MORTGAGE MARKETS the case of a foreclosure, the lender may evict the residents, sell the

MORTGAGES property, and use the money from the sale to pay off the mortgage debt.
• It is a type of loan used to purchase or maintain a home, land, or other The Mortgage Process
types of real estate. The borrower agrees to pay the lender over time, • Would-be borrowers begin the process by applying to one or more
typically in a series of regular payments that are divided into principal and mortgage lenders.
interest. (Investopedia) • The lender will ask for evidence that the borrower is capable of repaying
• These are long-term loan secured by real estate. the loan.
• These are obligations granted by banks or other financial institutions to • This may include bank and investment statements, recent tax returns,
the borrower that uses real estate or movable assets as collateral. he and proof of current employment.
• Both individuals and businesses obtain mortgages loans to finance real • The lender will generally run a credit check as well.
estate purchases. • If the application is approved, the lender will offer the borrower a loan of
• A developer may obtain a mortgage loan to finance the constructions of up to a certain amount and at a particular interest rate.
an office building, or a family may obtain a mortgage loan to finance the • Homebuyers can apply for a mortgage after they have chosen a property
purchase of a home. to buy or while they are still shopping for one, a process known as pre-
• In both cases, the loan is amortized. approval.
• The borrower pays it off over time in some combination of • Being pre-approved for a mortgage can give buyers an edge in a tight
principal and interest payments that result in full payment of the housing market because sellers will know that they have the money to
debt by maturity. back up their offer.
How Mortgages Work? • Once a buyer and seller agree on the terms of their deal, they or their
• Individuals and businesses use mortgages to buy real estate without representatives will meet at what’s called a closing. This is when the
paying the entire purchase price up front. borrower makes their down payment to the lender.
• The borrower repays the loan plus interest over a specified number of • The seller will transfer ownership of the property to the buyer and
years until they own the property free and clear. receive the agreed-upon sum of money, and the buyer will sign any
• Most traditional mortgages are fully-amortizing. This means that the remaining mortgage documents.
regular payment amount will stay the same, but different proportions of • The lender may charge fees for originating the loan (sometimes in the
principal vs. interest will be paid over the life of the loan with each form of points) at the closing.
payment. Typical mortgage terms are for 30 or 15 years. CHARACTERISTICS OF THE RESIDENTIAL MORTGAGE
• Mortgages are also known as liens against property or claims on property. A. Mortgage Interest Rates
• If the borrower stops paying the mortgage, the lender can foreclose on • Factors that affect the interest rate on the loan
the property. 1. Current long-term market rates
• For example, a residential homebuyer pledges their house to their lender,  Long-term market rates are determined by the
which then has a claim on the property. This ensures the lender’s interest supply and demand for long-term funds which
in the property should the buyer default on their financial obligation. In are in turn affected by a number of global,
national and regional factors.
  Mortgage rates tend to stay above the less risky F. BORROWER QUALIFICATION
treasury bonds most of the time but tend to track  Qualifying for a mortgage loan is different from qualifying for a
along with them. bank loan because most lenders sell their mortgage loans to one
2. Term or life of the mortgage of a few government agencies in the secondary mortgage market.
 Generally, longer-term mortgages have higher AMORTIZATION OF MORTGAGE LOAN
interest rates than short-term mortgages. The • Mortgage loan borrowers generally agree to pay a monthly amount of
usual mortgage lifetime is 15 or 30 years. principal and interest that will be fully amortized by its maturity.
3. Number of Discount Points Paid • “Fully amortized” means that the payments will pay off the outstanding
 Discount points (or simply points) are interest indebtedness by the time the loan matures.
payments made at the beginning of a loan. • Amortization in real estate refers to the process of paying off your
 A loan with one discount point means that the mortgage loan with regular monthly payments. These payments are made
borrower pays 1% of the loan amount at closing, in equal installments over the life of the loan, though the amount of the
the moment when the borrower signs the loan payment consisting of principal and interest can vary.
paper and receives the proceeds of the loan. In • The amortization period refers to how long it will take to pay off your
exchange for the points, the lender reduces the mortgage in full.
interest rate on the loan. • AMORTIZATION
B. LOAN TERMS – Mortgage loan contracts contain • It is the gradual extinction of a debt, principal and interest by
many legal and financial terms, most of which protect the sequence of equal periodic payments or installment payments
lender from financial loss. due at the ends of equal intervals of time.
C. COLLATERAL – One characteristic common to • AMORTIZATION SCHEDULE
mortgage loans is the requirement that collateral, usually • It is a table that shows how much is applied to reduce the
the real estate being financed, be pledged as security. principal and how much is paid for interest to show the
D. DOWN PAYMENT outstanding balance after each payment period.
• To obtain a mortgage loan, the lender also requires the borrower • OUTSTANDING BALANCE
to make a downpayment on the property, that is, to pay a portion • It is the amount left to be paid at a certain payment interval.
of the purchase price. • PERIODIC PAYMENT (OR PERIOD DEPOSIT)
• The balance of the purchase price is paid by the loan proceeds. • It is the amount paid or deposited at every payment or deposit
E. PRIVATE MORTGAGE INSURANCE (PMI) interval.
• PMI is an insurance policy that guarantees to make-up any • To compute the yearly payment for a fully amortized mortgage, we can
discrepancy between the value of the property and the loan use the formula for an annuity to determine the annual payment amount:
amount should a default occur.
• For example, if the balance on your loan was Php 120,000 at the
time of default and the property was worth only Php 100,000,
PMI would pay the lending institution Php 20,000.
AMORTIZATION SCHEDULE • Adjustable-Rate Mortgage (ARMs)
– The interest rate on adjustable-rate mortgage (ARMs) is tied to
some market interest rate (e.g., Treasury Bill Rate) and therefore
changes over time.
Explanations: – ARMs usually have limits called caps, on how high (or low) the
• Year - the specific year of the loan term interest rate can move in one year and during the term of the
• Beginning Balance - the outstanding loan balance at the start of the year loan.
• Annual Payment - the fixed annual payment amount • Graduated-Payment Mortgages (GPMs)
• Interest - the interest amount for the year – These mortgages are useful for home buyers who expect their
• Principal - the portion of the annual payment that goes towards reducing incomes to rise.
the principal balance – The GPM has lower payments in the first few years then the
• Ending Balance - the remaining loan balance after the annual payment payments rise.
Example: • Growing Equity Mortgage (GEMs)
• Given the following information, compute the annual payment and – With a GEM, the payments will initially be the same as on a

