Public

MODULE 1 1. When different commodities were used as a medium of

exchange (Barter System).
As introduction, what is Financial Market? 2.Discovery of precious metal like gold, copper and silver. Metals
Financial markets refer broadly to any marketplace where the were not used as coins but Bullions.
3.Refers to notes issued by Central Bank
trading of securities occurs, including the stock market, bond 4.Includes different instruments issued by banks like cheques,
market, forex market, and derivatives market, among others. drafts.
Financial markets are vital to the smooth operation of capitalist 5. Also known as e-money, electronic cash, e-currency, digital
economies. cash, digital currency

A financial market is a market where buyers and sellers trade

commodities, financial securities, foreign exchange, and other
freely exchangeable items (fungible items) and derivatives of
value at low transaction costs and at prices that are determined by
market forces.

c. Highlights in the History of Money in the Philippines – visit

the link below to picture out the history of Philippine money.
d. The Supply and Demand of money- Money facilitate the flow
of resources in the circular model of macroeconomy. Not enough
money will slow down the economy, and too much money can
cause inflation because of higher price levels. Monitoring the
Basically, financial markets are all about bringing investors supply and demand for money is vital for the economy’s central
(lenders) and borrowers together. bank policy, which aims to stabilize price levels and to support
economic growth.
1. Role of Money – Money is any item or commodity that is
Money supply refers to the amount of money which is in
generally accepted as a means of payment for goods and services
or for repayment of debt, and that serves as an asset to its holder. circulation in an economy at any given time. Money supply plays
Money is composed of bills and coins which have been printed or a crucial role in the determination of price level and interest rate.
minted by theBNational Government. Money includes also funds Growth of money supply helps in acceleration of Economic
stores as electronic entries in one’s checking and savings account. development and price stability. There must be a controlled
expansion of money supply i.e. no inflation or deflation in the
Money is any object that is generally accepted as payment for economy. The BangkoSentral ng Pilipinas (BSP) is responsible
goods and services and repayment of debts in a given country or
for determining the supply of money. It uses daily open market
socio-economic context. The main functions of money are
distinguished as: a medium of exchange; a unit of account; a store operations to influence the creation of money by banks and to
of value; and, occasionally, a standard of deferred guide the availability of money in the economy. BSP also has
impact on the creation of money by banks through reserve
Since its invention, money is used to measure the value of any requirements and the discount rate, the interest rate at which
commodity (goods and services) for easy exchange. It is said, banks can borrow from the BSP as a lender of last resort. Changes
money makes the world go round, which means the motive to in the supply of money will affect the interest rate and therefore
increase possession of more money occur. Money is the energy the cost of borrowing money. This will have an impact on
that allow all business transactions and events be measured and
consumption and investment levels in the economy.
translated into meaningful information.

a. Characteristics and key function of money: Key measures for the Money Supply are:
b.1 store of value - money acts as a means by which ● M1 – Includes money in circulation held by the nonbank
people can store their wealth for future use. public, demand deposits, other checkable deposits, and
b.2 item of worth - money has intrinsic value travelers’ checks. Primarily refers to money used as a
b.3 means of exchange–accepted in exchange for goods medium of exchange.
or services.
● M2 – In addition to M1, this measure includes money
b.4 Unit of account – issued by a recognized authority
which trust is vested in thee. held in savings deposits, money market deposit accounts,
b.5 standard of deferred payment – money can facilitate noninstitutional money market, mutual funds and other
exchange at any point by providing a medium of exchange short- term money market assets. M@ refers primarily to
money used as a store value.
b. Evolution of Money: ● M3 - In addition to M2, this measure includes the
financial institutions, refers primarily to money used as a
unit of account.
● L – In addition to M3, this measure includes liquid and
near-liquid assets (e.g., short- term Treasury notes, high-
grade commercial paper and bank acceptance notes)

Demand of Money - money is demanded because money serves

these purposes:
medium of exchange and store value. There are sources of
demand for money, these are as follows:
 ● Transaction demand – Money demanded for day-to- Interest rates link the future to the present. It allows individuals to
day payments through balances held by households and evaluate the present value (the value today) of future income and
firms (instead of stocks, bonds or other assets). This costs. In essence, it is the market price of earlier availability.
a. How interest rates are determined
demand varies with GSP, it does not depend on the rate
b. Determining the Interest rates
of interest. Gross Domestic Product, abbreviated as c. Money market equilibrium
GDP, is the total value of goods and services produced in d. The nominal or money rate versus the real rate of interest
a country. GDP in economics: GDP is measured over e. Interest rates and risk
specific time frames, such as a quarter or a year. GDP as f. The impact of changing interest rates – when interest rates
an economic indicator is used worldwide to show the raised; when interest raised are lowered
economic health of a country.
2. Overview of the Payment System–A payment system is any
● Precautionary demand – Money demanded as a result
system used to settle financial transactions through the transfer of
of unanticipated payments. This kind of demand varies monetary value. This includes the institutions, instruments,
with GDP. people, rules, procedures, standards, and technologies that make
● Speculative demand – Money demanded because of its exchange possible. A payment system is a mechanism
expectations about interest rates in the future. This means composed of rules, institutions, people, markets and organizations
that people will decide to expand their money balance that make exchanges of payments possible. It facilitates the
and hold off on bond purchases if they expect interest transfer of money from a payor to a payee in order to effect a
payment transaction. BSP Commodity money involves the use
rates to rise. This kind of demand has a negative
of an actual good in place of money (gold coin, tobacco). Fiat
relationship with the interest rate. money has no other value than as a medium for exchange; value
comes from government (paper money).
The Quantity Theory of money holds that changes in the money
supply MS directly influences the economy’s price level. This The value of fiat money is based largely on public faith in the
theory follows from the equation of exchange. issuer. Commodity money’s value, on the other hand, is based on
Where M = quantity of money the material it was manufactured with, such as gold or silver. Fiat
V = velocity of money money, therefore, does not have intrinsic value, while commodity
P = price level money often
Y or T = real GDP does.

In monetary economics, the quantity theory of money states that Commodity money is money whose value comes from a
the general price level of goods and services is directly commodty of which it is made. Commodity money consists of
proportional to the amount of money in circulation, or money objects having value or use in themselves (intrinsic value) as well
supply. as their value in buying goods. [1] This is in contrast to
representative money, which has little or no intrinsic value but
represents something of value, and fiat money, which has value
only because it has been established as money by government
regulation. Examples of commodities that have been used as
media of exchange include gold, silver, copper, salt, peppercorns,
tea, decorated belts, shells, alcohol, cigarettes, silk, candy, nails,
cocoa beans, cowries and barley.

