The Business

of the
CAPITAL
MARKETS
THE MARKETS THAT BRING BUYERS AND SELLERS TOGETHER TO TRADE BONDS, STOCKS, CURREN-

A Module in FINMAN 7

PAMANTASAN NG LUNGSOD NG VALENZUELA

College of Business Administration
FINANCIAL MANAGEMENT Department
 FOREWORD
With the continuing modernization in the financial system across borders and fast pace de-
velopment in the financial markets, this module introduces to the students the instruments
and diversified roles perform by different participants in the financial market. It describes
how market players operate and interact creating mutual benefits and consequently bring
about an economic impact. It also emphasizes on the regulatory authority of the govern-
ment in overseeing and regulating financial market transactions and operations through its
mandate. In addition, students will also be asked to share information or news relevant to
current trends in the capital market.

This module consists of six units of merged topics that are designed to facilitate learning
while under this current situation affecting not only our local finance, but global economy
as well. Each unit is guided with the essential questions to give the students a learning direc-
tion. Key term in text are provided to direct the students to the essential words and their
meanings. Illustrations and diagrams are used to depict key concept for better understand-
ing of the students. Nonetheless, activities and exercises will be given to gauge and realize
the expected learning outcomes of the students.

While the module was designed to facilitate learnings of the students in financial manage-
ment in the current global situation, it may also serve as a useful reference material for any
student with interest in the financial assets and financial markets, knowing how they con-
tribute to the economy. As what Warren Buffett says, “Someone’s sitting in the shade today,
because someone planted a tree a long time ago.”

SIXTO L. FERNANDEZ
Module Writer
 TABLE OF CONTENTS
Introduction
Financial Asset and PLANNED
1 Market Participants
The Mechanics of Arbitrage
FIRM

Risk and Return Theories

EXPANSION
2
Firms need money
Derivatives Market
3
Money
channeled
Structure of Interest Rate
through
4 capital

Valuation of Debt Contracts

5 Money Market & Securities Traded

6 International Bond

Surplus money to invest

UNIT 1 Financial Asset and Market Participants
1.1 Introduction
1.2 Financial Assets
1.3 Market Participants
1.4 The Mechanics of Arbitrage
1.4 Origination of Bonds/Stocks issued by Private Corporation
1.5 Origination of Bonds issued by the government
1.6 Primary and Secondary Markets
1.7 Government

UNIT 2 Risk and Return Theories

2.1 The Concept of Risk
2.2 The Concept of Return

UNIT 3 The Derivatives Market

3.1 Futures Contract
3.2 Options Contract
3.3 Swaps
3.4 Equity Market and Stock Options

UNIT 4 Structure of Interest Rate

4.1 Theories and Structure

UNIT 5 Valuation of Debt Contracts. Money Market and Securities Traded

5.1 Securities traded
5.2 Features of a bond
5.3 YTM and Bond’s return
5.4 Other products

UNIT 6 International Bond Market

6.1 Classification of global financial market
6.2 Eurobond market
6.3 Factors considered in the rating of a sovereign bond
Unit 1 : Introduction to Capital Markets, the Financial Asset and Market Participants

Intended Learning Objectives:

First and foremost, the students must realize how capital market is related to financial market
before they can analyze the nature, operations, and role of each participant in the financial sys-
tem. The students will also have to understand how market players interact in the system under
the mandate and authority of the financial regulatory bodies of the country; The Bangko Sen-
tral Ng Pilipinas and the Securities and Exchange Commission

Overview:
The lecture focuses on the different financial institutions in the market involved in the issuanc-
es, buying and selling of securities and the regulatory authorities overseeing their operations.
Moreover, analyzing the impact of the activities to the economy.

Essential Questions:
 How are financial assets classified and used?

 How do participant differ in terms of operation product/service they provide in the market?

 How do they impact the economy?

Words to Go By:
 Bank Deposits - money placed into banking institutions for safekeeping such as savings ac-
counts, checking accounts and money market accounts.
 Bond - Bond is a fixed income instrument that represents a loan made by an investor to a bor-
rower. Bonds are used by large companies, government/sovereign governments to finance pro-
jects and operations. Owners of bonds are debtholders, or creditors, of the issuer.
 Cash - Money is a medium of exchange that is generally accepted as payment
for goods / services and repayment of debts, taxes etc.
 GSED - Government Securities Eligible Dealer. Are financial institutions duly licensed by the
SEC to deal in government securities in public.
 IPO - Initial Public Offering, private company can go public sale of its stocks to general public.

 Securities Auction - A method used by the government to issue treasury bills, bonds and
notes to distribute securities through the secondary market and obtaining public funds
Stocks - also known as equity is a security that represents the ownership of a fraction of
a corporation.
This entitles the owner of the stock to a proportion of the corporation's assets and profits
equal to how much stock they own. Units of stock are called "shares.
 Underwriting (of securities) - is the process by which investment banks raise investment
capital from investors on behalf of corporations and governments issuing the securities (both
equity and debt capital). The services of an underwriter are typically used as part of a public
offering in a primary market.

Discussions:
1.1 Capital Markets : Capital markets consists of the primary market—where securities are
created, issued and sold for the first time, and , the secondary market— where already-
issued securities are traded between investors and brokers. The most common capital mar-
kets are the stock market and the bond market. Under financial market, money market
deals with short term securities, while on the other, capital market deals with short term se-
curities trading. Below is an illustration of a function of capital market under the system :

Financial Markets

Money Market Capital Market

 Commercial Paper  Stocks

 Treasury Bills  Bonds
 Certificate of Deposits  Derivatives

Primary Markets : Where securities are created. Firms sell (float) new stocks / bonds to the
public for the first time. An initial public offering, or IPO, is an example of a primary market.
These trades provide an opportunity for investors to buy securities from the bank that did
the initial underwriting for a particular stock. An IPO occurs when a private company issues
stock to the public for the first time. Examples of primary market which could facilitate
bond issuances or initial public offering (IPO); underwriters or book runner which could be an
investment house or a universal bank.
Secondary Market : Where investors buy and sell securities, also called the aftermarket
and follow on public offering, is the financial market in which previously issued financial
instruments such as stock, bonds, options, and futures are bought and sold. Secondary
markets could be PSE, PDEX, banks, financial brokers like AFS Financial, Tullet Prebon, Am-
stel etc., and other financial and securities exchange platforms like NASDAQ, DSE and CSE
abroad.

