The World of Financial Markets and Institutions

Unit 3– Financial Market

Financial markets are the meeting place for people, corporations and institutions
that either need money or have money to lend or invest. In a broad context, the
financial markets exist as a vast global network of individuals and financial
institutions that may be lenders, borrowers or owners of public companies
worldwide.
The flow of money around the world is essential for businesses to operate and
grow. Stock markets are places where individual investors and corporations can
trade currencies, invest in companies, and arrange loans. Without the global
financial markets, governments would not be able to borrow money, companies
would not have access to the capital they need to expand, and investors and
individuals would be unable to buy and sell foreign currencies
Participants in the financial markets also include national, state and local
governments that are primarily borrowers of funds for highways, education.
Welfare and other public activities, their markets are referred to as public
financial markets. Large corporations raise funds in the corporate financial
markets.

Learning Outcomes
At the end of this unit, you will able to

 To describe the significant functions and activities on how financial market, money
market, capital market , foreign exchange market mortgage market and derivatives
works in the economy.

Pretest

Directions: Read the following sentences. Write the letter “T” if the statement is True and
“F” if the statement is False. Write your answer on the space before the number. You may
view this test at our google class.

________1. Private placement involves selling securities to the general public whereas a
public offering is a negotiated sale involving a specific buyer.

________2. Money markets are the meeting place for people, corporations and institutions
that either need money or have money to lend or invest.

________3. When a corporation uses the financial markets to raise new funds, the sale of
securities is said to be made in the secondary market by way of a new issue.

________4. Funds in a financial market can be obtained by a firm or an individual by

issuing debt instrument and equity instruments

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The World of Financial Markets and Institutions

________5. Equity instrument is a contractual agreement by the borrower to pay the holder
of the instrument fixed peso amounts at regular intervals until a specified date when a final
payment is made.

________6. Public offerings of debt and equity must be approved by and registered with
the Securities and Exchange Commission.

________7. The price at which the securities are bought and sold on a recognized stock
exchange is known as official quotation.

________8. The difference between a price at which a share is sold, and that at which it is
bought is known as indifference price.

________9. Stocks that trade on an organized exchange are said to be listed on that
exchange and to be listed, firms must meet certain minimum criteria and these criteria are
similar from one exchange to another.

________10. Secondary market is popularly known as Stock Market or Exchange.

Thank you for answering the test. Please see the back
content for the answer key or you may view it in the google
class.
The next section is the content of this unit. It contains
vital information. Please read the content.

Content

FINANCIAL MARKETS IN ACTION

Thanks to the global financial markets, money flows around the world between investors,
businesses, customers, and stock markets. Investors are not restricted to placing their money
with companies in the country where they live, and big businesses now have international
offices, so money needs to move efficiently between countries and continents. It is also
important for the growth of the global economy that people are able to invest money outside of
their domestic markets.
Corporations rely on the financial markets to provide funds for short-term operations and for
new plant and equipment. A firm may go to the markets and raise financial capital by either
borrowing money through a debt offering of corporate bonds or short-term notes, or by selling
ownership in the company through an issue of common stock. When a corporation uses the
financial markets to raise new funds, the sale of securities is said to be made in the primary
market by way of a new issue.
After the securities are sold to the public (institutions and individuals), they are traded in the
secondary market between investors. It is in the secondary market that prices are continually
changing as investors buy and sell securities based on their expectations of a corporation's
prospects. It is also in the secondary market that financial managers are given feedback about

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The World of Financial Markets and Institutions

their firm's performance. Those companies that perform well and are rewarded by the market
with high priced securities have an easier time raising new funds in the money and capital
markets than their competitors. They are also able to raise funds at a lower cost.
FUNCTION OF FINANCIAL MARKETS
Financial markets (bond and stock markets) and financial intermediaries (banks. insurance
companies among others) have the basic function of getting people together by moving funds
from those who have a surplus of funds to those who have a shortage of funds. Well-functioning
financial markets and financial intermediaries are crucial to our economic health. Indeed, when
the financial system breaks down severe economic hardship results.
To determine the effects of financial markets and financial intermediaries on the economy we
need to acquire an understanding of their general structure and operation.
The function that financial markets perform is shown schematically in the chart below

Indirect Finance

Funds Financial Funds

Intermediaries

Funds
Lender-Savers Borrowers- Spenders
Funds Funds
1. Households Financial 1. Business firm
2. Business firms
Market 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners
5.
Direct Finance

Discussion:
Those who have savings and are lending funds (the lender-savers), are at the left and those
who must borrow funds to finance their spending (the borrowers-spenders), are at the right.
The principal lender-savers are households, but business enterprises and the government as
well as foreigners and their government, sometimes also find themselves with excess funds and
so lend them out.
The most important borrower-spenders are businesses and the government (particularly the
material government) but households and foreigners also borrow to finance their purchases of
cars, furniture s and houses.
The arrows show that funds flow from lender-savers to borrower-spenders, both directly and
indirectly.

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Funds flow from lenders to borrowers indirectly through financial intermediaries such as banks
or directly through financial markets, such as the Philippine Stock Exchange.
WHAT FINANCIAL MARKETS DO
Financial markets take many different forms and operate in diverse ways. But all of them,
whether highly organized or highly informal serve the same basic functions.

 Raising capital.
 Commercial transactions.
 Price setting.
 Asset valuation.
 Arbitrage.
 Investing.
 Risk management.
STRUCTURE OF FINANCIAL MARKETS
There are many different financial markets in a developed economy each dealing with a
different type of security serving a different set of customers, or operating in a different part of
the country,
Debt and Equity Markets
Funds in a financial market can be obtained by a firm or an individual in two ways.
The most common method is to issue a debt instrument, such as a bond or a mortgage, which
is a contractual agreement by the borrower to pay the holder of the instrument fixed peso
amounts at regular intervals (interest and principal payments) until a specified date (the maturity
date), when a final payment is made. The maturity of a debt instrument is the number of years
(term) until that instrument's expiration date. A debt instrument is short term if its maturity is less
than a year and long-term it its maturity is ten years or longer. Debt instruments with a maturity
between one and ten years are said to be intermediate-term.
The second method of raising funds is by issuing equity instruments, such as common or
ordinary stock, which are claims to share in the net income (income after expenses and taxes)
and the assets of a business. If you own one share of common stock in a company that has
issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and I one
millionth of the firm's assets. Equities often make periodic payments (dividends) to their holders
and are considered long-term securities because they have no maturity date. In addition,
owning stock means that you own a portion of the firm and thus have the right to vote on issues
important to the firm and to elect its directors.
The main disadvantage of owning a corporation's equities rather than its debt is that an equity
holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays
its equity holders. The advantage of holding equities is that equity holders benefit directly from
any increases in the corporation's profitability or asset value because equities confer ownership
rights on the equity holders. Debt holders do not share in this benefit because their peso
payments are fixed.
The following markets are of most interest to the financial manager:

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Financial Market functions as both primary and secondary markets for debt and equity
securities.

 Primary Market

Primary market refers to original sale of securities by governments and operations. The
primary markets for securities are not well known to the public because the selling of
securities to initial buyers often takes place behind closed door. In a primary market
transaction, the corporation or the government is the seller and the transaction raises
money for the corporation or the government.

Corporations engage in two types of primary market transactions, public offerings and
private placements. A public offering. as the name suggests, involves selling securities
to the general public whereas a private placement is a negotiated sale involving a
specific buyer. Public offerings of debt and equity must be approved by and registered
with the Securities and Exchange Commission. Registration requires the firm to disclose
a great deal of information before selling any securities. The accounting legal and selling
costs of public offerings can be considerable.

To avoid partly the various regulatory requirements and the expense of public offerings,
debt and equity are often sold privately to large financial institutions such as insurance
companies or mutual funds. Such private placements need also to be approved and
registered with the SEC. An important financial institution that assists in the initial sale of
securities in the primary market is the investment bank. It does this by underwriting
securities. It guarantees a price for a corporation's securities and then sells them to the
public.

 Secondary Market

After the securities are sold to the public (institutions and individuals) they can be traded
in the secondary market between investors. Secondary market is popularly known as
Stock Market or Exchange.

Securities brokers and dealers are crucial to a well-functioning secondary market.

Brokers are agents of investors who match buyers with sellers of securities, dealers Iink
buyers and sellers by buying and selling securities and stated prices.
There are two broad segments of the stock markets:
 The Organized Stock Exchange. The stock exchanges will have a physical location
where stocks buying and selling transactions take place in the stock exchange floor (e.g.
Philippine stock Exchange New York Stock Exchange, Japan Nikkel, Shangnai
components, NASDAQ, etc.)

 The Over-the-Counter (OTC) Exchange. Where shares, bonds and money market
instruments are traded using a system of computer screens and telephones. The
NASDAQ is an example of an Over-the counter market in which dealers linked by
computer buy and sell stocks. Dealers in an over-the-counter market attempt to match

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The World of Financial Markets and Institutions

up the orders they receive from investors to buy and sell its stock. Dealers maintain an
inventory of the stocks they trade to help balance buy and sell orders. Many common
stocks are traded over the counter although the majority of the largest corporations have
their shares traded at organized stock exchange.
Secondary markets serve two important functions:
 They make it easier to sell these financial instruments to raise cash that is they make the
financial instruments more ligula. The increased liquidity of these instruments then
makes them more desirable and thus easier for the issuing firm to sell in the primary
market.

 They determine the price of the security that the issuing firm sells in the primary market.
The firms that buy securities in the primary market will pay the issuing corporation no
more than the price that they think the secondary market will set for this security. The
high the security's price in the secondary market, the higher will be price that the issuing
firm will receive for a new security in primary market and hence the grater the amount of
capital it can raise. Conditions in the secondary market are therefore the relevant
corporations issuing securities.
Stock Exchange
Stock exchange is an organized secondary market where securities like shares, debentures o
public companies, government securities and bonds issued by municipalities, public
corporations, utility undertakings, port trusts and such other local authorities are purchased and
sold. In order to bring liquidity, the stocks are traded systematically in a stock exchange.
The stock exchange is an entity (a corporation or mutual organization) which is in the business
of bringing buyers and sellers of stocks and securities together. The purpose of stock exchange
is to facilitate the exchange of securities between buyers and sellers, thus providing a market
place, virtual or real. The stock market that does not have a physical presence, it is a virtual
market. Share brokers may be assembled in a place called the "trading ring" and bought and
sold shares. Technology has enabled the ring to be located on a central computer, which has
millions of buyers and sellers attached to it through a telecommunication network. These buyers
and sellers indicate their intentions through a computer at home or the office, their own or their
broker's. Buyers' and sellers' orders are matched by the central computer, and if quantities and
prices correspond, then a trade is set to be executed. The entire process of sending the order to
the stock exchange computer, confirmation of order and execution, if any, is communicated
within a fraction of a second.
The stock exchange supplies a platform from which to buy and sell shares in certain listed
companies. It regulates the company's behavior through requirements agreed upon by the
company in order to be listed. This is called a listing agreement which ensures that the company
provides all the information pertaining to its working from time to time, including events that
affect its valuation, such as mergers, amalgamations and such other sensitive matters. Large
volumes are possible in these markets because of two things. One is the ease of settlements.
The shares that are traded in are received and delivered through an electronic entry in the
books of buyers and sellers. The second reason is guarantee of trades. Sellers get their money,
buyers get their shares. The stock market is known as barometer of the company’s economy.

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The companies listed on stock exchanges collectively contribute to the country's gross domestic
product (GDP).
Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed,
firms must meet certain minimum criteria concerning, for example number of shareholder and
asset size. These criteria differ from one exchange to another.
Listing of Securities on Stock Exchange
Listing means admission of securities to dealings on a recognized stock exchange of any
incorporated company, central and stage governments, quasi-governmental and other financial
institutions/corporations, municipalities, electricity boards, housing boards and so forth. The
principal objective listing is to provide liquidity and marketability to listed securities and ensure
effective monitoring of trading for the benefits of all participants in the market. A company
desiring to get listing has to enter into listing agreement with the concerned stock exchange and
is required to pay the specified listing fees. Thereafter, the company is required to comply with
all clauses of the listing agreement and to send details of book closure, record dates, copies of
annual report, quarterly and half-yearly reports and cash flow statements to the respective stock
exchange where the securities are listed. A recognized stock exchange means a stock
exchange being recognized by the national government through the Securities and Exchange
Commission (SEC). Securities are bought and sold in recognized stock exchanges through
members who are known as brokers. The price at which the securities are bought and sold on a
recognized stock exchange is known as official quotation.
The securities of an entity may be listed at any of the following stages:

 At the time of public issue of shares or debentures

 At the time of rights issue of shares or debentures
 At the time of bonus issue of shares
 Shares issued on amalgamation or merger
THE PHILIPPINE STOCK EXCHANGE
The Philippine Stock Exchange, Inc. (Filipino: Pamilihang Sapi ng Pilipinas; PSE: PSE) is the
national stock exchange of the Philippines. The exchange was created in 1992 from the merger
of the Manila Stock Exchange and the Makati Stock Exchange. Including previous forms, the
exchange has been in operation since 1927
The main index for PSE is the PSE Composite Index (PSEi) composed of thirty 30) listed
companies. The selection of companies in the PSEi is based on specific set of criteria. There
are also six additional sector-based indices. The PSE is overseen by a 15-member Board of
Directors, chaired by José T. Pardo.
Snapshot of PSE History
On February 3, 1936, the Securities and Exchange Commission announced that it had
"relinquished control of the Manila Stock Exchange.
The Philippine Stock Exchange was formed on December 23, 1992 from the merger of the
Manila Stock Exchange (MSE) (established on August 12, 1921, based on Muelle de la
Industria, Binondo, Manila) and the Makati Stock Exchange (MkSE) (established on May 15,

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The World of Financial Markets and Institutions