Importance of checks - Use of checks in payment or settlement

of a specific transaction is a convenient way. A major innovation
in the payment system. Checks are promises to pay on demand
money deposited with a bank or other financial institutions.
Settling transactions with checks require more steps than settling
e. Time Value of Money- Interest is defined as the cost of using
transactions with currency. There are information costs in using
money over time. Economists prefer to say that interest represents
the time value of money. Use the link below for the discussion: checks – the time and effort required by the seller to verify
whether the issuer has sufficient amount of money the checking
Present value: account.
BSP supervises the payment system and had come up with
desirable outcomes for a bpayment system: Security; Efficiency;
Speed; Smooth international transaction and Effective
collaboration among participants in the system. Among other
payment system that are currently in use of technologies are 1)
Debit cards 2) Credit Cards 3) Proximity mobile payments 4)
Automated Clearing House (ACH) 5) Automated Teller Machine.

3. Financial Instruments – A financial instrument is any contract

that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity. Financial
instruments include primary instruments and derivative financial
instruments. Financial asset includes cash, equity instrument,
f. Interest Rates- An interest rate is the amount of interest due
per period, as a proportion of the amount lent, deposited or receivables.
borrowed. The total interest on an amount lent or borrowed a. Financial Assets that are considered financial instruments.
depends on the principal sum, the interest rate, the compounding 1) Cash on Hand and in Banks: Petty Cash Fund, Demand,
frequency, and the length of time over which it is lent, deposited savings and time deposits; Undeposited checks; Foreign
or borrowed. currencies; Money orders; Bank drafts
2) Accounts, notes and loans receivable and investment in bonds
and other debt instrument issued by other entities
3) Interest in shares or other equity instruments issued by other
entities: Stock Certificates; Publicly listed securities
4) Derivative Financial Assets: Future Contracts; Forward; Call
options; Foreign Currency Futures; Interest Rate Swaps

b. Financial Liabilities – a.) A contractual obligation; b) A

contract that will or may be settled in the entity’s own equity
instruments. Examples:
1) Accounts and notes payable, loans from other entities and
bonds and other debt Instruments issued by the entity.
2) Derivative financial liabilities
3) Obligations to deliver own shares worth a fixed amount of
cash.
4) Some derivative on own equity instruments.

c. Equity Instruments – is any contract that evidence a residual

interest in the assets of an entity after deducting all of its
liabilities. Examples are:
1) Ordinary Share
2) Preference Share
3) Warrants or written call option

d. Derivative Financial Instruments – that “derive” their value

on contractually required cash flows from other security or index.
Examples are:
● Future Contract
● Call Option
● Interest Rate Swaps
● Forward Contracts
● Foreign Currency Futures

MODULE 2
Financial System - It is a system that makes or channels funds
from people who save to people who have productive investment Indirect
opportunities? The financial system is complex in structure and
Fu
Financial Funds
functions throughout the world.
Intermedi
Financial System consist of a variety of institutions, markets and Fu
instruments related in a systematic manner and provide the
principal means by which savings are transformed into Lenders – Fu Fu Borrower –
investment, this is according to Prasanna Chandra. A system that Savers Fina Spenders
allows the transfer of money between savers. H ncial B
ous usin
The financial system plays a critical role in the economy. It ess
enables the financial intermediation process which facilitates the Direct
flow of funds between savers and borrowers, thus ensuring that
financial resources are allocated efficiently towards promoting Key Components of Financial System
economic growth and development. a) Financial Instruments
b) Financial Markets and Financial Institutions
c) The Central Bank and Other Financial Regulators

Three key services (functions) that the financial systems provide:

a) Risk sharing- Here are a few examples of how you regularly
share risk: Auto, home, or life insurance, shares risk with other
people who do the same. Taxes share risk with others so that all
can enjoy police, fire, and military protection. Retirement funds
and Social Security share risk by spreading out investments.
b) Liquidity - Liquidity risk is the risk that a business will have
insufficient funds to meet its financial commitments in a timely
The financial system plays a vital role in the economic manner. The two key elements of liquidity risk are short-term
development of a country. It encourages both savings and cash flow risk and long-term funding risk.
investment and also creates links between savers and investors c) Information – other function of financial system is the
and also facilitates the expansion of financial markets and aids collection of data or information of borrowers as well lenders.
financial deepening and broadening. Sometimes Asymmetric Information occurs thus, adverse
selection and moral hazard exists.
Hence, a major objective of a financial system is to
institutionalize and standardize many common financial Philippine Financial System – the basic function of the financial
transactions, such as the buying and selling of stocks, and to system is the moving of funds from those who has surplus to
provide common financial instruments with similar those who have shortage.
characteristics, such as options and futures.
Structure of the Philippine Financial System
The financial system is composed of the products and services Bangko Sentral Ng Pilipinas – principal regulatory agency
provided by financial institutions which includes banks, insurance which regulate all depository institutions. The BSP examines the
companies, pension funds, organized exchanges, and the many book of commercial banks that are members of the system, sets
other companies that serve to facilitate economic transactions. reserve requirements for all banks. Other regulatory agencies are;
Virtually all economic transactions are effected by one or more of Securities and Exchange Commission (SEC), Insurance
these financial institutions. They create financial instruments, Commission (IC) and Philippine Deposit Insurance Companies
such as stocks and bonds, pay interest on deposits, lend money to (PDIC).
creditworthy borrowers, and create and maintain the payment
systems of modern economies. Banking Institutions
A. Private Banking Institutions:
These financial products and services are based on the following 1. Universal Bank (UB) or Expanded Commercial Bank (EKB)
fundamental objectives of any modern financial system: 2. Commercial Bank or Domestic Bank (KB)
● to provide a payment system 3. Thrift Banks (TB)
● to give money time value, a. Stock Savings and Mortgage Bank (SSMB)
● to offer products and services to reduce financial risk or b. Private Development Bank (PDB)
to compensate risk-taking for desirable objectives, c. Stock Savings and Loan Association (SLA)
● to collect and disperse information that allows the most 4. Rural Bank (RB)
efficient allocation of economic resources, 5. Cooperative Bank
● to create and maintain financial markets that provide
prices, which indicates how well investments are B. Government Banks or Specialized Government Banking
performing, which also determines the subsequent Institutions
allocation of resources, and to maintain economic 1. Development Bank of the Philippines (DBP)
stability. 2. Land Bank of the Philippines (LBP)
3. Al-Amanah Islamic Investment Bank

Flow of Fund through the Financial System (Fig. 1) Non-Bank Financial Institutions
A. Private non-bank financial Institutions
1. Investment houses
2. Investment banks
3. Financing companies
4. Securities dealers/brokers
5. Savings and loans association
6. Mutual Funds
7. Pawnshops
8. Lending investors
9. Pension funds
10 Insurance companies
11. Credit Union

B. Government Non-bank financial institutions

1. Government Service Insurance System (GSIS)
2. Social Security System (SSS)
3. Pag-ibig

Philippine Financial System continue to evolve, and shows sign of

growth in the domestic market. The Philippine banking system
consistently posting double-digit asset growth since January 2016.
While total asset of the insurance industry more than doubled
from 2008 to 2016 and the securities market has also exhibited
growth. Through the continues effort of monitoring and controls
of the regulatory bodies the above goals were achieved.

