FM 415 - 5 9 For Print

Financial How do
FINANCIAL
Markets MARKETS
FUNCTION?
Prepared by: Ms. Ida
● Raising capital STRUCTURE OF FINANCIAL MARKETS

● Commercial
What do transactions
FINANCIAL ● Price setting ● Debt and Equity Markets
MARKETS ● Asset valuation ● Primary and Secondary Markets
● Arbitrage ● Stock exchange and OTC Market
do? ● Investing
● Risk management
It is the buying and selling

of shares, currency, or
other financial What you ● Market data
What is instruments in a single
need to ● Scalping
DAY day. The intention is to
● Margin trading
profit from small price know
TRADING? fluctuations - sometimes ● Bid-offer spread
traders hold shares for DAY TRADING
only a few minutes.
THE RISE OF THE FORMAL MARKETS
● a high risk
DAY occupation Characteristics
● Liquidity
TRADING is… ● a stressful
● Transparency
● expensive ● Reliability
● Legal procedures
● Suitable investor protection and regulation
● Low transaction costs
THE FORCES OF CHANGE FOR FORMAL

MARKETS
● Technology
● Deregulation
Money Markets
● Liberalization
Prepared by: Ms. Ida
● Consolidation
● Globalization
When a business needs cash for a

couple of months until a big
payment arrives, or when a bank
The term "Money Market" refers to wants to invest money that
What is the network of corporations, What is depositors may withdraw at any
MONEY financial institutions, investors and MONEY moment, or when a government
governments which deal with the tries to meet its payroll in the face
MARKET? flow of short-term capital.
MARKET? of big seasonal fluctuations in tax
receipts, the short-term liquidity
transactions occur in the money
market.
The money market exists to provide For example, most deposit accounts
the loans that financial institutions have a relatively short notice period
and governments need to carry out and allow customers access to their
How does How does
their day-to-day operations. For money either immediately, or within
MONEY instance, banks may sometimes MONEY a few days or weeks. Because of
MARKET need to borrow in the short term to MARKET this short notice period, banks
works? fulfill, their obligations to their works? cannot make long-term
customers, and they use the money commitments with all of the money
market to do so. they hold on deposit.
Banks may also find that they have

They need to ensure that a
greater demand for mortgages or
proportion of it is liquid (easily
loans than they do for savings
accessible) in market terms.
How does How does accounts at certain times. This
Otherwise, if a large number of
MONEY MONEY creates a mismatch between the
customers wish to withdraw their
money they have available and the
MARKET money at the same time, there may MARKET money they have loaned out, so the
works? be a shortfall between the money works? bank will need to borrow in order to
the bank has lent and the cash
be able to fulfill the demand for
deposits it needs to return to savers.
loans.
The money markets are the

There is an identifiable money
mechanisms that bring these
market for each currency, because
borrowers and investors together
interest rates vary from one
How does without the comparatively costly How does
currency to another. These markets
MONEY intermediation of banks. They make MONEY are not independent, and both
it possible for borrowers to meet
MARKET short-run liquidity needs and deal
MARKET investors and borrowers will shift
works? works? from one currency to another
with irregular cash flows without
depending upon relative interest
resorting to more costly means of
rates.
raising money.
However, regulations limit the
ability of some money market The primary function of the money
investors to hold foreign-currency market is for banks and other
How does instruments, and most Who uses investors with liquid assets to gain a
MONEY money-market investors are the Money return on their cash or loans. They
concerned to minimize any risk of provide borrowers such as other
MARKET loss as a result of exchange-rate Market? banks, brokerages, and hedge funds
works? fluctuations. For these reasons, most with quick access to short-term
money-market transactions occur in funding.
the investor's home currency.
Companies
The money market is dominated by When companies need to raise
professional investors, although money to cover their payroll or
retail investors with P50,000 can
Who uses Who uses running costs, they may issue
also invest. Smaller deposits can be commercial paper- short term,
the Money invested via money market funds. the Money unsecured loans for Php100,000 or
Market? Banks and companies use the Market? more that mature within 1-9
financial instruments traded on the months.
money market for different reasons,
and they carry different risks.
Companies Banks
A company that has a cash surplus If demand for long-term loans and
may “park” money for a time in mortgages is not covered by
Who uses short-term, debt-based financial Who uses “deposits from savings accounts,
instruments such as treasury bills banks may the issue certificates of
the Money and commercial paper, certificates
the Money deposit, with a set interest rate and
Market? of deposit, or bank deposits. Market? fixed-term maturity of up to five
years.
Investors
Individuals seeking to invest large The money markets do not exist in a
sums of money at relatively low risk particular place or operate
according to a single set of rules.
Who uses may invest in financial instruments. Who uses Nor do they offer a single set of
Sums of less that Php50,000 can be
the Money invested in money market funds.
the Money posted prices, with one current
Market? Market? interest rate for money. Rather, they
are webs of borrowers and lenders,
all linked by telephones and
computers.
Arrayed around the central bankers

are the treasurers of tens of
Who uses At the centre of each web is the Who uses thousands of businesses and
central bank whose policies the Money government agencies, whose job is
the Money determine the short-term interest to invest any unneeded cash as
Market? rates for that currency.
Market? safely and profitably as possible
and, when necessary, to borrow at
the lowest possible cost.
WHAT MONEY MARKETS DO

The connections among them are
established by banks and investment There is no precise definition of the money markets,
Who uses companies that trade securities as but the phrase is usually applied to the buying and
the Money their main business. The constant selling of debt instruments maturing in one year or
soundings among these diverse less. The money markets are thus related to the bond
Market? players for the best available rate at markets, in which corporations and governments
a particular moment are the forces borrow and lend based on longer-term contracts.
that keep the market competitive.
WHAT MONEY MARKETS DO WHAT MONEY MARKETS DO
Similar to bond investors, money-market investors are Yet the money markets and the bond markets serve
extending credit, without taking any ownership in the different purposes. Bond issuers typically raise money
borrowing entity or any control over management. to finance investments that will generate profits - or,
in the case of government issuers, public benefits for
many years into the future. Issuers of money-market
instruments are usually more concerned with cash
management or with financing their portfolios of
financial assets.
WHAT MONEY MARKETS DO WHAT MONEY MARKETS DO
A well-functioning money market facilitates the If the money markets are active, or "liquid",
development of a market for longer-term securities. borrowers and investors always have the option of
Money markets attach a price to liquidity, the engaging in a series of short-term transactions rather
availability of money for immediate investment. The than in longer-term transactions, and this usually
holds down longer term rates. In the absence of active
interest rates for extremely short-term use of money
money markets to set short-term rates, issuers and
serve as benchmarks for longer-term financial investors may have less confidence that longer-term
instruments. rates are reasonable and greater concern about being
able to sell their securities should they so choose.
WHAT MONEY MARKETS DO TYPES OF MONEY-MARKET INSTRUMENTS
For this reason, countries, with less active money Money market securities are short-term instruments
markets, on balance, also tend to have less active with an original maturity of less than one year.
bond markets. There are numerous types of money-market
instruments. The best known are commercial papers,
bankers' acceptances, treasury bills, repurchase
agreements, government agency notes, local
government notes, interbank loans, time deposits,
bankers' acceptance, and papers issued by
international organizations.
TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS
The amount issued the course of a year is much Money market securities are usually more widely
greater than the amount outstanding at any one time, traded than longer-term securities and so tend to be
as many money-market securities are outstanding for more liquid.
only short periods of time.
Money market securities are used to "warehouse"
funds until needed. The returns earned on these
investments are low due to their low risk and high
liquidity.
COMMERCIAL PAPER COMMERCIAL PAPER

Commercial paper is a short-term debt obligation of a They tend to be issued by highly rated banks and are
private-sector firm or a government-sponsored traded in a similar way to securities. In most cases, the
corporation. Only companies with good credit ratings lifetime, or maturity, greater than 90 days but less
than nine months. This maturity is dictated by
issue commercial paper because investors are
regulations. In the Philippines, most new securities
reluctant to bring the debt of financially compromised must be registered with the regulator, the Securities
companies. and Exchange Commission.

Commercial paper is usually unsecured although a Many large companies have continual commercial
particular commercial paper issue may be secured by paper programmes, bringing new short-term debt on
a specific asset of the issuer or may be guaranteed by to market every few weeks or months. It is common
a has paper bank. for issuers to roll over their paper, using the proceeds
of a new issue to repay the principal of a previous
issue.

In effect, this allows issuers to borrow money for long These continual borrowing programmes are not
periods of time at short-term interest rates, which may riskless. If market conditions or a change in the firm's
be significantly lower than long-term rates. The financial circumstances preclude a new commercial
short-term nature of the obligation lowers the risk paper issue, the borrower faces default if its lacks the
perceived by investors. cash to redeem the paper that is maturing.
BANKER’S ACCEPTANCES BANKER’S ACCEPTANCES

Before the 1980s, bankers' acceptances were the main Bankers' acceptances differ from commercial paper in
way for firms to raise short-term funds in the money significant ways. They are usually tied to the sale or
markets. An acceptance is a promissory note issued by storage of specific of specific goods, such as an export
a non-financial firm to a bank in return for a loan. The
order for which the proceeds will be received in two
bank resells the note in the money market at a
discount and guarantees payment. Acceptances or three months. They are not issued at all by
usually have a maturity of less than six months. financial-industry firms.
BANKER’S ACCEPTANCES TREASURY BILLS

They do not bear interest; instead, an investor Treasury bills, often referred to as T-bills, are
securities with a maturity of one year or less, issued
purchases the acceptance at a discount from face by national governments. Treasury bills issued by a
value and then redeems it for face value at maturity. government in its own currency are generally
Investors rely on the strength of the guarantor bank, considered the safest of all possible investments in
rather than of the issuing company, for their security. that currency. Such securities account for a larger
share of money-market trading than any other type of
instrument.
GOVERNMENT AGENCY NOTES LOCAL GOVERNMENT NOTES

National government agencies and Local government notes are issued by, provincial or
government-sponsored corporations are heavy local governments, and by agencies of these
borrowers in the money markets in many countries. governments such as schools authorities and transport
These include entities such as development banks, commissions. The ability of governments at this level
housing finance corporations, education lending to issue money-market securities varies greatly from
agencies and agricultural finance agencies. country to country.
LOCAL GOVERNMENT NOTES INTERBANK LOANS

In some cases, the approval of national authorities is Loans extended from one bank to another with which
required; in others, local agencies are allowed to it has no affiliation are called interbank loans. Many
borrow only from banks and cannot enter the money of these loans are across international boundaries and
markets. are used by the borrowing institution to re-lend to its
own customers.
TIME DEPOSITS TIME DEPOSITS

Time deposits, another name for certificates of deposit Time deposits with terms as brief as 30 days are
or CDs, are interest-bearing bank deposits that cannot common. Large time deposits are often used by
be withdrawn without penalty before a specified date. corporations, governments and money-market funds
to invest cash for brief periods. Interest rates depend
Although time deposits may last for as long as five
on length of maturity, with longer terms getting better
years, those with terms of less than one year compete rate. The main risks are being locked into low interest
with other money-market instruments. rates if rates rise and early withdrawal penalties.
REPOS REPOS
Repurchase agreements known as repos, play a A repo is a combination of two transactions. In the
critical role in the money markets. They serve to keep first, a securities dealer, such as a bank, sells
the markets highly liquid, which in turn ensures that securities it owns to an investor, agreeing to
repurchase the securities at a specified higher price at
there will be a constant supply of buyers for new
a future date. In the second transaction, days or
money-market instruments. months later, the repo is unwound as the dealer buys
back the securities from the investor.
TYPES OF MONEY-MARKET INSTRUMENTS
REPOS
The amount the investor lends is less than the market
value of the securities, a difference called the spread Bond Markets
or haircut, to ensure that it still has sufficient
collateral if the value of the securities should fall Prepared by: Ms. Ida
before the dealer repurchases them.
The most prevalent example of the

