Financial markets

Instructional Materials

College of accountancy and finance

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
STA. MESA MANILA
 Module 1 – Financial Systems and the Financial
Markets
Overview:
In commerce, Finance is the application of economic principles to decision-
making that involves the allocation of money under conditions of uncertainty. It provides
for the framework for making decisions as to how those funds should be obtained and
then invested. It is the financial system that provides the platform by which funds are
transferred from those entities that have funds to invest to those entities that need funds
to invest.

Finance came from a French word which means settlement of debt. The
Financial systems allow the flow of the funds to those who needs it and those who are
willing to extend or invest. In the system, financial market is a venue where the
demanders and suppliers of funds meet.

Module Objectives:
After successful completion of this module, you should be able to:

 Discuss the Financial Systems and its elements

 Identify the Financial Intermediaries
 Classify the players in the financial markets

Course Materials:
According to Dr. Faure (2013), Financial System is a set of arrangements or
conventions embracing the lending and borrowing of funds by non – financial economic
units and the intermediation of this function by financial intermediaries in order to
facilitate the transfer of funds, to create additional money when required, and to create
markets in debt and equity instruments (and their derivatives) so that the price and
allocation of funds are determined efficiently.

The Elements of Financial System

1. Demanders of Funds

The demanders of fund are the individuals or groups that need financing. They
are those who are in need of additional financing to sustain their business
operations or livelihood for domestic. In commerce, demanders of fund are those
who are willing to do actions to earn more but restricted with financial resources.

2. Supplier of funds

Supplier of funds are players in the system that have excess or willing to invest
their funds in the system with the intent of earning more out of these funds.
3. Financial Intermediaries

Financial intermediaries don’t have their own funds but acts as channels of
transmitting those funds from the demanders and suppliers of funds. They may
be financial institution, financial markets or through private placement.

a. Financial Institutions. Financial Institutions are entities that aims to collect

or gather funds from the suppliers and in return extend this to the
demanders of fund normally in the form of loans or any interest bearing
instruments. Financial institutions may be generally classified into
commercial banks, investment banks or universal banks.

b. Financial Markets. Financial Markets are arrangers of transactions

between the suppliers and demanders of fund. Financial Market acts as
the middleman or conduit between the parties with the aim to perfect the
exchange. Financial Markets are classified into:
i. Instruments Traded. Financial Markets may be classified
according to the instruments it is trading. Money Market are those
who are trading short term financial instruments that are legally
traded e.g. Treasury Bills, Commercial Papers, Certificates of
Deposits, Repurchase agreement, or Bankers’ acceptances.
Another type is Capital Market which trades equity or debt
instruments which are normally to mature in long term period.
These will take the form of stock markets and bond markets.

ii. Market Type. Financial markets may be classified to the type of

market that trades. If the instrument used to trade are issued first-
hand or original issuance these are called Primary Market. Once
these are traded again the player is now called Secondary Market.

iii. Origination. Financial Markets may be classified according to

where it originated or players are originated. If the transaction is
perfected within the same national boundary this is called
Domestic Market otherwise it is International or Foreign Market.

c. Private Placement. Private placement are intermediaries with a particular,

private or specific individual or entity where the supply and demand of
fund will be taken. For equity trade, these are normally issuance of stocks
to pre selected investors.

Financial intermediaries allow for the acceleration of flow of funds between

entities or players, efficiently allocating funds, creation of money and supports
price discovery.
 4. Regulators

Regulators play an important role in the financial system. They set the framework
and boundaries to protect the interest of the players in the system. The regulators
are the governance body ensures that all complies with the laws, rules and
regulations imposed to them. In the Philippines, the major financial regulator is
the Bangko Sentral ng Pilipinas or BSP. BSP, through its Monetary Board, issues
policies and guidelines where the players in the financial systems must comply.

5. Financial Instruments

Financial Instruments are documents or representation for the exchange. This

represents a specified value. The value maybe agreed by the parties or already
been determined. The financial instruments must adhere to the form which the
laws so require.

Read:

Books, published materials and references on Financial Markets, Financial Management

and Financial Systems.

Activities/Assessments:
1. Essay. What is financial system? Describe how the elements interact with each
other.
2. Select a public listed company, get their audited financial statements. Identify
who are financial intermediaries potentially tapped by the companies if they need
additional financing.
3. Get a list of players in the financial market and classify them into the different
types of financial market.
 Module 2 – Financial Regulation
Overview:
According to the Public Utility Research Center of University of Florida,
Regulation is a process whereby the designated government authority provides
oversight and establishes rules for firms in an industry. A regulatory agency who is the
governance body to ensure compliance to laws, rules and regulation is identified to
provide oversight to the players in the industry.
Financial Regulation ensures that the risks are managed and all parties in the
financial system are protected. This is a type of regulation that imposes standards and
policies to set controls over the market factors that will affect the financial sustainability.

Module Objectives:
After successful completion of this module, you should be able to:

 Identify the drivers that will affect the financial sustainability

 Recognize the different financial regulators in the Philippines
 Identify the risk in the Financial Markets

Course Materials:

Financial Regulation is a process of governing in the financial systems to ensure

balance and protection of the interest of all players in the systems. By doing so this
manages the risk that will potentially arise in the financial market system. General form
of risks in the financial systems are:

 Credit Risk. Credit Risk is the probability that the payor will not pay or settle its
obligation.
 Liquidity Risk. Liquidity Risk is the probability to raise sufficient resources to
repay its financial obligation
 Default Risk. Default Risk is the probability that currently maturing portion were
not settled on time.
 Technological Risk. Technological Risk is probability that services will be
interrupted due technological resource limitation.
 Legal Risk. Legal Risk is the probability that new laws, rules and regulation will
be imposed and might affect the ability to sustain its creditworthiness.

Since these risks, among others, may affect the financial operations of the
business or organizations. Laws are created to enforce financial regulations. In financial
markets, these laws, rules and regulations control the following drivers: competitiveness,
market behavior, consistency and stability.
 Competitiveness. Policies were imposed to the financial system to ensure parity
among parties which could drive the following: access to capital, credit and loan term
offerings, support to providers of financing, management of business risks, transaction
costs and tariffs. It must be noted that the main determinant of competition are the main
forces that drives the market i.e. buyers and sellers.

Market Behavior. Financial Regulation sets the parameters to ensure that firms
will comply with the standards and level the playing field. The policies were set to
regulate the information disclosure, advantage over internal information, entry of new
players, minimum capital requirement and minimum governance requirements.

Consistency. The reason why in the field of accountancy consistency is an

important principle because it enables development of reasonable decision. Consistency
plays a key attribute to ensure that the other drivers affecting the results were isolated
for better analysis and at the same time reducing the risk inherent in the results.

Stability. Market Stability is important. Given that market behavior is dependent

on a lot of factors, the risk is very high. Most of the players failed to survive because
their ability to forecast and to mitigate the market risk. In the financial market, the impact
of financial risk is something that the regulatory environment should consider. The
regulation must be able to protect the interest of the clients as well as the companies to
enable their corporate sustainability.

These drivers are among the key factors that were controller or regulated by the
Financial Regulators. In the Philippines, the key financial regulators are: Bangko Sentral
ng Pilipinas, Insurance Commission, Philippine Securities and Exchange Commission
and Board of Investments, among others.

Each financial regulator has specific industry, risk and players in the financial
system that they are tasked to oversee. Particularly for the Bangko Sentral ng Pilipinas
which is a Self-Regulating agency attached to the Department of Finance which is
generally focused on regulating the liquidity management, currency issues, and currency
reserves and exchange rates.

Basically, the financial regulators are focused on controlling the payment

systems. Payment system enables the transfer of funds from a party to another thereby
effecting settlement. Nowadays due to the emergence of financial technology, payment
systems are being automated, but nonetheless, it importance remain to be the same
which are:
 Managing safe and real time transaction
 Effective risk management
 Facilitates financial market transactions.

Read:

Republic Act 10607 or the Amended Insurance Code

Republic Act 7653 or the Bangko Sentral ng Pilipinas Charter
Other books and reference on Financial Markets, Risk Management and Financial
Regulation
Activities/Assessments:
1. Illustrate the charters of the Financial Regulators in the Philippines.
2. Tabulate the drivers that affect the financial market and identify the risks that may
arise.
 Module 3 – Money Market Financial Instruments
Overview:

Financial Instruments are the main vehicle used for transactions in the financial
market. There are two parties involved in the financial instruments – issuer and
investors. Financial Instruments are traded in the Financial Market. Money Market is the
type of financial market where these financial instruments with less than one year tenor
are traded. There are three fundamental characteristics: Sold in large denomination; low
default risk; and mature in one year or less from original issue date. Common types of
money market financial instruments are treasury bills, repurchase agreements or repo,
negotiable certificates of deposits, commercial paper, and banker’s acceptances.
In evaluating money market securities, interest and tenor of the securities before
maturity are the large factors. As the interest increases the value of the securities
reduces. Investors must ensure apples-to-apples comparison among the securities to
determine the value to be used in investing decisions.