Regulatory Landscape:
A. Alignment with global standards – BSP released several
circulars governing the issuance of bonds and liberalizing the
foreign exchange (FX) regulatory framework. The Insurance
Commission adopts the implementation of the Philippine
Financial Reporting Standards in congruence with the Financial
Reporting Standards Council. The SEC approved amendments to
Securities Regulation Code and Corporation Code, supporting the
bills on regulating Collective Investment schemes to enhance
local regulations and conform to international best practices.
PDIC has entered into a cross-border partnership by way of a
Memorandum of Understanding with eight deposit insurance
agencies from Asia, the UK and the US.

B. Deepening capital markets – Several financial products have

been introduced aimed to provide alternative options for raising
funds or for investing money. Includes: 1) dollar-denominated
securities, 2) exchange traded funds, 3) green bonds, 4) Personal
Equity and Retirement Account, 5) PHP government fund
forward, 6) public-private shares, and 7) real estate investment
trust.

C. Strengthening surveillance - PHL is Now a BIS-Reporting

Country, 01.15.2018

The Philippines will join an elite group of less than 50

jurisdictions worldwide which report cross-border banking
statistics to the Bank for International Settlements (BIS) as part of
the global database.

Current risks in the Philippine financial System

A. Repricing, refinancing and repayments risks (3rs)
B. Developments in the credit market
C. Continuous demand for credit by corporate enterprises and
households is evident in the domestic
 MODULE 3 1. Debt market- The debt market, or bond market, is the arena in
Financial Markets are the meeting place for people, corporations which investment in loans are bought and sold. There is no single
and institutions that either need money or have money to lend or physical exchange for bonds. Transactions are mostly made
invest. In a broad context, the financial market exists as a vat between brokers or large institutions, or by individual investors.
global network of individuals and financial institutions that may Investments in debt securities typically involve less risk than
be lenders, borrowers or owners of public companies worldwide. equity investments and offer a lower potential return on
investment. Debt investments by nature fluctuate less in price than
Stock markets are places where individual investors and stocks. Even if a company is liquidated, bondholders are the first
corporations can trade currencies, invest in companies, and to be paid. Bonds are the most common form of debt investment.
arrange loans. Without global financial markets, governments These are issued by corporations or by the government to raise
would not be able to borrow money, companies would not have capital for their operations and generally carry a fixed interest
access to the capital they need to expand and individuals and rate.
investors would not be to buy and sell foreign currencies.
2. Equity market - Equity, or stock, represents a share of
Functions of Financial Market – The basic function of financial ownership of a company. The owner of an equity stake may profit
markets (bond and stock markets) and financial intermediaries from dividends. Dividends are the percentage of company profits
(banks, insurance companies) is getting people together by returned to shareholders. The equity holder may also profit from
moving funds from those who have a surplus of funds to those the sale of the stock if the market price should increase in the
who have a shortage of funds. A healthy economy requires a well- marketplace. The owner of an equity stake can also lose money.
functioning financial markets and intermediaries. In the case of bankruptcy, they may lose the entire stake. The
equity market is volatile by nature. Shares of equity can
The chart below schematically shows the function that financial experience substantial price swings, sometimes having little to do
market performs: with the stability and good name of the corporation that issued
Indirect them.
Financial
Fu Intermedia Funds Primary and Secondary Market – debt and equity securities are
marketed both in primary and secondary markets.
Fu
1. Primary market is where securities are created. It’s in this
Lenders – Fu Fun Borrower –
Savers Financ Spenders market that firms sell (float) new stocks and bonds to the public
H ial B for the first time. An initial public offering, or IPO, is an example
ouse Marke usin of a primary market. These trades provide an opportunity for
hold Direct ess investors to buy securities from the bank that did the initial
Activities of financial market: underwriting for a particular stock. An IPO occurs when a private
a) Raising Capital - corporations/ firms needs funds to expand its company issues stock to the public for the first time. For example,
business, thus they can achieve this through issuance of shares company ABCWXYZ Inc. hires five underwriting firms to
and bonds determine the financial details of its IPO. The underwriters’ detail
b) Commercial transactions. Financial Market facilitates that the issue price of the stock will be $15. Investors can then
commercial transactions including arranging payment for sale of buy the IPO at this price directly from the issuing company. The
products abroad and providing working capital to supplement important thing to understand about the primary market is that
operating expenditure. securities are purchased directly from an issuer.
c) Price setting. The market determines the price or values of
different items based upon at which an individual’s willingness to 2. Secondary Market For buying equities, the secondary market
buy or sell. is commonly referred to as the "stock market." This
d) Asset Valuation. A firms’ asset or property prices are best includes the New York Stock Exchange (NYSE), Nasdaq, and all
determined by the market. major exchanges around the world. The defining characteristic of
e) Arbitrage. The simultaneous buying and selling of securities, the secondary market is that investors trade among themselves.
currency, or commodities in different markets or in derivative That is, in the secondary market, investors trade previously issued
forms in order to take advantage of differing prices for the same securities without the issuing companies’; involvement. For
asset. example, if you go to buy Amazon (AMZN) stock, you are
f) Investing. Stock, bond and money markets provide opportunity dealing only with another investor who owns shares in Amazon.
to earn a return on funds that are not needed immediately, and to Amazon is not directly involved with the transaction.
accumulate income generating assets in the future.
g) Risk Management. Derivative contracts provide protection Remember: a) The primary market is where securities are created,
against many types of risk, such as changes in foreign currency while the secondary market is where those securities are traded by
against local currency might result to losses. investors.
b) In the primary market, companies sell new stocks and bonds to
Structure of Financial Markets – when we say structure, we are the public for the first time, such as with an initial public offering
referring to what composed of financial market of what is it in a (IPO).
financial market. There are different financial markets in a c) The secondary market is basically the stock market and refers
developed economy each dealing with a different type of security to the New York Stock Exchange, the Nasdaq, and other
serving a different set of customers, or operating in a different exchanges worldwide.
part of the economy.
Two broad segments of the Stock Markets:
Debt and Equity markets – an entity or an individual may obtain 1. Organized Stock Exchange. – stock exchanges will have a
fund in the said ways. physical location where stocks buying and selling transactions
take place in the stock exchange floor. (PSE. NYSE, …
Stock Exchange – is an organized secondary market whose 2. Banker’s Acceptance - A banker’s acceptance is a financial
securities like shares, debentures of public companies, instrument that most commonly occurs in international trade
government securities and bonds issued by municipalities, public transactions. It provides a bridge between an importer and an
corporations, utility undertakings, port trusts and such other local exporter when they do not have an established relationship. A
authorities are purchased and sold. Stocks that trade in an banker’s acceptance can be used by an importer to finance his
organized exchange are said to be listed on the stock exchange. purchases or can be created through a letter of credit transaction.
To be listed, firms must meet certain minimum criteria concerning
their number of shareholders and asset size 3. Treasury Bills - The treasury bills or T-bills are a way for the
government to borrow money in the short term. Just like bonds,
2. Over-the-Counter (OTC) Exchange – Where shares, bonds they are debt instruments that allow the public to lend their money
and money market instruments are traded using a system of to the state. They’re called with that name because they’re issued
computer screens and telephones. Manny common stocks are by the Bureau of the Treasury. The Philippine government issues
traded over the counter although the majority of the largest them to raise funds. These funds are used in many different
corporations have their shares traded at organized stock exchange. purposes. They may be allocated to pay for the ballooning
OTC requires a brokerage firm to match a prospective buyer and a national debts or sustain social services such as education,
prospective seller at a price acceptable to both. healthcare, agriculture, and anti-poverty efforts. The money that’s
collected may also be used towards construction of roads, bridges,
Two important functions of Secondary market: and other infrastructure projects or it might be used to fund law
1. They make it easier to sell these financial instruments to raise enforcement and national defense. These bills are sold on a
cash, that is they make financial instruments more liquid. discount. Meaning, they are not sold on their face amount.
2. They determine the price of the security that the issuing firm Instead, they’re sold less than its price. A ₱1,000 treasury bill may
sells in the primary market. be sold for ₱990. The investor earns with the spread, which is just
another name for the difference between the face amount and the
Attributes that Investors and creditors are looking for in a price paid. In this case, you get ₱10 or 1% in exchange return for
financial market: letting the government borrow your money.
a. Liquidity
b. Transparency 4. Government-agency notes – National government agencies
c. Reliability and government-sponsored corporations are heavy borrowers in
d. Adequate legal procedures the money markets in many countries, These include entities such
e. Investors protection and regulations as development banks, housing finance corporations, education
f. Low transaction costs lending agencies and agricultural finance agencies.