1963, based in the Makati Central Business District, within Ayala Tower One). Both exchanges
traded the same stocks of the same companies.
In June 1998, the Securities and Exchange Commission (SEC) granted the PSE a Self-
Regulatory Organization" (SRO) status, which meant that the bourse can implement its own
rules and establish penalties on erring trading participants (TPs) and listed companies.
In 2001, the PSE was transformed from a non-profit, non-stock, member- governed organization
into a shareholder-based, revenue-earning corporation headed by a president and a board of
directors and on December 15, 2003 listed its own shares on the exchange (traded under the
ticker symbol PSE). On July 26, 2010 the PSE launched its new trading system, PSE trade,
which was acquired from the New York Stock Exchange.
In 2019, the PSE introduced a new index that will help track the overall returns of the main
index. The Total Return Index (PSE, TR), is part of the effort to create a broader investor base
for the market.
The Philippine newspapers publish daily the activities in the Philippine Stock Exchange by
reporting (a) the PSE index, gain / loss and (b) individual trading outcome of publicly-listed
securities.
THE OVER-THE-COUNTER MARKET
The vast majority of publicly available equities are seldom bought or sold and are of no interest
to institutional investors. Such shares are usually traded over the counter (OTC). Tn the United
States, which has far more publicly traded companies than any other country, an estimated
25,000 firms trade over the counter, about three times as many as trade on organized
exchanges. Most of these are very small firms, and some do not file the periodic financial
reports and audited financial statements required by stock exchanges. (in the United States,
trading on the NASDAQ stock market is sometimes referred to as over-the counter trading, but
this convention is outdated).
OTC trading requires a brokerage firm to match a prospective buyer and a prospective seller at
a price acceptable to both. Alternatively, the brokerage firm may purchase shares for its own
account or sell shares that it has been holding. Several electronic services post bid and offer
prices for OTC shares as well as information about trading volume. However, as such shares
trade infrequently, a trade may be difficult to arrange owing to a lack of sellers or investors, and
the price at which the transaction is completed may be very different from the last price at which
those shares were traded days or even hours before. Firms, whose shares trade over the
counter normally have few shareholders and little equity outstanding. If a firm wishes to raise
larger amounts of capital in the equity market and to appeal to a broader shareholder base, it
will seek to list its shares on a stock exchange.
DAY TRADING
Day trading is the buying and selling of shares, currency, or other financial instruments in a
single day. he intention Is to profit from small price fluctuations-sometimes traders hold shares
for only a few minutes.
How it works

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Investors typically buy or sell a share based on their analysis of economic or market trends,
research into specific companies, or as part of a strategy to benefit from the regular dividends
that companies’ issue. Unlike such investors, day traders look for small movements in prices
that they can exploit to make a quick profit.
Day traders favor shares that are liquid-- those are easy to buy and sell in the secondary
market. They may hold shares only momentarily, buying at one price and selling when the price
rises Dy a few cents, perhaps only minutes later. traders make profits by trading large volumes
of shares in one transaction, or making multiple trades during the course of the day. They buy
(or sell) shares and then sell (or buy) them again before payment becomes due, and usually
close out all trades (selling the shares they have bought, and vice versa) at the end or the day
to protect themselves from off-hours movements in the market. This is different from long-term
investing, in which assets are held for longer periods in order to generate growth or income.
Potential Day Traders should be knowledgeable of the following:

 Market data. The current trading information for each day-trading market. Rather than
using market data that is available free of charge but can be up to an hour old, day ds
pay a premium for access to real-time data. Day traders must be able to trade on news
or announcements quickly, so they need to watch the market and stay close to their
trading screens at all times.
 Scalping. A strategy in which traders hold their share or financial asset (known as their
position) for Just a few minutes or even seconds.
 Margin trading. A method of buying shares that involves the day trader borrowing a part
of the sum needed from the broker who is executing the transaction.
 Bid-offer spread. The difference between a price at which a share is sold, and that at
which it is bought.
Potential Day Traders should be aware that:

 Day trading is a high-risk occupation- Day traders typically suffer severe losses in their
first months to trading, and many never graduate to profit-making status.
 Day trading is a stressful -Day traders must watch the market nonstop during the day,
concentrating on dozens of fluctuating indicators in the hope or spotting market trends.
 Day trading is expensive Day traders pay large sums in commissions, for training, and
for computers.
THE RISE OF THE FORMAL MARKETS
The formal financial markets have expanded rapidly in recent years, as governments in
countries marked by shadowy, semi1-legal markets nave sought to organize institutions. The
motivation was in part self-interest: informal markets generate no tax revenue, but officially
recognized markets do. Every country has financial markets of one sort or another. In countries
as diverse as China, Peru and Zimbabwe, investors can purchase shares and bonds issued by
local companies. Even in places whose governments loudly reject capitalist ideas, traders, often
labeled disparagingly as speculators, make markets in foreign currencies and in commodities
such as oil. Governments have also recognized that its businesses are to thrive they must be
able to raise capital, and formal means of doing this, such as selling shares on a stock
exchange, are much more efficient than informal means such as borrowing from money lenders.

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Investors have many reasons to prefer financial markets to street-corner trading. Yet not all
formal markets are successful, as investors gravitate to certain markets and leave others
underutilized. The busier ones, generally, have important attributes that smaller markets often
lack:

 Liquidity, the ease with which trading can be conducted. In an illiquid market an investor
may have difficulty finding another party ready to make the desired trade, and the
difference, or "spread", between the price at which a security can be bought and the
price for which it can be sold, may be high. Trading is easier and spreads are narrower
in more liquid markets. Because liquidity benefits almost everyone, trading usually
concentrates in markets that are already busy.
 Transparency. the availability of prompt and complete information about trades and
prices. Generally, the less transparent the market, the less willing people are to trade
there,
 Reliability, particularly when it comes to ensuring that trades are completed quickly
according to the terms agreed.
 Legal procedures adequate to settle disputes and enforce contracts
 Suitable investor protection and regulation. Excessive regulation can stifle a market.
However, trading will also be deterred if investors lack confidence in the available
information about the securities they may wish to trade, the procedures for trading, the
ability of trading partners and intermediaries to meet their commitments, and the
treatment they Will receive as owners of a security or commodity once a trade has been
completed.
 Low transaction costs. Many financial-market transactions are not tied to a specific
geographic location, and the participants will strive to complete them in places where
trading costs, regulatory costs and taxes are reasonable.
THE FORCES OF CHANGE
Today's financial markets would be almost unrecognizable to someone who traded there only
two or three decades ago. The speed of change has been accelerating as market participants
struggle to adjust to increased competition and constant innovation.

 Technology. Almost everything about the markets has been reshaped by the forces of
technology. Abundant computing power and cheap telecommunications have
encouraged the growth of entirely new types of financial instruments and have
dramatically changed the cost structure of every part of the financial industry.
 Deregulation. The trend towards deregulation has been worldwide. It is not long since
authorities everywhere kept tight controls on financial markets in the name of protecting
consumers and preserving financial stability. But since 1975, when the United States
prohibited stockbrokers from setting uniform commissions for share trading, the
restraints have been loosened in one country alter another. Although there are great
differences, most national regulators agree on the principles that individual investors
need substantial protection, but that dealings involving institutional investors require little
regulation.
 Liberalization. The reduction of regulations has been accompanied by a general
liberalization of rules governing participation in the markets. Many of the conditions that
once separated banks, investment banks, insurers, investment companies and other

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financial institutions have been lowered, allowing such firms to enter each other's
businesses. Rules that made it difficult for companies to issue shares have generally
been eased as well, leaving the decision or whether a young unprofitable firm's shares
represent a worthwhile investment to investors rather than regulators. The big market
economies, most recently Japan and South Korea, have also allowed foreign firms to
enter financial sectors that were formerly reserved for domestic companies.
 Consolidation. Liberalization has led to consolidation, as firms merge to take advantage
of economies of scale or to enter other areas of finance. Almost all the UK's leading
investment banks and brokerage houses, for example, have been acquired by foreigners
seeking a bigger presence in London, and many of the medium-sized investment banks
in the United States were bought by commercial banks wishing to use new powers to
expand in share dealing and corporate finance. Financial crisis led to further
consolidation, as the insolvency of many major banks and investment banks led to
forced mergers in 2008. However, the crisis also prompted law makers and regulators in
some countries to force banks to provide safety nets in their consumer banking
operations, separating them from their trading and corporate banking operations so that
consumers' deposits will not be at risk if other, riskier businesses produce large losses.
 Globalization. Most of the important financial firms are now highly international, with
operations in all the major financial centers. Many companies and governments take
advantage of these global networks to issue shares and bonds outside their home
countries. Investor’s increasingly take a global approach as well, putting their money
wherever they expect the greatest return for the risk involved, without worrying about
geography.
MONEY MARKETS AND CAPITAL MARKETS
MONEY MARKETS
Introduction
The term "Money Market" refers to the network of corporations, financial institutions, investors
and governments which deal with the flow of short-term capital. when a business needs cash for
a couple of months until a big payment arrives, or when a bank wants to invest money that
depositors may withdraw at any moment, or when a government tries to meet its payroll in the
face of big seasonal fluctuations in tax receipts, the short-term liquidity transactions occur in the
money market.
The money markets have expanded significantly in recent years as a result of the general
outflow of money from the banking industry, a process referred to as disintermediation. Until the
start of the 1980s, financial markets in almost all countries were centered on commercial banks.
Savers and investors kept most of their assets on deposit with banks, either as short-term
demand deposits, such as cheque-writing accounts, paying little or no interest, or in the form of
certificates of deposits that tied up the money for years. Drawing on this reliable supply of low-
cost money, banks were the main source of credit for both business and consumers.
How it works
The money market exists to provide the loans that financial institutions and governments need
to carry out their day-to-day operations. For instance, banks may sometimes need to borrow in

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The World of Financial Markets and Institutions

the short term to fulfill, their obligations to their customers, and they use the money market to do
so.
For example, most deposit accounts have a relatively short notice period and allow customers
access to their money ether immediately, or within a few days or weeks. Because of this short
notice period, banks cannot make long-term commitments with all of the money they hold on
deposit. They need to ensure that a proportion of it is liquid (easily accessible) in market terms.
Otherwise, if a large number of customers wish to withdraw their money at the same time, there
may be a shortfall between the money the bank has lent and the cash deposits it needs to
return to savers.
Banks may also find that they have greater demand for mortgages or loans than they do for
savings accounts at certain times. This creates a mismatch between the money they have
available and the money they have loaned out, so the bank will need to borrow in order to be
able to fulfill the demand for loans.
The money markets are the mechanisms that bring these borrowers and investors together
without the comparatively costly intermediation of banks. They make it possible for borrowers to
meet short-run liquidity needs and deal with irregular cash flows without resorting to more costly
means of raising money.
There is an identifiable money market for each currency, because interest rates vary from one
currency to another. These markets are not independent, and both investors and borrowers will
shift from one currency to another depending upon relative interest rates. However, regulations
limit the ability of some money- market investors to hold foreign-currency instruments, and most
money-market investors are concerned to minimize any risk of loss as a result of exchange-rate
fluctuations. For these reasons, most money-market transactions occur in the investor s home
currency.
Who uses the money market?
The primary function or the money market is for banks and other investors with liquid assets to
gain a return on their cash or loans. They provide borrowers such as other banks, brokerages,
and hedge funds with quick access to short-term funding. The money market is dominated by
professional investors, although retail investors with P50,000 can also invest. Smaller deposits
can be invested via money market funds. Banks and companies use the financial instruments
traded on the money market for different reasons, and they carry different risks.
Companies Banks Investors
a. When companies need to a. If demand for long-term a. Individuals seeking to
raise money to cover their loans and mortgages is invest large sums of
payroll or running costs, nor covered by deposits money at relatively low
they may issue from saving accounts, risk may invest in financial
commercial paper-short- bank may then issue instrument. Sums of less
term, unsecured loans for certificates of deposit, with than P50,000 can be
P100,000 or more that a set interest rate and invested in money market
mature within 1-9 months fixed-term maturity of up funds.
to five years.
b. A company that has a
cash surplus may “park”
money for a time in short-

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term, debt-based financial

instrument such as
treasury bills and
commercial paper,
certificates of deposit, or
bank deposits.

The money markets do not exist in a particular place or operate according to single set of rules.
Nor do they offer a single set of posted prices, With one current interest rate for money. Rather,
they are webs of borrowers and lender, all linked by telephones and computers. At the centre of
each web is the central bank whose policies determine the short-term interest rates for that
currency. Arrayed around the central bankers are the treasurers of tens of thousands of
businesses and government agencies, whose job is to invest any unneeded cash as safely and
profitably as possible and, when necessary, to borrow at the lowest possible cost. The
connections among them are established by banks and investment companies that trade
securities as their main business. The constant soundings among these diverse players for the
best available rate at a particular moment are the forces that keep the market competitive.
WHAT MONEY MARKETS DO
There is no precise definition of the money markets, but the phrase is usually applied to the
buying and selling of debt instruments maturing in one year or less. The money markets are
thus related to the bond markets, in which corporations and governments borrow and lend
based on longer-term contracts. Similar to bond investors, money-market investors are
extending credit, without taking any ownership in the borrowing entity or any control over
management.
Yet the money markets and the bond markets serve different purposes. Bond issuers typically
raise money to finance investments that will generate profits or, in the case of government
issuers, public benefits – for many years into the future. Issuers of money-market instruments
are usually more concerned with cash management or with financing their portfolios of financial
assets.
A well-functioning money market facilitates the development of a market for 1onger-term
securities. Money markets attach a price to liquidity, the availability of money for immediate
investment. The interest rates for extremely short-term use of money serve as benchmarks for
longer-term financial instruments. If the money markets are active, or "liquid", borrowers and
investors always have the option of engaging in a series of short-term transactions rather than
in longer term transactions, and this usually holds down longer-term rates. In the absence of
active money markets to set short-term rates, issuers and investors may have less confidence
that longer-term rates are reasonable and greater concern about being able to sell their
securities should they so choose. For this reason, countries, with less active money markets, on
balance, also tend to have less active bond markets.
TYPES OF MONEY-MARKET INSTRUMENTS
Money market securities are short-term instruments with an original maturity of less than one
year.

