Financial Market

Introduction

a. Overview of Financial Systems

Financial market is a subset of financial
economics

Financial Economics
- a branch of economics that markets in
which decisions are made under
uncertainty
Financial System
- a set of institutions, such as banks,
insurance companies, and stock
 exchanges that permit the exchange of - Purpose
funds. 1. Accommodate corporate finance
- a system of complex and closely linked needs of deficit units (Financial
institutions, agents, banks and others management)
which enable the transfer of money 2. Accommodate investment needs of
between investors and borrowers surplus units (Investment
- Examples: 1. Money 2. Financial management)
Instruments 3. Financial Market 4.
Financial Institutions 5. Financial Functions of Financial Market
Services.

Financial Instruments

- Is a contract that gives rise to a

financial asset of one entity and a
financial liability or equity instrument of
another entity
- Is a monetary contract between parties
that can be created, traded, and Financial Institutions / Financial
modified. intermediaries
- It generates resources or asset by
issuing debt securities or equity - Transfer the funds of financial
securities resources from the sources to
- Trade = buy & sell borrowers
- Represents a financial claim against an - Example: Banks
entity asset (debt securities) b. Overview of Financial Instruments
- Represents a financial claim against an 3 ways of Disposition
entity’s future earnings (equity 1. Buy
securities) 2. Sell
- Examples: bonds & stocks 3. Hold

Financial Markets Investment Class

- It is where financial instruments are - Is a group of investments that exhibit

traded similar characteristics
- Market in which financial asset - Also called Asset class
(securities) such as stocks & bonds can
2 Common Investment class
be purchased and sold.
- Avenue where buyer and seller meet 1. Equity Securities -> Part owner ->
- Provides avenue for financial Claim against future earnings
management Share of stocks -> represent part
- 2 participants in Financial Market ownership -> dividends
1. Surplus units – extra to give (savers Share of stocks -> hold -> dividends
& investors) (return)
2. Deficit units – spent more than they Share of stocks -> buy -> low/high
can receive (users & borrowers) Share of stocks -> sell -> gain/loss
 2. Debt Securities - Financial market where money market
Bonds -> fixed income instrument that instruments are traded
represents a loan made by a creditor. - Short-term debt securities
Bonds -> sell -> premium/discount - Have maturity of 1 year or less
Bonds -> buy -> premium/discount - Examples: Treasury bills, Commercial
c. Overview of Financial Markets paper, Negotiable Certificate of Deposit
Types of Financial Markets
- Primary Capital Market
- Secondary
- Capital Market instruments are traded
- Money
- Long term DEBT & EQUITY
- Capital
instruments
- Derivative - Raise fund for the purchase of capital
- Exchange assets
- OTC - Examples: bonds stocks, and
Primary Market Vs. Secondary Market mortgages (long-term debt created to
finance the purchase of real estate)
Primary Market
Derivative Vs. Exchange Vs. OTC Markets
- Financial Market where securities are
Derivative Market
INITIALLY issued
- Is a financial market in which new - Derivative are traded
issues of securities are sold to INITIAL - Financial instruments whose value is
buyers derived from the value of another
- New funds are raised financial instrument or asset
- Initial Public Offering (IPO) - Example: Convertible bond
- First hand offering by underwriter
- Participants: Issuer & Investors Exchanges

Secondary Market - Secondary markets in which buyer and

seller, including their agents & brokers,
- Financial market in which securities of securities meet in one CENTRAL
that have PREVIOUSLY been issued location to conduct traes
can be resold - ORGAZINED & REGULATED
- No new funds are raised - Example: Stock Exchange
- Trade with following investors
- Stock exchange OTC (Over-the-counter) Market
- Liquid securities = sold quickly for a fair - A DECENTRALIZED Market om which
price market participants trade stocks,
- Gives information on LIQUIDITY & commodities, currencies, or other
PRICING instrument directly between two parties
Money Market Vs. Capital Market & without a central exchange or broker.
- NOT ORGANIZED & LESS
Money Market REGULATED
 -Example: Foreign Exchange Market 5. Denomination intermediation – FI such as
(FOREX) mutual funds allow small investors to
d. Overview of Financial Institutions overcome constraints to buying assets
- Acts as intermediary imposed by large minimum denomination
size
Role of Financial institution