Change in trading in the markets are brought about by certain 5. Local Government notes – Local government notes are issued
forces: by, provincial or local governments, and by agencies of these
a. Technology governments such as schools’ authorities and transport
b. Deregulation commissions.
c. Liberalization
d. Consolidation 6. Interbank loans – Loans extended from one bank to another
e. glocalization with which it has no affiliation are called interbank loans. Many
of these loans are across international boundaries and are used by
Money Markets and Capital Markets the borrowing institutions to re-lend to its own customers.
Money Market - Refers to trading in very short-term debt
investments. At the wholesale level, it involves large-volume 7. Time deposits - A certificate of deposit (CD) is a product
trades between institutions and traders. At the retail level, it offered by banks and credit unions that provides an interest rate
includes money market mutual funds bought by individual premium in exchange for the customer agreeing to leave a lump-
investors and money market accounts opened by bank customers. sum deposit untouched for a predetermined period of time.
Almost all consumer financial institutions offer them, although
Money market instruments are securities that provide businesses, it’s up to each bank which CD terms it wants to offer, how much
banks, and the government with large amounts of low-cost capital higher the rate will be compared to the bank’s savings and money
for a short time. The period is overnight, a few days, weeks, or market products, and what penalties it applies for early
even months, but always less than a year. withdrawal.

Types of Money – Market Instruments: 8. Repos – Repurchase Agreement or repos is a combination of

1. Commercial paper – a short-term debt obligation of a private- two transactions. In the first, securities dealer, such as a bank,
sector firm or a government-sponsored corporation. For a sells securities it owns to an investor, agreeing to repurchase the
company to be able to issue commercial paper, it needs to have securities at a specified higher price at a future date. In the second
the highest credit rating. Investors purchase CP based on the transaction, days or months later, the repo is unwound as the
credit ratings of the company. This is because the understanding is dealer buys back the securities from the investor.
that the company will buy the paper back, with interest, by the
maturity date. Only companies that have the highest credit ratings Capital Market - Capital market is a market where buyers and
will be able to do this. sellers engage in trade of financial securities like bonds, stocks,
A company will only have access to the commercial paper market etc. The buying/selling is undertaken by participants such as
and have investors who are willing to buy its paper if its excellent individuals and institutions.
credit rating is maintained. If the credit rating of the issuing
company is downgraded the interest rate for its paper will increase Description: Capital markets help channelize surplus funds from
and the company may no longer be able to issue commercial savers to institutions which then invest them into productive use.
paper. Generally, this market trades mostly in long-term securities.
Capital market consists of primary markets and secondary Credit Ratings - Bond ratings are important, these provide an
markets. Primary markets deal with trade of new issues of stocks indicator of default risk that in turn affect the rate of return that
and other securities, whereas secondary market deals with the must be paid on borrowed funds. Investment Grades: AAA, AA,
exchange of existing or previously-issued securities. Another A, BBB while Below Investment Grades are BB,B,CCC,CC, C, D
important division in the capital market is made on the basis of
the nature of security traded, i.e. stock market and bond market. Types of Bonds:
A. Unsecured Long-Term Bonds –Includes: Debentures,
a) National and local government one of the two primary issuers Subordinated Debentures, and Income Bonds
of capital market securities. Long-term notes and bonds are issued
by the national government to fund the national debt. expenditures B. Secured Long-Term Bonds – Mortgage Bonds which also be
and find other investment opportunities Corporations issue bonds subclassified as: First Mortgage Bonds, Second Mortgage Bond,
and stocks, the latter being another primary issuer of capital Blanket or General Mortgage Bonds, Close – end Mortgage
market security. Notes and bonds are issued by the local Bonds, Open-end Mortgage Bonds and Limited Open-end
governments to finance capital projects. Mortgage Bonds.
b) To finance its capital investment
Other Types of Bonds:
Capital Market Trading - occurs in either the primary market or 1. Floating Rate or Variable Rate Bonds
the secondary market. (look on discussion on Primary and 2. Junk or Low-Rated Bonds
Secondary market under Equity Market) Trading on different type 3. Eurobonds
of securities: 4. Treasury Bonds