Module Objectives:
After successful completion of this module, you should be able to:

 Describe the different financial instrument

 Identify the limitations or risk in using each financial instrument
 Describe how financial instruments be valued and treated in financial reports

Course Materials:

Financial Instruments according to Conceptual Framework for Financial

Reporting (2018), an asset is a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to the entity.
Assets can be classified in terms of physicality: tangible and intangible assets. Tangible
assets are assets that has physical properties and can be easily seen, touched or
perceived by the five senses. Intangible assets are identifiable assets that do not have
physical substance and usually represents a legal claim to some future economic
benefit. Financial instruments (also called as financial assets or securities) are basically
intangible as future economic benefit takes form of a claim to cash that will be received
in the future. Financial instruments are the main vehicle used for transactions in the
financial market. For the purposes of presentation in financial statements, financial
instruments may be presented under cash equivalents or investments. Securities that
are maturing within 90 days or less are classified under cash equivalents. Otherwise,
they are classified under investments.

There is a minimum of two parties involved in a financial instrument: the issuer;

and the investor. The issuer is the party that issues the financial instrument and agrees
to make future cash payments to the investor. On the other hand, the investor is the
party that receives and owns the financial instrument and bears the right to receive
payments to be made by the issuer. On an accounting perspective, investors recognize
financial instruments as an asset.

Financial instruments have two main economic purposes:

 Allows transfer of fund from entities with excess funds (investors) to entities who
needs funds (issuer) for business purposes (e.g. to pay for tangible assets).

 Permit transfer of fund that allows sharing of inherent risk associated with the
cash flows coming from tangible asset investment between the issuer and
investor.

Usually, the initial investor does not hold on to the instrument up until the time the
issuer can make the payment. In such cases, investors trade their financial securities to
other individuals or institutions who are willing to pay for their claim to future payment.
Financial intermediaries that operate in the financial system demand funds from
“investors” and convert these to various financial assets that the general public is willing
to buy. As a result of these interlinked activities, claims of the final wealth holders
generally differ from the liabilities recognized by the issuers (final demanders of funds).

Money Market

Financial instruments are the primary subject of trading in a money market. The
financial instruments traded in the money market are short-term and highly liquid, that it
can be considered close to being money.

Money market securities have three fundamental characteristics:

 Usually sold in large denominations

 Low default risk

 Mature in one year or less from original issue date. Most money markets
instruments mature in less than 4 months.

Transactions in the money market are not confined to one singular location.
Instead, the traders organize the purchasing and selling of the securities among
participants and closes the transactions electronically. As a result, money market
securities commonly have an active secondary market. An active secondary market
enables individuals / organizations to trade money market instruments to cater to short-
term financial needs. Money market instruments become a flexible tool as individuals /
organizations may invest in these for short-term gains and convert it back to cash quickly
once liquidity need arises. On an accounting perspective, most money market
instruments are considered as cash equivalents due to the fact that they mature (i.e.
cash can be redeemed) within three months or less from the date of purchase.

Most transactions in the money market are very large, hence, they are
considered as wholesale markets. The required size of the transaction usually averts
individual investors in directly participating in the money market. As a result, dealers and
brokers execute transactions in the trading rooms of brokerage houses and large banks
to match customers (buyers to sellers) with each other. Despite this limitation, individual
investors nowadays can invest in the money market by joining funds that trade mostly
using money market instruments.

A mature secondary market for money market instruments allows the money
market to be the preferred place for firms to temporarily store excess funds up until such
time they are needed again by the organization. Investors who place funds in the money
market do not intend earn high returns for their money. Instead, investors look at the
money market as a temporary investment that will provide a slightly higher return than
holding on the money or depositing it in banks. If investors believe that the prevailing
market conditions do not justify a stock purchase or there might be a possible interest
rate hikes impacting bonds, then they can choose to invest on money market
instruments in the meantime. Holding on to cash is a very expensive option for investors
as this does not generate any return. Any idle cash becomes an opportunity cost to
investors by means of the interest income not earned by holding on to the cash. To
reduce opportunity costs, money markets become a viable option to temporarily invest
idle funds.

Investors also plan their strategy to incur the lowest opportunity costs. Investors
want to have an easy source of cash to be able to act quickly if there are available
investment opportunities that come but at the same time do not want to let go of potential
interest income. As a result, they invest on money market securities to achieve these
objectives. Financial intermediaries also use money market instruments to attain
investment requirements or deposit outflows.

On the other hand, money markets offer a least expensive alternative for fund
demanders such as the government and financial intermediaries when they have short-
term fund requirements. Fund demanders need to have funds quickly because the
timing of cash inflows and outflows does not synchronize with each other. For
businesses, timing of cash collections from revenue may not match when the business
needs to pay its operating expenses. For government, collection of revenue only
comes at certain points of the year (tax payment deadlines) but expenses are incurred
throughout the year. To resolve the need for funds as a result of the mismatch, these
entities turn to money markets to obtain funds.

Participants in the money market include the following

  Bureau of Treasury. The bureau sells government securities to raise funds.
Short-term issuances of government securities allow the government to obtain
cash until tax revenues are collected.

 Commercial banks. Issues treasury securities; sell certificates of deposits and

extends loans; offers individual investor accounts that can be used to invest in
money markets. Banks are the primary issuer negotiable certificates of deposits,
banker’s acceptances and repurchase agreements.

 Private Individual. These private individuals made their investment through

money market mutual funds

 Commercial Non-Financial Institutions. These entities buy and sells money

market securities to manage their cash i.e. to temporarily store excess funds in
exchange of somewhat higher return and obtain short-term funds

 Investment companies. Trade securities in behalf of their clients. Makes a market

for money market securities through maintaining an inventory of financial
instruments that can be bought or sold. Investment companies help maintain
liquidity of money market since they make sure that sellers can easily sell their
securities when the need arises.

 Finance / commercial leasing companies. These companies raise money market

instruments i.e. commercial paper to lend funds to individual borrowers

 Insurance companies. These are companies that invest on money market to

maintain liquidity level in case of unexpected demands most especially for
property and casualty insurance companies.

 Pension funds. Maintain funds in money market as preparation for long-term

investing in stocks and bonds market. Need to maintain liquidity to meet
obligations but since future obligations are likely expected, huge money market
investments are not necessary.

 Money market mutual funds. These funds permit small investors (e.g. individuals)
to invest in the money market by accumulating funds from numerous small
investors to buy large-denomination money market securities.

Common Types of Money Market Financial Instruments

 Treasury Bills – are government securities issued by the Bureau of Treasury

which mature in less than a year. There are three tenors of Treasury Bills: (1) 91
day (2) 182-day (3) 364-day Bills. The number of days is based on the universal
practice around the world of ensuring that the bills mature on a business day.
Treasury Bills are quoted either by their yield rate, which is the discount, or by
their price based on 100 points per unit. Treasury Bills which mature in less than
91-days are called Cash Management Bills (e.g. 35-day, 42-day). Being
government securities, these are no longer certificated (i.e. scripless) same with
the practice in other countries such as China, Canada and USA. Banks that
compose majority of the Government Security Eligible Dealers (GSED) bid for T-
bills in the weekly auctions held by the Bureau of Treasury. The banks then resell
the T-bills to investors. Treasury bills can be sold via two methods: auctions or
competitive bidding and noncompetitive bidding.

Treasury bills have virtually zero default risk since the government can always
print more money that they can use redeem these securities at maturity. Risk of
inflationary changes is also lower since the maturity term is shorter. Market for
Treasury bills is both deep and liquid. Deep market means that the market has
numerous different buyers and sellers while liquid market means that securities
can be quickly traded at low transactions costs. Investors prefer to go to a deep
and liquid market such as Treasury bills since there is only little risk that they will
not be able to liquidate the securities when they prefer to.

Government securities, particularly treasury bills, are the safest investment

instrument in the market. Because they are backed by the full taxing power of the
government, they are practically default risk-free. While there may be market
risks owing to changes in interest rates, these are an attractive investment
vehicle since the safety of the investor’s principal is assured. These are also
marketable and highly liquid. They can be traded easily in the secondary market
anytime the market is open. Interest rate is not explicitly stated in the Treasury
bill; hence, interest is not actually paid by the government when they sell this
security. Instead, treasury bills are issued at a discount (meaning lower price than
the par value at maturity).

When analyzing investments, investors often try to compare performance of

financial instruments with each other. To address this, most investors look at
percentages to be able to compare returns better. At the point of view of
investors, the discount rate indicates how much return, in %, they can get from a
particular security. The annualized discount rate for a non-interest-bearing
security (like Treasury bill) is described in the equation below.

Bv−Bp 360
Eq . 3.1 Annualized Discount Rate= ×
Bv D

Bv = Face Value or Market Value

Bp = Purchase Price

D = tenor or period in days

For example, a P1,000 Treasury bill with a 91-day tenor can be purchased at
995. To compute for the discount rate, we just need to substitute above
information in the formula.