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There are numerous types of money-market instruments. The best known are commercial
papers, bankers’ acceptances, treasury bills, repurchase agreements, government agency
notes, local government notes, interbank loans, time deposits, bankers’ acceptance, and papers
issued by international organizations. The amount issued the course of a year is much greater
than the amount outstanding at any one time, as many money-market securities are outstanding
Tor only short periods of time.
Money market securities are used to "warehouse funds until needed. The returns earned on
these investments are low due to their low risk and high liquidity,
Money market securities are usually more widely traded than longer-term securities and so tend
to be more liquid.
Commercial paper
Commercial paper is a short-term debt obligation of a private-sector firm or a government-
sponsored corporation. Only companies with good credit ratings issue commercial paper
because investors are reluctant to bring the debt o financially compromised companies. They
tend to be issued by highly rated banks and are traded in a similar way to securities. In most
cases, the paper has lifetime, or maturity, greater than 90 days but less than nine months. This
maturity is dictated by regulations. In the Philippines, most new securities mu be registered with
the regulator, the Securities and Exchange Commission. Commercial paper is usually
unsecured although a particular commercial paper issue may be secured by a specific asset of
the issuer or may be guarantees by a bank.
Many large companies have continual commercial paper programmes, bringing new short-term
debt on to market every few weeks or months. It is common issuers to roll over their paper,
using the proceeds of a new issue to repay principal of a previous issue. In effect, this allows
issuers to borrow money for long periods of time at short-term interest rates, which may be
significantly lower than long term rates. The short-term nature of the obligation lowers the risk
perceived by investors.
These continual borrowing programmes are not riskless. If market conditions or a change in the
firm's financial circumstances preclude a new commercial paper issue, the borrower faces
default if it lacks the cash to redeem the paper that is maturing.
The use of commercial paper also creates a risk that if interest rates should rise, the total cost of
successive short-term borrowings may be greater than had the firm undertaken longer-term
borrowing when rates were low.
Bankers' acceptances
Before the 1980s, bankers’ acceptances were the main way tor firms to raise short-term funds in
the money markets. An acceptance is a promissory note issued by a non-financial firm to a bank
in return for a loan. The bank resells the note in the money market at a discount and guarantees
payment. Acceptances usually have a maturity of less than six months.
Bankers' acceptances differ from commercial paper in significant ways. They are usually tied to
the sale or storage of specific of specific goods, such as an export order for which the proceeds
will be received in two or three months. They are not issued at all by financial-industry firms.
They do not bear interest; instead, an investor purchases the acceptance at a discount from

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face value and then redeems it for face value at maturity. Investors rely on the strength of the
guarantor bank, rather than of the issuing company, for their security.
Treasury bills
Treasury bills, often referred to as T-bills, are securities with a maturity of one year or less,
issued by national governments. Treasury bills issued by aa government in its own currency are
generally considered the safest of all possible investments in that currency. Such securities
account for a larger share of money- market trading than any other type or instrument.
Government agency notes
National government agencies and government-sponsored corporations are heavy borrowers in
the money markets in many countries. These include entities such as development banks,
housing finance corporations, education lending agencies and agricultural finance agencies.
Local government notes
Local government notes are issued by, provincial or local governments, and by agencies of
these governments such as schools’ authorities and transport commissions. The ability of
governments at this level to issue money-market securities varies greatly from country to
country. in some cases, the approval of national authorities is required; in others, local agencies
are allowed to borrow only from banks and cannot enter the money markets.
Interbank loans
Loans extended from one bank to another with which it has no affiliation are called interbank
loans. Many of these loans are across international boundaries and are used by the borrowing
institution to re-lend to its own customers.
Banks lend far greater sums to other institutions in their own country. Overnight loans are short-
term unsecured loans from one bank another. They may be used to help the borrowing bank
finance loans to customers, but often the borrowing bank adds the money to its reserves in
order to meet regulatory requirements and to balance assets and liabilities.
Time deposits
Time deposits, another name for certificates of deposit or CDs, are interest bearing bank
deposits that cannot be withdrawn without penalty before a specified date. Although time
deposits may last for as long as five years, those with terms of less than one year compete with
other money-market instruments Time deposits with terms as brief as 30 days are common.
Large time deposits are often used by corporations, governments and money-market funds to
invest cash for brief periods. Interest rates depend on length of maturity, with long terms getting
better rate. The main risks are being locked into low interest rates " rates rise and early
withdrawal penalties.
Repos
Repurchase agreements known as repos, play a critical role in the money markets. They serve
to keep the markets highly liquid, which in turn ensures that there will be a constant supply of
buyers for new money-market instruments

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A repo is a combination of two transactions. In the first, a securities dealer, sun as a bank, sells
securities it owns to an investor, agreeing to repurchase securities at a specified higher price at
a future date. In the second transaction, days or months later, the repo is unwound as the
dealer buys back the securities from the investor. The amount the investor lends is less than the
market value of the securities, a difference called the spread or haircut, to ensure that it still has
sufficient collateral if the value of the securities should fall before the dealer repurchases them.
CAPITAL MARKETS
The capital market is a financial market in which longer-term debt (original maturity of one year
or greater) and equity instruments are traded. Capital market securities include bonds, stocks,
and mortgages. Capital market securities are often held by financial intermediaries such as
insurance companies and pension funds, which have little uncertainty about the amount of
funds they will have available in the future.
Capital Market Participants
The primary issuers of capital market securities are the

 National and local government, and

 Corporations
The national government issues long-term notes and bonds to fund the national debt while local
governments issue notes and bonds to finance capital projects.
Corporations issue both bonds and stock to finance capital investment expenditures and fund
other investment opportunities.
Capital Market Trading
Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks and bonds are introduced. Investment funds,
corporations, and individual investors can all purchase securities offered in the primary market.
You can think of a primary market transaction as one where the issuer of the security actually
receives the proceeds of the sale. When firms sell securities for the security actually receives
the proceeds of the sale. When firms sell securities for the very first time, the issue is an initial
public offering (IPO). Subsequent sales of a firm’s new stocks or bonds to the public are simply
primary market transactions (as opposed to an initial one).
The capital markets have well-developed secondary markets. A secondary market is where the
sale of previously issued securities takes place, and it is important because most investors plan
to sell long-term bonds before they reach maturity and eventually to sell their holdings of stock
as well. There are two types of exchanges in the secondary market for capital securities:
organized exchanges and over-the-counter exchanges. Whereas most money market
transactions originate over the phone, most capital market transactions, measured by volume,
occur in organized exchanges. An organized exchange has a building where securities
(including stocks, bonds, options, and features) trade. Exchange rules govern trading to ensure
the efficient and legal operation of the exchange, and the exchange's board constantly reviews
these rules to ensure that they result in competitive trading.
A. BONDS

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A bond is any long-term promissory note issued by the firm. A bond certificate is the tangible
evidence of debt issued by a corporation or a governmental body and represents a loan made
by investors to the issuer Bonds are the most prevalent example of the interest only loan with
Investors receiving exactly the same two sets of cash flows; (1) periodic interest payments, and
(2) the principal (par value or face value returned at maturity
Trading Process for Corporate Bonds
The initial or primary sale of corporate bond issues occurs either through a public offering, using
an investment bank serving as a security underwriter or through a private placement to a small
group of investors (often financial institutions). Generally, when a firm issues bonds to the
public, many investment banks are interested in underwriting the bonds. The bonds can
generally be sold in a national market.
Most often, corporate bonds are offered publicly through investment banking firms as
underwriters. Normally, the investment bank facilitates this transaction using a firm commitment
underwriting, illustrated in Figure 8-1. The investment bank guarantees the firm a price for newly
issued bonds by buying the whole issue at a fixed price (the bid price) from the bond-issuing
firm at a discount from par. The investment bank then seeks to resell these securities to
investors at a higher price (the offer price). As a result, the investment bank takes a risk that it
may not be able to resell the securities to investors at a higher price. This may occur if a firm's
bond value suddenly falls due to an unexpected change in interest rates or negative information
being released about the issuing firm. If this occurs, the investment bank takes a loss on its
security underwriting. However, the bond issuer is protected by being able to sell the whole
issue.

Sell Bonds Sell Bonds

Corporation Underwriter
Investors
(investment bank)

Pays Bid Price Pays Offer Price

Figure 8.1. Firm Commitment Underwriting of a Corporation Bond Issue

Other arrangements can be as follows:

 Competitive Sale
The investment bank can purchase the bonds through competitive bidding against other
investment banks or by directly negotiating with the issuer.
 Negotiated Sale
With a negotiated sale, a single investment bank obtains the exclusive right to originate,
underwrite and distribute the new bonds through a one-on-one negotiation process. With a
negotiated sale, the investment bank provides the origination and advising services to the
issuers.

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 Best Efforts Underwriting Basis

In their arrangement, the underwriter does not guarantee a firm price to the issuer. The
investment bank incurs no risk of mispricing the security since it simply seeks to sell the
securities at the best market price it can get for the issuing firm.
The advantages and disadvantages of using bonds can be summarized as follows:
Advantages

 Long-term debt is generally less expensive than other forms of financing because (a)
investors view debt as a relatively sale investment alternative and demand a lower rate
of return, and (interest expenses are tax deductible.
 Bondholders do not participate in extraordinary profits; the payment are limited to
interest.
 Bondholders do not have voting rights.
 Flotation costs of bonds are generally lower than those of ordinary (common) equity
shares.
Disadvantages

 Debt (other than income bonds) results in interest payments that, " if not met, can force
the firm into bankruptcy.
 Debt (other than income bonds) produces fixed charges, increasing the firm's financial
leverage. Although this may not be a disadvantage to all firms, it certainly is for some
firms with unstable earnings streams.
 Debt must be repaid at maturity and thus at some point involves a major cash outflow.
 The typically restrictive nature of indenture covenants may limit the firm's future financial
flexibility.
As of September, 2019, the following are bond issuances by the government, business firms in
the Philippines secured by Bond Funds and part of the Investment Portfolio of Mutual Funds:
ALFM Peso Bonds RCBC "Sustainability" Bonds
Grepalife Bonds Robinsons Bank
Philam Bonds Fixed Rate Corporate Bonds
Philequity Peso Bonds PH Samurai Bonds
Sun Life Prosperity Bonds Ayala Land lInc. (PH) Bonds

Bond Features and Prices

The various features of corporate bonds and some of the terminology associated with bonds
follow:
o Par Value. The face value of the bond that is returned to the bondholder at maturity.
o Coupon Interest Rate. The percentage of the par value of the bond that will be paid out
annually in the form of interest. Formula is: Stated interest payment divided the Par
value.
o Maturity. The length of time until the bond issuer returns the par value to the bondholder
and terminates the bond.

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o Indenture. The agreement between the firm issuing the bonds and the bond trustee who
represents the bondholders. It provides the specific terms of the loan agreement,
including the description of the bonds, the rights of the bondholders, the rights of the
issuing firm and the responsibilities of the trustees.
o Current Yield. This refers to the ratio of the annual interest payment to the bond's market
price.
o Yield to Maturity. This refers to the bond's internal rate of return, it is the discount rate
that equates the present value of the interest and principal payments with the current
market price of the bond.

Formula is:
Approximate Annual Interest Principal Payment - Price of the Bond
Yield = Payment + Number or Years to Maturity
60% (Price of the Bonds) + 40% (Principal Payment)

Illustrative Problem 8-1: Determination of Bond Yield to Maturity

Par value of bond: P1,000
Interest rate: 10%
Term: 10 years
Current price: P900
What is the bond's approximate yield to maturity?
Solution:
Approximate Yield = 100 + 1.000-900
To Maturity 10
.6 (900) +.4 (1,000)
= 110 or 11.70%
940

Credit Quality Risk

Credit quality risk is the chance that the bond issuer will not be able to make timely payments.
Bond ratings involve a judgment about the future risk potential of the bond provided by rating
agencies such as Moody's, Standard and Poor's and Fitch IBCA, Inc. Dominion Bond Rating
Services. Bond ratings are favorably affected by:

 A low utilization of financial leverage

 Profitable operations;
 A low variability of past earnings,
 Large firm size;
 Little use of subordinated debt.
The poorer the bond rating, the higher the rate of return demanded in the capital markets.

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The bond credit ratings agencies assign similar rating based on detailed analyses of issuers'
financial condition, general economic and credit market conditions, and the economic value of
any underlying collateral. The agencies conduct general economic analyses or Companies
business and analyze firm's specific financial situations. A single company for instance may
carry several outstanding bond issues and if these issues feature fundamental differences, then
they may nave different credit level risks. High quality corporate bonds are considered
investment grade, while higher credit risk bonds are speculative, also called junk bonds and
high-yield bonds.
Credit Ratings
For the finance manager, bond ratings are extremely important. They provide an indicator of
default risk that in turn affects the rate of return that must be paid on borrowed funds. An
example and description of these ratings follows:

Credit Risk Credit Rating Description

Investment Grade
AAA The obligor's (issuer's) capacity to meet its
Highest quality
financial commitment on the obligation is
extremely strong.
High quality AA The obligor's capacity to meet its financial
commitment on the obligation is very strong
A The obligor's capacity to meet its financial
commitment on the obligation is still strong
Upper medium grade
though somewhat susceptible to the adverse
effects of changes in circumstances and
economic conditions.
BBB The obligator exhibits adequate protection.
However, adverse economic conditions or
Medium grade
changing circumstances are more likely to lead a
weakened capacity to meet its financial
commitment.
Below Investment Grade
BB Faces major ongoing uncertainties or exposure
to adverse business, financial, or economic
Somewhat speculative
conditions which could lead to the obligor's
inadequate capacity to meet its financial
commitment.
B Adverse business, financial, or economic
Speculative
conditions will likely impair the obligor's capacity
or willingness to meet its financial commitment.
CCC Currently vulnerable to nonpayment, and is
Highly speculative dependent upon favorable business, financial,
and economic conditions for the obligor to meet
its financial commitment.
Most speculative CC Current highly vulnerable to nonpayment.

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Used to cover a situation where a bankruptcy

Imminent default petition has been filed or similar action taken, but
payments on this obligation are being continued.
D Obligations are in default or the filing of a
Default bankruptcy petition has occurred and payments
are jeopardized.

TYPES OF BONDS
A. Unsecured Long-Term Bonds
 Debentures. These are unsecured long-term debt and backed only by the reputation
and financial stability of the corporation. Because these bonds are unsecured, the
earning ability of the issuing corporation is of great concern to the bondholder, to provide
some protection to the bondholder, the issuing firm may be prohibited from issuing future
secured long-term debt that would create additional encumbrance of assets. To the
issuing firm, debentures will allow it to incur indebtedness and still preserve some future
borrowing power.
 Subordinated Debentures. Claims of bondholders of subordinated debentures are
honored only after the claims of secured debt and unsubordinated debentures have
been satisfied.
 Income Bonds. An income bond requires interest payments only if earned and non-
payment of interest does not lead to bankruptcy. Usually issued during the
reorganization of a firm facing financial difficulties, these bonds have longer maturity and
unpaid interest is generally allowed to accumulate for some period of time and must be
paid prior to the payment of any dividends to stockholders.
B. Secured Long-Term Bonds
 Mortgage Bonds
A mortgage bond is a bond secured by a lien on real property. Typically, the market
value of the real property is greater than that of the mortgage bonds issued. This
provides the mortgage bondholders with a margin safety in the event that the market
value of the secured property declines. Should the issuing firm fail to pay the bonds at
maturity; the trustees can foreclose or sell the mortgaged property and use the proceeds
to pay bondholders.
Mortgage bonds can further be subclassified as follows:
a) First Mortgage Bonds. The first mortgage bonds have the senior claim on the secured
assets it the same property has been pledged on more than one mortgage bond.

b) Second Mortgage Bonds. These bonds have the second claim on assets and are paid
only after the claims of the first mortgage bonds have been satisfied.

c) Blanket or General Mortgage Bonds. All the assets of the firm are used as security for
this type or bonds.

