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entities for a required return Borrowers - parties who
are willing to pay the required return to obtain
additional funds
CHAPTER 1 - FINANCIAL SYSTEMS AND THE
FINANCIAL MARKET
Sources of Wealth
1.
2.
3.
4.
Labor - will allow them to earn a salary/wage
Land - generate wealth in the form of rent
Capital - will earn interest when the venture is
realizing good returns
Entrepreneurship - generate more profit
2.
Financial Intermediaries (How will the change
occur?)
Acts as a third party to facilitate the
borrowing activity between lenders and borrowers.
3.
Financial Instruments (What will be used?)
Medium of exchange of contractual
obligation of a party, where such contract can be
traded.
Finance
- Key player in ensuring continuity of operations
- The application of economic principles to decision
making that involves the allocation of money under
conditions of uncertainty.
- Came from the french word “finer” which means “to
end and settle a debt”.
Financial System
- Allows households, companies and the government
who have available funds to invest these funds in
more potentially productive vehicles that can result in
faster growth in the economy.
- Composed of interrelated systems of financial
markets, intermediaries and services.
Enhances the welfare of individual consumers as they
have immediate access to funds allowing them to
purchase things as they prefer
Fund Providers
- Households (primary fund provider), companies and
government agencies who have available funds
Fund Demanders
- Households, companies and government agencies
(main fund demanders) who have shortage of funds
 Direct Financing
Borrower-spenders borrow and deal directly
with lenders through selling financial instruments
Ex. Buying stocks
 Indirect Financing
The borrowing activity between both parties
still happens through the intervention of a financial
intermediary.
Represent claims on future income or assets of the
borrower
Borrowers - Liabilities
Lenders - Asset
2 types of Financial Instruments
a. Cash
b. Derivative Financial Instruments
4.
Where suppliers and buyers of financial
instruments meet.
Money Market - Cash Financial Instruments
Capital Market - Derivative Financial Instruments
5.
Regulatory Environment (How is it controlled?)
The governance body to ensure that the
transactions that occur within the financial systems
comply with the laws and regulations.
They are normally regulated by Central
Banks
6.
Money Creation (What is the value it creates?
-Money is used to either be reinvested or earned out
from the system flows
7.
Elements of the Financial System
1. Lenders and borrowers (Who are the players?)
The most essential stakeholders that make up the
foundation of a transaction in the financial
system.
Financial Markets (Where will it be traded?)
Price discovery (How much is created?)
The process of determining or valuing the
financial instrument in the market.
Lenders - parties that have excess funds that they can
lend out to other
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Financial Markets
- Help in creating a more efficient allocation of capital
which results in higher production and efficient that
ultimately leads to economic growth.
Main economic function:
Serve as a channel transfer excess funds
from fund
providers to fund demanders.
Participants: household, government and
businesses, financial intermediaries, brokers and
dealers, regulators, fund managers and financial
exchanges.
“Trading” - Exchanging of Financial
Instruments
Major economic functions of Financial Market:
1. Price discovery
Interaction between buyers and sellers in the
financial market in order to come up with price of the
traded financial instrument.
Price is set at the level wherein the buyers
are willing to buy, and sellers are willing to sell.
Determines how the available funds from
providers are allocated towards the demanders based
on the demanders' willingness to accept the return
required by the fund.
2.
3.
Liquidity
Through Financial Markets, holders can sell
their own financial instruments to other investors to
earn cash.
Easy access to a venue where investors can
sell financial instruments for cash in an appealing
feature when circumstances may occur that push
investors to sell a financial instrument.
Without liquidity, an investor is forced
to hold to financial instrument up until…
Debt instrument: Maturity date Equity
instrument: Voluntary or involuntary liquidation
Implicit Search Costs
Include value of time consumed to look for
a counterparty
Information Costs
costs related in evaluating investment
characteristics of a financial instrument.
TYPES OF FINANCIAL MARKETS
1. Based on Instruments Traded
Money Market
-Where Financial Instruments that will mature or be
redeemed in one year or less(short-term) from
issuance date are traded.
For long term investors: they invest in money market
to meet their short-term liquidity needs.
Importance to fund demanders:
They need it since immediate cash requirements of
individuals, government and corporations do not
necessarily coincide in the timing of their cash
receipts.
Importance to fund providers:
They need it because excessive holdings of cash also
generates opportunity cost in the form of foregone
interest.
Money market instruments
-Offer an investment opportunity that yields a higher
return than just mere holding of cash(which generates
zero interest)
Are very liquid and has very little default risk
because of the associated short maturity term.
Ex. Treasury bills, Commercial papers, Certificate of
deposits, Repurchase agreement, Banker’s
acceptances.
Capital Market
Where Financial Instruments issued by governments
and corporations that will mature one year from
issuance date (long-term) are traded.
Reduction in transaction costs
The foundation of the capital market is made up by
the dealers and brokers market which creates a venue
for bond and stock transactions.
Types of Transaction Costs:
Search Costs
- costs incurred to look for financial instruments that
can be purchased or sold by a party.
Capital Market Securities:
a. Equity Instruments
b. Debt Instruments
Explicit Search Costs
Expenses needed to advertise intent to
purchase or sell a financial instrument.
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offer will not be fully subscribed to the
public.
2.
Based on Market Type
In primary market:
Lenders - suppliers
2.
fund Borrowers - demanders of funds
Secondary market:
Buyers - suppliers of fund
Sellers - demanders of funds
An underwriter subscribes to all securities
at a certain price and consequently, sell the
same securities at a higher price
Primary Market
Where fund demanders raise funds through new
issuance of financial instruments
3. Auction
Used for issuance of treasury bills, bonds and other
securities issued by the government and are
commonly executed exclusively with market makers.
e.g. bonds and stocks.
Transactions are coursed through Investment Banks
that act as intermediaries between issuing companies
(demanders) and potential investors (providers).
Investment Banks
- provide advice to issuers about prices of
the securities, transaction costs and number
of securities to be issued based on their fund
needs.
- Responsible to legal and financial exchange
requirements, appointments of lawyers and
auditors, due diligence, etc.