Banks, investment
companies
1.2 Financial Assets : are non-physical liquid asset which value is derived from a contrac-
tual claim.
 .Figure A (Peso bills and coins)
Figure
Figure BB (Other
(Other Currencies
Currencies with
with Php
Php conversion)
conversion)

$ US Dollar

Euro €

€ Euro
¥ Japanese Yen

Financial Assets: Other currencies with Php value (Peso conversion)

(AUD) Australian Dollar, (CAD) Canadian, (HKD) Hongkong Dollar, (SGD) Singapore Dollar,
(BND) Brunei Dollar, (GBP) English Pound, (CNY) Chinese Yuan etc.
International Bonds are issued primarily in USD and Euro denominations. Wealthy Filipino
individuals and known businesses are the primary investors in Eurobonds while multi cur-
rency trading is practiced in an over the counter in larger banks and thru exchange
platforms in the Philippines and internationally.

Note:
Not all foreign currencies are considered cash financial assets, those only having foreign ex-
change with the Philippine peso.
Bank Deposits

 Savings Account.
 Checking Account.
 Time Deposit Account. ...
 Dollar Account and other Foreign Currency Accounts. ...
 Joint Account

Investment in Bonds (Government: Treasury Bills, Treasury Notes)

Investment in Bonds (Private Corporations)

ALI raises P10-B from fixed-rate bonds

 financial asset

A mutual fund is a type of financial vehicle made up of a pool

of money collected from many investors to invest in securities
like stocks, bonds, money market instruments, and other as-
sets. Mutual funds are operated by professional money man-
agers, who allocate the fund's assets and attempt to produce

Shares of stock is a financial asset which entitles the owner of the stock to a proportion of
the corporation's assets and profits equal to how much stock they own. Units of stock are
called "shares."
Importance of Financial Assets
Financial assets, also referred to as financial instruments or securities, are intangible assets.
They are often used to finance the ownership of tangible assets as equipment and real es-
tate. In general, financial assets serve two main economic functions: the first is to transfer
funds from those who have surplus funds to invest to those who need a source of financing
tangible assets. The second is to redistribute the risk associated to the investment in tangi-
ble assets between different counterparties according to their preferences and risk aversion.
Financial assets represent legal claims to future cash expected often at a defined maturity.
The counterparties involved in the agreement are the institution or entity that will pay the
future cash (issuer) and the investors.
Some examples of financial assets as shown in the previous page are: stocks, bonds, bank
deposits and even loans due to the creditor. All these instruments can be classified in differ-
ent categories according to the features of the cash flow associated with them. They can be
classified as debt instruments or equity instruments. Debt instruments as bonds or loans
require a fixed amount payment; equity instruments have an uncertain cash flow, based on
the issuer’s earnings. Equity instruments are also referred to as residual claims because the
issuer can satisfy these claims only after holders of debt instruments have been paid.
There are also fixed income instruments that can be paid only after claims on debt instru-
ments have been satisfied. This is the case of preferred stocks and convertible bonds. In
general, all financial assets present some typical properties. Financial assets can be used as
a medium of exchange or can be converted into money at little cost or risk. This attractive
property for investors is called moneyless.
Divisibility and Denomination refers to the minimum amount or size in which assets can be
traded. For instance, Php denominated bonds are generally sold in P 1,000 denominations,
commercial paper in P100 units and deposits are infinitely divisible. Another property of
financial assets is reversibility, also referred to as turnaround cost or round-trip cost. It indi-
cates the cost of buying an asset and then re-selling it. The Cash Flow is the return associat-
ed to the investment on financial assets corresponded in different forms according to the
type of financial asset as dividends and options of stocks or coupon payments on
bonds. Term to maturity is the length of the period until the final repayment date or the
date at which the owner can demand the asset liquidation.
In different cases the financial assets may terminate before the stated maturity (in presence
of call provisions, bankruptcy of the issuer...) or can be also increased or extended on de-
mand of both counterparties.
Convertibility relates to the possibility to convert the financial assets into another type of
asset. This is the case of convertible bonds and preferred stocks.
Currency refers to the currency in which the asset’s cash flow is denominated. There are
some assets denominated in one currency that allow to earn cash flow in a different cur-
rency (dual currency securities), created to reduce the exchange rate risk. For example,
some types of Eurobonds can pay interest in one currency and principal in a second curren-
cy. Another property that characterizes financial assets is the Liquidity. The degree of liquid-
ity of an instrument can be determined either in the financial market or it can be deter-
mined by means of contractual obligations. An example of agreement that can determine
the degree of liquidity of an instrument is the claim of a private pension fund. In this case,
the asset is clearly considered illiquid in that the claim can be satisfied not before the re-
tirement date. Another basic property is the Risk/Return predictability, for which the riski-
ness associated to an asset depends on the uncertainty about future interest rates and fu-
ture cash flow (nominal expected returns). In case the future cash flow is known in ad-
vance, as contractually determined, the uncertainty may regard only the solvency of the
debtor. A financial asset can be also regarded as a combination of two or more simpler fi-
nancial instruments whose value is the sum of the price of its component parts. For in-
stance, the price of a callable bond corresponds to the price of a similar non-callable bond
less the value of the option that allows the issuer to redeem the bond early. This property is
called Complexity.
Finally, the last property is the so-called Tax status which depends on the governmental
regulations applying to the asset. The tax treatment generally varies according to the issuer
and owner nature, the asset maturity, the country’s or different territorial unit's legislation,
and so on. These properties are important to determine the pricing of the financial asset.
Basically, the true or correct price of a financial instrument is equal to the present value of
its expected cash flow. However, there are several theories on the pricing of financial assets
directly related to the notion of expected returns.

Bibliography
Fabozzi F., Modigliani F., Jones F. (2010), Foundation of Financial Markets and Institutions,
Pearson International Edition.

Editor: Bianca GIANNINI

© 2010 ASSONEBB
1.3 Financial Market Participants : Most basic component is the household , while Firms play
the major role in the interaction. Firms buy and sell securities for investment and financing
purposes, the financial institutions which are also firms may act as issuer, intermediary or
facilitator ( underwriter, broker, dealer) of the selling and distribution of securities. On the
other hand, the Government oversees and regulates all the financial claims and transactions
in the financial markets institutions. Moreso, the Government imposes penalties and sanc-
tion to the financial institutions upon violation of its policies.
Financial Market Participants is categorized into two;
(1) Investors/Lenders—consists of Corporations, Investment Banking ( Mutual Funds,
Pension Funds), Insurance Companies and Banks
(2) Issuers/Borrowers— are the Government. Corporations and Supra-national bodies.

