UNIVERSITY OF MINDANAO
College of Accounting Education
Program: BSA, BSIA, BSMA, BSAIS
Physically Distanced but Academically Engaged
Self-Instructional Manual (SIM) for
Self-Directed Learning (SDL)
Course/Subject: ACC 212 – FINANACIAL MARKETS
Name of Author: QUEENIE P. TENEDERO, CPA
KHEN O. ENRIQIEZ, MBA, CPA
THIS SIM/SDL MANUAL IS A DRAFT VERSION ONLY; NOT
FOR REPRODUCTION AND DISTRIBUTION OUTSIDE OF
ITS INTENDED USE. THIS IS INTENDED ONLY FOR THE
USE OF THE STUDENTS WHO ARE OFFICIALLY
ENROLLED IN THE COURSE/SUBJECT.
EXPECT REVISIONS OF THE MANUAL.
THIS IS NOT FOR COMMERCIAL USE.
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
TABLE OF CONTENTS
COURSE OUTLINE: 212
COURSE OUTLINE
COURSE INFORMATION
Big Picture: ULO a – d
Big Picture in Focus: ULO a
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO b
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO c
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO d
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Q & A List
Keyword Index ULOs a – d
Course Schedule
Big Picture: ULO e – g
Big Picture in Focus: ULO e
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO f
i
i
v
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9
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College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO g
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
In a Nutshell
Q & A List
Keyword Index ULOs e – g
Course Schedule
Big Picture: ULO h – m
Big Picture in Focus: ULO h-i
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO j-k
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO l
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
In a Nutshell
Big Picture in Focus: ULO m
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Q & A List
Keyword Index ULOs h - m
Course Schedule
Big Picture: ULO n – p
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116
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Big Picture in Focus: ULO n – o
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
Let’s Analyze
In a Nutshell
Big Picture in Focus: ULO p
Metalanguage
Essential Knowledge
Self-Help
Let’s Check
In a Nutshell
Q & A List
Keyword Index ULOs n – o
Course Schedule
Online Code of Conduct
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College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Course Outline: ACC212 – FINANCIAL MARKETS
Course Coordinator:
Email:
Student Consultation:
Mobile:
Phone:
Effectivity Date:
Mode of Delivery:
Time Frame:
Student Workload:
Requisites:
Credit:
Attendance Requirements:
Queenie P. Tenedero/Khen O. Enriquez
qtenedero@umindanao.edu.ph
By appointment
+63945-1065-168
c/o UM CAE 305-0645
June 2020
Blended (On-Line with face to face or virtual
sessions)
54 Hours
Expected Self-Directed Learning
None
3
A minimum of 95% attendance is required at all
scheduled Virtual or face to face sessions.
Course Outline Policy
Area of Concern
Contact and NonContact Hours
Details
This 3-unit course self-instructional manual is designed for
blended learning mode of instructional delivery with scheduled
face-to-face or virtual sessions. The expected number of hours
will be 54 including the face-to-face or virtual sessions. The
face-to-face sessions shall include the summative assessment
tasks (examinations) since this course is crucial in the CPA
licensure examination (CPALE).
Assessment Task
Submission
Submission of assessment tasks shall be on 3rd, 5th,7th and 9th
week of the term. The assessment paper shall be attached with
a cover page indicating the title of the assessment task (if the
task is performance), the name of the course coordinator,
date of submission and name of the student. The document
should be emailed to the course coordinator. It is also expected
that you already paid your tuition and other fees before the
submission of the assessment task.
If the assessment task is done in real time through the features
in the Blackboard Learning Management System, the schedule
shall be arranged ahead of time by the course coordinator.
Since this course is included in the licensure examination for
teachers, you will be required to take the Multiple-Choice
Question exam inside the University. This should be scheduled
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College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
ahead of time by your course coordinator. This is nonnegotiable for all licensure-based programs.
Turnitin Submission (if
necessary)
To ensure honesty and authenticity, all assessment tasks are
required to be submitted through Turnitin with a maximum
similarity index of 30% allowed. This means that if your paper
goes beyond 30%, the students will either redo her/his paper
or explain in writing addressed to the course coordinator the
reasons for the similarity. In addition, if the paper has reached
more than 30% similarity index, the student may be called for
a disciplinary action in accordance with the University’s OPM
on Intellectual and Academic Honesty.
Please note that academic dishonesty such as cheating and
commissioning other students or people to complete the task
for you have severe punishments (reprimand, warning,
expulsion).
Penalties for Late
Assignments/Assessm
ents
The score for an assessment item submitted after the
designated time on the due date, without an approved
extension of time, will be reduced by 5% of the possible
maximum score for that assessment item for each day or part
day that the assessment item is late.
However, if the late submission of assessment paper has a
valid reason, a letter of explanation should be submitted and
approved by the course coordinator. If necessary, you will also
be required to present/attach evidences.
Return of
Assignments/Assessm
ents
Assessment tasks will be returned to you two (2) weeks after
the submission. This will be returned by email or via
Blackboard portal.
For group assessment tasks, the course coordinator will
require some or few of the students for online or virtual
sessions to ask clarificatory questions to validate the originality
of the assessment task submitted and to ensure that all the
group members are involved.
Assignment
Resubmission
You should request in writing addressed to the course
coordinator his/her intention to resubmit an assessment task.
The resubmission is premised on the student’s failure to
comply with the similarity index and other reasonable grounds
such as academic literacy standards or other reasonable
circumstances e.g. illness, accidents financial constraints.
ii
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Re-marking of
Assessment Papers
and Appeal
You should request in writing addressed to the program
coordinator your intention to appeal or contest the score
given to an assessment task. The letter should explicitly
explain the reasons/points to contest the grade. The program
coordinator shall communicate with the students on the
approval and disapproval of the request.
If disapproved by the course coordinator, you can elevate
your case to the program head or the dean with the original
letter of request. The final decision will come from the dean of
the college.
Grading System
All culled from BlackBoard sessions and traditional contact:
Course Discussion/Exercises – 40%
1st formative assessment
– 10%
nd
2 formative assessment
– 10%
3rd formative assessment
– 10%
All culled from on-campus/on-site sessions (to be
announced):
Final Exam (summative assessment) – 30%
Submission of the final grades shall follow the usual
University system and procedures.
Preferred Referencing
Style
Student
Communication
Harvard Referencing Style
You are required to create a umindanao email account which
is a requirement to access the BlackBoard portal. Then, the
course coordinator shall enroll the students to have access to
the materials and resources of the course. All communication
formats: chat, submission of assessment tasks, requests etc.
shall be through the portal and other university recognized
platforms.
You can also meet the course coordinator in person through
the scheduled face-to-face sessions to raise your issues and
concerns.
For students who have not created their student email, please
contact the course coordinator or program head.
Contact Details of the
Dean
Contact Details of the
Program Head
Lord Eddie I. Aguilar
Email: aguilar_lordeddie@umindanao.edu.ph
Phone: (082) 3050645 local 137
Mary Grace S. Sombilon
Email: sombilon_marygrace@umindanao.edu.ph
iii
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Phone: (082) 3050645 local 137
Jade D. Solaña
(BSA, BSMA)
Email: jd_solano@umindanao.edu.ph
Phone: (082) 3050645 local 137
Devzon U. Porras
(BSIA, BSAIS)
Email: dporras@umindanao.edu.ph
Phone: (082) 3050645 local 137
Student with Special
Needs
Students with special needs shall communicate with the
course coordinator about the nature of his or her special needs.
Depending on the nature of the need, the course coordinator
with the approval of the program coordinator may provide
alternative assessment tasks or extension of the deadline of
submission of assessment tasks. However, the alternative
assessment tasks should still be in the service of achieving the
desired course learning outcomes.
Online Tutorial
Through LMS or PM Chats
Library and Information
Center (LIC) Resource
Brigida E. Bacani
Email: library@umindanao.edu.ph
09513766681
for inquiries, you can email
at umlic.eresources@gmail.com, raphael_digal@umindanao.
edu.ph or
chat with us here http://library.umindanao.edu.ph/
Facebook page: https://www.facebook.com/UM-Learningand-Information-Center-Davao-City-962331877193048/
Well-Being Welfare
Support Help Desk
Ronadora E. Deala
Email: Ronadora_deala@umindanao.edu.ph
09212122846
GSTC Facilitator
Zerdszen P. Rañises
Emai: gstcmain@umindanao.edu.ph
09058924090
GSTC Facebook Page:
https://facebook.com/UM-GSTC-Main-CAE111901303784349/?modal=admin_todo_tour
iv
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Course Information – see/download course syllabus in the Black Board LMS
CC’s Voice: Greetings, future accountants! Welcome to ACC 212 – Financial
Markets. This is your preparation for Financial Management and
Management accounting, and of course, future endeavors related
to finance soon. Hopefully, after this course, you may be able to
appreciate investing and may this help you step up financially.
CO
This course discusses the role of financial markets and institutions. It
deals with the study of the flow of funds across financial markets,
interest rates, and security prices. This course explains how various
factors influence interest rates and how interest rate and other factors
in turn affect the values of securities purchased by financial
institutions, how government instrumentalities affect financial
activities, and how market participants can more accurately value
securities and make more effective investment and financing
decisions. Emphasis is given on the stock investment valuation and
trading using the different technical and fundamental analytical tools.
Let us begin!
v
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Big Picture
Week 1-3: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to
a. Rationalize financial markets and institutions, and the different types of
markets under financial market’s umbrella.
b. Analyze the concepts of interest rates and what are the factors that affect
it.
c. Explain the distinction between different kinds of interests as return, and
apply; with the concept of time value of money in valuing securities
d. Evaluate the stock market, and how stocks are being traded
Big Picture in Focus: ULOa. a. Rationalize financial markets
and institutions, and the different types of markets under
financial market’s umbrella
Metalanguage
The goal in this section is to understand what financial markets and
institutions are and get acquainted with the different types of markets according
to different categories. Accordingly, we have to have a jump start with the terms
that we are going encounter in this section.
a. Financial Markets – place where funds supplied and demanded flow
b. Primary Markets – securities are traded here directly to the suppliers of
funds
c. Secondary Markets – where bought securities are resold to other
investors
d. Money Markets – markets for securities with short term maturities.
e. Capital Market – markets for those securities with long term maturities
Essential Knowledge
Financial Markets are arena where funds flow. This does not necessarily
mean physical market; this can also be a virtual setting. The main goal of the players
in this undertaking is to raise funds. It is also where buying and selling of trade
commodities, and securities occur. Let us recall that commodity means any good or
service that maybe bought at a price. In financial markets, commodities here are
usually stocks, treasury bills, bonds, etc. While securities collectively is a type of
commodity with monetary value that can be traded in the financial market.
Financial markets can be distinguished as to how securities are traded –
direct or indirect, and as to how long is the maturity of a security is. The former will
be can be primary market or secondary market, and the latter can be money
market or capital market.
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College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
The tables below will help us understand the terms above.
PRIMARY MARKET AND SECONDARY MARKET
Primary Market
Secondary Market
New issues of
securities from Securities that were once sold are
companies, usually corporations, are reissued or resold are sold in this type of
traded in this market with the help of market
financial intermediaries
If
we
say,
Jollibee
Food If we say, John bought ₱100,000 worth
Corporation(JFC) issued new securities of stocks of JFC from Matthew, this is
in form of stocks to the public, this is secondary market because stocks were
primary market since the securities are sold subsequently, and not by the
newly issued.
issuing corporation.
Figure 1. Primary vs. Secondary Market
Observe the flow of funds and instruments below.
This flowchart explains how funds and securities flow in a primary market.
Observe that financial intermediary is a little blur and small because they just act as
helper of corporations who issue new stocks. They can even be removed from the
picture if corporation opt to distribute securities themself.
The investor now owns the security, e.g. JFC stocks, and is entitled to receive
dividends (income), and can later sell the said security.
Corporations
(In need of funds)
Financial Instrument
Financial Instrument
Financial
Intermediary
Funds/Money
Funds/Money
Investors
(Suppliers of
Funds)
The one example of primary market transaction is through an IPO or initial
public offering. This is when a company goes public for the first time, and their stocks
can be traded to the public (anyone). Note that subsequent issuance of stocks are
also primary market transactions so long as the securities are new.
While in a secondary market, the investor above in the 3rd box becomes the
one who needs funds and wishes to sell it to another investor, usually with the help
of a broker.
Investors
(In need of funds)
Financial Instrument
Financial Instrument
Securities
Broker
Funds/Money
7
Funds/Money
Investors
(Suppliers of
Funds)
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Financial intermediary and securities broker are examples of financial
institutions. These are entities that process monetary transactions, and are
middlemen between two parties, i.e. those in need of funds and those who supply
funds.
MONEY MARKET AND CAPITAL MARKET
Money Market
Securities with maturities of less than a
year are sold in this market.
Debt securities/instruments only
Treasury bill, six-month bonds, threemonth commercial paper
Figure 2. Money vs. Capital Market
Capital Market
Securities with maturities of more than a
year are sold in this market.
Debt securities/instruments, and equity
securities/instruments
Five-year treasury bond, shares,
securitized mortgages
For the examples, kindly refer to the first chapter of the textbook.
FINANCIAL INSTITUTIONS
In addition to the definition above, financial institutions help channel funds
from those with surplus funds to those with shortages of funds. It is important to know
the function of financial institution as one of a business student’s backbone in
understanding finance and accounting.
The following are some of the most common financial institutions:
I. Commercial banks — these are financial institutions that mainly function as
depository unit. These deposits will serve as their liability, and will then be
loaned out to the users of funds as loan. Loans are assets of a commercial
bank. This will be described further in later chapters.
II. Mutual Funds – these financial institutions gather funds from different investors
and invest them in different securities or diversified portfolio to earn at a later
date
III. Insurance companies —financial institutions whose main objective is to protect
individuals and corporations from unforeseen events such as death,
bankruptcy, etc.
For more types of financial institutions, kindly refer to your books found in the
first chapter.
Without financial intermediaries, there will only be direct transfer of funds,
one with no meddling intermediary. (Indirect transfer are illustrated above under
primary and secondary markets)
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College of Accounting Education
3F, Business & Engineering Building
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Phone No.: (082)300-5456 Local 137
Direct Transfer
Users of
funds
Financial Instrument
Funds/Money
Suppliers of
funds
Although players in the market may avoid cost on having to pay financial
intermediaries, there may be risk coupled with it. Hence, there should be a trade-off
between the risk and rewards between availing the services of financial
intermediaries or not.
The following below are risks when financial institutions collectively is not in
the picture:
Services Benefiting Suppliers of
Services Benefiting the Overall
Funds:
Economy:









Monitoring costs
Liquidity and price risk
Transaction cost
Maturity intermediation
Denomination intermediation
Money supply transmission
Credit allocation
Intergenerational wealth transfers
Payment services
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Prorokowski, L. (2013). Lessons from financial crisis contagion simulation in
europe. Studies in Economics and Finance, 30(2), 159-188. doi:
shorturl.at/CXZ27
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College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Let’s Check
Activity 1. List down two (2) examples of (1.a.-1.b.) money market instruments, and two
(2) examples of (2.a.-2.b.) capital market instruments.
1.a._____________________________________________________________
________________________________________________________________
_______________________________________________________________.
1.b._____________________________________________________________
________________________________________________________________
_______________________________________________________________.
2.a._____________________________________________________________
________________________________________________________________
_______________________________________________________________.
2.b._____________________________________________________________
________________________________________________________________
_______________________________________________________________.
List down three (2) examples of financial institutions with its brief (one sentence)
description.
1.______________________________________________________________
________________________________________________________________
________________________________________________________________
.
2.______________________________________________________________
________________________________________________________________
________________________________________________________________
.
Activity 2. Now that you are already acquainted with what financial markets, and
institutions are, let us have a brief review. Kindly answer the following questions below.
1. The following are true, except:
a.
b.
c.
d.
Anna entered a secondary market when she bought stocks from her brother.
There are no intermediaries if the transaction is a primary market transaction
Money markets include repurchase agreements.
Belle bought shares from ABC Corporation during IPO. This is a primary
transaction
2. Which is false?
a. In direct transfers, users of funds directly acquire funds from suppliers of
funds.
b. In direct transfers, suppliers of funds directly acquire financial instruments
from users of funds.
10
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
c. Presence of financial intermediary indicates direct transfer.
d. All of the above are true.
3. The following are services benefiting suppliers of funds except
a.
b.
c.
d.
Monitoring costs
Credit allocation
Transaction cost
Maturity intermediation
4. These are commodities with monetary value and are traded in the financial
market
a.
b.
c.
d.
Securities
Exchange
Money
Some other answer.
5. These are entities that process monetary transactions, and are middlemen
between two transacting parties
a.
b.
c.
d.
Financial Money
Financial Institutions
Financial Instruments
Financial Markets
Let’s Analyze
Activity 3. Indicate whether the item is a primary or a secondary market for numbers 1 to
5, and money or capital market for numbers 6 to 10.
_________1. C through D, a broker, sold his stocks to E.
_________2. After IPO, F Corporation sold additional 5,000,000 shares to the
public.
_________3. Government issued treasury bills worth ₱15,000,000.
_________4. H Corporation bonds previously issued were resold at a lower price.
_________5. I Inc. issued their stocks through IPO.
_________6. J sold his treasury bill to K.
_________7. L Bank engaged in federal fund transaction.
_________8. Mortgage was availed by M.
_________9. 5-year treasury bonds sold bought by N.
_________10. O Company entered into a repurchase agreement with P
Enterprises.
11
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Activity 4. In addition to what we discussed above, I would like you to gather
additional information and give me 3 additional financial institutions and describe
them briefly.
1.________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_____________________________________________________
2.________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
__________________________________________________________
3.________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
___________________________________________________________
In a Nutshell
Activity 6. The study of what a financial market, and institutions are, are
essential to understand finance. Based on the discussions above, kindly list
down the lessons that you have learned below. I will start and give you a head
start.
1. Financial market is crucial in today’s setting especially that we are in a fastpaced era. It helps ease the flow of funds in the economy.
2. I have understood that in a money market, securities that are short term in
nature are traded.
YOUR TURN
3. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
___________________________________________________________
4. _______________________________________________________________
_______________________________________________________________
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College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
____________________________________________________________
5. _______________________________________________________________
_______________________________________________________________
____________________________________________________________
6. _______________________________________________________________
_______________________________________________________________
____________________________________________________________
7. _______________________________________________________________
_______________________________________________________________
____________________________________________________________
8. _______________________________________________________________
_______________________________________________________________
____________________________________________________________
9. _______________________________________________________________
_______________________________________________________________
____________________________________________________________
10. _______________________________________________________________
_______________________________________________________________
____________________________________________________________
13
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Big Picture in Focus: ULOb. Analyze the concepts of interest rates and
what are the factors that affect it.
Metalanguage
To learn the concepts of interest rate as a whole and learn the factors
that affect it, let us get acquainted with the core concept of this section.
Loanable Funds Theory explains interest rates and why rates change. It
relates concepts of supply and demand for loanable funds as the underlying
factor why interests change.
Equilibrium interest rate is affected by the changes in aggregate supply of
loanable funds and aggregate demand of loanable funds.
Risks also affect nominal interest rates. The greater the risk, the greater the
interest rate.
As we discuss further, we will be able to grasp that term interest rate is very
broad.
Essential Knowledge
Understanding interest rates is an essential foundation in this subject. Interest
rates impact decision making of the players in the financial market. It signal for them,
as whether they shall take a certain action or not.
The concept of loanable funds theory will help us understand interest rates
as it theory explains interest rates and its coresponding movements. This theory
draws attention to how supply and demand for loanable funds determines the
equilibrium interest rates.
To start, let us get acquainted with nominal interest rate. This is the interest
rate without taking inflation, and coumpounding (e.g., annual, semi-annual) effect into
account. Meaning to say if you take a hold of a bond certificate, the interest that you
see on its face is what we all as nominal interest rate (see picture below).