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d) Closed-end Mortgage Bonds. The closed-end mortgage bonds forbid the further use of
the pledged assets security for other bonds. This protects the bondholders from dilution
of their claims on the assets by any future mortgage bonds.

e) Open-end Mortgage Bonds. These bonds allow the issuance of additional mortgage
bonds using the same secured assets as security. However, a restriction may be placed
upon the borrower, requiring that additional assets should be added to the secured
property if new debt is issued.

f) Limited Open-end Mortgage Bonds. These bonds allow the issuance of additional bonds
up to a limited amount at the same priority level using the already mortgaged assets as
security.
OTHER TYPES OF BONDS

 Floating Rate or Variable Rate Bonds

A floating rate bond is one in which the interest payment changes with market
conditions. In periods of unstable interest rates this type of debt offering becomes
appealing to issuers and investors. To the issuers like banks and finance companies,
whose revenues go up when interest rates rise and decline as interest rates fall, this
type of debt eliminates some of the risk and variability in earnings that accompany
interest rate swings. To the investor, it eliminates major swings in the market value of the
debt that would otherwise have occurred if interest rates had changed.

A common feature of all the floating rate bonds is that an attempt is being made to
counter uncertainty by allowing the interest rate to float [e.g., interest rates may be
adjusted quarterly at 3% above the three-month London Interbank Offered Rate
(LIBOR). In this way a change in cash inflows to the firm may be offset by an adjustment
in interest payments.

 Junk or Low-Rated Bonds

Junk or low rated bonds are bonds rated BB or below. The major participants of this
market are new firms that do not have an established record of performance, although in
recent years junk bonds have been increasingly issued to finance corporate buyouts.
Since junk bonds are of speculative grade, they carry a coupon rate of between 3 to 5
payment more than AAA grade long-term debt. As a result, there is now an active
market for these new debt instruments. Because of the acceptance of junk or low-rated
bonds, many new firms without established performance records now have a viable
financing alternative to secure financing through a public offering, rather than being
forced to rely on more-costly commercial bank loans.

 Eurobonds

These are bonds payable or denominated in the borrower currency, but sold outside the
country of the borrower, usually by an international syndicate of investment bankers.
This market is denominated by bonds stated in U.S. dollars.

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The Eurobond is usually sold by an international syndicate of investment bankers and

includes bonds sold by companies In Switzerland, Japan, Netherlands, Germany, the
United States and Britain, to name the most popular countries

An example might be a bond of a U.S. company payable in dollars and sold in London,
Paris, Tokyo or Frankfurt.

Eurobonds are also referred to as bonds issued in Europe by an American company and
pay interest and principal to the lender in U.S. dollars.

The use of Eurobonds by U.S. firms to raise funds has fluctuated dramatically with the
relative interest rates an abundance or lack of funds in the European markets dictating
the degree to which they are used.

 Treasury Bonds

Treasury bonds carry the "full-faith-and-credit" backing of the government and investors
consider them among the safest fixed- income investments in the world. The BSP sells
Treasury securities through public auctions usually to finance the government's budget
deficit. When the deficit is large, more bonds come to auction. In addition, the BSP uses
Treasury securities to implement monetary policy.
B. ORDINARY (COMMON) EQUITY SHAREs
Ordinary equity shares (traditionally known as ordinary equity share) is a form of long-term
equity that represents ownership interest of the firm. Ordinary equity shareholders are called
residual owners because their claim to earnings and assets is what remains alter satisfying the
prior claims of various creditors and preferred shareholders. Ordinary (common) equity
shareholders are the true owners of the corporation and consequently bear the ultimate risks
and rewards of ownership.
Business firms organized as a corporation may choose to issue publicly traded stock (publicly
owned corporation) or keep ownership only among the original organizers (closely held
corporation). As owners of the firm, ordinary shareholders are considered to be residual
domains. This means that ordinary shareholders have the right to claim any cash flows or value
after all other claimants have received what they are owed. These profits can used to reinvest in
the firm to foster growth, pay out as dividends to shareholder or a combination of the two.
Shareholders assume a limited liability because their risk of potential loss is limited to their
investment in the corporation's equity shares
FEATURES OF ORDINARY EQUITY SHARES
 Par value/No par value

Ordinary equity share may be sold with or without par value. Whether or not ordinary
equity share has any par value is stated in the corporation's charter. Par value of
ordinary equity share is the stated value attached to a single share at issuance. It has

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little significance except for accounting and legal purposes. If ordinary equity share is
initially sold for more than Its par value, the issue price in excess of par is recorded as
additional paid-in capital, capital surplus, or capital in excess of par. A firm issuing no par
share may either assign a stated value or place it on the books at the price at which the
equity share is sold.

 Authorized, issued, and outstanding

Authorized shares are the maximum number of shares that a corporation may issue
without amending its charter. Issued shares is the number of authorized shares that
have been sold. Outstanding shares are those shares held by the public. Both the firm's
dividends per share and earnings per share are based on the outstanding shares. The
number of issued shares may be greater than the number of outstanding shares
because shares may be repurchased by the issuing firm. Previously issued shares that
are reacquired and held by the firm are called treasury Shares. Thus, outstanding share
is issued share less treasury share.

 No maturity

Ordinary equity share has no maturity and is a permanent form of long-term financing.
Although ordinary share is neither callable nor convertible, the firm can repurchase its
shares in the secondary markets either through a brokerage firm a tender offer. A tender
offer is a formal offer to purchase shares of a corporation.

 Voting rights

Each share of ordinary equity generally entitles the holder to vote on selection of
directors and in other matters. Shareholders unable to attend the annual meeting to vote
may vote by proxy. A proxy is done under transfer of the right to vote to another party.
Proxy voting is done under the rules and regulations of the Securities and Exchange
Commission, but proxy solicitations are the firm's responsibility. Not all ordinary equity
shareholders have equal voting power. Some firms have more than one class of share.
Class A ordinary (common) equity share typically has limited or no voting rights while
Class B has full voting rights.
There are two common systems of voting:
a) Majority voting

Majority voting is a voting system that entitles each shareholder to cast one vote for
each share owned. Majority voting is used to indicate the ordinary (common) equity
shareholders’ approval or disapproval of most proposed managerial actions on which
shareholders may vote. The directors receiving the majority or the votes are elected.
If a group controls over 50 percent of the votes, it can elect all of the directors and
prevent minority shareholders from electing any directors.

b) Cumulative voting

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Cumulative voting is a voting system that permits the shareholder to cast multiple
votes for a single director. Cumulative voting assists minority shareholders in electing
at least one director. Cumulative voting is required in some jurisdictions for electing
the board of directors.

 Book value per share

The accounting value of an ordinary equity share is equal to the ordinary share equity
(ordinary share plus paid-in capital plus retained earnings) divided by the number of shares
outstanding

 Numerous rights of stockholders

Collective and individual rights of ordinary equity shareholders include among others:
a) Right to vote on specific 1SSues as prescribed by the corporate charter such as
election of the board of directors, selecting the firm's independent auditors, amending
the articles of incorporation and bylaws, increasing the amount of authorized stock,
and so forth.
b) Right to receive dividends if declared by the firm’s board of directors.
c) Right to share in the residual assets in the event of liquidation.
d) Right to transfer their ownership in the firm to another party.
e) Right to examine the corporate banks.
f) Right to share proportionally in the purchase of any new issuance of equity shares.
This Is known as the pre-emptive right.
VALUATION
Ordinary or common equity share valuation is complicated by the uncertainty of future returns
and / or changes in the share's price.
C. PREFERRED SHARE
Preferred share is a class of equity shares which has preference over ordinary (common) equity
shares in the payment of dividends and in the distribution of corporation assets in the event of
liquidation.
Preference means only that the holders of the preferred share must receive a dividend (in the
case of a going concern firm) before holder of ordinary (common) equity shares are entitled to
anything. Preferred shares generally has no voting privileges but it is a form of equity from a
legal and tax stand point.
The issuance of preferred shares is favored when the following conditions prevail:

 Control problems exist with the issuance of ordinary share.

 Profit margins are adequate to make of additional leverage attractive.
 Additional debt poses substantial risk.
 Interest rates are low lowering the cost of preferred share.
 The firm has a high debt rati0, suggesting infusion of equity financing needed.
PREFERRED SHARE FEATURES

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The following are the major features of preferred share:

 Par value. Par values is the face value that appears on the stock certificate. In some
cases, the liquidation value per share is provided for in the certificate.
 Dividends. Dividends are stated as a percentage of the par value and are commonly
fixed and paid quarterly but are not guaranteed by the issuing firm. Some recent
preferred share issues called adjustable rate, variable rate, or Floating rate preferred, do
not have a fixed dividend rate but peg dividends to an underlying index such as one of
the Treasury bill rate or other money market rates.
 Cumulative and Noncumulative dividends. Dividends payable to preferred shares are
either cumulative or noncumulative; most are cumulative. lf preferred dividends are
cumulative are not paid in a particular year, they will be carried forward as an arrearage.
Usually, both accumulated (past) preferred dividends and the current preferred dividends
must be paid before the ordinary equity shareholders receive anything. If the preferred
dividends are noncumulative, dividends not declared in any particular year are lost
forever and the preferred shareholders cannot claim such anymore.
 No definite maturity dates. Preferred share is usually intended to be a permanent part of
a firm's equity and has no definite maturity date. However, preferred share sometimes
carries special retirement provisions. Almost all preferred shares have a call feature that
gives the issuing firm the option of purchasing the share directly from its owners, usually
at a premium above its par value. Some preferred shares have a sinking fund provision
that requires the issuer to repurchase and retire the share on a scheduled basis. Owners
of convertible preferred share have the option of exchanging their preferred share for
ordinary (common) equity share based on specified terms and conditions.
 Convertible preferred share. Owners of convertible preferred share have the option of
exchanging their preferred share for ordinary (common) equity share based on specified
terms and conditions.
 Voting rights. Preferred share does not ordinarily carry voting rights. Special voting
procedures may take effect if the issuing firm omits its preferred dividends for a specific
time period. Preferred shareholders are hen permitted to elect a certain number of
members to the board of directors in order to represent the preferred shareholder
interests.
 Participating features. Participating preferred share entitles its holders to share in profits
above and beyond the declared dividend, along with ordinary (common) equity
shareholders. Most preferred share issues are nonparticipating. Without nonparticipated
preferred, the return is limited to the stipulated dividend.
 Protective features. Preferred share issues often contain covenants to assure the regular
payment of preferred share dividends and to improve the quality of preferred share. For
example, covenants may restrict the amount of common share cash dividends, specify
minimum working-capital levels, and limit the sale of securities senior to preferred share.
Preferred shareholders have priority over ordinary (common) equity shareholders with
regard to earnings and assets. Thus, dividends must be paid on preferred share before
they can be paid on the ordinary (common) equity share, and in the event of bankruptcy,
the claims of the preferred shareholders must be satisfied before the ordinary (common)
equity shareholders receive anything. To reinforce these features, most preferred shares
have coverage requirements similar to those on bonds. These restrictions limit the

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amount of preferred share a company can use, and they also require a minimum level of
retained earnings before common dividends can be paid.
 Call provision. A call provision gives the issuing corporation the right to call in the
preferred share for redemption. As in the case of bonds, call provisions generally state
that the company must pay an amount greater than the par value of the preferred share,
the additional sum being termed a call premium. For example, Himaya Corporation's 12
%, P100 par value preferred share, issued in 2005, is noncallable for 10 year, but may
be called at a price of P112 after 2015.
 Maturity. Three decades ago, most preferred share was perpetual -it had no maturity
and never needed to be paid off. However, today most preferred share has a sinking
fund and thus an effective maturity date.
PREFERRED SHARE VALUATION
Preferred share is share that has a claim against income and assets before ordinary share but
after debt. Often, preferred share considered a hybrid security because it possesses
characteristics of both debt and equity. Generally, preferred share is considered similar to
ordinary (common) equity share because they do not have maturity and similar to debt in that
bon securities have fixed payments, dividends for preferred share and interest for debt.
Preferred share valuation is relatively simple if the firm pays fixed dividends at the end of each
year. If this condition holds, then the stream of dividend payments can be treated in perpetuity
and be discounted by the investor s required rate of return on a preferred share issue. A
perpetuity is an annuity with an infinite lite span. If. the preferred share has high risk, investors
normally require a higher rate of return. This is because creditors have priority over preferred
shareholders in their claims to both income and assets.
Thus, the intrinsic value of a share of preferred share (P o) is the sum of the present values of
future dividends discounted at the investor's required rate of return. This also can be determined
using the following valuation model.
Po = Dp________
Kp

where: Dp, = Per share cash dividend

Kp, = Investor's required rate of return on preferred share

For example, Federal Electric and Power Company has an issue of preferred share outstanding
that pays a yearly dividend or P10.80. Investors require a 12% return on this preferred share.
Determine the intrinsic value of the preferred share.
Solutions:
P0 = P10.80___
12%
P90

In the Philippines, the following preferred shares are actively traded in the Philippine Stock
Exchange:

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First Philippine Holding- Preferred

San Miguel Purefoods- Preferred
Petron Corporation Perpetual- Preferred
Swift Foods, Inc. - Convertible Preferred

COMPARATIVE FEATURES OF ORDINARY EQUITY SHARES, PREFERRED SHARES AND

BONDS
The characteristics of ordinary shares, preferred shares and bonds are compared in the
following table.

Ordinary Equity Preferred Shares Bonds

Shares
(a) Ownership and Belongs to ordinary Limited rights Limited rights under
control of the firm equity shareholders when dividends default in interest
through voting right missed payments
and residual claim to
income
(b) Obligation to None Must receive Contractual obligation
provide return payment before
ordinary
shareholder
(c) Claim to assets in Lowest claim of any Bondholders and Highest claim
bankruptcy security holder creditors must be
satisfied first
(d) Cost of Highest Moderate Lowest
distribution
(e) Risk-return trade Highest risk, highest Moderate risk, Lowest risk, moderate
off return (at least in moderate return return
theory)
(f) Tax status of Not deductible Not deductible Tax deductible
payment by Cost=interest payment x
corporation (1-tax rate)
(g) Tax status of A portion of Dividend Same as ordinary Government bond
payment to recipient paid to another shares interest is tax exempt
corporation is tax
exempt

FOREIGN EXCHANGE MARKET

INTRODUCTION
Most countries of the world have their own currencies: The United States has its dollar, France,
the euro, Brazil, its real; India, its rupee and in the Philippines is peso. Trade between countries
involves the mutual exchange of different currencies (or, more usually, bank deposits
denominated in different currencies) When an American firm buys foreign goods, services, or
financial assets, for example, U.S. dollars (typically, bank deposits denominated in U.S. dollars)
must be exchanged for foreign currency (bank deposits denominated in the foreign currency).