- They underwrite securities
Underwriting
Investment banks guarantee the price for the
securities of the issuing company and then sells to
the public.
Dutch Auction
Seller begins the sale at a high price. The price of
securities is continuously lowered down at specific
intervals until the potential buyer agrees
English Auction
Prospective buyers commerce the auction by
submitting an initial bid price. The bidding stops
when no other bidders wants to top the last bid.
Descending price sealed Auction (First-price sealed
auction)
Bidders submit sealed bids to the sellers that will be
ranked from highest to lowest price. Highest priced
bids receive full allocation while lower bids receive
allocation distributed pro rata.
4.
1.
Types of issue methods that can be done in the
primary markets:
Public Offering
Securities are offered for sale to the general
public through issuing a prospectus or
placing document
Private companies who will sell shares to
the general public for the very first time is
said to undergo an Initial Public Offering
(IPO) through the help in investment banks
Can either be an offer for subscription or an
offer for sale
An underwriter is appointed for public
offerings. It provides an undertaking to
purchase the remaining securities if the
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Private Placement(Limited Public Offer) Issuers
look for a single investor, an institutional buyer
or group of buyers to purchase the securities
issuance
Tap Issue
Issuers are open to receive bids for their securities at
all times, and they maintain the right to accept or
reject the bid prices.
Secondary Market
Securities issued in the primary market are subsequently
traded i.e. resold and repurchased.
Buyers are the ones who have excess funds while the sellers
are those who need funds.
Transactions usually occur through the help of securities
broker which acts as a facilitator between the seller and the
buyer of the security.
Ex. Foreign exchange market, futures market and
options market
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Economic functions:
●
Price discovery
The higher the price of the security in the secondary
market, the higher the price that issuing companies
can set on new securities that they will issue.
Market makers set a bid quote(to buy) and offer
quote(to sell).
●
Liquidity and reduction in borrowing costs
Allows active trading which improves liquidity and
marketability of the securities.
Spread
- difference bet the bid and offer quote
- Inures to the benefit of the market makers as
profit
- Represents the transactional costs and
reflects liquidity
●
●
Narrow Spread - Signals liquidity
Wide Spread - Indicates illiquidity
Support to the primary market
Implementation of monetary policy
Secondary Markets provide liquidity to the investors
who hold the securities as they are able to convert the
securities to cash quickly by selling to other
participants.
Classifications based on Market Structure:
Order-Driven Market Structure
Buyers and sellers propose their price through their
brokers who conveys the bid in a centralized
location. Also called as Auction Market.
Types of orders:
➢ Market Orders (At-best orders) - orders
placed with broker-dealers with the
instruction to execute transactions at the
prevailing best market price.
➢ Limit orders
Orders placed where clients set a price or
price range that may be below/above the
existing price.
➢ Day orders
Orders placed that only valid until the end
of the business day.
➢ Good-until-cancelled orders
Orders placed that remains valid for a
sustained period up until the client
voluntarily cancels and remove these from
the system.
Primary and Secondary Market can also be classified based on
where the financial instruments are traded:
Exchange (or Formalized)
Centralized trading locations where financial instruments are
purchased or sold between market participants.
In order to be traded, all Financial Instruments should be
listed by the organized exchange.
Over-the Counter Market (or Informal)
A place where unlisted financial instruments are allowed to
be traded, in addition to listed financial instruments.
Ex. Labor market, Fish market, Vegetable market
3.
Based on Country’s Perspective
Internal or National Market
Refers to the financial market operating in a certain
country.
Domestic Market - issuers who are considered
residents in a country issue the securities
Foreign Market - issuers who are not residents of a
country can sell or issue securities subsequently
traded. The rules of the regulatory authority
where the security is issued will prevail.
 External Market
Refers to the Financial market where securities that
have two unique characteristics are being traded:
Quote-Driven Market Structure
a.
Also called as primary dealer markets,
professional markets or market-made markets.
b.
Market makers establish a price quote at which the
market participants should trade with.
Upon issuance, these securities offered
simultaneously to investors in different
countries
Securities are issued outside the regulatory
jurisdiction of any single country
Ex. International Market, Offshore market and
Euromarkets
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4.
manage asymmetric information to a certain degree
in its operations.
Based on the manner of Financial Intermediaries
Broker Market
Buyers and sellers are brought together by a broker
and the trade occurs at that point.
Asymmetric Information
Occurs when potential borrowers have more
information about the transaction compared to the
bank. It may lead to two further problems:
➢Adverse selection
High risk borrowers that would tend to default is
more likely to be more active in borrowing
funds than low risk borrowers who pay on time.
Dealer Market
Buyers and sellers are not brought directly together
by a third party. Market makers execute the sell or
buy orders.
CHAPTER 2- FINANCIAL INTERMEDIARIES AND
OTHER PARTICIPANTS
Occurs before transaction happens
➢Moral hazard
Borrowers have a tendency to take undesirable
or immoral risks with the money, once they
receive it, not disclosed during the loan granting
process.
Financial Intermediaries
- Were formed during the time when market conditions
make it hard for lenders to transact directly with
borrowers.
- Ex. Depository institutions, insurance companies,
asset management firms, regulated companies and
investment banks
Happens after the loan is granted
Financial Intermediation
The process of indirect financing using financial
intermediaries as the main route to transfer funds from lenders
to borrowers.
Financial Intermediaries provide the ff services:
● Enable trading of financial assets for the customers of
the FI through brokering arrangements
● Enable trading of financial assets through its own
capital by buying a stake in a financial asset that its
customers want to transact in
● Assist in forming financial assets needed by its
customers and distribute these to its customers and
other market participants as well
● Provide investment advice and consultation services
to customers
● Manage Financial assets of customers
● Facilitate payment mechanism between merchants
and customers
Financial Intermediaries are better equipped at screening
out bad borrowers from good borrowers which may
reduce the risk of adverse selection.
Financial Intermediaries have the mechanism to monitor
action of their borrowers, potentially reducing losses
related to moral hazard.
3.
Creation of money
Financial Intermediaries, specifically banks, allow
creation of money through its bank loan services, thus
allowing existing and new funds to be allocated
efficiently.