GOVERNMENT
Fig 1. Market

HOUSEHOLD/INDIVIDUALS

FIRMS

Bank,Investment House, Insurance

Companies, Trading Flatforms, Securi-
ties Exchange and Clearing Houses

FINANCIAL INSTITUTIONS
Household - A household consists of one or more people who live in the same house and
share meals. It may also consist of a single family or another group of people. Generally,
household are also part of almost all forms of institutions. Household may buy invest-
ment with the purpose of obtaining additional income or securing future expenditures.
Firms - Generally these are institutions that are engaged in business for profit purposes
selling goods or services. Firms excess funds from its operations are placed as investments.
On the other hand, firms need some funds to run its operations or make some expansion
resort to financing by selling investments in the form of bonds, stocks and currencies.
Financial institutions play various roles in the financial system. It could be banks, invest-
ment houses, insurance companies, trading platforms and even the regulators. Banks can
play both the roles being the primary and the secondary market . Investment houses are
institutions duly licensed and authorized to underwrite securities in behalf of group of in-
vestors, corporations, including securities of the government.
Insurance companies are companies providing insurance is a contract for a premium. Repre-
sented by a policy, in which an individual or entity receives financial protection or reim-
bursement against losses from an insurance company. Insurance policies are used
to hedge against the risk of financial losses, both big and small, that may result from dam-
age to the insured or property, or from liability for damage or injury caused to a third party.
An insurance company operates by pooling risks among policyholders. Insurance companies
help businesses mitigate risk and protect their employees. As with consumers, helping busi-
nesses negate the effect of risk thus having a, positive impact to the economy which more
jobs is translated to an increased economic activity.

Provide safety and security:

Insurance provide financial support and reduce uncertainties in business and human life. It
provides safety and security against particular event. There is always a fear of sudden loss.
Insurance provides a cover against any sudden loss. For example, in case of life insurance
financial assistance is provided to the family of the insured on his death. In case of other in-
surance security is provided against the loss due to fire, marine, accidents etc.

Generates financial resources:

Insurance generate funds by collecting premium. These funds are invested in government
securities and stocks. These funds are gainfully employed in industrial development of a
country for generating more funds and utilized for the economic development of the coun-
try. Employment opportunities are increased by big investments leading to capital for-
Life insurance encourages savings:
Insurance does not only protect against risks and uncertainties, but also provides an invest-
ment channel too. Life insurance enables systematic savings due to payment of regular pre-
mium. Life insurance provides a mode of investment. It develops a habit of saving money by
paying premium. The insured get the lump sum amount at the maturity of the contract.
Promotes economic growth: generate impact by mobilizing domestic savings. Insurance
turn accumulated capital into productive investments. Insurance enables to mitigate loss,
financial stability and promotes trade resulting to economic growth and development .
Medical Support
Essential in managing risk in health. Rising medical expense is a crucial concern . Insurance
companies provide medical support in case of medical insurance policy.
Strategies and income generation
Insurance companies typically invest premiums, that are not used to pay claims and other
operating expenses. Through stock, corporate and government bonds, and real estate mort-
gages, these investments often finance building construction and provide other crucial sup-
port to economic development projects around the nation.
Asset Management Firms— An asset management company (AMC) is a firm that invests
pooled funds from clients, putting the capital to work through different investments including
stocks, bonds, real estate etc. AMC’s manage hedge funds and pension plans, and—to better
serve smaller investors—create pooled structures such as mutual funds, index funds, or ex-
change-traded funds, which they can manage in a single centralized portfolio.
Investment Banking is a specific division of banking related to the creation of capital for other
companies, governments and other entities. Investment banks underwrite new debt and equi-
ty securities for all types of corporations, aid in the sale of securities, and help to facili-
tate mergers and acquisitions, reorganizations and broker trades for both institutions and pri-
vate investors. Investment banks also provide guidance to issuers regarding the issue and
placement of stock.
•Unlike commercial banks and universal banks, investment banks do not take deposits
There is institutional separation of investment banking services from KB’s and UB’s. Invest-
ment banking activity is classed as either "sell side" or "buy side". The "sell side" involves trad-
ing securities for cash or for other securities (e.g. facilitating transactions, market-making), or
the promotion of securities (e.g. underwriting, research, etc.). The "buy side" involves the pro-
vision of advice to institutions that buy investment services. Private equity funds, mutual
funds, life insurance companies, unit trusts, and hedge funds are the most common types of
buy-side entities.
An advisor who provides investment banking must be a licensed broker-dealer
Investment banking provides investment management which is the professional management
of various securities (stocks, bonds, etc.) and other assets (e.g., real estate), to meet specified
investment goals for the benefit of investors. Investors may be institutions (insurance compa-
nies, pension funds, corporations etc.) or private investors (both directly via investment con-
tracts and more commonly via investment funds e.g., mutual funds).
Asset Management Companies in the Philippines

 Sun Life Asset Management

 BDO Capital & Investment Corporation
 Optima Balance Fund, Inc.
 Philam Managed Income Fund, Inc.
 ATR Kimeng Asiaplus Recovery Fund Inc.
 JAFTA Ventures & Investment Inc.
 JPGS Investment & Dev’t Corp.
 BPI Capital
Operations of Asset management Firms - manage funds for individuals and companies. They
make well-timed investment decisions on behalf of their clients. Working with a group of
several investors, asset management firms are able to diversify their clients' portfolios.
Generation of income - Asset management houses earn money through levying fees on their
clients, usually a proportion of the total money invested.
Investment Houses / Underwriters in the Philippines
 CLSA Exchange Capital, Inc
 Stateland Incorporated
 Investment and Capital Corporation
 RCBC Capital
 AB Capital and Investment Corporation
 Ortiz JM & Co., Inc.
 Abacus Capital & Investment Corporation
 BPI Capital Formation
 First Metro Investment Corporation
 Insular Investment and Trust Corp
Operations of Investment Houses - IPO, Investment Management, Structuring of Derivatives
(which involves highly technical and numerate people working on creating complex struc-
tured derivative products)
Generation of income- Investment houses profit by buying cheap and selling at higher prices
on the market. Investment banks are designed to finance or facilitate trade and investment
on a large scale. investment banks connect buyers and sellers in different markets, they
charge a commission on successful simple and large trades. Investment houses charge fees
for the services they offer from spinoffs ( company sells a piece of its operation to improve
efficiency or inject cash flow), underwriting of securities, mergers and acquisition. Moreo-
ver, Universal bank is also authorized to underwrite securities.
The Mechanics of Arbitrage