14
College of Accounting Education
3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Figure 1. ₱10,000 Bond Certificate from Development Bank of the Philipphines
The funds provided to the financial markets by net suppliers of funds is called
supply of loanable funds. This is the amount of money that the individuals,
government, and businesses decide not to spend, i.e. save. While the demand or
loanable funds is the total net amount of demand the users of funds necessitate. I this
the level of investment in search of financing.
The general rule is, other factors held constant, there is more supply of funds
as interest rates increase. The idea behind this is that when you deposit your money
in an increasing trend of interest rate, you will get more return from this deposit
through interest income. In the same way, demand for loanable funds will decrease
because interest rates are increasing, i.e. there will be an increase in interest expense
from borrowing/using funds. In this sense, there will then be surplus funds as there is
an increase in supply but decrease in demand. Therefore, the aggregate quantity of
funds supplied is positively related to interest rates, while the aggregate quantity of
funds demanded is inversely related to interest rates.
In the illustration below(Figure 2), draw your attention to “E.” Every E is what
we call the equilibrium interest rate. This is the point where aggregate quantity of
loanable funds supplied equates with aggregate quantity of loanable funds demanded
for a financial security. In the graph on the left side, we have E and E*, i* and i**, and
Q and Q** Let us analyze, and assume amounst for this graph. Say for example, Q*
is the point where quantity demanded is ₱1,000,000, and is equal to quantity supplied
₱1,000,000 also. Let us assume that in this scenario, i* is 12%. Assuming that for the
investors, 12% is an ideal interest rate, the will supply money to the financial market
through investing, and it raised the aggregate quantity of loanable funds to
₱1,500,000. In this sense, the aggregate quantity of money supplied(SS*) will shift to
the right(demand remained at ₱1,000,000). And will create surplus funds of
₱500,000. The general effect of the shift also lower the equilibrium interest rate E*,
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let us assume E* is 9%. And as an effect this will signal investors to halt supplying
funds since 9% is lower than the ideal return.
This concept used in a country’s fiscal and monetary policy. To avoid surplus
of funds and creation of disequilibrium, government lowers advised general interest
rate. At the end of this discussion, you will have an exercise on interpretting the graph
on the right side.
Figure 2. Effect on interest rates for loanable funds
FACTORS THAT INFLUENCE SUPPLY AND DEMAND
CURVES FOR LOANABLE FUNDS TO SHIFT
It is important to note that equilibrium interest is only a temporary equilibrium
and it changes because of underlying factors. Below are some, and not all factors
that affect the curves above other factors held constant. First table pertains to supply
of loanable funds, and the next table pertains to demand of loanable funds.
Factor
Wealth
Risk
Near-term spending
needs
Impact to equilibrium interest rate
>Inverse
Increase in wealth will generally increase the supply
of loanable funds. Hence, will lower the equilibrium
interest rate.
>Direct
Increase in risk in investing will generally decrease
the supply of loanable funds. Hence, will also
increase equilibrium interest rate.
>Direct
Increase in near-term spending needs (investors will
withdraw funds or will immediately use money
earned) will decrease the supply of loanable funds.
Hence, will increase equilibrium interest rate.
Figure 3. Factors and their corresponding impact to equilibrium interest rate – Supply
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Impact to equilibrium interest rate
Factor
Purchase of asset >Direct
through utilization of
Increase in desire to buy assets will generally
borrowed funds
increase the demand of loanable funds. Hence, will
increase the equilibrium interest rate.
Terms and
>Inverse
agreements on
Increase in restrictions on borrowing will generally
nonprice conditions
decrease the demand of loanable funds. Hence, will
of borrowed funds
lower equilibrium interest rate.
Economic Condition
>Direct
Increase/Growth in economic conditions will
generally increase the demand of loanable funds.
Hence, will increase the equilibrium interest rate.
Figure 4. Factors and their corresponding impact to equilibrium interest rate – Demand
DETERMINANTS OF INTEREST RATES
Factors that impacts nominal interest rates
Inflation —the general increase prices in the market coupled with
decease in purchasing power
Real Interest Rate —the interest rate when there is no inflation
Default Risk —risk that an issuer of security will not be able to
pay interest or principal on time
Liquidity Risk —inability to convert a security to cash, or
converted but lower than forecasts
Special Provisions —terms and conditions
Term to Maturity —time until a certain security will mature
Note that if any of the factors above increases, the level of interest rates also
increases.
Inflation
Inflation can be measured using consumer price index which is provided by
the government. How to get consumer price index is beyond this subject so it shall
not be discussed anymore. However, the formula for inflation rate of IP is
Using the data provided by the government, one can compute for the inflation
rate. Example, CPI last year 195, and CPI this year is 211, the inflation rate then is
8.21% because last year’s CPI will be CPIt or the base year and CPI this year is
CPIt+1.
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Real Interest Rates
Fisher Effect explains the relationship between inflation, nominal, and real
interest rates. This rate is how the general public wishes to consume today rather
than in the future.
RIR = Nominal Interest rate – Inflation(IP)
In totality, the impact of the following factors in the box above will form the
equation
ij* = f (IP, RIR, DR Pj , LRPj , SCPj ,MPj )
That is Inflation premium plus real interest rate plus default risk premium plus
liquidity premium plus special provision or covenant premium plus maturity risk
premium.
UNBIASAED EXPECTATIONS THEORY
This theory explains the term structure of interest through time. It attempts to
forecast (approximate rate) future short-term interest rate based on current long-term
interest rates. This proposes that two different investments will earn the same amount
of interest income given the same time frame for both. For example, A bought a bond
security that will mature after two years, will earn the same amount of interest as B’s
investment if B’s investment is a one-year bond invested for two consecutive years.
Example illustration.
X bought a ₱1,000,000 bond which will mature after two years. This will earn
annual interest income of 8%, compounded annually. This means, after two
years, the investment will become ₱1,166,000 (that is ₱1,000,000 times
(1+0.08) times another (1+0.08)).
Y bought a ₱1,000,000 bond which will mature after one year, and he plans
to reinvest the proceeds for another one-year bond. The interest rate of this
bond is at 6% Unbiased expectations theory or pure expectations theory will
attempt to help us find the interest rate for the reinvestment so that income
of Y will be the same with X’s.
The textbook presented a formula for this, however, let us use another
formula that will lead to the approximate answer.
The formula to find the interest rate is
𝐼1 + 𝐼2 + 𝐼3 +. . . +𝐼𝑛
𝐼𝑥 + 𝐼2 + 𝐼3 +. . . +𝐼𝑛
=
𝑛
𝑛
In this formula, our goal is to find Ix. The equation on the left side is the for
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the long term security, while the one on the right side is the investment which interest
rate for a year will be predicted. I1 here is the interest rate on the first year, I2 for the
second year, and so on. While n is the number of years until maturity.
So, going back to the example above, let us supply the equation
8+8
6 + 𝐼𝑥
=
2
2
8 (2) = 6 + 𝑥
16 − 6 = 𝐼𝑥
𝑰𝒙 = 𝟏𝟎
Therefore, using the amounts above for checking, the return on investment
after two years is ₱1,166,000 (₱400 difference because this is only an
approximation). For additional examples, kindly refer to the exercises below.
TIME VALUE OF MONEY
Time value of money is a concept that your money today is worth more than
a money received in tomorrow. This concept is from the idea that you may invest your
money today so that it may earn interest. This topic was thoroughly discussed in
Accounting Plus, hence there is no need to repeat it. However, kindly go to
https://studyfinance.com/time-value/ to review yourself on this because this topic is
going to be as you go along with this subject.
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
19
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Let’s Check
Activity 1. Problem solving. Having been able to discuss and have examples of the
concepts above. Kindly apply the concepts and show your solution for each item.
1. You want to invest in XYZ Corporation’s stocks. It is determined that the real
interest rate is at 2.5 percent, and the real interest rate is 4 percent. With the
help of a broker, you determined that the default risk premium is at 0.75 percent,
liquidity risk premium is at 1 percent, maturity risk premium is 1.1 percent, and
there is no special covenant. Determine the interest rate on XYZ Corporation’s
stocks.
2. The equilibrium interest rate of return of Security ABC is 12%. The current
inflation rate is at 2%, and the real interest rate is at 1.5%. The security’s liquidity
premium is at 1.5% and the maturity risk premium is at 1%. This security has no
special provision risk. Determine the default risk premium.
3. Suppose that the one-year treasury bill earns 4%. And it is expected that one
year from now, one-treasury bill will have 4.5% as return. Using the concept of
unbiased expectation theory, what should be the current rate on a two-year
treasury security?
4. It was reported on the newspaper that the following are current interest rates of
a treasury bill.
One-year
4.50%
Two-year
5.00%
Three-year
5.25%
Four-year
6.00%
Using unbiased expectation theory, determine the expected one-year interest
rate during year three.
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5. Calculate the present value. Principal is ₱150,000, interest rate is at 12%, and
maturity date is after 3 years.
a. Simple interest
b. Present value of 1, compounded quarterly
c. Present value of ordinary annuity, compounded semi-annually
d. Present value of annuity due, compounded annually
Let’s Analyze
Activity 2. Kindly explain the graph in Figure 2 (b) in one paragraph.
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Activity 3. In addition to what we talk about above, let us demonstrate what we
learned about the graphs above. Illustrate in a graph these scenarios and explain
briefly what happened to the supply, and demand curve, and the equilibrium interest
rate.
a. Demand remained constant, however, the aggregate supply of loanable funds
changed due to increase in financial literacy and more people were encouraged to
save.
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b. Supply remained constant, but the aggregate demand of loanable funds changed
due to more strict terms and conditions once one opt to borrow money from any
financial institution.
In a Nutshell
The chapter goes to show that interest rate is broad but understanding he concept
will help in understanding why interest rates are different, e.g. in each type of security
with different characteristics. Just like what we did in the last section, let us reflect on
what we have learned throughout.
1. The supply and demand for loanable funds affect the equilibrium interest rate.
2. One factor that affects the equilibrium interest rate is amount wealth the investors
have, the more supply there’ll be.
YOUR TURN
3. ______________________________________________________________________
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4. ______________________________________________________________________
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5. ______________________________________________________________________
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8. ______________________________________________________________________
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9. ______________________________________________________________________
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10. ______________________________________________________________________
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Big Picture in Focus:
ULOc. Explain the distinction between different kinds of interests
as return, and apply; with the concept of time value of money
in valuing securities
Metalanguage
In this section, the end goal of this section is to learn security valuation
applying the concept of interest rates and the previous lessons on time value
of money. To start with, here are essential terms that will help us during the
whole discussion
Coupon rate – interest rate seen in the face of a bond certificate and
used to compute the amount to be paid by the user of funds(issuer
of bonds) to the supplier of funds(investor)
Required rate of return – return, in terms of percentage, that an
investor wants or requires to receive. This rate is used to calculate
the fair present value on a security, e.i. effective interest rate
Expected rate of return – return, in terms of percentage, that a investor
expects to receive after buying securities at current market price.
For decision making purposes, expected rate of return must be
greater than required rate of retun.
Realized rate of return – this rate is associated after maturity or after
selling the security purchased. The return, in terms of interes,
earned on an investment.
Essential Knowledge
It is important to note that “interest rate” is not just a number with a percentage
and it is the same in all aspects because, there are a lot of kinds of interest rates to
begin with, depending on what is analyzed as defined above.
In this chapter, we will be acquainted with the different kinds of interest and
how do we use them to value securities.
REQUIRED RATE OF RETURN
Using the required return, the goal is to get the fair present value of bonds
which means discounting the future cash flows. At this point, you should have
understood time value of money for it shall help us analyse the problems.
Example for Required Rate of Return
Anna purchased a bond, costing ₱890, three years ago, with a
current price of ₱925. This bond paid ₱100 year as interest
payments (end of each year). She wants to hold the bond for 4
more years and it is expected to be sold at the end of year four
at ₱960. It is also expected
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that there will be no default of yearly interest payments.
Assuming that the required rate of return is 11.25%. Compute
the price of the bond.
100
100
100
𝑃𝑉 =
+
+
1
2
(1 + 0.1125)
(1 + 0.1125)
(1 + 0.1125)3
100 + 960
+
(1 + 0.1125)4
= ₱935.31
Or, let us remember that present value of ordinary annuity can
be used when there are uniform cash flows at a given time. And
present value of 1 or present value of single sum is for those
that has one-time/lump sum payment only. This means we can
use ordinary annuity for the ₱100 payment every end of each
year for the next 4 years, and present value of 1 for the ₱960
since it will only be received at the end of holding the bond.
1 − (1 + 0.1125)−4
𝑃𝑉 = [
× 100] + [(1 + 0.1125)−4 × 960]
0.1125
= ₱935.31
It will still give us the same answer. And given that the current
price is only at ₱925, our analysis is the bond is undervalued
and should be sold for ₱935.31 or higher.
EXPECTED RATE OF RETURN AND REALIZED RATE OF RETURN
Both of these rates still uses the concept of present value, however, since in
the Philippine setting, we are no allowed to use financial calculators in board exams,
then we have to alternatively use approximation through YTM formula or yield-tomaturity
𝑃𝑟𝑃 − 𝐵𝑃
𝑛
𝑌𝑇𝑀 =
(0.4 × 𝑃𝑟𝑃) + (0.6 × 𝐵𝑃)
𝐴𝐼𝑃 +
where, AIP = Annual Interest Payments
PrP = Principal Payment (or Par Value)
BP = Bond Price (or Current Price of Bond)
n = years until maturity or holding period
Example for Expected rate of return and Realized rate of return
Expected Rate of Return
Anna purchased a bond, costing ₱890, three years ago, with a
current price of ₱925. This bond paid ₱100 year as interest
payments (end of each year). She wants to hold the bond for 4
more years and it is expected to be sold at the end of year four
at ₱960. It is also expected that there will be no default of yearly
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Example for Expected rate of return and Realized rate of return
(cont.)
interest payments. Assuming that the required rate of return is
11.25%. Compute the expected rate of return on the bond over
the next four years this time.
960 − 925
4
𝑌𝑇𝑀 =
(0.4 × 960) + (0.6 × 925)
YTM = 11.58%
100 +
This approximates the 11.607% which is the result if
financial calculators will be used.
Realized Rate of Return
Using the problem above, let us apply the concept of realized
rate of return. And as mentioned a while ago, it is the earned
return on the security for holding it for a period. And since Anna
held it for two years, n now will be 2 years. The realized amount
is the current market price or how much Anna can sell the bond
for.
925 − 890
100 +
2
𝑌𝑇𝑀 =
(0.4 × 925) + (0.6 × 890)
YTM = 13.00%
BOND VALUATION
As mentioned, we shall value bonds using the concept of time value of
money. Hence it is important to know what are the amounts that should be used. In
bonds, we have what we call as coupon bonds. These are bonds that pay
bondholders interest that is reflected in the bond, meaning fixed in the bond. This
interest is used in computing the price of the bond or the fair market price of the
bond. Sometimes, bonds are sold higher than its par value, or sometimes lower than
its par value. If for example the bond has a face amount of ₱1,000,000 and it was
sold for ₱950,000, then it was sold at a discount, or if it was sold for ₱1,150,000,
then it is sold at a premium. If it is old at its face amount which is ₱1,000,000, then
it is at par. Also note that once a bond is sold at a discount, the coupon rate is less
than the required rate of return, and so therefore, vice versa if at a premium.
The computations found above are how we value bonds.
EQUITY VALUATION
Equity valuation pertains to measuring the values of equity instruments just
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like common shares. This time, there will three scenarios that will be the value of
the equity if there is no growth, there is a constant growth, or if there are several
changes in its growth.
One must understand a problem so that the correct formula will be used, and
Gordon growth model will help us with this.
The general concept of Gordon growth is the same as with bond valuation
which uses time value of money, and derive in this formula
𝐷𝑡+1
𝑟𝑠 =
+ 𝑔
𝑃𝑡
where,
Dt+1 = Dividend received from the investment at the end of the year t
Pi = Price of common share at the end of the year t
P0 = Current price of common share
rs = Interest rate used to discount cash flows.
g = Growth
Through the formula above, we shall derive different equations depending on
what is asked. Sometimes, the rate is what is asked for, sometimes, the price,
sometimes the dividends. It is also equally important to note that g is not present for
those common shares with zero growth rate, i.e. g is 0.
Zero growth rate
DJ Corporation’s stock is expected to pay a constant dividend
of ₱2 at the end of each year. It is expected that the stock’s return
is at 8%. Compute for the current market price.
Using the formula above, because the problem said constant (it
will always be ₱2, and will not increase or grow a year after), it
means we zero growth rate, i.e. we shall remove g from the
picture. Therefore, we may remove it from the formula
𝐷
𝐷
𝑟𝑠 = 𝑃𝑡+1  𝑃𝑡 = 𝑡+1
𝑟𝑠
𝑡
2
𝑃𝑜 =
0.08
Pt = ₱25
Constant growth rate
Panda Corporation’s paid a dividend of ₱5 at the end of last year.
Unlike DJ, Panda’s dividends have grown at a constant rate of
2% per year over the last 10 years, and will continue to grow
into the future. The required rate of return is at 12%. Calculate
the expected rate of return if the share sells for ₱40.
This time, the problem says that there is a constant growth and
what is asked is the rs. Also, note that the ₱5 is the dividend from
last year and is not Dt+1 just yet, i.e. Do. Therefore, we must
convert it to Dt+1 meaning 5 times (1+0.02).
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Constant growth rate (cont.)
𝑟𝑠 =
𝑟𝑠 =
In the equation,
𝐷𝑡+1
𝑃𝑡
𝐷𝑡+1
𝑃𝑡
+𝑔
5 (1 + 0.02)
+ 0.02
40
rs = 14.75%
+ 𝑔 , we call
𝐷𝑡+1
𝑃𝑡
as the capital gains yield because we
are trying to get the gain we had from investing our capital. And g is the dividend
yield.
While zero growth, and constant growth come in handy, nonconstant growth
may take quite a while for one to get the r s. Nonconstant growth happens usually
when the company where you invested in is new or a developing company. It
could be that for the first 3 years, percentage goes up at 5% each year, then goes
down the year after, and so on. So there are 3 general steps to get the return on
investment once the problem is has nonconstant growth in dividends.
The step process is as follows:
1. Get the summation of discounted dividends, for dividend yield,
during the period of supernormal/nonconstant growth.
2. (a) Get the price of the stock, for capital gains, at the end of the
supernormal/nonconstant growth period using the constant growth in
dividends model discussed above. This is the time is the terminal,
and the dividend grows constantly already. (b) Then, get the present
value.
3. Add whatever you get in steps 1 and 2.
Supernormal or Nonconstant Growth
You invested in Pumpkin Company and you want to evaluate the nonconstant
growth in its dividend payments. Dividends will grow at 8% over the next two
year, then 4% on the year after, then will constantly increase at 2%. The stock
paid ₱2 last year, and the required rate of return is at 12%. Calculate the fair
present value of the stock using the steps given above.
Step 1. Get the summation of discounted dividends during the period of
supernormal/nonconstant growth.
Dividend (Do (1 + gs)
Year
Dividend x (1+.12)Present
t
Value
1
2 (1 + . 08) = 2.16
2.16 (1+.12)-1
1.9286
2
2.16 (1 + . 08) = 2.3328
2.3328 (1+.12)-2
1.8597
3
2.3328 (1 + . 04) = 2.4261
2.4261 (1+.12)-3
1.7269
SUM
₱5.52
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Supernormal or Nonconstant Growth (cont.)
Problem says that dividends will grow at 8% for the next two years which
is why we have .08 for the first two years in column 2, then 4% on year
after, so that is .04 on the year 3, column 2. That is the terminal, or the
point when nonconstant ended. That will also be the last row on your table.
Also, note that the discount rate is required rate of return.
Step 2. (a) Get the price of the stock, at the end of the
supernormal/nonconstant growth period using the constant growth in
dividends model.
