where a real property like land, and big machineries, among
others are used to guarantee or secure big loans. It is also a type of loan, but a secured loan
guaranteed by the mortgage on the property. At times, a mortgage is used as a means of
buying properties. Those who want to own properties go to a bank or mortgage company
and get the loan to by the property then use the property as the collateral for the loan, that
is, the company mortgages the property. The mortgage market also includes the market for
foreclosed properties. These are the properties that are taken by lenders because the
borrowers were unable to pay their loan and since the property is used as the collateral for
the loan, the property is taken over by the lender.
LEASE MARKET
Lease market is where equipment, building, or other property is being leased / rented
out to another party. The one who owns the property and who is renting the property out is
the lessor and the party who is to use the property in exchange of the rent or lease is the
lessee. The lease could be an operating lease or a capital lease.
OTHER MARKETS
Other markets are a combination of the money and capital markets, because they
deal with both short – and long – term loans and securities. These may include the following:
1. Consumer Credit Market

- Consumer credit market involves parties and transactions related to loans granted to
households who desire to buy properties, such as cars or appliances, travel, obtain
education for themselves or their loved ones, or other similar needs. It is called
consumer credit market because the borrowers are the consumers.
2. Organized Market
- Organized markets are the exchanges. Exchanges, whether stock markets or
derivative exchanges, started as physical places where trading took place. Some of
the best – known organized markets are NYSE, which was formed in 1792, and the
Chicago Board of Trade, which has been trading futures contracts since 1851. Today,
there are more than a hundred stock and derivatives exchanges throughout the
developed and developing world. Exchanges are situated in a certain location with
definite rules of trading. Exchanges have members and a governing board. Members
have seats in the exchange and seat gives the member the right to rate in the
exchange. Non – members cannot trade in the exchange.
3. Over – the – counter (OTC) Market

- Unlike exchanges, OTC markets have never been a “place”. They are less formal,
although often well – organized networks of trading relationships centered on one or
more dealers. Dealers act as market makers by quoting prices at which they will sell
or buy to other dealers and to their clients or customers. Moreover, dealers in an OTC

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security can withdraw from market making at any time, which can cause liquidity to
dry up, disrupting the ability of market participants to buy or sell. Exchanges are far
more liquid because all buy and sell orders as well as execution prices are exposed
to one another.
- OTC markets are less transparent and operate with fewer rules than do exchanges.
All of the securities and derivatives involved in the financial turmoil that began with a
2007 breakdown in the US mortgage market were traded in OTC markets.
- There are a few dealers who hold inventories of OTC securities that act as a
securities market. Included in the OTCs are brokers who act as agents in bringing
together dealers and investors. OTCs cannot function without computers, terminals,
and electronic networks that facilitate transaction or trade between and among
dealers, brokers, and investors.
4. Auction Market
- Auction market is where the trading is done by an independent third party matching
prices on orders received to buy and sell a particular security. Stocks are sold to the
highest bidder on the trading floors. The highest bidder is the one who offered the
highest price for a particular security. It is where buyers and sellers are brought
together directly, announcing the prices at which they are willing to buy or sell
securities.
5. Foreign Exchange Markets

- Foreign exchange market provides the physical and institutional structure through
which the money of one country is exchanged for that of another country, the rate of
exchange between currencies is determined, and foreign exchange transactions are
physically completed.
6. Spot Market
- Spot markets are called such because buying and selling is done “on the spot”, that
is, for immediate delivery and payment. The buyer pays immediately and the seller
delivers immediately. If you pick up your phone and ask your trader to buy you a
certain stock, say PLDT stock at today’s prices, that is a spot market transaction. You
expect to acquire ownership of the PLDT stocks within minutes or hours. On the
spot, however, may mean one or two days to one week, depending on the practice in
the particular place where the spot market is located / conducted.
7. Futures Market
- Unlike the spot market, futures market is where contracts are originated and traded
that give the holder right to buy something in the future at a price specified in the
contract. It is an agreement to transact involving the future exchange of a set amount
of assets for a price that is settled daily. This is the difference between a futures
contract and a forward contract. In futures contract, the contract’s price is adjusted
each day as the price of the asset underlying futures contract changes and as the
contract approaches expiration. While the value of the forward contract can change
daily when the buyer and seller agree on the deal and the maturity date of the forward
contract, cash payment from buyer to seller occurs only at the end of the contract
period.
8. Forward Market
- Both the futures market and the forward market involve trading contracts calling for
the future delivery of financial instruments, commodities, or currencies. If you call your
broker today and ask him to purchase a contract for you from another investor calling
for delivery to you of 500,000, T – bonds 6 months form today, that could either be a
futures contract or a forward contract.
- If the contract calls for a fixed price for delivery, for example in 6 months, it is a
forward contract. You pay 500,000 for the T – bonds you wish to purchase,

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irrespective of the price of the T – bonds on the date of delivery, that is, whether it
goes up to, say 550,000 or down to 450,000. The buyer still pays 500,000.
9. Options Market
- Options market is where stock options are traded. This is the formal market where the
options are bought and sold, and not when a stockholder is given the option or pre-
emptive right to buy additional shares of stock to maintain his proportionate share or
ownership in a corporation. These options, given by the corporation to the
stockholders, can be sold by the stockholders if they do not want to exercise the
same. This gives rise to the options market.
- Options are traded in securities marketplaces among institutional investors, individual
investors, and professional traders, and trades can be for one contract or for many.
Fractional contracts are not traded. An option contract is defined by the following
elements:
a. Type (put or call)
b. Underlying security
c. Unit of trade (number of shares)
d. Strike price
e. Expiration date
10. Swap Market

- Swaps are agreements between two parties in exchanging specified periodic cash
flows in the future based on an underlying instrument or price. Like forward, futures,
and options, swaps allow firms to better manage their interest rate, foreign exchange,
and credit risks. The swap market is where swaps are traded.
- These are five general types of swaps:
a. Interest rate swaps
b. Currency swaps
c. Credit risk swaps
d. Commodity swaps
e. Equity swaps
- The asset or instrument underlying the swap may change, but the basic principle of a
swap agreement is the same in that it involves the transacting parties restructuring
their asset or liability cash flows in a preferred direction.
11. Third and Fourth Markets

- When securities that are listed in organized exchanges as NYSE, AMEX, and London
Stock Exchange Group, among others are sold in over – the – counter market, they
are referred to as third market and fourth market. Third market refers to transactions
between broker – dealers and large institutions. Fourth markets refer to transactions
that take place between securities firms and large institutional investors like pension
funds and investment companies. These transactions involve large block trades.
These markets have grown along with the growth of electronic communication
networks. Advantages of trading in these markets include speed, reduced trading
costs, and anonymity. Third and fourth market transactions occur to avoid placing the
orders through the main exchange and do away with the commissions that are paid to
floor brokers, which can greatly affect the price of the security.
TYPES OF INVESTORS
Having studied the different types of markets, let us now study the different types of
investors:
1. Risk–averse investors – They are the type of investors who, when faced with two
investment alternatives with equal returns but one is riskier than the other, will choose
the less risky investment. They prefer risk-free assets than risky assets as long as

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they expected returns on each asset are the same. In order for them to invest in a
risky asset, they will require a higher return.
2. Risk – taker investors – They are the investors who are ready to pay higher price for
an investment regardless of the risks involved.
3. Risk – neutral investors – They are investors who do not take into account the risks
involved in the investment and who are focused only on the expected returns.
2. Illustrate the process of investing into the stock market using the following:
a. ONLINE BROKERS
b. TRADITIONAL BROKERS
Provide an explanation of your illustration.
Guide questions:
1.1. Explain the role of the financial markets in terms of increasing the value of investments of an investor.
1.2. Differentiate the primary markets and the secondary markets.
1.3. What is the difference of a money market from a capital market?
1.4. What are the different types of investors? Explain each.
References
 CAPITAL MARKETS author Norma Dy Lopez – Mariano, PHD. (2017)

 https://fintrakk.com/types-of-investors-in-the-stock-market/
 https://www.wallstreetmojo.com/classification-of-financial-markets/
 https://efinancemanagement.com/investment-decisions/primary-market-vs-
secondary-market
 https://www.youtube.com/watch?v=w_20GIFn3pg
MODULE 3: FINANCIAL INSTRUMENTS
INTRODUCTION
This module will focus on these topics the money market instruments and the capital market
instruments. This module will also enlighten the students regarding the flow of the letter of credit in
being a tool for businesses who are engaged in conducting international transactions and trading.

1. Analyze the difference between money market instruments and capital market instruments.
2. Analyze the different government – issued money market instruments and capital market instruments.

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3. Discuss how a letter of credit operates.
4. Analyze the difference among the different non – negotiable capital market instruments.
5. Comprehend the differences among the different marketable capital market instruments.
COURSE CONTENT
MONEY MARKET INSTRUMENTS
- Money market instruments are short-term securities. They are paper or electronic
evidences of debt dealt in the money markets. Only debt securities are short – term.
Equity securities are long – term and belong to the capital market. Money market
instruments are issued by the government and corporations needing short – term
funds. Government securities are generally issued by the Bureau of the Treasury.
Cash Management Bills
- Cash management bills are government – issued securities with maturities of less
than 91 days, specifically 35 days or 42 days. They have shorter maturities than T-
Bills. Government securities are unconditional obligations of the government issuing
them, backed up by the full taxing power of the issuing government. As such, they are
theoretically default – free. Investing in these bills affords security and liquidity to
investors.
Treasury Bills (T – Bills)
- Treasury bills (T – bills) are issued by the Bureau of the Treasury with 91-day, 182-
day, and 364-day maturities. The odd number of days is to generally is to generally
ensure that they mature on a business day. Like Treasury bonds (T-bonds), they are
sold only through government securities eligible dealers, dealers authorized by the
government to sell T-bills. Transactions are done through bidding online.
Banker’s Acceptances
- Banker’s acceptance is a time draft issued by a bank payable to seller of goods. It is

drawn on and accepted by the bank. Before acceptance, the draft is not an obligation
of the bank; it is merely an order by the drawer to the bank to pay a specified sum of
money on a specified date to a named person or to the bearer of the draft just like an
ordinary check. Upon acceptance, which occurs when an authorized bank employee
stamps the draft “accepted” and signs it, the draft becomes a primary and
unconditional liability of the bank. If the bank is well known and enjoys a good
reputation, the accepted draft may be readily sold in an active market. The bank
substitutes its own creditworthiness for that of the drawer that makes banker’s
acceptances marketable instruments.
- Time draft issued by a bank is an order for the bank to pay a specified amount of
money to the bearer of the time draft on a given date. It is different from sight draft,
which is an order to pay immediately. A bank check is a sight draft.
Letters of Credit
- Banker’s acceptances are generally used with the purchase of goods or services
either domestically or internationally. In these cases, the buyer has its bank issue a
letter of credit on its behalf in favor of the seller. For imports, an international letter of
credit is opened; for local purchase, a domestic letter of credit is opened. A
commercial letter of credit is a contractual agreement between a bank, known as the
issuing bank, on behalf of the buyer, authorizing another bank, the correspondent
bank known as the advising or confirming bank, to make payment to the beneficiary,
the seller. The issuing bank, on the request of the buyer, opens the letter of credit.
The issuing bank makes a commitment to honor drawings made under the credit. The

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beneficiary is the seller of goods and services. Essentially, the issuing bank replaces
the buyer as the payor.
Negotiable Certificates of Deposit
- Certificate of deposit is a receipt issued by a commercial bank for the deposit of

money. It is a time deposit with a definite maturity date and a definite rate of interest.
CD stipulates that the bearer is entitled to receive annual interest payments at the
rate indicated in the certificate, together with the principal upon maturity of the
certificate.
Repurchase Agreements
- Repurchase agreements are legal contracts that involve the actual sale of securities
by a borrower to a lender with a commitment on the part of the borrower to
repurchase the securities at the contract price plus a stated interest charge at a later
date. A repurchase agreement is usually a short-term loan from a corporation, state
or local government, or other large entity that has idle funds to a commercial bank,
securities dealer, or other financial institutions. They were created by brokerage
houses and popularized by commercial banks. A reverse repurchase agreement or
reverse repo is an agreement involving the purchase of securities by one party to
another with the promise to sell them back at a given date in the future. Therefore,
from the point of view of the seller of the security, the transaction is a repurchase
agreement and from the point of view of the buyer, the transaction is a reverse repo.
Money Market Deposit Accounts
- Money market deposit accounts are PDIC-insured deposit accounts that are usually
managed by banks or brokerages and can be a convenient place to store money that
is to be used for upcoming investments or has been received from the sale of recent
investments. They are very safe and highly liquid investments, typically paying higher
interest than regular savings accounts but lower than money market mutual funds.
They are also called money market accounts. MMDAs usually offer check – writing
privileges. MMDAs are insured by the Philippine Deposit Insurance Corporation
(PDIC) up to 500,000 per person, per bank. As long as the balance in the account
remains below insurance limit, every bit of principal and interest earned on the
account is 100% guaranteed.
Money Market Mutual Funds
- Money market mutual funds are investment funds that pool funds from numerous
investors and invest in money market instruments offered by investment companies.
A mutual fund is an investment company that pools the funds of many individual and
institutional investors to form a massive asset base. The assets are then entrusted to
a full-time professional fund manager who develops and maintains a diversified
portfolio of security investments.
More comprehensively, mutual funds can be classified as:
1. Growth Funds – invest in assets that are expected to reap large capital gains
(generally equity securities)
2. Income Funds – invest in stocks that regularly pay dividends and in notes and bonds
that regularly pay interest
3. Balanced Funds – combine the features of both growth funds and income funds
4. Sector Funds – invest in specific industries as health care, financial services, utilities
extractive industries
5. Index Funds – invest in a basket of securities that make up some market index as
the S&P 500 index of stocks

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6. Global Funds – Invest in securities issued in many countries providing diversification
Certificate of Assignment
- Certificate of assignment is an agreement that transfers the right of the seller over a
security in favor of the buyer. The underlying security carries a promise to pay a
certain sum of money on a fixed date like a promissory note. The arrangement allows
the buyer to hold the security as a guaranteed source of repayment.
Certificate of Participation
- Certificate of participation is an instrument that entitles the holder to a proportionate

equitable interest in the securities held by the issuing firm or an entitlement to a pro
rata share in a pledged revenue stream, usually lease payments. The lessor assigns
the lease and the payments to a trustee, which then distributes the payments to the
certificate holders. The transaction is between the buyer and the original issuer of the
security. A dealer issues the certificate of participation. The dealer’s liability is to
vouch for the integrity of the original security rather than to repay the loan if the issuer
defaults. The certificate of participation is a useful instrument when the original
security is in a large denomination and when there are a few buyers.
CAPITAL MARKET INSTRUMENTS
- After gaining knowledge in examining the different money market instruments, we are
now ready to learn the different capital market instruments available to investors.
- As stated, these long – term instruments are basically either equity securities or debt
securities. Capital market instruments include corporate stocks, mortgages, corporate
bonds, treasury securities, state and local government bonds, US government agency
securities, and non-negotiable bank, and consumer loans and leases.