4.
Support in price discovery
Financial Intermediaries play the role as experts and
facilitators to enable to assign values to financial
instruments based on different factors.
●
Improved liquidity for lenders FI can manage
cash from different lenders through immediately
encashable products such as current and savings
deposit accounts
●
Reduced price risk for lenders
Price risk means that prices of financial
instruments may vary over time.
Benefits from Financial Intermediaries
1. Acceleration of flow funds between entities
Fund providers use Financial
Intermediaries to transfer funds to fund demanders.
FI also serves a savings and wealth storage function,
allowing parties with excess funds to store their
funds in risk-free low-risk financial instruments.
2.
Efficient allocation of funds
To ensure efficient allocation, Financial
Intermediaries
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Financial Intermediaries offer low-risk financial
products (deposits) to ultimate lenders and at the
same time offer financial products with high
price risk(shares, bonds, property financing) to
borrowers.
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Risk Sharing
Where lenders enjoy mitigated price risks as
they course the transfer of funds with very low
risk to FI which in turn bear the bigger risk
when lending to other entities.
Can also be called as asset transformation
●
Financial System serves as the main
structure for making payments for any
goods, services or securities that are
purchased.
●
Diversification of lenders Household do not
have as much investment opportunities for
their funds, which is a problem as lenders
may not be able to efficiently maximize
returns from their funds because of limited
investment opportunities. Through FI,
which have wider access to investment
possibilities, household can diversify their
portfolio better.
Financial system allows people and companies to
protect and build their wealth through having
insurance against threats to their life, income and
properties.
●
Diversification
Process of investing funds in a portfolio of
assets that have individual returns that do
not move in the same direction together.
Usually results in an overall portfolio risk
that may be lower than rick of individual
asset.
Allows lenders to share risk from their
investments.
Risk Mitigation
Risk may also pertain to the uncertainty that
something untoward or damaging may occur to a
person or entity.
Implementation of monetary policy function The
Financial System provides the best mechanism to
allow the government to implement its monetary
policies to manage economic growth, steady
employment rate, equilibrium of balance of payments
and inflation.
Financial Intermediaries are able to convert financial
assets that are not attractive to most investors into
another financial asset - as a liability of the FI - that
are more favored by the general public.
This transformation has 3 econ functions:
Risk
Uncertainty regarding the return an investor
will earn on their invested assets.
●
Economies of scale
Occur when fixed costs are optimized per
unit as a result of sheer volume of
transactions. Cost per transaction is reduced
as the number of transactions increases.
Transaction Costs
Cost associated with trading or managing
funds and investment transactions
Research Costs
Costs incurred in monitoring performance
of potential companies to be invested in
through economic. Industry and financial
analysis
Financial Intermediaries allow funds to be
concentrated to them and they will incur
transaction and research costs in behalf of
all its depositors.
●
Maturity intermediation
If FI did not exist, long-borrowers would have to borrow
money for shorter term to match the short duration at which
fund providers are willing to lend funds.
Maturity Intermediation gives fund providers/investors more
alternatives in terms of how long they want to invest in
financial instruments and borrowers have more choices on the
length of maturity of their debts.
Risk reduction through diversification
Diversification
Economic function exercised by financial intermediaries
which converts more risky assets to less risky assets through
sharing of risks. Ex. Mutual Funds
Cost reduction for contracting and information processing
Information Processing Costs
Refer to the cost of acquiring and processing information
needed to evaluate purchase or subsequent sale of a financial
instrument.
Payments System
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Contracting Costs
Refer to cost incurred for writing loan agreements
and enforcing the terms of agreements to the
concerned parties.
3.
4.
5.
●
Both Costs require time before they can be done. FI
employ personnel that possess both skills that they
can act on behalf of investors.
Classification of Financial Intermediaries
1. Depository Institution
Firms that accept cash deposits from individuals,
companies and entities. Once the deposit is received,
this becomes liability of the depository institution to
the depositor.
Loans
The biggest portion of the asset base of a depository
institution
The main revenue-generating assets for banks
They also keep significant investment on securities
such as interest-bearing deposits purchased from
other financial institutions, repurchase agreements,
treasury bills, mortgage-backed securities and other
equity and debt instruments.
Deposits
The biggest portion of a bank’s liabilities
Thrift Banks
Primarily mobilized small savings and provide loans at
generally longer and easier terms than do commercial
banks as they cater to lower income groups.
Farmers, cottage industry entrepreneurs, and consumers
rely on these banks.
●
Savings Banks
Organized for the purpose of accumulating deposits, and
investing them for specified purposes, such as readily
marketable bonds and securities, commercial papers and
accounts receivables, drafts, bills of exchange, such other
investments and loans as allowed by the Monetary of the
BSP in pursuit of national economic objectives.
4 types of deposit accounts issued:
1. Demand deposits or checking accounts Deposits
that can be withdrawn upon demand
2. Savings deposit
Deposits that earn interest at a level below
market interest rates
3. Money market demand accounts Deposits that
are placed on money markets
4.
In the Philippines, depository institution is
subdivided:
●
Commercial Banks
Authorized to accept drafts/checks and issue
letters of credit; discount and negotiate
promissory notes, drafts, bills of exchange,
and other evidence of debts; receive
deposits; buy and sell forex and gold or
silver bullion; and lend money against
securities consisting of personal property or
first mortgages on improved real estates and
the insured thereon.
Banks who operate as commercial bank and
also offer investment banking are known as
universal banks.
Top 5 commercial banks in the PH:
1. BDO Unibank Inc.
2. Metropolitan Bank Trust
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Time deposits
Deposits that have a fixed maturity date
Rediscounting
- Standing credit facility offered by the BSP to aid
banks to meet temporary liquidity needs through
refinancing the loans that banks extend to their
clients.
- One of the various monetary tools used by the
BSP to regulate the
liquidity level in the PH financial system
Department of Loans and Credit (DLC)
Administers BSP's rediscounting
2.
Raise funds through offering checking
deposit accounts, savings deposit accounts,
and time deposit.