A. BONDS - A bond is a fixed income instrument that represents B. ORDINARY (COMMON) EQUITY SHARES - Are shares
a loan made by an investor to a borrower (typically corporate or in a company that are owned by people who have a right to vote at
governmental). A bond could be thought of as an I.O.U. between the company’s meetings and to receive part of the company’s
the lender and borrower that includes the details of the loan and profits after the holders of preference shares have been paid.
its payments. Bonds are used by companies, municipalities, states, Features of Ordinary Equity Shares:
and sovereign governments to finance projects and operations. ● Par value/No par value
Owners of bonds are debtholders, or creditors, of the issuer. Bond ● Authorized, issued and outstanding
details include the end date when the principal of the loan is due ● No maturity
to be paid to the bond owner and usually includes the terms for ● Voting rights = Majority or Cumulative
variable or fixed interest payments made by the borrower. ● Book value per share
● Numerous rights of shareholders: right to vote on
Trading of corporate bond. The initial or primary sale of corporate specific issues as prescribed by the corporate charter,
bond issues occurs either through a public offering, using an right to receive dividends, right to share in the residual
investment bank serving as a security underwriter or through a assets in the vent of liquidation, right to transfer their
private placement to a small group of investors. ownership in the firm to another party, right to examine
corporate books and right to share proportionally in the
Bond Features and Prices- terminologies associated with bond: purchase of new issuance of equity shares. (pre-emptive
Par value – face value of the bond that is returned to the right)3
bondholder at maturity.
Coupon Interest Rate- The percentage of the par value of the C. PREFERRED SHARE - more commonly referred to as
bond that will be paid out. annually in the forms of interest. preferred stock, are shares of a company’s stock with dividends
Maturity- the length of time until the bond issuer returns the par that are paid out to shareholders before common stock dividends
value to the bondholder and terminates the bonds. are issued. If the company enters bankruptcy, preferred
Indenture – the agreement between the firm issuing the bonds stockholders are entitled to be paid from company assets before
and the bond trustee who represents the bondholders. It provides common stockholders. Preference shares, more commonly
the specific terms of the loan agreement, including the description referred to as preferred stock, are shares of a company’s stock
of the bonds, the rights of the bondholders, the right of the issuing with dividends that are paid out to shareholders before common
firm and the responsibilities of the trustees. stock dividends are issued. If the company enters bankruptcy,
Current yield – refers to the ration of the annual interest payment preferred stockholders are entitled to be paid from company assets
to the bond’s market price. before common stockholders. Most preference shares have a fixed
Yield to maturity – refers to the bond’s internal rate of return. It dividend, while common stocks generally do not. Preferred stock
is the discount rate that equates the present value of the interest shareholders also typically do not hold any voting rights, but
and principal payments with the current market price of the bond. common shareholders usually do.
Credit Quality Risk – the chance that the bond issuer will not be Features of Preferred Shares:
able to make timely payments. ● Par value
Bond Ratings – involve a judgement about the future risk ● Dividends
potential of the bond provided by rating agencies such as ● Cumulative and Noncumulative dividends
Moody’s Standard and Poor’s and Fitch IBCA, Inc., Dominion ● No definite maturity dates
Bond Rating Services. These are bond ratings are affected by: ● Convertible preferred shares
a. a low utilization of financial leverage ● Voting rights (special voting procedure)
b. profitable operations ● Participating features
c. a low variability of past earnings ● Protective features
d. large firm size ● Call provisions
e. little use of subordinated debt. ● Maturity
 MODULE 3.1 Illustration 2- Calculation of Intrinsic Value of Ordinary Equity
Valuation of Ordinary Equity shares as a Source of Funds share Under the Infinite -Period Dividend Valuation.

Using the above data in Illustration 1, determine the intrinsic

Ordinary Equity share Valuation
value of ordinary equity share under the infinite period dividend
Ordinary equity shares are share held by the owner of the firm. valuation.
Ordinary equity share valuation is complicated by the uncertainty
of future returns. This return may be in the form of cash dividend Answer:
payment and/ or changes in the share price (gains or losses. Over Dp
the holding period. Dividend are uncertain because there are no
Po =
Ks
legal requirements to pay them unless they are declared. Equity P 5.20
shares are generally riskier than bonds because the cash flow must Po =
15 %
be estimated. There are numerous ordinary equity share valuation Po = 34.67
models, the following discussion focuses on models that assume
varying holding periods (the length of time that an investor Ordinary Equity Share Valuation Models Based on Dividend
expects to own or hold a security and rates of dividend growth. Growth Rates

Ordinary Equity Share Valuation Models Based on Holding The Valuation models to determine the value of ordinary equity
Periods share based on dividend growth rates include the following:
A: Zero Growth Dividend Model
B. Gordon Constant Growth Dividend Model
A: Finite –Period Dividend Valuation C. Supernormal Growth Dividend Model
This model is one in which an investor plans to purchase an A: Zero Growth Dividend Model
ordinary equity share and hold it for a specific length of time. For A zero-growth dividend model assumes dividends remain a fixed
Example, the holding period may be for one or more period. amount overtime. The Formula is:
During the Holding period, the investor expects to receive cash Dp
Pn =
dividends and to sell the stock for a price at the end of the holding Ks
period. The equation to estimate the value of ordinary share is:
Illustration 3. Calculation of Share Value Using the Zero Growth
Dividend Model
YXZ Company expects to pay a P3.00 cash dividend at the end of
the year indefinitely into the future. If the investors in this stock
require a 15 percent return. The value of a share YXZ would be
computed as by substituting D p =P3.00 and k s = .15
P 3.00
P0 = = P20.00
Illustrative 1: Calculate of Intrinsic Value of Ordinary Equity
.15
Share Under the Finite Period Dividend Valuation.

An Investor plans to but ordinary share of Holyland Farms and to

sell it at the end of one year. If the investor expects Holyland to B. Gordon constant Growth dividend Model
pay P5.20 cash dividend and to sell for P50 at the end of the year. A. Gordon constant growth dividend model assumes that the
If the investor’s required rate of return is P15 percent, the value of dividend grows at a constant rate each period. The Formula is:
the stock to this investor would be computed as follows: Di
Po =
P5.20 P50 P 55.20 k s −g
Pn = + = = P48
1+ 0.15 1+ .015 1.15 Where: D 1 = Expected dividend
Ks = investor’s required rate of return on common
This indicates that the investor should pay no more than P48 per equity share
share for a share of Holyland’s ordinary share to realize an g = constant dividend growth rate
expected return of 15 percent
Illustration 3 _- Calculate of share Value using the Gordon
Constant Growth Dividend Model
B: Infinite-Period Dividend Valuation RST Corporation currently pay P2.00 per share in ordinary equity
This model assumes that an investor plans to purchase an ordinary share dividends. The Firm’s dividends are expected to grow at a
share and hold it indefinitely. The return is only in the form of constant rate of 5 percent per year. Investor require a 15 percent
dividends over multiple periods. The following equation is an return on RST ordinary equity share
infinite period model that shows the intrinsic value of a share of
Di is calculated by using Do (1+g ) where the Do is the per share
ordinary share is equal to the expected stream of dividends
discounted at the investor’s required rate of return dividend in the current period.
Di(P2.00) (1 + 0.05) = P2.10
Substituting D i = P2.10, K s = 0.15 and g = .05 in the above
equation produces an ordinary equity share value of P21.00.
P 2.10
Po = = P21.00
The above equation can be simplified into the following valuation 0.15−.05
model:
Dp C: Supernormal Growth Dividend Model
Po = A supernormal growth dividend model assumes that dividends
Ks
grow at an above normal rate over some time period and then
Where D p = per share cash dividend paid on a perpetuity
grow at a normal rate thereafter. This two-stage model is more
K s = investor’s required rate of return on ordinary share flexible than the zero or constant growth rate models and can be
∞ = sign of infinity adjusted to allow for any number of different expected growth
rate. This model states that the value of the firm’s ordinary equity
shares the present value of the expected dividends during the
above normal growth period plus the present value of the sale Dp
price at the end of the above normal growth period. Po =
Kp
Where D p = Per share cash dividend
K p = investor’s required rate of return on preferred
share
Illustration 1. Federal Electric and Power Company has an issue
of preferred share outstanding that pay a yearly dividend of
P10.80. investor requires a 12% return on this preferred share.
Illustration 4: Calculation of share Value using the Supernormal Determine the intrinsic value of the preferred share
Growth Dividend Model QC Company expects dividends to grow Solution:
at a rate of 10 percent a year for the next five years and 6 percent P 10.80
a year thereafter. The firm current dividend is P2.00 per share. An Po = = P90.00
investor who requires a 16 percent rate of return, would compute 125
the value of QC’ ordinary equity shares in four steps.
In the Philippines the following preferred share are actively traded
Step 1 Find the present value of the dividends during the above in the Philippine Stock Exchange:
normal growth period. First Philippine Holding – preferred
Year Dividend Present Present San Miguel Pure foods - Preferred
Petron Corporation Perpetual – Preferred
Value of Value of
Swift Foods Inc. = Convertible Preferred
Interest Dividend
factor Bonds
1 P2.00(1.100) = P2.20 .862 P 1.90 ** Current Yield
2 2.00 (1.210) = 2.42 .743 1.80 This refers to the ratio of the annual interest payment to the bonds
3 2.00 (1.331) = 2.66 .641 1.71 market price.
Yield to Maturity
4 2.00 (1.464) = 2.93 .552 1.62 This refers to the bond’s internal rate of return. It is the discount
5 2.00 (1.611) = 3.22 . 476 1.53 rate that requires the present value of the interest and principal
total P 8.56 payment with the current market price of the bond Formula is:
Approximate Yield to Maturity =
P 2.00 (1.10) Principal Payment−Price of the B
** Annual Interest Payment +
1.16 Numver of Years ¿