 Arbitrage is the purchase and sale of an asset in order to profit from a difference in the
asset's price between markets. It is a trade that profits by exploiting the price differences of
identical or similar financial instruments in different markets or in different forms. Arbitrage
is a type of trade in which a security, currency, or commodity is nearly simultaneously
bought and sold, in different markets. The purpose of arbitrage is to take advantage of the
difference in prices available for the same financial instrument being offered on different ex-
changes.
· Example :
As a simple example of arbitrage, consider the following. The stock of Company X is trading
at P20 on the Philippine Stock Exchange (PSE) while, at the same moment, it is trading for
P20.05 on the OTC dealer. A trader can buy the stock on the PSE and immediately sell the
same shares on the OTC, earning a profit of 5 cents per share. The trader could continue to
exploit this arbitrage until the specialists on the PSE run out of inventory of Company X's
stock, or until the specialists on the PSEE or OTC adjust their prices to wipe out the oppor-
tunity.
Arbitrage occurs when an investor can make a profit from simultaneously buying and selling
a commodity in two different markets. To cite an example in the international market, gold
may be traded on both New York and Tokyo stock exchanges in different prices.

Please watch on You Tube a very simple example how arbitrage works on a commodity (in
different markets) https://www.youtube .com/watch?v=0jk6uLZ1Tdc

Triangular arbitrage is the result of a discrepancy between three foreign currencies that oc-
curs when the currency's exchange rates do not exactly match up. These opportunities are
rare and traders who take advantage of them usually have advanced computer equipment
and/or programs to automate the process. The trader would exchange an amount at one
rate (EUR/USD), convert it again (EUR/GBP) and then convert it finally back to the original
(USD/GBP), and assuming low transaction costs, net a profit.

Basics of Triangular Arbitrage

This type of arbitrage is a riskless profit that occurs when a quoted exchange rate does not
equal the market's cross-exchange rate. International banks, who make markets in curren-
cies, exploit an inefficiency in the market where one market is overvalued and another is un-
dervalued. Price differences between exchange rates are only fractions of a cent, and in or-
der for this form of arbitrage to be profitable, a trader must trade a large amount of capital.
Risk Arbitrage (Investment Banker & Merger)
Usually after Mergers and Acquisitions of some firms, Investment Banker Plays an im-
portant role in the process;
Example :

Metrobank
MBTC acquires @ 30 per share, to trade maybe at 27, 28, or 29. The risk
is the gap in case the trade fails at that price.

Chinabank
CBC current price is @25/share

Riskless Arbitrage

Securities Securities
market A market B

Investment Banking doing

riskless arbitrage
on securities having exactly
the same characteristics

IB buys from A @100 and sells it to B @103, making .03 profit. Eventually, making an in-
crease in the demand for A thereby will tend to increase the price also maybe from 100
but not 105. For market, an increase in the supply would tend to lower and definitely
not 100. Price meets half way which mean arbitrage has ended.
1.4 Origination of Bonds issued by Private Corporations

SEC
approves

App
rov
es

Underwriting Contract

Private Underwriter
Proceeds—Bond Issue (Universal Bank, Investment
Corporations House)

Selling Agent
(GSED, secondary
market)

INVESTORS—FI’s, Private Corps., Insurance, Individuals

* Firm commitment by the Underwriter to sell the bond issue. Any un-
sold portion for account of the underwriter.
1.5 Origination of Bonds issued by the Government
Through the BSP and BTr: Via auction participated by the

BSP advise Bureau of Treasury

To CREDIT awarded bank for
the securities to their account
Custodian of securities
Banks individually tender bids,
holdings for all banks
via auction to the BSP
1.6 Primary and Secondary Market : A primary market issues new securities on an exchange
for companies, governments, and other groups to obtain financing through debt-based or eq-
uity-based securities. Primary markets are facilitated by underwriting groups consisting of in-
vestment banks that set a beginning price range for a given security and oversee its sale to in-
vestors. Once the initial sale is complete, further trading is conducted on the secondary mar-
ket, where the bulk of exchange trading occurs each day.
The secondary market is where investors buy and sell securities they already own. Stocks are
sold on the primary market when they are first issued during the IPO. Exchange such as
the Philippine Stock Exchange and the PDEX secondary market. Banks, on the other hand,
where debt securities are traded are also secondary markets.
1.7 Government: The BSP provides policy directions in the areas of money, banking and cred-
it. It supervises operations of banks and exercises regulatory powers over non-bank financial
institutions with quasi-banking functions, while SEC is the agency of the Government of the
Philippines responsible for regulating the securities industry in the Philippines. In addition to
its regulatory functions, the SEC also maintains the country's company register.
Along with these financial and security regulating bodies of the Philippine financial system is
the Philippine Insurance Commission which is an attached agency of the Department of Fi-
nance (DOF). One of our major functions is to promulgate and implement policies, rules and
regulations governing the operations of entities engaged in insurance and pre-need activities.
CONT… PG 23 AS OF SEPT 19
Activity 1 In liquidity order provide on the space provided below, the 5 kinds of financial
asset shown above.
1.
2.
3.
4.
5.
Activity 2 Brainstorming and matching : List down participants in the financial market
with the corresponding function;
1. _______________________, ______________________________
2. _______________________, ______________________________
3. _______________________, ______________________________
4. _______________________, ______________________________
5. _______________________, ______________________________
Activity 3 Brainstorming: List down top ten insurance companies in the Philippines
1. _______________________
2. _______________________
3. _______________________
4. _______________________
5. _______________________
6. _______________________
7. _______________________
8. _______________________
9. _______________________
10. _______________________

Activity 4 In 3 to 4 lines, how insurance companies contribute to economic growth?

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Activity 4 - Debt-Equity Concept Diagram : Below is a diagram that illustrates flow of
creditor-debtor relationship of an IPO for (equity) stocks. Do the same for bond issu-
ance by filling out the box, give specific name for the issuing company and the possi-
ble investors.