Land Bank of the Philippines
Bank of the Philippine Islands
Philippine National Bank
Contractual Savings Institutions Are Financial
Intermediaries that obtain funds at periodic
intervals based on an existing contract.
Focuses more on investing in long-term securities
like stocks, mortgages and corporate bonds.
Examples: Insurance companies and Pension funds
Insurance Companies
Offer services to assume risk or become underwriters
of the risk associated with
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various insurable occurrences. They also invest in
financial markets.
3.
Investment Intermediaries
Primary objective is to maximize return from
investments in various financial instruments to add
value for investors.
Asset Management Firms, Investment Banks and
Finance Companies
Asset Management Firms
Companies that manage funds owned by individuals,
companies or government through buying and selling
of financial instruments.
Types of accounts/funds usually handled by AMF:
➢Regulated Investment Companies
Financial intermediaries that sells shares to
the general public in exchange of cash.
AMF are contracted to manage the
investment portfolio of RIC.
Asset Management strategies in portfolios:
1. Passive funds/Indexed funds
Managed to mimic movements in the market index
2.
Active funds
Managed with the intention to outperform the index
fund via actively trading securities in the fund
portfolio.
Each share in the portfolio is valued at Net Asset
Value (NAV), which is interpreted to be a per share
metric.
2.
Closed-end funds
Have fixed no. of shares
Do not issue additional or redeem shares
Prices are associated with demand and supply in the
secondary market where the funds are being traded.
Market price of the fund’s shares may be higher or lower
than NAV.
Price of shares > NAV = premium
Price of shares < NAV = discount
➢ Exchange Traded Funds
Possesses characteristics of both open-ended and
close-ended funds. They are open-end funds, but
the share pricing has small premiums/discounts
from the NAV, like a closed-end fund.
Allowed to place limit orders, stop orders and
orders to sell short or at a margin since its shares
are directly traded in the secondary market
unlike open-end funds.
➢ Hedge Funds
Developed to cater sophisticated investors and
are usually not subject to the same regulations
covering mutual funds.
Open-end funds (mutual funds) Do not have fixed no.
of shares Offers additional shares as long as investors
are willing to invest
Organized as a private investment partnership or
offshore investment corporation which uses
various trading strategies to gain better position
in different markets.
Strategies employed:
- Leverage (use of borrowed money
to invest)
- Short selling (sale of security nor
owned with the expectation that the
price of security will eventually
decline)
- Derivatives
- Simultaneous selling and buying of
securities
Total no. of shares of the fund increases if there are more
investments made to the fund than withdrawals and viceversa.
➢Separately/Individually managed accounts
Distinct funds solely dedicated to an
individual or institutional investor
NAV= Pm−L
no.of shares
Pm = Market value of the Portfolio L =
Liability
AMF manage 2 types of RICs:
1.
Once the trading day ends, NAV will be the same for all
regardless of the net shares added or deducted because
new investments and withdrawals are valued at the endof-day NAV.
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Investment Banks
Assist entities in raising money to fund their
initiatives.
Corporations
●
Financial Corporations
Include depository institutions,
investment banks, asset
management companies and
insurance companies.
●
Non-financial Corporations
Issue financial instruments to raise
funds for their business
requirements and trade financial
instruments in the money market or
capital market as investment in
case they have excess funds. Ex.
Toyota Financial Services and
Puregold Finance, Inc.
Assist potential investors by serving as the dealer or
broker of transactions in the secondary market.
Activities that an investment bank can offer:
a. Public offering of securities
b. Private placement of Securities
c. Trading of securities
d. Advisory services for mergers, acquisitions
and financial restructuring
e.
Merchant banking
f.
Securities Finance and Prime
Brokerage Service
4.
g.
Asset Management
h.
Research
Supranational institutions Refer to an
international entity formed by two or
more central governments via
international treaties.
Finance Companies
Raise their funds through issuing stocks and bonds or
selling commercial papers.
They then lend out the funds to individual consumers
and small businesses.
Other Participants
1.
Household Sector
Composed of individuals and families,
including families serving charitable,
religious and non-profit organizations.
Also includes unincorporated businesses
(retailers, farmers, and professional
partnerships)
2.
3.
Government
Regulating all participants in the market in
general.
Foreign Sector
Consist of all entities, individuals, assets
and organizations that are situated outside
of the jurisdiction of a certain country.
5.
Non-profit organizations
Businesses that exist to respond to specific
causes like humanitarian aid, socio-civic
purposes, environment, arts and many more.
CHAPTER 3- FINANCIAL REGULATION AND THE
CENTRAL BANK
World bank sets regulatory measurement to access certain
risks and social factors:
a. Systemic Risk - probability of a firm to fail its
objective that will result to ripple effect
b. Consumer protection - policies enforced assumes the
effect of the consumers’ welfare
c. Efficiency enhancement - ensure the dynamism and
agility of the policy to adopt in a fast-changing
environment
Ph: National Government Agencies
(NGAs),
Local Government Units (LGUs), and
Government-Owned and Controlled
Corporations (GOCs).
Financial Regulation
Rules and standards were set to oversight the ability of the
companies to establish and maintain an appropriate level of
capital to sustain its operation.
They raise fund through Bureau of Treasury
Market Drivers Regulated
1. Competitiveness
Corporate Sector/Non-Financial
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The main determinants of competition are the main
forces that drives the market --- buyers and sellers
Firms in the financial market must be able to
understand how to respond and maximize their
leverage in the industry and compete.
Investors explore for those which can offer with the
less risk with favorable returns.
2.
Market Behavior
Behavior can be demonstrated on their
a. Integrity on their activities
b. Integrity on their representation
Regulation sets parameters to ensure that firms will
comply with certain standards to ensure the integrity
of the firms and level the playing field.
The government sets:
● Full disclosure of information
● Prohibition on insider trading
● Control of new players
● Setting minimum capital requirement
● Minimum governance rules
3.
Consistency
Demonstrated to the market’s information disclosure
and policies. The firm must enable themselves to
ensure that they provide sufficient information to
their customers.
Regulators of Financial Activities
Financial Activities
Activities that deals on funding certain transaction or
expenditures.