P 1,000−P 995 360

Annualized Discount Rate = ×
P 1,000 91

P 5.00 360
Annualized Discount Rate = ×
P 1,000 91

Annualized Discount Rate =1.98 %

Another variation of the annualized discount rate is what we call the investment
rate. The investment rate portrays a more accurate representation of how much
investor will earn from the security since it uses the actual number of days per
year and the true initial investment in the computation. Eq. 4.2 presents the
formula for the annualized investment rate.

Bv−Bp 365
Eq .4 .2 Annualized Investment Rate = ×
Bp M

Bv = Face Value or Market Value

Bp = Purchase Price

M = number of days to maturity

Using the previous example, the annualized investment rate is

P 1,000−P 995 365

Annualized Investment Rate= ×
P 995 91

P 5.00 365
Annualized Investment Rate= ×
P 995 91

Annualized Invesment Rate =2.02%

Treasury bills are also known to be very near to the definition of a risk-free asset.
As a result, interest earned on Treasury bills are among the lowest in the market.
Investors may find that earnings from Treasury bills may not be sufficient to cover
 for changes in purchasing power brought by higher inflation. Treasury bills are
mostly meant as an investment vehicle to temporarily store excess cash since it
may hardly catch up with inflation.

 A Repurchase agreement (repo) is a financial contract involving two securities

transactions, a sale/purchase of a debt security on a near date and a reversing
purchase/sale of the same or equivalent debt security on a future date.
Repurchase agreements enable short-term funds to be transferred between
financial or non-financial institutions, usually ranging from one-day to 3 to 14
days. Some repos can also range from one to three months. Repos are a key
component of the debt securities market that produces short-term cash or
securities liquidity critical to price-making activity of fixed income dealers.

Dealers of government securities commonly use repos to manage liquidity and

take advantage of expected changes in interest rates. Dealers sell their securities
to a bank with an accompanying repo agreement promising to buy the securities
back at a specified future date. Essentially, repos are collateralized loans. Since
repos are collateralized by the accompanying securities, these usually are treated
as low-risk investments with low interest rates.

 Negotiable certificates of deposit are securities issued by banks which records

a deposit made. The certificate indicates the interest rate and the maturity date of
the deposit. Since maturity date is stated in the certificate, negotiable certificates
of deposit are treated as a term security with a specific maturity date. It cannot be
easily withdrawn by the depositor since it is different from a demand deposit
account wherein money can be withdrawn upon demand of depositor. A
certificate of deposit essentially restricts holders from withdrawing funds on
demand. The concept behind CDs is that investors are willing to accept a higher
return in exchange of having no access to liquidity.

Negotiable certificate of deposit is also classified as a bearer instrument. As a

bearer instrument, whoever person or entity which possesses the instrument
upon maturity will receive the principal and interest. This feature allows
negotiable CDs to be purchased and sold between investors. Interest rates of
CDs are based on the outcome of the negotiation between the depositor and the
bank. Both parties should agree on the interest rate of the CD. The interest rates
of CDs are usually at the same level with other money market securities since it
carries a low level of risk.

Investors can buy or sell certificates of deposit up until the instrument’s maturity.
Negotiable CDs may have maturity period between one to four months up to six
months. However, there are lesser demand for CDs with longer maturity. Upon
maturity, the bank shall pay the principal plus the interest to the investor who
holds the CD.
 In the Philippines, the BSP allows and regulates the issuance of long-term
negotiable certificates of deposits (LTNCD). LTNCD refers to interest bearing
negotiable certificates of deposit with a minimum maturity of five years. LTNCD
offers a higher return compared to regular time deposit account because of the
long period that depositors will be unable to withdraw the money.

 Commercial Paper - Fundamentally, commercial papers are unsecured

promissory notes. Commercial paper may be short-term or long-term. Short term
commercial paper means an evidence of indebtedness of any person with a
maturity of three hundred and sixty-five (365) days or less. Long term commercial
paper is an evidence of indebtedness of any person with a maturity of more than
three hundred sixty-five (365) days.

Since commercial papers are unsecured, only large and creditworthy

corporations can issue this security. Lenders will not accept commercial papers
from small companies since they are going to assume high level of risk since this
security is not secured. Commercial papers are issued directly to the buyer and
usually, there is no secondary market for commercial papers. Dealers may
redeem commercial papers if the bearer needs cash, but this seldom happens.

Nonbank corporations like financing companies usually issue commercial papers

and use the proceeds to fund loans that they extend to their clients. Issuers often
maintain line of credits with banks to serve as backup for a commercial paper.
The line of credit is primarily for the benefit of the issuer of the commercial paper.
If the issuer is not able to pay the maturing commercial paper, the bank will lend
funds to the issuer to enable the latter to pay for the commercial paper. The
availability of line of credit reduces the risk associated with commercial papers,
hence, this reduces the interest rate. Banks usually extends the line of credit and
agrees to provide the loan in advance in case there is a need to pay off the
commercial paper. In exchange, the issuer pays of a service charge in exchange
of the line of credit. Issuers of commercial paper agrees to pay the line of credit
fee because this is lower versus paying interest on the commercial paper for an
extended period of time.

Commercial papers may either have a stated interest rate on its face or sold at a
discounted basis. In the Philippines, commercial papers are not required to
register with SEC if they meet the following requirements, otherwise, companies
need to register with SEC first prior to issuing any commercial paper.

 Issued to not more than 19 non-institutional lenders

 Payable to a specific person

 Neither negotiable nor assignable and held on to maturity

 Amount not exceeding P50 million.

  Banker’s acceptances refer to an order to pay a specified amount of money to
the bearer on a specified date. Banker’s acceptances are often used to finance
purchase of goods that have not yet been transferred from the seller to the buyer.
Banker’s acceptance is usually offered to importers and exporters. An
acceptance is formed when a draft or a promise to pay is made by the bank’s
client and the bank then ultimately accepts, promising to pay in behalf of the
client. The bank’s acceptance of the draft translates to a promise to pay to
whomever party presents it to the bank for payment. The client then gives the
draft (i.e. banker’s acceptance) to the vendor to finance the purchase.

Banker’s acceptances are usually payable to the bearer. Hence, this can be
subsequently purchased and sold until it matures. Banker’s acceptances are
usually sold at a discount, similar with Treasury bills. Market dealers also
facilitate the trading of banker’s acceptances by matching prospective sellers and
buyers. Interest rates on banker’s acceptances are usually low since default risk
is very minimal.

Evaluating Money Market Securities

As a finance person, you should be able to understand and evaluate which

money market securities to invest on depending on the purpose of the business. Money
market securities may be evaluated based on the interest rates and liquidity.

Interest rates are very relevant in deciding which money market securities to
invest since this dictate the potential return that can be received from the investment.
Interest rates on money market tend to be relatively low as a result of the low risks
associated with them and the short maturity period. Money market securities have a very
deep market; thus, they are competitively priced. If you would notice, most money
market securities carry the same risk profile and attributes, thus, making each instrument
a close substitute for each other. Hence, if a particular security may have an interest rate
that deviates from the average rate, supply and demand forces in the market would
ultimately correct it and force it back to the average rate.

Liquidity refers to how quick, efficient and cheap to convert a security into cash.
Treasury bills, that have a ready secondary market, are considered to be more liquid
than commercial papers which do not have a developed secondary market. Holders of
commercial papers tend to hold the security until it matures. For this reason, brokers
may charge a higher fee for investors that would want to liquidate its commercial paper
since more effort shall be made to look for potential buyers compared to treasury bills
that have buyers willing to purchase at short notice. Since most money market securities
are typically short-term, money market is often preferred by investors who desire liquidity
intervention – providing liquidity where it did not previously exist.

Valuation of Money Market Securities

 Valuation of money market securities is important to determine at what amount
an investor is willing to pay in exchange of a security. In some cases, investors need to
give an amount as a bid to be able to buy securities. Money market securities can be
valued using the present value approach. The interest rate used in the valuation shall
reflect the required return from the instrument based on the investor’s perceived risk.
Investors may also use the prevailing interest rate in the market for the type of security
being purchased. Eq 4.3 presents the valuation formula which is practically present
value formula.

Sb
Eq .3 .3 Market Security Value= n
(1+ I )

Sb = Face value of the security

I = Interest rate

n = Number of Periods

For example, face value of a one-year Treasury bill is at P1,000 with an annual interest
rate of 3%. To compute for the value of the Treasury bill, use the formula above. The
face value which will be received upon maturity is P1,000. The interest rate will be 3%
and the number of periods is 1 (since it has a one-year maturity term)

P 1,000
Market Security Value= 1
(1+3 %)

Market Security Value=P 970.87

This means that an investor is willing to pay P970.87 for a P1,000 Treasury bill based on
the risks surrounding the instrument. In absolute terms, the investor will get return of
P29.13 from this investment.

Assume that another P1,000 Treasury bill with maturity term of 90 days with an annual
interest rate of 4% is being evaluated. Assume 360 days. The value of said Treasury bill
is computed as follows:

P 1,000
Market Security Value= 1
(1+1 %)

Market Security Value=P 990.10

The annual interest rate should be converted to match the 90-day maturity term. Hence,
annual interest term of 4% shall be multiplied with 90 / 360 to get how much is the
interest rate for the tenor of the security. In this case, the interest rate to be used is 1%
which represents the interest cost associated with the 90 days that the money is held by
the government.