1. 2.

3. 4.
5.

7.
6.
8.

9.

10.
References and suggested readings

Avendan, F. W. (2019, August 13). 1 resource utilization [PowerPoint slides]. Google

Drive. https://drive.google.com/file/d/1Wk5Ylkdv85FcRu_5L_lswmAg6kyKF7WU/
view?usp=sharing
Mariano, N. D. (2020). Capital Markets( First ed., pp).economics (8th ed., pp. 4-15). Cen-
gage Learning.
Mankiw, N. G. (2018). Thinking like an economist. In Principles of microeconom-
ics (8th ed., pp. 20-34). Cengage Learning.
Orlick, N. (2013, February 14). The Giving Tree (Film Version) [Video]. YouTube. https://
www.youtube.com/watch?v=2wttWU3T34o
Slavin, S. L. (2008). Chapter 2. In Microeconomics (9th ed.). McGraw-Hill.
Slavin, S. L. (2008). Chapter 3. In Microeconomics (9th ed.). McGraw-Hill.
Sotelo, E. (n.d.). Economic systems [Infographics]. https://infograph.venngage.com/
p/76708/economic-systems

Altares et al., P. S. (2007). Mathematics of Investment (2007 ed.). (pp.3-16). Rex Book S
Unit 2 : Risk and Return Theory

Intended Learning Objectives:

 Explain and enumerate the different types of risks
 Explain the concept of return and relate risk and return
 Illustrate the different methods of calculating rates of return and explain the expected
return, variance and standard deviation of a portfolio
 Realize managed expected return after assessing the involved risks.

Overview:
 The lecture focuses on risk and return theory and the relationship of risk and return. It
also encompasses with the different tools used to calculate risk and measuring return.
 Essential Questions:
 How to calculate the following;
a) investment returns for a security or portfolio securities?
b) expected return and risk of a single asset and portfolio assets?

Words to Go By:
 Mean - is the average when all numbers are added up divided by the total numbers

 Net cash flows - the difference between the cash flow received from an investment and
the cash flow expended on an investment.
 Net income - the difference between the revenues from an investment and the expenses
spent on it. Normally translated into percentage called rates of return.
 Present Value - is the discounted value of the future returns.
 Rate of return - ratio of the net cash flow and the principal used to compare outcomes of
different investments, and also to measure historical performance, determining future in-
vestment and estimating cost of capital for capital investment decision. It shows the return
made on an investment.
 Range - is the highest data minus the lowest data
 Terminal Value - is the maturity value of an investment
 Standard Deviation- is a measure how spread out numbers are. It is the square root of
the variance (Mariano 2016)
 Variance - I the measure how close the scores in the data set are to the middle of dis-
tribution.
 Variability - the extent to which data points in a statistical distribution or data set di-
verge from the average or mean value. It is the extent to which these data points differ
from each other. Four commonly used measures of variability are; range, mean, variance
and standard deviation.
 Volatility - an asset’s price fluctuation and is accounted as the difference between maxi-
mum prices within trading session, trading day, month...the wider the range of swing in
the price , the higher the volatility and trading risks involved. Standard deviation is the
typical statistic used to measure volatility. Historical volatility equals to standard devia-
tion of an asset values within specified time frame, calculated from the historical prices.
Expected volatility is calculated from the current prices , on the assumption that the mar-
ket price of an asset reflects expected risks. Volatility may be shown by plotting the
changes in prices over a period of time graphically . You may refer to (NASDAQ: GOOG)
Graph, Alphabet Inc’s shares for the period March 21-27.
Risk Perception of an Asset Class
Directly proportion to the variability of its returns. The graph below shows the variance
(variability) and the standard deviation (volatility) of Conglomo Inc.

Frequency

-1 std +1 std

68% of all
outcomes

Variance

Monthly Return
E (r)

Source: CI Columbia.edu.com
(2017)
Discussions:
2.1 The Concept of Risk: Refer to the chances that the outcome of an event is unfavorable
or undesirable. Returns, on the other hand, refers to yields or earnings on an investment.
The risk-return tradeoff states that the potential return rises with an increase in risk. Using
this principle, individuals associate low levels of uncertainty with low potential returns, and
high levels of uncertainty or risk with high potential returns. According to the risk-return
tradeoff, invested money can render higher profits only if the investor will accept a higher
possibility of losses.
Types of Risks;
Credit Risk (also known as Default Risk ) Credit risk is the possibility of a loss due to bor-
rower's failure to repay its loan. It refers to the risk that a lender may not receive the owed
principal and interest from the borrower resulting in an interruption of cash flows.
Counterparty Risk is probability that the other party in an investment, credit, or trading
transaction is unable to fulfill its obligation on time. Failure to deliver securities or cash to
settle trades. Interest Rate Risk is a potential investment losses due to a change in interest
rates. If interest rates rise, for instance, the value of a bond or other fixed-income invest-
ment will decline. The change in a bond's price given a change in interest rates is known as
its duration. Interest rate risk can be reduced by holding bonds of different durations, and
investors may also mitigate interest rate risk by hedging fixed-income investments with in-
terest rate swaps, options, or other interest rate derivatives.
Foreign Exchange Risk Foreign exchange risk refers to the losses that an international fi-
nancial transaction may incur due to currency fluctuations. Also known as currency risk
Market Risk is the possibility of an investor experiencing losses due to factors that affect
the overall performance of the financial market. Market risk, also called "systematic risk,"
which cannot be eliminated through diversification
2.2 The Concept of returns: Are the revenues, earnings, yields, proceeds, income or profit
from investment and business operation. Measured based on the net cash flow or expected
to be realized or based on the net income from business operations. When talking about
investment in financial securities, returns could be an income, from price appreciation
which is the capital gain. Let say a 1 million investment in bond maturing 10 years, 40k
coupon interest semi annually, the income on the bond would be 80k a year equivalent to
8% of the face value of the bond (80,000/1,000,000). If the price of the bond increases and
the investor unloads his holdings, suppose the price is 100 and increases to 110, investors
earns additional from the increase if he decides to sell it at that higher price.
 Expected return , variance and standard deviation of a portfolio
Computation for interest rate on bond;
r = I/P
Where r = interest rate
I = interest received
P = principal or cost of investment
r = ₱80/₱1,000 = 8%
The increase in value or capital gain, which is the growth (g) in investment;
g = (CP-P)/P
Where CP = current price
P = principal or cost of =investment =

g = 1,100 - 1,000 = 100 = 10%

₱1,000 ₱1,000

Thus, the rate of return (ROR) = r+g

= 8% +10%
= 18%
Discussion will be focused on returns measured in form of cash flows expected to be realized.