Financial Activity Regulation
Setting rules to set standards, control and order on the
financial activities
In the Philippines, financial regulation is observed by:
Bangko Sentral ng Pilipinas (BSP)
Created under the New Central Bank Act or Republic Act
7653 and an attached agency of the Department of Finance.
Acts as the central monetary authority which will act as a
corporate body that is responsible concerning money, banking
and credit.
Functions of BSP:
● Liquidity Management
Formulates and issues monetary policy aimed at
influencing money supply in order to maintain price
stability.
●
Currency Issue
Issue notes and coins representing the national
currency of the Philippines
●
Lender of last resort
Acts as the provider of discounts, advances and
financial support to financial institution for them to
maintain liquidity
●
Financial supervision
Supervises the financial institutions and is
empowered to exercise regulatory powers over
nonbank institutions conducting quasi-banking
functions
●
Management of foreign currency reserves
Ensures that sufficient international reserves will be
available on time
●
Determination of exchange rate policy
Sets the policy that will determine the rate of
exchange of Philippine Peso over different currency
●
Other activities as a banker, financial advisor and
official depository of the Government and its
instrumentalities.
Information - vital asset in financial markets
Government role:
Set standards to ensure that the information provided
in the market are fair, consistent and conservative.
4.
Stability
External and fatal factor to be considered by the
firms in the financial market.
The regulation must be able to protect the interest of
the clients as well as the companies to enable their
corporate sustainability.
Systemic instability - threat whereby it arises where a
segment or firm was not able to meet its commitment
because of their failure to address the risks of the
market.
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BSP shall be governed by the Monetary Board
Monetary Board
- Composed of 7 members; Governor of the BSP, 1
member of the cabinet designated by the President, 5
members coming from the private sector.
The Governor/CEO is supported by four sectors/functions
1. Financial Supervision Sector
2. Monetary and Economics Sector
3. Currency Management Sector
4. Corporate Services Group
Insurance Commission (IC)
Mandated by virtue of Executive Order No. 192 s. 2015 to
ensure enforcement of the Insurance Code or Republic Act
10607
Governed by Department of Finance
IC issues licenses to insurance agents, general agents, resident
agents, underwriters, brokers, adjusters and actuaries.
Functions of IC:
1. Promulgation and implementation of policies, rules
and regulations governing the operations of entities
engaged in insurance, pre-need and HMO Activities
as well as benevolent features.
2. Licensing of insurance, reinsurance companies, its
intermediaries, mutual benefit associations, trusts for
charitable uses, pre-need companies, pre-need
intermediaries, and HMO companies
3. Conducting insurance agent’s examinations, as well
as processing of reinsurance treaties and request for
investments of insurance companies
4. Examination/verification of the financial condition
and methods of doing business of entities engaged in
insurance business, pre-need, mutual benefit
associations, trust for charitable uses, and HMO
companies.
5. Evaluation and preparation of statistical reports,
studies, researches, annual reports, and position
papers relative to insurance, pre-need matters, and
HMO matters.
6. Review of premium rates imposed by life and nonlife
companies, mutual benefit associations; statistical
reports of adjusters to determine compliance with
established standards.
7. Adjudication of claims and complaints involving
loss, damage or liability incurred by an insurer under
any kind of policy or contract of insurance or
suretyship
8. Review and approval of all life and non-life policies,
pre-need and HMO plans before sale to prospective
clients
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Philippine Securities and Exchange Commission (SEC)
Created on October 26, 1936 under the Commonwealth Act
No. 83
National government regulatory agency to administer
oversight on the corporate sector, capital market participants
and securities and investment instrument and promote
corporate governance over these.
Responsibilities of SEC under the Republic Act 8799 or the
Securities Regulation Code:
1. Have jurisdiction and supervision over all
corporations, partnerships or associations who are the
grantees of primary franchises and/or a license or
permit issued by the Government;
2. Formulate policies and recommendations on issues
concerning the securities market, advise Congress
and other government agencies on all aspects of the
securities market and propose legislation and
amendments thereto;
3. Approve, reject, suspend, revoke or require the
activities of persons to ensure compliance;
4. Regulate, investigate or supervise the activities of
persons to ensure compliance;
5. Supervise, monitor, suspend or take over the
activities of exchanges, clearing agencies and other
SROs;
6. Impose sanctions for the violation of laws and the
rules, regulations and orders issued pursuant thereto;
7. Prepare, approve, amend or repeal rules, regulations
and orders, and issue opinions and provide guidance
on and supervise compliance with such rules,
regulations and orders;
8. Enlist the aid and support of and/or deputize any and
all enforcement agencies of the Government, civil or
military as well as any private institution,
corporation, firm, association or person in the
implementation of its powers and functions under
this Code;
9. Issue cease and desist orders to prevent fraud or
injury to the investing public;
10. Punish for contempt of the SEC, both direct and
indirect, in accordance with the pertinent provisions
and penalties prescribed by the Rules of Court;
11. Compel the officers of any registered corporation or
association to call meetings of stockholders or
members thereof under its supervision;
12. Issue subpoena duces tecum and summon witnesses
to appear in any proceedings of the COmmission
and in appropriate cases, order the examination,
search and seizure of all documents, papers, files and
record, tax returns, and books of accounts of any
entity or person under investigation as may be
necessary for the proper disposition of the cases
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before it, subject to the provisions of existing laws;
13. Suspend, or revoke, after proper notice of hearing the
franchise or certificate of registration of corporations,
partnerships, or associations, upon any of the grounds
provided by law; and
14. Exercise such other powers as may be provided by
law as well as those which may be implied from, or
which are necessary or incidental to the carrying out
of, the express powers granted the SEC to achieve the
objectives and purposes of these laws.
Board of Investments (BOI)
Lead agency to promote investment in the country and thereby
generate local and foreign investment in the country An
attached agency of the Department of Trade and Industry
BOI provides the following services:
● Providing information for the knowledge-based
research
● Incentivize the investors through the provision of tax
holidays, tax and duty exemption of imported capital
equipment, etc.
● Participate through policy advocacy initiatives to
ensure that the laws and regulation are investment
friendly.