- Performs the essential function of

channeling funds from those with
surplus funds to those with shortage of
funds

Specific Roles

- They offer deposit account that can

accommodate the amount and liquidity
characteristics desired by most surplus
Financial Institutions provide services that benefit
units
the overall economy.
- They repackage funds received from
deposits to provide loans of the size 1. Money supply transmission – Depository
and maturity desired by deficit units financial institutions channel the effects of
- The accept the risks on loan provided monetary policies to the entire financial
- The have more expertise than system and economy
individual surplus units in evaluating the 2. Credit Allocation – FI are often viewed as a
credit worthiness if the deficit units major source of financing for deficit units
- They diversify their loans among 3. Intergenerational wealth transfer –
numerous deficit units and therefore Inheritance and pension payments. This
can absorb default loans better than service is particularly true for insurance
individual surplus units could. companies and pension funds
4. Payment services – The efficiency with
Unique Economic Function which depository institutions provide
payment services directly the economy.
1. Monitoring Costs – FI pool the resources of
e. Types and Risks of Financial Institutions
small savers, and because they
a. Depository
intermediate between savers and
1. Universal Banks- provide services
borrowers, they can collect info about
offered by both commercial banks
deficit unit at a relatively low cost.
as well as investment banks
2. Liquidity and Price risks – By pooling
2. Commercial Banks- accept deposits
savings, FI supply liquidity to the FM. The
and grant commercial or business
size of financial institution also put them in
loans
a better position to lessen price risk.
3. Thrift Banks- include savings & loan
3. Transaction Cost – economies of scale.
associations and savings banks;
Have a cost advantage because it
accept deposits and grant loans
represents many savers and borrowers.
except commercial loans
4. Maturity intermediation – FI can better bear
4. Rural Banks- provide basic financial
the risk of mismatching their assets and
services in rural communities
their liabilities
 5. Cooperative Banks (Credit union)–
Non profit and are exclusive for
credit union members. Accept
deposits and grant loans and other
financial services exclusively from/to
members
6. Islamic Bank- conduct business in
accordance with Shari’ah; prohibits
the imposition of interest (riba) on
any of their services or
productsCommercial banks – banks
that accept deposits and grant
commercial or business loans
b. Non- depository Institutions
1. Finance Companies- provide loans
to people or businesses
2. Mutual Funds- pool financial
resources and invest in diversified
portfolio Money Market
3. Securities Firms- include Investment
Banks and Brokerages; underwrite General Features
securities and engage in securities
brokerage and trading  Debt securities
4. Insurance Companies- protect their  Short-term maturity
customers from the financial  Highly liquid
distress that can be caused by  Issued by corporations or by the
unforeseen events government
5. Pension Funds- receive
Money Market Securities
contributions from individuals and/or
employers during their employment 1. Treasury Bills
to provide a retirement income for  Issued by the Philippine government
the individuals through the Bureau of Treasury
Risks Faced by Financial Institutions  Sold through an auction every
Monday- participated by GSEDs
(Government Securities Eligible
Dealer)
 Short term maturity - 91, 182 and
364 days
 Issued in series - same issue and
maturity dates
 Issued at a discount
 Traded only on weekdays (9 AM -
12 PM; 2-4 PM)
  Non-interest bearing debt security  An unbiased, independent, 3rd party
instrument evaluation of an issue or issuer
 Face amount + Plus purchase cost  A tool that can be used by investors,
= discount regulators, and the general public to
augment their own assessment of a
particulart investment
 Does not guarantee against future
losses nor it is a recommentation to
buy or sell specific securities
Credit Rating Agencies
 Sample Problem  Moody's investors services
 Standard and Poor's corporation
 Fitch Investor Service (F1-5)
Backings
 Asset- backed commercial paper -
backed by high quality collateral
(Accounts receivables)
 Credit-supported commercial
papers - guaranteed by an
 Computation
organization with excellent credit
rating like banks often in the form of
"letter of credit"(standby financial
place)(Bank acts as guarantor)
(LOC paper)

2. Commercial Paper Placement Methods

 Issued in a form of a promissory  Direct- Issued/ Direct Paper - sold
note directly to investors
 Issued by companies with excellent  Dealer- Issued/ Dealer Paper - sold
credit rating from a recognized using a banking or securities house
credit rating agency (Need to obtain intermediary
credit rating) Investment Houses
 With fixed maturity of 365 days or
less- common maturity is between
20-45 days with a max of 270 days
 Sold at a discount
What is a Credit Rating?
 An opinion that provides a measure
of credit quality
 A grading system which focuses on
a company's capability and
willingness to pay its obligations CP Yield Computation
upon maturity
  mainly bought by wealthy
individuals, corporations, and
institutional investors
 principal and interest paid on
maturity
 earns a fixed return if held until
Pros of Commercial Paper maturity
 Cost effective way of financing  insured by PDIC up to P500K
working capital  low risk, low interest security
 Cost of commercial papers to the Advantages of NCDs
issuing firm is lower than the cost of  offer a higher interest rate vs
securing a commercial bank loans savings account and T-bills
 good rating reduces the cost of  more liquid than a regular CD
capital for the company (tradable in the secondary market
 does not create any liens on assets  with deposit insurance coverage
of the company Disadvantages of NCDs
 its tradability provides investors with  requires a large amount of
exit options (ready market willing to investment
buy the commerial paper)  cannot be cashed before maturity
 Blue chip companies- companies  riskier than T-bills
who have good credit rating/ high Placement
income  sold directly to investors
Cons of Commerical Paper  sold to securities dealer who in turn
 Usage is typically limited to blue resell them
chip companies or those businesses Computation
that possess excellent credit ratings
 its issuance decreases bank credit
limits
 if a firm is not in a position to
redeem its paper due to financial
difficulties, extending the duration of
commerical paper is not possible 4. Banker's Acceptance
3. Negotiable Certificate of Deposit  Draft -
Product features  It is a short-term credit investment
 short term certificate of deposit made by a bank on behalf of a
(their are two types of NCD - long business in order to minimize risks
term and short term) involved in trade transactions
 payable to bearer or to the order of  It is commonly used for international
depositor (time deposit cerfiticate) trade transactions (import/export)
 negotiable in the secondary market where the bank acts as a guarantor
before maturity on behalf of the importor whose
 issued by large banks in large credit rating is not known to the
denominations exporter
  Credi facility, does not guarantee issuing bank has a good credit
the payment of money. rating
 It is similar to a post-dated check in  provides a modest profit, with yields
the sense that it cannot be cashed generally somewhere above those
or deposited before its due date T- bills
 It differs from a post-dated check in CONS
that it is seen as an investment and  traded through large banks and
can be traded on a secondary securities dealers (not trough
market regular trading platforms) so there
 Exporters can hold it until maturity are no formal bid and ask prices
to receive the payment in full or sell  pricing negotiations depends on the
in the secondary at a DISCOUNT to size and goodwill of the accepting
obtain cash immediately bank (if accepted by a bank with
 The investor who purchases the BA good credit rating, yield is lower
receives the payment guaranteed since chance of default is lesser)
by the bank on its due date 5. Repurchase Agreement ( REPO)
Sequence of Steps in the Creation of a  is a contract under which one party
Banker's Acceptance (the Seller) sells a security to
another party (the Buyer) on a given
date (the purchase date) for cash
proceeds (the repo amount) with a
commitment to repurchase
Equivalent securities at a future
date (Repurchase date)
Draft
 are true sales transactions which
involve a full transfer of ownership
of the underlying assets


 eligible securities are T-bills and T-
bonds issued by BTr
Participants of the Repo Market
Letter of Credit
 banks
 non-banks financial
institutions