2.3 Risk and Return - are interrelated because the returns from an investment should equate
the risk involved. Risk averse investor requires a higher return when making an investment in
a risky asset. Returns computed from a historical data can be used in measuring future re-
turns. Risk is the possibility that actual returns will deviate or differ from what is expected.
Actual returns may go up or down as dictated y the market. Terminal value, present value
and rate of returns must be considered when taking risks. Expected returns are the future
cash flows of the investment. Terminal value is the maturity value of an investment while
present value is the discounted value of the future returns. Rate of returns is the ratio of the
net cash flows and the principal or initial investment. Return is the profit or earnings on a
particular investment, which is why it is often termed ROI or return on investment. An in-
vestment of ₱1,000. Earning ₱100 translates to a 10% return ( ₱100 / ₱1,000)
2.4 Method of calculating rates of return; - There are several methods used in calculating
the rate of return on an investment
1. Holding period – rate of return measured for a given period which can be in a month or in
a year. The period covers 1 month to several months, or I year to several years. However,
rate of return in this method may seem to be unrealistic if it takes several years. It gives a
more accurate result if the holder does not hang on to the security until its maturity. Hold-
ing period is the time the investors hold the investment from the time of acquisition to time
of sale prior to maturity. The formula is:

R = EV + I- IV
IV
Where R = Returns for the period
EV= Ending value of an investment after an interval
I = Income received from investment
IV = Initial value of the investment at the beginning of the interval

Example: The market value of the stock Star Corp at the beginning of year is 1 is ₱120
per
share ; at the beginning of year 2 is ₱130 which shows an increase of ₱20 per
share. Find the holding period return of the investment?
R = EV + I - IV
IV
= ₱130 + ₱20 - ₱120
₱120
= ₱30
₱120
= 25%
Assume no dividend was declared. The holding period return is;
R = ₱130 + 0 - ₱120
₱120
= ₱10
₱120
= 8.33%
1. Average Rate of Return – measures the return across months or years
a. Arithmetic average - an unweighted average of the returns which formula is :
AR = ( Ʃ RoR ) ⁿ/n
Where AR = Average rate of return
n = Number of intervals
ROR = Holding period return for each month /year
For the month of January, return is computed as (February - January value)/January Value:
₱122-₱120 = ₱2 / ₱120 = .01667 = 1.667%
Then for the month of February, return is computed as (March value - February value)/
February value:
₱120-₱122 = (₱2) / ₱122 = (.01639) = (1.639%).
Take note that the return for February is negative because the value of return for March is
less than the value of return for February. (Same step to compute for the succeeding
months)
To compute for the average rate of return, the sum of calculated returns for each month is
is divided by the number of intervals which is 12.
Below is a table showing average return of .68%. The average rate of return for the first
five months would be 83% computed as [(1.67% - 1.64% + 1.67% + 0.82% + 1.63%)/5]
The holding period return for each month and the average rate of return are determined as
follows;

Month R in R in Decimals R in Percent (%)

Amount
January ₱120 ₱2 .0167 1.67%
February ₱122 (2) (.0164) (1.64%)
March ₱120 2 .0167 1.67
April ₱122 1 .0082 0.82
May ₱123 2 .0163 1.63
June ₱125 3 .0240 2.40
July ₱128 1 .0078 0.78
August ₱129 1 .0078 0.78
September ₱130 (2) (.0154) (1.54
October ₱128 2 .0156 1.56
November ₱130 0 0.0000 0.00
December ₱130 0 0.0000 0.00
January ₱130

Ʃ 0.0813/12 8.13% /12

AR = .006775 = .6775% = 68%
 b. Geometric average - measures the compounded growth rate of the initial investment
Which formula is:

1/n -
( 1 + R0R1)(1 + R0R2 )…(1 + R0Rn ) 1

Example: Taking the 5 months information from above, (Jan-May), the average rate of
return would be:
AR = [ 1.67% + (-1.64%) + 1.67% + 0.82% + 1.63% ]
= 5
4.15% / 5 = .83%

In geometric average method, RoRs are converted into decimal for easier computation.
1/5
ga = (1 + . 0167) [1 + (-.0164)]1 + .0167) (1 + .0082) (1 + .0163) -1

1/5
ga = (1 + . 0167) (.9836) ( .0167) (1.0082) (1.0163) ( 1.04177) -1
= 1.008218 -1
= .008218% or .8218
= .82%
*Note that the arithmetic average (.83%) is slightly higher than the geometric average (.82%)
c. Internal Rate of return (IRR)/ Yield to maturity - In computing for the IRR of the inves-
ment, the present value of the expected cash flows is taken into account. Present value table
of ₱1.00 per year for each of n years. Whether future returns are all the same or not discount
table will be used ( present value of ₱1.00 to be received after n years). Internal rate of re-
turn (IRR) is a metric used in capital budgeting measuring the profitability of potential invest-
ments. Internal rate of return is a discount rate that makes the net present value (NPV) of all
cash flows from a particular investment equal to zero.
Net Present Value (NVP) is the difference between the present value of future cash inflows
and the present value of the investment or the principal . If the NVP is positive, the invest-
ment is accepted . If negative, the investment is rejected.
IRR requires trial and error and interpolation. Yield to maturity is the IRR for bonds that
should start finding the estimated yield to maturity (Mejorada 1999). The approximate
yield to maturity (YM) would be:
C + __F - P___
Appox . YM = n_____
F + P___
2
Where C = Coupon / Interest collection
F = Face value
P = Price or principal
n = years to maturity

Example : A 10-year, 8% bond of ₱10,000 each was purchased at 98. What is the
yield to maturity of the bond?
Interest = ₱10,000 x 8% = ₱800
C + __F - P___
Appox . YM = n_____
F + P___
2

= 800 + [ (10,000 - 9,800)/10]

(10,000 + 9,800)/2

= 800 (200)/10 = 800 + 20 = .0828 = 8.28%

19,800/2 9,900
The yield to maturity (YM) or the IRR is between 8% and 9% . To compute for the exact
YTM;
Compute the present value using the said rates which should equal to the Initial value of
the
investment which is ₱9,800.00.