𝐷
𝐷
𝐷4
2 (1+.08)(1+.08)(1+.04)(1+.02)
𝑟𝑠 = 𝑃𝑡+1 + 𝑔  𝑃𝑡 = 𝑟 𝑡+1

𝑃
=
=
3
−𝑔
𝑟 −𝑔
.12 − .02
𝑡
𝑠
𝑠
Step 2. (b) Get the present value of the result from (a) to get Po or the
price today.
𝐷
2 (1+.08)(1+.08)(1+.04)(1+.02)
2.4746
𝑃3 = 4 =
=
= 24.7463
𝑟𝑠 − 𝑔
.12 − .02
.10
𝑃𝑜 = 𝑃3 (1 + .12)−𝑡 = 24.7463 (1 + .12)−3 = ₱17.61
Step 3. Add the amounts derived from step 1, and step 2.
Present Value of the stock = ₱5.52 + ₱17.61 = ₱23.13
Therefore, the fair market value of the stock is ₱23.13
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Kunwar, R., Yang, Z., Lai, J., & Cline, J. (2014). Review, theory and
implementation of convertible bonds for commercial investment. The Journal
of Risk Model Validation, 8(2), 39-57. Retrieved from shorturl.at/enBE5
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Let’s Check
Activity 1. At this juncture, it is expected that we have learned the concepts of interest
already. Here are some question to confirm our learnings.
1. In your own words, differentiate required, expected, and realized rate of return.
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2. Explain the when and why should one use zero growth rate model, or constant growth
model, or supernormal model.
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Let’s Analyze
Activity 1. To reinforce what we learned above in the application of interest rates,
here are some few problems for you to answer. Kindly show your solution.
1. You bought Porc Company’s bond will mature after 7 years. It has a par value of
₱1,000, and you will receive ₱70 worth of annual coupon payments. The market
interest rate is at 8.5%. What is the bond price?
2. Sweet Corporation offered ten-year bonds to the public last two years with a par
value of ₱1,000, and a purchase price of ₱980. You intend to hold the bond for 3
more years and sell it at the end of 3 years at ₱1,200. The bond will pay ₱80 for
the next years to come. If the required rate of return over the next 3 years is at 8%,
what is the fair present value of the bond?
3. What is the approximate expected rate of return of a bond which has a par value
of ₱1,000 and sells for ₱1,120 that matures in 6 years and pays an annual interest
of 12%?
4. Refer to number 2, assuming that you did not wait for years and sold the same for
₱1,020 today, what is the realized rate of return?
5. Compute the YTM given the following data:
Par Value of Bond: ₱10,000
Interest Rate: 12%
Term: 5 years
Current Price: ₱9,050
6. A stock is selling for ₱80 and has been constantly yielding ₱3.00 dividend. What is
the expected rate of return on this stock?
7. The expected return of a stock is at 11.5% today. If the constant dividend is at ₱12,
how much is the current market price of this stock?
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8. At the end of this year, a share is expected to yield ₱45 dividend at the end of the
year for the past 7 years, and this will grow at a constant rate of 4% each year
indefinitely. If the price of the share is at ₱760, what is the expected rate of return?
9. If a stock earned ₱4 dividend at the end of last year and is expected to grow 5%
each year, calculate the fair market price of the stock if the required rate of return
is at 15%.
10. You invested in a newly registered company and you want to evaluate the price of
the shares you bought from the said company. For the first 3 years, the growth in
dividend payments are expected to be 8% each year. Following the 3-year period,
dividends will grow for another 5%, and another 5% for the next two years. After
this, the dividends are expected to grow at a constant rate of 4% each year,
indefinitely. If the dividend payment at the end of last year is at ₱5, how much is
the fair present value of the stock if the required rate of return is 11.5%?
In a Nutshell
We have witnessed that interest rates are not just given but are derived as compared with
financial accounting wherein mostly, the interest rates are given. We also had a chance to
apply the concepts above. In this portion, let us remember what we have learned.
1. Different interest rates have different uses. For example, the discount rate is the required
rate of return and not the coupon rate. This is of importance because once we would use
different multiplier or divisor, then we would have a wrong answer
2. Realized rate of return is the ex post rate of return because it is the rate after selling the
security or after maturity.
YOUR TURN
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5. _______________________________________________________________________
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8. _______________________________________________________________________
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9. _______________________________________________________________________
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10. _______________________________________________________________________
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Big Picture in Focus:
ULOd. Evaluate the stock market, and how stocks are being traded
Metalanguage
Stock market is prominent nowadays, and to prepare you to become young
investors and future managers, it is vital for you to learn what stock market is. At the
end of this chapter, you are to do virtual trading. What is stock market then?
Stock market is where investors buy and sell stocks to earn from increase in
value of the stock and its dividend. The we call the latter as former as capital gains,
and the latter as dividend yield.
Please proceed immediately to the “Essential Knowledge” part since the
first lesson is also definition of essential terms.
Essential Knowledge
Stock market is one of the capital markets discussed in the previous chapter.
This market allows investors to trade with ease and efficiency. This also allows
corporations that sell stocks to easily obtain funds from the suppliers of funds or the
investors. One of the reasons why most investors opt to make stock market as their
main investing ground is because there are a lot of platforms now where they can
perform trading.
Once you buy stocks of a company, you will become part owner of the
company where you buy your stocks from. Another advantage is that you are to
receive dividends as your income from investing. Stockholders (term used for
investors who bought stocks) have voting privileges once major decision making will
be made in a company. This does not mean that stockholders can control the
operations of a company because that is the job of the board of directors. However,
if stockholders find it fitting to oust the board of directors because of
mismanagement, they may do so.
Another interesting part in stock market is its availability to all. One may trade
through a computer, or a mobile phone with just few clicks. Hence, the secondary
maker is closely observed and reported of all other mentioned financial markets that
were mentioned and will be mentioned in this subject. According to economists and
financial analysists, stock market of a country is a great indicator of how well a
country is performing economically. Plus, as mentioned earlier, most investors are
interested in knowing stock market situation since corporate shares are the most
widely held financial instrument of all.
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COMMON STOCK
The most basic form of equity instrument or stock instrument is the common
stock. There are different types of stocks, but this is the fundamental one. You might
have heard of preferred stocks. In case there are preferred stocks in a company, it
is understood that it has also common stocks.
CHARACTERISTICS OF COMMON STOCKS
Dividends and Residual claims – unlike preferred stocks which is
another kind of share, it is in the option of the board of directors whether
they will stockholders will receive or not. Also, common stockholders
receive the residual income in a way that bondholders receive interest
first, then preferred stockholders receive next, and after all others, only
then will a common stockholders will receive their dividends. And in the
event of liquidation, common stockholders also hav the lowest priority
Limited Liability – this one is an advantage because common
stockholders will not be liable to any creditor beyond what he had as his
investment.
Voting Rights – as mentioned above, common stockholders have voting
rights compared to preferred stockholders. They contribute in the major
decision making of a company
Proxy Votes – shareholders most likely cannot attend annual meetings
which is why we have proxy voting. A proxy is a a ballot sent by a
corporation to stockholders for absentee voting. Or a stckholder may
opt to send someone on his behalf to vote
PREFERRED STOCK
This stock had characteristics of both a bond and a common stock which is
why this is a hybrid security. As compared with the characteristics of common stocks
listed above, dividends are given beforehand to preferred stockholders compared to
common stockholders. In addition, should there be liquidation of a corporation, the
preferred stockholders are paid with their claims after the creditors and before the
common stockholders. This type of stock generally does not have voting rights
except if expressly stated in the by-law of a corporation.
In the part of the corporation, downside of this type of stock is that it does not
give tax benefit because it is paid after-tax earnings. And though dividend payments
maybe missed, corporations really choose to pay dividends because more likely,
new investors will then be hesitant on investing since dividends will be their only
source of income. Hence, preferred stocks are typically cumulative and
nonparticipating, e.g. preferred stockholders are paid ₱2 per share each year, if
you have 100 shares, you are to receive supposedly ₱200; if this is not paid, this
will go into arrears and accumulated; meaning to say, if next year there will be
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dividend payment and you still have 100 shares, you will receive ₱400 instead as
dividend income. If a stock is noncumulative, it means you get to be paid with what
is only due this year.
If a stock is nonparticipating, it means, the ₱2 fix dividend will only be the
income of the investor no more no less. But once it is participating, the
stockholder will receive more than the amount sworn. This topic will be discussed
intensively in financial accounting.
PRIMARY STOCK MARKETS
Investment banks generally help corporation selling their stocks once it the
selling is duly approved by the board of directors. Investment banks are financial
institutions that meddle between the supplier of funds and the users of funds.
Primary stock market is where new issues of stocks are sold to initial
investors. The investment bank may either buy the all stocks issued at a fixed price
and sell them, or in their best efforts, they will not guarantee a price to the issuer but
just acts as distributing agent. The investment bank chosen by the issuer of bonds
often form a group to help them sell these stocks – the group is called a syndicate.
If the stocks are sold for the first time by a company that just went public, we call
this as initial public offerings (IPOs). If what are sold are additional new shares,
we all this as seasoned offering. In addition, pre-emptive rights gives the existing
shareholders the benefit of being offered first with the seasoned offering.
How do investment banks earn from this? The investment bank will purchase
the stocks from the issuer called the net proceeds. The stocks will then be resold
to investors at a higher price called gross proceeds. The difference between the
two is called underwriter’s spread and this is the compensation or earnings of the
investment banks.
Kindly watch this video:
https://www.youtube.com/watch?v=A7fZp9dwELo
SECONDARY STOCK MARKETS
This is the market where stocks that were bought from the primary market
are resold. In the Philippines, we have the well-known secondary market, the
Philippine Stocks Exchange, Inc. (PSEi or PSE). In the US, they have NYSE or the
New York Stocks Exchange and NASDQ or the National Association of Securities
Dealers Automated Quotation. Securities broker or firms help those investors who
wants to sell their stocks to other investors, and the original investor does not
intervene with these transactions anymore.
This section will give you a jump start on your stock trading. The virtual stock
trading that you will do is a secondary market transaction, and you are going to buy
and sell stocks using vTrade.
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PSE has a specific location in the Philippines particularly in Taguig – we call
this place is trading post. What happens here is brokers trade on behalf the
investors; the specialists, who manage each stock, see to it that there are no over
buying or over selling of the stocks, and they regulate the transactions executed;
and these specialist transact or their account.
In the exchange, brokers buy and sell stocks and they earn commissions
when doing so. One must note that it does not seem like just buying in the
supermarket. Orders must match. Meaning to say, person who wants to sell this
specific stock to any one at this price or the ask price, should match the price that
buyers are willing to buy it for or the bid price. At the end of the day, some orders
are rejected due to mismatch, and some are accepted.
Terms
Market order – transacting in the seondary market at the best price
available
Limit order – transacting at a specified, usually fixed price
Order book – a record of unexeecuted orders
Nowadays, because of the increasing number of people interested in
trading, we have online platforms that will help you trade. One of which here in the
Philippines is the BDO Nomura, and First Metro Sec. In your respective houses, or
any where you’ll go, you can perform trading.
CONTROVERSIAL TRADING PRACTICES
Due to prominence of stock trading and how it gives income to investors,
there have been controversial practices. One of which is flash trading. This gives
the opportunity or others who pays for it, to see milliseconds earlier than the general
market traders. This is helpful for those who use statistical or technical analysis in
buying stocks but is unfair to others.
Another one is naked access. This allows others to buy and sell
anonymously, and rapidly. The problem with this is that it may destabilize the
exchanges. And lastly, we have dark pools. It provides liquidity to some, but these
transactions are not recorded in the order books because these transactions are not
displayed.
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Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Singh, S., PhD., Jain, P. K., P., & Yadav, S. S., PhD. (2016). EXPECTED RATES
OF EQUITY RETURNS: EVIDENCE FROM INDIAN STOCK MARKET.
Journal of Financial Management & Analysis, 29(1), 48-64. Retrieved from
shorturl.at/yNT57
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Let’s Check
Activity 1.
1. List down, and define the jargons hear in the video you were asked to watch.
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2. Have a little research on what stocks are you planning to buy and why. Kindly
present three.
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Let’s Analyze
Activity 1 Kindly answer whether it is true or false. If false, kindly explain.
1. Seasoned offering and initial public offering are both primary stock market
transactions.
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2. Once a stockholder cannot attend annual meetings with voting activity, he cannot
cast his vote by any other means
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3. A preferred stock is said to be nonparticipating if it can receive its dividends in
arrears.
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4. One of the advantages of having preferred stocks is that, generally, it can cast a
vote.
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5. If a corporation goes bankrupt, due to part ownership, creditors can go after
common shareholders’ personals properties in order for them to be paid.
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In a Nutshell
In preparation for your stock trading, at this juncture, I hope that you already have an
idea of what a stock market is to guide you on your investment. Now, let us check
what we have learned.
1. The most common type of stocks are common stock and preferred stock. Common
stock is the basic stock of a corporation.
2. Stock market is within reach and accessible nowadays due to the surge of
information technology. Through the use of gadgets, we may be able to invest
already.
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YOUR TURN
3._______________________________________________________________________
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Q&A LIST
Do you have any questions for clarification?
Questions/Issues
Answers
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
KEYWORDS INDEX
This section lists down the keywords that help you for recall the discussions.
ULOa.
Capital markets
Direct transfer
Financial institutions
Financial markets
Indirect transfers
Initial public offerings
Money markets
Primary markets
Secondary markets
Securities
Nominal interest rates
Supply of loanable funds
Real interest rates
Unbiased expectation
theory
Expected rate of return
Par value
Premium bond
Realized rate of return
Required rate of return
Nonparticipating
Participating
Preferred Stocks
Pre-emptive rights
Primary stock markets
Proxy
Seasoned Offering
Specialist
Stockholders
Syndicate
Trading Post
ULOb.
Demand of loanable
funds
Fisher Effect
ULOc.
Coupon rate
Coupon bonds
Discount bond
ULOd.
Common stocks
Cumulative
Dark Pools
Flash Trading
Naked Access
Noncumulative
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Course Schedule
This section calendars all the activities and exercises, including readings and lectures, as well as
time for making assignments and doing requirements.
Activity
Orientation
ULOs a-b
Let’s Check ULO a
Let’s Analyze ULO a
In a nutshell ULO a
Let’s Check ULO b
Let’s Analyze ULO b
In a nutshell ULO b
ULO c-d
Let’s Check ULO c
Let’s Analyze ULO c
In a nutshell ULO c
Let’s Check ULO d
Let’s Analyze ULO d
In a nutshell ULO d
Q & A of ULOs a-d
1st Formative Assessment
Date
August 17, 2020
Where to Submit
Blackboard LMS
August 20,2020
August 20,2020
August 20,2020
August 22,2020
August 22,2020
August 22,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
August 25,2020
August 25,2020
August 25,2020
August 27,2020
August 27,2020
August 27,2020
Any day
September 4,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
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Big Picture
Week 4-5: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to
e. Discuss fundamental stock analysis and learn to compute the necessary
ratios that are involved in this topic;
f. Assess what money market is and how it operates, and dig down deeper
to how prices of money market instruments and rates are computed;
g. Rationalize more concepts on bond markets and how it operates;
Big Picture in Focus:
ULOe. Discuss fundamental stock analysis and learn to
compute the necessary ratios that are involved in this topic
Metalanguage
To further our knowledge about stock markets, we have to learn how to
recognize when is a stock a healthy one or not from some quantitative items
in the financial statements, and the qualitative characteristics of a company.
In this topic, we will focus on the fundamental analysis, a stock valuation,
where we will determine a stock’s “fair market value.” Along the way, we will
come across with the following:
 Intrinsic Value – a measurement of an asset, e.g. shares and
bonds, worth
 Technical analysis – another type of stock market analysis that
mainly evaluates the price of the stocks through the trends and
patterns of the charts or the price changes in the market
 EIC – Economy, Industry, and Company, a valuation philosophy
 Value investors – investors that believe that purchasing
securities should be justified by the overall economy and the
issuing firm
 Growth investors – investors that focus on long-term growth of
company and invest in companies that are performing well
despite the price of shares during the time of purchase
 Stock analysis ratios – ratios which are involved in the analysis
of the stocks
Essential Knowledge
Fundamental analysts focus on measuring the intrinsic value of stocks.
In fundamental analysis, they evaluate the price of a stock and do forecasts
through examining different factors relating to a company, inter or
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intracompany factors, e.g. global financial markets, country’s political
conditions, company financial statements, etc. They study macro and micro
economic factors, and qualitative and quantitative factors that impact a price
of a share.
The following are the valuation philosophies under fundamental
analysis:
 Investors are almost always risk averse or reluctant to take risks.
 Time value of money is one of its basic principles.
 Cash flows are helpful in predicting future company’s earning.
 Tax affects valuation process.
Fundamental analysts use EIC or Economy, Industry, and Company
analysis wherein they first consider the condition of the overall (1) economy.
Whether it is booming or in recession, and they consider the market risks. The
global economy like export and import, exchange rates, and even the domestic
economy which involves the deflation rate, budget surplus or deficit,
employment rate, etc. Then they consider which of the two (2) industries is
most attractive in the period. It is difficult for a firm to do well if the industry is
in distress.
Look!
Illustration source: http://www.bsp.gov.ph/downloads/Publications/2020/BES_1qtr2020.pdf
The construction sector or industry, as of the latest data (Q1 of 2020), has the highest index and this
PREFERRED
STOCK
means
investing in this
sector is reasonable as it has the best performance compared to other sectors.
And after analyzing the industry, analysts look at the (3) company’s
health. They check how risky a business is and analyze its sales sensitivity,
operating leverage, financial leverage through its quantitative and qualitative
characteristics.
One of the factors that analysts look at is industry life cycle of
companies. This is the progress of a business through four (4) stages that are
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common to most businesses. It starts with embryonic or introduction, then
growth/build-up/consolidation, maturity, and decline. One shall make sure that,
as decline phase is happening to a company that a fundamental analyst
invested in, that company has ways to cope with the pressure of the industry.
Companies must have concrete plans and use their competitive advantages
to manage possible losses from decline.
These fundamental analysts are called value investors as they look
at macroeconomic information, industry news, and the business itself to
justify the purchase. In addition, these factors outside the company’s control
are:
 Industry and its growth – as stated above, the overall
performance of a specific sector, e.g. mining and oil, services,
finance, etc. It is better to invest in a growing industry
 Customer – the behavior of customers towards a product which
may be affected by preference
 Market share – the percentage of the total sales a company
has over other all companies within a specific market, say for
example, Marco Polo’s percentage sales over all the hotels in
the Philippines
 Competition – rivalry of companies that affects their sales. One
should look for a company that already earned its name or one
that has huge potential to grow and build name
 Regulations – rules and laws set by the authority, usually by
the government
These are also factors that a company can control:
 Intangibles of a company – assets that are not physical in
nature say brand name, copywrites and trademarks that a
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





company built up
Business model – design of a company’s operations and
strategy that leads to its success
Competitive advantage – attribute that makes a company
better than its competitors. This can be earned through good
management.
Management – how the executives grow its company using a
business model
Corporate Governance – compared to management, this is
more on how the executives protect the company and its
reputation
Transparency – deals with honesty and openness about the
company and its operations. Say, whenever problems arise,
this should not be sugarcoated and be reported to come up
with solution
Structure of the Board of Directors – board of directors are
important element of a company as it links the shareholders
and the managers for decision making
Compared to Value investors, Growth investors pursue steadily growing
companies that have overcome decline stage. They do not really consider the
purchase price that much, as long as the performance of such shares is above
average. They focus more on capital appreciation.
Having been able to discuss the qualitative factors above, we may proceed
to the quantitative factors which is the analysis of financial statement. At this point
in time, we shall focus on the ratios that is related to buying securities. And later on,
other ratios will be tackled in the next sections.