Trading procedures

1. Pre trade
PROS 2. Trade Execution - counterparties
 Relatively safe and liquid complete confirmation
investment specially when the 3. Purchase date
4. Margining and Initial Margin/Haircut
 3. Coupon – the periodic interest payment
promised to bondholders which is equal to the
coupon rate times the face value of the bond
4. Maturity – the length of time until the principal
is scheduled to be repaid.
Benefits of Repo
5. Call Provisions – a provision that enables the
issuer to buy the bond back from the bondholder
at a pre- specified price prior to maturity.
6. Put Provisions – a provision that enables the
buyer to sell the bond back to the issuer at a pre-
specified price prior to maturity.
7. Sinking Fund Provisions – a provision that
requires the issuer to repurchase a fixed
percentage of the outstanding bond each year,
Risks of Repo
regardless of the level of interest rates.
Types of Bonds
 By Issuer Category
1. Issued by the National Government
through the Bureu of the Treasury (BTr)
a) Treasury Bonds- also known as
Fixed- rate Treasury Notes (FXTNs)
have maturities greater than a year;
normally issued in 2-, 3-, 4-, 5-, 7-,
Philippine Bond Market 10-, 20-, and 25-year tenors; pay
coupon or interest on a semi-
Bonds: Definition and Key Characteristics
annual basis; from time to time, the
 Are securities that represent a debt owed government also issues zero
by the issuer to the investor coupon bonds.
 Are long term debt securities that are b) Retail Treasury Bonds- part of the
issued by government agencies or government’s savings mobilization
corporations program designed to make
 Issuer of a bond is obligated to pay interest government securities available to
payments periodically such as annually or retail investors and, at the same
semi-annually and the par value at time, create savings consciousness
maturity among Filipinos; minimum issue
P5,000.
1. Face Value (Par Value) – is the price at which c) Multi- currency retail treasury
the bond is sold to investors when first issued and bonds- offered to overseas Filipino
also the price at which the bond is redeemed at workers (OFWs) and migrant
maturity. Filipinos, and their families to
2. Coupon Rate – periodic interest payments provide safe haven for their hard-
expressed as a fixed percentage of the bond’s earned foreign currency savings.
face value d) Dollar- linked peso notes- term is
usually 2-3 years; coupon is paid
semi-annually; notes track the
 movement of the Philippine Peso  Revenue Bond- If interest and principal
and US Dollar exchange rate; payments are dependent on the income of
payments of interest and principal the project financed by the bond issuance
are linked to the movement of the
3. Issued by Private Entities – Corporate Bonds
exchange and computed based on
the foreign exchange factor. A. Secured Bonds- the issuer is backing it
2. Issued by the National Government with collateral
through Other Entities – GOCCs and i. Senior Secured Bonds- holders will
govt. agencies always be first to receive a payout
a) Agency Bonds- to raise funds that from a company’s holdings in the
are used for purposes that event of default.
Congress has deemed to be in the ii. Mortgage Bonds- secured with real
national interest. estate property
Example: Bonds issued by the iii. Collateral Trust Bonds- secured by
HDMF to fund housing programs a financial asset – such as stock or
b) Municipal Bonds (Munis)- issued by other bonds – that is deposited and
states, cities, countries and other held by a trustee for the holders of
government entities bond.
 Puerto Princesa Green iv. Equipment Trust Certificate-
Bonds- used to finance the secured by tangible non-real-estate
rehabilitation of Puerto property, such as heavy equipment
Princesa or airplanes
 Boracay- Aklan Provincial B. Unsecured Bonds/ Debentures- backed
Bonds- to finance the only by the general creditworthiness of the
Boracay- Aklan Jetty Port issuer
 Tagaytay City Tourism i. Senior Secured Bonds- bondholders
Bonds- to finance first full- enjoy a privileged position in the
service convention center event of default with respect to the
complex with an assembly payout order.
hall that can accommodate ii. Junior Subordinated Bonds-
800 delegates unsecured corporate bonds where
 Caloocan City “Katipunan” bondholders are the last of all
Bonds- to finance the bondholders to have a claim on the
construction and issuing company’s assets if it goes
redevelopment of the out of business.
Caloocan City Hospital, the iii. Investment Grade Bonds- have
public market and the higher credit rating thus implying
decongestion and less credit than high-yield corporate
commercial development of bonds.
the City Hall area. iv. High- Yield/ Junk Bonds- have lower
 Iloilo City Bonds- to fund the credit rating thus implying higher
construction and credit risk than investment grade
development of 410 housing bonds and therefore, offer higher
units for city hall employees, interest rate in return for the
public school teachers and increased risk.
police officers. v. Convertible Bonds- can be
 General Obligation Bond- If backed by the converted into a fixed number of
full taxing power of the municipality
 ordinary shares in the same auction to participating dealers; terms and
company at a set price conditions of the issuance are prescribed
 By Currency of Instrument in an offering document or prospectus
1. Philippine Peso issued by the GOCC or government
2. United States (US) Dollar agency
3. Euro 3. Bonds Issued by Private Entities
 By Offering Type I. Public Offer- intended for sale to both
1. Public Offering- sold to both non- the retail and qualified investor markets
qualified and qualified investors II. Private Placement- intended to be sold
2. Private Placement- sold to a limited to a limited number of investors,
number of investors (currently set at 19) typically qualified investors
and typically to qualified investors only
Participants in the Bond Market
Methods of Issuing Bonds
1. Issuers
1. Bonds issued by Government through 2. Investors
Bureu of Treasury A. Qualified investors- persons with high
A. Regular Issuance net worth or with financial background
i. Auction- mode of sale or offering that allows him or her to bear the that
government securities participated by may arise from participating in an OTC
accredited Government Securities Eligible market
Dealers (GSEDs); bids are submitted i. Banks
electronically through the auction front- ii. Registered investment houses
end system Automated Debt Auction iii. Insurance companies
Processing System (ADAPS) and iv. Pension funds or retirement plans
evaluated for acceptance or rejection by maintained by the Government of
the Auction Committee the Philippines or any of its political
subdivisions, or those managed by
a bank or other persons authorized
by the BSP to engage in trust
functions
v. Investment companies
vi. Other persons the SEC may
ii. Tap Method- used only whenever there determine by rule as qualified
is an acute shortage of securities in the buyers on the basis of financial
market; bonds are issued over a period of sophistication, net worth,
time rather in one auction sale; bonds are knowledge and experience in
sold at market value but under the same financial and business matters, or
terms- face value, coupon rate and amount of assets under
maturity date management
iii. OTC Method- represents the sale of vii. A natural person who has a
government securities to tax- exempt minimum annual gross income of
institutions, GOCCs, and local government PHP25 million at least 2 years prior
units (LGUs) to registration, or a total portfolio in
B. Special Issuance- targeted for retail securities of at least PHP10 million
investors registered with the SEC, or a
personal net worth of at least
2. Bonds Issued by GOCCs- bonds are PHP30 million; and has been
typically priced and allocated through engaged in securities trading in his
 personal capacity, or through a received its accreditation as a CRA from
fund manager, for a period 1 year, the SEC in 2008
or held for at least 2 years a
International Credit Rating Agencies (Big Three):
position of responsibility in any
professional or business entity that 1. S & P Global Ratings (previously Standard
requires knowledge or expertise in & Poor’s)
securities trading. 2. Moody’s Investors Services (Moody’s)
3. Fitch Ratings Inc.
B. Non- Qualified Investors- public or retail
investors Philippine Market Regulatory Structure
1. BSP- supervises banks and non-bank
3. Underwriters- a person who guarantees on a financial institutions that perform quasi-
firm commitment and/or declared best- effort banking functions
basis the distribution and sale of securities of 2. SEC- regulates both primary and
any kind by another company (UBs & secondary debt markets, oversees the
Investment Houses) Philippine Stock Exchange, the three
4. Securities Registries or Transfer Agents- a subsidiaries of the Philippine Dealing
BSP accredited bank or non-bank financial Systems Holdings Corporation (PDS
institution designated or appointed by the Group), brokers, registrars, transfer agents
issuer to maintain the securities registry book, and clearinghouses
either in electronic or printed form 3. Department of Finance- regulates the
Credit Rating issuance of government securities in the
market
 As a general under Republic Act (RA) No. 4. Philippine Dealing System (PDS Group of
8799, or the Securities Regulation Code (SRC) Companies)
Rule 12.1 -6, a credit rating from a SEC- A. Philippine Dealing and Exchanging
accredited CRA is required to issue corporate Corporation (PDEx)- operates the
bonds and CPs, except: 1) when the issuance electronic trading platforms for
amounts to not more 25% of the issuer’s net securities, providing price discovery
worth; or 2) where there is an irrevocable and transparency services, self-
committed credit line with a bank covering regulatory functions, and is linked to
100% of the proposed issuance. the settlement systems
 Credit rating requirements do not apply to B. Philippine Depository and Trust
government and government- guaranteed debt Corporation (PDTC)- provides central
securities. securities depository services for both
the equities and fixed income markets,
and registry services for the fixed
income market
C. Philippine Securities Settlement
Domestic Credit Rating Agencies: Corporation (PSSC)- provides
1. Philippine Rating Service Corporation- is electronic settlement facilities with
the only domestic credit rating agency straight- through process (STP) and
(CRA) in the Philippines accredited by both delivery- versus- payment (DVP)
the BSP and the SEC. The rating is also capabilities
an affiliate of Standard and Poor’s. Trading of Bonds
2. Credit Rating and Investors Services
Philippines (CRISP)- was launched and 1. Bureau of Treasury- for primary market
 2. Philippine Dealing and Exchange (PDEx)-
for secondary market; provides a
centralized infrastructure for trading,
clearing and settlement of fixed- income
securities, which ensures price discovery,
transparency and investor protection