.
 At 8% At 9%
PV of Interest = ₱800 x PV of ordinary annuity for 10 years
= ₱800 x 6.710 ₱5,368
= ₱800 x 6.418 ₱5,314
PV of Principal = ₱10,000 x PV factor
= ₱10,000 x 0.4632 ₱4,632
= ₱10,000 x 0.4224 ______ ₱4224
Total PV ₱10,000 ₱9,358

Using interpolation,
Difference Difference Exact Rate
At 8% = 10,000 8%
? = 9,800 642 200 200/642 = + .31
At 9% = 9,358 YM 8.31%
The 642 is the difference between 10,000 and 9,358 and the 200 is the difference between
10,000 and 9,800. Dividing the difference with the first difference as the denominator and
the second difference as the numerator, we get .31, which we add to the 8% ( inasmuch as,
we are getting the rate between 8% and 9% ). To arrive at 8.31%, the exact rate of interest.
d. Trial and Error. If bond is trading below par ( at a discount), we can assume the YM
(discount rate) to be above the nominal rate on the bond and vice versa.
Assume a 15-year ₱1,000 bond paying interest of ₱110 (11%). The current price of the bond
is ₱932.21. We find the YM.
Since bond is trading at a discount, we assume that the YM is higher than 11% nominal rate .
So let us try 12%
Present value of interest payments = ₱110 x ordinary annuity PV factor at 12% for 15 years
₱110 x 6.811 ₱749.21.
Present value of interest principal = ₱1,000 x PV factor at 12% for 15 years
= ₱1,000 x 1.83 = ₱183.00
Total present value or price of the bond = ₱932.21.
The YM is exactly 12% as the price of the bond is equal to the total present value of interest
payments and principal.
e. Approximate YM
C + __F - P___
Appox . YM = n_____
F + P___
2
Applying the formula:

₱110 + (₱1,000 - ₱932.21)

Appox . YM = 15_____ = ₱110 + 4.52 = 11.85%
₱1,000 + ₱932.21 966.10
2
Take note that the 12% we got from the trial and error process is very near 11.85% we got
Using the formula. It said to be at discount if the purchase price is lower than the face value
of the bond like a ₱10,000 bond acquired at ₱9,800, and at a premium if the purchase price
is higher than the face value, like ₱10,000 bond purchased at ₱10,200. Bonds purchased
at discount have higher yield than nominal rate because the principal is lower than the face
value; consequently, bonds purchased at premium have a lower yield than the nominal rate,
because the principal is higher than the face value, which is the maturity value.

EXPECTED RETURNS, VARIANCE, AND STANDARD DEVIATION OF A PORTFOLIO

In making an investment decision, risk is always taken into consideration. There can be posi-
tive or negative outcomes of the choices. Risks are measured by calculating the standard
deviation of the historical return or average returns of the investment. The higher the risk,
the greater the chances of losses or gains. Returns are what we receive from our invest-
ment.
Two types of returns;
1. expected returns - is what we expect to get on our investment
2. Unexpected returns - gains or losses caused by unforeseen events.
Expected return is the sum of the products of the weight of each asset and their forecasted
returns. It is calculated as the weighted average of the likely profits of the assets in the
portfolio, weighted by the likely profits of each asset class. Expected return is calculated by
using the following formula;
 n
E (R) = Ʃ Pi x Ri
I=1
A simple way to write the formula;

E (R) = W1R1 + W2Rq + ...WnRn

Example 1: For simple portfolio of two mutual funds , one investing in stocks and the other
one in bonds if we expect the stock fund to return 12% and the bond to return 8% and our
allocation is 50% to each asset class, we have the following;
E (R) = (0.12)*(0.5) + (0.08)*(0.5)
= 0.06 + .04
= .10 or 10%
Example 2: Assume an investment manager has created a portfolio with stock A & Stock B.
Stock A has an expected return of 15% and a weight of 40% in the portfolio while Stock B
has
20% expected return and a weight of 60%. What is the expected return of the portfolio?
E (R) = (0.40)(0.15) + (0.60)(0.20)
= .06 + .12
= .18 = 18%

Variance
Variance (σ2 ) is measure of how numbers are distributed, how far each value in the data set
is from the mean ( µ ). It is the average of the squared differences from the mean. Variance
measures the variability from an average, that is, volatility, which is a measure of risk.
Therefore, this statistic can help determine the risk an investor might take when purchasing
a specific security. To find the variance, we follow three basic steps;
1. Subtract the mean from each value in the data set
2. Square each difference and add all the squares together.
3. Divide the sum of the squares by the number of values in the data set.
To incorporate expected returns with the concept of variance, we first compute for the ex-
pected returns. Given the probability and the forecasted sales for given scenarios, for exam-
ple, we get the expected returns by multiplying each probability by each forecasted sales.
Adding all the expected returns together gives the mean, which we need in computing the
variance.
Example: Assume that we were given the following assumptions relative to the sales of a
company and the related probabilities:
Variance

Scenario Probability Sales (in million)

1 0.15 ₱17
2 0.25 ₱15
3 0.25 ₱14
3 0.35 ₱12

The expected mean for the forecasted sales is:

(0.15)*(17.0) + (0.25)*(15.0) + (0.25)*(14.0) + (0.35)*(12.0)
= 2.55 + 3.75 + 3.5 + 4.2
= ₱14 million
Calculating variance starts by computing the difference in each potential sales outcome.
From ₱14 million mean value, we obtain and then square the differences:

Scenario Probability Deviation from Squared

Expected Value

1 0.15 (17-14) = 3 9
2 0.25 (15.0-14) =1 1
3 0.25 (14.0-14) = 0 0
4 0.35 12.0—14) = -2 4