Step 2 Find the present value of the stock price in year 5. This Example: Determination of Bond Yield to Maturity
step involves calculating the share value at the end of year 5 Par Value of Bond: P1,000
P 3.22 x .06 Interest rate : 10%
PS = Term : 10 years
10 % Current price: : P900.00
P 3.413 What are the bonds approximate yield to maturity?
=
10 % Solution:
= P34.13 1,000−900
100+
Approximate Yield to Maturity = 10
Step 3: Discount the share value at the end of year 5 to the present
at the 16% required rate of return .6 ( 900 ) +.4 (1,000)
PV ( Ps ) = P34.13 (0.476)
= P16.25 110
= or 11.70 %
940
Step 4: Add the present of the 5 years dividends and the present
value of the share value in year 5 to get the value of the share at 1. Foreign Exchange Market – An entity has to buy raw
the end of the above normal growth period. materials for his product operation from other country, and that
Po = P8.56 + P16.25 seller required him to pay his purchases in their local
= P24.81 currency. The system to which that entity should undergo to meet
the seller’s requirement is a
Preferred share Valuation typical example of which the entity should exchange his local
Preferred share is share that has a claim against income and assets currency to the sellers pay
before ordinary share but after debt. Preferred share considered a requirement.
hybrid security because it possesses characteristics of both debt
and equity. Preferred share is considered similar to ordinary Foreign Exchange Market or FX (forex) – A place or market in
equity share because they do not have maturity and similar to debt which people or firms use one currency to purchase another
in that both securities have fixed payments. Dividends for currency. Mostly international transactions such as selling,
preferred share and interest for debt. buying, travelling, borrowing and investing requires partakers to
convert one currency to another. The trading of currency and bank
Preferred share valuation is relatively simple if the firm pay fixed deposits denominated in particular takes place in the foreign
dividends at the end of each year. If this condition hold. Then the exchange market.
stream of dividend payments can be treated in perpetuity and be
discounted by the investor’s required rate of return on a preferred International Monetary Fund (IMF) administered the world
share issue. A perpetuity is an annuity with an infinite life span. If exchange rate system from the end of world war II until the early
the preferred share has high risk. Investors normally requires a 70’s. All countries were required to set a specific parity rate for
higher rate of return. This is because creditors have priority over their currency in measured with US dollar. Adjustments in the
preferred share holders in their claims to both income and assets. exchange rate through changing the parity rate with respect to the
dollar, such as it made the currency cheaper thereby devaluation
occurs. An upvaluation or revaluation resulted when a currency
The intrinsic value of the share of preferred share ( P0 ) is the
become more expensive with respect to the dollar. (Cabrera)
sum of the present value of future dividends discounted at the
investor’s required rate of return. This also can be determined
using the following valuation model.
The FX market provides service to individuals, businesses and It is a theoretical exchange rate that allows you to buy the same
governments who need to buy or sell currencies, other than that amount of goods and services in every country. Government
used in their country. It is also a market place in which currencies agencies use PPP to compare the output of countries that use
are bought and sold purely to make profit via speculation. It also different exchange rates. You could use it to find out where to get
provides mechanism for the transfer of purchasing power from the cheapest hamburger in the world.
one currency to another.
E. Foreign Currency Exchange Rate Transactions:
1.Spot transactions -are those which involve(two-day) exchange
of bank deposits. The spot exchange rate is the exchange rate for
the spot transactions.
2.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.
The foreign exchange market (also known as forex (FX), or the SPOT EXCHANGE RATES If we are exchanging currency for
currency market) is global marketplace that determines the another one immediately, we participate in a spot transaction. A
exchange rate for currencies around the world. Like any other typical spot transaction may involve a Philippine firm buying
market, foreign exchange market is a system, not a place where foreign currency from its bank and paying it in Philippine pesos.
foreign money is bought and sold. Participants include
individuals, firms, foreign exchange broker, commercial banks, DIRECT AND INDIRECT QUOTES - A direct quote indicates
and the central bank are able to buy, sell, exchange, and speculate the number of units of the home currency require to buy one unit
on currencies. The transaction in this market is not confined to of foreign currency. Direct quote is the peso/foreign currency rate:
only one or few foreign currencies. In fact, there are large number 1 US dollar = P48.0530
of foreign currencies which are traded, converted, and exchange 1 UK pound = P65.1938
in the foreign exchange market 1 HK dollar= P6.1977
1 Japan Yen = P0.4629
A Foreign Exchange Rates - the value of one currency for the - An Indirect quote indicates the number of units of
purpose of conversion to another. It is the price of one’s country foreign currency that can be bought for one unit of the
currency expressed in terms of another country’s currency. home currency. An Indirect quote is the foreign
Exchange Rates are important because they affect the relative currency/peso rate.
price of domestic and foreign goods. When a country’s currency
appreciates (rises in value relative to other currencies), the Illustrative case:
country’s goods abroad become more expensive and foreign Compute the indirect quotes from the Philippine direct quotes of
goods in that country become cheaper, in reverse, when a spot rates for US dollars, UK pound, Hong Kong dollar and
country’s currency depreciates, its goods abroad become cheaper Japanese Yen as of January 08, 2021.
and foreign goods in that country become expensive.
Compute the indirect quotes from the Philippine direct
B. Factors Influencing Exchange Rates - As with any other
quotes of spot rates for US dollars, UK pound, Hong Kong
market the currency exchange rate between two currencies is
determined by the supply of the demand for those currencies. dollar and Japanese Yen as of January 08, 2021.
Factors that tend to increase the supply or decrease the demand
schedule for a given currency will bring down the value of that 1 US dollar = P48.0530
currency in foreign exchange matters. Similarly, the factors that 1 UK pound = P65.1938
tend to decrease the supply or increase the demand for a currency 1 HK dollar= P6.1977
will raise the value of that currency.
1 Japan Yen = P0.4629
Major reasons for exchange rate movements are: Indirect quote = 1/Direct quote
1. Inflation - a general increase in prices and fall in the Thus: US dollars = 1/48.0530 = 0.02081 (US dollar/P1)
purchasing value of money. Inflation tends to deflate the value of UK pounds = 1/65.1983 = 0.01533 (pound/P1)
a currency because holding the currency results in reduced HK dollars = 1/6.1977 = 0.16135 (HK dollar/P1)
purchasing power.
2. Interest Rates - if interest returns in a particular country are Japan Yen = 1/0.4629 =2.16029 (yen/P1)
higher relative to other countries, individuals and companies will
be enticed to invest in that country. As a result, there will be an CROSS RATE is the indirect computation of the exchange rate
increased demand for the country’s currency. of one currency from the exchange rates of two other currencies.
3. Balance of Payments - is used to refer to a system of accounts For instance: The peso/pound and the US dollar/peso rates are
that catalogs the flow of goods between the residents of two given in the figure. From this information, we could determine
countries. that US dollar/pound and pound/US dollar exchange rates.
4. Government Intervention - Through intervention (e.g., buying P65.1983 = £1
or selling the currency in the foreign exchange markets) the P48.0530 = $1
central bank of a country may support or depress the value of its P65.1983/P48.0530 = 1.35679 US dollar per 1 pound
currency. Thus, the pound/US dollar exchange rate is:
5. Other factors - Other factors that may affect exchange rates P48. 0530/65.1983 = 0.73702 pound per 1 US dollar
are political and economic stability, extended stock market rallies
and significant declines in the demand formajor exports. F. Arbitrage - the simultaneous buying and selling of securities,
currency, or commodities in different markets or in derivative
C. Forex trading always involves selling one currency in order to forms in order to take advantage of differing prices for the same
buy another, which is why it is quoted in pairs – the price of a asset. Arbitrage is the process of a simultaneous sale and purchase
forex pair is how much one unit of the base currency is worth in of currencies in two or more foreign exchange markets with an
the quote currency. Foreign exchange market is organized as an objective to make profits by capitalizing on the exchange-rate
over-the-counter market in which several hundred dealers (mostly differentials in various markets.
bank) stand ready to buy and sell deposits denominated in foreign Arbitrage is the process of buying and selling currency in more
currencies. than one market to make a riskless profit. The person behind this
strategy is the arbitrageur.
D. Theory of Purchasing Power Parity - Purchasing power
parity (PPP) is an economic theory that allows the comparison of G. Forward Rates - The forward exchange rate is the rate of
the purchasing power of various world currencies to one another. exchange, agreed upon now, for a foreign exchange market
transaction that will occur at a specified date in the future. The estate purchases. A family may obtain a mortgage loan to finance
agreement to make such an exchange in the future at a rate agreed the purchase of a home; in this case, the loan is amortized. The
upon now is called a forward contract. In making a forward borrower pays it over time in some combination of principal and
contract---purchasing yen forward in this case---our Japanese interest payments that result in full payment of the debt by
exporter and Canadian importer hedge or cover themselves maturity.
against a future rise in the dollar price of the yen. They shift the
risk from future exchange rate changes onto the party who sells Characteristics of Mortgage:
them yen forward. That seller of forward yen has to deliver yen A. Mortgage Interest Rates - It is the interest charged on a loan
for dollars at an exchange rate of 355 yen for one Canadian dollar used to purchase a property. The amount of interest owed is
in 90 days. When the forward contract matures in 90 days, the calculated as a percentage of the total amount of the mortgage
forward seller has to purchase yen for Canadian dollars spot at the issued by the lender. Mortgage interest rates may either be fixed
going market price---that is, the spot exchange rate---at that time or variable (adjustable)
in order to deliver them at the agreed-upon forward price.
Factors that Affect Interest Rates:
FORWARD RATES The forward rate for a currency is the 1. Current Long-Term Market Rates – occurs due to the
exchange rate at which the currency for future delivery is quoted. Central Bank trying to keep prices stable and to encourage job
The trading of currencies for future delivery is called a forward creations.
market transaction. In an instance Aquarius Corporation expects 2. Term or Life of the Mortgage – the usual mortgage lifetime is
to pay US$ 5 million to US supplier 30 days from now. It is not 15 or 30 years. A mortgage with a longer term has higher interest
certain however, what these dollars will be worth in Philippine rate than shorter-term mortgages
pesos 30 days from today. 3. Number of Discount Points Paid – refers to interest payments
made at the beginning of a loan, also called as “buying down the
FACTORS THAT AFFECT EXCHANGE RATES IN THE rate”. A loan with one discount point means that the borrower
LONG RUN pays 1% of the loan amount which lowers the rate by 0.25%.
1. Relative Price Levels - Arise in a country’s price level causes
its currency to depreciate, and a fall in the country’s relative price B. Loan Terms - Mortgage loan contracts contain many legal and
level causes its currency to appreciate. financial terms, most of which protect the lender from financial
2.Trade Barriers - Increasing trade barriers causes a country’s loss. Conditions involved include the number of years to pay on
currency to appreciate. the loan, the interest rate and the monthly payment.
3. Preferences for Domestic Versus Foreign Goods - Increased
demand for a country’s experts causes currency to appreciate in C. Collateral - One characteristic common to mortgage loans is
the long run, conversely increased demand for imports causes the the requirement that collateral, usually the real estate being
domestic currency to depreciate. financed, be pledged as security.
4. Productivity – As a country becomes productive relative to
other countries, its currency appreciates in the long run. D. Down Payment - The lender requires the borrower to make a
down payment on the property, that is, to pay a portion of
EXCHANGE RATE IN THE SHORT RUN The key to purchase price. Some lenders require the borrower to pay 5% to
understanding the short-term behavior of exchange rates is to 20% as down payment.
recognize that an exchange rate is the price of domestic bank
deposits in terms of foreign bank deposits. Earlier approaches to E. Private Mortgage Insurance (PMI) - It is an insurance policy
exchange rate determination emphasized the role of import and that protects the lenderfrom losses in the event that the borrower
export demand. defaults on the primary mortgage and the property goes into
foreclosure. PMI is applied when the down payment is less than
MANAGING FOREIGN EXCHANGE RISK Foreign 20%. PMI costs between 0.5% and 1% of the mortgage annually.
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 F. Borrower Qualification- Before granting a mortgage loan, the
foreign exchange rates. International business transactions are lender will determine whether the borrower qualifies for it. If the
denominated in foreign currencies. The rate at which one currency lender gives a mortgage loan to a borrower who does not fit the
unit is converted into another is called the exchange rate. guidelines, the lender may not be able to resell the loan to the few
government agencies in the secondary market.
AVOIDANCE OF EXCHANGE RATE RISK IN FOREIGN
CURRENCY MARKETS AMORTIZATION OF MORTGAGE LOAN Mortgage loan
1. The firm may hedge its risk by purchasing or selling forward borrowers generally agrees to pay a monthly amount of principal
exchange contracts. and interest that will be fully amortized by its maturity. Fully
2. The firm may choose to minimize receivables and liabilities. amortized- means that the payments will pay off the outstanding
3. Maintaining a monetary balance between receivables and indebtedness by the time loan matures. Look on Figure 10-1:
payable denominated in a particular foreign currency avoids a net Amortization of a 30-year, P130,000 loan at 8.5%.
receivable or net liability position in that currency.
4. Another means of managing exchange rate risk is by the use of TYPES OF MORTGAGE LOANS:
trigger pricing. Conventional Mortgages- These are originated by banks or other
5. A firm may seek to minimize its exchange rate risk by mortgage lenders but are not guaranteed by government or
diversification. government-controlled entities, most lenders though now insure
6. A speculative forward contract does not hedge any exposure to many conventional loans against default or they require the
foreign currency fluctuations. borrower to obtain private mortgage insurance on loans.