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Capital market instruments, just like capital markets, can be classified as:
1. Non – negotiable / non – marketable instruments

2. Negotiable / marketable instruments
Non – negotiable / Non – Marketable instruments
Non- negotiable or non – marketable instruments in the capital markets are the following:
1. Loans
- Loans are direct borrowings of deficit units from surplus units like banks. They can be
short-term or long-term. Companies needing large amounts of funds to finance
special projects like purchase of land or building, plan expansion, or even bond
retirement usually resort to borrowing from capital markets. They do one-on-one
transaction with the lenders. Stockholders usually guarantee these loans. The amount
of loan granted depends on how well the lenders know the borrowers and generally
on their deposits with said banks or with the amount of transactions they do with the
said banks. Long – time, established companies can really borrow large amounts of
funds to finance their capital needs.
2. Leases
- Leases are rent agreements. The owner of the property is called the lessor and the
one who is renting and using the property is the lessee. The lease can be an
operating lease, where the lessor shoulders all expenses including insurance and
taxes related to the property leased out and the lessee pays a fixed regular amount
usually on a monthly basis. It can also be a financing or capital lease, where the
lessee shoulders all expenses of the property as insurance and taxes. Generally,
capital leases are lease – to – own contracts where the lessee pays a big initial down
payment, pays a fixed regular amount, and later pays a minimal amount to finally own
the asset or property being leased.
3. Mortgages
- Mortgages are agreements where a property owner borrows money from a financial
institution using the property as a security or collateral for the loan. The assets
covered by mortgages are non – current assets or permanent assets as land, building
and other real estate properties. Land, building, and machineries are usually

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mortgaged upon purchase. The companies borrow money from banks and other
lending institutions to buy the land, building or machinery and such land, building, or
machinery are used as collateral for the loan thus obtained. Lending institutions are
more secure knowing that something of value guarantees the loan. In essence,
mortgages are secured loans.
4. Lines of Credit
- Line of credit is a bank’s commitment to make loans to regular depositors up to a
specific amount. The line of credit includes letters of credit, standby letters of credit,
and revolving credit arrangements, under which borrowings can be made up to a
maximum amount as of any point in time conditional on satisfaction of specified
terms; before, as of, and after the date of drawdowns on the line. Lines of credit
provide the convenience of a readily available source of money that can be used
anytime and for whatever purpose. Personal lines of credit are for households and
can be used for home renovation, buying a car, vacation, or any major purchase.
Commercial lines of credit are for businesses and can be used for current or short-
term proposes like purchase of merchandise and pay operating expenses or for
capita; expenditures. But since the credit is ongoing and has no termination, it is
considered long-term. It is flexible providing ongoing access to funds. Generally, it is
secured against home equity. Borrowers only pay interest on the funds used with
flexible repayment options, sometimes including the ability to pay as a little as interest
only. It can also have the option to combine with a mortgage to benefit from automatic
rebalancing; therefore, available credit increases automatically as payment is made. It
is a great option if you are looking for flexibility.
Negotiable / Marketable Instruments
- The following are specific marketable or negotiable instruments dealt with in the
capital markets:
Corporate Stocks
- Corporate stocks are the largest capital market instruments. Stocks are evidences of
ownership in a corporation. The holders are called shareholders or stockholders.
Shares of stocks are actually intangible while the stock certificates are the tangible
evidence of ownership. While there are stocks held for short-term use, classified as
current assets under marketable securities or temporary investments, stocks are by
nature long – term. They do not have maturity dates, although redeemable preferred
shares, like callable bonds, can be called for redemption at the option of the issuing
company.
Bonds
- Bonds are debt instruments issued by private companies and government entities to
borrow large sums of money that no single financial institution may be willing or able
to lend. A government bond is issued by a national government and is denominated
in the country’s own currency.
Corporate Bonds
- Corporate bonds are certificates of indebtedness issued by corporations who need

large amount of cash. Bond agreements are called bond indentures. At times, it is
impossible to borrow a large amount from single institution. This is the time
corporations decide to issue bonds instead.
Bonds can be classified as follows:

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1. As to Security
a. Secured bonds
- Secured bonds are collateralized either by mortgages or other assets. Securitized
mortgages are mortgages packaged together by financial institutions and sold as
bonds backed by mortgage cash flows such as interest and principal repayments on
these mortgages.
b. Unsecured bonds
- Unsecured bonds, also called debenture bonds, do not have any sort of guarantee.
They do not provide any lien against any specific property or security for the
obligation, that is, there is no collateral. This is the reason why debenture bonds are
generally issued by companies with a steady high credit rating. Companies such as
large mail – order houses and commercial banks are some of these companies.
2. As to interest rate:
a. Variable rate bonds
- Variable rate bonds are bonds whose interest rate fluctuates and changes when the
market rates change
b. Fixed rate bonds
- Fixed rate bonds have rates that are fixed as stated in the bond indenture.
3. As to retirement
a. Putable bonds
- Putable bonds are bonds that can be turned in and exchanged for cash at the
holder’s option. The put option can only be exercised if the issuer takes some
specified action as being acquired by a weaker company or increasing its outstanding
debt by a large amount.
b. Callable / redeemable bonds

- Callable / redeemable bond is bond in which the issuer has the right to call the bond
for retirement for a price determined at the time the bond is issued. This amount will
typically be greater than the principal amount of the bond.
c. Convertible bonds
- Convertible bonds can be exchanged for common stocks. This feature attracts
investors, but these convertible bonds usually carry lower interest rates. Usually,
these bonds come with warrants, which are options to buy common stock at a stated
price.
4. Other classification
a. Income bonds
- Income bonds are bonds that pay interest only when the interest is earned by the
issuing company. If the issuing company incurs a loss, it is not required to pay
interest on the income bonds. These bonds cannot put issuing companies into
bankruptcy, but from the point of view of the investor, these bonds are riskier than the
ordinary bonds.
b. Indexed or purchasing power bond

- Popular in Brazil, Israel, Mexico, and a few other countries plagued by high rates of
inflation is the indexed or purchasing power bond. The interest rate paid on these
bonds is based on an inflation index such as the consumer price index. Therefore, the
interest paid rises automatically when the inflation rate rises protecting the
bondholders against inflation.
c. Junk bonds

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- Junk bonds are speculative, below – investment grade, high-yielding bonds. They are
big default risk investment; hence, these bonds are high-yielding. High-yield bond
mutual funds and other institutional investors, like energy-related firms, cable TV
companies, airlines, and other industrial companies, buy these bonds. These bonds
are usually used to finance corporate restructuring or company buy – outs. Investors
are generally large companies involved in multibillion dollar takeovers. These bonds
are not attractive to individual investors.
Municipal Bonds
- State and local governments and other political subdivisions must finance their own
capital investment projects like roads, schools, bridges, sewage plants, and airports.
These projects need financing and these local governments usually issue municipal
bonds or local government unit bonds. New issues of municipal bonds are generally
bought by investment bankers and resold to commercial banks, insurance firms, and
high – income individuals. They are not, however, as saleable as corporate bonds.
Municipal / LGU bonds come in the following two varieties:
1. General obligations bonds
2. Revenue bonds
- General obligation bonds are issued to raise immediate capital to cover expenses and
are supported by the taxing power of the issuer. Revenue bonds, on the other hand,
are issued to fund infrastructure projects and are supported by the income generated
by those projects. Both types of bonds are tax exempt and particularly attractive to
risk – averse investors because they are default – risk – free.
Long – Term Negotiable Certificates of Deposit
- Long-term negotiable certificates of deposit are negotiable certificates of deposit with

a designated maturity or tenor beyond 1 year, representing a bank’s obligation to pay
the face value upon maturity, as well as periodic coupon or interest payments during
the life of the deposit. It is exactly the same as the short – term negotiable CDs, but is
long-term.
Mortgage – Backed Securities
- Individual mortgages are non – negotiable and as such are neither liquid nor suited to
trading in secondary markets. As a result, an instrument that came as a result of
mortgage companies and banks grouping mortgages into a standard million block
group and issuing securities backed up by these mortgages, called mortgage-backed
securities, came to evolve. These are mortgage-backed securities, which are usually
in the form of bonds. These are usually sold to pension funds or life insurance
companies. The mortgage houses or banks continue to collect the payments on the
mortgages and pass them on to the owner of the security in the form of interest on the
bonds held. This has resulted in a more efficient mortgage market contributing to
lower mortgage rates for homeowners.
2. Analyze the different money market instruments and capital market instruments based on its purpose,
risks and benefits:
MONEY MARKET
NO. INSTRUMENTS PURPOSE / USE RISKS BENEFITS
1 TREASURY BILLS
2 BANKER'S ACCEPTANCE
3 CORPORATE BONDS
REPURCHASE
4 AGREEMENT

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5 CERTIFICATE OF DEPOSITS
6 COMMERCIAL PAPERS
CAPITAL MARKET
NO. INSTRUMENTS PURPOSE / USE RISKS BENEFITS
1 BONDS
2 DEBENTURES
3 ORDINARY SHARES
4 PREFERENCE SHARES
Guide questions:
1.1. What are money market instruments? How can they be beneficial to the investors?
1.2. What are capital market instruments? Why are they being utilized by investors as well as
businesses?
1.3. Differentiate money market instruments from capital market instruments.
References
- https://commons.wikimedia.org/wiki/File:Money_Market_Instruments.jpg
- https://financialyard.com/capital-market-instruments/
- CAPITAL MARKETS author Norma Dy Lopez – Mariano, PHD. (2017)
MODULE 4: FINANCIAL INTERMEDIATION
INTRODUCTION
This module will discuss the following topics such as the definition of financial intermediaries,
direct and indirect finance, changing the nature of financial intermediaries, classification of financial
intermediaries, the depository institutions, non – depository institutions, risks of financial
intermediation, the role of financial intermediaries in socio – economic development, and lastly the
economic bases for financial intermediation.
Furthermore, the students will also be able to learn the different rating methods the central
banks use in order to assess the performance of different banking institutions. This will provide them
significant knowledge to assess different financial intermediaries’ performance which will greatly
impact the economic development of a country.

1. Analyze the concept of financial intermediation.

2. Analyze the difference between the old and new financial environment.
3. Differentiate depository financial institutions and non-depository financial institutions.
4. Explain the roles of different depository financial institutions and non-depository financial institutions.
5. Elaborate the CAMELS rating for bank supervision and regulation.
6. Analyze the different risks faced by financial intermediaries and investors.
7. Analyze the role played by financial intermediaries and investors.
8. Explain the role played by financial intermediaries in the socio – economic development of a country.
9. Discuss in detail the economic bases for financial intermediation.
COURSE CONTENT
FINANCIAL INTERMEDIARIES: DEFINITION
- Financial intermediaries are the financial institutions that act as a bridge between
investors or savers and borrowers or security issuers. They may simply act as a
bridge between deficit units and surplus units without owning the securities issued by
the deficit units. However, they can transfer them directly to the surplus units or
investors, just like market specialists or brokers, or in certain instances, like
investment banks / merchant banks which underwrite certain original issues.
Generally financial intermediaries buy the securities issued by the deficit units for their

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own account. What they do is issue their own financial instruments called secondary
securities, which they sell directly to investors as surplus units. Financial
intermediaries can therefore either help sell the primary securities issued by the
original issuers or issue their own financial instruments as secondary securities.
DIRECT AND INDIRECT FINANCE
- A borrower – lender relationship is the typical direct finance relationship or

transaction. A bank and a bank depositor are engaged in direct finance; similarly, a
bank and a bank borrower are engaged in direct finance. If you borrow money from
your aunt, that is direct finance. An incorporator buying shares from issuing
corporation also engages in direct finance. There is no need for any financial
intermediary.
- Indirect finance is like the relationship between the depositor of a bank and borrowers
of the same bank. The funds lent to the borrowers came from the deposits of the
bank’s depositors. The relationship between the bank and the depositors is direct like
the relationship between the bank and the borrowers, while that between the
depositors and the borrowers is indirect and therefore, indirect finance.
CHANGING THE NATURE OF FINANCIAL INTERMEDIARIES
- Financial intermediaries have changed over time not only in structure but also in its
functions. Old simple financial intermediaries, which specialized in a single function
like getting deposits and granting loans, had become complex in structure with
different departments performing several specialized functions.