Variance then weighs each squared deviation by its probability, giving us the following cal-
culation;
(0.15)*(9) + (0.25*(1) + (0.25)*(0) + (0.35)*(4)
= 1.35 + .25 + 0 + 1.4
=3
Therefore , variance is equal to ₱3 million. The mean is ₱14 million.
STRUCTURES OF RATES OF RETURN
The interest rates on various securities or investment are determined by factors such as
length of time to maturity , credit or default risk and liquidity. The difference in interest
rates arising from differences in length of time to maturity or term of the security is called
the
term Structure of interest rate. It is the relationship between interest rates and the length
of the time to maturity on dent securities, other things being equal.
The difference in interest rates arising from the credit or default risk is termed default risk or
credit risk structure of interest rates, It is the relationship between the return or yield on
debt securities and the risk that issuer may default on its obligation to pay the interest or
the principal. Default risk premium is the difference between the interest on the debt secu-
rity of a specific issuer and the interest on a government treasury security with the same
maturity. Comparison with a government security is made because government securities
are default free.
YIELD CURVE
Unit 3 : The Derivatives Market

Intended Learning Objectives:

 Analyze the nature and purpose of the derivative market. Differentiate each type of de-
rivative instrument or exchange contract in terms of use in making a business decision

Overview:
 The lecture focuses on the different financial exchange contracts and instruments in the
derivatives market involving different applicable currencies. To simplify the approach,
an example using a single commodity in different market prices will be given.

Essential Questions:
 What is a derivative market?
 How is derivatives contracts differ from the other?
 How are swaps/options contracts used in business transactions?

Words to Go By:
 Call Option - If you buy an options contract, it grants you the right, but not the obligation
to buy or sell an underlying asset at a set price on or before a certain date.
 Commodity futures- Contracts are agreements to buy or sell a raw material or any goods at
a specific date in the future at a particular price.
Currency Futures - are a exchange-traded futures contract that specify the price in
one currency at which another currency can be bought or sold at a future date.
Hedge - a transaction that offset any exposure to the fluctuations in financial prices of some
contract or business risk.
Intrinsic Value - The economic value of a financial contract, as distinct from the contract’s
time value. One way to think of the intrinsic value of the financial contract is to calculate its
value if it were a forward contract with the same delivery date. If the contract is an option,
its intrinsic value cannot be less than zero. The economic value of a financial contract, as dis-
tinct from the contract’s time value. One way to think of the intrinsic value of the financial
contract is to calculate its value if it were a forward contract with the same delivery date. If
the contract is an option, its intrinsic value cannot be less than zero.
Hedge - a transaction that offset any exposure to the fluctuations in financial prices of some
contract or business risk.
LIBOR - London Interbank Offer Rate, The rate of interest paid on offshore funds in the Euro-
dollar markets.
Premium - The cost associated with a derivative contract referring to intrinsic value and time
element.
Put Option - A put option is a contract giving the owner the right, but not the obligation, to
sell–or sell short–a specified amount of an underlying security at a pre-determined price
within a specified time frame. This pre-determined price that buyer of the put option can sell
at is called the strike price.
Strike Price - The price at which the holder of a derivative contract executes his right.

Discussions:
3.1 Derivative Market : The derivatives market is the financial market for derivatives, financial
instruments like futures contracts or options, which are derived from other forms of assets.
The market can be divided into two, that for exchange-traded derivatives and that for over-the
-counter derivatives.
3.2 Futures Contract : is a legal agreement to buy or sell a particular commodity asset, or se-
curity at a predetermined price at a specified time in the future. Futures contracts are stand-
ardized for quality and quantity to facilitate trading on a futures exchange.
3.3 Option Contract : is an agreement between a buyer and seller that gives the purchaser of
the option the right to buy or sell a particular asset at a later date at an agreed upon
price. Options contracts are often used in securities, commodities, and real estate transac-
tions.
3.4 Swaps : is a derivative contract through which two parties exchange the cash flows or lia-
bilities from two different financial instruments. Most swaps involve cash flows based on
a notional principal amount such as a loan or bond, although the instrument can be almost an-
ything. Usually, the principal does not change hands. Each cash flow comprises one leg of the
swap. One cash flow is generally fixed, while the other is variable and based on a benchmark
interest rate, floating currency exchange rate or index price.
How Does Futures Contract Work?
 Pleass see video clips at investopedia.com/terms/f/futurescontract.asp
The Basics of Future Contract vs. Forward Contract
Unlike standard future contracts, a forward contract can be customized to a commodity,
amount and delivery date. Commodities traded can be grains, precious metals, natural gas,
oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.
Forward contracts do not trade on a centralized exchange and are therefore regarded as
over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize
terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default
risk. As a result, forward contracts are not as easily available to the retail investor as futures
contracts.
Forward Contracts Versus Futures Contracts
Both forward and futures contracts involve the agreement to buy or sell a commodity at a
set price in the future. But there are slight differences between the two. While a forward
contract does not trade on an exchange, a futures contract does. Settlement for the forward
contract takes place at the end of the contract, while the futures contract p&l settles on a
daily basis. Most importantly, futures contracts exist as standardized contracts that are not
customized between counterparties.
How Does Option Contract Work?
There are several types of options contracts in financial transactions. An exchange trad-
ed option, for example, is a standardized contract that is settled through a clearing house
and is guaranteed. These exchange traded options cover stock op-
tions, commodity options, bond and interest rate options, index options,
and futures options. Another type of option contract is an over –the-counter option which
is a trade between two private parties. This may include interest rate op-
tions, currency exchange rate options, and swaps (i.e. trading long and short terms interest
rates).
Example of commodity option: Pls see www.youtube.com/watch?V=4HMm6mBvGKE
Call Option / Put option www.youtube.com/watch?V=EfmTWu2yn5Q
The main features of an exchange traded option, such as a call options contract, provides a
right to buy 100 shares of a security at a given price by a set date. The options contract
charges a market-based fee (called a premium). The stock price listed in the contract is
called the "strike price. At the same time, a put options contract gives the buyer of the
contract the right to sell the stock at a strike price by a specified date. In both cases, if the
buyer of the options contract does not act by the designated date, the option expires.
For example, in a simple call options contract, a trader may expect Company XYZ's stock
price to go up to $90 in the next month. The trader sees that he can buy an options con-
tract of Company XYZ at $4.50 with a strike price of $75 per share. The trader must pay
the cost of the option ($4.50 X 100 shares = $450). The stock price begins to rise as ex-
pected and stabilizes at $100. Prior to the expiry date on the options contract, the trader
executes the call option and buys the 100 shares of Company XYZ at $75, the strike price
on his options contract. He pays $7,500 for the stock. The trader can then sell his new
stock on the market for $10,000, making a $2,050 profit ($2,500 minus $450 for the op-
tions contract).