Loan Amount 𝑃
construct an amortization schedule: conventional mortgage. Over time, however, the payment will

Annual Interest Rate 𝑟 6%

Php 5,000,000 increase.

Loan Term 𝑛
– This increase will reduce the principal more quickly than the
10 years conventional payment stream would.
TYPES OF MORTGAGE LOANS • Shared Appreciation Mortgages (SAMs)
• Conventional Mortgages – In a SAM, the lender lowers the interest rate in the mortgage in
– These are originated by banks or other mortgage lenders but are exchange for a share of any appreciation in the real estate (if the
not guaranteed by government or government controlled property sells for more than a stated amount, the lender is
entities. entitled to a portion of the gain).
– Most lenders though now insure many conventional loans against • Equity Participating Mortgage (EPM)
default or they require the borrower to obtain private mortgage – In EPM, an outside investor shares in the appreciation of the
insurance on loans property. This investor will either provide a portion of the
• Insured Mortgages purchase price of the property or supplement the monthly
– These mortgages are originated by banks or other mortgage payment. In return, receives a portion of any appreciation of the
lenders but are guaranteed by either the government or property.
government-controlled entities. – As with the SAM, the borrower benefits by being able to qualify
• Fixed-rate Mortgages for a larger loan than without such help.
– In fixed-rate mortgages, the interest rate and the monthly • Second Mortgages
payment do not vary over the life of the mortgage. – These are loans that are secured by the same real estate that is
used to secure the first mortgage.
 – The second mortgage is junior to the original loan which means b. Mortgages are not standardized. They have different terms to
that should a default occur, the second mortgage holder will be maturity interest rates and contract terms. Thus, it is difficult to
paid only after the original loan has been paid off, if sufficient bundle a large number of mortgages together; and
funds remain. c. Mortgage loans are relatively costly to service. The lenders must
• Reverse Annuity Mortgages (RAMs) collect monthly payments, often advances payment of property
– In a RAM, the bank advances funds to the owner on a monthly taxes and insurance premiums and service reserve accounts.
schedule to enable him to meet living expenses he thereby d. Mortgages have unknown default risk. Investors in mortgages do
increasing the balance of the loan which in secured by the real not want to spend a lot of time and effort in evaluating the credit
estate. of borrowers.
– The borrower does not make payments against the loan and • Mortgage-backed security – is a security that is collateralized by a pool of
continues to live in his home. When the borrower dies, the estate mortgage loans. This is known as securitized mortgage.
sells the property to pay the debt. • Securitization is the process of transforming illiquid financial assets into
MORTGAGE LENDING INSTITUTIONS marketable capital market instruments.
• The institutions that provide mortgage loans to familiar and business and • The most common type of mortgage-backed security is the mortgage pass
their share in the mortgage market are as follows: through, a security that has the borrower’s mortgages pass through the
Mortgage tools and trusts 49% trustee before being disbursed to the investors in the mortgage=pass
Commercial banks 24% through.
Government agencies and others 15% • If borrowers pre-pay their loans, investors receive more principal than
Life insurance companies 9% expected.
Savings and loans associates 9% • Securitized mortgage are low-risk securities that have higher yield than
Source: Federal Revenue Bulletin, 2018 comparable government bond and attract funds from around the world.
• Many of the institutions making mortgage loans do not want to hold large BENEFITS DERIVED FROM
portfolios of long-term securities. SECURITIZED MORTGAGE (SM)
• Commercial loans, thrifts and most other loan organization do make • SM has reduced the problems and risks caused by regional lending
money through the fees that they earn for packaging loans for other institutions’ sensitivity to local economic fluctuations.