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OLD FINANCIAL ENVIRONMENT
- Thomas (1997) described the changing nature of financial intermediation. According

to him, the US Congress, after the Great Depression of the 1930s, devised a host of
measures to promote a highly specialized financial system. Banks were set up to take
in deposits and grant only short – term loans. Creation of branches was limited and
interest rates were duly regulated. Thrift institutions, to protect banks, were prohibited
to grant consumer and commercial loans and issue checking accounts and were
forced to specialize in long-term fixed-rate mortgages. Life insurance companies were
allowed only to issue policies and purchase corporate bonds, not stocks. In 1933, the
Banking Act of 1933 (Glass Steagall Act) separated commercial and investment
banking. Commercial banks were no longer allowed to underwrite corporate stocks
and bonds, which function became the dominion of investment banks, and they were
not allowed to accept household deposits of grant commercial loans, which became
the domain of commercial banks. Financial institutions therefore became highly
specialized. Households can no longer go to one financial institution and transact all
their business there. They have to go to banks to open checking accounts, go to an
insurance company to purchase insurance policies, go to a thrift institution to
mortgage their house and lot, etc. Companies who issue stocks and bonds have to go
to an investment bank for underwriting of their issues and go to a commercial bank for
a loan. Severe restrictions were placed on the portfolios of depository institutions,
especially thrifts. This was known as the old financial environment.
NEW FINANCIAL ENVIRONMENT
- OFE began to change in the mid – 1970s when the increase in market rates of
interest accompanied by high and rising rates of inflation clashed with the existing
regulatory structures. The Hadjimichalakises (1995) described the new financial
environment as being characterized by market – determined or deregulated rates on
assets and liabilities of financial intermediaries and by greater homogeneity among
financial institutions, which emerged in the 1980s. Financial institutions can now
perform various financial functions, which enable households and companies to go to
a single financial institution to transact various financial businesses. Thereupon
emerged the new financial environment characterized by financial innovations. New
practices and new products emerged. Laws, regulations, institutional arrangements,
and technological innovations were introduced. These innovations sprung from
attempts by households, firms, and banks to circumvent existing regulations to
maximize profit / wealth. The governments were left with no other choice but to simply
protect the health of their respective economic and financial systems.
CLASSIFICATION OF FINANCIAL INTERMEDIARIES
- Financial intermediaries varied but they have one common characteristic. All of them
issue secondary securities to be able to purchase primary securities issued by deficit
units. They can however be grouped into two basic categories:
1. Depository institutions
2. Non – depository institutions
DEPOSITORY INSTITUTIONS
- Depository institutions, as the name implies, refer to financial institutions that accept
deposits from surplus units. They issue checking or current accounts / demand
deposits, savings, time deposits, and help depositors with money market placements.
Current or checking accounts can be withdrawn by issuing checks. Most current
accounts do not earn interest, although due to competition, there are now banks
offering interest on these checking or current accounts. These are called NOW
accounts. Savings accounts can be withdrawn by using passbooks given by the bank
to the depositors when they initially make their deposits. All the deposits and
withdrawals are recorded in the same passbook. It also details the interest earned

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and any taxes or charges deducted from the account. Time deposits refer to deposits
that have maturity, like 30 days, 60 days, 180 days, or one year. These deposits may
not be withdrawn without penalty prior to maturity, but they earn more interest than
the savings account. Time deposits are evidenced by certificates of deposits;
however, these are not negotiable CDs bought and sold in the open markets. These
banks or depository institutions help the depositors if the depositors want to earn
more than time deposits, and do riskier money market placements.
- These depository institutions pool the deposits of the depositors and lend the pooled
funds to deficit units or purchase securities. The deposits that depository institutions
issue are free of risk as the amount of deposit or principal does not fluctuate like
stocks and bonds. Deposits are only reduced if the depositor makes withdrawals or if
there are certain bank charges, like in cases when deposits go below the allowed
minimum balance. The deposits placed in these institutions, generally, can be
withdrawn on demand or in certain cases only a short notice. Individuals and
business companies are depositors and they are also borrowers.
Depository institutions include:
1. Commercial banks
a. Ordinary commercial banks
b. Expanded commercial or universal banks
2. Thrift banks
a. Savings and mortgage banks
b. Savings and loan associations
c. Private development banks
d. Microfinance thrift banks
e. Credit unions
3. Rural Banks
Commercial banks
- Commercial banks are perhaps the biggest of the depository institutions. Universal
and commercial banks represent the largest single group of financial institutions,
resource – wise, in the country. They could have been the pioneers in financial
intermediation.
MACRO RATING (Old rating)
M – Management
A – Asset quality
C – Capital Adequacy
R – Risk management
O – Operating Results
CAMELS RATING (New rating)
C – Capital Adequacy
A – Asset quality
M – Management
E – Earnings

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L – Liquidity
S – Sensitivity to Risk
- The CAMELS rating aims to determine a bank’s overall condition and identify its
strengths and weaknesses financially, operationally, and managerially. Each element
is assigned a numerical rating based on the five key components. The CAMELS
rating is a comprehensive rating with one signifying the best rating and five the
lowest. It provides an early warning signal to prevent a collapse. A rating of one
means most stable, two or three are average suggesting supervisory attention, and
four or five for below average signaling a problem bank.
Thrift banks
- Thrift banking system is composed of savings and mortgage banks, stick savings and
loan associations, private development banks, microfinance thrift banks, and credit
unions. Credit unions, although not classified as banks, can be considered as a thrift
institution in the sense they encourage people to save. These different thrift
institutions in the sense that they encourage people to save. These different thrift
institutions cater to the needs of households, agriculture, and industry. They
encourage the bait of thrift and savings and provide loans at reasonable rates. Thrift
banks are engaged in accumulating savings of depositors and investors them. They
also provide short-term working capital and medium and long-term financing to
business engaged in agriculture, services, industry and housing, and diversified
financial and allied services, and to their choses markets and constituencies,
especially small and medium enterprises and individuals.
Rural and Cooperative Bank
- Rural and cooperative banks are the more popular type of banks in the rural
communities. Their role is to promote and expand the rural community in an orderly
and effective manner by providing the people in the rural communities with basic
financial services. Rural and cooperative banks help farmers through the stages of
production from buying seedlings to marketing of their produce. Rural banks and
cooperative banks are differentiated from each other by ownership. While rural banks
are privately owned and managed, cooperative banks are organized / owned by
cooperatives or federation of cooperatives.
NON – DEPOSITORY INSTITUTIONS
- Non – depository institutions issue contracts that are not deposits. These are pension
funds, life insurance companies, mutual funds, and finance companies like depository
institutions which perform financial intermediation. Pension funds and insurance
companies issue contracts for future payments under certain specified conditions.
Mutual funds issue shares in a portfolio of securities or “basket” securities. Mutual
funds differ in accordance with the types of securities they buy for their portfolios.
Money market mutual funds issue accounts like checking accounts that can be
withdrawn by checks. Finance companies raise funds that they lend to households
and firms by selling marketable securities and borrowing from banks.
Non – depository institutions can be classified into the following:
1. Insurance companies
a. Life insurance companies
b. Property / casualty insurance companies
2. Fund Managers
3. Investment banks / houses / companies
4. Finance companies
5. Securities dealers and brokers
6. Pawnshops

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7. Trust companies and departments
8. Lending investors
Life Insurance Companies
- Life insurance companies are financial intermediaries that sell life insurance policies.
Policy holders pay regular insurance premiums. These premiums are used to
purchase investments so that they can pay cash as needed. Life insurance
companies provide protection over a contracted period or term, which may be a year,
5 years or for a lifetime. If the insured person dies during the term of the policy, the
insurance company pays the beneficiaries the agreed-upon sum, called the face
value of the insurance policy. If the insured person outlives the term of the policy, the
insurance company pays nothing. That is the reason why these policies have what is
termed as loan values and cash surrender values. Loan value of a policy is the
amount that can be borrowed against the policy during the term of the policy. Cash
surrender value is the amount that will be given to the insured or beneficiary if the
insured or the beneficiary decides to surrender the policy before the term ends, which
means the policy is discounted.
Property / Casualty Insurance
- Property / casualty insurance companies offer protection against pure risk. They
insure against injury or property loss resulting from accidents, work-related injuries,
malpractice, natural calamities, and at the extreme, exotic adventures as trips to the
wild like African Safaris. Property and casualty insurance gives protection against
property losses to one’s business, home, or car and against legal liability that may
result from injury or damage to the property of others. This type of insurance can
protect a person or a business with an interest in the insured physical property
against losses.
Examples of property / casualty insurance coverage:
a. Medical bills – Whether the injured person has medical insurance or not is beside
the point. If you are found to be at fault, you could be held responsible for the
payment of those bills.
b. Pain and suffering – This is another type of damage people typically claim when in
an accident. Medical bills aside, if someone is seriously injured, he can also seek to
hold you financially responsible for the monetary equivalent of the pain and suffering
he has experienced as a result of the accident.
c. Loss of wages – If someone gets injured severely at your fault, he may not be able
to work for quite a while. If this happens, you could be held liable for those lost
earnings.
d. Legal fees – Being sued can cost you to hire a lawyer to defend you. Casualty
insurance typically covers your attorney’s fees if someone injured in your home sues
you for damages.
Homeowners insurance – insures one’s house and its contents. Your home and its contents are
your great assets. That is why it is imperative that you protect its value.
Auto insurance – covers one’s, spouse’s, and relative’s home and other licensed drivers to whom
the insurer givers permission to drive his car. The policy is a “package protection” which provides
coverage for both physical injury and property damage liability, as well as physical damage to the
vehicle. This damage can include both that caused by the collision and damage caused by things
“other than collision” such as flood, fire, wind, and hail among others.
Flood insurance – it is a special type of insurance that covers damage to any structure or the
contents therein caused by flood. Coverage could be on a per occurrence sub – limit, an annual
aggregate limit, or as a separate deductible. Flood insurance could be residential flood insurance or

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commercial flood insurance. Residential flood insurance applies to residences of households, while
commercial flood insurance applies to businesses. This is a special type of insurance because
regular homeowners or commercial insurance policy do not cover against flood.
Windstorm insurance – is also a special type of insurance that protects homeowners and business
establishments from devastations caused by windstorms and hurricanes. It is special in the sense
that homeowners and business establishments need to secure additional coverage, either through a
separate policy of a rider to their existing homeowners or commercial insurance policy.
Umbrella liability policy – is also a special type of insurance that provides coverage over and
above one’s automobile or homeowner’s policy. Damages due to an accident or injuries sustained by
somebody else on someone’s property may exceed the limit set on one’s automobile or
homeowner’s property. This is the time an umbrella liability policy will kick in.
Health Insurance – it is a type of insurance that covers cost of an insured individual’s medical and
surgical expenses during an illness. The insured may pay costs out-of-pocket and is then reimbursed
or the insurer makes payments directly to the provider. Usually, the insurer contracts healthcare
providers and hospitals to provide benefits to its members at discounted rate. These costs include
medical exams, drugs, and treatments referred to as “covered services” in the insurance policy.
Long – term care – is defined as need for assistance with some of the activities of daily living. Long-
term care insurance is designed to cover long-term services and supports, including personal and
custodial care in a variety of settings such as your home, adult day health centers, hospice care,
respite care, assisted living facilities or residential care facilities, or nursing homes.
Professional liability insurance – protects professionals, such as doctors, financial advisors,

nursing home administrators, lawyers, etc. against financial losses from lawsuits filed against them
by their clients or patients. These types of policies are often called errors and omissions or
malpractice policies. These policies cover against alleged or actual negligence, defense costs,
personal injury, copyright infringement, claims arising from services provided in the past, and claims
and damages.
Credit insurance – it is an optional protection purchased from lenders and often associated with
mortgages, loans, or credit cards. It protects the lender and the borrower on the risk that he is unable
to repay the debt due to death, disability, or involuntary unemployment.
Fund Managers

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- Fund managers are the ones who handles the pool of funds provided by different
investors and his or her role is to increase the value of investments based on the risk
appetite or risk tolerance of the investors.
Some of the companies who handle these pool of funds are as follows:
a. Pension fund companies – sell contracts to provide income policy holders during
their retirement years.
b. Mutual fund companies – are companies engaged in mutual funds market. They
allow investors to purchase mutual funds that buy different securities in the securities
market like stocks, long-term bonds, or short-term debt instruments issued by
business or government units.
c. Money market mutual funds – Invest in high-quality short-term securities. They
have check-writing privileges combining the features of current account and mutual
funds.
Investment Banks / Houses / Companies
- Investment companies are financial intermediaries that pool relatively small amounts
of investors’ money to finance large portfolios of investments that justify the cost of
professional management. They could be closed-end investment companies that
issue is a fixed number of shares and sell to the public to raise money to purchase
investments. These shares trade in the open market like the shares of any
corporation and their price varies with the demand.
- Investment banks underwrite new issues of equity and debt securities. In an
underwriting transaction, the investment bank, also known as merchant bank,
guarantees the sale of the issues at an agreed price. The investment bank will try to
resell all the issues to investors and any remaining unsold issues will have to be
bought by the investment bank for its own account. Aside from providing the funds in
advance, the investment bank also gives advice to the issuing company as to the
price and number of securities to issue. The issuer is spared the risk and cost of
creating a market for its securities on its own. This is called underwriting. An
investment house or investment bank / merchant banks works primarily for
corporations and governments. These banks help raise money for their clients
through debt and stock offerings. They also advise companies on mergers and
acquisitions and help bring prospective buyers together with sellers. Investment
banks provide advisory services to investors but primarily to larger institutional
customers such as pension and mutual funds.
FINANCE COMPANIES
- Finance companies are profit – oriented financial institutions that borrow and lend
funds to households and businesses. They are like banks and thrifts. However,
finance companies do not issue checking or savings accounts and time deposits.
They raise funds in the open markets and borrowing from banks and then relend
these funds to households and businesses.
Finance companies had been traditionally grouped into three:
1. Sales finance companies

2. Consumer finance companies
3. Commercial finance companies
- Sales finance companies provide installment credit to buyers of big – ticket items like
cars and households appliances. Most sales finance companies are subsidiaries of
major manufacturers of these cars and household appliances. They serve as outlets
for the manufacturers; hence, they are captive finance companies because they
cannot sell any other item except those manufactured by the parent company.