RATIOS
Earnings Per Share (EPS)
This gives us the amount on how much profit is allocated to each
outstanding share of common stock and measures the profitability of a
company. The higher the EPS, the better.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐸𝑃𝑆 =
𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠
Price-Earnings Ratio (P/E Ratio)
This is about the relationship between an entity’s share price and
earnings per share and tells us the how a company is performing.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Book Value Per Share (BPS)
Through this ratio, we can determine how much equity is available
to stockholders (common BPS or preferred BPS).
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𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
Price-to-book value ratio (P/B Ratio)
PB Ratio lets us calculate the value of a firm relative to its book
value. The traditional consideration on good P/B value is less than 1.0 as
it is said to be undervalued. Meaning to say, one may buy the shares
below its supposed equity share.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
𝑃/𝐵 𝑅𝑎𝑡𝑖𝑜 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐵𝑃𝑆 =
Sample problem
The balance sheets of PQR Company at the end of each of the first two
years of operations indicate the following:
2017
2016
Total current assets
₱600,000 ₱560,000
Total property, plant and equipment
960,000
740,000
Total current liabilities
150,000
80,000
Total long-term liabilities
350,000
250,000
Preferred 9% stock, P100 par
100,000
100,000
Common stock, P10 par
600,000
600,000
Paid-in capital in excess of par-common stock
60,000
60,000
Retained earnings
300,000
210,000
The net income is ₱115,000 and interest expense is ₱30,000 for 2017.
And the current market price of the share is ₱22.20 in 2017, and ₱21.25 in
2016.
1. What is the earning per share ratio for 2017?
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐸𝑃𝑆 =
𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠
₱115,000 − ₱9,000
𝐸𝑃𝑆 =
60,000 𝑠ℎ𝑎𝑟𝑒𝑠
𝑬𝑷𝑺 = ₱𝟏. 𝟕𝟕
2. Given the EPS above, what is the P/E Ratio PQR’s security in 2017?
₱22.20
𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜 =
₱1.77
𝑷/𝑬 𝑹𝒂𝒕𝒊𝒐 = 𝟏𝟐. 𝟓𝟒
3. Assuming it was made certain that common stock’s share in the equity
is P675,000, net of all deductions, what is the book value per common
shares in 2016?
₱675,000
𝐵𝑃𝑆 =
60,000 𝑠ℎ𝑎𝑟𝑒𝑠
𝑩𝑷𝑺 = ₱𝟏𝟏. 𝟐𝟓
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Sample problem (cont.)
4. Given the EPS above, what is the P/E Ratio PQR’s security in
2017?
₱22.20
𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜 =
₱1.77
𝑷/𝑬 𝑹𝒂𝒕𝒊𝒐 = 𝟏𝟐. 𝟓𝟒
In the problem above, if the industry average EPS for 2017 is ₱1.50, we may
say that the share is a good buy as it is higher than industry average. However, the
P/E ratio in 2017 is 12.54 meaning to say, the share is overvalued 12.54 times.
Investors are willing to pay 12.54 times its price. In addition, the book value per
share tells us that, should the company dissolve, each share has ₱11.25 in 2016.
And lastly, we may interpret P/B ratio in 2016 this way. It depends upon the
characteristic of an investor. By tradition, if P/B ratio is less than 1.0, this means the
stock is potentially undervalued. But for value investors, they consider 3.0 as their
ceiling therefore, PQR may be a good business for them.
We may also look at the ROE of a company, or the Return on Equity. This
ratio shows how much an entity has changed or increased its earnings. The higher
the ROE, the more efficient a company is.
Return on Equity
𝑅𝑂𝐸 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
or 𝑅𝑂𝐸 =
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
To continue the problem above, PQR company, we may say that the ROE
for 2017 is 10.85%. That is:
₱115,000
𝑅𝑂𝐸 =
₱100,000 + ₱600,000 + ₱60,000 + ₱300,00
𝑅𝑂𝐸 =
₱115,000
₱1,060,000
𝑹𝑶𝑬 = 𝟎. 𝟏𝟎𝟖𝟓 𝐨𝐫 𝟏𝟎. 𝟖𝟓%
We have noted that the computations above are only our guide and will not
necessarily immensely lessen the risk on investment as investment is risky in its
entirety. Nonetheless, having basis on how and where to invest will narrow down
the potential businesses or corporation that are favorable.
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
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Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Wang, Yun-Chin, et al. “Does Fundamental and Technical Analysis Reduce
Investment Risk for Growth Stock? An Analysis of Taiwan Stock Market.”
International Business Research, vol. 7, no. 11, 2014,
doi:10.5539/ibr.v7n11p24.
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Let’s Check
Activity 1. Now that you have a grasp of what is Fundamental Analysis is, let us see
what you have understood in this chapter. In each item, kindly choose the letter of the
best answer.
1. This type of stock analysis believes that the value of stocks is affected by
the business activities of a company and its economic activities.
A. Stock analysis
B. Fundamental analysis
C. Technical analysis
D. Financial analysis
2. This type of stock analysis focuses more on the movement of chart prices
to evaluate value of securities.
A. Stock analysis
B. Fundamental analysis
C. Technical analysis
D. Financial analysis
3. The following are true regarding EIC analysis, expect
A. EIC analysis means Economy, Industry, and Company.
B. The best way to analyze stocks is through analyzing the company
first, then the industry that it is in, and finally checking the economy.
C. After looking for the best industry, qualitative and quantitative
elements of a company is analyzed.
D. All are true.
4. I. Growth investors seek for steadily growing companies.
II. While value investors believe that securities are of good buy once the
underlying EIC factors are desirable.
A. Statement I is true.
B. Statement II is true.
C. Statements I and II are true.
D. Statements I and II are false.
5. I. Management and corporate governance has the same objectives.
II. Intangibles of a company involves nonphysical assets such as
trademarks, property plan and equipment, and copy rights.
A. Statement I is true.
B. Statement II is true.
C. Statements I and II are true.
D. Statements I and II are false.
6. The following are the valuation philosophies under fundamental analysis,
except:
A. Investors almost always non-risk takers.
B. Tax affects valuation process.
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C. Cash flows are helpful in predicting past company’s earning.
D. Time value of money is one of the principles it applies.
7. The price/earnings ratio
A. measures the past earning ability of the firm.
B. is a gauge of future earning power as seen by investors.
C. relates price to dividends.
D. relates to the price of the security.
8. ROE
A. means return on equality.
B. is net income over net assets.
C. is BPS over EPS
D. helps one to know the liquidity of a company and its performance.
9. Which of the following is/are true?
A. The higher the EPS of a company, the better.
B. Investors generally prefer P/E Ratio which are below 3.0.
C. Book value per share dictates how much income is attributable to one
share.
D. P/E ratio is Net income divided by market price.
10. This ratio will guide us in checking whether the price of a share is
overvalued or undervalued by comparing the EPS and the market price.
A. Price to book ratio
B. Earnings per share
C. Market value
D. Price-earnings ratio
Let’s Analyze
Activity 2. In addition to the problems above, let us apply what we have learned to
these problems below. Kindly show your solutions as you answer.
1. On December 31, 2016 and 2017, Rose Group of Companies had 200,000
shares of common stock and 40,000 shares of noncumulative and
nonconvertible preferred stock issued and outstanding.
Additional information:
Stockholders’ equity at 12/31/17
₱4,000,000
Net income year ended 12/31/17
1,500,000
Dividends on preferred stock year ended 12/31/17
400,000
Market price per share of common stock at 12/31/17
₱ 144.00
The P/E ratio on common stock at December 31, 2017, was
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2. Daffodils Corporation’s stockholders’ equity at December 31, 2018 consists of the
following:
6% cumulative preferred stock, P100 par, liquidating value
was P110 per share; issued and outstanding 5,000 shares ₱500,000
Common stock, par, P5 per share; issued and
outstanding, 40,000 shares
200,000
Retained earnings
100,000
Total
₱800,000
Dividends on preferred stock have been paid through 2017.
On December 31, 2018, Daffodils Corporation’s book value per share was
3. The current annual sales of Amethyst, Inc. are ₱180,000. Sales are expected to
increase by 5% next year. The company has a net profit margin of 6.5% which is
expected to remain constant for the next couple of years. There are 12,000
common stock outstanding. The market multiple is 16.4 and the relative P/E of the
firm is 1.31. What is the expected market price per share of common stock for next
year?
4. A company’s total common shares are valued at ₱600,000 and had a par value of
₱10. If net income is ₱115,000 and interest expense is ₱30,000 for 2020 and the
company had declared ₱12,000 preferred dividends, and the market price is ₱30,
What is the price-earnings ratio on common stock for 2020.
5. What is Marigold Company's net income given the following?
Total assets = $250,000
Total Liabilities = 25,000
Revenue = $30,000
ROE = 12%
In a Nutshell
Now that you have had necessary basics for stock trading, let us see what we have
learned in this chapter.
1. There are two types of stock analysis that were mentioned in this section. Those
are fundamental analysis and technical analysis
2. In doing fundamental analysis, one should consider the economic conditions of a
company and later on narrow down one’s analysis to company level through several
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quantitative and qualitative factors.
YOUR TURN
3._________________________________________________________________
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4._________________________________________________________________
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________________________________________________________________
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5._________________________________________________________________
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________________________________________________________________
________________________________________________________________
6._________________________________________________________________
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7._________________________________________________________________
________________________________________________________________
________________________________________________________________
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8._________________________________________________________________
________________________________________________________________
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9._________________________________________________________________
________________________________________________________________
________________________________________________________________
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10.________________________________________________________________
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Big Picture in Focus:
ULO f. Assess what money market is and how it operates, and dig down
deeper to how prices of money market instruments and rates are
computed
Metalanguage
We have several kinds of instruments, but there is only one topic for shortterm investments and that is money market. Its basics, that are vital to your
understanding in finance, management, and even financial accounting, will be
tackled in this section. These are several terms that we have to know in advance:
 Money markets – market where instruments sold mature in less than a
year, usually sold in large denomination size. Money market
instruments are characterized by low liquidity risk and low default risk.
 Bond equivalent yield – the rate used to calculate the present value of
money market instruments, but does not consider the effects of
compounding.
 Effective annual return – the true annual rate earned when interest is
paid more than once in a year or compounded.
 Discount yields – return received for having been able to buy bonds at
a discount as a result of pre-deducted interest income
These shall all be discussed further as we go along with the discussion.
Essential Knowledge
Money markets sell short-term debt instruments to keep a government’s or
corporation’s cash flow steady. This market that does not have a particular
geographic location, and the instruments sold here are in large denominations sizes
like treasury bills from the Bureau of Treasury. (Illustration on the next page.)
Money market instruments
Treasury bills – short-term instruments issued by the government.
This instrument is said to be zero-risk security.
Federal funds – short-term funds transferred between two financial
institutions for no more than one day.
Repurchase agreements – contract that involves sale of securities by
one party to another with a promise to repurchase the same at a
specified date and price.
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Money market instruments
Commercial paper – short-term unsecured promissory notes issued by
large and prominent companies to raise short-term cash
Negotiable certificates of deposit – a bank-issued time deposit that
specifies an interest rate and maturity date and is negotiable
(saleable on a secondary market)
Banker’s acceptance – time drafts payable to a seller of goods, with
payment guaranteed by a bank
Source: https://www.treasury.gov.ph/wp-content/uploads/2020/09/Treasury-Bills-Public-Offering-on-07-SEPTEMBER-2020.pdf
Treasury bills are sold through auction. In the Philippines, the auction date is
every Monday and/or Tuesday for 35-day, 91-day, 182-day, and 364-day treasury
bills. And the cut-off time 1:00pm. Bid price is the amount the dealers are willing to
pay the T-bills holder to purchase their T-Bills. While ask price is the price set by
the dealers that is available to the investor. These prices are usually set at a
discount, which will lead to our next topic, calculating the price and returns of
treasury bills.
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BOND EQUIVALENT YIELD and DISCOUNT YIELD
In addition to the details discussed in the essential knowledge, this gives the
quoted nominal interest rate in a year.
𝑃𝑓 − 𝑃0
𝑖𝑏𝑒𝑦 =
𝑃0
×
365
and
ℎ
𝑖𝑑𝑦 =
𝑃𝑓 − 𝑃0
𝑃𝑓
×
360
ℎ
where
Pf = Face value
P0 = Purchase price of the security
h = Number of days until maturity
Sample problem
The Republic of the Philippines issued ₱100,000 T-Bill that can be bought for
99. This T-Bill will mature 90 days. Compute for the bond equivalent yield
and the discount yield.
Bond equivalent yield
𝑃𝑓 − 𝑃0
365
×
𝑃0
ℎ
₱100,000 − ₱100,000(0.99)
365
=
×
₱100,000(0.99)
90
𝒊𝒃𝒆𝒚 = 𝟒. 𝟏𝟎%
𝑖𝑏𝑒𝑦 =
𝑖𝑏𝑒𝑦
Discount yield
𝑃𝑓 − 𝑃0
365
×
𝑃0
ℎ
₱100,000 − ₱100,000(0.99)
360
=
×
₱100,000
90
𝒊𝒅𝒚 = 𝟒. 𝟎𝟎%
𝑖𝑑𝑦 =
𝑖𝑑𝑦
The formulas above are useful to get the fair value of a security, particularly
money market instrument, through applying these interest rates to these formulas
which either ways, will give us the same answers.
𝑃0 = 𝑃𝑓 − [𝑖 𝑇−𝑏𝑖𝑙𝑙,𝑑𝑦 ×
ℎ
360
× 𝑃𝑓 ]
and
𝑃0 = 𝑃𝑓 ÷ [1 + (𝑖 𝑇−𝑏𝑖𝑙𝑙,𝑏𝑒𝑦 ×
ℎ
365
Sample problem
At a point in time, the asked (discount yield) of a ₱10,000 T-Bill is
0.158%. How much is the price of this bill if the settlement date is on 77
days?
Discount yield
ℎ
𝑃0 = 𝑃𝑓 − [𝑖 𝑇−𝑏𝑖𝑙𝑙,𝑑𝑦 ×
× 𝑃𝑓 ]
360
57
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Sample problem (cont.)
77
× ₱10,000]
360
𝑷𝟎 = 𝟗, 𝟗𝟗𝟔. 𝟔𝟐
𝑃0 = ₱10,000 − [0.00158 ×
The asked yield (bond equivalent yield) of the same bill at that same
time is 0.160%. Find the price of the bill.
Bond equivalent yield
ℎ
)]
𝑃0 = 𝑃𝑓 ÷ [1 + (𝑖 𝑇−𝑏𝑖𝑙𝑙,𝑏𝑒𝑦 ×
365
77
)]
𝑃0 = ₱10,000 ÷ [1 + (0.00160 ×
365
𝑷𝟎 = 𝟗, 𝟗𝟗𝟔. 𝟔𝟐
EFFECTIVE ANNUAL RETURN
In this portion, we shall get the effective annual interest rate of return (EAR)
using the equation below:
𝑖𝑏𝑒𝑦
)
𝐸𝐴𝑅 = (1 +
365⁄
ℎ
365⁄
ℎ
−1
Sample problem
Suppose on can invest in a money market instrument that matures
in 70 days that offers 8% nominal annual interest rate, what is the
effective annual interest return on this security?
Effective Annual Return
365⁄
70
0.08
)
𝐸𝐴𝑅 = (1 +
365⁄
75
𝐸𝐴𝑅 = 1.0826 − 1
𝑬𝑨𝑹 = 𝟖. 𝟐𝟔%
−1
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Fernández, Pablo. “Interest Rates.” Valuation Methods and Shareholder Value
Creation, 2002, pp. 133–144., doi:10.1016/b978-012253841-4.50020-2.
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Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions.
McGraw-Hill/Irwin, 2018.
Let’s Check
Activity 1. In addition to our discussion above, let us check and supplement
your knowledge regarding money markets.
1. Give three common characteristics of money markets.
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
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_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
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_______________________________________________________________
_______________________________________________________________
______________________________
2. Kindly cite the difference between discount yield and bond equivalent yield.
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
_____________________________________________
3. What is the difference between repurchase agreement and a reverse repurchase
agreement?
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
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_____________________________________________________________
_____________________________________________________________
________________________________________________
Let’s Analyze
Activity 2. Let us apply the formula we have above to problems given in this activity.
1. You can purchase a T-bill that is 95 days from maturity for $9,965. The T-bill has a
face value of $10,000.
a. Calculate the T-bill’s quoted yield.
b. Calculate the T-bill’s bond equivalent yield.
c. Calculate the T-bill’s EAR.
2. Calculate the bond equivalent yield and effective annual return on a jumbo CD that
is 115 days from maturity and has a quoted nominal yield of 6.56 percent.
3. You can buy commercial paper of a major U.S. corporation for $495,000. The paper
has a face value of $500,000 and is 45 days from maturity. Calculate the discount
yield and bond equivalent yield on the commercial paper.
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In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1. Money market instruments are sold in large denomination sizes
2. There are other methods of computing interest rates and fair value for money
market instruments compared.
YOUR TURN
3. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
5. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
6. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
7. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
8. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
9. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
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10. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
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Big Picture in Focus:
ULO g. Rationalize more concepts on bond markets and how
it operates
Metalanguage
It was mentioned in the previous chapter that we have several types of capital
markets, and one of these is stock market which was already discussed above.
Another type of stock market that we will discuss in this chapter is Bond Market. In
this chapter, we will get acquainted with how it operates and the necessary
knowledge we can use in understanding not just the topic, but other related topics
as well. Here are some few definitions that are vital in understanding the bond
markets.
 Bonds – are long-term debt instruments that are issued by both the
government and corporations to raise funds for long-term
operations.
 Bond markets – a market where new and existing bonds are
traded. This market generally trades three types of bonds: (1)
Treasury notes and bonds (2) municipal bonds, and (3) corporate
bonds.
 Competitive bidding – a process wherein firms/investors who wish
to buy securities submit their competing bids to the issuer who wish
to sell
Essential Knowledge
Bond markets sell long-term obligation, called bonds, and transfer funds from
individuals, corporations, and government with excess funds for investment to
those who need funds which are also corporations and government. Bonds that
promise to pay periodic interests and the principal itself on maturity date.
TREASURY BONDS AND NOTES
Treasury bonds and notes are issued by government, say the Philippine
treasury, to fund national expenditures and projects, and the national debt. It is
important to note that just like the treasury bills, government bonds or treasury
bonds are also default risk free as the government will always pay their debts to its
investors.
More often, than not, bonds are bought in between interest dates. If this
happens, it means an accrued interest is already existing. The buyer has the
responsibility to pay not just the bond’s purchase price but the accrued interest as
well. Purchase price plus accrue interest is called full price or dirty price. When
a price does not include accrued interest rates, we call it clean price. In the market,
prices are quoted in clean price, but when the sale happens between the buy and
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the seller, the buyer pays the dirty or full price.
The primary market transaction for treasury bonds happens when the Bureau
of Treasury issues bonds, that is every other Tuesday. Below is an example of an
offer from Bureau of Treasury.
Source: https://www.treasury.gov.ph/?p=36842
If one wishes to invest in the primary market of treasury bonds, the Bureau
of Treasury set out these few steps.
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Source: https://www.treasury.gov.ph/rtb/
While most secondary market trading occurs through brokers and dealers
such as BDO, Security Bank, BPI and other banks that offer bonds. One will usually
fill up forms that intends purchase of retail treasury bonds. And once approved by
the chosen bank, the amount will be automatically deducted from the investor’s
bank balance.
MUNICIPAL BONDS
Municipal bonds are instruments that are issued by the local government unit
or the state (applicable in USA) with the same reason with the Bureau of Treasury,
to augment temporary shortages in funds. Some opt to buy this type of bonds as
this is tax free which means therefore that transaction cost is lower, therefore return
is also lower compared to corporate bonds.
There are two types of municipal bonds. One is the general obligation bonds,
and the revenue bonds.
 General obligation (GO) bonds – the government promises to pay
these bonds with all their might, including using taxation power to pay
such bonds
 Revenue bonds – bonds sold to finance project that are intended to
generate revenue. The revenue generated from these projects will be
used to pay off the bonds issued.