Any long term promissory note interest only loan with investors
issued by the firm. A bond receiving exactly the same two sets
What are What are of cash flows;
certificate is the tangible evidence
BONDS? of debt issued by a corporation or a BONDS? 1. the periodic interest payments,
governmental body and represents a and
loan made by investors to the issuer. 2. the principal (par value or face
value) returned at maturity.
Trading Process for Corporate Bonds Trading Process for Corporate Bonds
The initial or primary sale of corporate bond issues occurs Most often, corporate bonds are offered publicly through investment
banking firms as underwriters. Normally, the investment bank facilitates
either through a public offering, using an investment bank
this transaction using a firm commitment underwriting. The investment
serving as a security underwriter or through a private bank guarantees the firm a price for newly issued bonds by buying the
placement to a small group of investors (often financial whole issue at a fixed price (the bid price) from the bond-issuing firm at a
institutions). Generally, when a firm issues bonds to the discount from par. The investment bank then seeks to resell these
public, many investment banks are interested in underwriting securities to investors at a higher price (the offer price).
the bonds. The bonds can generally be sold in a national
market.
Other arrangements can be as follows:

Sell Bonds Sell Bonds
1. Competitive Sale
Underwriter
Corporation Investors
(Investment Bank)
The investment Bank can purchase the bonds through competitive
Pays Bid Price Pays Oﬀer Price
bidding against other investment banks or by directly negotiating with
the issuer.
Firm Commitment Underwriting of a Corporate Bond Issue
Other arrangements can be as follows: Other arrangements can be as follows:
2. Negotiated Sale 3. Best Efforts Underwriting Basis
With a negotiated sale, a single investment bank obtains the exclusive In their arrangement, the underwriter does not guarantee a firm price
right to originate, underwrite and distribute the new bonds through a to the issuer. The investment bank incurs no risk of mispricing the
one-on-one negotiation process. With a negotiated sale, the security since it simply seeks to sell the securities at the best market
investment bank provides the organization and advising services to price it can get for the issuing firm.
the issuers.
Advantages of using Bonds Advantages of using Bonds
1. Long-term debt is generally less expensive than

2. Bondholders do not participate in extraordinary
other forms of financing because
profits; the payments are limited to interest.
a. Investors view debt as a relatively safe
3. Bondholders do not have voting rights.
investment alternative and demand a lower rate
4. Floatation costs of bonds are generally lower than
of return, and
those of ordinary (common) equity shares.
b. Interest expenses are tax deductible.
Disadvantages of using Bonds Disadvantages of using Bonds
1. Debt (other than income bonds) results in interest

payments that, if not met, can force the firm into
3. Debt must be repaid at maturity and thus at some
bankruptcy.
point involves a major cash outflow.
2. Debt (other than income bonds) produces fixed
4. The typically restrictive nature of indenture
charges, increasing the firm’s financial leverage.
covenants may limit the firm’s future financial
Although this may not be a disadvantage to all
flexibility.
firms, it certainly is for some firms with unstable
earnings streams.
Bond Features and Prices

The various features of corporate bonds and some of the terminology associated with bonds follow:
Par Value The face value of the bond that is returned to the bondholder at maturity.
As of September, 2019 the following are bond issuances by the government business Coupon Interest The % of the par value of the bond that will be paid out annually in the form of
firms in the Philippines secured by Bond Funds and part of the Investment Portfolio of Rate interest. Formula is: Stated interest payment divided the Par value.
Mutual Funds.
Maturity The length of time until the bond issuer returns the par value to the bondholder and
ALFM Peso Bonds RCBC “Sustainability” Bonds
terminates the bond.
Grepalife Bonds Robinsons Bank
Indenture The agreement between the firm issuing the bonds and the bond trustee who
Philam Bonds Fixed Rate Corporate Bonds represents the bondholders. It provides the specific terms of the loan agreement,
including the description of the bonds, the rights of the bondholders, the rights of the
Philequity Peso Bonds PH Samurai Bonds issuing firm and the responsibilities of the trustees.
Sun Life Prosperity Bonds Ayala Land Inc. (PH) Bonds Current Yield This refers to the ratio of the annual interest payment to the bond’s market price.
Yield to Maturity This refers to the bond’s internal rate of return. It is the discount rate that equates
the present value of the interest and principal payments with the current market
price of the bond.
Formula is: Illustrative Problem:
Par value of bond: Php 1,000 What is the bond’s approximate

Interest rate: 10% yield to maturity?
Annual Interest Principal Payment - Price of the Bond Term: 10 years
+
Approximate Payment Number of Years to Maturity Current price: Php 900
Yield:
0.6 (Price of the Bond) + 0.4 (Principal Payment)
Annual Interest Principal Payment - Price of the Bond
+
Approximate Payment Number of Years to Maturity
Yield:
0.6 (Price of the Bond) + 0.4 (Principal Payment)
Credit Quality Risk

Illustrative Problem:
Credit Quality Risk is the chance that the bond issuer will not be able to
make timely payments.
Par value of bond: Php 1,000 What is the bond’s approximate
Interest rate: 10% yield to maturity? Bond ratings involve a judgement about the future risk potential of the
Term: 10 years bond provided by rating agencies such a as Moody’s, Standard and
Current price: Php 900 Poor’s and Fitch IBCA, Inc. Dominion Bond Rating Services. Bond ratings
are favorably affected by:
A. A low utilization of financial leverage; The poorer the bond
Approximate B. Profitable operations; rating, the higher the
Yield: = 11.70%
C. A low variability of past earnings; rate of return
D. Large firm size; demanded in the
E. Little use of subordinated debt. capital markets.
Credit Quality Risk TYPES OF BONDS

The bond credit ratings agencies assign similar rating based on detailed
analyses of issuers’ financial condition, general economic and credit A. Unsecured Long-term Bonds
market conditions, and the economic value of any underlying collateral. Debentures
The agencies conduct general economic analyses of companies’ business
and analyze firm’s specific financial situations. A single company of These are unsecured long-term debt and backed only by the
instance may carry several outstanding bond issues and if these issues reputation and financial stability of the corporation. Because these
feature fundamental differences, then they may have different credit level bonds are unsecured, the earning ability of the issuing corporation is
risks. High quality corporate bonds are considered investment grade, of great concern to the bondholder. To provide some protection to
while higher credit risk bonds are speculative, also called junk bonds and the bondholder, the issuing firm may be prohibited from issuing
high-yield bonds. future secured long-term debt that would create additional
encumbrance of assets. To the issuing firm, debentures will allow it
to incur indebtedness and still preserve some future borrowing
power.
TYPES OF BONDS TYPES OF BONDS
A. Unsecured Long-term Bonds A. Unsecured Long-term Bonds

Subordinated Debentures Income Bonds
Claims of bondholders of subordinated debentures are honored only An income bond requires interest payments only if earned and
after the claims of secured debt and unsubordinated debentures have non-payment of interest does not lead to bankruptcy. Usually issued
been satisfied. during the reorganization of a firm facing financial difficulties, these
bonds have longer maturity and unpaid interest is generally allowed
to accumulate for some period of time and must be paid prior to the
payment of any dividends to stockholders.
B. Secured Long-term Bonds B. Secured Long-term Bonds

Mortgage Bonds Mortgage Bonds can further be subclassified as follows:
A mortgage bond is a bond secured by a lien on real property. a) First Mortgage Bonds
Typically, the market value of the real property is greater than that of The first mortgage bonds have the senior claim on the secured
the mortgage bond issued. This provides the mortgage bondholders assets if the same property has been pledged on more than one
with a margin of safety in the event that the market value of the mortgage bond.
secured property declines. Should the issuing firm fail to pay the
b) Second Mortgage Bonds
bonds at maturity; the trustees can foreclosure or sell the mortgaged
property and use the proceeds to pay the bondholders. These bonds have the second claim on assets and are paid only
after the claims of the first mortgage bonds have been satisfied.
B. Secured Long-term Bonds B. Secured Long-term Bonds

Mortgage Bonds can further be subclassified as follows: Mortgage Bonds can further be subclassified as follows:
c) Blanket or General Mortgage Bonds e) Open-end Mortgage Bonds
All the assets of the firm are used as security for this type of These bonds allow the issuance of additional mortgage bonds
bonds.
using the same secured assets as security. However, a restriction
d) Closed-end Mortgage Bonds may be placed upon the borrower, requiring that additional assets
The close-end mortgage bonds forbid the further use of the should be added to the secured property if new debt is issued.
pledged assets security for other bonds. This protects the
bondholders from dilution of their claims on the assets by any
future mortgage bonds.
TYPES OF BONDS OTHER TYPES OF BONDS
B. Secured Long-term Bonds 1. Floating Rate or Variable Rate Bonds

Mortgage Bonds can further be subclassified as follows: A floating rate bond is one in which the interest payment changes
f) Limited Open-end Mortgage Bonds with market conditions. In periods of unstable interest rates this type
of debt offering becomes appealing to issuers and investors. To the
These bonds allow the issuance of additional bonds up to a
issuers like banks and finance companies, whose revenues go up
limited amount at the same priority level using the already
when interest rates rise and decline as interest rates fall, this type of
mortgaged assets as security.
debt eliminates some of the risk and variability in earnings that
accompany interest rate swings. To the investor, it eliminates major
swings in the market value of the debt that would otherwise have
occurred if interest rates had changed.
OTHER TYPES OF BONDS OTHER TYPES OF BONDS
1. Floating Rate or Variable Rate Bonds 2. Junk or Low-Rated Bonds

A common feature of all the floating rate bonds is that an attempt is Junk or low rated bonds are bonds rated BB or below. The major
being made to counter uncertainty by allowing the interest rate to participants of this market are new firms that do not have an
float [e.g., interest rates may be adjusted quarterly at 3% above the established record of performance, although in recent years junk
three-month London Interbank Offered Rate (LIBOR)]. In this way a bonds have been increasingly issued to finance corporate buyouts.
change in cash inflows to the firm may be offset by an adjustment in Since junk bonds are of speculative grade, they carry a coupon rate
interest payments. of between 3 to 5 percent more than AAA grade long-term debt. As a
result, there is now an active market for these new debt instruments.
2. Junk or Low-Rated Bonds 3. Eurobonds

Because of the acceptance of junk or low-rated bonds, many new These are bonds payable or denominated in the borrower's currency,
firms without established performance records now have a viable but sold outside the country of the borrower, usually by an
financing alternative to secure financing through a public offering, international syndicate of investment bankers. This market is
rather than being forced to rely on more-costly commercial bank denominated by bonds stated in U.S. dollars.
loans.
The Eurobond is usually sold by an international syndicate of
investment bankers and includes bonds sold by companies in
Switzerland, Japan, Netherlands, Germany, the United States and
Britain, to name the most popular countries.
3. Eurobonds 4. Treasury Bonds

An example might be a bond of a U.S. company payable in dollars Treasury bonds carry the "full-faith-and-credit" backing of the
and sold in London, Paris, Tokyo or Frankfurt.
government and investors consider them among the safest
Eurobonds are also referred to as bonds issued in Europe by an fixed-income investments in the world. The BSP sells Treasury
American company and pay interest and principal to the lender in securities through public auctions usually to finance the
U.S. dollars. government's budget deficit. When the deficit is large, more bonds
come to auction. In addition, the BSP uses Treasury securities to
The use of Eurobonds by U.S. firms to raise funds has fluctuated
dramatically with the relative interest rates an abundance or lack of implement monetary policy.
funds in the European markets dictating the degree to which they are
used.
Bond markets refer to the financial It is a platform for companies and

markets where the issuance, buying, governments to raise capital by
What is the What is the
and selling of debt securities like issuing debt instruments like bonds.
BOND bonds occur. The other names BOND Companies issue bonds commonly
MARKET? include debt markets, fixed-income MARKET? to finance operations and
markets, and credit markets. large-scale projects.
At the same time, the government

Bond markets are boon to corporate
issues bonds intending to finance
and government bodies since it
What is the government spending or What is the
helps them raise capital easily and
BOND expenditure, including BOND flexibly. Primarily, it allows
infrastructure spending and debt
MARKET? repayment. One example is the
MARKET? companies to obtain capital without
causing equity dilution.
Treasury securities market.
Inflationary phenomena have an
In addition, using the debt impact on debt markets. Bond
instruments to obtain capital prices fall when interest rates rise,
reduces the cost of capital since the and vice versa. Stock market rallies
What is the What is the and companies outperforming the
interest expense associated with
BOND BOND market are common when the
such instruments is tax-deductible. economy is booming, and investors
MARKET? Altogether, companies can build an MARKET? will be more interested in stocks
optimal capital structure and are a than debt instruments, causing
place to trade debt securities. investment to shift from the debt
market to the stock market.
Bond Market
Simultaneously, during a bear
market or stock market collapse,
What is the
investors will shift their investments
BOND to bonds, which are a safe haven in
MARKET? comparison to stocks in a volatile or
bear market.
CORPORATE BONDS CORPORATE BONDS
Characteristics of Corporate Bonds Characteristics of Corporate Bonds

Remember that while bonds are a corporation's promise to repay with Bond covenants: A portion of a bond agreement that specifies what the
interest, stocks represent ownership of a corporation. Since stockholders borrower (the bond issuer) may or may not do during the life of the
have the power to hire and fire the executives of a corporation, those bond.
executives may pay more attention to the interests of stockholders than
they do those of bondholders. To more closely align the interests of Most often bond covenants are "financial covenants" that specify, for
bondholders and executives, many bonds carry with them bond example, that management must maintain a stated leverage ratio, or a
covenants, which either tell management what to do or place restrictions debt-to-equity ratio, within a given range. These types of ratios are
on what management can do. designed to make sure that management does not overload the
corporation with debt.