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The trading of currency and bank deposits denominated in particular currencies takes place in
the foreign exchange market. The volume of these transactions worldwide averages over P1
trillion daily. Transactions conducted in the foreign exchange market determine the rates at
which currencies are exchanged, which in turn determine the cost of purchasing foreign goods
and financial assets.
Firms that do business internationally must be concerned with exchange rates, which are the
relationships among the values of currencies. For example, a Philippine firm selling products in
Europe will be very interested in the relationship of the Euro to the Philippine peso as well as
the US dollar. The constant change in exchange rates causes problems for financial managers
as the change in relative purchasing power between countries affects imports and exports,
interest rates and other economic variables. The relative strength of a particular currency to
other currencies changes many times over a business cycle.
RECENT HISTORICAL PERSPECTIVE OF EXCHANGE RATES
From the end of World War Il until the early 70’s, the world was on a fixed exchange rate
system administered by the international Monetary Fund (IMF) Under this system, all countries
were required to set a specific parity rate for their currency vis-a-vis the United States dollar. A
country could effect a major adjustment in the exchange rate by changing the parity rate with
respect to the dollar. Then the currency was made cheaper respect to the dollar, this adjustment
was called a devaluation. An upvaluation or revaluation resulted when a currency became more
expensive with respect to the dollar.
A floating rate international currency system has been operating since 1973 Most major
currencies fluctuate freely depending upon their values as perceived by the traders in foreign
exchange markets. The determination or exchange rates are influenced by such important
factors as (a) the country s economic strengths, (b) its level of exports and imports, (c) the level
of monetary activity, and (d) the deficits or surpluses in its balance of payments. Short term,
day-to-day fluctuations in exchange rates are caused by supply and demand conditions in the
foreign exchange market
THE FOREIGN CURRENCY EXCHANGE MARKET
The forex market provides a service to individuals, businesses, and governments who need to
buy or sell currencies other than that used in their country. This might be in order to travel
abroad, to make investments in another country, or to pay for import products or convert export
earnings.
It is also a marketplace in which currencies are bought and sold purely to make profit via
speculation. When trading very large volumes of currency, even small fluctuations in price can
provide profits or losses. The forex market is open 24 hours, 5 days a week, which makes it
unusual, as equity markets have set daily trading hours and are closed overnight.
The foreign exchange (or forex) market provides a mechanism for the transfer of purchasing
power from one currency to another. This is where traders convert one foreign currency into
another and is one of the largest financial markets in the world. Currency trading entails no
specific physical location; instead, it is an over-the-counter market whose mam participants are
commercial and investment banks, and foreign exchange dealers and brokers around the world.

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They communicate using electronic networks. Any firm's bank or experts within the firm, can
access this market to exchange one currency for another.
Some important commercial centers for foreign exchange trading are New York, London,
Zurich, Frankfurt, Hong Kong, Singapore and Tokyo.
Since this market provides transactions in a continuous manner for a very large volume of sales
and purchases, the currencies are efficiently priced, or the market is efficient. In short, it is
difficult to make a profit by shopping around from one to another. Minute differences in the
quotes from different bank are quickly arbitraged away. The concept or arbitrage will be
discussed later. Owing to the arbitrage mechanism, simultaneous quotes to different buyers in
London and New York are likely to be the same.
EXCHANGE RATES
An exchange rate is simply the price of one country's currency expressed in terms of another
country's currency. In practice, almost all trading of currencies takes place in terms of the U.S.
dollar. For example, both the Euros, the Swiss franc, and the Japanese yen are traded with
prices quoted in U.S. dollar. Exchange rates are constantly changing.

Figure 9-1: Reference Exchange Rate Bulletin (August 27,2019)

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WHY ARE EXCHANGE RATES IMPORTANT?

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Exchange rates are important because they affect the relative price of domestic and foreign
goods. The dollar price of French goods to an American Is determined by the interaction of two
factors: the price of French goods in euros and the euro / dollar exchange rate.
When a country's currency appreciates (rises in value relative to other currencies), the country'
s goods abroad become more expensive and foreign goods in that country become cheaper
(holding domestic prices constant in the two countries). Conversely, when a country's currency
depreciates, its goods abroad become cheaper and foreign goods in that country become more
expensive.
Appreciation of a currency can make it harder for domestic manufacturers to sell their goods
abroad and can increase competition at home from foreign goods because they cost less.
FACTORS INFLUENCING EXCHANGE RATES
As with any other market, the exchange rate between two currencies determined by the supply
of the demand for those currencies. The present international monetary system consists of a
mixture of "freely" floating exchange rates and fixed rates. The currencies of the major trading
partners of the United States are traded in free markets. This activity, however, is subject to
intervention by many countries’ central banks. Factors that tend to increase the supply or
decrease the demand schedule for a given currency will bring down the value of that currency in
foreign exchange markets. Similarly, the factors that tend to decrease the supply, or increase
the demand for a currency will raise the value of that currency. Since fluctuations in currency
values result in foreign exchange risk, the financial manager must understand the factors
causing these changes in currency values. Although, the value of a currency is determined by
the aggregate supply and demand for that currency, this alone does not help financial managers
understand or predict the changes in exchange rates.
The major reasons for exchange rate movements which include inflation, interest rates, balance
of payments, government's policies or intervention and so forth are discussed briefly in the
following sections.

 Inflation. Inflation tends to deflate the value of a currency because holding the currency
results in reduced purchasing power.

 Interest rates. If interest returns in a particular country are higher relative to other
countries, individuals and companies will be enticed to invest in that country. As a result,
there will be an increased demand for the country's currency.

 Balance of payments. Balance of payments is used to refer to a system of accounts that

catalogs the Flow or goods between the residents of two countries. For instance, if
Philippines is a net exporter of goods and therefore has a surplus balance or trade,
countries purchasing the goods must use the country’s currency. This increases the
demand for the currency and its relative value.

 Government intervention. Through intervention (e.g., buying or selling ne currency in the

foreign exchange markets), the central bank of a county may support or depress the
value of its currency.

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 Other factors. Other factors that may affect exchange rates are political and economic
stability, extended stock market rallies and significant declines in the demand for major
exports.
HOW IS FOREIGN EXCHANGE TRADED
You cannot go to a centralized location to watch exchange rates being determined, currencies
are not traded on exchanges Such as the New York Stock Exchange. Instead, the foreign
exchange market is organized as an over-the- counter market in which several hundred dealers
(mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. Because
these dealers are in constant telephone and computer contact, the market competitive, in effect
t functions no differently from a centralized market.
An important point to note Is that while banks, companies, and governments talk about buying
and selling currencies in foreign exchange markets, they do not take a fistful of dollar bills and
sell them for British pound notes. Rather, most trades involve the buying and selling of bank
deposits denominated in different currencies. So, when we say that a bank is buying dollars in
the foreign exchange market, what we actually mean is that the bank is buying deposits
denominated in dollars.
INTERACTION IN FOREIGN CURRENCY MARKETS
Exchange Rate Determination
Equilibrium exchange rate in floating markets are determined by the supply of and demand for
the currencies.

S
Price Pe
The equilibrium rate of Pe
will prevail in the market.
No surplus (or deficit)
occurs at Pe.

Fixed Exchange Rate

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

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

Price
Pe S

PA

PE

PB

Quantity

An exchange rate A (Pa foreign currency units per peso), a greater quantity of peso is supplied
by Philippine interests than demanded by foreign interests (i.e., Philippine imports exceed
exports). The result is a trade deficit. An exchange rate B, a smaller quantity of peso 1S
supplied by Philippine interests than demanded by foreign interests (i.e., Philippine exports
exceed imports). The result is a trade surplus.
Managed Float
A managed float is the current method of exchange rate determination. During periods of
extreme fluctuation in the value of a nation’s currency, intervention by governments or central
banks may occur to maintain fairly stable exchange rates.
Floating rates permit adjustments to eliminate balance of payments deficits or surpluses. For
example, if the Philippine has a deficit in its trade with Japan, the Philippine peso will depreciate
relative to Japan's currency. This adjustment should decrease imports from and increase
exports to Japan.
THEORY OF PURCHASING POWER PARITY
One of the most prominent theories of how exchange rates are determined is the theory of
purchasing power parity (PPP). It states that exchange rates between any two Currencies will
adjust to reflect changes in the price levels of the two Countries. The theory of PPP is simply an
application of the law o one price to national price levels. To illustrate, if the law of one price
holds, a 10% rise in the yen price of Japanese steel results in a 10% appreciation of the dollar.
Applying the law of one price to the price levels in the two countries produces the theory of
purchasing power parity, which maintains that is the Japanese price level rises 10% relative to
the U.S. price level, the dollar will appreciate by 10%. The theory of PPP suggests that if one
country's price level rises relative to another’s, its currency should depreciate (the other
country's currency should appreciate).
The PPP conclusion that exchange rates are determined solely by changes in relative price
levels rests on the assumption that all goods are identical in both countries. When this

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assumption is true, the law of one price states that the relative prices of all these goods (that is,
relative price level between the two countries) will determine the exchange rate. PPP theory
furthermore does not take into account that many goods and services (whose prices are
included in a measure of a country's price level) are not traded across borders. Housing, land,
and services such as restaurant meals, haircuts and golf lessons are not traded goods. So even
though the prices of these items might rise and lead to a higher price level relative to another
country' s, there would be little direct effect on the exchange rate.
WHAT ARE THE FOREIGN CURRENCY EXCHANGE RATE TRANSACTIONS?
The two kinds of Foreign Exchange Rate Transactions are:
 Spot transactions are those which involve immediate (two-day) exchange or bank
deposits. The spot exchange rate is the exchange rate for the spot transactions.
Forward Transactions

 Forward Transactions involve the exchange of bank deposits at some specified

future date. The forward exchange rate is the exchange rate for the forward
transaction.

SPOT EXCHANGE RATES

If we are exchanging one currency for another immediately, we participate in a spot transaction.
A typical spot transaction may involve a Philippine firm buying Foreign currency from its bank
and paying for it in Philippine pesos (or an American firm buying currency from its bank and
paying for it in US dollar).
The price of the foreign currency in terms of the domestic currency is the exchange rate- in this
instance, the Philippine peso. Another case of a spot transaction is when a Philippine firm
receives foreign currency from abroad. The firm would typically sell the foreign Currency to its
bank Philippine peso. These are both spot transactions, where one currency is exchanged for
another currency immediately. The actual exchange rate quotes are expressed in several ways,
as explained below.
The spot rate for a currency is the exchange rate at which the currency is traded for immediate
delivery. For example, if you walk into a local commercial bank, ask for US dollars. The banker
will indicate the rate at which the US dollar is selling, say P52.60 per US$1. If you like the rate,
you buy what you need and walk out the door. This is a spot market transaction at the retail
level.
DIRECT AND INDIRECT QUOTES
In the spot exchange market, the quoted exchange rate is typically called a direct quote. A
direct quote indicates the number of units of the home currency required to buy one unit of the
foreign currency. Figure 9-1 shows the spot rates and the direct exchange quotes the Philippine
Daily Inquirer on August 27, 2019.
The table above shows that in order to by one US dollar on August 27, 2019, P52.326 were
needed. In order to buy one Japanese yen and one UK pound on the same date, P.4931 and

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The World of Financial Markets and Institutions

P63.9424 were needed, respectively. The quotes in the spot market in New York are given in
terms of US dollars and those in European Union in terms of Euros.
An indirect quote indicates the number of units of foreign currency that can be bought for one
unit of the home currency. In Summary, a direct quote is the peso foreign currency rate, and an
indirect quote is the foreign currency/ peso rate. Therefore, an indirect quote is the reciprocal or
a direct quote and vice versa. (Source: Bangko Sentral ng Pilipinas Official Website (http:/www.bsp.gov.ph)
ILLUSTRATIVE CASE
Compute the indirect quotes from the Philippine direct quotes of spot rates US dollars, UK
pound, EU euros, and Japanese yen as of August 27, 2019 given in Figure 9-1 The related
indirect quotes are computed as follows:
Thus: Indirect Quote = 1_____
Direct Quote

US Dollars = 1_____ = .01911 (dollar/P1)

52.3260

UK Pounds = 1_____ = .01564 (pound/P1)

63.9424

EU Euros = 1 = .01721 (euro/P1)

58.1028

Japan Yen = 1 = 2.028 (yen/P1)

.4931
The direct and indirect quotes are useful in computing foreign currency requirements. Consider
the following examples:
a. A Filipino businessman wanted to remit P1,000 UK pounds to London on August
27,2019. How much is pesos would have been required for this transaction?

P63.9424/pounds X 1,000 pounds = P63.942.40

b. A Filipino businessman paid P112,148.20 to an Italian supplier on August 27, 2019. How
many euros did the Italian supplier receive?