investors to hold. • Borrowers now have access to a national capital market.
• Loans organization fees are typically 1% of the loan amount, through this • Investors can enjoying the low-risk and long-term nature of investing in
varies with the market. mortgages without having to service the loan.
SECURITIZATION OF MORTGAGES • Mortgage rates are now more open to national and international
• Intermediaries face several problems when trying to sell mortgages to the influences. As a consequence, mortgage rates are more volatile than they
secondary market; that is lenders selling the loans to another investor. were in the past.
• These problems are:
a. Mortgages are usually too small to be wholesale instruments.
 DERIVATIVE MARKETS Risk-averse brokers and traders who wish to play it safe in the stock market.
Rather than invest in tricky stocks which may give them either a huge profit or a
Learning Objectives:
huge loss, hedgers invest their money in derivative markets, in a bid to protect
their portfolio. By assuming an opposite position concerning the derivatives
1. Explain how Derivative Financial Instruments work market, they can protect themselves against market risk and price fluctuations.
2. Discuss the characteristics and examples of Derivative Financial 2. Speculators:
Instruments They are the primary risk-takers of any derivative market as they don’t mind
taking risks to earn large profits. Therefore, they have a frame of mind that is the
Derivatives: Meaning, Features, and Importance polar opposite to the one possessed by hedgers, who wish to play safe always.
3. Margin Traders:
Derivatives Margin is the bare minimum that an investor needs to pay the broker to take part
are financial instruments that derive their value on contractually required in derivatives trading. This margin is a form of representing market fluctuations as
cash flows from some other security or index. it reflects the loss or gain made on that day.
serve as financial contracts of a kind, in which their value depends on 4. Arbitrageurs:
some underlying asset or a group of such assets. Some of the most They make use of market imperfections to make money by buying low-priced
commonly used derivatives are bonds, stocks, commodities, currencies, stocks and then selling them at higher prices in a different market. However, this
and indices. becomes possible only if the commodity in question is priced differently in
They are complex financial instruments that are used for various different markets.
purposes, including hedging and getting access to additional assets
How it works
or markets.
Investors may buy derivatives in order to reduce the amount of
Characteristics of Derivatives volatility in their portfolios, since they can agree on a price for a
deal in the present that will, in effect, happen in the future, or to
A derivative is a financial instrument: try to increase their gains through speculation.
a) whose value changes in response to the change in a specified It can enable an investor to gain exposure to a market via a smaller
interest rate, security price, commodity price, foreign exchange outlay than if they bought the actual underlying.
rate, index of prices or rates, credit rating or credit index, or similar
variable Why invest in derivative contracts?
b) that requires no initial net investment or little net investment Earning profits is not the only reason investors flock towards derivative
contracts. One of the biggest reasons investors prefer derivatives is because it
relative to other types of contracts that have a similar response to
gives them an Arbitrage advantage. This comes as a result of buying an asset at a
changes in market conditions; and
low price and then selling it at a higher price in another market. This way, the
c) that is settled at a future date. buyer is protected by the difference in the value of the product in the different
markets, and thereby, gets an added benefit from both markets. Furthermore,
certain derivative contracts protect you from market volatility and help shield
Participants of the derivatives market your assets against fall in stock prices. If that wasn’t enough, derivative contracts
1. Hedgers: are also a great way to transfer risk and balance out your portfolio.
TYPICAL EXAMPLES OF DERIVATIVES