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- Consumer finance companies grant credit to consumers. They grant small loans to
individuals, generally those with low credit ratings and are unable to borrow from
regular lending institutions like banks and thrifts. Due to the high credit or default risk,
the interests charged on these loans are higher.
- Commercial finance companies, also known as business finance companies, grant
credit to businesses. Therefore, while consumer finance companies grant loans to
consumers, commercial finance companies grant loans to commercial enterprises or
businesses. Like consumer finance companies, they grant loans to businesses with
difficulty in obtaining loans from the regular source of these loans because of their low
credit rating. Again, interests on these loans are therefore higher. These loans are
usually secured by the businesses’ assets like accounts receivables, inventories, or
equipment and other fixed assets that the businesses may have.
Securities Dealers and Brokers
- Securities dealers and brokers can be counted among the other finance companies.
Securities brokers are only compensated by means of commission. They act as
financial intermediaries in the sense that they look for investors or savings units for
the benefit of the borrowers or deficit units. They help in the meeting if these units.
They only earn commission on any sale they make. They do not buy securities
directly. Securities dealers, on the other hand, buy securities and resell them and
make a profit on the difference between their purchase price and their selling price.
Pawnshops
- Pawnshops are the agencies where people and some small businesses “pawn” their
assets as collateral in exchange of an amount much smaller than the value of the
asset. Pawnshops are in the business of lending money on the security pledged
goods left in pawn, or in the business of purchasing tangible personal property to be
left in pawn on the condition that it may be redeemed or repurchased by the seller for
a fixed price within a fixed period of time. A “pawn transaction” does not include
pledge to, or purchase by, a pawnbroker of real personal property from a customer
followed by the sale or the leasing of that property back to the customer in the same
or related transaction.
Trust Companies / Departments
- Trust companies are corporations organized for the purpose of accepting and
executing trusts and acting as trustee under wills, as executor, or as guardian. Some
trust companies, mostly banks, perform banking services with a special trust
department. They can perform trust functions for companies issuing bonds to ensure
that bondholders are paid as needed. They can act as fiscal agents or paying agents
for the government.
Lending Investors
- Lending investors are individuals or companies who loan funds to borrowers,

generally consumers or households. Lending investors perform granting loans, but
they are not as big as the regular financial intermediaries. No matter how small they
are, they still bridge the gap between lenders and borrowers or the deficit units or the
saving units. They also charge a higher rate of interest on the loans they grant.
Individuals that grant loans under the so called “5/6” terms are, in effect, lending
investors. Companies that grant loan to SSS pensioners are lending investors.
RISKS OF FINANCIAL INTERMEDIATION
- Risk is the possibility that actual returns will deviate or differ from what is expected. If
you expect prices to go up and you buy securities, you are taking a risk because

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prices could go either up or down. If prices go up, you gain; if prices go down, you
lose. Financial intermediation is highly market sensitive, that is, it changes with the
changes in the market environment. As such, financial intermediaries face several
risks.
These risks are as follows:
a. Interest rate / market price risk

b. Reinvestment risk
c. Refinancing risk
d. Default / credit risk
e. Inflation / purchasing power risk
f. Political risk
g. Technology and operation risk
h. Liquidity risk
i. Currency or Foreign exchange risk
j. Country or Sovereign risk
ROLE OF FINANCIAL INTERMEDIARIES IN SOCIO – ECONOMIC DEVELOPMENT
- In a developing country like the Philippines, financial intermediaries play an important

role in its socio – economic development. While financial intermediaries play an
important role in the urban areas, where a lot of businesses are located and where
the financial markets are very active, they are also very instrumental in the rural areas
for the development of these less developed economies. It is the financial
intermediaries that bring the available funds from the urban areas to the rural areas,
which have the most need for such funds. Rural banks, cooperative banks, and
microfinance thrift banks have been a great help in these disadvantaged areas. They
are the ones doing the lending to farmers and other rural residents that need to
develop their status in life. They can borrow from the rural banks, cooperative banks,
and microfinance thrift banks and start their own small business or send their children
to school.
- In addition to rural banks, cooperative banks, and microfinance thrift banks, the
growth of commercial banks in the rural areas has helped the areas tremendously by
making credit available to the rural residents so they can use the same to advance
themselves. Entrepreneurship and micro and small industries had been pushed in
these areas to help these areas develop and improve not only the economic aspects
of the residents’ lives but also their social life. Financial intermediaries had been
influential and helpful in the establishment of schools and businesses in these areas
aiding in their socio – economic development. Schools are needed in these areas to
help the residents attain economic sufficiency by academic achievement. Educated
individuals have greater potential to earn more and become economically self –
sufficient. Businesses are similarly necessary in these areas to give jobs or
employment to their residents to help them attain a higher economic status in life.
Financial intermediaries had helped the government in securing funds for
infrastructure development of these areas. Infrastructure is needed to facilitate
business growth. Financial intermediaries had helped individuals pursue education or
businesses and livelihood projects for them to attain economic independence.
ECONOMIC BASES FOR FINANCIAL INTERMEDIATION
- Imagining a world without financial intermediaries helps explain the role financial
intermediaries play in the economic, if not, social development of a country. Imagine a
world without banks or stock markets. There would be no place to put our money
where it would earn interest. Putting our money in a piggy bank or a house post would
not earn us anything. If there were not financial intermediaries, we would have no
place to get help to put our children to school to improve our lives. Similarly, if

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financial intermediaries did not exist, we would have no help to start our own business
and improve the life of our family. All of these are impossible without the financial
intermediaries in our midst.
- Financial intermediaries help both the surplus units and the deficit units. They help
surplus units by pooling funds of thousands of individual entities overcoming
obstacles that stop them from purchasing primary claims directly. Such obstacles
include lack of financial expertise, lack of information, limited access to financial
markets, absence of many financial instruments in small denominations, and a lot
more. The spread of risk is made possible only by the pooling funds. This is generally
termed as diversification. Risk is spread by the pooling of resources. If borrowers
default, several lenders suffer the loss, instead of just one lending shouldering the
loss.
- Financial intermediaries also help the deficit units by broadening the range of
instruments, denominations, and maturities of financial instruments enabling even
small savers or surplus units to take advantage of the safer and more profitable
investment alternatives. Even governments are helped a lot by these institutions in
disposing of government securities to a broader base. Financial intermediaries
increase economic efficiency, boost economic activity, and elevate living standards.
- Other than helping in the socio-economic development of the nation, financial
intermediaries bear a large part of the cost that individuals and small borrowers
should have shouldered if they themselves had done what the financial intermediaries
were doing. It is costly to do market research and analysis including determining the
most profitable and the safest means of investing our hard-earned savings. The big
network and economies of scale available to these financial intermediaries allow them
to shoulder all the costs, including transaction costs, which the individual and small
borrowers should have shouldered. This makes the existence of financial
intermediaries indispensable.
- In this connection, let us study the role of two market imperfections – transaction
costs and information gathering. The financial market, just like any other market, is
imperfect. An imperfect market is a market where information is not quickly disclosed
to all participants in it and where buyers and sellers are not matched immediately.
Even in the most advanced financial markets, there are still numerous cases of price
corruption, improperly disseminated information, and other market imperfections.
1. Transaction costs – refers to all fees, commissions, and other charges paid when
buying or selling securities including research costs, cost of distributing securities to
investors, cost of SEC registration, and the time and hassle of the financial
transaction. In general, the greater the transaction cost, the more likely it is that a
financial intermediary will provide the financial service. Banks and other financial
intermediaries are experts in reducing transaction cost. Much of the cost savings
come from economies of scale and from the use of sophisticated digital technology.
2. Information gathering – Financial intermediaries are major contributors to
information production. They are especially good at selling information about a
borrower’s credit standing. The need for information about financial transactions
occurs because of asymmetric information. Asymmetric information occurs when
buyers and sellers do not have access to the same information. Sellers usually have
more information than buyers, especially when the sellers produce or own the asset
to be sold. For financial transactions, issuers of securities know more about investors
about the credit quality of the securities being issued. As can be expected,
informational asymmetry exists more for consumer loans and loans to small
businesses because little information is publicly available.
2. How would financial intermediaries help or aid in economic growth? Research for an article or news
regarding financial intermediaries and write a reaction paper answering the question. Minimum of 300
words.
Guide questions:
1.1. Why are financial intermediaries integral for businesses in making financial transactions?
1.2. Differentiate direct finance from indirect finance.
1.3. How do financial intermediaries help improve a country’s economic status?

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References
- https://theinvestorsbook.com/financial-intermediaries.html
- https://www.researchgate.net/figure/Traditional-financial-market-Mishkin-2012_fig4_279236256
- https://www.mbaknol.com/financial-management/role-of-financial-intermediaries-in-economic-
development/
- https://www.investopedia.com/ask/answers/052515/what-usual-profit-margin-company-insurance-
sector.asp
MODULE 5: OVERVIEW OF RISK AND RETURN
INTRODUCTION
This module will tackle the different topics such as the concept of risk, measurement of risk,
concept of returns, the risk and return relationship, structure of rates and return, term structure of
interest rates, theories of term structure and risk structure of interest rates.
With this module, the students will enhance their knowledge in terms of assessing if the
investment’s risk profile is worth taking or could provide a significant return compared to possible
losses.

1. Analyze the concept of risk and the different types of risk.

2. Analyze the concept of return.
3. Analyze the relationship between risk and return.
4. Elaborate on the structure of rates and return and term structure of interest rates.
5. Discuss the different theories of term structure of interest rates.
COURSE CONTENT
CONCEPT OF RISK
- Risks refer to chances that the outcome of an event is unfavorable or undesirable.

Returns, on the other hand, refer to yields or earnings on an investment. Generally,
the higher the risks, the higher the required returns on an investment. Risk is a
chance or possibility of danger, loss, injury, and the like. It is the uncertainty of the
expected outcome. It is the consequence or the stake of doing things. It is oftentimes
associated with the game of chance.

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Risks are further classified as systematic and unsystematic risk:
1. Systematic risk – also called undiversifiable risk or market risk. Systematic risk
results from the general market and economic conditions that cannot be diversified
away.
2. Unsystematic risk – sometimes called diversifiable risk, residual risk, or company –
specific risk. This is the risk that is unique to a company such as a strike, the outcome
of unfavorable litigation, or a natural catastrophe.
MEASUREMENT OF RISK

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- It is axiomatic that “if it can’t be measured, it can’t be managed.” This is perhaps the
reason why experts try to measure risks. Following are the different standards for
risks:
1. BS 25999 – Risk is an average effect by summing the combined effect of each

possible consequence weighted by the associated likelihood of each consequence.
2. ISO 27005 – Risk estimation is the process to assign values to the probability and
consequences of a risk.
3. NFPA 1600 – Risk assessment categorizes threats, hazards, or perils by both their
relative frequency and severity.
- BS 25999 – 2 specifies requirements for establishing, implementing, operating,

monitoring, reviewing, exercising, maintaining, and improving a documented Business
Continuity Management System within the context of managing an organization’s
overall business risks. ISO 22301 superseded the original British Standard, BS
25999-2, and builds on the success and fundamentals of this standard. BS ISO
22301 specifies the requirements for setting up and managing an effective BCMS for
any organization, regardless of type or size. British Standards Institution recommends
that every business has a system in place to avoid excessive downtime and reduced
productivity in the event of an interruption.
- The ISO27K standards are deliberately risk – aligned, meaning, organizations are
encouraged to assess the security risks to their information. Dealing with the highest
risks first makes sense from the practical implementation and management
perspectives. The standard provides guidelines for information security risk
management. ISO 27005 is broader in scope than merely addressing the risk
management requirements identified in ISO / IEC 27001. However, the standard does
not specify, recommend, or even name any specific risk management method. It does
however imply a continual process consisting of a structured sequence of activities,
some of which are iterative:
a. Establish the risk management context (e.g., scope, compliance obligations,

approaches / methods to be used, and relevant policies and criteria such as the
organization’s risk tolerance or appetite);
b. Quantitatively or qualitatively assess (i.e., identify, analyze, and evaluate) relevant
risks, taking into account the information assets, threats, existing controls, and
vulnerabilities to determine the likelihood of incidents or incident scenarios, and
the predicted business consequences if they were to occur to determine a level of
risk;
c. Treat (i.e., modify [use information security controls] retain [accept], avoid and / or
share [with third parties] the risks appropriately using those levels of risk to
prioritize them;
d. Keep stakeholders informed throughout the process; and
e. Monitor and review risks, risk treatments, obligations, and criteria on an ongoing
basis, identifying and responding appropriately to significant changes.
The National Fire Protection Association (NFPA) 1600 “Standard on Disaster / Emergency
Management and Business Continuity Programs’ is designed to be a description of the basic criteria
for a comprehensive program that addresses disaster recovery, emergency management, and
business continuity. NFPA is an international body with over 60,000 members from all over the world.
Less than a quarter of these members are affiliated with fired departments. The majority of the
members are representatives of the private and public sectors and come from a wide variety of fields.
NFPA standards are developed through a consensus standards development process approved by
the American National Standards Institute.
NFPA 1600 is considered by many to be an excellent benchmark for continuity and emergency
planners in both the public and private sectors. The standard addresses methodologies for defining
and identifying risks and vulnerabilities and provides planning guidelines which address:

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a. Stabilizing the restoration of the physical infrastructure;
b. Protecting the health and safety of personnel;
c. Crisis communications procedures; and
d. Management structures for both short – term recovery and ongoing long-term
continuity of operations.
Spurred by the financial crisis in late 2008, risk management experienced increased importance as a
function within the financial services industry. Accordingly, familiarity with the basic methodologies for
measuring, assessing, and controlling risk is vital for those wishing to get ahead in finance. Some of
these methods are:
1. Loss of principal and / or interest payments

- The crudest yet most conservative measurement of risk is the total sum of money
invested or loaned. The worst possible outcome is that the entire investment
becomes worthless or that the borrower defaults.
2. Probability
- A refinement is the introduction of probabilities to the analysis. The mathematical
theory of probability deals with patterns that occur in random events. Probability is a
set of all possible outcomes like an 80% probability of success and a 20% probability
of failure.
3. Volatility and variability

- Volatility is a basic measure for risks associated with a financial market’s instrument.
It represents an asset’s price fluctuation and is accounted as the difference between
maximum and minimum prices within trading session, trading day, month, and the
like. The wider range of fluctuations (higher volatility) means higher trading risks
involved.
4. Assessment of counterparty risks

- Counterparty risk, which includes default risk, is the risk that the other party to a
transaction, such as another firm in the financial services industry, will prove unable
to fulfill its obligations on time. Examples of these obligations include delivering
securities or cash to settle trades, and repaying short-term loans as scheduled.
Assessments of counterparty risk often are made based in the analyses of
companies’ financial strengths provided by rating agencies.
5. The Role of Actuaries

- Actuaries are most associated with analyzing mortality tables on behalf of life
insurance companies and any other venture which involves measurement of risks. It
plays a critical part in setting of premiums on policies and payout schedules on
annuities. Actuarial science, as it is often called, is an application of advanced
statistical techniques to huge data sets which themselves have high degrees of
measurement accuracy. Additionally, the risks assessments made by life insurance
actuaries are based on data that is almost completely uncorrelated with the financial
system and movements in the financial markets. By contrast, measurements of
counterparty risk, the future behavior of investment securities, and the outlook for
specific business initiatives are not amenable to such precise scientific analysis.
Thus, risk managers probably will never have the ability to develop predictive models
that have anywhere near the degree of confidence that one can place in those
estimated by life insurance actuary.
CONCEPT OF RETURNS
- Returns are the revenues, earnings, yields, proceeds, income, or profit from some
undertakings made, like financial investment, capital investment, and business

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operation. They are measured based on the net cash flow realized or expected to be
realized from an investment or based on the net income from business operations.
Net cash flows refer to the difference between the cash flows received from an
investment and the cash flows expended on an investment. Net income from an
investment refers to the difference between revenues from an investment and the
expenses spent on an investment. They are normally translated in the form of
percentages, which are called rates of return. Rate of return is used to compare the
outcomes of different investments. It is also used to measure historical performance,
determining future investment and estimating cost of capital for capital investment
decision. It shows the return made on an investment.
RISK AND RETURN
- Risk and return are interrelated because the returns from an investment should
equate the risk involved. As stated earlier, the risk–averse investor, before making
investment in a risky asset, requires a higher return than the risk – free asset. Returns
computed from historical data can be used in measuring future returns; however, the
uncertainty of the occurrence or the risk involved should also be taken into account.
- Risk is the possibility that actual returns will deviate or differ from what is expected.
The actual returns can go up or down depending on the market. If the returns go up,
the risk in investing is worth it; if the returns go down, then the risk is not worth taking.
Taking risks involves knowledge of expected returns, terminal value, present value
and rate of return. Expected returns are the future cash flows associated with the
investment. Terminal value is the maturity value of an investment. Present values are
the discounted value of the future returns. Rate of return is the ratio of the net cash
flows and the principal or initial investment. The different risks that financial
intermediaries face are the same risks that the public and the government, as
borrowers and lenders, also face.
- Return is the profit or earnings and rate of return is the percentage of profit or
earnings on a particular investment, which is why it is often termed ROI or return on
investment.
STRUCTURE OF RATES OF RETURN
- The interest rates on various securities or investments are determined by factors such
as length of time to maturity, credit or default risk, and liquidity. The difference in