P112,148.20 X 0.1712 = €1,930.07 euros

CROSS RATES
Also important in understanding the spot-rate mechanism is the cross rate. A cross rate is the
indirect computation of the exchange rate of one currency from the exchange rates of two other
currencies.
For instances:

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The peso/pound and the euro/peso rate are given in Figure 9.1. from this information, we could
determine the euro/pound and pound/euro exchange rates.
We see that:
P 63.9424= £1
P58.1028= €1
P63.9424/ P58.1028 = 1.1005 euro per 1 pound

Thus, the pound/euro exchange rate is:

P58.1028/P63.9424 = .90867 pound per 1 euro
Cross rate computations make it possible to use quotations in New York to compute, the
exchange rate between pounds, euros and so forth in other foreign currency exchange markets.
If the rates prevailing in London and Paris were different from the computed cross rates, using
quotes from New York, a trader could use three different markets and make arbitrage profit. The
arbitrage condition for the cross rates is called triangular arbitrage
ARBITRAGE
The foreign exchange quotes in two different countries must be in line with each other. For
example, the direct quote for U.S. dollars in London is given in dollars/pound. Since the foreign
exchange markets are efficient, the direct quotes for the United States dollar in London, on April
25, 2019, must be very close to the indirect rate of .6691 pound/dollar prevailing in New York on
that date.
lf the exchange-rate quotations between the London and New York spot exchange markets
were out of line, then an enterprising trader could make a profit by buying in the market where
the currency was cheaper and selling it in the dearer. Such a buy-and-sell strategy would
involve an investment of funds for a very short time and no risk bearing, yet the trader could
make a sure profit. Such a person is called an arbitrageur, and the process of buying and selling
in more than one market to make a riskless profit is called an arbitrage. Spot exchange markets
are efficient in the sense that arbitrage opportunities do not persist for any length of time. That
is, the exchange rates between two different markets are quickly bought in line, aided by the
arbitrage process.
Some people intentionally look for exchange rate mispricing by comparing direct quote
exchange rates between two currencies with cross rates determined through a third currency. If
direct quotes and cross rates differ, arbitrage-a form of buying low and selling high -----is
possible.
Because three exchange rates are necessary to profit from a mispricing, process is sometimes
called triangular arbitrage and as previously mentioned, the person doing it is called an
arbitrageur.
FORWARD RATES
The forward rate for a currency is the exchange rate at which the currency o future delivery is
quoted. The trading of currencies for future delivery is called a forward market transaction.
Suppose Sta. Lucia Corporation expects to pay USSI.0 million to a US supplier 30 days from

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now. It is not certain however, what these dollars Will be worth in Philippine pesos 30 days from
today to eliminate is uncertainty, Sta. Lucia Corporation calls a bank and offers to buy USS1.0
million to a US supplier 30 days from now. In their negotiation, the two parties may agree on an
exchange rate of P46 million to the bank and receives S1 million.
The forward exchange rate could be slightly different from the spot rale prevailing at that time.
Since the forward rate deals with a future time, the expectations regarding the future value of
that currency are reflected in that forward rate. Forward rates may be greater than the current
spot rate (premium) or less than the current spot rate (discount).
The discount or premium is usually expressed as an annualized percentage deviation from the
spot rate.
Normally, the forward premium or discount is between 0.1 percent and 5 percent. The spot and
forward transactions are said to occur in the over-the-counter market. Foreign currency dealers
(usually large commercial banks) and their Customers (importers, exporters, investors,
multinational firms and so forth) negotiate the exchange rate, the length of the forward contract
and the commission in a mutually agreeable fashion. Although the length of a typical ward
contract may generally vary between one month and six months, contracts for longer maturities
are not common. The dealers, however, may require higher returns for longer contracts.
FACTORS THAT AFFECT EXCHANGERATES IN THE LONG RUN
Our analysis indicates that relative price levels and additional factors affect the exchange rate.
In the long run, there are four major factors: relative price levels, lars and quotas, preferences
for domestic versus Foreign goods, and productivity.

 Relative Price Levels

In the long run, a rise in a country's price level (relative to the foreign price Ievel) causes
its currency to depreciate, and a fall in the country’s relative price level causes its
currency to appreciate.

 Trade Barriers
Increasing trade barriers causes a country’s currency to appreciate in the long-run.

 Preferences for Domestic Versus Foreign Goods

Increased demand for a country's exports causes its currency to appreciate in the long
run, conversely, increased demand for imports causes the domestic currency to
depreciate.

 Productivity
In the long run, as a country becomes more productive relative to other countries, its
currency appreciates.
EXCHANGE RATES IN THE SHORT RUN
The key to understanding the short-run behavior of exchange rates is to recognize that an
exchange rate is the price of domestic bank deposits (those dominated in the domestic
currency) in terms of foreign bank deposits (those denominated in the foreign currency).
Because the exchange rate is the price of one asset in terms of another, the natural way to

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investigate the short-run determination of exchange rates is through an asset market approach
that relies heavily on our analysis of the determinants of assets demand.
Earlier approaches to exchange rate determination emphasized the role of import and export
demand. 1lhe more modern asset market approach used here does not emphasize the flows of
purchases of exports and imports over short periods because these transactions are quite small
relative to the amount of domestic and foreign bank deposits at any given time. Thus, over short
periods such as a year, decisions to hold domestic or foreign assets play a much greater role in
exchange determination than the demand for exports and imports does.
MANAGING FOREIGN EXCHANGE RISK
Foreign exchange risk refers to the possibility of a drop-in revenue or an increase in cost in an
international transaction due to a change in foreign exchange rates. Importers, exporters,
investors and multinational firms are all exposed to this foreign exchange risk. When the parties
associated with a commercial transaction are located in the same country, the transaction is
denominated in a single currency. International transactions inevitably involve more than one
currency (because the parties are residents of different countries). Since most foreign currency
values fluctuate from time to time, the monetary value of an international transaction measured
in either the seller's currency or the buyer's currency is likely to change when payment is
delayed. As a result, the seller may receive less revenue than expected or the buyer may have
to pay more than the expected amount for the merchandise. International business transactions
are denominated in foreign currencies. The rate at which one currency unit is converted into
another is called the exchange rate. In today's global monetary system, the exchange rates of
major currencies are fluctuating rather freely. These “freely” floating exchange rates expose
multinational business firms to foreign exchange risk. To deal with this foreign Currency
exposure effectively, the financial manager must understand foreign exchanged rates and how
they are determined. Foreign exchange rates are influenced by differences in inflation rates
among countries, differences in rest rates, government policies and the expectations of the
participants in the foreign exchange markets.
AVOIDANCE OF EXCHANGE RATE RISK IN FOREIGN CURRENCY MARKETS
The international financial manager can reduce the firm’s foreign currency exposure by hedging
in the forward exchange markets, money markets and currency future markets.

 The firm may hedge its risk by purchasing or selling forward exchange Contracts. A firm
may buy or sell forward contracts to cover liabilities or receivables, respectively,
denominated in a foreign currency. Any gain or loss on the foreign payables or
receivables because of changes in exchange rates is offset by the loss or gain on the
forward contract.
 The firm may choose to minimize receivables and liabilities denominated in foreign
currencies.
 Maintaining a monetary balance between receivables and payables denominated in a
particular foreign currency avoids a net receivable or net liability position in that
currency. Monetary items are those with fixed cash flows. A firm may attempt to achieve
a net monetary debtor (creditor) position in countries with currencies expected to
depreciate (appreciate). Large multinational corporations have established multinational
netting centers as special departments to attempt to achieve balance between foreign

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receivables and payables. They also enter into foreign currency futures contracts when
necessary to achieve balance.
 Another means of managing exchange rate risk is by the use of trigger pricing. Under
trigger pricing, foreign funds are supplied at an indexed price but with an option to
convert to a future-based fixed price when a specified basis differential exists between
the two prices.
 A firm may seek to minimize its exchange-rate risk by diversification. If it has
transactions in both strong and weak currencies, the effects of changes in rates may he
offsetting.
 A speculative forward contract does not hedge any exposure to foreign currency
fluctuations, it creates the exposure.
MORTGAGE MARKETS AND DERIVATIVES
PART I: MORTGAGE MARKETS
Introduction
Money markets, the markets for short-term funds, and capital markets, the markets for long-
term funds (bonds, equity). The first section of this chapter discusses the mortgage markets,
where borrowers- individual businesses and governments can obtain long-term collaterized
loan.
From one perspective, the mortgage markets form a subcategory of the capital markets
because mortgages involve long-term funds. But the mortgage markets differ from the stock and
bond markets in a number of ways.
First, the usual borrowers in the capital markets are businesses and government entities,
whereas the usual borrowers in the mortgage markets are individuals.
Second, mortgage loans are made for varying amounts and maturities, depending on the
borrower’s needs, features that cause problems for developing a secondary market.
WHAT ARE MORTGAGES?
Mortgages are long-term loan secured by real estate. Both individuals and businesses obtain
mortgages loans to finance real estate purchases. A developer may obtain a mortgage loan to
finance the construction of an office building, or a family may obtain a mortgage loan to finance
the purchase of a home. In both cases, the loan is amortized. The borrower pays it off over time
in some combination of principal and, interest payments that result in full payment of the debt by
maturity.
CHARACTERISTICS OF THE RESIDENTIAL MORTGAGE
The modern mortgage lender has continued to refine the long-term loan to make it more
desirable to borrowers. Even in the past 20 years, both the nature or lenders and the
instruments have undergone substantial changes. One of the biggest changes is the
development of an active secondary market for mortgage contracts.
The mortgage market has become very competitive in recent years. Twenty years ago, Savings
and loan institutions and the mortgage departments of large banks originated most mortgage
loans. Currently, there are many loan production offices that compete in real estate financing.

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Some of these offices are subsidiaries of banks, and others are independently owned. As a
result of the competition for mortgage loans, borrowers can choose from a variety of terms and
options.
A. Mortgage Interest Rates
One of the most important factors in the decision of the borrower of how much and from whom
to borrow is the interest rate on the loan. There are three important factors that affect the
interest rate on the loan. These are
 Current long-term market rates

Long-term market rates are determined by the supply of and demand for long-term
funds, which are in turn affected by a number of global, national, and regional factors.
Mortgage rates tend to stay above the less risky treasury bonds most of the time but
tend to track along with them.

 Term or Life of the mortgage

Generally, longer-term mortgages have higher interest rates than short-term mortgages.
The usual mortgage lifetime is 15 or 30 years. Because interest rate risk falls as the term
to maturity decreases, the interest rate on the 1S-year loan Will be substantially less
than on the 30-year loan.

 Number of Discount Points Paid

Discount points (or simply points) are interest payments made at the beginning of a loan.
A loan with one discount pot means that the borrower pays 1% of the loan, amount at
closing, the moment when the borrower signs the loan paper and receives he proceeds
of the loan. In exchange for the points, the lender reduces the interest rate on the loan.
In considering whether to pay points, Borrowers’ must determine whether the reduced
interest rate over the life of the loan fully compensates for the increased up-front
expense. To make this determination, borrowers must take into account how long they
will hold on to the loan. Typically, discount points should not be paid if the borrower will
pay off the loan in five years or less. This breakeven point is not surprising since the
average home sells every five years.
B. Loan Terms
Mortgage loan contracts contain many legal and financial terms, most of which protect the
lender from financial loss.
C. Collateral
One characteristic common to mortgage loans is the requirement that collateral, usually the real
estate being financed, be pledged as security.
D. Down Payment
To obtain a mortgage loan, the lender also requires the borrower to make a down payment on
the property, that is, to pay a portion of the purchase price. The balance of the purchase price is

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paid by the loan proceeds. Down payments (like liens) are intended to make the borrower less
likely to default on the loan. A borrower who does not make a down payment could walk away
from the house and the loan and lose nothing. Furthermore, it re estate prices drop even a small
amount, the balance due on the loan will exceed the value or ne collateral. The down payment
reduces moral hazard for the borrower. The amount of the down payment depends on the type
mortgage loan. Many lenders require that the borrower pay 5% of the purchase price, in other
situations, up to 20% may be required.
E. Private Mortgage Insurance (PMI)
Private Mortgage Insurance (PMI) is an insurance policy that guarantees to make up any
discrepancy between the value of the property and the loan amount, should a default occur. For
example, if the balance on your loan was P120,000 at the time of default and the property was
worth only P100,000, PMI would pay the lending institution P20,000. The default still appears on
the credit record of the borrower, but the lender avoids sustaining the loss. PMI is usually
required on loans that have less than a 20% down payment. the loan-to-value ratio falls
because of payments being made or because the value of the property increases, the borrower
can request that the PMI requirement be dropped. PMI usually costs between P200 and P300
per month for a Pl00,000 loan.
F. Borrower Qualification
Before granting a mortgage loan, the lender will determine whether the borrower qualifies for it.
Qualifying for a mortgage loan is different from qualifying for a bank loan because most lenders
sell their mortgage loans to one of a few government agencies in the secondary mortgage
market. These agencies establish very precise guidelines that must be followed before they will
accept the loan. If the lender gives a mortgage loan to a borrower who does not fit these
guidelines, the lender may not be able to resell the loan. That ties up the lender's funds. Banks
can be more flexible with loans that be kept on the bank's own books.
AMORTIZATION OF MORTGAGE LOAN
Mortgage loan borrowers generally agree to pay a monthly amount of principal and interest that
will be fully amortized by its maturity. "Fully amortized" means that the payments will pay off the
outstanding indebtedness by the time the loan matures.
TYPES OF MORTGAGE LOANS
 Conventional Mortgages
These are originated by banks or other mortgage lenders but are not guaranteed by government
or government-controlled entities. Most lenders though now Insure many conventional l0ans
against default or they require the borrower to obtain private mortgage insurance on loans.
 Insured Mortgages
These mortgages are originated by banks or other mortgage lenders but are guaranteed by
either the government or government-controlled entities.
 Fixed-rate Mortgages

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In fixed-rate mortgages, the interest rate and the monthly payment do not vary over the life of
the mortgage
 Adjustable-Rate Mortgages (ARMs)
The interest rate on adjustable-rate mortgage (ARMs) is tied to some market interest rate, (e.g.,
Treasury bill rate) and therefore changes over time. ARMS usually have limits, called caps, On
how high (or low) the interest rate can move in one year and during the term of the loan
 Graduated-Payment Mortgages (GPMs)
These mortgages are useful for home buyers who expect their incomes to rise. The GPM has
lower payments in the first few years, then the payments rise. The early payment may not even
be sufficient to cover the interest due, in which case the principal balance increases. As time
passes, the borrower expects income to increase so that higher payment will not be too much of
a burden.
 Growing Equity Mortgage (GEMs)
With a GEM, the payments will initially be the same as on a conventional mortgage. Over time,
however, the payment will increase. This increase will reduce the principal more quickly than the
conventional payment stream would.
 Shared Appreciation Mortgages (SAMs)
In a SAM, the lender lowers the interest rate in the mortgage in exchange for a share of any
appreciation in the real estate (if the property sells for more than a stated amount, the lender is
entitled to a portion of the gain).
 Equity Participating Mortgage (EPM)
In EPM, an outside investor shares in the appreciation of the property. This investor will either
provide a portion of the purchase price of the property or supplement the monthly payment. In
return, the investor receives a portion of any appreciation of the property. As with the SAM, the
borrower benefits by being able to qualify for a larger loan than without such help.
 Second Mortgages
These are loans that are secured by the same real estate that is used to secure the first
mortgage. The second mortgage is junior to the original loan which means that should a default
occur, the second mortgage holder will be paid only after ne original loan has been paid off, if
sufficient funds remain.
 Reverse Annuity Mortgages (RAMS)
In a RAM, the bank advances funds to the owner on a monthly schedule to enable him to meet
living expenses he thereby increasing the balance or the loan which in secured by the real
estate. The borrower does not make payments against the loan and continues to live in his
home. when the borrower dies, the estate sells the property to pay the debt. The various
mortgages types are summarized in Figure 10-2
Figure 10-2: Summary of Mortgage Types

Conventional mortgage Loan is not guaranteed, usually requires private

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mortgage insurance, 5% to 20% down payment.