Despite that municipal bonds are issued by a branch of the government that
are not default risk free, it happened in the US during one crisis there.
Just like any other bonds, the trading process for municipal bonds starts with
public offering processed and assisted by investment banks using (1) firm
commitment underwriting. The investment bank guarantees the sale of bonds,
buying the whole issue at a fixed price, and selling the same to the public at a
higher price. This purchase of shares happens through competitive bidding with
other banks or through direct negotiation with the issuing state or local government.
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Another method to sell these bonds is through (2) best-efforts offering
where investment bank does not guarantee the issued shares but only acts as a
distributing agent for a fee. The price of the bonds is lower in this type of sale
because selling price of the bonds is set at the original price.
One may also opt to distribute the bonds through (3) private placement
where banks help the issuing body sell their bonds to large institutions or group of
buyers to purchase the whole issue.
And lastly, we have secondary market trading for municipal bonds, but it is
infrequent because of “lack of information.” People are not well-informed that these
bonds exist plus analyzing such securities is costly.
CORPORATE BONDS
Corporate bonds are debt instruments are issued by corporations. This is
backed up by a legal contract called a bond indenture which contains the
covenants of the bond issued. It contains the rights and obligations of the bond
issuer and the bond holders. This contract lowers the risk of this security.
Characteristics of bonds
Types of ownership
Maturity
Collateral
Claims on asset
Bearer bonds – does not record the
information of the bearer(owner) of the bond.
The bond has attached coupon to be paid each
interest period.
Registered bonds – the bondholder’s
identification is kept by the issuer in an
electronic record
Term bond – the entire issue of bond matures
at a single date
Serial bonds – bonds that mature on a series
of dates (not one time), with a portion of the
issue paid off on each of that period
Mortgage bonds – bonds that are issued to
finance specific projects that are pledged as
collateral for the bond issue
Equipment trust certificates – bonds
collateralized with tangible (movable) non-real
estate property
Collateral bonds – bonds collateralized by a
financial asset
Debentures – bonds backed solely by the
general credit rating of the issuing firm,
unsecured
Subordinated Debentures – unsecured
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Provisions
Other characteristics
debentures that are junior in their rights to
mortgage bonds and regular debentures
Senior debt – first priority to general assets
Sinking fund provisions – the periodic
retirement of a number of bonds
Call provision – gives issuer right to retire
bonds before maturity
Convertible bonds – bonds that can be
converted into common stock
Stock warrants – bonds that give the
bondholder an opportunity to purchase
common stock at a specified price up to a
specified date
Callable bonds – bonds that allow the issuer
to force the bondholder to sell the bond back
to the issuer at a price above the par value (call
price)
Sinking fund provision – bonds that include
a requirement that the issuer retire a certain
amount of the bond issued each year
These bonds are traded public sale or private placement. The process is the
same with how municipal bonds are issued. But unlike corporate bonds, secondary
market is more active for corporate bonds. In the US, NYSE serves as its exchange
market called New York Exchange Bonds Trading Platform, and there are also
OTC markets for bonds.
Bond Ratings
The confidence of investors on whether they will buy a certain bond or not
lies on the bond rating of a company. This serves as a gauge on the riskiness of
security especially default risk. There are independent companies that rank bonds
based on probability of default. In this module, we shall only present two types of
ratings in the table below.
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Those who are risk-averse will choose Aaa or AAA companies while those
who are risk-takers can opt to choose riskier bonds (Baa) as they may earn higher
interest rates. These speculative-grade bonds are called junk bonds.
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Choudhry, Moorad. “Review of Bond Market Instruments.” The Bond & Money
Markets, 2001, pp. 86–101., doi:10.1016/b978-075064677-2.50008-5.
Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions.
McGraw-Hill/Irwin, 2018.
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Let’s Check
Activity 1. Let us see if we understood the topics above through these true-or-false
questions. Answer true if it is true, and if it is false, explain briefly.
1. Capital markets include mortgage markets, foreign exchange markets, money
markets and bond markets.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
2. Bonds are long-term debt obligations issued by the government only.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
3. Aside from maturity value of the bonds, the investor of a bond shall also earn coupon
dividend.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
4. Treasury notes and bonds are issued by the government treasury as well as the
corporations to finance debt and other expenditures.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
5. In computing the present value of the bonds, the interest and the principal shall be
multiplied by present value factor of ordinary annuity.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
6. Municipal bonds have lower interest rate compared to taxable bonds such as
corporate bonds.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
7. Best-efforts offering does not guarantee the price to the issuer and just acts as a
distributing agent only on a fee basis.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
8. A junk bond is a legal contract that specifies the rights and obligations of the bond
issuer and the bondholders.
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_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
9. Sinking fund provisions include a requirement that the issuer retire certain amount
of the bond issue each year.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
10. Debenture bond holders will receive cash distribution only after mortgage bond and
subordinated debenture bond holders have been repaid in full.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
Activity 2. To further our retention on the topics above, let us answer these questions below
briefly.
1. Rate the following, mortgage bond, debenture, and subordinate debenture lowest
to highest.
a. Cost to the bond issuer – _________________________________________
b. Risk to the bondholder – _________________________________________
c. Yield to the bondholder – _________________________________________
2. Explain the difference between general obligation bonds and revenue bonds.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
3. Which is more attractive to investors a convertible bond or a non-convertible bond?
Explain why.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
4. Which is more attractive to investors, bonds with call provision or non-callable bond?
Explain why.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
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In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1. Bond market is a type of capital market wherein long-term bonds are issued.
2. There is a thing we call bond indenture that underscores the covenants of a
certain bond. This lists all risks and rewards attributable to the issuer and
bondholder
YOUR TURN
3. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
5. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
6. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
7. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
8. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
9. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
10. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
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Q&A LIST
Do you have any questions for clarification?
Questions/Issues
1.
2.
3.
4.
5.
Answers
1.
2.
3.
4.
5.
KEYWORDS INDEX
This section lists down the keywords that help you to recall the discussions.
ULO e.
Book value per share
Earnings Per Share
Fundamental Analysis
Growth Investor
Industry Life Cycle
Intrinsic Value
Price Earnings Ratio
Price-to-Book Ratio
Return on Equity
Stock Analysis Ratio
Technical Analysis
Value Investor
Discount Yield
Effective Annual Return
Federal Funds
Money market
Negotiable certificates of
deposit
Repurchase agreements
Treasury bills
Competitive bidding
Convertible Bonds
Debentures
Dirty Price / Full Price
Equipment trust certificates
Firm commitment
underwriting
General Obligation (GO)
Bonds
Junk bonds
Mortgage bonds
Municipal bonds
Private placement
Registered bonds
Revenue bonds
Senior debt
Serial Bonds
ULO f.
.
Ask price
Bid price
Banker’s Acceptance
Bond Equivalent Yield
Commercial paper
ULO g.
Bearer bonds
Best-efforts offering
Bond Indenture
Bond Market
Bond rating
Bonds
Call Provision
Callable Bonds
Clean Price
Collateral bonds
72
Sinking fund provisions
Stock warrants
Subordinated Debentures
Term bonds
Treasury bonds and notes
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Course Schedule
This section calendars all the activities and exercises, including readings and lectures, as well as
time for making assignments and doing requirements.
Activity
ULOs e-g
Orientation on virtual trading
and start of virtual trading
Let’s Check ULO e
Let’s Analyze ULO e
In a nutshell ULO e
ULOs f-g
Let’s Check ULO f
Let’s Analyze ULO f
In a nutshell ULO f
Let’s Check ULO g
In a nutshell ULO g
Q & A for ULOs a-g
2nd Formative Assessment
Date
Where to Submit
September 7,2020
Blackboard LMS
September 10,2020
September 10,2020
September 10,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
September 15,2020
September 15,2020
September 15,2020
September 17,2020
September 17,2020
Any day
September 18,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
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Big Picture
Weeks 6-7: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to
h. Rationalize further the characteristics and functions of mortgage markets, and
how it operates
i. Compute for the present value of mortgage
j. Discuss foreign exchange markets, what is spot foreign exchanges
transactions and forward foreign exchange transaction, and also purchasing
power parity
k. Compute for exchange rates using purchasing power parity concept
l. Discuss the basics of derivative markets, and describe the different types of
derivative market transactions
m. Assess commercial banks and other financial institutions, and the type of
services they offer.
Big Picture in Focus:
ULO h. Rationalize further the characteristics and functions of
mortgage markets, and how it operates i. To compute for the
present value of mortgage
Metalanguage
We have mentioned about other capital markets like stock markets and bond
markets. This time let us talk about mortgage market as this is related to real estate
and one of the basic necessities of human is shelter. It is important for us to get
acquainted with the important terms in this section like:
 Mortgages – these are loans to individuals or companies that
intends to purchase land, home, and/or other real properties
 Securitized – when securities are packaged and sold as security
of debt instruments such as mortgage
 Mortgage-backed security (MBS) – a bond-like investment that
is collateralized by a mortgage or set of mortgages and pays
periodic interests
 Liens – legal claim attached to the title of the property that gives
the financial institution the right to take and sell the property if the
mortgage borrower defaults
 Private mortgage insurance (PMI) – an insurance that
guarantees payment to the lender/financial institution the
difference between the value of the property and the remaining
balance of the mortgage
 Amortization schedule – shows the computation on how fixed
monthly payments are split between principal and interest
 Correspondent banking – relationship between two banks in
which the larger one provides a number of services to the other
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
bank
Trances – bondholder class associated with collateralized
mortgage obligation
Essential Knowledge
Home mortgages are the largest loan category as shelter is considered as a
basic need. When does mortgage market transaction comes in place? One
example is when the mortgage is securitized. The concept of mortgage
securitization entails combining or grouping different mortgages into a marketable
security. This then creates liquidity for mortgages as it may be bought and sold by
investors and provides periodic interest and also is backed by specific real
property. Along with home mortgage, other types of mortgages are commercial
mortgage, multifamily dwellings, and farms which will be discussed later on.
Security
As mentioned above, mortgages are secured through specific piece of
property. And in case the borrower defaults or misses to pay interest or principal
on the agreed time, the financial institution can take ownership of the property
attached to the mortgage. All other instruments generally do not have this type of
characteristic.
Size
Unlike stocks and bonds that already set its denomination size at the time of
issue, mortgage does not work that way. The amount of mortgage depends upon
how much a borrower needs and its ability to pay.
Number of investors
There is only one investor in the primary mortgage market, that is the
borrower. While in stock market and bond markets, new issues are most of the
time, bought by more than one of investors.
Rules and regulations
The needers of funds from mortgage market which are the individuals who
loans out money are often not reviewed and checked in a regular manner. In the
bond markets and stock markets, wherein the needers of funds are the
corporations, these corporations have sets of rules and regulations for people who
are interested in these markets and the corporations under these respective
markets.
PRIMARY MORTGAGE MARKET
As mentioned above, are 4 types of mortgages, and these are home
mortgages, multifamily dwellings mortgages, commercial mortgages and farm
mortgages.
 Home mortgages – used to purchase one- to-four family
dwellings
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


Multifamily dwellings mortgages – used to purchase
apartment complexes, townhouses, and also condominiums
commercial mortgages – used to finance the purchase of real
estate for business purposes
farm mortgages – used to finance the purchase of farms
CHARACTERISTICS
Collateral
Mortgages are backed by specific property, plus the lenders
place liens against properties that remain in place until loans are
fully paid off
Down payment
A down payment is a portion of the purchase price of the property
a financial institution requires the borrower to pay up front
- Twenty percent (20%) loan-to-value ratio is the
down payment generally required at least for
mortgages. But if it goes lower, the borrower
should purchase PMI.
Insured vs Conventional Mortgage
Federally insured mortgages – originated by financial
institutions, with repayment guaranteed by Community
Mortgage Program through National Housing Mortgage
Finance Corporation
Conventional mortgages – held by private financial institutions
and are not federally insured
Maturities and interest rates
Maturity period is long for mortgages which may reach up to 30
years or could be more, depending on the contract. The shorter
the maturity period, the lower the interest rate. The longer the
maturity period, the higher the interest rate.
The payment scheme is generally fixed monthly payments and
can be presented though amortization schedule. And there is
also balloon payment mortgages that requires fixed monthly
interest payments for 3 to 5 years and the full payment will be at
the end of the period.
Fixed vs Adjustable-rate mortgages
- Fixed-rate mortgage does not look at the
market rate every period, what is the agreed
interest in the inception of the mortgage will be
the rate for the rest of the period. Lenders
assume interest rate risk.
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-
Adjustable-rate mortgage (ARM) looks at the
market rate or index thus interest payments
change over time. Borrowers assume interest
rate risk.
Discount points
Discount points are fees or payments made when a
mortgage loan is issued.
Mortgage refinancing
Refinancing occurs when a mortgage borrower takes
out a new mortgage to pay off the existing mortgage.
(Second mortgages are those mortgages taken out
from properties that has existing mortgage.)
Other fees
 Application fee – initial processing cost
 Title search – fee for confirming legal ownership
 Title insurance – lender’s protection on title search
 Appraisal fee – cost on assessing the value of the property
 Loan origination fee – cost on processing the mortgage
 Closing agent fees – cost of closing agent who closes the
mortgage
 Other costs
There are also other types of mortgages prominent especially in western
countries such as jumbo mortgages, subprime mortgages, Alt-A, option ARMs, and
reverse-annuity mortgages
Jumbo mortgages are those that exceeds the limits set by housing agencies
as they are too expensive and have high credit quality. While subprime
mortgages are the ones issued to borrowers with low credit ratings that do not
qualify for conventional mortgages, thus have higher interest rates. Alt-A or
Alternative A-paper on the other hand is a classification between
prime/conventional and subprime mortgages. Another classification is option
ARMs that is a variation of adjustable-rate mortgage that allows the borrowers
design their option payments. We also have conventional mortgage which was
already mentioned above. This is not backed by government agencies and
covenants of this type of mortgage is set by private institutions. And lastly, one
which does not talk about riskiness is the reverse annuity mortgage. This
mortgage is secured against the value of the real property and allows one to cash
in some of the real property’s equity.
CALCULATION FOR PERIODIC MORTGAGE PAYMENTS
The concept is the same with bond price computation wherein we get the
present value of all future cash flows. But this time, we already have the value of
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the mortgage. Our goal is to get the periodic cash flows.
𝑡
1 𝑗
𝑃𝑉 = 𝑃𝑀𝑇 ∑
1+𝑟
𝑗=1
or
PMT = PV ÷
1 − (1 + 𝑖)−𝑛
𝑖
where
PV = Principal amount borrowed through the mortgage
PMT = Monthly mortgage payment
r = Monthly interest rate on the mortgage (equals the nominal
annual interest rate, i, divided by 12 [months per year])
t = Number of months (payments) over the life of the mortgage
Sample problem
Suppose you borrowed ₱1,200,000 from BDO to finance your farm lot and paid
20% for the mortgage. How much is your monthly amortization if the interest
rate of your loan is 12% and will be paid for 15 years?
Note that the I should be divided by 12 which will give us an
i of 1% or 0.01 and the n will be 15 times 12. That is 180.
PMT = ₱980,000 ÷
𝟏 − (𝟏 + 𝟎.𝟎𝟏)−𝟏𝟖𝟎
𝟎.𝟎𝟏
PMT = ₱980,000 ÷ 83.32166
PMT = ₱11,761.65
Month
1
2
3
4
5
Loan Bal,
Beg
980,000
978,038
976,056
974,053
972,029
Payment
11,761.65
11,762.65
11,763.65
11,764.65
11,765.65
Interest
9,800
9,780
9,761
9,741
9,720
Principal
1,961.65
1,982.27
2,003.09
2,024.12
2,045.36
Loan Bal,
End
978,038
976,056
974,053
972,029
969,984
178
179
180
34,591
23,175
11,645
11,761.65
11,761.65
11,762.65
346
232
116
11,415.74
11,529.90
11,645.19
23,175
11,645
0
SECONDARY MORTGAGE MARKETS
Securitization or sale of mortgage in the secondary market reduces liquidity
risk, interest rate risk, and credit risk experienced by the originating FIs. Mortgage
sales happens when an FI originates a mortgage and sells it with or without
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recourse to another buyer. The very reason for this selling is for the financial
institution to manage its risk and achieve diversification. This can be sold with or
without recourse. Once sold with recourse, there are certain conditions that will
allow the buyer to return the mortgage to the originating FI. While if it is without
recourse, the risks and rewards of the said instrument will be transferred to the
buyer. Mortgage sale happens in correspondent banking where in one is the
mortgage seller and one is mortgage buyer.
Another way to diversify and lower the risk is through securitization.
Mortgage-backed security is the product of this securitization. And the three major
types of mortgage-backed securities are (1) pass-through security, (2)
collateralized mortgage obligation (CMO), and mortgage-backed bonds.
 Pass-through securities – are “pass through” promised payments of
principal and interest on pools of mortgages created by FIs to secondary
investors holding interest in these pools
 Collateralized Mortgage Obligations – are secondary vehicle for
securitizing financial institution assets, compared with pass-through that
is primary. In this scheme, each bondholder class has different
guaranteed coupon, and mortgage prepayments retire only one tranche
at a time, so all other trances are sequentially prepayment protected
 Mortgage backed bonds – allows long-term low-cost funds without
removing mortgages from their balance sheets as compared with selling
of mortgages
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions.
McGraw-Hill/Irwin, 2018.
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Let’s Check
Activity 1. Let us answer the following questions to assess what we remember in the
topic above.
1. Which of the following are not considered money market securities?
a. Treasury bills
b. mortgage-backed securities
c. negotiable certificates of deposit
d. commercial paper
2. The debentures that are considered as junior bonds as compared to debentures
and mortgage bonds are classified as
a. subordinated debentures
b. ordinate debentures
c. expansion debentures
d. premium
3. As compared to unsecured bonds, the mortgage bonds are considered as
a. more risky
b. less risky
c. term risk
d. serial
4. The commercial mortgages, farm mortgages and home mortgages are categories
of
a. swapped mortgages
b. sovereign mortgages
c. secondary mortgages
d. primary mortgagees
5. The primary mortgages involve
a. three institutions
b. single investor
c. multiple investor
d. multiple institutions
6. The ownership of mortgaged property will be transferred to financial institution if the
a. borrower defaults
b. borrower does not default
c. borrower want less rate
d. borrower want profit
7. The loan which is made available for businesses or individuals to buy land, home or
other property is classified as
a. secondary loan
b. primary loan
c. mortgages
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d. swapped mortgages
8. The mortgages used to purchase the townhouses and apartment complexes are
classified as
a. multi mortgage
b. multifamily dwelling mortgages
c. sovereign dwelling mortgages
d. primary dwelling
9. The following are true regarding mortgage, except:
a. Mortgages generally require 20% down payment to ensure risk
b. Mortgage is a secured type of loan as it is backed by a real property
c. Mortgage market is a capital market
d. Mortgage market has a secondary market
10. Which among the following is least risky?
a. Alt-A
b. Subprime Mortgage
c. Jumbo mortgages
d. All of the above have the same riskiness
11. The mortgages used to purchase the shopping malls and office buildings are
classified as
a. developed mortgages
b. dwelling mortgages
c. commercial mortgages
d. non-commercial mortgages
12. If a borrower cannot pay upfront down payment of at least 20% of the loan-to-value
amount, it must pay for
a. Private Mortgage Insurance
b. Public Mortgage Insurance
c. Philippine Mortgage Insurance
d. Primary Mortgage Insurance
Activity 2. Identify the following.
1. Loans to individuals, secured by real property
2. A process that groups securities into groups to be sold as portfolio and therefore
reduces liquidity risk, interest rate risk, and credit risk.
3. A public record that when attached to a contract, it will give rights to one party to
sell the property once the other party defaults.
4. This upfront payment upon having a mortgage agreement will most likely decrease
the chances of the borrower to default.
5. This scheme allows borrowers to pay periodic payments for three to five years,
then the rest will be paid at maturity.