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interest rates arising from differences in length of time to maturity or term of the
security is called the term structure of interest rates. It is the relationship between
interest rates and the length of time to maturity on debt securities, other things being
equal.
- The difference in interest rates arising from the credit or default risk is termed default
risk or credit risk structure of interest rates. It is the relationship between the return or
yield on debt securities and the risk that the issuer may default on its obligations to
pay the interest or the principal. Default risk premium is the difference between the
interest on the debt security of a specific issuer and the interest on a government
security is made because government securities are default-free.
- The yield curve is a graphical representation of the term structure of interest rates at a
particular point in time. Constructing the yield curve involves measuring the length of
time to maturity or the term of the instrument on the horizontal axis or x – axis and the
yield to maturity or interest rate on vertical axis or y – axis. Then, we plot the yields on
comparable debt securities of different maturities. Thus, a yield curve shows the yield
to maturity.
TERM STRUCTURE OF INTEREST RATES
- The term of loan (also called term-to-maturity) is the length of time the principal
matures. It is the period from the time the loan is acquired up to its maturity date. The
relationship between a security’s yield to maturity and the term-to-maturity is known
as the term structure of interest rates. The term structure can be graphically shown by
plotting the YM and the maturity for equivalent-grade securities at a point in time,
giving us the yield curve that we have studies under structure rates of return. It is
important to note that for yield curves to be meaningful, other factors that affect
interest rates, such as default risk, tax treatment, and marketability must be held
constant.
THEORIES OF TERM STRUCTURE
- There are four basic theories related to the term structure of interest rates. These are:
1. Pure or unbiased expectation theory
2. Liquidity / term premium theory
3. Segmented markets theory
4. Preferred habitat theory
Pure or Unbiased Expectations Theory
- Pure or unbiased expectations theory states that for the same holding period (term),
investors should expect to earn the same return, whether they invest in short – term
or long – term securities. This theory points to the role of current expectations about
future interest rates as the crucial determinant of the current term structure of interest
rates. Market forces dictate that the yield on a long – term security of any particular
maturity is equal to the geometric mean of the current short-term yield and the
successive future short-term yields currently expected to earn the same average
return over the long run by (1) purchasing a long – term bond and holding it to
maturity in the same manner as (2) purchasing a short – term bond and rolling it over,
that is, reinvesting the proceeds each year in a new short – term security.
The following assumptions are the bases of the pure expectations theory:
1. Investors desire to maximize holding period returns, that is, the returns earned over
their relevant time horizon.
2. Investors have no institutional preferences for particular maturities. They regard
various maturities as perfect maturities as perfect substitutes for one another.
3. There are no transaction costs associated with buying and selling securities; hence,
investors will always swap maturities in response to perceived yield advantages.

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4. Large numbers of investors from expectations about the future course of interest
rates and act aggressively on those expectations.
Liquidity / Term Premium Theory
- The liquidity / term premium theory emanates from the pure expectations theory
based on the idea that investors will hold long – term maturities only if they are
offered a premium to compensate for future uncertainty in a security’s value which
increases with an asset’s maturity, that is, the longer the term of security, the riskier
the security becomes, relative to default. Also, a longer maturity security is less liquid
and therefore, the liquidity risk inherent in these longer maturity securities is greater.
This increased risk deserves to be paid a premium, hence the term “liquidity
premium”. Short-term securities are more liquid and more marketable than longer-
term securities and are less prone to market or interest rate risk. Therefore, investors
prefer the short-term securities over the long-term securities given the same yield or
rate of return. Moreover, longer-term securities are more sensitive to interest rate
changes than short-term securities. Therefore, it follows that the longer the maturity,
the higher the liquidity premium.
- This theory is sometimes called “term premium theory” because the premium is
placed on the term of the security. The longer the term, the riskier the security
becomes and therefore, the extra risk arising out of the longer term of the security
needs to be compensated by what is known as “term premium”. It can also be
referred to as “risk premium theory” because it names the risks inherent in longer-
term securities – market price risk, inherent rate risk, liquidity risk, and default or
credit risk.
Segmented Markets Theory
- The segmented markets theory, also known as the market segmentation theory, is
the total opposite of the pure expectations theory where securities with different
maturities are perfect substitutes for each other. Under this theory, investors do not
consider securities with different maturities as perfect substitutes. Under this theory,
investors have certain preferred investment horizon (term of securities they invest in)
in accordance with or to agree with the kind of assets and the kinds of liabilities they
hold. If the assets and liabilities they are holding are short-term, they would prefer
short-term securities over long-term securities. If the assets and liabilities, they are
holding are long-term securities over the short-term securities. Also, from the vantage
point of lenders, short-term securities possess liquidity and greater stability of
principal and have low market risk. On the other hand, long-term securities provide
stability of income over time and are therefore preferred by those who prefer stability
of income over time, versus those who prefer stability of principal. This theory
assumes that investors and borrowers are generally unwilling to shift from one
maturity sector to another without adequate compensation in the form of an interest
rate premium.
Preferred Habitat Theory
- Preferred habitat theory combines the elements of the three other theories of term
structure. Under this theory, borrowers and lenders have strong preferences for
particular maturities, just like the segmented theory. The yield curve therefore will not
conform strictly with the predictions of the pure expectations and liquidity premium
theories. However, if the expected additional returns (excess returns) to be gained by
deviating from their preferred maturities, become large enough, investors will deviate
from their preferred habitats. Assuming expected returns on long-term securities
significantly exceed those on short-term securities, investors will lengthen the
maturities of their assets or investments, that is, they will buy long-term securities. On
the other hand, if the excess returns expected from buying short-term securities
significantly exceed long-term returns, investors will stop limiting themselves to the

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long-term securities and will make short-term securities a limited portion of their
portfolios.
- This theory is based on the notion that investors will accept additional risk in
exchange of additional expected returns. As such, this theory moves closer to what is
happening in the real world. In this theory, both investor expectations and the factors
emphasized in the segmented markets theory come into play to influence the term
structure of interest rates.
The following are the observations relating the foregoing theories and yield curves:
1. Upward – sloping yield curve predominates. On the average, long-term yields have
been significantly higher than short-term yields.
2. The yield curve typically shifts rather than rotates. In other words, when short-term
yields are rising, long-term yields are usually also rising; when short-term yields are
falling, long-term yields are usually falling. Yields very seldom move in opposite
directions; they move in the same direction.
3. The yield curve exhibits a regular cyclical pattern. Both short-term and long-term
yields exhibit a pro-cyclical pattern with short-term rates exhibiting much greater
amplitude over the business cycle than long-term yields do. Short-term yields fall
faster than long-term yields in a recession and rise faster than long-term yields during
an economic expansion. Therefore, the yield curve exhibits a regular cyclical pattern,
sloping steeply upward near the low point of the business cycle but flattening out as
the expansion phase proceeds and frequently even inverting as the economy
approaches the peak of the business cycle.
RISK STRUCTURE OF INTEREST RATES
- Risk structure is the relationship of interest rates on bonds with the same term to
maturity. Embedded in the yields of risky securities is a premium to compensate for
the risk that goes with the security, such as market or interest rate risk, liquidity risk,
default or credit risk, and the like. The magnitude of this premium varies widely
among different securities in accordance with the risks involved with these different
securities. Theoretically, this magnitude can be estimated by comparing the yield on
the risky security versus the yield on a similar risk-free security. For example,
government securities are generally used as benchmark yields because government
securities are generally default or risk-free. The spread between these yields is
known as the risk premium.
- The magnitude of the gap between the yields on these bonds increases in periods of
recession and at the other times when issuing firms experience financial distress,
making their issues riskier. Therefore, during periods of expansion or at times when
issuing companies experience significant growth, the yield spread between the yields
is less. It is therefore safe to assume that the risk premium fluctuates over the course
of the business cycle, that is, it is cyclical. During recession, when more companies
go bankrupt, lenders refrain from buying riskier securities and tend to buy safer
securities, particularly government-issued securities. During a period of economic
growth, investors are more leaned toward riskier but higher-yielding securities.
2. Research for a current investment of a publicly listed company (either acquiring another company or
new venture) and assess its risk and returns. Provide your answer in this format:
INVESTMENT
:
COMPANY
WHY DO YOU CONSIDERED
NO. TYPE OF RISK IT AS A RISK IN THIS POSSIBLE RETURNS
INVESTMENT?
1
2

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3
4
5
3. Based from the analyzation that you have made, do you think the risks outweighs the returns or vice
versa? Defend your answer. Minimum of 300 words.
Guide questions:
1.1. Why is it important for an investor to assess the risk and return of a certain investment?
1.2. How can an investor assess the risk and return of a certain investment?
References

- https://www.researchgate.net/figure/Risk-Management-Process-flow-chart-2-All-steps-are-performed-
periodically-throughout_fig1_292398414
- https://www.upwork.com/resources/systematic-vs-unsystematic-risk
MODULE 6: INTEREST RATES AND THEIR ROLE IN FINANCE
INTRODUCTION
This module will discuss the following topics pertaining to interest rates and their role in
finance such as the concept of interest rates, demand for velocity of money, interest rate, prices,
demand for money and velocity of money, types of interest rates, difference between interest rates
and rates of return, interest rates and their role in finance, interest rate theories, determinants of
interest rates and measurement of interest rate.
These topics will provide students significant insights pertaining to the relationship of interest
rates, demand for money, velocity of money and the general price levels. With this the students can
now analyze how to affect these factors to ensure the economic stability of a certain country and also
provide solutions to avoid hyperinflation effects.

1. Analyze the concept of interest rate.

2. Explain demand for and velocity of money.
3. Discuss the interrelationship among demand for money, velocity of money, interest rate, and prices.
4. Differentiate the types of interest rates.
5. Differentiate interest rate from rate of return and interest from discount.
6. Elaborate on the rile of interest rate in finance and in the economy.
7. Analyze the different theories of interest rate determination and their limitations.
8. Explain the determinants of interest rate and how they affect interest rate.
COURSE CONTENT
CONCEPT OF INTEREST RATES
- Interest rate denotes percentage earnings or yield on investment. It is the cost of

using money expressed as a percentage of the principal for a given period of time,
which is usually per year. It is generally regarded as the cost of borrowing or lending
out money or the cost of credit. It plays an important role in finance, such as demand
for money and the velocity of money. Interest rate fluctuates and affects market prices
of securities in the financial markets and the prices of goods and services. It is
therefore an important consideration for decision makers. How attractive interest rates
are will show how investors will react to them. The higher the interest rate, the better
it would be for investors, but is undesirable for borrowers for they have to pay a
higher cost for their borrowings.

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DEMAND FOR AND VELOCITY OF MONEY
- Specifically, nominal interest rate, the monetary return on saving, is determined by

the supply and demand of money in an economy. The amount of money that people
desire to hold as a store of value is the demand for money. It is how much money
people and firms decide to hold in their wallets or coffers. The demand for money is a
financial benefit of holding money is that it is the most liquid of all assets. So, the
demand for money is the demand for liquidity. As it turns out, the price of money is
the opportunity cost of holding money. Since cash does not earn interest, people give
up the interest that they would have earned on non – cash savings when they choose
to keep their wealth in cash instead. Therefore, the opportunity cost of money and as
a result, the price of money is the nominal interest rate.
- People have different reasons for holding on to money or their demand for money. As
such, we have the following types of demand:
a. Transaction demand – since payment for expected expenditures like purchases of
goods, payments for electricity bill, water bill, telephone bill, tuition fee and others,
does not coincide with the receipt of income, people tend to hold on to money to
pay for all those expenses.
b. Precautionary demand – others hold on to money in preparation for unforeseen
additional expenses caused by unexpected events like sickness, injury from
accident, or loss of property.
c. Speculative demand – for some, particularly businessmen and investors, they hold
on to money with the intention of using it when an opportunity to earn more arises.
- Velocity of money is the average number of times a unit of currency is used to

purchase final goods and services. More, specifically, velocity of money (V) is:
V = (P*Y) / M
Where:
- P – the price level
- Y – real output
- M – the money supply
- P*Y is nominal output. Therefore, velocity of money can be defined as the number of
times that a unit of money is spent on the total value of goods and services produced
per year. It refers to the number of times per year that the peso or currency travels
around the economy from wallet to wallet, person to person, firm to firm, person to
firm, and firm to person.
- The demand for money has an inverse relationship with the velocity of money. A low
demand for money means that people hold only a small amount of money. Holding a
small amount of money is translated into using such small amount of money many
times. This is because people are careful in spending money and they spend less;
thus, they use a small amount of money many times. On the other hand, if there is a
high demand for money, people hold more money in their wallets. Therefore, if they
have more money in their wallets, they will use such bigger amount less often, thus
reducing the velocity of money. This inverse relationship can be shown as:
a. Demand for money increases; velocity of money decreases

b. Demand for money decreases; velocity of money increases
INTEREST RATE, PRICES, DEMAND FOR MONEY, AND VELOCITY OF MONEY
- We can now ask ourselves: What causes the demand for money to rise or fall?
Basically, interest rates and prices are among the factors that cause the demand for
money to rise or fall. Whatever reasons people have for holding on to money, they
may change when the interest rate changes. As the real rate of interest rises, the
opportunity cost of holding money rises. As the cost of holding money rises, people

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will desire to hold less money; therefore, as interest rate rises, demand for money
falls. This is because, in addition to the rising opportunity cost of holding money,
people tend to restrict borrowings because they know it will cost them more. Similarly,
those who have money will not hold on to it because it will not earn them anything.
Rather than holding on to their money, people will invest or place their money in
interest – bearing assets, like in the money market or securities, to earn more. High
interest rates will benefit the investors more than the borrowers. The foregoing being
the case, we can see the inverse relationship between interest rates and demand for
money. High interest rates result in lower demand for money; decreasing interest
levels result in a highe demand of money.
a. Interest rate increases; demand for money decreases

b. Interest rate decreases; demand for money increases
Let us combine the concepts:
a. Interest rate increases; demand for money decreases; velocity of money increases
b. Interest rate decreases; demand for money increases; velocity of money decreases
- Other than interest rates, prices also affect the demand for money. In general,
consumers need money to purchase goods and services. If debit cards or credit cards
are plenty, consumers many demand less money at a given time than they would if
money was difficult to acquire. The most important variable in determining money
demand is the average price level within the economy. If the average price level is
high and goods and services then to cost a significant amount of money, consumers
will demand more money. If, on the other hand, the average price level is low and
goods and services tend to cost little money, consumers will demand less money. As
the price level rises, people require more money to conduct a given level of
transaction. Therefore, as the price increase, the demand for money increases.
Higher prices increase the quantity of money demanded because people are looking
after the fact that they need more money to buy goods and services. Therefore, if
prices are higher, they need to have more money on hand to spend. As such, there is
a direct relationship with prices and demand for money, that is, the higher the prices,
the higher the demand for money, and vice versa. Therefore, there is a direct
relationship between prices of goods and services and the demand for money.
a. Prices increase; demand for money increases

b. Prices decrease; demand for money decreases
Incorporating the foregoing relationships among interest rate, demand for money, velocity of money,
and prices:
a. Interest rate increases; demand for money decreases; velocity of money increase;
prices decrease
b. Interest rate decreases; demand for money increases; velocity of money decreases;
prices increase
TYPES OF INTEREST
- The terms “interest” and “interest rate” are commonly used in mathematics,
accounting, finance and in business, in particular, in relation to lending and borrowing.
Interest is the amount paid in addition to the principal for the use of money. Interest
rate refers to the percentage of the principal, that is, the ratio of the interest and the
principal. Interest rate is often expressed as annual percentage, although it could also
be on a per month, per quarter, or per day basis. Interest rates often change as a
result of inflation.