2. MORTGAGE MARKET- Mortgage market forms a Insured Mortgages- These mortgages are originated by banks or
subcategory of the capital markets because it involves long-term other mortgage lenders but are guaranteed by either the
funds. Mortgage Market differs from the stock and bond markets government or government-controlled entities.
in a number of ways.
• Usual borrowers in capital markets are businesses and Fixed-rate Mortgages -In fixed-rate mortgages, the interest rate
government entities while in mortgage markets are individuals. and the monthly payment do not vary over the life of the
• Mortgage loans are made for varying amounts and maturities mortgage.
depending on the borrower’s needs, features that cause problems
for developing a secondary market. Adjustable-Rate Mortgages (ARMs)- The interest rate on
adjustable-rate mortgage (ARMs) is tied to some market interest
Mortgages are long-term funds secured by a real estate. Both rate, (e.g., Treasury bill rate) and therefore changes over time.
individuals and businesses obtain mortgage loans to finance real
ARMs usually have limits, called caps, on how high (or low) the transforming illiquid financial assets into marketable capital
interest rate can move in one year and during the term of the loan. market instruments. The most common type of mortgage-backed
security is the mortgage pass through the trustee before being
Graduated-Payment Mortgages (GPMs)-These mortgages are disbursed to the investors in the mortgage-pass through. If
useful for home buyers who expect their incomes to rise. The borrowers pre-pay their loans, investors receive more principal
GPM has lower payments in the first few years then the payment than expected.
rises. The early payment may not even be sufficient to cover the
interest due, in which case the principal balance inreases.as time Impact of Securitized Mortgage on the Mortgage Market
passes, the borrower expects income to increase so that higher Mortgage-backed securities (also called securitized mortgages)
payment will not be too much of burden. have been growing in popularity in recent years as institutional
investors look for appreciative investment opportunities that
Growing Equity Mortgage (GEMs)- With a GEM, the payments compete for funds with government notes bonds, corporate bonds
will initially be the same as on a conventional mortgage. Over and stock. Securitized mortgage are low-risk securities that have
time, however, the payment will increase. This increase will higher yield than comparable government bond and attract funds
reduce the principal more quickly than the conventional payment from around the world.
stream would.
DERIVATIVES A derivative is a financial security with a value
Shared Appreciation Mortgages (SAMs) -In a SAM, the lender that is reliant upon or derived from, an underlying asset or group
lowers the interest rate in the mortgage in exchange for a share of of assets a benchmark. The derivative itself is a contract between
any appreciation in the real estate (if the property sells more than two or more parties, and the derivative derives its price from
a stated amount, the lender is entitled to a portion of the gain). fluctuations in the underlying asset. The most common underlying
assets for derivatives are stocks, bonds, commodities, currencies,
Equity Participating Mortgage (EPM)-In EPM, an outsider interest rates, and market indexes. These assets are commonly
investor share in the appreciation of the property. This investor purchased through brokerages
will either provide a portion of the purchase price of the property
or supplement the monthly payment. In return the investor CHARACTERISTICS OF DERIVATIVES A derivative is a
receives a portion of any appreciation of the property. As with the financial instrument
SAM, the borrower benefits by being able to qualify for a larger 1.Whose value changes in response to the change in a specified
loan than without such help. interest rate, security price, commodity price, foreign exchange
rate, index of prices or rates credit rating o credit index, or similar
Second Mortgages -These are loans that are secured by the same variable.
real estate that is used to secure the first mortgage. The second 2.That requires no initial net investment or title net investment
mortgage is junior to the original loan which means that should a relative to other types of contracts that have a similar response to
default occur, the second mortgage holder will be paid only after changes in market and conditions; and
the original loan has paid off, if sufficient funds remain. 3.That is settled at a future date.