Covenants can also be "nonfinancial," such as requiring management to When a corporation issues a long-term bond, it may wish to pay off all
provide financial information to bondholders, placing restrictions on the or part of the bond early, before it reaches its maturity date. To allow the
selling of assets, and/or making sure the assets of the company have issuer of a bond to pay off its bond early or recall it, the bond must have
adequate levels of insurance. a call provision. The call provision of a bond stipulates under what
conditions the issuer can buy back the bond or pay it off early. Bonds
In general, bonds with covenants have lower interest rates because the with call provisions usually have multiple call dates and stated prices of
restrictions on what management can and cannot do makes the firm the buyback.
more stable and the bonds less risky.

Call provision: A clause in a bond contract that allows the issuer of the The call provision of a bond might state that a bond due June 1, 2030, is
bond the right to buy back all or part of the bond issued before the callable on June 1, 2017, at a price of 105% of par. The indenture, or
bond's maturity date. bond contract, usually includes a table of call dates and prices. The call
price is normally higher than the face value of the bond, but it decreases
the closer the bond comes to its maturity date. For example, the issuer
may offer 105% of the face value if it calls the bond after 4 years, but it
may offer only 102% if it calls the bond in 10 years because it is closer
to the bond's maturity date.

Indenture: A legal contract between the bond issuer and the bond Sometimes the early buyback of bonds is required under the terms of a
holder or purchaser. The contract lays out the legal requirements of the sinking fund. A sinking fund is a pool of money a corporation sets aside
borrower or bond issuer. to help repay a bond issue. Sinking funds are often created to help
ensure the bond issuer can repay the face value of the bonds they issue.
Sinking fund: A pool of money set aside for the repayment of a bond.

For example, suppose Fred's Beer Company sells a 10-year bond with a To reduce the risk of being short on cash 10 years from now, the
$10,000 face value and a coupon rate of 5%. The issuer has to pay company may create a sinking fund for repurchasing a portion of the
bondholders $250 twice a year for the next 10 years, which may not be existing bonds, say, every year. By repaying a portion of its debt each
much of a financial strain for Fred's. But at the end of 10 years Fred's year, the company will face a much smaller payout when the bonds
has to repay the $10,000 face value, which might cause some cash flow mature. Sinking fund provisions usually allow an issuer to repurchase
problems for Fred's, especially if the company is in a poor financial their bonds periodically and at a specific price, usually at par or the
condition when the bond matures. The company may be in fine shape prevailing market price.
today, but how many beers will they be selling 10 years from now?

A sinking fund might sound a lot like a call provision, but they are Some bonds can be converted into shares of common stock at some
different. Sinking funds usually limit how many of the bonds the issuer point in the future at an agreed-upon price. Although convertible bonds
can buy back early, whereas call provisions often allow the issuer to pay generally have a lower yield than nonconvertible bonds with the same
off all the bonds it issues. Also, sinking fund buyback prices are usually characteristics, convertible bonds allow a bondholder to share in the
lower than call provision buyback prices, so the holder of a bond from a success of the economic growth of the firm. From an issuer's point of
company with a sinking fund actually stands to lose more money should view, convertible bonds are beneficial because they require lower
a sinking fund provision result in the early payoff of their bond. interest payments than nonconvertible bonds. The downside to the issuer
is, if the firm is successful in the future, this success will have to be
shared with bondholders as they convert their bonds to common stock.
CORPORATE BONDS GOVERNMENT BONDS
Characteristics of Corporate Bonds Government and Agency Bonds

Convertible bonds: A bond where the bondholder can convert the bond Because of the very low level of default risk, government debt-including
into a specified number of shares of stock of the firm that issued the Treasury notes and Treasury bonds-pay relatively low interest rates
bond. compared with other bonds in the market. But this is not to say these
government bonds are risk free. Because of their longer maturity dates,
While bonds have many different characteristics, one of the most
important distinguishing features of a bond is the potential for default. when interest rates change, Treasury notes and bonds have bigger
Bond buyers are very concerned about default risk. Yet properly swings in their market prices than do Treasury bills or other short-term
evaluating default risk is a difficult thing to do. Next we examine one of debt. Thus government bonds have price risk, even if their default risk is
the most controversial methods used to evaluate default risk: the bond almost zero.
rating system.
GOVERNMENT BONDS CORPORATE BONDS
Government and Agency Bonds Municipal Bonds

Government agencies would sell bonds in the market and use the There are two types of municipal bonds: general obligation bonds and
proceeds to buy mortgages from the financial institutions that wrote revenue bonds. As the name suggests, the proceeds from general
them. The agencies then would pool these mortgages together and sell obligation bonds are used by the issuing government for general
slices of the pooled mortgages to a wide variety of investors.
expenses and are not targeted for a specific project. Most general
Since investors believed these government agencies had the full backing obligation bonds must be approved by taxpayers because future taxes
of the government, the agencies could borrow funds in the market at a will be used to repay the debt plus interest.
relatively low interest rate. Even though these rates were generally General obligation bond: A bond issued and backed by a state or local
higher than Treasury bill rates, the agency bonds were often viewed as municipality to raise funds that will be used for a variety of public works
almost perfectly default risk-free projects.
Municipal Bonds Municipal Bonds

Revenue bonds, on the other hand, are repaid in part using the cash flow Federal Income Tax Exemption of Muni Bonds
from a particular cash-generating project. Since the muni bond pays a higher rate than the equivalent tax-free rate,
Revenue bond: A bond issued and backed by a state or local the saver will choose the muni bond, ceteris paribus.
municipality to raise funds that will be used for a specific Thus, when comparing bonds with taxable interest payments with
income-generating project. tax-free bonds such as muni bonds, investors cannot simply compare
rates of return. Instead, investors must be certain that they are comparing
equivalent tax-free rates of return; otherwise they may be making
inefficient use of their resources.
CORPORATE BONDS
Municipal Bonds
Default Risks with Muni Bonds
Although muni bonds are issued by state and local governments, they
are not risk-free promises to repay. General obligation bonds are usually
Stock Markets
viewed as having a lower default risk than revenue bonds. This is
because revenue bonds depend on a specific source of revenue for Prepared by: Ms. Ida
repayment. If that specific source or project does not perform as
planned, then repayment of the bond can become doubtful.
traditionally known as ordinary Ordinary equity shareholders are
called residual owners because their
What are equity share, a form of long-term What are
equity that represents ownership claim to earnings and assets is what
STOCKS? STOCKS? remains after satisfying the prior
interest of the firm.
claims of various creditors and
preferred shareholders.
Business firms organized as a

Ordinary (common) equity corporation may choose to issue
What are shareholders are the true owners of What are publicly traded stock (publicly
STOCKS? the corporation and consequently STOCKS? owned corporation) or keep
bear the ultimate risks and rewards ownership only among the original
of ownership. organizers (closely held
corporation).
As owners of the firm, ordinary

shareholders are considered to be
These profits can be used to reinvest
What are residual domains. This means that What are
in the firm to foster growth, pay out
STOCKS? ordinary shareholders have the right STOCKS? as dividends to shareholders, or a
to claim any cash flows or value
combination of the two.
after all other claimants have
received what they are owed.
FEATURES OF ORDINARY EQUITY SHARES
Par value/No Ordinary equity share may be sold with or without par value. Whether or not ordinary
Shareholders assume a limited par value equity share has any par value is stated in the corporation's charter. Par value of ordinary
equity share is the stated value attached to a single share at issuance. It has little
What are liability because their risk of significance except for accounting and legal purposes. If ordinary equity share is initially
sold for more than its par value, the issue price in excess of par is recorded as additional
STOCKS? potential loss is limited to their paid-in capial, capital surplus, or capital in excess of par. A firm issuing no par share may
either assign a stated value or place it on the books at the price at which the equity share
is sold.
investment in the corporation's
Authorized, Authorized shares is the maximum number of shares that a corporation may issue without
equity shares. issued, and amending its charter. Issued shares is the number of authorized shares that have been
outstanding sold. Outstanding shares are those shares held by the public. Both the firm's dividends per
share and earnings per share are based on the outstanding shares. The number of issued
shares may be greater than the number of outstanding shares because shares may be
repurchased by the issuing firm. Previously issued shares that are reacquired and held by
the firm are called treasury shares. Thus, outstanding share is issued share less treasury
share.
FEATURES OF ORDINARY EQUITY SHARES FEATURES OF ORDINARY EQUITY SHARES
No Maturity Ordinary equity share has no maturity and is a permanent form of long- term financing. Voting rights There are two common systems of voting:
Although ordinary share is neither callable nor convertible, the firm can repurchase its a) Majority voting
shares in the secondary markets either through a brokerage firm a tender offer. A tender Majority voting is a voting system that entitles each shareholder to cast one vote for each
offer is a formal offer to purchase shares of a corporation. share owned. Majority voting is used to indicate the ordinary (common) equity
shareholders' approval or disapproval of most proposed managerial actions on which
Voting rights Each share of ordinary equity generally entitles the holder to vote on the selection of shareholders may vote. The directors receiving the majority of the votes are elected. If a
directors and in other matters. Shareholders unable to attend the annual meeting to vote group controls over 50 percent of the votes, it can elect all of the directors and prevent
may vote by proxy. A proxy is a temporary transfer of the right to vote to another party. minority shareholders from electing any directors.
Proxy voting is done under the rules and regulations of the Securities and Exchange
Commissions, but proxy solicitations are the firm's responsibility. Not all ordinary b) Cumulative voting
equity shareholders have equal voting power. Some firms have more than one class of Cumulative voting is a voting system that permits the shareholder to cast multiple votes for
share. Class A ordinary (common) equity share typically has limited or no voting rights a single director. Cumulative voting assists minority shareholders in electing at
while Class B has full voting rights. least one director. Cumulative voting is required in some jurisdictions for electing the
board of directors.
FEATURES OF ORDINARY EQUITY SHARES
Book value
per share
The accounting value of an ordinary equity share is equal to the ordinary share equity
(ordinary share plus paid-in capital plus retained earnings) divided by the number of
Preferred share is a class of equity
shares outstanding. shares which has preference over
What are
Numerous
rights of
Collective and individual rights of ordinary equity shareholders include
among others: ordinary (common) equity shares in
shareholders A. Right to vote on specific issues as prescribed by the corporate charter such as PREFERRED the payment of dividends and in the
election of the board of directors, selecting the firm's independent auditors,
amending the articles of incorporation and bylaws, increasing the amount of
authorized stock, and so forth.
SHARES? distribution of corporation assets in
B. Right to receive dividends if declared by the firm's board of directors.
C. Right to share in the residual assets in the event of liquidation. the event of liquidation.
D. Right to transfer their ownership in the firm to another party.
E. Right to examine the corporate banks.
F. Right to share proportionally in the purchase of any new issuance of equity shares.
This is known as the pre-emptive right.
The issuance of preferred shares is
Preference means only that the favored when the following conditions
prevail:
holders of the preferred share must
1. Control problems exist with the
receive a dividend (in the case of a issuance of ordinary share.
What are going concern firm) before holder What are 2. Profit margins are adequate to make
of ordinary (common) equity shares of additional leverage attractive.
PREFERRED PREFERRED 3. Additional debt poses substantial
SHARES? are entitled to anything. Preferred SHARES? risk.
shares generally has no voting 4. Interest rates are low lowering the
cost of preferred share.
privileges but it is a form of equity 5. The firm has a high debt ratio,
from a legal and tax standpoint. suggesting infusion of equity
financing is needed.
Corporations Issuing Stocks Corporations Issuing Stocks
If a corporation wants to raise capital, it might go out and borrow funds or Not only do corporations not have to "repay" the stockholders, the
it might issue stock-sell ownership shares of the corporation. If the corporation doesn't I have to pay any of its profits to the shareholders in
corporation borrows money, it has to pay back those funds with interest. the form of dividends if it doesn't want pays to stockholders, are usually
However, there is no required payback when a corporation raises funds by paid out of current earnings or profits. Some well-established to.
issuing shares of stock. A corporation that sells its shares to investors Remember, dividends, the distributions of cash, shares, or other property
doesn't have to buy back the shares from its stockholders. It might choose the corporation corporations pay out 80% or 90% of their earnings or
to do so-called a share buyback - but it is not under any obligation to do profits, whereas many startups and technology companies may not pay
so. any dividends at all.
Savings Buying Stocks Savings Buying Stocks
One of the main reasons why savers, or surplus units, wish to buy stock is In addition to getting a claim on future profits of the corporation, stocks
because they want to share in a corporation's future profits. But also come with voting rights. For example, common stockholders are the
remember, this paying out of dividends is not guaranteed, so there is risk ones who elect the board of directors, authorize the issuance of new
in purchasing stock. The buyer of the stock faces the uncertainty that the shares of stock, approve amendments to the corporate charter, and adopt
corporation my not pay dividends in the future or that the dividends they or amend the corporate bylaws. Stockholders get to cast their votes at the
do pay are lower than what is anticipated. The dividends a corporation corporation's annual meeting or they can assign a proxy. A proxy is a legal
pays could be paid in the form of cash, additional stock, or whatever form form whereby a shareholder transfers their voting rights to someone else,
the board of directors of the corporation chooses. It is, however, most usually another shareholder.
often in the form of a cash dividend.
Primary versus Secondary Market for Equities Primary versus Secondary Market for Equities
When stocks are sold by a corporation to members of the public, this is Most stock market transactions, however, are not IPOs or another type of
called a primary market transaction. In the primary market the corporation primary market transaction. Instead, most stock market transactions are in
has an investment bank sell its shares to the public. An initial public the secondary market-someone who had previously purchased the stock
offering, or IPO, is when the corporation sells its shares in the primary is now selling it to someone else. Who are these “someones" buying and
market to the public for the first time. selling stock in the secondary market?
Buyers and sellers in the secondary equity market can either be