As a general rule, as the interest rate rises, the value of the security becomes lower.
This means that the market risk is increases thus the impact on the value of the
securities also reduces.

Read:

 Treasury Bills in auction/competitive bidding and non-competitive bidding

 Difference of Annualized Discount Rate and Annualized Investment rate.
 Securities and Exchange Commission and Bangko Sentral ng Pilipinas
Regulation on the discussed money market financial instruments
 Other books and reference on Financial Markets specifically Money Market

Activities/Assessments:
1. Tabulate the common types of money market financial statements and
differentiate.
2. Create a summary of the formulas discussed in this module in three columns.
First column is the Name of the formula, the Formula and last column will be
where to use the formula
3. Get an example document of each of the money market financial instruments
discussed.
 Module 4 – Managing the Credit Risk of the
Financial Instrument
Overview:
One of the challenges in financing is to ensure the ability of the borrowers to
settle the obligation. The risk involve in financing are: default risk, liquidity risk, and
market risk among others. It is theoretically assumed that the cost of financing is
affected by the availability of loanable funds which is the Loanable Funds Theory and
the maturity of the loans, where the longer the life of the loans the higher the rate is
Liquidity Preference Theory. The three factors that affect the interest rates: (1) industry;
(2) risk exposure; and (3) compensation for the market expectation. Hence, the interest
formula will require the function of default or risk-free rate, inflation and debt premium for
the compensation.
In order to mitigate the risk, most businesses hedge forward rates or enter into a
swap rate agreement. It is important for the borrowers and lenders to know what the spot
rate in the prevailing market is and employ certain expectations in the future.

Module Objectives:
After successful completion of this module, you should be able to:

 Understand theories relating to credit risk and interests

 Determine how interest rates are computed
 Identify ways to mitigate credit risks and interest rate risks
 Identify the different levels and methods of credit rating of entities

Course Materials:

Credit Risk and Interest Rates

Credit risk is a type of business risk. This is the risk that the borrower may not be
able to repay its obligation. Such risk is included in valuation as a factor to determine the
cost of lending or financing using debt. Credit risk also affects the valuation of accounts
receivable.

Theories related in Setting Interest Rates

According to Fabozzi and Drake, there are two economic theories that drive the
interest rates. These are loanable funds theory and liquidity preference theory.
Loanable funds theory assumes that it is ideal to supply funds when the interests are
high and vice versa. This theory was introduced by Knut Wicksell in 1900s.
 On the other hand, liquidity preference theory was introduced by John
Maynard Keynes and states that the interest rates are dependent on the preference of
the household whether they hold money or use it for investment. Hence, the longer the
term, the higher the interest rates because investors prefer short-term investments more.

The tenor of the investment also defines the riskiness of the repayment of debt.
The longer the life of the debt, the riskier the repayment; hence, the interest rate is
higher. There are two economic theories that affect the term structure of interest rate.
These are expectations theory and market segmentation theory.

 Expectation Theories
Expectation theories state that the interest rates are driven by the
expectation of the lender or borrowers regarding the risks of the market in the
future. It can either be a pure expectation theory or biased expectation
theory. Both theories understand how interest rate, or the term, should be
structured over time.
Pure expectations theory is based on the current data and statistical
analysis to project the behavior of the market in the future. They all rely on
forward rates or the future interest rates based on their projection on the
future prices. Of course, expectation on the interest rates varies depending
on the perspective and the maturity. For example, Company A needs to
finance a project that will be operated in perpetuity. Company A applied for a
loan to Company B payable for 20 years. The prevailing interest rate at
present is 7%. Based on the current environment, the market seems to
worsen in the future. How will the interest rate behave in the future? With the
given information, Company B must assume a higher rate than 7% since the
probability that Company A may pay in the future is becoming low. The pure
expectations shall be based on the strong estimates based on the uncertainty
of the future. The rates to be agreed should be reasonable enough for both
parties otherwise one will not be fully compensated especially on the part of
the lenders. Observed that the pure expectations theory only relies on the
term and not on other factors.
Biased Expectation Theory includes that there are other factors that
affect the term structure of the loans as well as the interest to be perceived
moving forward. The forward rates will be affected or will be adjusted if the
liquidity of the borrower will be weaker or stronger in the future. The
adjustment or increase on the interest rate is called the liquidity premium.
Liquidity premium increases as the maturity lengthens. This theory is called
the liquidity theory. Another theory under the Biased Expectation Theory is
the preferred habitat theory. This theory does not only consider the liquidity
but the risk premium as well but disregarding the consensus of the market on
the future interest rates. The habitat being referred here is the biased
estimate over the market behavior in the future.

 Market Segmentation Theory

This theory assumes that the driver of the interest rates are the
savings and investment flows. The maturities are segmented depending on
 how the assets and liabilities were managed as well as the lenders on how
they extend financing. It is the same with preferred habitat theory however it
does not assume that any of the players are willing to shift sector should
opportunity to arise for the asset or liabilities to be retired or lenders to offer
higher rates.

Determination of Interest Rate

To determine the appropriate interest rate or rates the following factors should be
considered assuming the cash flows are already been established:
 Interest rates in the industry
 Risk exposure
 Compensation on the market expectation.
In finance, interest can be determined by the function of the risk and the
compensation of the investor on the difference between the risk-free rate and the market
fluctuations (Eq 5.1).
Eq 4.1 i=(R ¿ ¿ f + D m)¿
i = interest
Rf = risk free rate where (Real risk free rate = Rf - inflation)
Dm = debt margin or debt spread or the risk premium

The risk-free rate should the rate that assumes zero default in the market where
this is more or less equivalent to the rates offered by the sovereign. Hence, normal basis
of the risk-free rate is the Treasury bills issued by the republic. In the Philippines, this
can also be referred in the Philippine Dealing Systems or PDS Group.

The risk free rate can be real or excludes the effect of inflation or the exclusion of
the effect of the purchasing power of Philippine Peso. Since the real risk free rate
excludes the inflation, the nominal which is the risk free adjusted for inflation may
assume a compounding effect in the future. Since the BSP is the main supplier of the
bank reserves, it cannot set the real interest rates because it cannot set the inflation
expectations. Hence, it is more appropriate to say the real risk free rate can be
determined by deducting the prevailing inflation.

Let’s illustrate, Morgana Corp. would like to borrow funds from Oberon Financing.
The risk free rate is 6% and the current inflation is 2%. In the following year, the inflation
is expected to grow to 3%. Oberon still finds that the 4% margin remains to be relevant.
How much is the interest rate that Oberon Financing should impose to Morgan Corp.?

i=(R ¿ ¿ f + D m)¿

We know that the risk free rate is nominal hence we have to recalculate to
incorporate the forecasted risk of purchasing power in the future. Hence, the real risk
free rate should be recalculated.
R fr =(R ¿¿ f −Inflation)¿
 R fr =6 %−2 %
R fr =4 %
The real risk free rate is 4%, since the repayment will be made in the future,
Oberon should consider the forecasted inflation. Transposing the formula to determine
the risk free rate nominal in the future and incorporate the 3% inflation forecast:
R f =(R¿¿ fr + Inflation)¿
R f =4 % +3 %
R f =7 %

Now the nominal risk free rate applicable for the loan is 7%. We can calculate the
applicable return that Oberon Financing need in order to kept them whole by

i=7 % +4 %
i=11%

Therefore, the interest rate that Oberon Financing should charge Morgan is 11%.
Now the question is will this be acceptable to Morgana Corporation? The assessment
then again will be different to the borrower. Morgana should consider if their assessment
in the future that the interest will go worse in the long term then 11% is a good offer.
Suppose, another financing company is offering 9% then Morgana should reconsider. In
addition, Morgana Corporation in the long run should also consider that the interest cost
on their end would also result to tax benefits, if the interest cost is considered as a tax-
deductible expense.

Another way on how to calculate the interest rate is by the function of the market
value, par value and the interest expense paid by debt securities or bonds. Eq 5.2
presents the formula suggested to determine the interest rate on debt securities.

Eq 4.2 i=
I+ ( V −M
n )
x 100 %
V +M
2

i = interest rate
I = periodic interest payments
V = par value of bonds
M = market value of bonds
n = term of bonds

To illustrate, Merlin Corporation issued bonds with 10% nominal rate for a
Php1,000 par value bond payable for 20 years. The bonds were sold for Php1,200. How
much is the interest rate of the Merlin bonds in the market?
Using the formula in Eq 4.2 the interest rate of Merlin bonds
 i=
(1,000 x 10 %)+ ( 1,000−1,200
20 ) x 100 %
1,000+1,200
2

i=
100+ ( −200
20 )
x 100 %
2,200
2

100−10
i= x 100 %
1,100

i=0.0818 x 100 %=8.18 %

The interest rate in the market is 8.18% which is lower than the nominal rate of
10% for the Merlin Bonds. This means that the same bonds are perceived to be riskier in
the market as compared to the nominal rate. But what if the bonds were sold on a
premium? Note that the market value of the bond is Php1,200 hence there is a premium
on the Php1,000 par value of Php200. This is because the bonds are guaranteed by
Merlin Corporation to earn 10% interest while the market can only provide about 200 bps
lower than market.