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Nominal Interest Rate
- As discussed under the demand for and velocity of money, the opportunity cost of
money, and as a result, the price of money is the nominal interest rate. Conceptually,
nominal interest rate is the simplest type of interest rate. It is the stated interest rate of
a given bond or loan. This type of interest rate is referred as the coupon rate for
bonds and other fixed – income investments or loans granted by financial institutions.
The nominal interest rate is, in essence, the actual monetary price that borrowers pay
to lenders to use their money. If the nominal rate on a loan is 10%, then borrowers
can expect to pay 10 pesos of interest for every 100 pesos loaned to them.
Real Interest Rate
- Real interest rate is so named because it states the “real” rate that the lender or
investor receives or a borrower pays after considering inflation. Real interest rate is
the interest rate that is adjusted for expected changes in the price level to accurately
reflect the true cost of borrowings. It is more accurately defined by the Fisher
equation, named after Irving Fisher:
Nominal Rate = Real Interest Rate + Expected Rate of Inflation
Real Interest Rate = Nominal Rate – Expected Rate of Inflation
- So, assuming the nominal interest rate is 8% and the expected rise in the price level
is 3%, then the real interest rate is 8% - 3% = 5%. If the expected inflation rate is
higher than the nominal rate, it is better to spend the money now because it will just
lose its value. If the inflation rate exceeds the nominal rate, the real interest rate
becomes negative. For example, a bond with a 3% nominal rate will have a real
interest rate of -1% of the inflation rate is 4%. If the inflation rate is lower than the
nominal rate, the real interest rate is positive; if the inflation rate is higher than the
nominal rate, the real interest rate is negative.
- If instead of inflation there is deflation, real rates will exceed the nominal rate because
instead of deducting inflation, we add the deflation rate to the nominal rate, thus:
Real interest rate = Nominal rate + Deflation
- For example, if the nominal rate is 6% and the deflation rate is 2%, the real interest
rate would be 8% (6% + 2%).
- Generally, the inflation rate moves as nominal interest rates move over time making
the real interest rates become stable over longer periods of time. Therefore, investors
who are in it for the long run may be able to more accurately assess their investment
returns on an inflation – adjusted basis in contrast with investors who only make
short-term investments. Therefore, investing in long-term bonds gives the investor a
more accurate assessment of his returns than an investor who invests in short – term
marketable securities.
- Knowing the difference between nominal rates enables investors and borrowers to
make better decisions about their loans and investments. A loan with frequent
compounding periods will be more expensive than one that compounds annually. A
bond that only pays a 1% real interest rate may not be worth the investors’ time if they
seek to grow their assets over time. These rates effectively reveal the true return that
will be posted by a fixed-income investment and the true cost of borrowing for an
individual or business. Investors who seek protection from inflation in the fixed-
income arena can look to instruments such as Treasury Inflation Protected Securities
(TIPS), a similar instrument to indexed bonds, which pays an interest rate that is
indexed to inflation. In addition, mutual funds invest in bonds, mortgages, and senior-
secured loans that paying floating interest rates that periodically adjust with current
rates.

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Fixed Interest Rate
- A fixed interest rate means that the interest rate that you will be charged over the
term of your loan will not change, no matter how high or how low the market may
drive interest rates. Your payment will remain the same on your last payment as it
was on your first payment.
Variable Interest Rate
- Also called floating rate, a variable interest rate means that the interest you are
charged charges as whatever index your loan is based on changes. Loans can be
based on the rate of the 1-year T-bill or the prime lending rate among other factors.
Variable rates consist of two components: An index, plus a credit-based margin
determined by the lender. The starting rate on a variable rate loan is usually lower
than the rate on a fixed rate loan. The index rate will vary over time based on
economic conditions. The index can be the rate on T-bills, the prime lending rates of
banks.
DIFFERENCE BETWEEN INTEREST RATES AND RATES OF RETURN
- Sometimes, interest rate and rate of returns are interchangeably used; however, there
is a big distinction between the two. Take note that both interest and capital gain are
a percentage of the principal. The interest rate is the measurement of interest income,
yields, dividend, income, or profit directly derived from the investment. The capital
gain is the increase in value. ROR is generally applied to financial assets.
- To illustrate, let us take an investment in bonds of P10,000 with an interest rate or
coupon rate of 10% and a market value at the end of the year after acquisition of
P11,000:
Interest rate is computed as r = l / P
Where:
r = Interest rate

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I = Interest received for the period or coupon payment
P = Principal or price of the bond
Interest rate = 1,000 / 10,000 = 10%
Capital gain is computed as:
Cg = MV – P / P
Where:
Cg = capital gain
MV = Market value
P = Principal
MV – P = Change in value / Gain in Peso
Cg = MV – P / P
= 11,000 – 10,000 / 10,000 = 1,000 /10,000
= 10%
Therefore,
ROR = r + cg = 10% + 10% = 20%
- The first part in the computation of rate of return is the current yield and the second
part is the rate of capital gain or the change in the bond’s price relative to the initial
purchase price. In the illustration, the 10% is the interest rate and the other 10% is the
capital gain as a result of the increase in value of another 10%, making the total yield
or ROR equal to 20%.
- If the bond has decreased in value from P10,000 to P9,000, the second part would
give us:
9,000 – 10,000 / 10,000 = (1,000) / 10,000 = (10%)

ROR = 10% (interest / coupon rate) + (-10%) = 0%
- The investor earned 10% interest, but lost 10% due to the decrease in value of the
bonds of 10%, making the net yield to the investor equal to 0%. What the investor
earned in terms of interest was entirely lost due to decrease in value.
- The return on a bond will not always equal the interest rate of the bond. Even for a
bond whose current yield is an accurate measure of the yield to maturity, the return
can differ substantially from the interest rate especially if there are large fluctuations
in the price of the bond that produce substantial capital gains or losses. Key findings
which are generally true of all bonds are modified as follows:
a. The only bond which return equals the initial yield to maturity is one which time to
maturity is the same as the holding period, meaning, the investor holds the bond
to maturity.
b. A rise in interest rate is associated with a fall in bond prices, resulting in capital
losses on bonds which terms to maturity are longer than the holding period,
meaning, the investor holds the bond and sells the same prior to maturity.
c. The more distant a bond’s maturity, the greater the size of the percentage price
change associated with an interest rate change.
d. The more distant a bond’s maturity, the lower the rate of return that occurs as a
result of the increase in the interest rate.
e. Even though a bond has a substantial initial interest rate, its return can turn out to
be negative if interest rate rises. When interest rates rise, market values of
financial assets generally fall.

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INTEREST RATES AND THEIR ROLE IN FINANCE
- Finance deals with funds, and funds generally denote money. The earnings on money
lent and the cost of money borrowed are expressed as a percentage of the principal
amount of money lent or borrowed call interest rate. Based in our discussion on the
interrelationship among interest rate, money demand, money velocity, and prices, it is
evident that interest rates play a major role in finance. Since finance is a major
concern of monetary policy, we have also seen that the BSP uses interest rate as the
primary instrument of monetary control. Remember that the official interest rate is the
reverse repo rate (RRP) or the overnight borrowing rate, which is the borrowing rate
on the reverse requirement for banks set by the BSP.
- Changes in interest rates have implications for a multitude of phenomena in the
business and economic world. The level of investment spending, level of consumer
expenditures, redistribution of wealth between borrowers and lenders, and prices of
financial securities are among the ones affected by any change in the interest rate.
They either go with the direction of the interest rate or go against it, that is, they can
have a direct relationship or an inverse relationship.
- Central banks use interest rates to control money supply, demand for money, reserve
requirements, and other monetary tools to maintain a healthy and stable economy.
The multitude of yields at any given time is accounted for by differences in default
risk, tax considerations, marketability and liquidity, maturity period, and the like.
Interest rates in government securities, because they are almost default-free, are
usually used as benchmark yields for all other securities.
INTEREST RATES AND THE ECONOMY
Interest rates have the following important roles in the economy:
1. Ensure that current savings will flow into investment to promote economic growth.
2. Ration the available supply of credit to provide loanable funds to those investment
projects with the highest expected returns.
3. Bring into balance the supply of money with the public’s demand for money.
4. Act as an important government tool through its influence on the volume of savings
and investment. If the economy is growing too slowly and unemployment is rising, the
government can use its policy tools to lower interest rates in order to stimulate
borrowing and investment which will eventually encourage production and create
employment. On the other hand, an overhead economy experiencing rapid inflation
calls for a government policy of higher interest rates to slow both borrowing and
spending.
- There are multitude of interest rates operating in the economy. Different maturities will
bring different rates or yields. However, we will assume that there is one fundamental
interest rate operating in the economy and we will call this rate the pure or risk-free
interest rate, which is, in fact, a component of all interest rates. This rate is usually the
one associated with government securities because government securities are
generally risk-free, being guaranteed by the issuing government, backed up by its
taxing power. This rate represents the opportunity cost of holding idle cash because
the investor can always invest in these government securities and earn the minimum
rate of return that it gives.
- Once the interest rate is determined, all other interest rates may be determined from it
by examining the special characteristics and risks associated with the securities being
analyzed or for which the interest rate is being determined. As aforementioned,
differences in marketability, liquidity, default, and maturity are some of the important
factors causing differences in interest rates.
INTEREST RATE THEORIES

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- There exist theories concerning the determinants of the pure or risk-free interest rate.
These theories are:
1. Classical theory / Fisher hypothesis

2. Loanable funds theory
3. Liquidity preference theory
4. Rational expectations theory
Classical Theory
- This is one of the oldest theories concerning the determination of the pure or risk-free
interest rate developed during the eighteenth and nineteenth centuries by a number
of British economists. This theory posits that the rate of interest is determined by two
factors:
1. Supply of savings
2. Demand for investment capital
Loanable Funds Theory
- Loanable funds theory is often used for forecasting interest rates. This theory is
based on the premise that the interest rate is the price paid for the right to borrow or
use loanable funds. Therefore, borrowers create the demand for loanable funds
needed by the borrowers. Households, businesses, and governments participate in
both sides of the market. They are all both borrowers and lenders at one time or
another.
Liquidity Preference Theory
- This theory introduces the concept of money demand and used the term “liquidity
preference” for money demand. This theory stipulates that the interest rate is
determined in the money market by the money demand and the money supply.
Interest rate is the point where the money demand is equal to money supply.
- The liquidity preference theory gives insights on how an investor behaves and how
the government uses interest rate as a monetary tool. Investors purchase securities
when interest rates are high for the simple reason of yield, increasing the supply of
funds in the financial system. They shy away from buying securities when interest
rates are low, thereby reducing the supply of money in the financial system. Similarly,
the government can regulate the money supply ensuring that it grows more slowly
than money demand to bring about higher interest rates. Contracting money supply
when there is plenty of it in the financial system ensures higher interest rates. In
contrast, if the government expands money supply when there is low supply, interest
rates go down.
- Like the other theories, this theory also has its limitations. It is a short-term approach
to interest rate determination, modified because it assumes that income remains
stable. In the longer term, interest rates are affected by changes in the level of
income and inflationary expectations. It considers only the supply and demand for the
stock of money, whereas business, consumer, and government demands for credit
clearly have an impact on the cost of credit. There is a need for a more
comprehensive theory giving consideration to the roles of all participants in the
financial system.
Rational Expectations Theory
- Rational expectations theory came about in the advent of the Information Age. It is
based on the premise that the financial markets are highly efficient institutions in
digesting new information affecting interest rates and security prices. When new
information appears about investment, saving, or money supply, investors
immediately translate this information into investment or borrowing decisions. Interest

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rates and security prices fluctuate rapidly as new information into investment or
borrowing decisions. Interest rates and security prices fluctuate rapidly as new
information appears.
- In the rational expectations world, people are assumed to behave as if they were
tuned into the state-of-the-art model of inflation. Thus, as new information on key
determinants of inflation becomes available, they quickly plug it into their inflation
model and revise their outlook accordingly.
DETERMINANTS OF INTEREST RATES
- There are various factors in the economy – inflation expectations, the government’s
monetary policy, the business cycles, government budget deficits, savings,
investment demand, money supply growth, demand for cash balances – that
determine interest rates. The supply of or demand for loanable funds trigger changes
in interest rates. Among the major determinants of interest rates are:
1. Inflation expectations
2. Monetary policy
3. Business cycle
4. Government budget deficits
2. According to Rappler, the inflation rate of our country as of May 2022 is at 5.4% which is very high
considering that the inflation rate should only be at the range of 2% - 3%. If you will be an economic
advisor, how would you somehow ease the inflation rate or the price increases using these factors:
a. Interest rate
b. Velocity of money
c. Demand for money
Create a flow or diagram showing how you would provide solutions to inflation and to show the relationship of
the factors stated above. Explain and defend your diagram.
Guide questions:
1.1. Why is interest rate important in maintaining balance / equilibrium in the financial system?
1.2. Differentiate interest rates and rates of return.
1.3. Elaborate the different types of interest and its purpose to the financial institutions.
1.4. What are the different determinants of the interest rates and which of these provide a significant
impact on the value of interest rates?
References

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- https://www.semanticscholar.org/paper/The-Determinants-of-Interest-Rates-Spread-in-Kenya-
Nyansera-Mukras/ad670b97bceb98d781ff1976cad05f4ff8b4d4a0
- https://www.babypips.com/learn/forex/interest-rates-101
- https://www.rappler.com/business/inflation-rate-philippines-may-2022/
VIDEO REFERENCES
1. Velocity of Money - https://www.youtube.com/watch?v=KVrBwMu_rcM

2. Demand for Money - https://study.com/academy/lesson/money-demand-and-interest-
rates-economics-of-demand.html
MODULE 7: TIME VALUE OF MONEY
INTRODUCTION
This module will tackle the different topics pertaining to time value of money such as the
concept of time value of money, simple and compound interest, future value and compounding,
present value and discounting, net present value, ordinary annuity and annuity due.
With these topics, the students can now compute using simple interest method and also
compounding interest method which will equip them with skills which will be helpful when they will
process, apply, or assess a loan during their professional career.