institutional investors or individual investors.
PRICING COMMON STOCK PRICING COMMON STOCK
Stocks or equity shares give you a claim on the future profits or earnings The present value in time t of those cash payments that occur in time
of a corporation, plus the liquidation or salvage value. period t + 1 is calculated as
Think about the idea that you buy a share of a corporation today, and the
corporation will pay you a dividend (or a slice of their profits) in one year
and then immediately close up shop. When the business closes, its assets where DIV₁+1 is the dividend you receive in t + 1 and LIQ+, is the
are sold, debts are paid, and whatever is left over is given to the liquidation or salvage value you receive in t + 1. Assume that the dividend
shareholders. Thus, as a stock or equity holder, you get the liquidation, or in time t + 1 is $10, the termination value of the share is $2, and the rate
salvage, in one year. of time preference (r) is 5%. Then the present value of the $12 cash
flow in one year would be $11.42:
Dividend Discount Model: Single Period Dividend Discount Model: Single Period
where DIV₁+1 is the dividend you receive in t + 1 and LIQ+, is the

liquidation or salvage value you receive in t + 1. Assume that the dividend
in time t + 1 is $10, the termination value of the share is $2, and the rate Since the present value of the cash stream of holding the stock is $11.42,
of time preference (r) is 5%. Then the present value of the $12 cash someone (with the same information set) would be willing to pay no more
flow in one year would be $11.42: than $11.42 for that cash stream; that is, the price of the share would be
$11.42.
So, the market price of the share of stock-which is the claim on these
cash flows-is $11.42. Thus you can see the market price of a share of
stock is simply the discounted cash flows the share of stock provides.
Dividend Discount Model: Single Period Dividend Discount Model: Single Period
In the example above we assumed the corporation issuing the shares For instance, notice in our example that if the liquidation or salvage value
would be around for only the next period. This, of course, is pretty is expected to be $2 per share, and the corporation is expected to go out
unrealistic; most corporations are expected to be around for a long while. of business in 75 years, with a discount rate of 5%, that liquidation or
In fact, they are expected to be around so long that their liquidation or salvage value is worth only $0.02. That is why, in the multiperiod case, the
salvage values are viewed as being so far into the future that they can be liquidation or salvage value often is ignored.
ignored.
Instead, the value of a share is assumed to be the discounted dividends
that share is going to pay the shareholder. Mathematically this is
Dividend Discount Model: Multiperiod Dividend Discount Model: Multiperiod
Instead, the value of a share is assumed to be the discounted dividends While this is a bit more realistic than our previous formulation because it
that share is going to pay the shareholder. Mathematically this is allows for multiple periods, it is also still a bit unrealistic for many
corporations because dividends are not expected to remain constant
forever. In the 1950s Myron Gordon, along with Eli Shapiro, came up
a simple pricing formula that allowed for growth in dividends at a constant
rate. This is sometimes referred to as the Gordon growth model. In this
framework the price of a share in time with period t is
where g is the rate at which the dividend is expected to grow. In their What about firms that keep some or even all of their earnings in the form
model Gordon and Shapiro assumed that the dividend growth rate g of retained earnings and perhaps don't pay out any dividends at all? The
would never be higher than the required rate of return or rate of time Gordon growth model suggests the stock price should be zero. Yet may
preference (r), and these are all in real terms. technology companies (such as Apple) and new startup firms do not pay
any dividends to shareholders. Instead of paying dividends, many startup
So the Gordon growth model did give us a more realistic way to calculate firms plow all of their profits back into the firm. Clearly, the price of these
the price of a share, but it wasn't completely realistic. For example, it firms' stock is not zero! So, we have a bit of a problem if we think the
requires the analyst to accurately predict what the corporation's dividend Gordon growth model is the perfect way to calculate stock price.
payments are going to be, plus it requires perfect knowledge of what the
dividend growth rate is going to be over time.

Another way to calculate the price of stock that does not depend on So, if you multiply the PE ratio by the earnings per share, you get the
predicting dividends in the future is the PE ratio. The PE ratio simply stock price
means the price, or current price of the share, relative to the earnings per
share the corporation is expected to generate (EEPS). Earnings simply a
corporation's net income divided by the number of shares outstanding.
per share are Mathematically, the PE ratio is The PE ratio is often easy to get; it is published on websites such as
Yahoo! Finance, WSJ.com, FT.com, CNNMoney, and many others. What
does the PE ratio tell you? As it turns out, this can be a complicated
question to answer.
PE (Price/earnings) Ratio PE (Price/earnings) Ratio
If the PE ratio for a given share is higher than the PE ratio of "similar" On the other hand, if the PE ratio of a given firm is lower than the PE ratio
firms, then you might think these shares are expensive and may not want of "similar" firms, then you might think its shares are cheap or a bargain.
to buy them. On the other hand, a high PE ratio might mean the market Or, a low PE ratio might mean the market thinks this firm's earnings are
thinks this firm's earnings are going to increase in the future. That would going to decrease in the future. A low PE ratio might also mean that the
mean purchasing this stock now would be a good idea. Or it might mean market sees this firm as unstable or unreliable, and thus people are
that the market sees this firm as stable and reliable, and thus you have to dumping the shares at low price. So, is a low PE ratio a good thing or not?
pay a premium to buy the shares. Is that a positive or a negative? It The PE ratio shows us the importance of other stocks in helping to
depends on whether you want stability and are willing to pay for it. So, is a determine whether any given stock price is a "good deal." Next we turn
high PE ratio a good thing or not? It's not that simple! our attention to the stock market overall, looking at the prices of all of the
stocks in the market at once.
PE (Price/earnings) Ratio PE (Price/earnings) Ratio
FEATURES OF PREFERRED SHARES FEATURES OF PREFERRED SHARES
Par value Par value is the face value that appears on the stock certificate. In some cases, the Convertible Owners of convertible preferred share have the option of exchanging their preferred share
liquidation value per share is provided for in the certificate. preferred share for ordinary (common) equity share based on specified terms and conditions.
Dividends Dividends are stated as a percentage of the par value and are commonly fixed and paid Voting Rights Preferred share does not ordinarily carry voting rights. Special voting procedures may take
quarterly but are not guaranteed by the issuing firm. Some recent preferred share issues effect if the issuing firm omits its preferred dividends for a specific time period. Preferred
called adjustable rate, variable rate, or floating rate preferred, do not have a fixed dividend shareholders are then permitted to elect a certain number of members to the board of
rate but peg dividends to an underlying index such as one of the Treasury bill rate or other directors in order to represent the preferred shareholder' interests.
money market rates.
Participating Participating preferred share entitles its holders to share in profits above and beyond the
Cumulative and Dividends payable to preferred shares are either cumulative or noncumulative; most are features declared dividend, along with ordinary (common) equity shareholders. Most preferred share
Noncumulative cumulative. If preferred dividends are cumulative are not paid in a particular year, they will issues are nonparticipating. Without non-participated preferred, the return is limited to the
dividends be carried forward as an arrearage. Usually, both accumulated (past) preferred dividends stipulated dividend.
and the current preferred dividends must be paid before the ordinary equity shareholders
receive anything. If the preferred dividends are noncumulative, dividends not declared in Maturity Three decades ago, most preferred share was perpetual - it had no maturity and never
any particular year are lost forever and the preferred shareholders cannot claim such needed to be paid off. However, today most new preferred share has a sinking fund and
anymore. thus an effective maturity date.
FEATURES OF PREFERRED SHARES
Protective Preferred share issues often contain covenants to assure the regular payment of preferred
features share dividends and to improve the quality of preferred share. For example, covenants may
restrict the amount of common share cash dividends, specify minimum working-capital
levels, and limit the sale of securities senior to preferred share.
Preferred shareholders have priority over ordinary (common) equity shareholders with
regard to earnings and assets. Thus, dividends must be paid on preferred share before
they can be paid on the ordinary (common) equity share, and in the event of bankruptcy,
the claims of the preferred shareholders must be satisfied before the ordinary (common) End of Discussion
equity shareholders receive anything. To reinforce these features, most preferred shares
have coverage requirements similar to those on bonds.
Prepare for Quiz #3
Call provision A call provision gives the issuing corporation the right to call in the preferred share for
redemption. As in the case of bonds, call provisions generally state that the company must
pay an amount greater than the par value of the preferred share, the additional sum being
termed a call premium. For example, Himaya Corporation's 12 percent, P100 par value
preferred share, issued in 2005, is noncallable for 10 year, but it may be called at a price of
P112 after 2015.
Mortgage Markets
Financial Markets Derivatives
Prepared by: Ms. Ida Prepared by: Ms. Ida
From one perspective, the mortgage

markets form a subcategory of the First, the usual borrowers in the
What are capital markets because mortgages What are capital markets are businesses and
MORTGAGE involve long-term funds. But the MORTGAGE government entities, whereas the
mortgage markets differ from the usual borrowers in the mortgage
MARKETS? MARKETS?
stock and bond markets in a number markets are individuals.
of ways.
Second, mortgage loans are made Mortgages are long-term loan
What are for varying amounts and maturities, What are secured by real estate. Both
MORTGAGE depending on the borrowers' needs, MORTGAGES? individuals and businesses obtain
features that cause problems for mortgages loans to finance real
MARKETS?
developing a secondary market. estate purchases.
A developer may obtain a mortgage CHARACTERISTICS OF THE

loan to finance the construction of RESIDENTIAL MORTGAGE
an office building, or a family may
The modern mortgage lender has continued to refine the
obtain a mortgage loan to finance
What are long-term loan to make it more desirable to borrowers.
the purchase of a home. In both Even in the past 20 years, both the nature of the lenders
MORTGAGES? cases, the loan is amortized. The and the instruments have undergone substantial changes.
borrower pays it off over time in One of the biggest changes is the development of an active
some combination of principal and secondary market for mortgage contracts.
interest payments that result in full
payment of the debt by maturity.
CHARACTERISTICS OF THE A. Mortgage Interest Rates