On the other hand, the bond sold at a discount expects that the nominal rate of
the instrument or bond of the same class is lower than the market. Assume that Merlin
Corporation issued Php1,000 par value bonds paying Php100 interest every year for 20
years where their bonds were sold at Php950. How much is the rate of cost of debt in
the market?

It can be noted that the difference this time is that the interest is given at Php100
and the bonds market value is Php950 lower than the par value of Php1,000, therefore
there is a discount. The same problem can be solve using Eq 4.2

i=
(100)+ ( 1,000−950
20 ) x 100 %
1,000+ 950
2

i=
100+ ( 5020 ) x 100 %
1,950
2
 100+2.50
i= x 100 %
1,950

i=0.1051 x 100 %=10.51 %

This time the interest rate is 10.51% higher than the nominal rate of 10%. Given
that the difference is about 51 bps, the market value is discounted by about Php50 only
(Php1,000 – Php950). You may observe that using this formula, interest rates can be
determined depending on how the nominal or guaranteed interest rate fairs with the
market or effective cost of debt.

In commerce, risk is a very important factor to consider that may drives the
business up or down. Risk relates to the volatility of return patterns in the business.
Thus, the challenge on quantifying the risk is imperative for the investors to be able to
determine how much they can keep themselves whole. There are risks that are inherent
in every financing transaction. These are default risk, liquidity risk, legal risks, and
market risks, among others.

 Default risk arise on the inability to make payment consistently. Most of the
businesses was able to raise financing on their demands, however their cash
flows projected were not that guaranteed. Basically, the cash flows
management principle is to allow the business to self-liquidate or self-finance.
While, the company is made aware of their periodic obligation but there are
still chances that they may fail to make sure that the funds were available
upon servicing of debt or paying the amortization including interest. This type
of risk may be quantified by determining the probability of the borrower to
default in their payments in the duration of the loan.

 Liquidity risk is identified by ensuring the business to be capable of meeting

all its currently maturing obligation. This is different in default risk. Liquidity
risk is focusing on the entire liquidity of the company or its ability to service its
current portion of their debt as it comes due. In practice, this risk is quantified
by determining the opportunity cost of the lender on the period within which
the borrowers were able to recoup or worst the value there cannot be salvage
because of the ability of the company to be liquid.

 Legal risk is dependent on the covenants set and agreed in between the
lenders and the borrowers. The legal risk will arise only upon the ability of any
of the parties to comply with the covenants of the contract. Normally, the
burden is to the borrower to comply given that the party who is obliged to pay
back is them. The common defaults in the covenants are as follows: (1)
maintaining the financial ratios; (2) significant acquisition or disposal of
assets; (3) repayment of other obligation; or (4) declaration of dividends of
any form without the consent of the lenders.

 Market risk is the impact of the market drivers to the ability of the borrowers
to settle the obligation. Market risk is classified as a systematic risk because
 it arises from external forces or based on the movement of the industry.
Among the risks that affects the interest, market risk is the most difficult to
quantify. The experts and analysts can just only set certain parameters to
measure it.

Mitigating the Interest Rate Risks

Since there interest rate is dependent on the inflation, tenor and other market
risks. Companies should consider and make reasonable estimates to mitigate these
risks. Commercially, there are measures that the company may consider mitigating the
impact of the interest rates. The movement of the yield maybe normal or increasing,
inverted or declining or flat or constant over time. There different types of interest rates
are as follows needs to be understood in order to know how to mitigate them:

Spot rate is the interest rate or yield available / applicable for a particular time.
Spot rates are already actual rates and are not hedge. When the agreement is a spot
rate the applicable interest rate is based on the prevailing market rate at the particular
time. It is important to know the spot rates to be used for establishing market expectation
in the future. Spot rates will be used to mitigate the risk by referring to historical yield vis-
à-vis the forces that occur in those times. For example, a typhoon occurred in the Metro
Manila that causes the prices of the resources to rise because of the scarcity of
resources resulting to increase in interest rates. Upon noting the effect on the spot rates
of the external forces, we will expect in the future that when such incident will recur the
spot rates will increase. Thus, it is incumbent to the supplier of funds to consider
quantifying its effect so that the variability of rates will be managed.

Forward rates are normally contracted rates that fixed the rates and allow a
party to assume such risk on the difference between the contracted rate and the spot
rate. It is a challenge for the financial consultants and economic experts to determine
that most probable rates in the future. The clash will be that the lenders would like a
more conservative rate while borrowers are aggressive or lower as much as possible
versus the expected spot rate in the future.

Another way on how to mitigate the interest rate risk is enter into a swap rate.
Swap rate is another contract rate where a fixed rate exchange for a certain market rate
at a certain maturity. Usually the one used as reference is the LIBOR. For the swap rate,
it is normally the fixed portion of a currency swap.

LIBOR or London Interbank Offered Rate is used to benchmark interest rates

which is used as reference for international banks to borrow. It is calculated using the
Intercontinental Exchange or ICE. The rates issued short term from 1 day up to 1 year
and releasing more than 30 rates based on about five currencies. This is the reason why
this rate is used as the reference for consumer loans across the world.

The correlation of the swap rate and the maturity rate is called the swap rate
yield curve. The curve is useful for countries as reference for the credit risks and for
future decisions.
Credit Ratings

Credit rating affects the confidence level of the investors to countries or

companies. The credit ratings are determined by companies that are recognized globally
that objectively assigns or evaluates countries and companies based on the riskiness of
doing business with them. The riskiness is primarily driven by their ability to manage
their liquidity and solvency in the long run. The higher the grade the lower the default risk
associated to the country or company. These three major rating companies are:
Standard & Poor’s Corporation (S&P); Moody’s Investors Service; and Fitch Ratings.
Although, the credit ratings provided by these companies are just
recommendatory opinion and will serve as reference only and is not an absolutely
provide default probability to the companies.

 Standard and Poor’s Corporation or S&P is an American financial services

corporation was founded in 1941 by Henry Varnum Poor in New York, USA.
The company uses data gathered from 128 countries using more than 1,500
credit analysts to assess the creditworthiness to the industry. The credit
ratings provided by S&P were categorized to Investment Grade and Non-
Investment Grade and scaled from AAA to D.

 Moody’s Investors Services or Moody’s is credit rating company particularly

on debt securities established in 1909 in New York, USA. The company
gathers information from more than 130 countries, more than 4,000 non-
financial corporate issues and more than 4,000 financial institutions. The
company employs more than 13,000 across the whole world. Moody’s
classify the credit standing into the ratings from Aaa to C.

 Fitch Ratings. The third credit rating agency is Fitch Ratings. It was founded
in 1914 in New York, USA. The company was owned by Hearst. Hearst is a
global information and services company. Fitch provides credit opinions
based on the credit expectations based on the certain quantitative and
qualitative factors that drive a company, they assess based on the credit
analysis and intensive research. They conduct their assessment over more
than 8,000 entities around the globe with 25 different currencies. Fitch same
with the other rating agencies publishes its opinion based on a certain scale
of ratings to represents their opinion from AAA to D.

 There are other credit rating agencies other than the three major like DBRS
and CARE Ratings. Unlike S&P, Moody’s and Fitch, these credit rating
agencies were not located in the United States. DBRS was established in
1976 in Toronto, Canada. The company was considered as the fourth largest
ratings agency. The company observe almost 50,000 securities worldwide.
DBRS also has offices in New York, Chicago, London, Frankfurt and Madrid
in Spain. The rating follows from AAA to C as the least. CARE Ratings started
its operation in 1993 based in India. The company is based in Mumbai with
partners in Brazil, Portugal, Malaysia and South Africa. Other than Mumbai
they also have about 10 regional officers that aims to provide information to
 investors to serve as guide as they enter into new investment. They also use
AAA as the best instrument to D as the least.

Read:

Books, published materials and references on Financial Markets: Credit Risk

Management and Credit Rating Agencies.