1. Differentiate simple interest and compound interest.

2. Compute for simple interest and compound interest.
3. Analyze future value, present value, ordinary annuity, and annuity due.
4. Evaluate the best investment alternative using the concept of net present value.
COURSE CONTENT
CONCEPT OF TIME VALUE OF MONEY
- Money has a time value. Money kept in a vault loses its value over time. What you
can purchase for P1,000 today will no longer be the same after a period of time. Time
value of money denotes the value of money over time. This means that money
changes its value over time. P1 today may no longer be P1 after a year, or even
perhaps 6 months from today. This is because the value of money changes over time.
Generally, this is due to inflation. The recognition of the time value of money and risk
is extremely vital in financial decision – making. Time value of money is central to the
concept of finance. It recognizes that the value of money is different at different
periods time. Since money can be put to productive use, its value is different
depending on the date of receipt or payment.
- Inflation is an economic disorder characterized by continuous increase in the price
level of goods and services without the corresponding increase in the production of
these goods and services. When production does not increase, the supply of goods
does not increase; when prices increase without any corresponding increase in the
supply of goods, inflation happens. This is because of the economic law of supply and
demand. When supply is limited, demand increases in relation to the supply, causing
prices to increase; when supply is abundant, demand is decreased and prices
decrease to encourage purchase.
- The concept of the time value of money is based on the notion that a peso received
today is worth more than a peso received in the future. This is because a peso
received today can be invested and its value is increased by an interest rate of return.
This concept is based on the belief that people have a positive time preference for
consumption, that is, people prefer to consume goods today rather than consume
similar goods in the future. Therefore, people would rather have their peso today than
in the future.

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SIMPLE AND COMPOUND INTEREST
- Before we go to the future value and present value discussion, let us review simple
interest and compound interest. Compound interest is the interest involved in future
value determination. Interest is the earnings or yield on investments. To avoid the
loss in the value of money, the holder thereof must learn to manage it well. One way
of managing money is through investment where it can earn interest. Even
promissory notes could earn interest that is why there are interest-bearing promissory
notes. Bonds are interest-bearing; hence, the earnings on bonds are in the form of
interest.
- Interest, in financial parlance, is the money paid for the use of money lent. Interest is
measured by a certain percentage commonly known as interest rate. With interest,
the value of money after some period of time grows.
There are two basic types of interest measurement, namely:
1. Simple interest
2. Compound interest
Simple interest
- For simple interest, the interest is computed based on principal throughout time. The
formula is:
I=PxRxT
Where:
P = Principal amount lent
R = Interest rate
T = Time period money is borrowed / invested
- Time is generally computed per year, unless stated otherwise in the instrument or
agreement. It follows the period in which the interest rate is stated, which could be per

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day, per month, per quarter, or per year, which means that if the rate is per year, the
time should be expressed in terms of year; if the rate is per month, the time should be
expressed in terms of months.
Compound Interest
- For compound interest, the interest is computed by adding the interest to the principal
to be used as the new basis or new principal for the succeeding year or period.
Generally, this is on the assumption that interest is not paid monthly, but is
accumulated until maturity date. Simply stated, interest earns interest throughout
time. This is the idea of compounding, that is, interest added to the original principal
becomes the new principal.
YEAR PRINCIPAL RATE TIME INTEREST PRINCIPAL MATURITY VALUE

1 1,000,000.00 0.05 1.00 50,000.00 1,000,000.00 1,050,000.00
2 1,050,000.00 0.05 1.00 52,500.00 1,050,000.00 1,102,500.00
3 1,102,500.00 0.05 1.00 55,125.00 1,102,500.00 1,157,625.00
- At the end of the first year, interest earned is 50,000, which is added to the principal
of 1,000,000 for a total of 1,050,000, which becomes the new basis or new principal
for the second year. At the end of the second year, the interest earned is 52,500, The
52,500 earned on the second year is now added to the previous higher principal of
1,050,000 to give us 1,102,500. This figure becomes the new principal that is
multiplied by 5% to get the new interest for the third year of 55,125. Added to the
principal at the beginning of the third year of 1,102,500, the maturity value at the end
of the third year becomes 1,157,625.
- Compounding interest yields a higher return because interest earned becomes part of
the principal that will still earn additional interest. The computation above just shows
how interest earns interest. This is the idea behind rolling over of time deposits, that
is, to accumulate interest to earn higher interest every succeeding period. However,
the method above is tedious; hence, it is applicable only for a short period of time.
- For longer periods of time, like 10 or 20 years, it is easier to use following formula
with the aid of a scientific calculator.
MV = P (1 + r) n
Where:
MV = Maturity Value
P = Principal
R = Interest rate
N = Number of years
Examples:
1. Assuming the amount of P1,000,000 is invested in a 10 – year time deposit earning

5% interest compounded annually.
MV = P(1 + r ) n
= 1,000,000 (1 + 5%) 10
= 1,000,000 (1.6289)
= 1,628,900

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I = MV – P
= 1,628,900 – 1,000,000
=628,900
The interest in the above example is earned once a year. For interest which is earned more than
once a year, the formula for MV is:
MV = P (1 + r / m) mn
Where:
MV = Maturity value
R = Interest rate
N = number of years (term)
M = number of times interest is earned in a year
2. Assume the amount of 1,000,000 is invested in a 10-year time deposit earning 5%

interest compounded semi – annually. The interest is earned twice a year.
MV = P (1 + r / m)mn
= 1,000,000 (1 + .05 / 2) 2(10)
= 1,638,600
I = 1,638,600 – 1,000,000
= 638,600
3. Assume instead of semi – annually, the interest is compounded quarterly, meaning,

four times in a year.
MV = 1,000,000 (1 + .05/4) 4(10)
= 1,000,000 (1.6436)
I = 1,634,600 – 1,000,000
= 643,000
- Take note that interest received quarterly (643,600) for a year is higher than interest
received semi – annually for a year (638,600), which is higher than interest received
annually (628,900). Remember that the more times that the interest is compounded,
the higher the interest will be. Compounding interest monthly will yield a higher return.
FUTURE VALUE AND COMPOUNDING
- Future value is the sum of money which will be received in the future period resulting
from investment, taking into account the interest it will earn. It is synonymous with the
terms “terminal value” and “maturity value”. Compounding or accumulation is the
process in which future value is determined.
- Assuming 1,000,000 is invested in a 4 –year, 10% financial asset. What is its future
value?
YEAR P r I FV (P + I)

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1 1,000,000.00 10.00% 100,000.00 1,100,000.00
2 1,100,000.00 10.00% 110,000.00 1,210,000.00
3 1,210,000.00 10.00% 121,000.00 1,331,000.00
4 1,331,000.00 10.00% 133,100.00 1,464,100.00
- At point 0 or the period when the amount is invested, the amount is P1,000,000. It
earns compound interest from year 1 to year 4. At the end of the fourth year, the
value is P1,464,100, its future value. Substituting FV for MV in the formula for
maturity value, we get:
FV = P (1 + r)n
= 1,000,000 (1 + .10)4
= 1,000,000 (1.4641)
= 1,464,100
- The investment is made once; hence, the factor used to multiply the principal with is
(1 + r)n which represents the future value of 1 at the end of a given period, the FV
factor available in the future value table. The factors in the FV table are the reciprocal
of corresponding factors in the PV table. This is because for the FV, we use (1 + r)n,
while for the PV factor, we use 1/(1 + r)n.
- If, instead of using the formula, we use the FV table:
FV = PV x Future value factor for n periods at i%

FV = PV (FVFn, i)
- Using the FV table, we look at 10% and year 4 and we get 1.4641, exactly what we
got when we raised 1.1 to the fourth power.
FV = PV (FVFn, i)
= 1,000,000 x 1.4641 = 1,464,100
PRESENT VALUE AND DISCOUNTING
- Present value is the value at the current time of the cash flow expected to be received
after some period of time. It answers the question how much is the worth today of an
amount that will be received in the future. The present value is always a smaller
quantity than the future amount. For example, how much is the present value of
1,000,000 to be received in 5 years at a discount rate of 5%? The 1,000,000 is the
future value and the 5% is the discount rate. In present value calculations, we use the
idea of discounting. The method of determining the present value is called
discounting. The rate applied in discounting is called the discount rate. The discount
rate is the expected rate of return.
- The net cash flow could be received in two ways:
1. After a number of years; or

2. Annually
- The formula in determining the present value of net cash flow received after a number
of years is as follows:
PV = CF [1 / (1 + r)n]
Where:

CAPITAL MARKETS FM3

17
CF = net cash flow
R = discount rate
= So, if one is to receive a cash flow of P1,000,000 after 5 years with a discount rate of 5% its
present value is P783,500 computed as follows:
PV = CF [1 / (1 + r)n]
= 1,000,000 [1 / (1 + .05)5]
= 1,000,000 (0.784)
= 784,000
Using the present value table,
PV = FV x Present value factor for n periods at i%
PV = FV (PVFn, i)
= 1,000,000 (0.784) = 784,000
NET PRESENT VALUE
- The concept of net present value us used in financial decision – making, particularly
in evaluating investment alternatives. Drawing on the concept of present value, the
total present value of all future cash flows is obtained. Deducting the investment or
principal needed for the project or investment from this total present value, the result
is the net present value (NPV). If the NPV is positive, the project or investment
alternative is accepted; if negative, the project or investment alternative is rejected.
- Let us take an investment opportunity to build a housing project. Assume that a land
for sale is suitable for the project for P4.5M. The construction of a townhouse will cost
P15.5M. Therefore, the total project will cost P20M. Currently, the opportunity cost of
capital is 6%.
Assume the following scenarios:
1. In a year’s time, the entire complex can be sold for P23M.

2. You can’t rent the project for 4 years at a total yearly sum of P1.5M. At the end of the
fourth year, you can sell the townhouse to the tenants for cash worth P23M.
Let us take scenario 1:
PV of the P23M to be received in a year’s time = P23M x PV factor at 6%, n = 1
= 23M x 0.943
= 21,689,000
Investment required (20,000,000)
Net present value (NPV) = 1,689,000
The NPV is positive, therefore, we can accept the project.
However, let us see what the NPV would be for scenario 2:
YEAR CASH FLOW PV FACTOR PV

1 1.5M 0.943 1,414,500.00
2 1.5M 0.89 1,335,000.00
3 1.5M 0.84 1,260,000.00
4 24.5M 0.792 19,404,000.00
TOTAL PRESENT 23,413,500.00

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17
VALUE
INVESTEMNT
(20,000,000.00)
REQUIRED
NPV 3,413,500.00
- The NPV is positive and should be accepted. Comparing the NPV for the second
option with the NPV for the first option, the NPV for the second option is higher;
therefore, it would be better if the townhouse project is rented out and then sold at the
end of the fourth year than selling it after the project is done in the first year.
ORDINARY ANNUITY AND ANNUITY DUE
- An annuity is defined as a stream or series of payments made or receipts received

over time. Annuity problems involve a series of equal periodic payments or receipts
called rents. In an ordinary annuity, the rents occur at the end of each period. The first
rent will occur one period from now. In an annuity due, the rents occur at the
beginning of each period. The first rent will occur now. Most annuities are ordinary
annuities. Installment loans and coupon – bearing bonds are examples of ordinary
annuities. Rent payments, which are typically due on the day commencing with the
rental period, are an example of an annuity due.
- In deferred annuity, the rents occur in the future. A deferred annuity does not begin to
produce rents until two or more periods have expired. A deferred annuity problem can
occur in either an ordinary annuity situation or an annuity due situation. In an ordinary
annuity of n rents deferred for y periods, the first rent will occur (y + 1) periods from
now.
- Let us use scenario 2 under NPV to use the ordinary annuity table, since the future
cash flow during the first 4 years is a series of P1.5M. A final cash flow of P23M is
received in the fourth year. The problem can be solved in two ways:
1. PV of P1.5M received for 4 years = 1.5M x PV of ordinary annuity 6%, 4 years

= 1.5M (3.465) = 5,197,500
PV of 23M received on the fourth year = 23M x PV of 1.00 6%, 4 years
= 23M (0.792) = 18,216,000
Total PV = 23,413,500
Investment required = (20,000,000)
NPV = 3,413,500
2. PV of 1.5M received for the first 3 years = 1.5M x PV of ordinary annuity 6%, 3 years
= 1.5M (2.673) = 4,009,500
PV of 24.5M received on the fourth year = 24.5M x PV of 1.00 6%, 4 years
= 24.5M (0.792) = 19,404,000
Total PV = 23,413,500
Investment required (20,000,000)
NPV = 3,413,500
- To illustrate annuity due, let us assume that the 1.5M in our example is received at
the beginning of the year. We will assume further that we sold the housing project at
the end of the fourth year. Our solution would be modified as follows:
PV of 1.5M received for 4 years = 1.5M x PV of Annuity Due 6%, n = 4