RESIDENTIAL MORTGAGE One of the most important factors in the decision of the borrower of how
much and from whom to borrow is the interest rate on the loan.
The mortgage market has become very competitive in
recent years. Twenty years ago, savings and loan There are three important factors that affect the interest rate on the loan.
institutions and the mortgage departments of large banks These are:
originated most mortgage loans. Currently, there are many 1) Current long-term market rates
Long-term market rates are determined by the supply of and demand
loan production offices that compete in real estate
for long-term funds, which are in turn affected by a number of global,
financing. Some of these offices are subsidiaries of banks, national, and regional factors. Mortgage rates tend to stay above the
and others are independently owned. As a result of the less risky treasury bonds most of the time but tend to track along with
competition for mortgage loans, borrowers can choose them.
from a variety of terms and options.
A. Mortgage Interest Rates A. Mortgage Interest Rates
One of the most important factors in the decision of the borrower of how One of the most important factors in the decision of the borrower of how
much and from whom to borrow is the interest rate on the loan. much and from whom to borrow is the interest rate on the loan.
There are three important factors that affect the interest rate on the loan. There are three important factors that affect the interest rate on the loan.
These are: These are:
2) Term of Life of the mortgage 3) Number of Discount Points Paid
Generally, longer-term mortgages have higher interest rates than Discount points (or simply points) are interest payments made at the
short-term mortgages. The usual mortgage lifetime is 15 or 30 years. beginning of a loan. A loan with one discount point means that the
Because interest rate risk falls as the term to maturity decreases, the borrower pays 1% of the loan amount at closing, the moment when
interest rate on the 15-year loan will be substantially less than on the the borrower signs the loan paper and receives the proceeds of the
30-year loan. loan. In exchange for the points, the lender reduces the interest rate
on the loan.
A. Mortgage Interest Rates A. Mortgage Interest Rates

One of the most important factors in the decision of the borrower of how One of the most important factors in the decision of the borrower of how
much and from whom to borrow is the interest rate on the loan. much and from whom to borrow is the interest rate on the loan.
There are three important factors that affect the interest rate on the loan. There are three important factors that affect the interest rate on the loan.
These are: These are:
3) Number of Discount Points Paid 3) Number of Discount Points Paid
In considering whether to pay points, borrowers must determine Typically, discount points should not be paid if the borrower will pay off
whether the reduced interest rate over the life of the loan fully the loan in five years or less. This breakeven point is not surprising
compensates for the increased up-front expense. To make this since the average home sells every five years.
determination, borrowers must take into account how long they will
hold on to the loan.
B. Loan Terms C. Collateral

Mortgage loan contracts contain many legal and financial terms, most of One characteristic common to mortgage loans is the requirement that
which protect the lender from financial loss. collateral, usually the real estate being financed, be pledged as security.
D. Down Payment E. Private Mortgage Insurance (PMI)
To obtain a mortgage loan, the lender also requires the borrower to make Private Mortgage Insurance (PMI) is an insurance policy that guarantees
a down payment on the property, that is, to pay a portion of the purchase to make up any discrepancy between the value of the property and the
price. The balance of the purchase price is paid by the loan proceeds. loan amount, should a default occur. For example, if the balance on your
Down payments (like liens) are intended to make the borrower less likely loan was P120,000 at the time of default and the property was worth only
to default on the loan. A borrower who does not make a down payment P100,000, PMI would pay the lending institution P20,000. The default still
could walk away from the house and the loan and lose nothing. appears on the credit record of the borrower, but the lender avoids
Furthermore, if real estate prices drop even a small amount, the balance sustaining the loss. PMI is usually required on loans that have less than a
due on the loan will exceed the value of the collateral. The down payment 20% down payment. If the loan-to-value ratio falls because of payments
reduces moral hazard for the borrower. The amount of the down payment being made or because the value of the property increases, the borrower
depends on the type of mortgage loan. Many lenders require that the can request that the PMI requirement be dropped. PMI usually costs
borrower pay 5% of the purchase price; in other situations, up to 20% may between P200 and P300 per month for a P100,000 loan.
be required.
F. Borrower Qualification AMORTIZATION OF MORTGAGE LOAN

Before granting a mortgage loan, the lender will determine whether the Mortgage loan borrowers generally agree to pay a monthly amount of
borrower qualifies for it. Qualifying for a mortgage loan is different from principal and interest that will be fully amortized by its maturity. "Fully
qualifying for a bank loan because most lenders sell their mortgage loans amortized" means that the payments will pay off the outstanding
to one of a few government agencies in the secondary mortgage market. indebtedness by the time the loan matures.
These agencies establish very precise guidelines that must be followed
before they will accept the loan. If the lender gives a mortgage loan to a
borrower who does not fit these guidelines, the lender may not be able to
resell the loan. That ties up the lender's funds. Banks can be more flexible
with loans that be kept on the bank's own books.
AMORTIZATION OF MORTGAGE LOAN TYPES OF MORTGAGE LOANS

Figure 10-1 shows the amortization table of a 30-year, P130,000 loan at Conventional Mortgages
annual interest rate 8.5%.
These are originated by banks or other mortgage lenders but are not
guaranteed by government or government controlled entities. Most
Figure 10-1: Amortization of a 30-Year, P130,000 loan at 8.5%
lenders though now insure many conventional loans against default or
they require the borrower to obtain private mortgage insurance on loans.
Insured Mortgages
These mortgages are originated by banks or other mortgage lenders but
are guaranteed by either the government or government-controlled
entities.
TYPES OF MORTGAGE LOANS TYPES OF MORTGAGE LOANS
Fixed-rate Mortgages Graduated-Payment Mortgages (GPMs)
In fixed-rate mortgages, the interest rate and the monthly payment do not These mortgages are useful for home buyers who expect their incomes to
vary over the life of the mortgage. rise. The GPM has lower payments in the first few years, then the
payments rise. The early payment may not even be sufficient to cover the
Adjustable-Rate Mortgages (ARMs) interest due, in which case the principal balance increases. As time
passes, the borrower expects income to increase so that higher payment
The interest rate on adjustable-rate mortgage (ARMs) is tied to some
will not be too much of a burden.
market interest rate, (e.g., Treasury bill rate) and therefore changes over
time. ARMS usually have limits, called caps, on how high (or low) the
interest rate can move in one year and during the term of the loan.

Growing Equity Mortgage (GEMs) Equity Participating Mortgage (EPM)
With a GEM, the payments will initially be the same as on a conventional In EPM, an outside investor shares in the appreciation of the property.
mortgage. Over time, however, the payment will increase. This increase This investor will either provide a portion of the purchase price of the
will reduce the principal more quickly than the conventional payment property or supplement the monthly payment. In return, the investor
stream would. receives a portion of any appreciation of the property. As with the SAM,
the borrower benefits by being able to qualify for a larger loan than without
Shared Appreciation Mortgages (SAMs) such help.
In a SAM, the lender lowers the interest rate in the mortgage in exchange
for a share of any appreciation in the real estate (if the property sells for
more than a stated amount, the lender is entitled to a portion of the gain).

Reverse Annuity Mortgages (RAMs) Figure 10-2: Summary of Mortgage Types
In a RAM, the bank advances funds to the owner on a monthly schedule Conventional mortgage Loan is not guaranteed; usually requires private mortgage
to enable him to meet living expenses he thereby increasing the balance insurance; 5% to 20% down payment.
of the loan which in secured by the real estate. The borrower does not Insured mortgage Loan is guaranteed by FHA or VA; low or zero down payment
make payments against the loan and continues to live in his home. When Adjustable-rate mortgage (ARM) Interest rate is tied to some other security and is adjusted
the borrower dies, the estate sells the property to pay the debt. periodically; size of adjustment is subject to annual limits
Graduated-payment mortgage (GPM) Initial low payment increase each year; loan usually amortized in
The various mortgages types are summarized in Figure 10-2. 30 years
Growing-equity mortgage (GEM) Initial payment increases each year; loan amortizes in less than
30 years
TYPES OF MORTGAGE LOANS MORTGAGE LENDING INSTITUTIONS
Figure 10-2: Summary of Mortgage Types The institution that provide mortgage loans to familiar and business and
their share in the mortgage market are as follows (as of 2018)
Shared-appreciation mortgage (SAM) In exchange for providing a low interest rate, the lender shares in
any appreciation in value of the real estate
Mortgage tools and trust 49%
Equity participation mortgage In exchange for paying a portion of the down payment or for
Commercial banks 24%
supplementing the monthly payments, an outside investor shares
in any appreciation in value of the real estate Government agencies and other 15%
Second mortgage Loan is secured by a second lien against the real estate; often Life insurance companies 9%
used for line of credit or home improvement loans
Savings and loans associates 9%
Reverse annuity mortgage Lender disburses a monthly payment to the borrower on a
increasing-balance loan; loan comes due when the real estate is
sold
MORTGAGE LENDING INSTITUTIONS SECURITIZATION OF MORTGAGES

Many of the institutions making mortgage loans do not want to hold large Intermediaries face several problems when trying to sell mortgages to the
portfolios of long-term securities. Commercial loans, thrifts and most other secondary market; that is lenders selling the loans to another investor.
loan organization do make money through the fees that they earn for These problems are
packaging loans for other investors to hold. Loans organization fees are
typically 1% of the loan amount, through this varies with the market. A. Mortgages are usually too small to be wholesale instruments
B. Mortgages are not standardized. They have different terms to
maturity, interest rates and contract terms. Thus it is difficult to
bundle a large number of mortgages together and
C. Mortgage loans are relatively costly to service. The lenders must
collect monthly payments, often advances payment of property
taxes and insurance premiums and service reserve accounts
SECURITIZATION OF MORTGAGES HOW IT WORKS

Intermediaries face several problems when trying to sell mortgages to the Investors may buy derivatives in order to reduce the amount of volatility in
secondary market; that is lenders selling the loans to another investor. their portfolios, since they can agree on a price for a deal in the present
These problems are that will, in effect, happen in the future, or to try to increase their gains
through speculation. Derivatives can enable an investor to gain exposure
D. Mortgages have unknown default risk. Investors in mortgages do to a market via a smaller outlay than if they bought the actual underlying
not want to spend a lot of time and effort in evaluating the credit of asset. The most common are futures and options - leveraged products in
borrowers. which the investor puts down a small proportion of the value of the
underlying asset and hopes to gain by a future rise in the value of that
These problems inspired the creation of mortgaged-backed security asset.
HOW IT WORKS HOW IT WORKS
Derivatives for hedging Derivatives for hedging
Companies use derivatives to protect against cost fluctuations by fixing a To protect itself from potential future price increase, it can buy fuel at
price for a future deal in advance. By settling costs in this way, buyers today’s price for delivery and payment of a future date. This is known as a
gain protection - known as a hedge - against unexpected rises or falls in, forward transaction. The financial instrument is called a futures contract. If
for example, the foreign exchange market rates, or the value of the the price of fuel then falls instead of rising, the company will be locked in
commodity or product they are buying, to paying a higher price.
For example: A Philippine-based airline company reviews its fuel stock

levels and decides that it will need to buy jet fuel for its fleet of planes in
three month’s time.

Derivatives for speculation Derivatives for speculation
Investors may buy or sell an asset in the hope of generating a profit from If share prices do rise, the investor can profit by buying at a fixed option
the asset’s price fluctuations. Usually this is done on a short-term basis in price and selling at the current higher price.
assets that are liquid or easily traded. If share prices fall, the investor can sell the option or let it lapse, losing a
fraction of the value of the asset itself.
For example: An investor notices a company’s share price is going up and
buys an option on the share. An option gives a right to the holder to buy
shares at a future date.