Activities/Assessments:
1. Visit the website of PDS Group and research on its functions and role to debt
market of the Philippines.
2. Visit the websites of the various Credit rating agency discussed and further
understand their process of rating an entities.
3. Tabulate each Credit rating agency and differentiate
4. Essay: What are the risks inherent to Financial Instruments and how to mitigate
them?
 Module 5 – Debt Securities Market
Overview:

Debt Securities Market is the type of financial market in the form of debt
transactions between demanders and suppliers of funds. Debt instrument is legally
enforceable evidence of a financial debt and the promise of timely repayment of
principal, plus any interest. Debt security is a debt instrument however not all debt
instruments are debt securities. Debt securities are different from equity securities as
equity securities represent claims on earnings and assets of a corporation, while debt
securities are investment into debt instruments. The characteristics of a regular bond are
coupon rate, maturity date and current price.
Bond Valuation in Practice essentially is calculating the present value of a bond's
expected future coupon payments. The theoretical fair value of a bond is calculated by
discounting the present value of its coupon payments by an appropriate discount rate.
The discount rate used is the yield to maturity, which is the rate of return that an investor
will get if s/he reinvested every coupon payment from the bond at a fixed interest rate
until the bond matures. It takes into account the price of a bond, par value, coupon rate,
and time to maturity. Discount rate used normally is the risk free or default free rate plus
the risk premium, if applicable. There are 2 approaches in Bond Valuation for option-free
bonds: traditional approach and arbitrage free valuation approach. There are 2
approaches in Bond Valuation for bonds with embedded options: lattice model and
Monte Carlo Simulation

Module Objectives:
After successful Completion of this module, you should be able to:

 Identify different types of bonds

 Select the bond or debt security investments that will yield higher value

Course Materials:
Debt Securities Market and Debt Instrument

Debt market or Debt Securities Market is the financial market where the debt
instruments or securities are transacted by suppliers and demanders of funds. This
chapter shall focus on this type of financial market.

A debt instrument is a paper or electronic obligation that enables the issuing

party to raise funds by promising to repay a lender in accordance with terms of a
contract. Types of debt instruments include notes, bonds, debentures, certificates,
mortgages, leases or other agreements between a lender and a borrower. These
instruments provide a way for market participants to easily transfer the ownership of debt
obligations from one party to another.
 A debt instrument is legally enforceable evidence of a financial debt and the
promise of timely repayment of the principal, plus any interest. The importance of a debt
instrument is twofold. First, it makes the repayment of debt legally enforceable. Second,
it increases the transferability of the obligation, giving it increased liquidity and giving
creditors a means of trading these obligations on the market. Without debt instruments
acting as a means of facilitating trading, debt would only be an obligation from one party
to another. However, when a debt instrument is used as a trading means, debt
obligations can be moved from one party to another quickly and efficiently.

Types of Debt Instruments

Debt instruments can be either long-term obligations or short-term obligations.

Short-term debt instruments, both personal and corporate, come in the form of
obligations expected to be repaid within one calendar year. Long-term debt instruments
are obligations due in one year or more, normally repaid through periodic installment
payments.

 Short-Term Debt Instruments

In corporate finance, short-term debt usually comes in the form of revolving
lines of credit, loans that cover networking capital needs and Treasury bills. If for
example, a corporation looks to cover six months of rent with a loan while it tries to
raise venture funding, the loan is considered a short-term debt instrument.

 Long-Term Debt Instruments

Long-term debt instruments in personal finance are usually mortgage
payments or car loans. For example, if an individual consumer takes out a 30-year
mortgage for Php 500,000, the mortgage agreement between the borrower and the
mortgage bank is the long-term debt instrument.

Debt Security

Debt security refers to a debt instrument, such as a government bond, corporate

bond, certificate of deposit (CD), municipal bond or preferred stock, that can be bought
or sold between two parties and has basic terms defined, such as notional amount
(amount borrowed), interest rate, and maturity and renewal date. It also includes
collateralized securities, such as collateralized debt obligations (CDOs), collateralized
mortgage obligations (CMOs), mortgage-backed securities issued by the Government
National Mortgage Association (GNMAs) and zero-coupon securities.

Types of Debt Securities

 Money market debt securities. Money market securities are debt securities with
maturities of less than one year. Money market securities of most interest to
individual investors are treasury bills (T-bills) and certificates of deposit (CDs).
 Capital market debt securities. Capital market debt securities are debt securities
with maturities of longer than one year. Examples are notes, bonds, and mortgage-
backed securities.

The Bond Market

Debt market or Debt securities market is also known as bond market is a

financial market in which the participants are provided with the issuance and trading of
debt securities. The bond market primarily includes government-issued securities and
corporate debt securities, facilitating the transfer of capital from savers to the issuers or
organizations requiring capital for government projects, business expansions and
ongoing operations. In the bond market, participants can issue new debt in the market
called the primary market or trade debt securities in the market called the secondary
market. These products are typically in the form of bonds, but they may also come in the
form of bills and notes. The goal of the bond market is to provide long-term financial aid
and funding for public and private projects and expenditures.

Types of Bond Markets

 Corporate Bond. Corporations provide corporate bonds to raise money

for different reasons, such as financing ongoing operations or expanding
businesses. The term "corporate bond" is usually used for longer-term
debt instruments that provide a maturity of at least one year.
 Government Bonds. National governments issue government bonds and
entice buyers by providing the face value on the agreed maturity date with
periodic interest payments.
 Municipal Bonds. Local governments and their agencies, states, cities,
special-purpose districts, public utility districts, school districts, publicly
owned airports and seaports, and other government-owned entities issue
municipal bonds to fund their projects.
 Mortgage Bonds. Pooled mortgages on real estate properties provide
mortgage bonds. Mortgage bonds are locked in by the pledge of particular
assets. They pay monthly, quarterly or semi-annual interest.
 Asset-backed bonds. Also known as asset-backed security (ABS),
asset-back bond is a financial security collateralized by a pool of assets
such as loans, leases, credit card debt, royalties or receivables.
 Collateralized Debt Obligation (CDO). CDO is a structured
financial product that pools together cash flow-generating assets and
repackages this asset pool into discrete tranches that can be sold to
investors.
Characteristics of Bonds

The characteristics of a regular bond include:

 Coupon rate. Some bonds have an interest rate, also known as the coupon
rate, which is paid to bondholders semi-annually. The coupon rate is the fixed
return that an investor earns periodically until it matures.

 Maturity date. All bonds have maturity dates, some short-term, others long-
term. When the bond matures, the bond issuer repays the investor the full face
value of the bond. For corporate bonds, the face value of a bond is usually Php
1,000 and for government bonds, face value is Php 10,000. The face value is
not necessarily the invested principal or purchase price of the bond

 Current or Market Price. Depending on the level of interest rate in the

environment, the investor may purchase a bond at par, below par, or above
par. For example, if interest rates increase, the value of a bond will decrease
since the coupon rate will be lower than the interest rate in the economy.
When this occurs, the bond will trade at a discount, that is, below par.
However, the bondholder will be paid the full face value of the bond at maturity
even though he purchased it for less than the par value.

Bond Valuation

Bond valuation is a technique for determining the theoretical fair value of a

particular bond. Bond valuation includes calculating the present value of the bond's
future interest payments, also known as its cash flow, and the bond's value upon
maturity, also known as its face value or par value. Because a bond's par value and
interest payments are fixed, an investor uses bond valuation to determine what rate of
return is required for a bond investment to be worthwhile. Eq 5.1 describe the formula to
value a bond.

[ ] [ ]
n

Eq 5.1 Bo=I × ∑ (1+1r )t +M ×

1
t =1 d ( 1+r d ) n
Bo = present value of the bond
I = annual interest paid in dollars
n = number of years to maturity
M = par value in dollars
rd = required return

To illustrate, suppose a 10-year 10% bond with a par value of Php1,000 is traded
in the market. The similar debt instrument is expecting 9% returns in the market. How
much is the value of the bonds?
 Using Eq 5.1 the bond is valued at Php 1,064. The value is higher than par and
issued on a premium because the market offers a lower return as compared the
guaranteed returns of 10%.

[ ] [ ]
10
Bo=Php 1,000 x 10 % × ∑ (1+ 91%)10 + Php 1,000 ×
1
10
t=1 ( 1+9 % )
Bo=Php 100 ×6.4177+ Php 1,000 × 0.4244
Bo=Php 641.77+ 422.41
Bo=Php 1,064.18

This principle simply states that the bonds can be resold at Php1,064 since this is
perceived by the market to be better off that what is available to everyone else.

A zero-coupon bond makes no annual or semi-annual coupon payments for the

duration of the bond. Instead, it is sold at a deep discount to par when issued. The
difference between the purchase price and par value is the investor’s interest earned on
the bond. To calculate the value of a zero-coupon, we only need to find the present
value of the face value.

Following our example above, if the bond paid no coupons to investors, its value
will simply be the present value of the face value of the bonds i.e. Php422.41. Under
both calculations, a coupon paying bond is more valuable than a zero-coupon bond.

Valuation for a Non-Treasury bond (Adding Risk Premium)

The above valuation assumes a default free rate and thus for a non-Treasury
bond, a risk premium has to be added to the base interest rate (the Treasury rate). The
risk premium is the same regardless of when a cash flow is to be received. This risk
premium is also called constant credit spread. So, for the above, assuming the
appropriate risk premium / credit spread is 100 bps equivalent to 1%, the discount rate to
be used should be 6% i.e. 5% the risk free interest rate (the Treasury rate) + 1% risk
premium.

Approaches in Valuation

The above formula can be adjusted based on the approaches in valuation. There
are at least 2 approaches in valuation of bonds. Below are approaches which assumed
option-free bonds.