Factors that Affect Bond Investment

 Interest Rates
 When interest rates rise, bond
prices fall
 When interest rates fall, bond prices
rise
 Inflation
 When inflation is on the rise, bond FORMULA
prices fall
 When inflation is decreasing, bond T-Bill Purchase Price = Par Value x 360
prices rise 360 + rate (term)
 Credit ratings
Discount = Par Value – Purchase Price
 If the issuer’s credit rating goes up,
the price of its bonds will rise Yield = Discount x 360
 If the rating goes down, it will drive Purchase Price term
their bond prices lower
NCD Maturity Value = Principal + Interest
NCD Interest = Principal x Interest Rate x
Term/365
NCD Yield = (Principal – Purchase Price) +
Interest
Purchase Price

Bond Price: Coupon Bonds

 Mortgage Market

History of Mortgages

Semi-Annual Coupon Bonds The term mortgage comes from the Old
French and literally means “death vow.” This
refers not to the death of the borrower but to the
“death” of the loan through repayment over the
fixed term of the loan.

The word for this repayment is referred to as

Zero Coupon Bond amortization which comes from Middle English for
“kill.” It refers not to the borrower’s murder but to
the “killing off” the mortgage by paying it down
over time.

What are Mortgages?

- Are securities used to finance real estate

purchases.

- Are long-term loans secured by real estate

- Are real estate loans payable at some future

time.

- Are obtained to finance investment in real

estate- construction of commercial, industrial or
residential buildings.

- Represent the difference between the down

Yield to Maturity (YTM) / Internal Rate of Return payment and the value to be paid for the
(IRR) property.

Characteristics of Mortgages

1. Mortgage Interest Rates- rate borrowers pay

on their mortgages
Factors in Determining Interest Rate:

A. Market rates- long-term market rates are

determined by the supply of and demand for long-
Bond Duration
term funds
B. Term- longer-term mortgages have higher 3. Prepayment Risk - borrower repays the loan
interest rates than shorter-term mortgages sooner than its original term in response to a
(usually between 15- 30 years) decline in interest rate
C. Discount points- are interest payments made  Borrowers can prepay either by paying off the
at the beginning of a loan or at the moment when remaining loan balance themselves or by
the borrower signs the loan paper and receives obtaining another loan known as a
the proceeds of the loan in exchange for reduced “refinancing.”
interest rate on the loan  Prepayment is a cost to lenders because
2. Loan Terms- protect the lender from financial lenders do not receive the entire stream of
loss interest payments they expected from the
A. Collateral- lending institution will place a lien loan. Thus, the loan generates less revenue
against the property and this remains in effect than expected and may no longer cover the
until the loan is paid off costs associated with the loan.
B. Downpayment- reduces moral hazard for the Types of Mortgages
borrower
C. Loan Amount- sum of money that the borrower 1. Fixed- Rate Mortgage- most common type of
receives upon signing the loan agreement mortgage
D. Term of the Loan- the length of time over  monthly payment (interest and principal) is
which the loan amount is to be repaid constant for the term of the mortgage
E. Private Mortgage Insurance- guarantees to  regardless of the behavior of market interest
make up any discrepancy between the value of rates, the interest rate paid by the borrower is
the property and the loan amount should a default the same for the life of the loan
occur 2. Adjustable-Rate Mortgage (ARM)
F. Borrower Qualification- credit scoring base d  interest rates vary over the term of the loan in
on past payment history, outstanding debt, length step with some index
of credit history, number or recent credit
applications, and types of credit and loans you
have.  usually an introductory rate is fixed for a
3. Mortgage Loan Amortization- states how the period of time ranging from 2 to 5 years then
loan is to be repaid in subsequent years interest rate will rise or
Risks Associated with Mortgage Lending fall with the index (plus a fixed mark-up called
the margin) at some specified time interval
1. Credit Risk - represents the size and likelihood  rates are normally lower vs. fixed-rate
of a loss that investors will mortgages because the borrower is bearing
experience if borrowers make late payments or some of the market risk
even default  ARMs have less market risk than the
corresponding fixed-rate loan with the same
2. Interest Rate Risk - arises when interest rates maturity
change over time thereby 3. Hybrid Mortgage - features a fixed interest rate
affecting the value of mortgages for a set number of years at the beginning of the
mortgage (3, 5, 7), after which becomes an
 If market interest rates rise after the lender annual adjustable-rate product.
has offered a mortgage contract, not only will
the lender earn less interest than he would
have had he waited and lent at the higher Other Types of Mortgages
interest rate, but the market value of the
investment will decline. 1. Prime Mortgages- are high quality mortgages
 If market interest rates fall, the lender will that are expected to pose little credit risk for
earn more interest than if he waited and the originators and secondary market
market value of his investment will increase. purchasers/investors because borrowers have
satisfied the traditional lending standards
2. Subprime Mortgages- are those made to The mortgage market is a phrase that
borrowers who do not qualify for loans at the describes a vast array of institutions and
usual market rate of interest because of a poor individuals who are involved with mortgage
credit rating or because the loan is larger than
finance in one way or another.
justified by their income
3. Insured Mortgages- mortgages covered by 1. Primary Mortgage Market- where new
Mortgage Default Insurance to protect the lender mortgages are originated (include financial
(not the borrower) against any losses related to institutions)
borrower default and foreclosure and are 2. Secondary Mortgage Market- where existing
guaranteed by the government mortgages are bought and sold
4. Conventional Mortgages- mortgages that are US Mortgage Market
privately insured; insurance cost is usually paid
by the borrower I. Federal National Mortgage Association (Fannie
5. Graduated Payment Mortgages (GPMs)- allow Mae)
the borrowers to make small payments initially on II. Federal Home Loan Mortgage Corporation
the mortgage; the payments increase on a (Freddie Mac)
graduated basis over the first 5 to 10 years and III. Government National Mortgage Association
then level off; tailored for families who anticipate (Ginnie Mae)
higher income (and thus the ability to make larger Philippine Mortgage Market
monthly mortgage payments) as time passes
6. Growing-Equity Mortgages (GEMs)- similar to IV. National Home Mortgage Finance Corporation
GPMs but payments never level off but continue (NHMFC)
to increase (typically by about 4 percent per year) V. Social Housing Finance Corporation (SHFC)
throughout the life of the loan; its goal is to let the
borrower pay off early. Mortgage Market
7. Second Mortgages (Piggyback)- are loans that
are secured by the same real estate that is used Securitization is the process of transforming
to secure the first mortgage; also called an 80-10- traditional forms of bilateral financial relationships
10 loan- lets you buy a home with two mortgages (e.g., loans, leases, payments, other receivables)
that total 90% of the purchase price and a 10% into freely tradable investment instruments or
down payment; it gets its name because the
securities.
smaller loan “piggybacks” on the larger loan
8. Reverse Annuity Mortgages (RAMs)- are loans Functions:
offered to retired individuals that are secured by
the value of their homes; borrowers do not make (1) mortgage securities can tap new funds for
any payments against the loan; when the housing and the increase in supply of funds can
borrower dies, the borrower’s estate sells the reduce the relative cost of mortgage finance;
property to retire the debt; a desirable option for (2) mortgage securities can mobilize long-term
retirees in resources thereby reducing the risk for originators
need of supplemental funds to meet living
and the risk premium charged by lenders;
expenses
(3) mortgage securities increase competition in
9. Shared- Appreciation Mortgage- allows a home
purchaser to obtain a mortgage at a below- primary markets by providing small lenders
market interest rate but in return, the lender will access to mortgage origination and servicing.
share in the price appreciation of the home
10. Balloon-Payment Mortgage- requires only
interest payments for 3-5 years and at the end of
this period, the borrower must pay the full amount
of the principal (the balloon payment

Mortgage Market
 rate from 6.5 percent in May 2000 to as low
as 1 percent by June 2003.
 The low interest rate regime fueled a boom in
mortgages, including among borrowers with
doubtful credit histories or those fancifully
called NINJA loans – that is, loans to No
Income, No Job or Assets loans. Thus, house
prices in the US began rising in 2000,
surpassing the growth of disposable income.
 Various financial institutions bundled the
mortgages into complex securities which
The transformed securities are referred to in were largely unregulated. The continued
appreciation of house prices ensured
general as asset-backed securities (ABS) and the
attractive returns for these mortgage-related
assets that are used to create ABS are called securities.
securitized assets.  The rating agencies, which are paid by the
issuers that want their MBS rated, gave AAA
 Asset Backed Securities- are backed by non- ratings to these MBS even though they
mortgage assets like credit card receivables, represented risky mortgages.
student loans  With too much liquidity in the US economy,
 Mortgaged Backed Securities- are backed by the Fed began a cycle of hikes in the Federal
a pool of mortgages funds in June 2004- June 2006 to as high as
 Collateralized Debt Obligations- are backed 5.25 percent.
by diverse sets of assets—from corporate  When interest rates were raised, an asset
bonds to mortgage bonds to bank loans to car bubble burst became imminent. The elevated
loans to credit card loans interest rates discouraged availments of
 Collateralized Mortgage Obligations- type of mortgage loans, which led to a build up in
mortgage-backed security that contains a unsold homes. This precipitated the steep
pool of mortgages bundled together and sold descent in house prices from their peak in
as an investment. 2006 by 25%.
 With the glut in supply and as housing prices
fell, the value of the collaterals supporting
mortgage loans eroded. Higher delinquency
rates on sub-prime mortgage loans triggered
a wave of bankruptcies of sub-prime
mortgage lenders. As bankruptcy filings by
mortgage lenders mounted, unnerved
investors began draining liquidity from
financial markets.
 Since the loans were securitized and sold to
other investors as credit derivatives, the
defaults in the mortgage lending market
spread to the wider credit markets.
2008 Global Financial Crisis: Subprime Equity Market
Mortgage Crisis
- Is where financial institutions and
 The United States aggressively eased its companies interact to trade financial
monetary policy to facilitate recovery from the instruments and raised capital for
dotcom bubble and the September 11 companies
terrorist attacks. The US Federal Reserve
began a cycle of cuts in the Fed funds target
 - Equity capital is raised by selling a part of iv. Number of shares held publicly
a claim/right to a company’s assets in
Over-the-Counter Market
exchange for money.
- An equity market (also known as stock  Is a network of dealers who facilitate the
market) is a market in which shares are trading of stocks bilaterally between two
issued and traded, either through parties without a stock exchange acting as
exchanges or over-the-counter markets an intermediary
Equity Market Structure  A brokerage acts as a broker or agent
when it executes orders on behalf of its
clients
Equity Instruments