Money Supply and Payment System
Financial System
An interrelated financial process by which is fueled by money
Money Supply
Availability of financial resources for deployment in the
financial system
Money will take the form of the following:
● Cash (bills and coins)
● Demand deposits
● Other financial instruments
For a monetary policy to be effective, the BSP must ensure
the following:
● Alignment to the target goals
● Access to information
● Responsiveness of the variable set
Regulation of Circulation of Notes
BSP has the sole power to issue currency, within the territory
of the Philippines.
Chapter 4 of BSP Circular No. 829 series 2014 amending the
consolidated rules and regulations on currency notes and coins
issued in the Philippines…
For notes:
● Banks shall classify their cash deposits and sorted by
series and by denomination. They should classify it
according to:
1. Clean or fit notes
2. Dirty of unfit notes
● Banks shall provide securely sealed bags separately
for the clear or fit notes, and for the dirty or unfit
notes. It must be labelled “UNFIT”
● Handling of deposits, banks’ deposits shall be packed
in sealed bags in standard quantity of twento full
bundles per denomination. Each bundle containing
1,000 notes in equal 10 straps.
● Banks located in the provinces may make direct
deposits of currency notes with the nearest BSP
regional office. For those without regional office,
they may arrange it with their respective head offices
to be shipped to BSP in Quezon City.
● Banks shall incorporate measures on the
implementation thereof in their compliance program
For coins:
● Coins shall be free from adhesive tapes
● Coins shall be sorted into fit, unfit or mutilated per
denomination and per series Currency note is unfit
when:
● It contains heavy crinkles which break the fiber of
the paper and indicate that disintegration of the note
has begun
● It is badly soiled with writing even if it has proper
life or sizing
● It presents a limp or rag-like appearance and it cannot
sustain its upright position when help at the
midportion of one of the shorter borders
Currency coin is unfit when:
● It is bent or twisted out of shape or defaced, but its
genuineness and denomination can still be readily
and clearly determined
● It has been considerable reduced in weight by natural
abrasion/wear and tear
8 countries using Peso as a currency:
Argentina. Chile, Colombia, Cuba, Dominican Republic,
Mexico, and the Philippines
Purchasing Power
Based on the Consumer Price Index
Consumer Price Index
Weighted average of the basket of prices of all commodities
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●
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●
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Commodity group:
Food and non-alcoholic beverages; Alcoholic beverages and
tobacco; Clothings and footwear; Housing, utilities and other
fuels; Furnishings and maintenance costs; Health; Transport;
Communication; Recreation and culture; Education;
Restaurant and miscellaneous.
Inflation rate
Degree of the movement of CPI from a period to another
CPI 1
Inflation=
(
3.
)−1}x100% CPI 0
CPI1 = Current price index
CPI0 = Base price index
Inflation
A driver of the financing costs
BSP - controls inflation and enable continuous flow of funds
in the marker
PSA - determines the current inflation based on the current
movement of the commodities set as index in the market
2 types of inflation:
1. Core inflation - excludes in the equation the
movement of the commodities or incidents with very
volatile movement
2. Headline inflation - captures the change of the cost of
living based on the movement of the basket of
commodities as a whole
Payment System
Set of interrelated processes of settlement of goods and
services rendered in exchange for a set of instruments
Characteristics for an Effective Payment System
1. Standard methods of Transmitting Payment
Conventional way of transmitting is the literal arm's
length exchange of transaction
It is a challenge for those located in a remote location
2.
Electronic banking or e-banking system enables
settlement to be made through fund transfer, online
payment or special requests from the bank made
virtually.
Agreed means of settlement Normal means of
settlement includes:
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Cash or cheque payment
Online payment
Automated Teller Machine
Fund Transfer
Credit cards
Debt Cards and Store Calue Cards
Electronic Money
Manual Money transfer
Paybox System
Cash deposit
Assignment
Common operating procedures and rules These
agreements are normally provided by the
payment system facility to provide guidelines and
protection for both parties in case of breach
Importance of Payment System
1. Safe and Real Time Transactions Payment systems
are deemed safe given that the characteristics are
mutually agreed by the parties, including the manner
of payment
Real time are normally applicable for
electronic/internet-based system, but can also be
applicable to manual payment system.
2.
3.
Effective Risk Management
Facilitates Financial Market Transactions
CHAPTER 4 - MONEY MARKET & RELATED
FINANCIAL INSTRUMENTS
Financial Instruments
- Are basically intangible assets as future economic
benefit takes form of a claim to cash that will be
received in the future.
- Are the main vehicle used for transactions in the
financial market
Two parties involved in a financial instrument:
1. Issuer
Party that issues the financial instrument and
agrees to make future cash payments to the
investor Needs additional funds for investment
2.
Investor
Party that receives and owns the financial instrument
and bears the right to receive payments to be made
by the investor
Have surplus funds
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Two main economic purposes of Financial Instruments:
1. Allows transfer of funds from entities with excess
funds (investors) to entities who need funds (issuer)
for business purposes.
2. 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.
Money Market
Where short-term and highly liquid financial instruments are
being traded
Characteristics of Money market securities:
1. Usually sold in large denominations
2. Low default risk
3. Mature in one year or less from the original issue
date. Most money market instruments mature in less
than 4 months
Money markets offer a least expensive alternative for fund
demanders such as the government and financial
intermediaries when they have short term fund requirements.
Participants in the money market:
● Bureau of Treasury - sells government securities to
raise funds
● Commercial banks - primary issuer of negotiable
certificates of deposits, banker’s acceptances and
repurchase agreements
● Private Individual - made their investment through
money market mutual fund
● Commercial Non-Financial Institutions - buy and
sells money market securities to manage their cash
● Investment Companies - trade securities on behalf of
their clients. 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 - raise money
market instruments to lend funds to individual
borrowers
● Insurance companies - invest on money market to
maintain liquidity level in case of unexpected
demands
● Pension funds - maintain funds as preparation for
long-term investing in stocks and bonds market
● Money market mutual funds - permit small investors
to invest in the money market
Types of Money Market Financial Instruments
Treasury Bills
Government securities issued by the Bureau of Treasury
which mature in less than a year.