Feature Options Swaps Futures Forward Contracts

Contracts giving the right,

but not the obligation, to Agreements to exchange Standardized Custom agreements to
buy or sell an asset at a cash flows or other contracts to buy or buy or sell an asset at a
specified price before a financial instruments sell an asset at a specified future date
Definition specified date. over a set period. future date and price. and price.

Interest rate swaps, Commodity futures,

Types Call options, put options currency swaps financial futures Tailored contracts

Exchanges (e.g., CME,

Traded On Exchanges (e.g., CBOE) Over-the-counter (OTC) NYMEX) Over-the-counter (OTC)

Standardization Standardized Customizable Highly standardized Customizable

Regulated by financial Less regulated, largely Highly regulated by Less regulated, largely
Regulation authorities (e.g., SEC) OTC financial authorities OTC

Depends on the Subject to margin Depends on the

Limited to the premium counterparties' credit requirements and counterparties' credit
Risk paid risk daily settlements risk

Hedging, interest rate Hedging, speculation,

Use Cases Hedging, speculation management price discovery Hedging, speculation

American (anytime before

expiration) or European (at
Exercise Style expiration) N/A N/A N/A

Cash flows exchanged Usually cash settled Physical or cash

Settlement Physical or cash settlement periodically daily settlement

Swapping fixed interest Agreeing to buy euros in

Buying a call option on payments for floating Trading a crude oil six months at a fixed
Examples Apple stock rate payments futures contract rate
Advantages of Derivatives Disadvantages of Derivatives
1. Hedging risk exposure 1. High risk

Since the value of the derivatives is linked to the value of the The high volatility of derivatives exposes them to potentially huge losses.
underlying asset, the contracts are primarily used for hedging risks. For The sophisticated design of the contracts makes the valuation extremely
example, an investor may purchase a derivative contract whose value complicated or even impossible. Thus, they bear a high inherent risk.
moves in the opposite direction to the value of an asset the investor owns.
2. Speculative features
In this way, profits in the derivative contract may offset losses in the
underlying asset. Derivatives are widely regarded as a tool of speculation. Due to the
extremely risky nature of derivatives and their unpredictable behavior,
unreasonable speculation may lead to huge losses.
2. Underlying asset price determination
3. Counter-party risk
Derivatives are frequently used to determine the price of the
Although derivatives traded on the exchanges generally go through a
underlying asset. For example, the spot prices of the futures can serve as
thorough due diligence process, some of the contracts traded over-the-
an approximation of a commodity price.
counter do not include a benchmark for due diligence. Thus, there is a
3. Market efficiency possibility of counter-party default.

It is considered that derivatives increase the efficiency of financial

markets. By using derivative contracts, one can replicate the payoff of the
assets. Therefore, the prices of the underlying asset and the associated
derivative tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable

assets or markets. By employing interest rate swaps, a company may
obtain a more favorable interest rate relative to interest rates available
from direct borrowing.
DERIVATIVES 2. Speculators:

Derivatives They are the primary risk-takers of any derivative market as they don’t
- are financial instruments that derive their value on contractually mind taking risks to earn large profits. Therefore, they have a frame of mind that
required cash flows from some other security or index. is the polar opposite to the one possessed by hedgers, who wish to play safe
always.
For instance, a contract allowing company to purchase a particular asset at a
designated future date, at a predetermined price is a financial instrument that 3. Margin Traders:
drives its value from expected and actual changes in the price of underlying asset. Margin is the bare minimum that an investor needs to pay the broker to
take part in derivatives trading. This margin is a form of representing market
Characteristics of Derivatives fluctuations as it reflects the loss or gain made on that day.