Typical Examples of Derivatives Typical Examples of Derivatives
The most frequently used derivatives are (1)futures contracts, (2)forward The most frequently used derivatives are (1)futures contracts, (2)forward
contracts, (3)options, (4)foreign currency futures & (5)interest rate swaps. contracts, (3)options, (4)foreign currency futures & (5)interest rate swaps.
1) Futures contracts 1) Futures contracts

A futures contract is an agreement between a seller and a buyer that When the “commodity” is a financial instrument such as a Treasury bill
requires that seller to deliver a particular commodity (say corn, gold, or commercial paper, the agreement is referred to as a financial
or soy beans) at a designated future date, at a predetermined price. futures contract. Futures contracts are purchased either as an
These contracts are actively treated on regulated future exchanges investment or as a hedge against the risks of future price changes.
and are generally referred to as “commodity futures contract.”
2) Forward contracts 2) Forward contracts

A forward contract is similar to a futures contract but differs in three B. Unlike a futures contract, forward usually is not traded on a
ways: market exchange.
A. A forward contract calls for delivery on a specific date, whereas a C. Unlike a futures contract, a forward contract does not call for a
futures contract permits the seller to decide later which specific daily cash settlement for price changes in the underlying contract.
day within the specified month will be the delivery date (if it gets Gains and losses on forward contracts are paid only when they
fas as actual delivery before it is closed out). are closed out.

The most frequently used derivatives are futures contracts, forward The most frequently used derivatives are (1)futures contracts, (2)forward
contracts, options, foreign currency futures and interest rate swaps. contracts, (3)options, (4)foreign currency futures & (5)interest rate swaps.
3) Options 3) Options
Options give its holder the right either to buy or sell an instrument, say On the other hand, the holder of a futures contract must buy or sell
a Treasury bill, at a specified price and within a given time period. within a specified period unless the contract is closed out before
Options frequently are purchased to hedge exposure to the effects of delivery comes due.
changing interest rates. Options serve the same purpose as futures in
that respect but are fundamentally different. Importantly, though, the
option holder has no obligation to exercise the option.

The most frequently used derivatives are (1)futures contracts, (2)forward TThe most frequently used derivatives are (1)futures contracts, (2)forward
4) Foreign Currency Futures 4) Foreign Currency Futures

Foreign loans frequently are denominated in the currency of the To hedge against ‘foreign exchange risk’ exposure, some firm buy or
lender (Japanese yen, Swiss franc, German mark, and so on). When sell foreign currency futures contract. These are similar to financial
loans must be repaid in foreign currencies, a new element of risk is futures except specific foreign currencies are specified in the futures
introduced. This is because if exchange rates change, the peso contracts rather than specific debt instruments. They work the same
equivalent of the foreign currency that must be repaid differs from the way to protect against foreign exchange risk as financial futures
peso equivalent of the foreign currency borrowed. protect against fair value or cash flow risk.
5) Interest rate swaps 5) Interest rate swaps

There are contracts to exchange cash flows as of a specified date or a For example, suppose you owe P100,000 on a 10% fixed rate home
series of specified dates based on notional amount and fixed and loan. You envy your neighbor who is also paying 10% on her
floating rates. P100,000 mortgage, but hers is a floating rate loan, so if market rates
fall, so will her loan rate. To the contrary, she is envious of your fixed
Over 70% of derivatives are interest rate swaps. These contracts rate, fearful that rates will rise, increasing her payments. A solution
exchanged fixed interest payments for floating rate payments, or vice would be for the two of you to effectively swap interest payments
versa, without exchanging the underlying principal amounts. using an interest rate swap agreement.


The way a swap works, you both would continue to actually make In other words, you have effectively converted your fixed rate debt to
your own interest payments, but would exchange the net cash floating rate debt; your neighbor has done the opposite.
difference between payments at specified intervals. So, in this case, if
market rates (and thus floating payments) increase, you would pay Examples of financial instruments that meet the characteristics of a
your neighbor; if rates fall, she pays you. The net effect is to exchange derivative together with the underlying variable affecting its value are
the consequences of rate exchanges. as follows:


Types of Contract Underlying Variable (main Types of Contract Underlying Variable (main
pricing-settlement variable) pricing-settlement variable)
Commodity swap Commodity price Currency swap (FOREX swap) Commodity price
Commodity futures Commodity price Currency futures Commodity price
Commodity forward Commodity price Currency forward Commodity price


Credit swap Credit rating, credit index, or credit price Interest rate swap Interest rates
Equity swap (equity of another firm) Equity prices Interest rate future linked to government Interest rates
debt (Treasury futures)
Equity forward Equity price (equity of another firm)
Interest rate forward Interest rates


Purchased or written Treasury bond option Interest rates Purchased or written stock option Equity price (equity of another firm)
(call or put)
Total return swap Total fair value of the reference asset and
Purchased or written currency option Currency rates interest rate
Purchased or written commodity option Commodity price
ILLUSTRATIVE CASES ON DERIVATIVES ILLUSTRATIVE CASES ON DERIVATIVES
Example 1: Forward Contract Example 1: Forward Contract
Assume that a company like XYZ believes that the price of ABC shares will What is the benefit of this derivative contract?
increase substantially in the next three months. Unfortunately, it does not
have the cash resources to purchase the shares today. XYZ therefore XYZ can buy ABC shares today and take delivery in three months. If the
enters into a contract with a broker for delivery of 10,000 ABC shares in price goes up, it expects XYZ profits. If the price goes down, XYZ loses.
three months at a price of P110/share.
XYZ has entered into a forward contract a type of derivative. As a result of

the contract, XYZ has received the right to receive 10,000 ABC shares in
three months. Further, it has an obligation to pay P110/share at that time.
Example 2: Call Option Example 2: Call Option
A contract or call option allows the holder to call (purchase) at any time in The holder can acquire the call contract at a considerably lower cost than
the next 12 months 10,000 shares of ABC share at a price of P50/share. If that of actually buying the 10,000 shares at P50/share. Holding the call
the call is exercised, it can be settled by payment by the contract issuer to option contract has the same response to market price changes as does
the contract holder of an amount equal to 10,000 times the difference holding the individual shares themselves.
between the market price of ABC share on the call date and strike price of
P50. Assume that ABC is a publicly traded company with a current market This contract need not require the actual transfer of shares upon the
price of P50. The underlying is the share price of ABC share, as the price contract being exercised. The issuer of the contract can settle with payment
of this contract will depend on this underlying variable. The notional amount of cash in an amount equal to the net gain of the holder.
is the 10,000 shares that can be called.
Example 3: Put Option Example 3: Put Option
Sampaguita Inc. acquired 1,000 shares of Sunflower Company on January Sampaguita, however, does not want to be exposed to possible declines in
2, 2014 at a cost of P50/shr. The company does not plan to sell the shares the fair value of the investment. Therefore, it acquires a put option to sell
until mid-2015 at the earliest and therefore classifies this investment as the 1,000 shares at a price of P50/shr on June 30, 2015. The cost of the
financial asset at fair value/OCI. put option contract is zero (or minimal). Sampaguita designates the put
contract as a fair value hedging contract for the investment in Sunflower
Company.
Solution 1 Solution 1
Assume that on December 31, 2014, Sunflower Co. common stock is PAS 39 would require that Sampaguita include the following in its income
trading at P35/shr. Suppose further that the fair value of the option contract statement:
has increased to P15,000. [This change is due to the decline in the fair ● The unrealized loss on the investment of P15,000 (equal to the decline
value of the underlying asset (P50-P35 times 1,000 shares)]. Under these in fair value per share of P15 times the 1,00 shares).
circumstances, PAS 39 would require that Sampaguita include the following ● The portion of the unrealized gain on the derivative financial
in its income statement: instruments that relates to the hedging activity of P15,000
In this particular case, the hedge is fully effective, and the gain on the
hedging instrument exactly offsets the loss on the hedged item.
Solution 2 Solution 2
Suppose instead that the fair value of the put option at December 1, 2014, If this investment were not hedged, the entire unrealized loss of P15,000
is only P10,000. (There are number of reasons why this might be the case.) would be included only in comprehensive income and reported as a
separate component of shareholders’ equity as an accumulated unrealized
In this case, the hedge is not fully effective, and the ineffective portions of lost from investments in securities available for sale.
the hedge are included in net income because the unrealized loss of
P15,000 is only partially offset by the unrealized gain of P10,000. The net
effect would be to report a loss of P5,000 related to this hedge. End
Financial Markets FOREX Markets

Prepared by: Ms. Ida Prepared by: Ms. Ida
INTRODUCTION INTRODUCTION
The trading of currency and bank deposits denominated in Firms that do business internationally must be concerned
particular currencies takes place in the foreign exchange with exchange rates, which are the relationships among the
market. The volume of these transactions worldwide values of currencies. For example, a Philippine firm selling
averages over P1 trillion daily. Transactions conducted in products in Europe will be very interested in the
the foreign exchange market determine the rates at which relationship of the Euro to the Philippine peso as well as
currencies are exchanged, which in turn determine the cost the US dollar.
of purchasing foreign goods and financial assets.
INTRODUCTION Recent Historical Perspective of Exchange Rates
The constant change in exchange rates causes problems From the end of World War II until the early 70's, the world was on
a fixed exchange rate system administered by the International
for financial managers as the change in relative purchasing
Monetary Fund (IMF), Under this system, all countries were
power between countries affects imports and exports, required to set a specific parity rate for their currency vis-a-vis the
interest rates and other economic variables. The relative United States dollar. A country could affect a major adjustment in
strength of a particular currency to other currencies the exchange rate by changing the parity rate with respect to the
changes many times over a business cycle. dollar. Then the currency was made cheaper with respect to the
dollar, this adjustment was called a devaluation. An upvaluation or
revaluation resulted when a currency became more expensive with
respect to the dollar.
Recent Historical Perspective of Exchange Rates The forex market provides a service
to individuals, businesses, and
A floating rate international currency system has been operating since
1973. Most major currencies fluctuate freely* depending upon their values
What is the
governments who need to buy or
as perceived by the traders in foreign exchange markets. The
determination of exchange rates are influenced by such important factors
FOREIGN sell currencies other than that used
as (a) the country's economic strengths, (b) its level of exports and CURRENCY in their country. This might be in
imports, (c) the level of monetary activity, and (d) the deficits or surpluses
in its balance of payments. Short term, day-to-day fluctuations in EXCHANGE order to travel abroad, to make
exchange rates are caused by supply and demand conditions in the investments in another country, or
foreign exchange market. MARKET?
to pay for import products or
convert export earnings.
It is also a marketplace in which

What is the What is the
currencies are bought and sold The forex market is open 24 hours,
FOREIGN purely to make profit via FOREIGN 5 days a week, which makes it
CURRENCY speculation. When trading very CURRENCY unusual, as equity markets have set
EXCHANGE large volumes of currency, even EXCHANGE daily trading hours and are closed
small fluctuations in price can overnight.
MARKET? MARKET?
provide profits or losses.
The foreign exchange (or forex)
Currency trading entails no specific
What is the market provides a mechanism for What is the
physical location; instead, it is an
FOREIGN the transfer of purchasing power FOREIGN over-the-counter market whose
CURRENCY from one currency to another. This CURRENCY main participants are commercial
is where traders convert one foreign
EXCHANGE currency into another and is one of EXCHANGE and investment banks, and foreign
exchange dealers and brokers
MARKET? the largest financial markets in the MARKET?
around the world.
world.
They communicate using electronic

networks. Any firm's bank or Since this market provides
What is the experts within the firm, can access What is the transactions in a continuous manner
this market to exchange one
FOREIGN currency for another.
FOREIGN for a very large volume of sales and
CURRENCY CURRENCY purchase, the currencies are
Some important commercial centers EXCHANGE efficiently priced; or the ‘market is
EXCHANGE efficient.’ In short, it is difficult to
for foreign exchange trading are
MARKET? New York, London, Zurich, MARKET? make a profit by shopping around
Frankfurt, Hong Kong, Singapore from one bank to another.
and Tokyo.
An exchange rate is simply the price