 Traditional approach. The traditional approach to valuation has been to

discount every cash flow of a bond by the same interest rate (or discount
rate). The cash flows are viewed as default free / risk free, the traditional
practice is to use the same discount rate to calculate the present value of
securities and use the same discount rate for the cash flow for each period.
So, suppose that the yield on a 10-year Treasury trading at par value is 5%.
Then, the practice is to discount each cash flow using a discount rate of 5%.
In case of non-treasury securities, the risk premium has to be added.
  Arbitrage Free Valuation approach. The fundamental flaw of the traditional
approach is that it views each security as the same package of cash flows.
For example, consider a 10-year Philippine Treasury bond with an 8%
coupon rate. The cash flows per Php 100 of par value would be 19 payments
of Php 4 every 6 months and Php 104 for 20 six month periods from now.
The traditional practice is to discount every cash flow using the same interest
rate. The proper way to view the 10-year 8% coupon bond is as a package of
zero-coupon bonds. Each cash flow should be considered a zero-coupon
bond whose maturity value is the amount of the cash flow and whose maturity
date is the date that the cash flow is to be received. Thus, the 10-year 8%
coupon bond should be viewed as 20 zero-coupon bonds. The reason this is
the proper way to value a bond is that it does not allow a market participant to
realize an arbitrage profit by taking apart or “stripping” a security and selling
off the stripped securities at a higher aggregate value than it would cost to
purchase the security in the market. This approach to valuation is referred to
as the arbitrage-free approach.
Valuation of Bonds with Embedded Options

 The lattice model is used to value callable bonds and putable bonds.
 The Monte Carlo simulation model is used to value mortgage-backed
securities and certain types of asset-backed securities.

Read:

Books, published materials and references on Financial Markets, Debt Market.

Activities/Assessments:
1. Tabulate the different type of bonds and identify its differences
2. Essay: Discuss each bond valuation method and distinguish its differences and
where and how it should be used.
 Module 6 – Equity Securities Market
Overview:

Equity securities market is the type of financial market wherein equity instruments
are traded between demanders and suppliers of funds. Equity instruments is a legal
agreement which serves as evidence ownership interest in a business. Investors
include equity instruments in their portfolio because of capital appreciation and
dividends. The most common example of equity securities is shares. Shares can be
classified in two – preference shares and ordinary shares. Shares are publicly traded in
the stock market. Stock market is composed of two components – exchanges and over
the counters (OTC). Share valuation can be computed via different methodologies:
through dividends (zero-growth, constant growth, variable growth), free cash flow, book
value, liquidation value and price-earnings multiples.

Module Objectives:
After successful Completion of this module, you should be able to:

 Understand equity instruments and its characteristics

 Distinguish equity from debt
 Understand how shares are valued through different methodologies

Course Materials:
Equity instrument is a type of financial instrument wherein an issuing company decides
to compensate investors at an amount dependent on the future earnings of the company
(like dividends). Equity instrument is a contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities. Future earnings set aside for these
investors should be after settling all mandatory payments of the business including
financing charges. Shares are example of equity instrument.

Aside from compensation, shares represent ownership in a business. People who own
shares are called shareholders. They physical legal document to evidence shares is
called a stock certificate. Stock certificates specify who own the shares and how many
shares are owned by this shareholder. For equity instruments, the company is the issuer
while shareholders are investors.

Authorized capital stock pertains to the maximum amount or number of shares that can
be issued as shares to investors as documented in the Articles of Incorporation.
Outstanding shares are shares of stocks that are issued to or subscribed by
shareholders (whether fully paid or not). Outstanding shares exclude treasury shares.
Treasury shares are shared bought back by the company from previous shareholders.
Only corporations are allowed to issue shares.

There are two reasons why investors should consider equity instruments:
  Capital Appreciation – pertains to the possibility of increase in value of shares
often reflected through its market price. Investors can buy and sell shares in the
secondary market, providing a mechanism that allow trading which influences the
value of shares. However, since market price results from interaction of different
market forces, this can be highly volatile which brings uncertainty to
shareholders.
 Dividends – refers to payments distributed by corporation to their shareholders.
The amount of dividend declared is based on the excess earnings of the
company and is approved by the board of directors. Dividends can be in the form
of cash, property (i.e. shares in other companies) or the company’s own shares.
Dividend declaration is primarily based on the current performance of the
business though this the level of declaration can be levelled by businesses to
manage expectations of shareholders.

Comparison between Equity and Debt

Equity Debt

Participation in the Can participate through Does not participate

businesses voting on specific
decisions like election of
board directors

Claim on Assets and Subordinate to debt Prioritized over Equity.

Income
Least priority in terms of Claim of creditors are
asset and income satisfied before distributing
distribution to shareholders.

Type of Financing Permanent Temporary

Maturity Date No maturity date Maturity date is based on

what is stipulated in
contract

Risk and Return Profile Higher risk versus debt; Lesser risk versus equity;
investors expect higher return is limited to interest
returns (through infinite stipulated in agreement
capital appreciation and
dividends)

Impact to Tax Cannot be claimed as tax- Tax-deductible expense for

deductible expense by company
company

Types of Shares
Preference Shares – shares that possess certain characteristics that prioritize them
over ordinary shares. Typically, dividend is already promised to preference shareholder
regardless of business performance. Preference shares generally do not have voting
rights though some corporations can grant this based on their Articles of Incorporation.
Preference share is quasi-debt; the dividend is somewhat like a contractually obligated
interest without maturity date of debt agreements. Other features that preference shares
can possess include:

 Cumulative – Dividends that are not paid in previous years (in arrears) should be
paid, together with the current year dividends, prior to dividend distribution to
ordinary shareholders. Non-cumulative preference shares mean that company is
not liable to pay out dividend in arrears.
 Callable – Features which permits corporations to repurchase outstanding
preference shares within a period of time at a set price. This feature allows
corporations to cease commitment to pay required dividends of preference
shares by repurchasing it and is exercised when market conditions deems it
reasonable to do so.
 Convertible – Option given to shareholders to convert preference shares to
ordinary shares.

Ordinary Shares – shares that represent equity in the business. Holders of these are
known as residual owners since they will only enjoy return once claims from creditors
and preference shareholders are satisfied. Ordinary shareholders only receive dividend
upon the discretion of the company’s board of directors and possess voting rights
(usually one vote, one share) to act on specific corporate actions such as issuance of
new shares and election of company directors. Preemptive right - which grants the right
to purchase shares during additional share issuance to protect their stake from dilution –
is given to shareholders. Ordinary shareholders enjoy limited liability i.e. if the company
goes under, they are only liable up to the amount they invest. In recent years, other
types of ordinary shares are developed such as supervoting shares (share with multiple
votes) and nonvoting ordinary shares.
Stock Market
Stock market is the avenue where shares are traded publicly. Stock market can be
physical or virtual. This is composed of exchanges and over the counters (OTC) and can
function as primary or secondary market.

 Exchanges – organized physical venues for trading of shares which are

facilitated by floor traders. Floor traders, often members of brokerage firms, meet
at the exchange and collect bid and ask offers from each other. Through this,
they connect matching deals and execute trade orders coming from their clients
or their own firms.
 OTC market – markets where shares are traded electronically by dealers.
Dealers or also commonly called as market makers create market by linking buy
and sell orders from their clients. They maintain inventory of shares from
different companies that they use to trade in the OTC market to maintain
equilibrium between purchase and sell orders. Profits are earned by dealers via
the spread between bid price and ask price or commission through trading.
  Electric Communications Network – network that directly connects key
brokerage firms and traders. ECN is becoming relevant because of its
transparency, cost effectiveness and quicker execution.
 Exchange-traded Funds – these are formed when portfolio containing different
securities is established and a share is traded in the exchange representing the
portfolio. Exchange-traded funds are value based on the market value of the
shares within the portfolio.
Platforms for Capital Markets

 Conventional Brokerage – Brokers sell and buy shares in the exchange in behalf
of their investors, earning commission in the process.
 Online Trading – Digital platforms that investors can use which have lower
commission. Though, investments insights might not be available in the absence
of traditional brokers.
 Mutual Funds – Funds set up by investment companies that brings together
money from different investors and invests the pooled money in different stocks
in behalf of all the investors.
Share Valuation
Dividend-based Valuation