3 tenors of treasury bills:
1.
2.
3.
91 day
182-day
364-day
Treasury bills are quoted either by their yield rate, which is
the discount, or by their price based on 100 points per unit.
Cash Management Bills - those that mature in less than 91
days
Treasury bills have virtually zero default risk since the
government can always print more money that they can use to
redeem these securities at maturity.
Market for Treasury bills:
1. Deep - market has numerous different buyers and
sellers
2. Liquid - securities can be quickly traded at low
transactions costs
Government securities
- safest investment instrument in the market
- Backed by the full taxing power of the government,
making them default risk-free
- Marketable and highly liquid
- Can be traded easily in the secondary market
Interest rate is not explicitly stated in the Treasury bill
Treasury bills are issued at a discount (lower price than the
par value at maturity)
2 methods of selling T-Bills:
1. Auctions or Competitive bidding
Bureau of Treasury announces quantity and type of
securities that they will sell
Interested parties give bid offering
Treasury accepts highest bids
Treasury accepts the bids in ascending order of yield
until the accepted bids reach the offering amount
Each accepted bid is awarded at the highest yield
paid to any accepted bid
2.
Noncompetitive bidding
Bidders give the amount of securities
Treasury accepts all noncompetitive bids The price
for all the securities under is set at the highest yield
paid to any accepted competitive bid
Noncompetitive bidders still pay the same price
that are paid out by competitive bidders
*difference: Competitive bidders may not receive allocation
from the securities being sold, while Noncompetitive bidders
are guaranteed to receive the securities.
Discount Rate
The discount rate indicates how much return, in %, they can
get from a particular security.
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Annualized Discount Rate=Bv−Bp x 360
Bp
D
Bv = Face Value or Market Value
Bp = Purchase price
D = tenor or period in days
Interest rates of CDs are based on the outcome of the
negotiation between the depositor and the bank. It is usually at
the same level with other money market securities since it
carries a low level of risk.
Investment Rate
Addresses two weaknesses of discount rate; the use of face
amount as the denominator; the use of 360 days to annualize
the return which also understates the return.
Annualized Investment Rate= Bv−Bp x 365
Bp
M
Bv = Face Value or Market Value
Bp = Purchase price
M = number of days to maturity
Repurchase Agreement (repo)
A financial contract involving two securities transactions
a. Sale/purchase of a debt security on a near date
b. Reversing sale/purchase of the same or equivalent
security on a future date
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 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.
Repos are collateralized loans, usually treated as low-risk
investments with low interest rates
Negotiable Certificates of Deposit
Securities issued by banks which records a deposit made. The
certificate indicates the interest rate and the maturity date of
the deposit.
Essentially restricts holders from withdrawing funds on
demand.
The concept of CD is that investors are willing to accept a
higher return in exchange of having no access to liquidity.
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Classified as a bearer instrument (whoever possesses the
instrument upon maturity will receive the principal and
interest)
Long-term Negotiable Certificates of Deposits(LTNCD)
Refers to the interest bearing negotiable COD with a
minimum maturity of 5 years. Offers a higher return
compared to regular time deposit account because of the long
period that depositors be unable to withdraw the money.
Commercial Paper
Unsecured promissory notes
May be:
a. Short-term - maturity of 365 days or less
b. Long-term - maturity of more than 365 days
Only large and creditworthy corporations can issue this
security. Lenders will not accept commercial papers from
small companies since they are going to assume a high level
of risk.
Issued directly to the buyer and usually, there is no secondary
market for commercial papers.
Nonbank corporations like financing companies usually issue
commercial papers and use the proceeds to fund loans that
they extend to their clients.
Issuers maintain line of credit
- To serve as backup for a commercial paper
- Primarily for the benefit of the issuer
- The availability of line of credit reduces the risk
associated with commercial papers, hence, reduces
the interest rate
Commercial papers may either have a stated interest rate on
its face or sold at a discounted basis
In PH, commercial papers are not required to register with
SEC if they meet the ff requirements:
● 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
An order to pay a specified amount of money to the bearer on
a specified date.
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Used to finance the purchase of goods that have not yet been
transferred from the seller to the buyer.
1.
2.
3.
Risk Taker
Risk Averse
Risk Neutral
Usually offered to importers and exporters
Formed when a draft or promise to pay is made by the bank’s
client and the bank then ultimately accepts, promising to pay
on behalf of the client.
Banker’s acceptances are usually sold at a discount.
Theories Related in Setting Interest Rates
According to Fabozzi and Drake:
1. Loanable Funds Theory
It is ideal to supply funds when the interests are high
and vice versa
Introduced by: Knut Wicksell in1900s
Interest rates on banker’s acceptances are usually low since
2.
default risk is very minimal
Evaluating Money Market Securities
May be evaluated based one:
a. Interest rates
Dictate the potential return that can be received from
the investment.
b.
Liquidity
Refers to how quick, efficient and cheap to convert a
security into cash.
T-Bills, that have a ready secondary market, are more
liquid than Commercial Papers
Valuation of Money Market Securities
Determines at what amount an investor is willing to pay in
exchange for a security
Liquidity Preference Theory
Interest rates are dependent on the preference of the
household whether they hold or use it for investment
Introduced by: John Maynard Keynes
Interest Rates
- A type of price
- Compensate for the risk of allowing the finances to
flow into the financial system
For lenders: lending rate or return
For borrowers: Cost of debt
Theories that affect the term structure of Interest rate
● Expectation Theories
Interest rates are driven by the expectation of the
lender or borrower in the risks of the market in the
future
1.
Pure Expectations Theory
- Based on the current data and
statistical analysis to project the
behavior of the market in the future
- Relies on forward rates/future
interest rates
- Shall be based on the strong
estimates based on the uncertainty
of the future
2.
Biased Expectations Theory
- There are other factors that affect
the term structure of the loans
- Forward rates will be affected if
the liquidity of the borrower will
be weaker or stronger in the future
Money market securities can be valued using the present value
approach
Sb
Market SecurityValue=
n
(1+I)❑
Sb = Face value of the security
I = Interest rate
N = Number of periods
As a general rule, as the interest rate rises, the value of the
security becomes lower. This means that the market risk
increases, thus the impact on the value of the securities also
reduces.