1. Common Shares
- Represent ownership capital
- Holder of common shares/stock are paid
dividends out of the company’s profits but
pay-out is discretionary with the company’s
Private Placement Market management
- Have a residual claim to the company’s
 Companies raise private equity through
income and assets
unquoted shares
- Are entitled to a claim in the company’s
 Securities are sold directly to investors
profits only after the preferred
 Companies do not need to register
shareholders and bondholders have been
securities with the Securities and
paid
Exchange Commission (SEC)
- Owners of common stock are permitted to
 Investors in this market demand a
vote on certain key matters concerning the
premium as compensation for their risk-
firm, such as the election of the board of
taking and the lack of liquidity in the market
directors, authorization to issue new share
Primary Public Market of common stock, approval of amendments
to the corporate charter, and adoption of
1. Initial Public Offering (IPO) bylaws
 Company issues equity publicly for the first - Common shareholders face a higher
time and becomes listed on the stock degree of risk than other creditors of the
exchange company but also have the prospect of
2. Seasoned Equity/Secondary Offering higher returns
 A listed company issue new/additional 2. Preferred Shares
equity - Are hybrid securities because they
Stock Exchange combine some features of debenture and
common equity stock
 Is a central trading location where the - Have a fixed/stated rate of dividend
shares of companies listed on the stock - Have a claim to the company’s income and
exchange are traded assets before equity
 Has its own criteria for listing a company - Do not have a claim in the company’s
on its exchange residual income/assets
i. Minimum earnings - Do not confer voting rights to shareholders
ii. Market capitalization
Types:
iii. Net tangible assets
  Cumulative- pays a fixed dividend at predetermined price at a specified time in
regular intervals; is a dividend is not the future
paid, the sum of the unpaid dividends - Allows an investor to speculate on the
accumulates and must be paid prior to direction of a security, commodity, or a
common stockholders being issued a financial instrument, either long or short,
dividend using leverage
 Participating- may be issued a special - Often used to hedge the price movement
dividend if certain financial goals are of the underlying asset to help prevent
achieved by the company; is mainly losses from unfavorable price change
issue by newer companies that are in 7. Stock Option
need of cash infusion - Gives an investor the right, but not the
 Convertible- may convert their shares obligation, to buy or sell a stock at an
of convertible preferred stock to shares agreed upon price and date
of common stock of the same company i. Call Option- gives the holder the right to
 Callable- callable at a given date in the buy a stock
future ate issuer’s discretion at the ii. Put Option- gives the holder the right to
redemption price which may be the sell a stock
original issue price or higher 8. Swaps
 Adjustable-rate- dividends vary with a - Is an agreement between two
specifies benchmark typically the T-bill counterparties to exchange financial
rate instruments or cashflows or payments for a
3. Private Equity certain time
- Made through private placements to - Can be used to hedge certain risks such
institutional investors and/or wealthy as interest rate risk or to speculate on
individuals, family members and friends changes in the expected direction of
- Raised by private limited enterprises, underlying prices
partnerships and start-up companies as
they cannot trade their shares publicly Philippines Stock Market Participants
because of limited access to bank capital,
1. Philippines Stock Exchange
limited access to public equity
 Trading on the PSE pre-opens at 9:00AM;
4. American Depository Receipts (ADR)
is in recess between 12:00 and 1:30PM;
- Is a certificate of ownership issued in the
pre-closes at 3:15PM; in run-off from
name of a foreign company by an 3:20PM; and closes at 3:30PM
American Bank  PSEi – is a stock market index consisting
- Certificates are tradeable and represent 30 companies
ownership of shares in a foreign company
- ADRs and their associated dividends are Stock Exchanges in the US:
denominated in US dollars
I. New York Stock Exchange – world’s
5. Global Depository Receipts (GDRs)
largest stock exchange “The Big Board”
- Are negotiable receipts that are issued
auction market
against the shares of foreign companies by
II. NASDAQ – dealer market; where
financial institutions situated in developed
technology and speculative stocks are
countries
mostly traded
6. Futures Contract
III. American Stock Exchange – specialized in
- Is a legal agreement to buy or sell a
trading stock of emerging companies
particular commodity asset, or security at a
 Dow Jones Industrial Average – oldest,
most well known and most frequently used
 indexes in the world; it includes the stocks
of 30 of the largest and most influential
companies in the United States
 S&P 500 – market-capitalization-weighted
index of the 500 largest US publicly traded
companies; widely regarded as the best
gauge of large-cap US equities
 NASDAQ Composite – is market-
capitalization-weighted index of all the
stocks traded on the NASDAQ stock
exchange
2. Publicly Listed Companies
- 261 listed companies
3. Trading Participants/Stockbrokers
- Examples: Abacus Securities Corp., COL
Financial Group, Inc., BPI Securities Corp.,
First Metro Securities Brokerage Corp.,
BDO Nomura Securities, Inc
Types of Transactions:

a. Limit order – order to buy or sell at a

specifies price of a shares of stock
b. Market order – order to buy or sell at the
current market price
c. Good-til-cancelled order – order to buy or
sell which remains outstanding for 7
calendar days until cancelled by the
investor or trader
d. Day order – order to buy or sell that is only Key Risks in Stock Market Investing
valid for one trading day
4. Investors  Market Risk – the risk of investments
declining in value because of economic
Costs of Stock Trading developments or other events that affect
the entire market
 Inflation Risk – the risk of a loss in your
purchasing power because the value of
your investments does not keep up with
inflation
 Liquidity Risk – the risk of being unable to
sell you investment at fair price and get
your money out when you want to
Stock Valuation Methods-Stock Price
Stock Trading Terminologies
1. Absolute Valuation – absolute stock
valuation relies on the company’s
fundamental information. The method
generally involves the analysis of various
 financial information that can be found in
or derived from a company’s financial
statements. Many techniques
A. Dividend Discount Model (DDM)
B. Discounted Cash Flow Model (DCF)

Dividend Discount Model – Non-Constant Growth

A. Dividend Discount Model

Dividend Discount – No Growth

Dividend Discount – Constant Growth

 - A company with a low P/E ratio is trading
at a lower price per dollar of EPS and is
considered undervalued

A. Relative Valuation: Price-Earnings

Method
- This method implicitly assumes that the
growth in earnings in future years will be
similar to that of the industry
B. Discounted Cash Flow (DCF) - This method may result in an accurate
valuation of a firm if errors are made in
forecasting the firm’s future earnings or in
choosing the industry composite used to
derive the PE ratio

B. Required Rate of Return (RRR)

2. Relative Valuation - Is the minimum return an investor will
- Concerns the comparison of the accept for owning a company’s stock, as
investment with similar companies compensation for a given level of risk
- Deals with the calculation of the key associated with holding the stock (also
financial ratios of similar companies and known as “hurdle rate”)
derivation of the same ratio for the target - Is the net gain or loss of an investment
company over a specified time period expressed as
percentage of the investment’s initial cost
- The required rate is commonly used a
threshold that separates feasible and
unfeasible investment opportunities
- The general rule is that if an investment’s
return is less than the required rate, the
investment should be rejected
Valuation Methods:

- A company with a high P/E ratio is trading 1. CAPM

at a higher price per dollar of earning than 2. DDM
its peers and is considered overvalued I. Capital Asset Pricing Model (CAPM)
 4 Golder Rules in Stock Investing

 Invest EARLY – to take advantage of

compounding over a greater period of time
 Invest REGULARLY – enables you to
apply disciplines savings approach to help
successfully build wealth over time and
reduce long-term portfolio volatility
 Invest LONG TERM – solves the problem
of short-term volatility (choppiness in price)
 Invest using DIVERSIFICATION – to
allocation your capital evenly toa number
of stocks in different industries or sectors
so as not to put too much risk in one area
Supplementary Lesson: Foundation of Finance -
CAPM RRR Formula:
Chapter 2

Financial Markets: Transfer of Capital

Financial Markets play a critical role in capitalist

economies. Financial markets help facilitate the
transfer of funds from "saving surplus" units to
"saving deficit" units, ie. transfer money from
those who have the money to those who need it.

Three ways to transfer capital in the economy:

1. Direct transfer
II. Dividend Discount Model 2. Indirect transfer using the investment banker
3. Indirect transfer using the financial
intermediary

How does money grow in the Stock MARKET?