Loan is guaranteed by FHA or VA, low or zero down
Insured mortgage
payment
Interest rate is tied to some other security and is
Adjustable-rate mortgage (ARM) adjusted periodically; size of adjustment is subject
to annual limits
Initial low payment increases each year, loan
Graduated-payment mortgage (GPM)
usually amortizes in 30 years
Initial payment increases each year, loan amortizes
Growing-equity mortgage (GEM)
in less than 30 years
In exchange for providing a low interest rate, the
Shared-appreciation mortgage (SAM) lender shares in any appreciation in value of the
real estate
In exchange for paying a portion of the down
payment or for supplementing the monthly
Equity participation mortgage
payments’, an outside investor shares in any
appreciation in value of the real estate
Loan is secured by a second lien against the real
Second mortgage estate, often used for Iine of credit or home
improvement loans
Lender disburses a monthly payment to u borrower
Reverse annuity mortgage
on an increasing-balance loan, loan comes due
when the real estate is sold

MORTGAGE LENDING INSTITUTIONS

The institutions that provide mortgage loans to familiar and business and their share in the
mortgage market are as follows
Mortgage tools and trusts 49%
Commercial banks 24%
Government agencies and others 15%
Life insurance companies 9%
Savings and loans associate 9%

Source: Federal Revenue Bulletin, 2018

Many of the institutions making mortgage loans do not want to hold large portfolios or long-term
securities. Commercial loans, thrifts and most other loan organization do make money through
the fees that they earn for packaging loans for other investors to hold. Loans organization fees
are typically 1% of the loan amount, through this varies with the market.
SECURITIZATION OF MORTGAGES
Intermediaries face several problems when trying to sell mortgages to the secondary market,
that is lenders selling the loans to another investor. These problems are
a) Mortgages are usually too small to be wholesale instruments
b) Mortgages are not standardized. They have different terms to maturity, interest rates and
contract terms. Thus, it is difficult to bundle a large number of mortgages together and

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c) Mortgage loans are relatively costly to service. The lenders must collect monthly
payments, often advances payment of properly taxes and insurance premiums and
service reserve accounts
d) Mortgages have unknown default risk. Investors in mortgages do not want to spend a lot
of time and effort in evaluating the credit of borrowers.
The above problems inspired the creation of mortgage-backed security
Mortgage-backed security is a security that is collateralized by a pool of mortgage loans. This is
also known as securitized mortgage. Securitization is the process of transforming illiquid
financial assets into marketable capital market instruments.
The most common type of mortgage-backed security is the mortgage pass through, a security
that has the borrower's mortgages pass through the trustee before being disbursed to the
investors in the mortgage-pass through. If borrowers pre-pay their loans, investors receive more
principal than expected.
Impact of Securitized Mortgage on the Mortgage Market
Mortgage-backed securities (also called securitized mortgages) have been growing in popularity
in recent years as institutional investors look for appreciative investment opportunities that
compete for funds with government notes bonds, corporate bonds and stock.
Securitized mortgage are low-risk securities that have higher yield than comparable government
bond and attract funds from around the world.
What benefits are derived from Securitized Mortgage (SM)?
The benefits are

 SM has reduced the problems and risks caused by regional lending institutions'
sensitivity to local economic fluctuations.
 Borrowers now have access to a national capital market
 Investors can enjoying the low-risk and long-term nature of investing in mortgages
without having to service the loan
 Mortgage rates are now more open to national and international influences. As a
consequence, mortgage rates are more volatile than they were in the past.
PART II: DERIVATIVES
In addition to primary instruments such as receivables, payables and equity instruments,
financial instruments also include derivatives such as financial options, futures and forwards,
interest rate and currency swaps. Derivatives are useful for managing risks. They can effectively
transfer the risks inherent in an underlying primary instrument between the contracting parties
without any need to transfer the underlying instruments themselves (either at inception of the
contract or even, where cash settled, or termination).
The development of powerful computing and communication technology has aided the growth in
derivative use. The technology provides new ways to analyze information about markets as well
as the power to process high volumes or payments.
DERIVATIVE FINANCIAL INSTRUMENTS

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Derivatives are financial instruments that "derive" their value on contractually required cash
flows from some other security or index. For instance, a contract allowing a company to
purchase a particular asset (say gold, flour, or cofree bean) at a designated future date, at a
predetermined price is at financial instrument that derives its value from expected and actual
changes in the price of the underlying asset.
CHARACTERISTICS OF DERIVATIVES
A derivative is a financial instrument:

 whose value changes in response to the change in a specified interest rate, security
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or
credit index, or similar variable (sometimes called the "underlying");
 that requires no initial net investment or little net investment relative to other types of
contracts that have a similar response to changes in market conditions; and
 that is settled at a future date.
Derivatives are commonly used by investors to spread risk and/ or to speculate.
HOW IT WORKS
Investors may buy derivatives in order to reduce the amount or volatility in their portfolios, since
they can agree on a price for a deal in the present that will, in effect, happen in the future, or to
try to increase their gains through speculation. Derivatives can enable an investor to gain
exposure to a market via a smaller outlay than it they bought the actual underlying asset. The
most common are futures and options- leveraged products in which the investor puts down a
small proportion of the value of the underlying asset and hopes to gain by a future rise in the
value of that asset.
Derivatives for hedging
Companies use derivatives to protect against cost fluctuations by fixing a price for a
future deal in advance. By settling costs in this way, buyers gain protection - known as
a hedge - against unexpected rises or falls in, for example, the foreign exchange
market, interest rates, or the value of the commodity or product they are buying
For example: A Philippine-based airline company reviews its fuel stock levels and
decides that it will need to buy jet fuel for its fleet of planes in three months’ time.
To protect itself from potential future price increase, it can buy fuel at today's prices for
delivery and payment at a future date. This is known as a forward transaction. The
financial instrument is called a futures contract. It the price of fuel then falls instead of
rising, the company will be locked in to paying a higher price.
Derivatives for Speculation
Investors may buy or sell an asset in the hope of generating a profit from the asset's
price fluctuations. Usually this Is done on a short-term basis in assets that are liquid or
easily traded.
For example: An investor notices a company's share price is going up and buys an
option on the share. An option gives a right to the holder to buy shares at a future date.

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if share prices do rise, the investor can profit by buying at a fixed option price and
selling at the current higher price.
If share prices fall, the investor can sell the option or let it lapse, losing a fraction of the
value of the asset itself.
Typical Examples of Derivatives
The most frequently used derivatives are futures contracts, forward contracts, options, foreign
currency futures and interest rate swaps
 Futures Contracts

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

 Forward Contracts

A forward contract is similar to a futures contract but differs in three ways:

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

 Options

Options give its holder the right either to buy or sell an instrument, say a Treasury bill, at
a specified price and within a given time period. Options frequently are purchased to
hedge exposure to the effects of changing interest rates. Options serve the same
purpose as futures in that respect but are fundamentally different. Importantly though,
the option holder has no obligation to exercise the option On the other hand, the holder
of a futures contract must buy or sell within a specified period unless the contract is
closed out before delivery comes due.

 Foreign Currency Futures

Foreign loans frequently are denominated in the currency of the ender (Japanese yen,
Swiss franc, German mark, and so on). When loans must be repaid in foreign
currencies, a new element of risk is introduced. This is because if exchange rates
change, the peso equivalent of the foreign currency that must be repaid differs from the
peso equivalent of the foreign currency borrowed. To hedge against "foreign exchange

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risk" exposure, some firms buy or sell foreign currency futures contracts. These are
similar to financial futures except specific foreign currencies are specified in the futures
contracts rather than specific debt instruments. They work the same way to protect
against foreign exchange risk as financial futures protect against fair value or cash flow
risk.

 Interest Rate Swaps

There are contracts to exchange cash flows as of a specified date or a series of

specified dates based on a notional amount and fixed and floating rates.

Over 70% of derivatives are interest rate swaps. These contracts exchanged fixed
interest payments for floating rate payments, or vice versa, without exchanging he
underlying principal amounts. For example, suppose you owe P100,000 on a 10% fixed
rate home loan. You envy your neighbor who Is also paying 10% on her PI00,000
mortgage, but hers is a floating rate loan, so if market rates fall, so will her loan rate. to
the contrary, she is envious of your fixed rate, fearful that rates will rise, increasing her
payments. A solution would be for the two of you to effectively swap interest payments
using an interest rate swap agreement.

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

Type of Contract Underlying Variable (main pricing-

settlement variable)
Commodity swap Commodity price
Commodity futures Commodity price
Commodity forward Commodity price
Credit swap Credit rating, credit index, or credit price
Currency swap (foreign exchange swap) Commodity rates
Currency futures Commodity rates
Currency forward Commodity rates
Equity swap (equity of another firm) Equity prices
Equity forward Equity price (equity of another firm)
Interest rate swap Interest rates
Interest rate future linked to Interest rates Interest rate
government debt (Treasury futures)
Interest rates forward Interest rates
Purchased or written treasury bond option (call Interest rates
or put)
Purchased or written currency option Currency rates
Purchased or written commodity option Commodity price

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Purchased or written stock option Equity price (equity of another firm)

Total return swap Total fair value of the reference asset and
interest rate
Figure 10.1. Financial Instruments That Meet the Characteristics of a Derivative Together with the Underlying
Variable Affecting its Value

ILLUSTRATIVE CASES ON DERIVATIVES

In order to understand derivatives, consider the following examples.
Example: Forward Contract
Assume that a company like XYZ believes that the price of ABC shares will increase
substantially in the next three months. Unfortunately, it does not have the cash resources to
purchase the shares today. XYZ therefore enters into a contract with a broker for delivery of
10,000 ABC shares in three months at a price of PIIO per share.
XYZ has entered into a forward contract, a type of derivative. As a result of the contract, XYZ
has received the right to receive 10,000 ABC shares in three months. Further, it has an
obligation to pay P110 per share at that time.
What is the benefit of this derivative contract?
XYZ can buy ABC shares today and take delivery in three months. If the price goes up, it
expects XYZ profits. It the price goes down, XYZ loses.
Example 2: Call Option
A contract or call option allows the holder to call (purchase) at any time in the next 12 months
10,000 shares of ABC share at a price of P50 per share. If the call is exercised, it can be settled
by payment by the contract issuer to the contract holder of an amount equal to 10,000 times the
difference between the market price of ABC share on the call date and the strike price of P50.
Assume that ABC is a publicly traded company with a current market price of P50. The
underlying is the share price of ABC share, as the price of this contract will depend on this
underlying variable. The notional amount is the 10,000 shares that can be called.
The holder can acquire the call contract at a considerably lower cost than that of actually buying
the 10,000 shares at P50 per share. Holding the call option contract has the same response to
market price changes as does holding the individual shares themselves.
This contract need not require the actual transfer of shares upon the contract being exercised.
The issuer of the contract can settle with payment of cash in an amount equal to the net gain of
the holder.
Example 3: Put Option
Sampaguita Inc. acquired 1,000 shares of Sunflower Company on January 2, 2014 at a cost of
P50 per share. Sampaguita does not plan to sell the shares until mid-2015 at the earliest and
therefore classifies this investment as financial asset at fair value/OCI.
Sampaguita, however, does not want to be exposed to possible declines in the fair value of the
investment. Sampaguita therefore acquires a put option to sell the 1,000 shares at a price of
P50 per share on June 30, 2015. The cost of the put option contract is zero (or minimal).

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Sampaguita designates the put contract as a fair value hedging contract for the investment in
Sunflower Company.
Situation1.
Assume that on December 31, 2014, Sunflower Company common stock is trading at P35 per
share. Suppose further that the fair value or the put option Contract has increased to P15,000.
[This change is due to the decline in the fair value of the underlying asset (P50 - P35 times
1,000 shares]. Under these circumstances, PAS 39 would require that Sampaguita include the
following in its income statement:

 The unrealized loss on the investment of P15,000 (equal to the decline in fair value per
share of P15 times the 1,000 shares).
 The portion of the unrealized gain on the derivative financial instrument that relates to
the hedging activity of P15,000.
In this particular case, the hedge is fully effective, and the gain on the hedging instrument
exactly offsets the loss on the hedged item.
Situation 2.
Suppose instead that the fair value of the put option at December 31, 2014, is only P10,000.
(There are number of reasons why this might be the case.)
In this case, the hedge is not fully effective, and the ineffective portions of the hedge are
included in net income because the unrealized loss of P15,000 is only partially offset by the
unrealized gain of P10,000. The net effect would be to report a loss of P5,000 related to this
hedge.
If this investment were not hedged, the entire unrealized loss of P15,000 would be included only
in comprehensive income and reported as a separate component of shareholders equity as an
accumulated unrealized loss from investments in securities available for sale.
INTERNATIONALIZATION OF FINANCIAL MARKETS
INTRODUCTION
The flow of money around the world is essential for business to operate and grow. Stock
markets are places where individual as well as institutional corporations) investors can trade
currencies, invest in companies and arrange loans.
Without the global financial markets, governments would not be able to borrow money,
companies would not have access to the capital they need to expand and, investors and
individuals would be unable to buy and sell foreign currencies.
The growing internationalization of financial markets has become an important trend. Before the
1980s, U.S. financial markets were much larger than financial markets outside the United
States, but in recent years the dominance of U.S. markets has been disappearing. The
extraordinary growth of foreign financial markets has been the result of both large increases in
the pool of savings in foreign countries such as Japan and the deregulation of foreign financial
markets, which has enabled them to expand their activities. American corporations and banks
are now more likely to tap international capital markets to raise needed funds, and American

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investors often seek investment opportunities abroad. Similarly, foreign corporations and banks
raise funds from Americans, and foreigners are becoming important investors in the United
States. A look at national bond markets and world stock markets will give us a picture of how
this globalization of financial markets is taking place.
FINANCIAL MARKETS AROUND THE WORLD
New York, US
The New York Stock Exchange (NYSE) 1s the largest in the world (market capitalization- the
market value of its outstanding shares: $14.14 trillion) followed by the NASDAQ. which 1s also
based in New York, (S5.63 trillion)
Toronto, Canada
The Toronto stock Exchange (TSE) in Canada is run by the TMX Group (S145 trillion).
Toronto, Japan
The Japan Exchange Group (JPX), based in Tokyo, is the largest exchange in Asia ($3.73
trillion).
China
China has three stock exchanges: the Shanghai Stock Exchange (SSE), (>L.7 trillion);
Shenzhen Stock Exchange (SZSE) ($2.36 trillion); and the Stock Exchange of Hong Kong
(SEHK) ($3.32 trillion).
London, UK
The London Stock Exchange (LSE) is Europe's largest ($2.68 trillion).
European Union
Euronext has headquarters in Amsterdam. Brussels, Lisbon, London, and Paris ($2.56 trillion).
Frankfurt, Germany
Deutsche Borse is based in Frankfurt (FWB) ($1.24 trillion).
WORLD STOCK MARKETS
By all these measures, financial markets grew rapidly during the 1990s. At the start of the
decade, active trading in financial instruments was confined to a small number of countries, and
involved mainly the same types of securities, bonds and equities that had dominated trading for
two countries. By the first years of the 21 century, financial markets were thriving in dozens of
countries, and new instruments accounted for a large proportion of market dealings.
Until recently, the U.S. stock market was by far the largest in the world, but foreign stock
markets have been growing in importance. Now the United States is not always number one: ln
the 1990s, the value of stocks traded in Japan at times exceeded the value of stocks traded in
the United States. The increased foreign stocks has prompted the development in the United
States of mutual funds specializing in trading in foreign stock markets. American investors now
pay attention not only to the Dow Jones Industrial Average but also to stock price indexes for