6. This fee intends to check whether the borrower has the legal title to the mortgaged
property.
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7. This is also called pick-a-payment or pay-option ARMs that has 15 or 30 year
maturity and offers borrowers several monthly payment options.
8. This type of mortgage lets the borrower receive periodic payments from a financial
institution rather than making them, and when this type of mortgage matures, the
property is sold.
9. This occurs when a financial institution originates a mortgage and sells it with or
without recourse to an outside buyer.
10. ___________________ is when a mortgagee applies for another mortgage to
repay the old mortgage.
Let’s Analyze
An borrower approached you and asked for advice about the two options
that the bank presented to him.
I.
II.
₱4,000,000 for a house with 8% interest, payable for 15 years.
₱4,500,000 for a house with 10% interest payable for 20 years.
Suppose he is capable to pay the minimum down payment so that he will
not be paying for any PMI anymore, how much is the monthly amortization
for each scenario? Please provide the first year and last year amortization
schedule for both scenarios.
In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
2. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
3. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
4. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
5. _________________________________________________________________
_________________________________________________________________
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_________________________________________________________________
_________________________________________________________________
6. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
7. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
8. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
9. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
10. _________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
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Big Picture in Focus:
ULO j. Discuss foreign exchange markets, what is spot foreign
exchanges transactions and forward foreign exchange
transaction, and also purchasing power parity and interest
rate parity theorem
k. Compute for exchange rates using purchasing power
parity concept
Metalanguage
Another type of capital market is the foreign exchange markets. In this short
section, we shall learn the basics of the said market. This is essential for business
students especially for those who will later deal with multinational companies such
as Procter and Gamble, Nestle, Palmolive, etc. The terms and definitions under
this topic will be discussed in the essential knowledge
Essential Knowledge
The foreign exchange market is where cash flows from the sale of goods,
services, or assets are transacted and denominated in foreign currency.
Businessmen, financial managers, and even business students must understand
at least the fundamentals of this market such as how to interpret the events in other
countries that may affect the rise and fall of currencies. Foreign exchange rate is
the price at which one currency can be exchanged for another currency in the
foreign exchange markets, e.g. dollar to peso rate: $1.00 = ₱48.59. It means one
dollar can be purchased for ₱48.59. Because of the changes in the exchange rate,
corporations and financial institutions are exposed to foreign exchange risk. This
is the risk that might cause one to incur losses due to the change in foreign
exchange rate. For example, a US company bought goods in the Philippines for a
total price of ₱50,000 (which is equal to $1,000), that is 10 pieces of pearls, when
the exchange rate was ₱50.00 = $1.00. At the time payment was made, the
exchange rate became ₱48.00 = $1.00. And now $1,000 is only equivalent to
₱48,000, a loss of $41.67 to the US company as he had to pay $1,041.67 because
of the change in the exchange rate. The term used if a currency rises is
appreciation/appreciate,
and
when
it
declines,
we
may
say
depreciate/depreciation.
Foreign Exchange Transactions
There are generally two types of foreign exchange transactions, that is spot
foreign exchange transaction, and forward foreign exchange transaction. Spot
foreign exchange (FX) transaction involve immediate exchange of currency
using the spot rate. An example of Spot FX transaction is when a purchase or sale
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of one currency for another takes places in one or two business days using the
rate at the time both completely agreed on the terms and conditions of the contract.
While forward foreign exchange (FX) transaction is the exchange of
currencies at a specified time in the future using forward rate – two parties
exchange two specified currencies at specified future date. These contracts are
not traded on the exchanges unlike spot FX transactions, and generally
noncancellable except by mutual agreement by the parties involved. An example
of forward FX transaction is when two parties agreed today to exchanged peso for
pounds at a forward exchange rate two months into the future.
In addition to what were mentioned above, here are the basic foreign
exchange trading activities:
 Buying and selling of currencies for international transactions
 Foreign investments
 Hedging activities (intends to reduce the risk of unfavorable price
movements in the market)
 Speculation (involves trading of instruments with high risk with
expectation to earn significant return)
Purchasing Power Parity
To help us understand to concept of Purchasing Power Parity(PPP), let us
define first what purchasing power is. Purchasing power is the amount of goods
and/services one can buy with a certain amount of money. Ones purchasing power
has declined when last year, he can buy 50kg of rice for ₱2,000.00 but now
₱2,000.00 can only buy 45kg. And has increased if today, he can buy more than
50kg of rice.
The theory PPP states that currencies are in equilibrium if purchasing power
between two countries. If US dollar to PH peso is $1.00 = ₱50.00, purchasing
power is in equilibrium if in the US, a liter of Coca Cola is $1.00 and, in the
Philippines, a little of Coca Cola is ₱50.00. It also means that no matter what
currency one uses to purchase a basket of goods in one country, he can also
purchase the same amount of goods from another country. It also says that long
run exchange rates should move toward rates that would later on equalize the
prices of identical basket of goods as well as services in any two different countries.
Absolute PPP suggests same products in different countries should be
equal. Let us apply this concept to foreign exchange. A bottle of the same lotion
costs ₱64.00 in the Philippine, and $1.25 in the US. It means the exchange rate is
$1.00 = ₱51.20. That is:
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦1
𝐶1
⁄𝐶 =
2
𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦2
₱64.00
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 ₱⁄$ =
$1.25
𝑬𝒙𝒄𝒉𝒂𝒏𝒈𝒆 𝒓𝒂𝒕𝒆 ₱⁄$ = ₱𝟓𝟏. 𝟐𝟎 𝐩𝐞𝐫 $𝟏. 𝟎𝟎
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Absolute PPP follows the theory of law of one price wherein economic
goods/assets/services will be the same price in different markets or countries,
ceteris paribus. However, absolute PPP is not perfectly valid because there are
certain reasons that will make the prices not the same such as transportation costs
and trade restrictions, non-tradable goods, and imperfect information. Which is why
we have to consider Relative PPP instead. It takes inflation into account. We must
note that price level increases when there is inflation.
SAMPLE PROBLEM
The current exchange rate applying the concept of Absolute
PPP is $1.00 = ₱49.82. Assuming the inflation rate in the US
is 4.5% and 2.9% in the Philippines, how much is the new
exchange rate?
1st. Deduct the lower inflation from the higher inflation.
4.5% – 2.9% = 1.6%
Difference in IP(DIP) = 1.6%
2nd. Increase the value of the currency that has higher inflation with
the difference. That is
$1.00 × (1 + DIP) : ₱49.82
$1.00 × (1 + 0.016) : ₱49.82
$1.016 : ₱49.82
$1.00 : ₱49.035
Purchasing power parity is considered more accurate than the market rates.
However, due to product differences between countries, different preferences of
the people, hedging and speculation activities, etc., it is difficult to make the prices
certain.
Interest Rate Parity Theorem (IRPT)
Interest Rate Parity Theorem (IRPT) states that there is a relationship
between spot exchange rate and the expected forwards exchange rate of two
currencies based on the interest rates relating to them. This theory suggests
hedging in the forward exchange market will give the same returns whether the
investment is domestic or foreign.
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
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Phone No.: (082)300-5456 Local 137
(Philippine Branch), [2014] [2015].
Graham, Alastair. “Foreign Exchange Markets.” 2013,
doi:10.4324/9781315063416.
Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions.
McGraw-Hill/Irwin, 2018.
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Let’s Check
Activity 1. Let us answer the following questions to assess what we remember in the
topic above.
1. The foreign exchange market helps the exchange of:
a. information between supplier of funds in different countries.
b. debt securities.
c. equity securities.
d. currencies.
2. The rule which states that similar set of goods and services produced in various
countries should have equal price is classified as
a. law of similar mortgage rate
b. law of one type manufacturing
c. law of similar labor rules
d. law of one price
3. The theory which considers the change in exchange rate with the fluctuations in
inflation rates is classified as
a. liquidated power parity
b. purchasing power parity
c. selling power parity
d. volatile power parity
4. The inflation rate in Philippines is added into real rate of interest to calculate
a. quoted interest rate in Philippines
b. nominal interest rate in Philippines
c. interest rate in Philippines
d. discount rate of country
5. Suppose the previous exchange rate was $1.00 = ₱48.50 and now it became $1.00
= ₱49.80. Which is true?
e. Peso appreciated
f. Dollar appreciated
g. Dollar depreciated
h. Cannot be determined
6. The rate governing the transaction between two parties who agreed to exchange
currencies and carry out a deal at some specified future date
a. Foreign Exchange Rate
b. First Exchange Rate
c. Forward Exchange Rate
d. Stop Exchange Rate
7. The theory according to which the difference between expected appreciation and
foreign interest must be equal to domestic interest rate, is called
a. interest rate parity theorem
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b. appreciation parity theorem
c. domestic parity theorem
d. foreign interest parity
8. Which of the following reasons suggests that absolute PPP is not valid?
a. The foreign exchange rates are equal
b. There are limitations in the information in the market
c. There is no inflation premium in any country
d. Transportation costs, taxes and tariffs are the same in different countries
9. Rate at which the currency is exchange to another
a. Spot rate
b. Forward rate
c. Exchange rate
d. Interest rate
10. This activity wishes to protect firms from foreign exchange risk
a. Hedging
b. Parity
c. Risk taking
d. Speculation
Activity 2. Differentiate the following in two to four sentences
1. Foreign Exchange Market vs Stock market
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
2. Spot Foreign Exchange Transaction vs Forward Foreign Exchange Transaction
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
3. Absolute PPP vs Relative PPP
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4. Purchasing Power Parity vs Interest Rate Parity Theorem
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
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Let’s Analyze
Assuming your Filipino friend is planning to travel to Europe this 2021. He wanted
to know about foreign exchange and how currencies are computed using Relative
PPP. The forecasted inflation premium in the Philippines next year is 3.2% and
Europe is forecasted to have 2.8% inflation premium. Suppose it is also speculated
that the exchange rate on that period is €1.00 = ₱58.42.
The total cost is €5,000 and he is certain he can come up with ₱300,000 during his
designated travel time. What is your advice to him?
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
___________________________________________________________________
______________________________________________________________________
______________________________________________________________________
In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
2. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
3. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
4. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
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5. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
6. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
7. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
8. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
9. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
10. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
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Big Picture in Focus:
ULO l. Discuss the basics of derivative markets, and describe the
different types of derivative market transactions
Metalanguage
The last type of capital markets that we are going to talk about in this course
is derivative markets. As we go along, we want to know about the essential
concepts under this topic. These are terms that we need to know:
 Derivate securities – these are securities whose values depend upon
another asset’s value or its settlement is linked to another
security/securities
 Marked to market – this is the process of valuing assets at the end of
each trading day, adjusted daily to reflect market conditions
 Floor brokers – members of the exchange who place trades from the
public
 Long position – purchase of a futures contract
 Short position – sale of futures contract
 Clearinghouse – a separate corporation and intermediary between
buyers and sellers of futures, responsible for settling the accounts,
clearing trade, regulations and also reporting the data for a period
 Black-Scholes option pricing model – used to determine the fair
market price or the theoretical value and the intrinsic value for a call or
put option based on several variables
 Notional Principal – principal amount involved in a swap agreement
Essential Knowledge
Derivative securities have been very helpful in reducing financial risks. These
are financial contracts whose value is derived from a value of an underlying asset.
Mortgage securities market is where derivates are traded and it is claimed that this
market is growing because investors or financial people are concerned about
minimizing losses. There are four (4) main types of derivatives and these are
futures, forwards, options, and swaps.
Illustration
On September 1, 2020, Don decided to buy half kilo of gold as
one of his investments. The price of gold on this day is ₱2,350.00
per gram. He would like to hold this gold for one year and sell it at
the prevailing rates. Should he bought it on September 1,2020
and the price of the gold a year from now it at ₱2,500, then he
clearly earned ₱150 per gram. Or that is ₱150 x 500g = ₱75,000.
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Suppose Don do not have money yet but he decides to enter a
contract to buy the half kilo for ₱2,420 a year from now – the seller
shall deliver, and Don will pay for the price no matter what. This
contract did not have any exchange of assets at the beginning of
the contract. A year later, Don settled the contract paying ₱2,420
per gram and getting half kilo of gold from the seller. Suppose the
selling price of the gold at this time is selling at ₱2,500 and if Don
sells the gold right away, he gains ₱80 per gram. Thus, we may
say that the value of the contract is ₱80 × 500g = ₱40,000. This
contract is a forward contract.
Derivatives involves exchange of assets between two contracting parties at
a specified future date. This contract is again, intended to avoid risk of loss but
sometimes, because no price is permanent, and prices are fluctuating, large losses
are unavoidable. Mortgage-backed security is an example of derivative security
which involves large amounts of money. This security is based on the value of the
mortgage.
FORWARDS AND FUTURES CONTRACTS
Forwards and futures contracts involve exchange of asset for cash at a
specified future date. Compared to spot contract, this is an agreement between
a buyer and seller to pay cash and deliver the asset immediately and
simultaneously. If the price is at ₱100.00 for an item, pay ₱100 to get the item right
ahead. The goal is to avoid increase of prices for the buyer and decrease of prices
for the seller. Plus the seller’s income is guaranteed, and the buyer’s asset is
guaranteed.
Forward Markets
Forward contract is a contractual agreement at time 0 between two parties
to exchange a nonstandardized asset for cash at some time in the future. At point
0, the price is already specified, and is fixed over the life of the contract. This type
of contract already has an illustration above. The major participants in this type of
contract are the commercial banks, the investment banks, and the broker-dealers.
Their income sprouts out from the spread between the price of the contract and
the price of the underlying assets.
Futures Markets
While futures contract, this is a contractual agreement at time 0 between
two parties to exchange a standardized asset for cash at some time in the future.
Futures and forwards are almost the same, but futures are bilateral contracts
subject to default risk. Hence there are intermediaries, located in specific venues,
that fix legal agreements on this type of contract such as standardizing interest
rates and the size of the contracts. And unlike forwards, there are mark-to-market
activities in the futures market. Futures markets that are popular in the US is the
Chicago Board of Trade (CBT) and New York Mercantile Exchange (NYMEX). In
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the trading platform, open-outcry auction method is used where traders face
each other and “cry out” their offers to buy or sell securities.
Futures market exchange only cater members as nonmembers are not
allowed to transact in the exchange, and nonmembers may only transact through
floor brokers. Just like the stock market, futures have long position and short
position trading. The trade will be completed through a clearinghouse who
oversees the exchange.
Traders in Futures Market
Professional traders – they are like specialists on the stock
exchanges who trade using their own account
Position traders – they base their expectations about the future
directions of prices of underlying assets
Day traders – they buy and sell within the day and liquidate before
the day ends
Scalpers – active traders that hold securities for short period of
time, say minutes, to earn more profit
OPTIONS
Options contract is an agreement between two parties, a buyer and seller,
that gives the buyer of the option the right to purchase to buy or sell a particular
asset at a future date at a predetermined price. We classify options as either call
options or put options.


Call option – a contract that gives the buyer the right to purchase an
underlying security at a price called exercise or strike price. The buyer of
the call option should pay the seller a fee called call premium in addition
to the purchase price.
Put option – a contract that gives the buyer the right to sell an underlying
security at a specified price. The buyer shall also pay put premium.
Valuing options
Black-Scholes pricing model is the most commonly used method by
financial people in pricing options using the following factors:
1. Spot price of the underlying asset
2. Exercise price on the option
3. Option’s exercise date
4. Price volatility of the underlying asset
5. Risk-free rate of interest
This model estimates the prices mathematically using the variation in prices
over time, and solves the prices using differential equation. This will not be tackled
in this section anymore.
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Options Market
The Chicago Board of Options Exchange (CBOE), the European Options
Exchange and the London International Financial Futures Exchange are the
prominent options market. These exchanges, just like futures, only let members
transact on the option floor. Trades from the public or nonmembers are also placed
in with the floor broker, market maker or professional trader. Stock options is one
type of options whose underlying asset is the stock of a publicly traded corporation.
Stock options gives rights to an investor, but not an obligation to purchase
additional shares at an agreed date and price.
CAPS, FLOORS and COLLARS
Caps, floors, and collars are means to hedge interest rate risks.
When someone decides to buy a cap, it means buying a call option
on interest rate. While buying a floor means buying a put option
on interest rate. And a collar occurs when an intermediate takes
a simultaneous position in a cap or a floor.
SWAPS
The last type of derivative is swap, an agreement between two contracting
parties, called counterparties, to exchange cash flows in the future based on some
underlying asset. An example of this type of derivate is when two contracting banks
agrees that bank one pays the bank two the fixed interest on a certain principal.
While bank two pays bank one the interest on the same principal mentioned above
but at a variable rate called floating rate. The reason why firms enter into this
agreement is for comparative advantage. In this chapter, we shall talk about
interest rate swaps and currency swaps. Swap features may vary depending on
the type, but its general principles are basically the same
Interest Rate Swaps
Interest rate swap, sold over-the-counter, is the largest sector in the swap
market wherein two counterparties agree to exchange one stream of future interest
payment for another based on a specific principal amount over a specified period.
In this market, a swap buyer agrees to make a number of fixed interest rate based
on notional principal on a periodic manner to the swap seller. While the swap
seller pays variable rate.
Currency swaps
Currency swap is used to protect or hedge against exchange rate risk when
firms mismatch currencies of their assets and liabilities. This involves exchange of
interest and/or principal in once currency to another. Counterparties agree
beforehand whether or not they will exchange the principal amounts of the two
currencies at the beginning of the transaction. There are three approaches on the
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exchange of interest rates: fixed rate to fixed rate; floating rate to floating rate;
or fixed rate to floating rate.
Credit swaps
Credit swap is a kind of insurance against credit risk wherein a third party
agrees to pay a lender if default happens, in return for receiving payments from the
lender. Two types of credit swaps are total return swaps and pure credit swaps.
If we say total return swap, this involves swapping an obligation to pay interest at
a fixed or floating rate for payments representing the total return on a loan, that is
interest and principal value. And if we say pure credit swap, lender will send each
swap period a fixed fee or payment to the counter party.
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions.
McGraw-Hill/Irwin, 2018.
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Let’s Check
Activity 1. Let us answer the following questions to assess what we remember in the
topic above.
1. The example of derivative securities include
a. swap contract
b. option contract
c. futures contract
d. all of the above
2. The example of derivative securities is
a. return backed security
b. mortgage backed security
c. cash flow backed security
d. interest backed
4. The type of financial security whose payoff is linked to any other security is called
a. strong security
b. semi-strong security
c. derivate security
d. non-derivate security
4. Derivatives are
a. complex financial securities that derive their value from another financial
security.
b. simple financial securities that derive their value from another financial
security.
c. complex financial securities that do not derive their value from another
financial security.
d. simple financial securities that do not derive their value from another financial
security.
5. Derivatives are contracts that:
a. allow the holder to buy/sell a given commodity
b. are sold only in established financial markets
c. usually expose the holder to increased risk
d. completely remove risk in financial and economic transactions
6. The difference between futures and forwards is:
a. that forwards are standardized and futures customized contracts
b. that most forwards are exercised and most futures closed out before expiry
c. that futures predetermine the price of an underlying commodity, but a forward
price is flexible
d. that forwards are on currencies, and futures on interest rates
7. Futures are _____.
a. absolutely the same as forwards.
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b. over-the-counter derivatives.
c. exchange-traded derivatives.
d. customizable like forwards.
8. The purchaser or holder of a call option has:
a. the obligation to sell the underlying security
b. the obligation to buy the underlying security
c. the right but not the obligation to sell the underlying security
d. the right but not the obligation to buy the underlying security
9. The type of unit which guarantees that all the buying and selling will be made by
traders of exchange is called
a. Trading house
b. Guarantee house
c. Clearinghouse
d. Professional house
10. The type of option that gives the buyer the right to sell the underlying option at
specific exercise price considered as
a. Call option
b. Put option
c. Class option
d. Take option
11. Derivative instrument have the following advantage:
a. They help control risk
b. They have lower transaction costs than most other financial assets
c. They aid in keeping spot prices close to their true values
d. All of the above are advantages of derivative instruments
12. Which of the following is most similar to a stock broker?
a. Futures commission merchant.
b. Pit trader.
c. Floor broker.
d. Local.