Reverse Annuity Mortgage (RAMs) -In a RAM, the bank Derivative for Hedging Companies use derivatives to protect
advances funds to the owner on a monthly schedule to enable him against cost fluctuations by fixing a price for a future deal in
to meet living expenses he thereby increasing the balance of the advance. By setting costs in this way, buyers gain protection-
loan which in secured by the real estate. The borrower does not known as a hedge against unexpected rises or falls in, for
make payments against the loan and continues to live in his home. example, the foreign market, interest rates, or the value of the
When the borrower dies, the estate sells the property to pay the commodity or product they are buying. Derivative for Speculation
debt. Look on Fig 10-2 Summary of Mortgage types (Cabrera, Investors may buy or sell an asset in the hope of generating a
page 166). profit from the asset’s price fluctuations. Usually this is done on a
short-term basis in assets that are liquid or easily traded. The most
MORTGAGE LENDING INSTITUTIONS The institutions commonly used derivatives are future contracts, forward
that provide mortgage loans to familiar and business and their contracts, options, foreign currency futures and interest rate
share in the mortgage market are as follows swaps.
Mortgage tools and trusts 49% Life insurance companies 9%
Commercial banks 24% Savings and loans associates 9%
Government agencies and others 15%

Many of the institutions making mortgage loans do not want to

hold large portfolios of 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
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