CAPITAL MARKETS FM3

17
= 1.5M x 3.673 = 5,509,500
PV of 23M received on the fourth year = 23M x PV of P1.00 6%, 4 years
= 23M (0.792) = 18,216,000
Total PV = 23,725,500
NPV = 3,725,500
- Take note that the present value of ordinary annuity (5,197,500), being received at
the end of the year, is lower than the present value of annuity due (5,509,500), being
received at the beginning of the year.
- In annuity problems, the rents, interest, payments, and number of periods must all be
stated in the same basis. For example, if interest is compounded semi – annually,
then n = the number of semi – annual rents paid or received, i=the annual interest
rate divided by 2, and R = the amount of rent paid or received every 6 months.
- The following is a computation for the PV of an ordinary annuity, the PV of an annuity
due, the FV of an ordinary, and the FV of an annuity due.
The present value of an ordinary annuity of 50 per year over 3 years at 7% would be:
PV ordinary = PMT (1=(1+i)-n / I) = 50.00 (1-(1+0.07)-3 / 0.07) = 131.22
The present value of an annuity due would be:
PV due = PV ordinary (1+i) = 131.22 (1.07) = 140.40
- The PV of the annuity due is greater than the PV of the ordinary annuity because it is
received ahead. That illustrates exactly what time value of money means.
- The future value of an ordinary annuity of P25 per year over 3 years at 9% would be:
FV ordinary = PMT ((1+i)-n -1 / i) = 25.00 ((1 + 0.09)3 -1 / 0.09) = 81.95
The future value of an annuity due under the same terms is calculated as:
FV due = FV ordinary (1+i) = 81.95 (1.09) = 89.33
Again, the FV of the annuity due is greater than the FV of the ordinary annuity.
The differences between the ordinary annuity due of n rents deferred for y periods are as follows:
Ordinary Annuity of n Rents Annuity Due of n Rents

Deferred for y Periods Deferred for y Periods
First rent occurs (y+1) periods from now y periods from now
Last rent occurs (y+n) periods from now (y + n - 1) periods from now
Future amount
is immediately after the last rent one period after last rent

CAPITAL MARKETS FM3

17

2. Compute for the simple and compound interest of the following:
a. Principal = 10,000, Interest rate = 5% per month, Term = 2 years
b. Principal = 25,000, Interest rate = 3% per quarter, Term = 5 years
c. Principal = 40,000, Interest rate = 4% semi – annually, Term = 10 years
d. Principal = 35,000, Interest rate = 4.25% per month, Term = 3 years
e. Principal = 28,000, Interest rate = 3.75% per quarter, Term = 4 years
Guide questions:
1.1. How does time affect the value of money? Discuss the process of it.
1.2. Why is it important to invest your money which will provide returns more than the current inflation
rate?
1.3. Differentiate simple interest from compounding interest.
1.4. Differentiate ordinary annuity from annuity due.
References

- https://corporatefinanceinstitute.com/resources/knowledge/valuation/time-value-of-money/
- https://keydifferences.com/difference-between-ordinary-annuity-and-annuity-due.html
MODULE 8: CAPITAL MARKET THEORY
INTRODUCTION
This module will discuss the different theories in relation to capital markets such as Markowitz
Portfolio theory, capital market theory assumptions, capital asset pricing model and the mean –
variance analysis.
These theories would help the students explain the various behavior of different investment
and portfolios including developing an efficient portfolio. With this knowledge gained, the students
can now assess of the existing market or investments can produce or provide an efficient portfolio or
not.

1. Explain the Markowitz portfolio theory.

2. Discuss the capital market theory assumptions.
3. Analyze the concept of capital asset pricing model (CAPM); and
4. Elaborate on the expected return to a portfolio composes of two assets.
COURSE CONTENT
MARKOWITZ PORTFOLIO THEORY
- Capital market theory is built upon Markowitz portfolio theory. Markowitz portfolio
theory identifies an efficient frontier, which is set of efficient portfolios. An efficient
portfolio represents that set of portfolios with the maximum rate of return for every
given level or risk, or the minimum risk for every level of return. It is that portfolio
which has no alternative with the same higher expected return of portfolio and the
same lower standard deviation.
- Nasdaq.com defines “portfolios” as a collection of investments, real and financial. It is
a collection of all assets available to investors with each asset held in proportion to its
market value relative to the total market value of all assets.
- While there are many portfolios available to an investor, there is only one super-
efficient portfolio that cannot be improved upon. The super – efficient portfolio was
none other than the market portfolio; the portfolio of all risky assets proportionally
weighted by their total market capitalization.
Basically a market portfolio has three observations:

CAPITAL MARKETS FM3

17
1. Each investor will want to hold a certain positive amount of each risky security.
2. The current market price of each security will be at a level where the number of
shares demanded equals the number of shares outstanding.
3. The risk-free rate will be at a level where the total amount of money borrowed equals
the total amount of money lent.
This gives rise to the following definition of market:
- Market portfolio is a portfolio consisting of all securities where the proportion invested
in each security corresponds to its relative market value. The relative market value of
a security is simply equal to the aggregate market value of the security divided by the
sum of the aggregate market values of all securities. In equilibrium, the proportions of
the tangency portfolio will correspond to the proportions of the market portfolio. This
tells us that the market portfolio plays a central role in CAPM since the efficient set
consists of an investment in the market portfolio, coupled with a desired amount of
either risk – free borrowing or lending.
CAPITAL MARKET THEORY ASSUMPTIONS
The main assumptions of the capital market theory are as follows:
1. All investors are efficient investors. They choose to invest in portfolios along the
efficient frontier. The exact location on the efficient frontier and therefore, the specific
portfolio selected, will depend on the individual investor’s risk – return utility function.
2. Investors can borrow or lend any amount of money at a risk – free rate of return.
Government-issued securities are considered risk-free securities. Risk-free securities
are securities with zero standard deviation and zero correlation with all other risky
assets.
3. All investors have homogenous expectations, that is, they estimate identical
probability distribution for future rates of return.
4. All investors have the same investment one – period time horizons – 1 month, 6
months, or 1 year.
5. All investments are infinitely divisible. Fractional shares of any portfolio can be
purchased or sold.
6. There are no taxes or transaction costs involved in buying or selling assets, that is,
investors’ results are not affected by taxes and transaction costs.
7. There is no inflation or change in interest rates or inflation is fully anticipated. Returns
are not affected by the inflation rate in a capital market.

CAPITAL MARKETS FM3

17
8. Capital markets are in equilibrium. All investments are correctly priced at par with their
risk levels. All assets are included in the market portfolio in proportion to their market
value. The market portfolio contains all risky assets and is completely diversified,
meaning, all the unique risk of individual assets is diversified away.
- Some of these assumptions are unrealistic. Relaxing many of them will have minor
influence on the model and will not change its main implications or conclusions.
Remember that a theory should be judged on how well it explains and helps predict
behavior, not on its assumptions.
CAPITAL ASSET PRICING MODEL (CAPM)
- CAPM explains that every investment carries two distinct risks: (1) systematic risk, the
risk of being in the market and (2) unsystematic risk, the risk specific to a company’s
fortunes. Systematic risk, later dubbed “beta”, cannot be diversified away.
Unsystematic risk is an uncertainty that can be mitigated through appropriate
diversification. A portfolio’s expected return hinges solely on its beta – its relationship
to the overall market. CAPM helps measure portfolio risk and return an investor can
expect for taking that risk. It explains the relationship that should exist between the
securities’ expected returns and their risk in terms of the means and standard
deviation. All investors can satisfy their investment needs by combining the risk-free
asset with the identical tangency portfolio, which is the market portfolio of all risky
assets.

CAPITAL MARKETS FM3

17
MEAN – VARIANCE ANALYSIS
- Mean – variance analysis is part of modern portfolio theory that deals with the trade –
offs between risk, as represented by variance or standard deviation of return and
expected return. Mean – variance analysis assumes the following:
1. Investors are risk – averse

2. Assets’ expected returns, variances of returns, and covariance of returns are known.
3. Investors need to know only the expected returns, the variances of returns, and
covariance between returns in order to determine which portfolios are optimal.
4. There are no transaction costs or taxes.
- In general, the expected return on a portfolio is the weighted average of the expected
returns on the individual assets, where the weight applied to each asset’s return us
the fraction of the portfolio invested in that asset. The global minimum – variance
portfolio of risky assets having the minimum variance. An efficient portfolio is one
providing the maximum expected return for a given level of variance or standard
deviation of return.
- According to the mean – variance analysis, investors optimally select a portfolio from
portfolios that lie on the efficient frontier. By restricting attention to the efficient
portfolio, the investor’s portfolio selection task is greatly simplified. When the
correlation between the returns on two assets is less than +1, the potential exists for
diversification benefits. Diversification benefits occur when portfolio standard
deviation of return can be reduced through diversification without decreasing
expected returns.

CAPITAL MARKETS FM3

17

2. Provide actual scenarios in the market using the capital market theory assumptions. Use this format:
CAPITAL MARKET THEORY

NO
ACTUAL SCENARIOS IN THE MARKET
. ASSUMPTIONS
1. All investors are efficient investors. They choose to invest in
portfolios along the efficient frontier. The exact location on
1 the efficient frontier and therefore, the specific portfolio
selected, will depend on the individual investor’s risk – return
utility function.
Investors can borrow or lend any amount of money at a risk –
free rate of return. Government-issued securities are
2 considered risk-free securities. Risk-free securities are
securities with zero standard deviation and zero correlation
with all other risky assets.
All investors have homogenous expectations, that is, they
3 estimate identical probability distribution for future rates of
return.
All investors have the same investment one – period time
4
horizons – 1 month, 6 months, or 1 year.
All investments are infinitely divisible. Fractional shares of any
5
portfolio can be purchased or sold.
There are no taxes or transaction costs involved in buying or
6 selling assets, that is, investors’ results are not affected by
taxes and transaction costs.
There is no inflation or change in interest rates or inflation is
7 fully anticipated. Returns are not affected by the inflation rate
in a capital market.

CAPITAL MARKETS FM3

17
Capital markets are in equilibrium. All investments are
correctly priced at par with their risk levels. All assets are
8 included in the market portfolio in proportion to their market
value. The market portfolio contains all risky assets and is
completely diversified, meaning, all the unique risk of
individual assets is diversified away.
Guide questions:
1.1. Discuss Markowitz Portfolio Theory.
1.2. What is capital market theory? Why are the assumptions stated in this theory important to have a
clear understanding of capital markets?
1.3. Why is mean – variance analysis an important tool in investing?
References

- https://www.wallstreetmojo.com/modern-portfolio-theory/
- https://www.wallstreetmojo.com/capital-market-line/
- https://www.wallstreetmojo.com/capital-asset-pricing-model-capm/
- https://www.researchgate.net/figure/Mean-Variance-Analysis-Opportunities-and-
Choices_fig3_323170247
FINAL OUTPUTS
Final Output 1: “FINANCIAL MARKET INVESTING SEMINAR” Learn the basics of

investing in financial markets.
Objectives of the seminar:
a. The students will now learn how to prepare and organize an academic seminar.
b. The students will acquire knowledge pertaining to actual stock market scenarios and
the basics of investing from a financial expert or advisor.
c. The students can now invest in the stock market using the learnings and pointers
provided by the resource speaker.
Details of the Seminar:
1. Resource speaker should come from the industry preferably a fund manager of a
certain company or financial institution.
2. Topics of the seminar should include:
a. Discussion of investing.
b. All about the PSE (Philippine Stock Market)
c. Online brokers vs Traditional brokers
d. How to invest using online brokers and traditional brokers?
e. Current trends in the stock market industry.
3. The seminar can be opened to other participants or students from other schools.
4. A fee should be computed in order to cover the expenses of the seminar.
5. Venue should be at the school, Manuel V. Gallego Foundation Colleges.
Final Output 2: Investing in the stock market
Objectives:
a. Students will experience first-hand how to invest in the stock market.

b. Students will be aware with the current stock market trends and practices.
c. Students can now analyze different market factors that might affect their investments.
d. Students can now assess the risk and return factors of different industries.
e. Students can apply the knowledge and skills they gain which are provided by this
module.

CAPITAL MARKETS FM3

17
Instructions:
a. Form a group composing of 5 students.

b. Contribute 1,000 pesos each to accumulate a 5,000 initial investment for the stock
market. (Mutual fund principle)
c. Invest your 5,000 pesos at the start of the semester. You will evaluate your
investment after 5 months (1 semester).
d. Use an online broker for this. (BDO Nomura, Col financial, BPI Philam, etc.)
e. Make a narrative report as your final output for this activity composing the following:
- Companies you invested in. Discuss your reasons.
- Adjustments you made in order for you to gain and recover your losses.
- Net gain or net loss for the whole 5 months.
- Overall market scenario you have experienced.
- Recommendations to improve the stock market system.

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MANUEL V GALLEGO FOUNDATION COLLEGES, INC.

INSTITUTE OF ACCOUNTANCY AND BUSINESS

CAPITAL MARKETS FM3

VISION AND MISSION OF THE INSTITUTE OF BUSINESS AND MANAGEMENT

Desired Students’ Learning Outcomes

The Graduates Manifest the Attributes of A “Gallegan” Which Are as Follows:

Course Title : CAPITAL MARKETS

COURSE LEARNING OUTCOMES:

Students at the end of the course are expected to:

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CAPITAL MARKETS FM3

WEEK. 4 1st PRELIMINARY PERIOD

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CAPITAL MARKETS FM3

Expectations from Students

Observance of Academic Honesty and Professionalism

1. Plagiarism – using ideas, data, or language of another without specific or proper

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CAPITAL MARKETS FM3

3. Fabrication – submitting contrived or improperly altered information in any academic

Evaluation and Grades

HOUSE RULES DURING THE ONLINE CLASS MEETINGS

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CAPITAL MARKETS FM3

3. Be an active participant in class activities.

5. Be interested in the class.

 Main ideas clear  Ideas are not well

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CAPITAL MARKETS FM3

Grading Table – 60% Passing

MODULE 1. PART I. ORIENTATION

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CAPITAL MARKETS FM3

C. Desired Students’ Learning Outcomes

MODULE 1: Part II. THE FINANCIAL SYSTEM

INTENDED LEARNING OUTCOME

1. Analyze a financial system’s role in the economy.

FINANCIAL SYSTEM: DEFINITION

With the advent of globalization, we have a multinational financial system. Multinational

Prepared by: Macky C. Herezo, PHD. BA. Page 7 of 71

CAPITAL MARKETS FM3

FINANCIAL SYSTEM PARTICIPANTS

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CAPITAL MARKETS FM3

BANGKO SENTRAL NG PILIPINAS AND THE PHILIPPINE FINANCIAL SYSTEM

BSP VISION AND MISSION

1. Maintain monetary policies conducive to a balanced and sustainable growth of the

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CAPITAL MARKETS FM3

2. Government’s banker, agent, and adviser

3. Custodian of the cash reserves of banks

4. Custodian of the nation’s reserves of international currency

5. Bank of rediscount and lender of last resort

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CAPITAL MARKETS FM3

6. Banks of central clearance and settlement

BSP can control credit by:

a. Increasing or decreasing interest rates;

MONETARY POLICY AND FINANCIAL SYSTEM