CHAPTER 5 - MANAGING THE CREDIT RISK OF
THE FINANCIAL INSTRUMENT
Credit Risk - borrower was not able to repay its obligation
Default Risk - you are not able to repay your obligation
➢Liquidity Theory
Liquidity Premium
Increase on interest rates
Increases as maturity lengthens
3 types of Risk Appetite:
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➢Preferred Habitat Theory
Considers liquidity & risk premium but
disregarding the consensus of the market on
future interest rates
1.
2.
3.
Habitat = Biased estimate/Market behavior
in the future
4.
●
Market Segmentation Theory
- Driver of interest rates are the savings and
investment flows
- Maturities are segmented depending on how
the assets and liabilities were managed as
well as the lenders on how they extend
financing
2.
(
i=
i = interest rate I = periodic
interest payments
V = par value of bonds M
= market value of bonds n
= term of bonds
Risk
-
Drives the business up or down
Relates to volatility of return pattern sin the business
1.
Default Risk
- Arise on the inability to make payments
consistently
- May be quantified by determining the
probability of the borrower to default in
their payments in the duration of the loan
2.
Liquidity Risk
- Identified by ensuring the business to be
capable of meeting all its currently maturing
obligation
- Risk is quantified by determining the
opportunity cost of the lender on the period
within which the borrowers were able to
recoup
3.
Legal Risk
- Dependent on the covenants set and agreed
in between the lenders & borrowers
BSP cannot set the real interest rate because it cannot
set the inflation expectations
PDS Group
- Organized market that was formed out of
financial distress in 1997
- Provides full financial service from trading
to clearing and settlement
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x100%
V +M
2
i=( Rf+Dm)
Risk-free rate
The rate that assumes zero default in the market
where this is more or less equivalent to the rates
offered by the sovereign Riskfree rate can be:
a. Real - excludes the effect of inflation or
exclusion of the effect of PPP
b. Nominal - risk-free adjusted for inflation
)
n
By the function of the risk and the compensation of
the investor
i = interest
Rf= risk free rate where (Real risk free rate
= Rf-inflation
Dm = debt margin or debt spread or the risk
premium
By the function of the market value, par value and
the interest paid by debt securities or bonds
I+ V −M
Determination of Interest Rate
The following should be considered assuming the cash flows
have already been established:
● Interest rates in the industry
● Risk exposure
● Compensation on the market expectation
1.
Composed of:
Philippine Dealing and Exchange Corp.
(PDEx) - trading services arm
Philippine Depository and Trust Corp
(PDTC) - securities services
Philippine Securities Settlement Corp
(PSSC) - payments and transfer services
PDS Academy for Market Development
Corp (PDSA) - training center
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4.
Will arise upon the ability of any of the
parties to comply with the covenants of the
contract
- Common defaults in the covenants:
● Maintaining the financial ratios
● Significant acquisition or disposal
of assets
● Repayment of other obligation
● Declaration of dividends of any
form without the consent of the
lenders
Market Risk
- Impact of the market drivers to the ability of
the borrowers to settle the obligation
- Most difficult to quantify
- Classified as a Systemic Risk
● Because it arises from external
forces or based on the movement
of the industry
Mitigating the Interest Rate Risk
1.
2.
3.
Spot Rates
- Interest rate or yield available for a
particular time
- Actual rates and are not hedge
- The applicable interest rate is based on the
prevailing market rate at the particular time
- Will be used to mitigate the risk by referring
to historical yield vis-a-vis the forces that
occur in those times
Forward Rates or Hedge Rates
- 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
-
Calculated using the Intercontinental
Exchange (ICE)
Swap rate yield curve
- Correlation of the swap rate and the maturity
rate
- Useful for countries as reference for the
credit risks and for future decisions
Credit Ratings
- Affects the confidence level of the investors to
countries or companies
- Determined by companies that are recognized
globally that objectively assigns or evaluates
countries & companies based on the riskiness of
doing business with them
- Driven by their ability to manage their liquidity and
solvency in the long run - Higher grade, Lower
default risk
3 major rating companies:
1. Standard & Poor’s Corporation
American financial services corporation
Founded in 1941 by Henry Varnum Poor in New
York, US
Uses data gathered from 128 countries using more
than 1,500 credit analysts to asses the
creditworthiness to the industry
Categorized to Investment Grade and NonInvestment Grade and scaled from AAA to D
2.
Moody’s Investors Service
Particularly on debt securities
Established in1909 in New York, USA
Lenders - would like a more conservative rate
Borrowers - Aggressive or lower as much as possible
versus the expected spot rate in the future
Gathers information from more than 130 countries,
more than 4,000 non-financial corporate issues and
more than 4,000 financial institutions
Swap Rate
- Another contract rate where a fixed rate
exchange for a certain market rate at a
certain maturity
- The one used as reference is the LIBOR
(London Interbank Offered Rate. For the
swap rate, it is normally the fixed portion of
a currency swap
Employs more than 13,000 across the whole world
London Interbank Offered Rate (LIBOR)
- Used to benchmark interest rates which is
used as reference for international banks to
borrow
Scale: AAA to C
3.
Fitch Ratings
Founded in 1914 in New York, USA
Owned by Hearst - a global information and services
company
Provides credit opinions based on the credit
expectations based on certain quantitative and
qualitative factors that drive a company, they asses
based on the credit analysis and intensive research
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Conducts their assessment over more than 8,000
entities with 25 different currencies
Scale: AAA to D
Other Rating Agencies:
1. DBRS
● Established in 1976 in Toronto, Canada
● Fourth largest ratings agency
● Observes almost 50,000 securities
worldwide
● Has offices in New York, Chicago, London,
Frankfurt and Madrid
● Scale: AAA to C
2.
CARE Ratings
● Started in 1993 based in India
● Based in Mumbai with parties in Brazil,
Portugal, Malaysia and South Africa ●
Scale: AAA to D
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