13. Derivatives are contracts that:
a. allow the holder to buy/sell a given commodity
b. are sold only in established financial markets
c. usually expose the holder to increased risk
d. completely remove risk in financial and economic transactions
14. The difference between futures and forwards is:
a. that forwards are standardized and futures customized contracts
b. that most forwards are exercised and most futures closed out before expiry
c. that futures predetermine the price of an underlying commodity, but a forward
price is flexible
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d. that forwards are on currencies, and futures on interest rates
15. The purchaser or holder of a call option has:
a. the obligation to sell the underlying security
b. the obligation to buy the underlying security
c. the right but not the obligation to sell the underlying security
d. the right but not the obligation to buy the underlying security
Activity 2. Differentiate the following in two to four sentences
1. Derivative vs Mortgage
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
2. Futures vs Forwards
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
3. Caps vs Floors vs Collars
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4. Fixed rate to fixed rate vs Floating rate to floating rate vs Fixed rate to floating rate.
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1) ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
2) ________________________________________________________________
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________________________________________________________________
________________________________________________________________
________________________________________________________________
3) ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4) ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
5) ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
6) ________________________________________________________________
________________________________________________________________
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________________________________________________________________
7) ________________________________________________________________
________________________________________________________________
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________________________________________________________________
8) ________________________________________________________________
________________________________________________________________
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9) ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
10) ________________________________________________________________
________________________________________________________________
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Big Picture in Focus:
ULO m. Assess financial markets and institutions, and the
different types of markets under financial market’s
umbrella.
Metalanguage
The goal in this section is to understand what commercial banks and
get acquainted with the different types of services they offer. Accordingly, we
have to have a jump start with the terms that we are going encounter in this
section.
a. Commercial Banks – makes money primarily by providing different
types of loans to customers and charging interest.
b. Bank Loan – an amount of money offered by a bank to a borrower at
a defined interest rate for a fixed period.
c. Cash Credit – allows the client to withdraw money beyond their
account limit.
d. Bank Overdraft – allows the current account holders to overdraw
their account up to a specified limit.
e. Discounted Bills of Exchange - providing money immediately to the
holder of the bill
f. Bangko Sentral ng Pilipinas (BSP) – aims to promote and
preserve monetary stability and the convertibility of the national
currency.
g. Securities and Exchange Commission – the national
government regulatory agency charged with supervision over
the corporate sector, the capital market participants, and the
securities and investment instruments market, and the
protection of the investing public.
Essential Knowledge
Commercial Banks, a financial company, which provides loans, receive deposits,
and supply financial products like savings accounts and deposit certificates. It
makes money primarily by providing different types of loans to customers and
charging interest.
The funds of the banks came from the deposited money of the customers in
savings, checking and money market accounts and certificate of deposits (CDs)
which allows the latter to gain interest but in lesser interest rate given to borrowers.
Some of the loans offered by commercial banks are mortgage, personal, business
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and motor vehicle loans.
FUNCTIONS OF COMMERCIAL BANKS
One general role of commercial banks is to offer financial services to the public and
to make sure that the economy is stable and sustainable in one’s economy. A
commercial bank performs the following functions:
1. Accepting Deposits
This is the oldest responsibility of the commercial banks and with the development
in the banking sector and profitability of the business, banks now pay a lesser
interest to their customers but resulted to more administrative costs to keep their
accounts.
Banks accept three types of deposits. The first one is the savings deposit for small
customers who are paid interest on their accounts and allows them to withdraw up
to a specific amount by issuing a cheque. The second type of deposit is the current
account for business which allows to withdraw money at any time with no
notification. In this type of deposit, the account holders are charged a nominal fee
for the services offered.
The last type of deposit is the term or fixed deposit which allows investors to save
money for 6 months or more and the interest rate paid arises with the length of the
fixed deposit. Consequently, investors can only withdraw the money at the maturity
date agreed by writing to the bank.
2. Advancing Credit Facilities
Advancing loans is the most earning revenue annually of the banks due to its short
and medium-term loans charged with bigger interest rates but does not offer longterm financing due to the necessary liquidity maintenance of the assets. Before
approval, banks conduct financial checks to ensure financial capability, business
earning capacity, nature and size of the business and its ability to pay loans without
defaults.
3. Credit Creation
Instead of providing cash to the customers in the form of loan, commercial banks
will initiate the creation of deposit accounts from which the borrower can withdraw
the money which makes the creditor draw cash by cheque. Through this, circulation
of cash rises because banks will create demand deposit instead of printing
additional money.
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4. Agency Functions
Commercial banks help in the collection and payment of cheques, dividends,
interest warrants and bills of exchanges by being an agent of the clients. Moreover,
they trade marketable securities such as shares and bonds in behalf of the
customer. In the field asset management, commercial banks play as the trustee and
executors of the estate on behalf of the client and charges initial fee for their
service.
5. Other Functions
Provision of foreign exchange to customers by purchasing and trading foreign
currencies but banks should get a license to operate from the regulatory body such
as the central bank before doing so. Moreover, they can act as a custodian of
precious metals by providing lockers which are considered safer from theft and
damages.
TYPES OF LOANS OFFERED BY COMMERCIAL BANKS
There are various kinds of loans offered by commercial banks to their customers.
These loans include:
1. Bank Loan
A bank loan is a value of cash advanced by a bank to a creditor at a fixed interest
rate for a definite period of time. For verification processing, a bank must require a
client to submit various critical documents for due diligence and credit capacity,
these may include an identification card, income proof and/or audited financial
statement for corporate borrower. This may come with collateral in which the banks
may sell the collateralized assets in terms of defaults by the client to recover losses
which may come in the form of fixed assets, inventory, ownership rights and other
assets.
2. Cash Credit
This is a contract between a bank and a customer which allows the latter to draw
cash beyond their account limit. Moreover, this is offered for a period of 1 year but
may extend to 3 years in specific instances. The interest charges may depend on
the length of time the cash is withdrawn.
3. Bank Overdraft
Bank overdrafts allow the current account holders to withdraw beyond their savings
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up to their account limit, it does not need any written documents and can be used in
any urgent event. Interest charges are charged in the overdrawn amount.
4. Discounted Bills of Exchange
Bank can provide cash immediately to bill holders through discounted bills of
exchange
Once the bill of exchange matures, the bank gets its payment from the banker of the
bill holder.
It is important to note that commercial banks are govern by certain set of rules
and regulations in the lead of Central Bank of the Philippines.
In this chapter, we will be acquainted with the different laws and how their role
in the commercial banking sector.
REGULATION OF COMMERCIAL BANKS
1. Applicable laws and regulation
The most pertinent banking laws in the Philippines are:
a. The New Central Bank Act (Rep. Act No. 7653) (the "BSP Law") - The BSP Law
establishes the Bangko Sentral ng Pilipinas (“BSP”), its organizational set-up,
responsibilities, corporate authorities, key operational procedures, and special
powers over banks.
b. The General Banking Law of 2000 (Rep. Act No. 8791) ("GBL") - The GBL provides
for the regulatory supervision of the BSP over all banks in the Philippines. It likewise
provides for the authority of the BSP and the organization, management, and
administration of foreign and local banks, quasi-banks, and trust entities, and other
types of banks.
c. Foreign Bank Liberalization Act (Rep. Act No. 7221) (“FBLA”) - The FBLA provides
for the different modes of entry by foreign banks into the Philippines. Under this Act,
foreign banks which are among the top 150 in the world or the top five in their country
of origin are allowed to invest in up to 60% of the voting stock of a Philippine bank or
to establish branches with full banking authority, provided they can only opt for one
mode of entry, and provided that only 14 foreign banks may establish branches with
full banking authority.
d. Thrift Banks Act (Rep. Act No. 7906) - The Thrift Banks Act provided for the creation
of a new class of bank – the thrift bank – which are savings and mortgage banks,
stock savings and loan associations, and private development banks. Under the Thrift
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Banks Act, thrift banks may exercise similar powers as those of a commercial bank,
but with prior approval of the Monetary Board for particular activities, such as: (a)
opening of current accounts, (b) engaging in trust, quasi-banking, and money market
operations, (c) acting as collection agent for government entities, (d) acting as official
depository of national agencies where the thrift bank is located, (e) issuing of
mortgage and chattel mortgage certificates, and (f) investing in the equity of allied
undertakings.
e. Investment Houses Law (Pres. Decree No. 129, as amended) - Corporations
engaged in the underwriting of securities of other corporations are required to be
licensed as investment houses under the Investment Houses Law. Investment
houses are also allowed to act as financial consultant, investment adviser, portfolio
manager, financial agent, and broker. Foreigners are allowed to own up to 60% of the
voting stock of an investment house. Universal banks are allowed to perform the
functions of an investment house on an in-house basis.
f. Financing Company Act (Rep. Act No. 7906) - A corporation primarily engaged in
extending credit facilities by direct lending, discounting or factoring commercial
papers or accounts receivable, buying and selling evidences of indebtedness, or
financial leasing is required to be licensed as a financing company under the
Financing Company Act, unless the corporation is a bank, investment house,
insurance company, or other financial institution with a secondary license. Foreigners
are allowed to own up to 60% of the voting stock of a financing company.
g. Secrecy of Bank Deposits Act (Rep. Act No. 1405, as amended) - This law prohibits
the examination and inquiry into all bank deposits and investments in government
securities with Philippine banks by any person, government official, bureau, or office,
and prohibits the disclosure by any bank official or employee to any unauthorized
person of any information concerning the said deposits, subject to certain.
h. Anti-Money Laundering Act (Rep. Act No. 9160, as amended) (“AMLA”) - The
AMLA criminalizes money laundering and identifies the predicate crimes from which
money laundering can arise. In order to prevent money laundering, the AMLA created
the Anti-Money Laundering Council (“AMLC”) and granted it such powers ranging
from requiring reports from covered institutions (including banks and other financial
institutions), rule-making, prosecution, and actual imposition of sanctions. In addition,
the AMLA requires covered institutions to adopt Know-Your-Customer guidelines and
to report transactions involving at least PhP500,000 as well as suspicious
transactions to the AMLC.
i. Foreign Currency Deposit Act (Rep. Act No. 6426, as amended, and Pres. Decree
No. 1035) (the “FCDU Law”) - By virtue of the FCDU Law, banks with a Foreign
Currency Deposit Unit (“FCDU”) license are authorized to accept foreign currency
deposits, to issue certificates to evidence such deposits, to discount said certificates,
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and to accept deposits as collateral for loans, while banks with an expanded FCDU
license are authorized to obtain foreign currency loans from and conduct foreign
currency transactions with non-residents, offshore banking units, and other
depository banks with expanded FCDU licenses. Interest earnings from such foreign
currency deposits are granted absolute tax exemptions. It is also provided that there
shall be no restriction on the withdrawal or transfer by the depositor of his deposits,
except upon mutual agreement with the bank.
2) Entities/ Authorities in charge of the control and supervision
A banking institution has a primary license (as a corporation) and a secondary license
(as a bank or quasi-bank). As a corporation, and especially if its shares are registered
and listed in the stock exchange, it is under the general supervision of the Securities
and Exchange Commission (“SEC”). As a bank, it is under the supervision of the BSP,
which is its primary regulator.
Securities and Exchange Commission (SEC)
The SEC is the specialized government agency that exercises general supervision
over
corporations and partnerships in general, including registered or publicly-listed
corporations. It exercises the powers and functions provided by the Securities
Regulation Code of 2000 (“SRC”), the Corporation Code of the Philippines, the
Investment Houses Law, the Financing Company Act, Pres. Decree No. 902-A,
among others. Among its powers and functions specified in Section 5.1 of the
Securities Regulation Code are (a) to regulate, investigate, or supervise the activities
of persons to ensure compliance with corporation and securities laws; (b) to
supervise, monitor, suspend, or take over the activities of exchanges, clearing
agencies, and other self-regulatory organizations; (c) to impose sanctions for
violations of laws and the rules, regulations, and orders issued pursuant thereto; and
(d) to issue cease and desist orders to prevent fraud or injury to the investing public;
and (e) to compel the officers of any registered corporation or association to call
meetings of stockholders or members under its supervision.
Bangko Sentral ng Pilipinas (BSP)
The BSP is the specialized government agency that provides policy directions in the
areas of money, banking, and credit. It supervises the operations of banks and
regulates the operation of finance companies and non-bank financial institutions
performing quasi-banking functions and those performing similar functions. The
fundamental roles of the BSP are: (a) as central monetary authority; (b) as banker
and adviser of the national government, and (c) as the banker of banks.
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Self-Help: You can also refer to the sources below to help you
further understand the lesson:
- Corporate Finance Institute Education Inc. (2020). Commercial Banks.
doi:https://corporatefinanceinstitute.com/resources/knowledge/finance/c
ommercial-bank/
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Let’s Check
Activity 1. List down two (2) examples of (1.a.-1.b.) commercial banks, and two (2)
examples of (2.a.-2.b.) loans.
1.
a.__________________________________________________________
____________________________________________________________
____________________________________________________________
1. b._______________________________________________________
____________________________________________________________
____________________________________________________________
2. a._______________________________________________________
____________________________________________________________
____________________________________________________________
2.b._________________________________________________________
____________________________________________________________
____________________________________________________________
List down three (2) examples of financial institutions who provide credits/borrowings
with its brief (one sentence) description.
1.__________________________________________________________
____________________________________________________________
____________________________________________________________
2.__________________________________________________________
____________________________________________________________
____________________________________________________________
Activity 2. Now that you are already acquainted with what commercial banks, and
loans it offers, let us have a brief review. Kindly answer the following questions
below.
1. Which of the following is the best explanation of a commercial bank?
a.
b.
c.
d.
A federally chartered bank.
A bank that services only businesses.
A bank that accepts deposits and lends money.
A bank whose primary activity is raising capital by selling securities in an
IPO for new business start-ups
2. Which federal organization monitors commercial banks?
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a.
b.
c.
d.
Department of Finance.
Department of Justice.
Securities and Exchange Commission.
Central Bank of the Philippines.
3. Which of the following is not a traditional commercial banking function?
a.
b.
c.
d.
Accepting deposits
Promoting initial public offerings
Lending money
Disbursing payments
4. Which banks do not accept deposits?
a.
b.
c.
d.
Commercial banks
Retail Banks
Investment banks
None of the above
5. What is the average rate on savings accounts?
a.
b.
c.
d.
5 percent
1-3 percent
0.5 percent
10 percent
Activity 3. At this juncture, it is expected that we have learned the concepts of
commercial bank regulations already. Here is some question to confirm our
learnings.
1. In your own words, explain the importance of regulatory bodies in the
operation of the commercial banks.
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
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Let’s Analyze
Activity 4. Indicate whether the item is true or false.
_________1. A credit report is a loan and bill payment history.
_________2. A savings account offers the highest returns.
_________3. Investment banking is NOT a commonly used term in the
context of Banking.
_________4. Line of credit is a loan backed by collateral.
_________5. Conduct of monetary policy is a common function of the
central bank.
_________6. Lending to the commercial banking system is a common
function of the central bank.
_________7. Banker to the banking system is a function of central bank
that may potentially conflict with its monetary policy role.
_________8. Banker to the government is a function of central bank that
may potentially conflict with its monetary policy role.
_________9. Issuing currency is a function of central bank that may
potentially conflict with its monetary policy role.
_________10. Notes and coin held by banks are normally regarded as
banks’ reserves.
Activity 5. In addition to what we discussed above, I would like you to gather
additional information and give me 3 additional commercial banks and describe
them briefly.
1.____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
2.____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
3.____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
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In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
2._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
3._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
4._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
5._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
6._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
7._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
8._______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
9._______________________________________________________________
_______________________________________________________________
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_______________________________________________________________
_______________________________________________________________
10.______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
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Q&A LIST
Do you have any questions for clarification?
Questions/Issues
1.
2.
3.
4.
5.
Answers
1.
2.
3.
4.
5.
KEYWORDS INDEX
This section lists down the keywords that help you to recall the discussions.
ULO h and i.
Adjustable-rate mortgage
Alternative A-paper
Amortization schedule
Commercial mortgages
Conventional mortgages
Correspondent banking
Farm mortgages
Fixed-rate mortgage
Home mortgages
Jumbo mortgages
Liens
Mortgage sales
Mortgage-backed bonds
Mortgage-backed security
Mortgages
Federally insured mortgages
Multifamily dwellings mortgages
Collateralized Mortgage obligations
Option arms
Pass-through securities
Private mortgage insurance
Reverse annuity mortgage
Second mortgages
Securitized
Subprime mortgages
Trances
ULO j and k.
Absolute PPP
Foreign exchange market
Foreign exchange rate
Foreign exchange risk
Forward foreign exchange transaction
Relative PPP
Forward rate
Interest rate parity theorem
Purchasing power
Spot foreign exchange transaction
Spot rate
ULO l.
Black-Scholes option pricing model
Call option
Cap
Clearinghouse
Collar
Day traders
Derivative securities
Floor
Floor brokers
Forward contract
Future contracts
Long position
Marked to market
Notional principal
Option contracts
Position traders
Professional traders
Pure credit swaps
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Put option
Scalpers
Short position
Spot contract
Stock options
Swap buyer
Swap seller
Swaps
Total return swaps
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ULO m.
Bank loans
Bank overdraft
Banko Sentral ng Pilipinas
Cash Credit
Commercial banks
Discounted Bills of Exchage
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Securities and Exchange
Commission
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Course Schedule
This section calendars all the activities and exercises, including readings and lectures, as well as
time for making assignments and doing requirements.
Activity
ULOs h-k
Let’s Check ULOs h-i
Let’s Analyze ULOs h-i
In a nutshell ULO h-i
Let’s Check ULOs j-k
Let’s Analyze ULOs j-k
In a nutshell ULOs j-k
ULOs l-m
Let’s Check ULO l
Let’s Analyze ULO l
In a nutshell ULO l
Let’s Check ULO m
Let’s Analyze ULO m
In a nutshell ULO m
Q & A for ULOs a-m
3rd Formative Assessment
Date
Where to Submit
September 22,2020
September 22,2020
September 22,2020
September 24,2020
September 24,2020
September 24,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
September 29,2020
September 29,2020
September 29,2020
October 1,2020
October 1,2020
October 1,2020
Any day
October 2,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
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Big Picture
Weeks 8-9: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to
n. Apply the concepts of financial analysis in commercial banks and what are the factors
that affect it.
o. Compute financial analysis in commercial banks and its significance in management.
p. Assess the functions of financial institutions and to know the difference between
these financial institutions
Big Picture in Focus:
ULO n. Apply the concepts of financial analysis in commercial
banks and what are the factors that affect it.
o. Compute and interpret financial analysis in commercial banks
and its significance in management.
Metalanguage
To learn the concepts of financial analysis as a whole and learn the
factors that affect it, let us get acquainted with the core concept of this
section.
Balance Sheet consists of the core accounting equation, assets equal
liabilities plus equity.
Income Statement consists of the core accounts, income and expenses.
Essential Knowledge
Financial analysis is the examination of the company’s performance to
derive decisions or recommendation. The focus of financial analysis is
evaluating the ability to earn a return that is equal to the cost of capital,
profitable growth in operation and generate cash to meet liabilities as they fall
due. This initiate with the data found in a financial reports which includes
audited financial statements, additional disclosures required by regulatory
bodies, and any commentary by the management.
FINANCIAL STATEMENTS FOR BANKS
The general structure of financial statement for banks is somewhat
similar to a regular company but there is a significant difference in the
classification of accounts. Banks use much more leverage than other
businesses and earn a spread between the interest income they generate on
their assets (loans) and their cost of funds (customer deposits).
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Typical Balance Sheet
A typical balance sheet consists of the core accounting equation, assets
equal liabilities plus equity. This might be composed of large accounts such as
Property, plant and Equipment, Intangible assets, current assets, accounts
receivable, accounts payable and other accounts.