1. Capital Appreciation
- Increase in the market price of the stock
- Buy low, sell high
2. Dividends Direct Transfer
- Cash dividend- earnings for every share of  Firm seeking funds directly approaches
stock declared by the company the wealthy investor
- Stock dividend- additional shares given to  Example: a new business venture seeking
shareholders at no cost
funding from venture capitalist
  Venture capitalist Money Market VS Capital Market
 prime source of funding for start-up  Money Market - This is the market for short-
companies and companies in term debt instruments (maturity periods of one
"turnaroud" situations. Funding such year or less). Money market is typically a
ventures is very risky but carries telephone and a computer market (rather than
potential for high return a physical building). Example: T-bill,
 The borrowing firm may not have the commercial paper, NCG, bankers'
option of pursuing public offering due to acceptance.
small size, no record of profits, and  Capital Market - This is the market for long-
uncertain future growth prospects. term financial securities (maturity greater than
Public Offering VS Private placements one year) Examples: Corporate bonds,
 Public offering - both individuals and common stocks, t-bonds, term loans, financial
institutional investors have the opportunity to lease , mortgages
purchase securities. The securities are initially Spot Markets VS Futures Markets
sold by the managing investment bank firm.  Cash Markers- This is the market in which
The issuing firm never actually meets the something sells immediately
ultimate purchaser of securities  Futures Markets - This is the market for
 Private or Direct Placement - The securities buying and selling at some future date.
are offered and sold directly to a limited Organized Securities Exchnges VS OTC
number of investor.  OSE
Primary Markets VS. Secondary Market  are tangible entities and financial
 Primary Market (initial issue) - This is market instruments are traded on its premises.
in which new issues of a securities are sold to  Example: New York Stock Exchange
initial buyers. This is the only time the issuing  OTC
firm ever gets any money for the securities.  telecommunication platform where u place
Example: Google raised 1.76 billion through your order.
public sale of shares in August 2004  If firms do not meet the listing
 Seasoned Equity Offering (SEO, secondary requirements of the exchange or wish to
offering) - It refers to sale of additional shares avoid higher reporting requirements and
by a company with shares that are already fees of exchanges, they may choose to
publicly traded. Example: Google raised 4.18 trade on over-the-counter markets.
billion in September 2005.  OTC markets refers to all securities market
 Secondary Market (subsequent trading) - This except organized exchanges. There is no
is the market in which previously issued specific geographic location for OTC
securities are traded. The issuing corporation market. Most transactions are done
does not get any money for stocks traded on through a network of security dealers who
the secondary market. Example: trading are known as broker-dealers and brokers.
among investors today of Google stocks. Their profit depends on the price at which
Primary and secondary markets are they are willing to buy (bid price) and the
regulated by the SEC. Firms have to get price at which they are willing to sell (ask
SEC approval before the sale of securities price)
in primary market. Firms must report  The most prominent OTC market for
Financial information to SEC on a regular stocks is NASDAQ, NASDAQ list more
basis (ex. financial statements) to protect than 5000 securities. Most corporate bond
investors.
 transactions are also conducted on OTC select group of investors such as current
Markets. stockholders, employees, or customers.
Stock Exchange Benefits 5. Dutch Auction - Investors place bids
1. Provides a continuous market indicating how many shares they are
2. Establishes and publicizes fair security willing to buy and at what price. The price
prices the stock is then sold for becomes the
3. Helps businesses raise new capital lowest price at which the issuing company
Investment Banking Function - Investment can sell all the available shares.
Banker/ Underwriter
 They are financial specialists involved as
an intermediary in the sale of securities
(stocks and bonds). They buy the entire
issue of securities from the issuing firm
and then resell it to the general public.
 The difference between the price the
corporation gets and the public offering
price is called underwriter's spead.
 Functions
1. Underwriting - it means assuming
risk. Because money for securities 6. Direct Sale - Issuing firm sells the
is paid to the issuing firm before the securities directly to the investing public.
securities are sold, there is risk to No investment banker is involved.
the investment bank. Private Debt Placements
2. Distributing - once the securities are  Private debt placements of debt refers to
purchased from issuing firm, they raising money directly from prominent
are distributed to ultimate investors. investors such as life insurance companies,
3. Advising - on the timing of sale, type pension funds. It can be accomplished with or
of secutiry, etc. without the assistance or investment bankers.
Distibution Method  Advantages
1. Negotiable purchase - Issuing firm selects 1. faster to raise money
an investment banker to underwrite the 2. reduces flotation costs
issue. The firm and the investment banker 3. offers financial flexibility
negotiate the terms of the offer  Disadvantages
2. Competitive Bid purchase - Several 1. interest costs are higher than public issues
investment bankers bid for the right to 2. restrictive covenants
underwrite the firm's issue. The firm 3. possible future SEC registration
selects the banker offering the highest Sarbanes-Oxley Act (SOX)
price.  In response to corporate scandals, Congrass
3. Commission or Best-effort basis - Issue is passed SOX in2002
not underwritten. ie. no money is paid  SOX holds senior corporate advisors (such as
upfront for the stocks. Investment bank, accountants, lawyers, bod, officers)
acting as an agent , attempt to sell the responsible for any instance of misconduct
stocks in return for a commission.  SOX attempts to protect the interest of
4. Priveledge Subscription - Investment investors by improving transparency and
banker helps market the new issue to a accuracy of corporate disclosures.
 SOX has been critized for imposing additional  the returns are affected by the degree of
compliance costs on the firms. Some firms inflation, default premium, maturity
have responded by delisting from major premium, and liquidity premium
exchanges or choosing to list on foreign
exchanges.
RATES OF RETURN IN THE FINANCIAL
MARKETS
Long-Term Rates of return
 Higher returns are associated with higher
risk
 Investors demand compensation for
inflation and other elements of risk (such
as default)

Interest rate determinants

Important Definitions  Nominal interest rate = Real risk-free rate
 Opportunity cost - rate of return on next + inflation premium + default-risk premium
best investment alternative to the investor + maturity-risk premium + liquidity-risk
 Standard deviation - Dispersion or premium
variability around the mean rate of return in  thus nominal rate or quoted rate for
the financial markets securities is driven by all these risk
 Real return - return earned above the rate premium factors. Such knowledge is
of inflation critical when companies set an interest
rate for their issues.
 Maturity risk premium - additional return
Real and Nominal rates
required by investors in long-term
securities to compensate for greater risk of  Real risk-free interest rate = risk-free rate -
price fluctuations on those securities inflation premium
caused by interest rate changes  Nominal interest rate = real rate of interest
 Liquidity risk-premium - additional return + inflation risk premium
required by investors in securities that  The real rate of interest is the nominal
cannot be quickly converted into cash at a (quoted) rate of interest less any loss in
reasonably predictable price purchasing power of the dollar during the
Interest Rate Levels time of the investment.
 Inflation and interest rates have a direct The Term structure of interest rate
relationship
 determined by demand and supply for a
given maturity.

SOLVING:

1. (Calculating the maturity-risk premium) at

present, the risk-free rate of interest is 2%, which
inflation is expected to be 2% for the next 2
years. If a 2-year Treasury note yields 4.5%, what
is the maturity- risk premium for this 2- year
Treasury note?

Questions:
 Among the rates given, which one is the
nominal interest? Nominal rate is the
stated rate- The nominal rate is 4.5%
- Nominal rate is the rate inclusive of all
the factors that influence the interest
rate

Formula:

Nominal rate= risk free rate+ inflation rate + credit

default risk premium + all other premiums

What explains the shape of the term

structure?
1. The unbiased expectations theory - term
structure is determined by an investor’s
expectations about future interest rates
2. The liquidity preference theory - investors
require maturity-risk premiums to
compensate them for buying securities that
expose them to the risks of fluctuating
interest rates.
3. The market segmentation theory - legal
restrictions and personal preference limit  The longer the term and the higher the
choices for investors to certain ranges of risk, the nominal rate should also be
maturities. This theory implies that the rate higher- upward trend
of interest for a particular maturity is
2. (Inflation and interest rates) You’re considering 4.
an investment that you expect will produce an 8%
return next year, and you expect that your real
rate of return on the investment will be 6%. What
Question: How much is the nominal rate? 6.8%
do you expect inflation will be next year?

Question:

 Where is the nominal rate? 8%

Nominal rate is higher than the real rate of
return

 Why would there be a higher risk of

default? Because this is issued by 2
different institutions (government and
private)

5.
In case inflation rate is not given:

IR= (1+ Nominal rate) -1

¿¿

To calculate the Nominal rate: Question:

NR= Real rate of return + Inflation rate + (RRI)  What is the nominal rate of the bond?
(IR) 3.75%
3.

 The keyword is ignoring the cross product

Question:
 How much is the nominal rate? 2.4%

6.