Minute differences in the quotes of one country's currency expressed
What is the from different bank are quickly in terms of another country's
FOREIGN arbitraged away. The concept of What are currency. In practice, almost all
CURRENCY arbitrage will be discussed later. trading of currencies takes place in
Owing to the arbitrage mechanism, EXCHANGE terms of the U.S. dollar. For
EXCHANGE simultaneous quotes to different RATES? example, both the Euros, the Swiss
MARKET? buyers in London and New York are franc, and the Japanese yen are
likely to be the same. traded with prices quoted in U.S.
dollar.
When a country's currency
appreciates (rises in value relative
Exchange rates are important to other currencies), the country's
because they affect the relative goods abroad become more
Why are price of domestic and foreign Why are expensive and foreign goods in that
EXCHANGE goods. The dollar price of French EXCHANGE country become cheaper (holding
RATES goods to an American is determined RATES domestic prices constant in the two
by the interaction of two factors: the countries). Conversely, when a
important? price of French goods in euros and
important? country's currency depreciates, its
the euro / dollar exchange rate. goods abroad become cheaper and
foreign goods in that country
become more expensive.
When a country's currency

appreciates (rises in value relative
Why are Why are Conversely, when a country's
to other currencies), the country's
currency depreciates, its goods
EXCHANGE goods abroad become more EXCHANGE abroad become cheaper and foreign
RATES expensive and foreign goods in that RATES goods in that country become more
country become cheaper (holding
important? domestic prices constant in the two
important? expensive.
countries).
FACTORS INFLUENCING EXCHANGE RATES
Appreciation of a currency can As with any other market, the exchange rate between two
Why are make it harder for domestic currencies is determined by the supply of the demand for
those currencies. The present international monetary system
EXCHANGE manufacturers to sell their goods
consists of a mixture of "freely" floating exchange rates and
RATES abroad and can increase competition fixed rates. The currencies of the major trading partners of the
at home from foreign goods because United States are traded in free markets. This activity,
important? they cost less. however, is subject to intervention by many countries' central
banks. Factors that tend to increase the supply or decrease
the demand schedule for a given currency will bring down the
value of that currency in foreign exchange markets.
FACTORS INFLUENCING EXCHANGE RATES FACTORS INFLUENCING EXCHANGE RATES
Similarly, the factors that tend to decrease the supply, or The major reasons for exchange rate movements which
increase the demand for a currency will raise the value of include inflation, interest rates, balance of payments,
that currency. Since fluctuations in currency values result in government's policies or intervention and so forth are
foreign exchange risk, the financial manager must understand discussed briefly in the following sections.
the factors causing these changes in currency values.
Although, the value of a currency is determined by the 1. Inflation. Inflation tends to deflate the value of a currency
aggregate supply and demand for that currency, this alone because holding the currency results in reduced
does not help financial managers understand or predict the purchasing power.
changes in exchange rates.
FACTORS INFLUENCING EXCHANGE RATES FACTORS INFLUENCING EXCHANGE RATES
2. Interest rates. If interest returns in a particular country are 3. Balance of payments. For instance, if Philippines is a net
higher relative to other countries, individuals and exporter of goods and therefore has a surplus balance of
companies will be enticed to invest in that country. As a trade, countries purchasing the goods must use the
result, there will be an increased demand for the country's country's currency. This increases the demand for the
currency. currency and its relative value.
3. Balance of payments. Balance of payments is used to 4. Government intervention. Through intervention (e.g.,
refer to a system of accounts that catalogs the flow of buying or selling the currency in the foreign exchange
goods between the residents of two countries. markets), the central bank of a country may support or
depress the value of its currency.
FACTORS INFLUENCING EXCHANGE RATES HOW IS FOREIGN EXCHANGE TRADED
5. Other factors. Other factors that may affect exchange You cannot go to a centralized location to watch exchange
rates are political and economic stability, extended stock rates being determined; currencies are not traded on
market rallies and significant declines in the demand for exchanges such as the New York Stock Exchange. Instead,
major exports. the foreign exchange market is organized as an over-the-
counter market in which several hundred dealers (mostly
banks) stand ready to buy and sell deposits denominated in
foreign currencies. Because these dealers are in constant
telephone and computer contact, the market competitive; in
effect it functions no differently from a centralized market.
HOW IS FOREIGN EXCHANGE TRADED INTERACTION IN FOREIGN CURRENCY MARKETS
An important point to note is that while banks, companies, and Exchange Rate Determination
governments talk about buying and selling currencies in
foreign exchange markets, they do not take a fistful of dollar Equilibrium exchange rate in floating markets are determined
bills and sell them for British pound notes. Rather, most by the supply of and demand for the currencies.
trades involve the buying and selling of bank deposits The equilibrium rate of Pe will
denominated in different currencies. So when we say that a prevail in the market. No
bank is buying dollars in the foreign exchange market, what surplus (or deﬁcit) occurs at
Pe.
we actually mean is that the bank is buying deposits
denominated in dollars.
INTERACTION IN FOREIGN CURRENCY MARKETS INTERACTION IN FOREIGN CURRENCY MARKETS
Fixed Exchange Rate Fixed Exchange Rate

An exchange rate set too high (in foreign currency units per A major reason for a country's devaluation is to improve its
peso) tends to create a deficit Philippine balance of payments. balance of payments. As an alternative to drawing down its
This deficit must be financed by drawing down foreign reserves, a country might change its trade policies or
reserves or by borrowing from the central banks of the implement exchange controls or exchange rationing. Many
foreign countries. This effect is short-term because at some developing countries use currency exchange rationing
time, the country will deplete its foreign reserves. to avoid a deficit balance of payments.
Fixed Exchange Rate Fixed Exchange Rate

An exchange rate set too low (in foreign currency units per
peso) tends to create a surplus Philippine balance of
payments. In this case, surplus reserves build up. At some
time, the country will not want any greater reserve balances
and will have to raise the value of its currency.
Fixed Exchange Rate Manage Float

An exchange rate A (PA foreign currency units per peso), a A managed float is the current method of exchange rate
greater quantity of peso is supplied by Philippine interests than determination. During periods of extreme fluctuation in the
demanded by foreign interests (i.e., Philippine imports exceed value of a nation’s currency, intervention by governments or
exports). The result is a trade deficit. An exchange rate B, a central banks may occur to maintain fairly stable exchange
smaller quantity of peso is supplied by Philippine interests than rates.
demanded by foreign interests (i.e., Philippine exports exceed
imports). The result is a trade surplus.
Manage Float THEORY OF PURCHASING POWER PARITY

Floating rates permit adjustments to eliminate balance of One of the most prominent theories of how exchange rates are
payments deficits or surpluses. For example, if the Philippine determined is the theory of purchasing power parity (PPP). It
has a deficit in its trade with Japan, the Philippine peso will states that exchange rates between any two currencies will
depreciate relative to Japan's currency. This adjustment adjust to reflect changes in the price levels of the two
should decrease imports from and increase exports to Japan. countries. The theory of PPP is simply an application of the
law of one price to national price levels.
THEORY OF PURCHASING POWER PARITY THEORY OF PURCHASING POWER PARITY

To illustrate, if the law of one price holds, a 10% rise in the yen price of The PPP conclusion that exchange rates are determined
Japanese steel results in a 10% appreciation of the dollar. Applying the solely by changes in relative price levels rests on the
law of one price to the price levels in the two countries produces the assumption that all goods are identical in both countries. When
theory of purchasing power parity, which maintains that is the Japanese
price level rises 10% relative to the U.S. price level, the dollar will
this assumption is true, the law of one price states that the
appreciate by 10%. The theory of PPP suggests that if one country's relative prices of all these goods (that is, relative price level
price level rises relative to another's, its currency should depreciate (the between the two countries) will determine the exchange rate.
other country's currency should appreciate).
INTERACTION IN FOREIGN CURRENCY MARKETS WHAT ARE THE FOREIGN CURRENCY EXCHANGE
RATE TRANSACTIONS?
THEORY OF PURCHASING POWER PARITY
PPP theory furthermore does not take into account that many The two kind of Foreign Exchange Rate Transactions are:
goods and services (whose prices are included in a measure A. Spot Transactions
of a country's price level) are not traded across borders. B. Forward Transactions
Housing, land, and services such as restaurant meals,
haircuts, and golf lessons are not traded goods. So even
though the prices of these items might rise and lead to a
higher price level relative to another country's, there would be
little direct effect on the exchange rate.
WHAT ARE THE FOREIGN CURRENCY EXCHANGE WHAT ARE THE FOREIGN CURRENCY EXCHANGE
RATE TRANSACTIONS? RATE TRANSACTIONS?
The two kind of Foreign Exchange Rate Transactions are: The two kind of Foreign Exchange Rate Transactions are:
A. Spot Transactions A. Spot Transactions
● Spot transactions are those which involve immediate B. Forward Transactions
(two-day) exchange of bank deposits. The spot ● Forward transactions involve the exchange of bank
exchange rate is the exchange rate for the spot deposits at some specified future date. The forward
transactions. exchange rate is the exchange rate for the forward
B. Forward Transactions transaction
If we are exchanging one currency

for another immediately, we
The price of the foreign currency in
participate in a spot transaction. A
terms of the domestic currency is
SPOT typical spot transaction may involve SPOT the exchange rate in this instance,
a Philippine firm buying foreign
EXCHANGE currency from its bank and paying EXCHANGE the Philippine peso. Another case of
RATES RATES a spot transaction is when a
for it in Philippine pesos (or an
Philippine firm receives foreign
American firm buying currency
currency from abroad.
from its bank and paying for it in
US dollar).
The spot rate for a currency is the
The firm would typically sell the exchange rate at which the currency
foreign currency to its bank is traded for immediate delivery.
SPOT Philippine peso. These are both spot SPOT For example, if you walk into a local commercial
transactions, where one currency is bank, ask for US dollars. The banker will indicate
EXCHANGE exchanged for another currency EXCHANGE the rate at which the US dollar is selling, say
RATES immediately. The actual exchange RATES If you like the rate,
P52.60 per US$1.
rate quotes are expressed in several you buy what you need and walk
ways, as explained below. out the door. This is a spot market
transaction at the retail level.
The table above shows that in order

In the spot exchange market, the
to by one US dollar on August 27,
quoted exchange rate is typically
2019, P52.326 were needed. In
DIRECT called a direct quote. A direct quote DIRECT order to buy one Japanese yen and
indicates the number of units of the
AND AND one UK pound on the same date,
home currency required to buy one
INDIRECT INDIRECT P.4931 and P63.9424 were needed,
unit of the foreign currency. Figure
respectively. The quotes in the spot
QUOTES 1 shows the spot rates and the direct QUOTES
market in New York are given in
exchange quotes the Philippine
terms of US dollars and those in
Daily Inquirer on August 27, 2019.
European Union in terms of Euros.
An indirect quote indicates the ILLUSTRATIVE CASE

number of units of foreign currency
that can be bought for one unit of Compute the indirect quotes from the philippine direct quotes
DIRECT the home currency. In summary, a of spot rates for US dollars, UK pound, and Japanese yen as
AND of August 27, 2019 given in Figure 1. The related indirect
direct quote is the peso/ foreign
quotes are computed as follows:
INDIRECT currency rate, and an indirect quote
is the foreign currency / peso rate.
QUOTES
Therefore, an indirect quote is the
reciprocal of a direct quote and vice
versa.
ILLUSTRATIVE CASE ILLUSTRATIVE CASE
The direct and indirect quotes are useful in computing foreign The direct and indirect quotes are useful in computing foreign
currency requirements. Consider the following examples: currency requirements. Consider the following examples:
A. A Filipino businessman wanted to remit 1,000 UK pounds B. A Filipino businessman paid P112,148.20 to an Italian
to London on August 27, 2019. How much in pesos would supplier on August 27, 2019. How many euros did the
have been required for this transaction? Italian supplier receive?
P63.9424/pounds x 1,000 pounds = P63,942.40 P112,148.20 x 0.1721 = 1,930.07 euros
For instance:
Also important in understanding the
spot-rate mechanism is the cross
CROSS rate. A cross rate is the indirect CROSS The peso/pound and the euro/peso
rates are given in Figure 1. From
RATES computation of the exchange rate of RATES
one currency from the exchange this information, we could
rates of two other currencies. determine the euro/pound and
pound/euro exchange rates rates.
We see that: Cross rate computations make in

possible to use quotations in New York
P63.9424 = 1 pound to compute, the exchange rate between
pounds, euros and so forth in other
P58.1028 = 1 euro foreign currency exchange markets. If
CROSS P63.9424 / P58.1028 = 1.1005 euro CROSS the rates prevailing in London and
RATES per pound RATES Paris were different from the computed
cross rates, using quotes from New
York, a trader could use three different
Thus, the pound/euro exchange rate markets and make arbitrage profits.
is: P58.1028/P63.9424 = 0.98697 The arbitrage condition for the cross
pound per 1 euro rates is called triangular arbitrage.
Since the foreign exchange markets
The foreign exchange quotes in two are efficient, the direct quotes for
different countries must be in line the United States dollar in London,
ARBITRAGE with each other. For example, the ARBITRAGE on April 25, 2019, must be very
direct quote for U.S. dollars in close to the indirect rate of .6691
London is given in dollars/pound. pound/dollar prevailing in New
York on that date.
Such a buy-and-sell strategy would