 Zero-growth model – This assumes that dividend will not change in the future and
is used for valuing preference shares.
Expected Dividend per Share at end of Year 11
ShareValue=
Required Return(%)
Example: Tony Stark estimates that the dividend of Ironman Company, an
established technology producer, is expected to remain constant at P6 per share
indefinitely. If his required return on its stock is 15%, what is the value per share?
P 6.00
ShareValue= =P 40.00
15 %
 Constant-growth model – Most popular approach in dividend-based share
valuation which assumes that dividends will increase at a constant rate
indefinitely but always lower than the required rate of return.
Expected Dividend per Share at end of Year 11
ShareValue=
Required Return ( % )−Growth Rate (%)
Example: ProGo Company, a selfie stick company, assumes that dividend will
grow by 5%. The last dividend declared is at P2.00. Required return is 15%
2.00 x 1.05 2.10
ShareValue= = =P 21.00
15 %−5 % 10 %
  Variable growth model – This model assumes that dividend may growth at
varying rates and may go up or down depending on business and economic
conditions. In order to capture the variations in growth in the valuation, these four
steps should be considered.
a. Compute for the value of cash dividends based on the estimated growth rate
for each individual year.
b. Compute for the present value of each dividend for each year during initial
growth period.
c. Compute for the value at the end of the initial growth period by using the
expected growth rate until infinity through the constant growth model.
Compute the present value of this value in relation to current year.
d. Add present value computed in Step B & C.
Example: Vicky Company forecasts that dividends of Vir Company will grow by
10% in the next three years and 5% from Year 4 onwards. Required return of
Vicky is 15%. Last dividend received by Vicky Company from Vir Company is
P3.00.
Step 1. Dividends for the next 3 years: Y1 = P3.30, Y2 = 3.63 ; Y3 = 3.99
Step 2. Present value during initial growth period
Y1 = 3.30 x 0.8696 = P2.87
Y2 = 3.63 x 0.7561 = P2.74
Y3 = 3.99 x 0.6575 = P2.62
Step 3. Value from Year 4 onwards using constant growth model.
Dividends to be received by Year 4 = P4.19
3.99 x 1.05 4.19
ShareValue= = =P 41.90
15 %−5 % 10 %
Present Value by end of Y3 = P41.90 x 0.6575= P27.55
Step 4. Add present value for all years.
Share Value = P2.87 + P2.74 + P2.62 + P27.55
Share Value = P35.78
Other Alternative Valuation Methodologies

 Free Cash Flow – cash flow available to creditors and shareholders after
satisfying all contractual obligations. Free cash flow follows the premise of
present value computation wherein annual free cash flow is discounted using
weighted average cost of capital. Since free cash flows estimates the value of the
entire company, market value of debt and preference shares should be
subtracted to arrive at value of ordinary shares.
 Book Value per Share – value per share based on the exact book value as
recorded in the accounting records. This method does not consider future
earning potential of the firm.
 Book value of assets−Book value of liabilities−¿ Book value of preferences shar
Value per share=
Total No. of Outstanding Shares

 Liquidation Value per Share – value per share based on the current market
value of assets (assuming it is sold today) and all liabilities (including preference
shares) are fully paid. This method is more realistic compared to book value per
share but does not consider future earning potential of the firm.

 Price/Earnings Multiples Method – share price is computed by using the

average price/earnings ratio of comparable companies in the same industry. This
is done by multiplying the current earnings per share by the P/E multiple.

Hybrid and Derivative Securities

 Hybrid Securities – financial instruments which possess characteristics of both

debt and equity
o Stock purchase warrants – instruments that give bearers the right to
purchase stated number of shares of a company at a given price within a
limited time frame. Warrants are detachable and are often used as
sweeteners to bond issuances.
o Convertible securities – bonds or preference shares that can be converted
to ordinary shares in the future.

 Derivative Securities – securities that are neither debt nor equity but derives
value from underlying asset.
o Options – gives holders chance to purchase (call option) or sell (put
option) a specific asset. Holder can decide whether to exercise the option
or not.

Read:

Books, published materials and references on Financial Markets and Equity Market.

Activities/Assessments:
1. Research on the Philippine Stock Exchange, its functions and its roles in the
Philippine financial market. Enumerate criteria how companies can list in the
PSE and the disclosure requirements for listed companies.
2. Essay: Discuss each share valuation method and distinguish its differences
and where and how it should be used.
 Module 7 – International Financial Market
Overview:

International trade is one of the most important factors of growth and prosperity
of participating economies. International financial market exists due to the fact that
economic activities of businesses, governments, and organizations get affected by the
existence of nations. It is a known fact that countries often borrow and lend from each
other. This is also applicable to the investing public residing in these countries. Different
concepts are associated with international financial market such as foreign exchange
transactions, international bonds, foreign direct investment, country risk premium and
offshore banking units.

Module Objectives:
After successful completion of this module, you should be able to:

 Describe the background and importance of international financial markets

 Understand how investments are executed in international financial markets and
relevant concepts

Course Materials:
The international financial market is the worldwide marketplace in which buyers
and sellers trade financial assets, such as stocks, bonds, currencies, commodities and
derivatives, across national borders. The international financial market is the place
where financial wealth is traded between individuals (and between countries). It can be
seen as a wide set of rules and institutions where assets are traded between agents in
surplus and agents in deficit and where institutions lay down the rules.

Motives for Investing in International Financial Market

 Economic Conditions – investors think that companies operating in countries

with favorable economic outlook may yield better operating results.
 Exchange Rate Outlook – investors consider investing in currencies they
believe will appreciate as compared to their local currency
 International Diversification – investing in different countries with varying
economic conditions might mitigate overall risk in terms of portfolio management.

History of Foreign Exchange

 Gold Standard – exchange rates were dictated by these from 1876 to 1913.
Every currency is convertible into gold and relative conversion rates dictates the
exchange rate. Gold standard was suspended due to World War I.
 Agreements on Fixed Exchange Rates – an international agreement, known as
Bretton Woods Agreement) established fixed exchange rates between currencies
 and was in effect from 1944 until 1971. Governments intervene if exchange rates
move 1% higher or lower than the established level.
 Floating Exchange Rates – The existing foreign exchange model. Widely used
currency were permitted to fluctuate based on prevailing market conditions and
restrictions were lifted.

Foreign Exchange Transactions

 Spot Rate – most common type of foreign exchange transaction which signifies
immediate exchange. These transactions happen in the spot market.
 Forward Transactions – forex transactions wherein investors may secure an
exchange rate (known as forward rate) at which it will sell or buy currency during
a specified time period. This is documented via a forward contract and is typically
offered by commercial banks.
 Currency Futures – agreement stipulating standard volume of a specific
currency that will be exchanged on a predetermined settlement date and is
usually sold in exchanges
 Currency Options – instruments that can be used to buy (call option) or sell (put
option) a specific currency based on the discretion of holder. Call options are
used to hedge future payables while put options are used for future receivables.

International Bonds

 Foreign Bonds – Bonds issued by a borrower that has different nationality from
the country where bond is issued. It is denominated in the currency of the country
where bond is issued.
 Eurobonds – Bonds sold in countries other than the nation which uses the
currency. For example, companies in the US offer dollar bonds which are sold in
countries other than US. Characteristics of Eurobonds may include its bearer
form, yearly coupon payments and conversion feature.

Foreign Direct Investments

 Foreign Direct Investment – investments placed by an entity in countries other

than where it is situated. This typically happens when a firm starts a foreign
business operation, acquire foreign assets or buying ownership stake in a foreign
company. FDI is usually made by investors in countries with open economies
equipped with skilled labor force, less red tape and attractive growth prospects.
Primary characteristic of FDI is the exercise of substantial influence in decision
making of an entity. According to Organisation of Economic Co-operation and
Development (OECD), foreign direct investment exists when controlling interest
is established which is equivalent to 10% ownership in a foreign-based company.
This definition is flexible as effective controlling interest may be present with less
than 10% ownership.

o Horizontal direct investment – occurs when the investor starts same type
of business it does in its home country.
 o Vertical direct investment – occurs when investors has a stake in a
business in a foreign country which is related to its business in the home
country. For example, obtaining ownership in a foreign raw material
supplier.
o Conglomerate investment – investors make an investment in a foreign
company which is unrelated to its business in their home country.

Country Risk Premium

 Country Risk Premium (CRP) - is the additional return or premium demanded

by investors to compensate them for the higher risk associated with investing in a
foreign country, compared with investing in the domestic market. CRP considers
the following factors: political instability, economic risks, sovereign debt burden,
currency fluctuation and adverse government regulations (such as expropriation
or currency controls). Country risk is the primary factor looked at when investing
in foreign markets.

Country risk premium can be estimated through the following methods:

o Sovereign Debt Method - CRP for a particular country can be estimated

by comparing the spread on sovereign debt yields between the country
and a mature market like the U.S.
o Equity Risk Method. In equity risk method, CRP is measured based on
the relative volatility of equity market returns between a specific country
and a developed nation.

Offshore Banking Units

 Offshore banking units - is a financial service unit (normally a branch or
subsidiary of a non-resident bank), which plays an intermediary role between
non-resident borrowers and lenders. It is a bank shell branch, located in another
international financial center. For instance, a London-based bank with a branch
located in Delhi. Offshore banking units make loans in the Eurocurrency market
when they accept deposits from foreign banks and other OBUs. Under law,
offshore banking units (OBUs) are not authorized to take domestic deposits or
conduct activity with local establishments or clients. All trade activity of the
offshore banking unit must be offshore.

Advantages of offshore banking units as compared to onshore bank include the

following:

o Free of regulations and restrictions normally imposed on domestic

financial establishments as it pertains to foreign exchange and sometime
tax concessions and relief packages.
o Activities of an offshore banking unit are not subject to the local
restrictions as there might be on foreign exchange or other banking
activities or regulations.
Read:

Books, published materials and references on International Financial Markets

Activities/Assessments:
1. Research about World Bank and why is it important to the international
financial market.
2. Essay: Why is international financial market important to investors?