A derivative is a financial instrument: 4. Arbitrageurs:

a) whose value changes in response to the change in a specified interest They make use of market imperfections to make money by buying low-
rate, security price, commodity price, foreign exchange rate, index of priced stocks and then selling them at higher prices in a different market.
prices or rates, credit rating or credit index, or similar variable However, this becomes possible only if the commodity in question is priced
differently in different markets.
b) that requires no initial net investment or little net investment relative to
other types of contracts that have a similar response to changes in The Structure of Derivative Markets
market conditions; and Exchange-traded Derivative Markets
c) that is settled at a future date. Clearing and settlement process

All contract terms standardized except price

More liquid
Participants of the derivatives market More transparent
Credit guarantee
1. Hedgers:
Over-the-counter Derivative Markets
Risk-averse brokers and traders who wish to play it safe in the stock
market. Rather than invest in tricky stocks which may give them either a huge Informal network of market participants
profit or a huge loss, hedgers invest their money in derivative markets, in a bid to dealer market
protect their portfolio. By assuming an opposite position concerning the less liquid
derivatives market, they can protect themselves against market risk and price less transparent
fluctuations. customized
How it works value of the product in the different markets, and thereby, gets an added
benefit from both markets. Furthermore, certain derivative contracts
Investors may buy derivatives in order to reduce the amount of volatility protect you from market volatility and help shield your assets against fall
in their portfolios, since they can agree on a price for a deal in the present in stock prices. If that wasn’t enough, derivative contracts are also a great
that will, in effect, happen in the future, or to try to increase their gains way to transfer risk and balance out your portfolio.
through speculation.
 Futures Contracts
It can enable an investor to gain exposure to a market via a smaller outlay
than if they bought the actual underlying.  It is an agreement between a seller and a buyer that requires that seller
to deliver a particular commodity (say corn, gold, or soya beans) at a
DERIVATIVES FOR HEDGING designated future date, at a predetermined price. These contracts are
Companies use derivatives to protect against cost fluctuations by actively treated on regulated future exchanges and are generally referred
fixing a price for a future deal in advance. By settling costs in this way, to as "commodity futures contract." When the "commodity" is a financial
buyers gain protection – known as a hedge – against unexpected rises or instrument such as a Treasury bill or commercial paper, the agreement is
falls in. referred to as a financial futures contract. Futures contracts are
purchased either as an investment or as a hedge against the risks of
For example, the foreign exchange market, interest rates, or the value of future price changes.
the commodity or product they are buying.
Forward Contracts A forward contract is similar to a futures contract but differs in
DERIVATIVES FOR SPECULATION three ways:

Investors may buy or sell an asset in the hope of generating a 1. A forward contract calls for delivery on a specific date, whereas a futures
profits from the asset`s price fluctuations. Usually this is done on a short- contract permits the seller to decide later which specific day within the specified
term basis in assets that are liquid or easily traded. month will be the delivery date (if it gets as far as actual delivery before it is
closed out).
For example, an investor notices a company`s share price is going up and
buys an option on the share. An option gives a right to the holder to buy 2. Unlike a futures contract, a forward usually is not traded on a market exchange.
shares at a future date
 3. Unlike a futures contract, a forward contract does not call for a daily
Why invest in derivative contracts? cash settlement for price changes in the underlying contract. Gains and
losses on forward contracts are paid only when they are closed out.
 Earning profits is not the only reason investors flock towards derivative
contracts. One of the biggest reasons investors prefer derivatives is  Options
because it gives them an Arbitrage advantage. This comes as a result of
buying an asset at a low price and then selling it at a higher price in  It give its holder the right either to buy or sell an instrument say a
another market. This way, the buyer is protected by the difference in the Treasury bill, at a specified price and within a given time period. Options
 frequently are purchased to hedge exposure to the effects of changing
interest rates. Options serve the same purpose as futures in that respect
but are fundamentally different. Importantly. though, the option holder
has no obligation to exercise the option On the other hand, the holder of
a futures contract must buy or sell within a specified period unless the
contract is closed out before delivery comes due.

 Foreign Currency Futures

 Foreign loans frequently are denominated in the currency of the

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

 To hedge against "foreign exchange risk" exposure, some firms

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

 Interest Rate Swaps

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

or a series of specified dates based on a notional amount and fixed and
floating rates. Over 70% of derivatives are interest rate swaps. These
contracts exchanged fixed interest payments for floating rate payments,
or vice versa, without exchanging the underlying principal amounts.