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foreign stock markets such as the NiKkel 25 Average (Tokyo) and the Financial Times-Stock
Exchange 100-Share Index (London).
The internationalization of financial markets is also leading the way to a more integrated world
economy in which flows of goods and technology between countries are more commonplace.
Trading in foreign-exchange markets fell markedly at the turn of the century. Credit and equity
markets around the world were buoyant in 2006-07, but then contracted abruptly as financial
crisis led to the failures of several major financial institutions and a dramatic reduction in
lending. Although credit markets began to recover in 2009, their expansion was subdued
because of the prolonged financial crisis affecting the euro zone, recession or sluggish growth in
a number of major economies, and new regulatory requirements that constrained bank ending
and discouraged use of certain financing methods, notably securitization
In 2017, the US Federal Reserve Board and the European Central Bank announced that they
would gradually end their bond-purchase programmes. This is likely to occur over a number of
years, gradually making it more costly for firms and governments to issue bonds and possibly
dampening total issuance.
SIZE OF THE MARKETS
Estimating the overall size of the financial markets is difficult. It is hard in the first place to
decide exactly what transactions should be included under the rubric "financial markets", and
there is no way to compile complete data on each of the millions of sales and purchases
occurring each year.
It is different to estimate the overall size of the financial markets. In the first place it is hard to
decide exactly what transaction should be included under the expression financial markets, and
there is no practical way to compile complete data on each of the millions of sales and
purchases occurring each year.
Dialogic, a financial information provider, estimates that total capital market financing was
approximately 2.5 trillion worldwide in 2018 including $80 billion of equity issues, $7.9 trillion of
debt issues, and $5.8 trillion of syndicated loans. However, this excludes large amounts of loans
that were not resold form of securities and is not adjusted for the fact that governments and
firms often issue new securities to replace existing ones, leaving the total stock of outstanding
securities unchanged.
The figure of S12.5 trillion for 2018, sizeable as it is, represents only a single year's activity.
Another way to look at the markets is to estimate the value of all the financial instruments they
trade. When measured in this way, the financial markets accounted for approximately $200
trillion of capital in 2018 (see Table 11.1. This figure excludes many important financial
activities, such as insurance underwriting, bank lending to individuals and small businesses, and
trading in financial instruments Such as futures and derivatives that are not means of raising
capital. It all these other financial activities were to be included, the total size or the markets
would be much larger.
Table 11.1: The world’s financial markets
Year end, trn
2015 2016 2017 2018
International bank loans 13.6 22.6 20.4 27.0

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The World of Financial Markets and Institutions

International debt securities 11.5 18.9 21.9 21.3

Domestic debt securities 44.1 59.8 62.5 68.7
Equities 37.2 32.6 54.6 67.2
Other 5.2 8.0 8.4 8.8
Total value outstanding 111.6 141.9 167.8 193.0
Source: Bank for International Settlements; World Federation of Exchange

CROSS-BORDER MEASURE
Another way of measuring the growth of finance is to examine the value of cross- border
financing. Cross-border finance is by no means new, and at various times in the past (in the late
19th century, for example) it has been quite large relative to the size of the world economy. The
period since l1990 has been marked by a huge increase in the amount or international financing
broken by financial crises in Asia and Russia in 1998, the recession in the United States in
2001, and the financial meltdowns of 2008-09 in the United States and 2008-13 in Europe. The
total stock of cross-border finance in 2010, Including international bank loans and debt issues,
was more than 46 trillion, according to the Bank for international Settlements.
INTERNATIONAL BOND MARKET, EUROBONDS, AND EUROCURRENCIES
The traditional instruments in the international bond market are known a foreign bond. Foreign
bonds are sold in a foreign country and are denominated in that country's currency. For
example, if the German automaker Porsche sells a bond in the United States denominated in
U.S. dollars, it is classified as a foreign bond. Foreign bonds have been an important instrument
in the international capital market for centuries.
The ways in which firms and governments raise funds in international markets nave changed
substantially. In 1993, bonds accounted for 59% of international financing. By 1997, before
financial crises in Asia and Russia shook the markets, only 47 % of the funds raised on
international markets were obtained through bond issues. Equities became an important source
of cross-border financing in 2000, when share prices were high, but bonds and loans regained
importance in the low-interest-rate environment of 2007-2010. In 2018, syndicated lending fell
off as lack of capital forced banks to restrain their lending activities. Issuance of international
bonds was relatively flat in the years following 2018, as non- financial companies increased their
bond issuance even while banks reduced their outstanding bond indebtedness. In more recent
years, international bank lending has fallen off, but extremely low interest rates in the United
States, Japan, Britain, and the EU have encouraged greater use of long-term bond financing
FACTORS AFFECTING THE LONG-RUN TRENDS OF INCREASED FINANCLAL MARKET
ACTIVITY
A. Lower inflation

Inflation rates around the have fallen markedly since the 1990s. Inflation erodes the
value of financial assets and increases the value of physical assets, such as houses and
machines, which will cost far more to replace than they are worth today. when inflation is
high, as was the case in the Unites States, Canada and much of Europe during the
1970s and throughout Latin America in the 1980s, firms avoid raising long-term capital

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The World of Financial Markets and Institutions

because investors require a high return on investment, knowing that price increases will
render much of that return illusory. In a low inflation environment, however, financial-
market investors require l of an inflation premium, as they do not expect general
increases in price to devalue their assets.

B. Pensions

A significant change in pension policies occurred many countries starting in the 1990s..
Changes in demography and working patterns have mads pay-as-you-go schemes
increasingly costly to support, as there are fewer young workers relative to the number
of pensioners. This has stimulated interest in pre-funded individual pensions, whereby
each worker has an account in which money must be saved, and therefore invested,
until retirement. Although these personal investment accounts have to some extent
supplanted firms' private pension plans. they have also led to a huge increase in
financial assets in countries where private pension schemes were previously
uncommon.

C. Stock and bond market performance

Many countries' stock and bond markets performed well during most or the 1990s and in
the period before 2008, with the global bond-market boom continuing until interest rates
began to rise in 2013. Stock markets, after several difficult years, rose steeply in many
countries in 2012 and 2013 and again in 2016 and 2017. A rapid increase in financial
wealth feeds on itself: investors whose portfolios have appreciated are willing to reinvest
some of their profits in the financial markets. And the appreciation in the value of their
financial assets gives investors the collateral to borrow additional money, which can then
be invested.

D. Risk management

Innovation has generated many new financial products, such as derivatives and asset-
backed securities, whose basic purpose is to redistribute risk. This led to enormous
growth in the use of financial markets for risk-management purposes. To an extent
previously unimaginable, firms and investors could choose which risks they wished to
bear and use financial instruments to shed the risks they did not want, or, alternatively,
to take on additional risks in the expectation of earning higher returns. The risk-
management revolution thus resulted in an enormous expansion of financial-market
activity. The credit crisis that began in 2007, however, revealed that the pricing of many
of these risk- management products did not properly reflect the risks involved. As a
result, these products have become more costly, and are being used more sparingly,
than in earlier years

E. The Investors

The driving force behind financial markets is the desire of investors to cam a return on
their assets. This return has two distinct components:

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The World of Financial Markets and Institutions

 Yield is the income the investor receives while owning an investment.

 Capital gains are increases in the value of the investment itself, and are often not
available to the owner until the investment is sold.
Investors' preferences vary as to which type of return they prefer, and these preferences, in
turn, will affect their investment decisions. Some financial-market products are deliberately
designed to offer only capital gains and no yield, or vice versa, to satisfy these preferences.
THE CATEGORIES OF INVESTORS
Individuals
Collectively, individuals own a small proportion of financial assets. Most households in the
wealthier countries own some financial assets, often in the form of retirement savings or of
shares in the employer of a household member. Most such holdings, however, are quite small,
and their composition varies greatly from one country to another.
Institutional Investors
Insurance companies and other institutional investors (see below), including high-frequency
traders, are responsible for most of the trading in financial markets. The assets of institutional
investors based in the 34 member countries of the OECD totaled approximately S120 trillion in
2018. The size of institutional investors varies greatly from country to country, depending on the
development of collective investment vehicles. Investment practices vary considerably as well
Types of Institutional Investors
 Mutual funds
The fastest-growing institutional investors are investment companies, which combine the
investments of a number of individuals with the a1m of achieving particular financial
goals in an efficient way. Mutual funds and unit are investment companies that typically
accept an unlimited number of individual investments. The fund declares the strategy it
will pursue, and as additional money is invested the fund managers purchase financial
instruments appropriate to that Strategy. In some cases, the trust acquires securities at
its inception and never sells them; in other cases, the fund changes its portfolio from
time to time. Investors wishing to enter or leave the unit trust must buy or sell the trust's
share from stockbrokers.
 Hedge funds
Another type of investment company, a hedge fund, can accept investments from only a
small number of wealthy individuals or big institutions. In return it is freed from most
types of regulation meant to protect consumers. Hedge funds are able to employ
aggressive investment strategies, such as using borrowed money to increase the
amount invested and focusing investment on one or another type of asset rather than
diversifying. If successful, such strategies can lead to very large returns; if unsuccessful;
they can result in sizeable losses and the closure of the fund.
All investment companies earn a profit by charging investors a fee for their services.
Some, notably hedge funds, may also take a portion of any gain in the value of the fund.
Hedge funds have come under particular criticism because their fee structures may give

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The World of Financial Markets and Institutions

managers an undesirable incentive to take large risks with investors’ money, as fund
managers may share in their fund's gains but not its losses.
 Insurance companies
Insurance companies are the most important type or institutional investor, owning one-
third of all the financial assets owned by institutions. In the past, most of these holdings
were needed to back life insurance policies. In recent years, a growing share of insurers’
business has consisted of annuities, which guarantee policy holders a sum of money
each year as long as they Iive, rather than merely paying their heirs upon death. The
growth of pre-funded individual pensions has benefited insurance companies, because
on retirement many workers use the money in their accounts to purchase annuities.
 Pension funds
Pension funds aggregate the retirement savings of a large number of workers. Typically,
pension funds are sponsored by an employer, a group of employers or a labour union. In
the Philippines, the SSS and GSIS represent the largest investors of pension fund.
Unlike individual pension accounts, pension funds do not give individuals control over
how their savings are invested, but they do typically offer a guaranteed benefit once the
individual reaches retirement age. Pension-fund assets in the OECD countries exceeded
$25 trillion at the end of 2016.
 Algorithmic traders
Algorithmic trading, also known as high-frequency trading, has expanded dramatically in
recent years as a result of increased computing power and the availability of low-cost,
high-speed communications. Investors specializing in this type of trading program
computers to enter buy and sell orders automatically in an effort to exploit tiny price
differences in securities and currency markets. They typically have no interest in
fundamental factors, such as a company's prospects or a country's economic outlook,
and ow the asset for only a brief period before reselling it. Algorithm trading firms control
only a tiny proportion of the world's financial assets, but they account for a large
proportion of the trading in some markets.,
OTHER INSTITUTIONS
Other types of institutions, such as banks, foundations and university endowment funds, are
also substantial players in the markets.
INTERNATIONAL MONEY AND CAPITAL MARKETS
International Credit Markets
There are three major types of international credit markets:
 Eurocredits

This is the market for floating-rate bank loans whose rates are tied to LIBOR, which
stands for London Interbank Offer Rate. LIBOR is the interest rate offered by the largest
and strongest banks on large deposits. Eurocredits are usually issued for a fixed term
with no early repay Currently, Eurocredit exist for most major trading currencies. An

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The World of Financial Markets and Institutions

example of a Eurocredit is a Eurodollar deposit, which is a U.S. dollar deposited in a

bank outside the United States.

 Eurobond Market

A Eurobond is an international bond underwritten by an international syndicate of banks

and sold to investors in countries other than the one in whose money unit the bond is
denominated.
For example, a U.S. dollar-denominated Eurobonds are not sold in the United States nor
Yen Eurobonds are not sold in Japan. These bonds are usually issued in bearer form
which means that the investor's identity is not registered and thus is not known. Interest
is claimed through a coupon which is presented for payment at one of the designated
payor banks. Most Eurobonds are not rated by the rating agencies such as Moody's or
Standards & Poor's. Eurobonds can be issued with either a floating-coupon rate
depending on the preferences of the issuer and they have medium or long-term
maturities.

 Foreign Bond Market

Foreign bonds are international bonds issued in the country in whose currency the bond
is denominated, and they are underwritten by investment bank in that country. The
borrower may be located in a different country. Foreign bonds issued in the USA are
sometimes called "Yankee bonds" while Samurai bonds are foreign bonds issued in
Tokyo. They can have a floating-rate coupon or a fixed-rate coupon and they have the
same maturities as the purely domestic bonds with which they must compete for funds.
TOWARDS INTERNATIONAL STANDARDS
As it is difficult for national regulators to set rules for markets that operate all over the world, the
leading dealers created the International Capital Markets Association (ICMA) to establish
standard practices. Based in Switzerland, the ICMA is now recognized as a self-regulatory
organization by the British authorities, and all major dealers adhere to its rules. Among the other
things, the ICMA has established procedures for clearing transaction, including a reporting
system so firms can identify and reconcile errors that may have occurred in writing down the
name and quantity of a security that has been bought or sold. The ICMA has also agreed on
settlement procedures, so that for all international bond trades among its members, money and
securities change hands on the third business day after the transaction.
LOOKING AHEAD
Over the years, however, many of the distinctive features of the international market have been
eroded. As national governments have liberalized their rules for issuing and trading securities
and eased restrictions on cross-border capital flows the advantages of international issues have
ceased to loom large. Global bond issues and the creation of cross-border issues within the EU
have blurred the distinction between Eurobonds and other international bond issues. Some
securities traditionally considered to be domestic.
These changes have blurred the difference between Eurobonds and foreign bonds. The term
international bonds is now applied to both, and the Euromarkets label has fallen out of use. But

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The World of Financial Markets and Institutions

although the Euromarkets may have faded into history, the international bond markets are
flourishing and are likely to grow rapidly.

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