If the exchange-rate quotations involve an investment of funds for a
between the London and New York very short time and no risk bearing,
spot exchange markets were out of yet the trader could make a sure
ARBITRAGE line, then an enterprising trader ARBITRAGE profit. Such a person is called an
could make a profit by buying in the arbitrageur, and the process of
market where the currency was buying and selling in more than one
cheaper and selling it in the dearer. market to make a riskless profit is
called an arbitrage.
Some people intentionally look for

Spot exchange markets are efficient exchange rate mispricings by
in the sense that arbitrage comparing direct quote exchange
opportunities do not persist for any rates between two currencies, with
ARBITRAGE length of time. That is, the exchange ARBITRAGE cross rates determined through a
rates between two different markets third currency. If direct quotes and
are quickly bought in line, aided by cross rates differ, arbitrage - a form
the arbitrage process. of buying low and selling high- is
possible.
The forward rate for a currency is
the exchange rate at which the
Because three exchange rates are currency for future delivery is
necessary to profit from a quoted. The trading of currencies
mispricing, this process is for future delivery is called a
FORWARD forward market transaction.
ARBITRAGE sometimes called triangular
Suppose Sta. Lucia Corporation
arbitrage and as previously RATES
expects to pay US$1.0 million to a
mentioned, the person doing it is US supplier 30 days from now. It is
called an arbitrageur. not certain however, what these
dollars will be worth in Philippine
pesos 30 days from today.
The forward exchange rate could be

To eliminate this uncertainty, Sta. slightly different from the spot rate
Lucia Corporation calls a bank and prevailing at that time. Since the
offers to buy US$1.0 million to a forward rate deals with a future
FORWARD FORWARD time, the expectations regarding the
US supplier 30 days from now. In
future value of that currency are
RATES their negotiation, the two parties RATES reflected in that forward rate.
may agree on an exchange rate of Forward rates may be greater than
P46 million to the bank and receives the current spot rate (premium) or
$1 million. less than the current spot rate
(discount).
The discount or premium is usually

expressed as an annualized Foreign currency dealers (usually
percentage deviation from the spot large commercial banks) and their
rate. customers (importers, exporters,
FORWARD FORWARD investors, multinational firms and
RATES Normally, the forward premium or RATES so forth) negotiate the exchange
discount is between 0.1 percent and rate, the length of the forward
5 percent. The spot and forward contract and the commission in a
transactions are said to occur in the mutually agreeable fashion.
over-the-counter market.
FACTORS THAT AFFECT EXCHANGE RATES IN
Although the length of a typical THE LONG RUN
forward contract may generally vary
between one month and six months, Our analysis indicates that relative price levels and additional
FORWARD factors affect the exchange rate. In the long run, there are four
contracts for longer maturities are
RATES not common. The dealers, however,
major factors: relative price levels, tariffs and quotas,
preferences for domestic versus foreign goods, and
may require higher returns for productivity.
longer contracts.
FACTORS THAT AFFECT EXCHANGE RATES IN FACTORS THAT AFFECT EXCHANGE RATES IN
THE LONG RUN THE LONG RUN
Relative Price Levels Trade Barriers
In the long run, a rise in a country's price level (relative to the Increasing trade barriers causes a country's currency to
foreign price level) causes its currency to depreciate, and a fall appreciate in the long run.
in the country's relative price level causes its currency to
appreciate.
FACTORS THAT AFFECT EXCHANGE RATES IN FACTORS THAT AFFECT EXCHANGE RATES IN
THE LONG RUN THE LONG RUN
Preferences for Domestic Versus Foreign Goods Productivity
Increased demand for a country's exports causes its currency In the long run, as a country becomes more productive relative
to appreciate in the long run; conversely, increased demand to other countries, its currency appreciates.
for imports causes the domestic currency to depreciate.
EXCHANGE RATES IN THE SHORT RUN EXCHANGE RATES IN THE SHORT RUN
The key to understanding the short-run behavior of exchange Earlier approaches to exchange rate determination
rates is to recognize that an exchange rate is the price of emphasized the role of import and export demand. The more
domestic bank deposits (those dominated in the domestic modern asset market approach used here does not emphasize
currency) in terms of foreign bank deposits (those the flows of purchases of exports and imports over short
denominated in the foreign currency). Because the exchange periods because these transactions are quite small relative to
rate is the price of one asset in terms of another, the natural the amount of domestic and foreign bank deposits at any given
way to investigate the short-run determination of exchange time. Thus, over short periods such as a year, decisions to
rates is through an asset market approach that relies heavily hold domestic or foreign assets play a much greater role in
on our analysis of the determinants of assets demand. exchange rate determination than the demand for exports and
imports does.
MANAGING FOREIGN EXCHANGE RISK MANAGING FOREIGN EXCHANGE RISK
Foreign exchange risk refers to the possibility of a drop in When the parties associated with a commercial transaction are
revenue or an increase in cost in an international transaction located in the same country, the transaction is denominated in
due to a change in foreign exchange rates. Importers, a single currency. International transactions inevitably involve
exporters, investors and multinational firms are all exposed to more than one currency (because the parties are residents of
this foreign exchange risk. different countries). Since most foreign currency values
fluctuate from time to time, the monetary value of an
international transaction measured in either the seller's
currency or the buyer's currency is likely to change when
payment is delayed.
MANAGING FOREIGN EXCHANGE RISK MANAGING FOREIGN EXCHANGE RISK
As a result, the seller may receive less revenue than expected These "freely" floating exchange rates expose multinational
or the buyer may have to pay more than the expected amount business firms to foreign exchange risk. To deal with this
for the merchandise. foreign currency exposure effectively, the financial manager
must understand foreign exchange rates and how they are
International business transactions are denominated in foreign determined. Foreign exchange rates are influenced by
currencies. The rate at which one currency unit is converted differences in inflation rates among countries, differences in
into another is called the exchange rate. In today's global interest rates, government policies and the expectations of the
monetary system, the exchange rates of major currencies participants in the foreign exchange markets.
are fluctuating rather freely.
AVOIDANCE OF EXCHANGE RATE RISK FOREIGN AVOIDANCE OF EXCHANGE RATE RISK FOREIGN
CURRENCY MARKETS CURRENCY MARKETS
The international financial manager can reduce the firm's The international financial manager can reduce the firm's
foreign currency exposure by hedging in the forward exchange foreign currency exposure by hedging in the forward exchange
markets, money markets and currency future markets. markets, money markets and currency future markets.
1. The firm may hedge its risk by purchasing or selling 1. Any gain or loss on the foreign payables or receivables
forward exchange contracts. A firm may buy or sell forward because of changes in exchange rates is offset by the loss
contracts to cover liabilities or receivables, respectively, or gain on the forward contract.
denominated in a foreign currency.
2. The firm may choose to minimize receivables and liabilities 3. A firm may attempt to achieve a net monetary debtor
denominated in foreign currencies. (creditor) position in countries with currencies expected to
3. Maintaining a monetary balance between receivables and depreciate (appreciate). Large multinational corporations
payables denominated in a particular foreign currency have established multinational netting centers as special
avoids a net receivable or net liability position in that departments to attempt to achieve balance between foreign
currency. Monetary items are those with fixed cash flows. receivables and payables. They also enter into foreign
currency futures contracts when necessary to achieve
balance.
4. Another means of managing exchange rate risk is by the 5. A firm may seek to minimize its exchange-rate risk by
use of trigger pricing. Under trigger pricing, foreign funds diversification. If it has transactions in both strong and
are supplied at an indexed price but with an option to weak currencies, the effects of changes in rates may he
convert to a future-based fixed price when a specified basis offsetting.
differential exists between the two prices. 6. A speculative forward contract does not hedge any
exposure to foreign currency fluctuations, it creates the
exposure.
End

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Financial How do

● Raising capital STRUCTURE OF FINANCIAL MARKETS

It is the buying and selling

THE FORCES OF CHANGE FOR FORMAL

When a business needs cash for a

Banks may also find that they have

The money markets are the

Arrayed around the central bankers

WHAT MONEY MARKETS DO

WHAT MONEY MARKETS DO WHAT MONEY MARKETS DO

WHAT MONEY MARKETS DO TYPES OF MONEY-MARKET INSTRUMENTS

TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS

COMMERCIAL PAPER COMMERCIAL PAPER

TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS

COMMERCIAL PAPER COMMERCIAL PAPER

COMMERCIAL PAPER COMMERCIAL PAPER

TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS

BANKER’S ACCEPTANCES BANKER’S ACCEPTANCES

TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS

BANKER’S ACCEPTANCES TREASURY BILLS

GOVERNMENT AGENCY NOTES LOCAL GOVERNMENT NOTES

TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS

LOCAL GOVERNMENT NOTES INTERBANK LOANS

TYPES OF MONEY-MARKET INSTRUMENTS TYPES OF MONEY-MARKET INSTRUMENTS

TIME DEPOSITS TIME DEPOSITS

TYPES OF MONEY-MARKET INSTRUMENTS

The most prevalent example of the

Other arrangements can be as follows:

Firm Commitment Underwriting of a Corporate Bond Issue

Other arrangements can be as follows: Other arrangements can be as follows:

2. Negotiated Sale 3. Best Efforts Underwriting Basis

1. Long-term debt is generally less expensive than

Disadvantages of using Bonds Disadvantages of using Bonds

1. Debt (other than income bonds) results in interest

Bond Features and Prices

Par value of bond: Php 1,000 What is the bond’s approximate

Credit Quality Risk

Credit Quality Risk TYPES OF BONDS

A. Unsecured Long-term Bonds A. Unsecured Long-term Bonds

TYPES OF BONDS TYPES OF BONDS

B. Secured Long-term Bonds B. Secured Long-term Bonds

TYPES OF BONDS TYPES OF BONDS

B. Secured Long-term Bonds B. Secured Long-term Bonds

B. Secured Long-term Bonds 1. Floating Rate or Variable Rate Bonds

OTHER TYPES OF BONDS OTHER TYPES OF BONDS

1. Floating Rate or Variable Rate Bonds 2. Junk or Low-Rated Bonds

OTHER TYPES OF BONDS OTHER TYPES OF BONDS

2. Junk or Low-Rated Bonds 3. Eurobonds

3. Eurobonds 4. Treasury Bonds

Bond markets refer to the financial It is a platform for companies and

At the same time, the government

CORPORATE BONDS CORPORATE BONDS

Characteristics of Corporate Bonds Characteristics of Corporate Bonds

Characteristics of Corporate Bonds Characteristics of Corporate Bonds

CORPORATE BONDS CORPORATE BONDS

Characteristics of Corporate Bonds Characteristics of Corporate Bonds

CORPORATE BONDS CORPORATE BONDS

Characteristics of Corporate Bonds Characteristics of Corporate Bonds

Characteristics of Corporate Bonds Characteristics of Corporate Bonds