A bank, however, has unique classes of balance sheet line items that
other companies won’t. The typical structure of a balance sheet for a bank is:




Assets
Property
Trading assets
Loans to
customers
Deposits to
the central
bank




Liabilities
Loans from the
central bank
Deposits from
customers
Trading
liabilities
Misc. debt

Equity
Common and
preferred
shares
Recall that ASSETS = LIABILITIES + EQUITY.
NOTE: Most Balance Sheet of the Philippine banks are not classified as to
current and non-current in the face of the financial statement.
Financial Statements for Banks: Balance Sheet
A bank’s balance sheet has certain unique items. We visit each unique line
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item in the subsections below.
1. Loans and Deposits to Customers
Loans and Deposits to Customers is the main source of income of the banks.
As such, loans to customers are classified as assets as the bank receives
interest and principal payment of loans in the future, thus, generating income
from loans for the banks.
Deposits, on the other hand, are expected to be withdrawn by customers or
also pay out interest payments, generating an economic outflow in the future.
Deposits to customers are, thus, classified as liabilities.
2. Loans and Deposits to Central Bank
Deposits from a bank in a central bank are considered assets, similar to cash
and equivalents for a regular company because the bank can withdraw these
deposits easily. It also expects to receive a small interest payment, using the
central bank’s prime rate.
Loans from the central bank are considered liabilities, much like normal debt.
3. Trading Assets and Liabilities
Banks may hold marketable securities or certain currencies for the purposes
of trading. These will naturally be considered trading assets. They may have
trading liabilities if the securities they purchase decline in value.
Below is a sample of an actual Balance Sheet of a Philippine commercial bank.
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Figure 1: Balance Sheet of a commercial bank
Typical Income Statement for Banks
Again, the overall structure of an income statement for a bank doesn’t stray
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too far from a regular income statement. The top of the income statement is
revenue and the bottom is net income.
However, revenue is derived differently from that of regular companies. The
income statement will generally look as follows:
Financial Statements for Banks: Income Statement
Again, let’s walk through the unique line items not found in common income
statements.
1. Non-interest Revenue
Non-interest revenues consist of ancillary revenue the bank makes in
supporting its services. This can consist of:
 Broker fees
 Commissions and fees from products and services
 Underwriting fees
 Gain on sale of trading assets
 Other customer fees (NSF fees, swipe fees, overdrawn fees)
These revenues come from anything that does not constitute interest revenue.
2. Interest Revenue
Interest revenue are the interest payments received by banks on loans that
they issue which are sometimes netted with interest expenses.
3. Credit Loss Provisions
Just like accounts receivables and bad debt expense, a company must prepare
in the event that borrowers are not able to pay off their loans. These bad pieces
of credit are written off in the income statement as a provision for credit loss.
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Figure 2: Income Statement of a commercial bank
FINANCIAL STATEMENT ANALYSIS FOR COMMERCIAL BANKS
Profitability Performance
1. Return on assets (ROA): often described as the primary ratio which
connects the income earned by the bank to the assets it used in daily
operation. It is commonly defined as net income (or pre-tax profit)/total assets.
This shows the management’s performance in the utilization of assets in the
business to generate income. Profit before tax is generally ideal because
calculations using net income after tax figures may show trends due simply to
changes in the
rates of taxation, (Bodie et al 2009).
Return on Assets = Net Income / Total Assets
Using the figure 1 & 2:
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Return on Assets = 424,714,481 / 154,081,637,400
Return on Assets = 0.0028 or 0.28%
2. Return on Deposits (ROD): Is one of the best measure of bank’s
profitability and is computed through the division of net profits by total deposits
which shows the bank management capacity to use the customer’s deposits
to generate income.
Return on Deposit (ROD) = Net Income / Total Deposit
Using the figure 1 & 2:
Return on Deposits (ROD) = 424,714,481 / 131,178,223,364
Return on Deposits (ROD) = 0.0032 or 0.32%
3. Return of equity (ROE): Measure the profitability of a commercial bank by
showing the profit generate with the investor’s money. The higher the ratio is,
the more efficient is the profitability of the corporation, however, this is just a
part of the bank’s performance.
Return on Equity = Net Income / Shareholder’s Equity
Using the figure 1 & 2:
Return on Equity = 424,714,481 / 18,085,729,632
Return on Equity = 0.0235 or 2.35%
3. Net Profit Margin (NPM): Is the percentage of net profit to revenues of the
commercial banks and is commonly expressed as a percentage but can also
be shown in a decimal point format. In short sense, this measures the dollar
revenue collected in translating revenues into profits.
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Using the figure 1 & 2:
Net Profit Margin = 424,714,481 / (5,218,255,921 + 1,370,310,272)
Net Profit Margin = 424,714,481 / 6,588,566,193
Net Profit Margin = 0.0645 or 6.45%
Liquidity Performance
1. Total Loans to Total Deposits Ratio (TLN/TADP): This ratio is typically
utilized to assess liquidity and credit risk by dividing the commercial bank’s
loans by its total deposits. As this ratio go higher, it indicates many things such
potential source of illiquidity and insolvency due to deposits are consistent
source of funding for banks and loans are lot risky than other financial assets
due to its lower market liquidity. Therefore, a higher loan deposit ratio means
more financial stress by making excessive loans. So, the lower loan deposit
ratio is always favorable to the higher one.
Using the figure 1 & 2:
Total Loans to Total Deposit Ratio (TLN/TADP) = 72,271,060,842 /
131,178,223,364
Total Loans to Total Deposit Ratio = 0.5509 or 55.09%
2. Total Deposits to Total Assets Ratio (TDP/TA): This ratio is considered
as the traditional liquidity and is computed by dividing banks total loans by its
total assets.
Using the figure 1 & 2:
Total Deposits to Total Assets Ratio (TDP/TA) = 131,178,223,364 /
154,081,637,400
Total Deposits to Total Assets Ratio = 0.8514 or 85.14%
Assets Quality (Credit Performance)
Being a creditor is still one of the most vital role of commercial bank but still
they must bear positive level of bad loans and loan losses. While it is expected
that all banks will have to bear some positive level of bad loans and loan
losses; one of the key objective of bank management is to minimize such
losses, (Casu et al, 2006).
1. Total Revenue to Total Assets Ratio (Asset Turnover Ratio): This ratio
computes that efficiency of company’s generation of revenue or sales. Higher
ratio indicates company’s efficiency in generation revenues and varies in
different industries. Thus, ideally, only those with same industries shall be
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compared and it’s computed annually.
Using the figure 1 & 2:
Asset Turnover Ratio = (5,218,255,921 + 1,370,310,272) / 154,081,637,400
Asset Turnover Ratio = 6,588,566,193 / 154,081,637,400
Asset Turnover Ratio = 0.0428 or 4.28%
2. Non-Performing Loans to Total Loans Ratio (Non-Performing Loans
Ratio): The total amount of loan is divided by the NPL total. For example, a
customer had a P100,000 loan, paid P40,000 on time but went 90 days behind
on his payments with P60,000 still due, the entire P100,000 would be classified
as a nonperforming loan. If the borrower started to repay the outstanding
balance, then it will be removed from being an NPL, as well as if it was sold.
Usually, this ratio is use to the comparison of the quality of loan portfolios
among banks showing lenders with high NPL ratios to be considered as highrisk lending.
Below is an example of a notes disclosure for Loans and Receivables
(highlighted in yellow is the sample disclosure of Non-Performing Loans:
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To compute the Non-Performing Loans Ratio:
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Non-Performing Loans Ratio = 2,490,000 / 51,862,675
Non-Performing Loans Ratio = 0.0480 or 4.80%
(the discrepancy could be due to rounding off of values and basis of total loans
used by the sample bank)
Self-Help: You can also refer to the sources below to help you
further understand the lesson:
European Journal of Accounting Auditing and Finance Research Vol.2, No.6, pp. 162177, August 2014 Published by European Centre for Research Training and
Development UK (www.ea-journals.org
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Let’s Check
Activity 1. Problem solving. Having been able to discuss and have examples
of the concepts above. Kindly apply the concepts and show your solution for
each item.
1.
2.
3.
4.
5.
6.
7.
Using the above data, the gross profit margin is _________________.
Using the above data, the operating profit margin is ________________.
Using the above data, the net profit margin is __________________.
Using the above data, the return on equity is __________________.
Using the above data, the return on investment is ________________.
Using the above data, the cash flow margin is _________________.
Krisle and Kringle's debt-to-total assets (D/TA) ratio is .4. What is its debtto-equity (D/E) ratio?
8. If current assets are $90,000 and total assets are $270,000, what
percentage of total assets are current assets?
Let’s Analyze
Activity 2. Write a memorandum for circulation to all the junior members of
the credit control department that highlights FIVE key indicators of customer
solvency problems, which can be identified from published financial
statements. (10 marks)
In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
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______________________________________________________________
2. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
3. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
4. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
5. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
6. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
7. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
8. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
9. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
10. _______________________________________________________________
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
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Big Picture in Focus:
ULO p. Assess the functions of financial institutions and to
know the difference between these financial institutions
Metalanguage
The last chapter for this course is other financial institutions. In this
chapter, we will talk further about the financial institutions that were first
mentioned in the first chapter of this course. The goal is to gather more
information about financial institutions other than commercial banks. The
terms will be discussed in the essential knowledge.
Essential Knowledge
Financial institutions, as discussed in the previous sections, are
businesses that deal with financial and monetary activities and transactions
such as investment, loans deposits, currency exchange, etc. Commercial
bank was already discussed above and in this chapter, we will talk about
other financial institutions.
Thrifts
Besides commercial banks, there are other financial institutions that can
also provide saving, credit, and financing. Saving institutions serve the
needs of individuals requiring funds for their home. Which is why savings
institutions mainly caters mortgage and other securities for individuals. Two
groups of depository institutions are savings associations and saving banks.
While credit unions offer nonprofit depository services that are intended for
its members, and nonprofit consumer loans. It should be noted that both
savings institutions and credit unions are referred to as thrifts.
Finance Companies
On the other hand, we have finance companies that provide lending to
business and consumers. Finance companies cater customers with higher
risk and they sometimes offer reasonable interest rate. This makes them
compete with depository institutions that offer consumer loans. However,
compared with the mentioned financial institutions, finance companies do not
accept deposits. There are three major types of finance institutions. They are
sales finance institutions that offer specialized loans to specific customers.
The other is personal credit institutions provide loans to customers that
has low income and bad credit history. They specialize in making installment
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loans to customers. And lastly, there are also business credit institutions
that provide financing to companies and corporations. One of the methods
that business credit institutions use to secure their loaned out money is
through factoring wherein the borrower sell their receivable at a discount to
the finance companies.
Insurance Companies
Insurance companies specialize in providing benefit to the policyholders
who encounter unfavorable event in exchange for premiums paid by these
policyholders beforehand. One can invest in insurance through an insurance
underwriter or through an insurance broker. The former normally assesses
the risk of a potential applicant then sells insurance contracts to them. The
insurance broker simply sells insurance contracts. There are two major
insurance groups. That is life insurance and property-casualty insurance. Life
insurance provides indemnity against injury, illnesses and even retirement.
While property-casualty insurance protects against accidents, fire, theft,
and other catastrophes.
Life insurance protects individuals and their beneficiaries against
retirement and sudden death. The four classes of life insurances are:
(1) Ordinary life – policyholders make periodic premium payments
in for a prearranged insurance coverage.
(2) Group life insurance – large group of people are insured under
one policy. This type of insurance is usually availed by employers
for their employees wherein it could be contributory wherein
employer and employee contribute, or noncontributory where
only the employer contributes
(3) Credit life – protects lenders against untimely deaths of their
borrowers who have not repaid their debts.
(4) Other life insurance activities – sale of annuities, pension
plans, health and accident insurances
Securities Firms and Investment Banks
Securities firms and investment banks help suppliers of funds transfer
funds to those that need funds which is usually at a low cost and with a
maximum degree of efficiency. These financial institutions serve as brokers
or middlemen between the suppliers and users of funds.
There are the eight major undertakings of securities firms and
investment banks:
Investment
banking
Venture capital
Market marking
Investment
Cash management
Mergers and
acquisition
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Trading
Other service
functions
Investment banking is an activity related to underwriting and
distributing new debt and equity securities. The new securities can be first
time issues or seasoned offering. One of activities that it does that was
already introduced to us in the previous sections is assembling different
banks called as syndicate to help each other sell securities.
Note that both securities firms and investment banks have the same
functions. They differ in their relationship to their clients. Investment banks
maintain their relationships with companies while securities firms are retailoriented in nature.
MUTUAL FUNDS AND HEDGE FUNDS
Another set of financial institutions is mutual funds and hedge funds.
These pool financial resources from investors, individuals and companies, to
be invested in diversified portfolio of securities/assets. Mutual funds offer
investment products to the public which are available for trading on a daily
basis. They give opportunities to small investors to invest in diversified
portfolio with lower transaction costs and commissions. While hedge funds
involves private investments that are available to select investors. Hedge
funds are of higher risk and usually achieves higher return as well. Hedge
funds is not necessarily required to register with SEC.
Mutual funds offer long term and short term securities. Long term funds
include:
 Equity funds which is composed of common or ordinary shares
and preferred shares
 Bond funds which is composed of fixed-income securities with
maturities of more than a year
 Hybrid funds which is composed of both equity and debt
securities
While short term funds include moment market mutual funds which is
composed of diverse money market instruments with maturities of less than
a year. Other types of funds include index funds and exchange traded
funds.
Hedge funds is not that regulated compared with mutual funds but their
functions are basically the same. Hedge funds do not need to disclose their
activities to third parties which is why their market are those that want high
degree of privacy. This venture rely highly on the expertise of fund manager
so that high profit will be attained.
These are the classification of hedge funds:
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PENSION FUND
Pension funds are actually similar to life insurance companies and at
the same time mutual funds. This type of institution intends to attract small
saves’ funds and invest the money pooled from them to the financial markets
to be later liquidated with profit. On the other note, funds from this institution
are tax exempt at the time premiums are paid. They are only taxed one time
when the funds are already distributed to the fund participants. There are two
sectors in the pension fund industry. These are private pension funds and
public pension funds. Private pension funds are managed by private
corporations. While public pension funds are managed by the government
such as GSIS or local government.
Pension funds can either be defined benefit fund or defined contribution
fund. If the employer agrees to provide the employee a specific amount of
cash benefit upon retirement of the employee based on the pension plan, we
call this defined benefit pension fund. While in defined contribution
pension fund, the employer does not commit a specific amount of retirement
income but instead, employer contributes a specific amount of money for the
employee during his/her work duration. The final pay then is based on the
employer’s payments or contributions.
OTHER FINANCIAL INSITUTIONS



Mortgage companies – these are financial institutions that
provide loans specifically for buying real properties such as
homes, farms, land, buildings for commercial use
Federal Reserve System – this is the central bank of a country,
e.g. Banko Sentral ng Pilipinas
Pawnshops – these are financial institutions that charge high
rates for loans of money which usually comes with collateral
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that can be foreclosed or auctioned when interest or principal
are not paid
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial
Management (13th Edition). Pasig City: Cengage Learning Asia Pte Ltd
(Philippine Branch), [2014] [2015].
Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions.
McGraw-Hill/Irwin, 2018.
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Let’s Check
Activity 1. Let us answer the following questions to assess what we remember in the
topic above.
1. Financial institutions transfer money from
a. Savers to borrows
b. Borrowers to savers
c. Seller to buyers
d. Individuals to corporations
2. The following are examples of financial institutions for consumers, except:
a. Banks
b. Mortgage firms
c. Credit unions
d. Federal reserve system
3. Financial institutions offer ____________ to attract savings from suppliers of
funds
a. Profits
b. Revenues
c. Benefits
d. Interest
4. This type of financial institution is nonprofit depositary institution that offers
services to its members only
a. Commercial banks
b. Mutual funds
c. Kapa
d. Credit Union
5. Financial institution that lets people borrow money from it by surrendering high
value items, such as jewelries, gadgets, in exchange for cash
a. Retail Bank
b. Credit unions
c. Pawnshops
d. Mortgage companies
6. Investors in insurance companies are most concerned with
a. Safety
b. Convenience
c. Necessities
d. Job
7. Financial intermediaries
a. Exist because there are substantial information and transaction costs in
the economy
b. Improve the lot of the small savers through mutual funds
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c. Involved in the process of indirect financing
d. All of the choices are correct
8. Which of the following does not fall under investment intermediary?
a. Life insurance company
b. Pension fund
c. Mutual Fund
d. Both A and B
9. I. Mutual funds are not depository institutions.
II. Pension fund is not a contractual saving institution
a. Statement I is true
b. Statement II is true
c. Statements I and II are true
d. Statements I and II are false
10. One of the following is not a role of financial intermediaries, which is it?
a. Brokerage
b. Collection and parceling
c. Setting exchange rates
d. Maturity transformation
e. Risk transformation
11. The act of financial intermediation consists of
a. transforming equity shares into debt instruments such as bonds.
b. converting gold into paper currency.
c. transforming liabilities into assets.
d. safekeeping other people's funds.
12. A portfolio is
a. a collection of personal liabilities
b. a collection of assets.
c. a collection of various debt instruments.
d. the information collected by banks to evaluate a customer's borrowing
capacity.
13. This type of pension fund does not set the amount of money that the employee
will get at the end of its tenure, and depends upon the contributions made by the
employer
a. Defined Benefit Plan
b. Defined Contribution Plan
c. Defined Concentration Plan
d. Defined Pension Plan
14. These are financial intermediaries that make loans available and accept long
term and short term debts for funding are considered
a. Activity institutions
b. Investment institutions
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c. Mortgage Companies
d. Finance Companies
15. These hedge funds seek high returns using leverage with basis to anticipated
events
a. Market directional
b. Market neutral
c. Market value orientation
d. Market Marking
Activity 2. Answer the following questions briefly
1. Why are financial institutions important in the economy?
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
2. What particular financial institution are you planning to invest in, and why?
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
3. Differentiate mutual funds and hedge funds
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4. What is the difference between insurance companies and pension funds?
________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
In a Nutshell
In this portion, let us check and somehow summarize what we have learned in this
chapter.
1. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
2. ________________________________________________________________
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________________________________________________________________
________________________________________________________________
________________________________________________________________
3. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
4. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
5. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
6. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
7. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
8. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
9. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
10. ________________________________________________________________
________________________________________________________________
________________________________________________________________
________________________________________________________________
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Q&A LIST
Do you have any questions for clarification?
Questions/Issues
Answers
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
KEYWORDS INDEX
This section lists down the keywords that help you to recall the discussions.
ULO n and o
Balance Sheet
Income Statement
Noninterest revenue
Interest revenue
Credit loss provision
Net profit margin
Total Revenue to Total
Assets Ratio
Total loans to total deposits ratio Non-Performing Loans to
Total Loans Ratio
Total Deposits to Total assets ratio
ULO p.
Bonds funds
Business credit institutions
Credit life
Credit unions
Defined benefit pension fund
Group life
Hedge funds
Hybrid funds
Index funds
Insurance broker
Defined contribution pension fund Insurance underwriter
Equity funds
Investment banks
Exchange traded funds
Market directional
Factoring
Market neutral
Federal reserve system
Mortgage companies
Finance companies
Mutual funds
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Ordinary life
Pawnshops
Pension fund
Personal credit institutions
Private pension fund
Public mortgage fund
Sales finance institutions
Savings institutions
Securities firms
Thrifts
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Course Schedule
This section calendars all the activities and exercises, including readings and lectures, as well as
time for making assignments and doing requirements.
Activity
ULOs n-o
Let’s Check ULOs n-o
Let’s Analyze ULOs n-o
In a nutshell ULOs n-o
Deadline of Trading Journal
ULO p
Let’s Check ULO p
Let’s Analyze ULO p
In a nutshell ULO p
Review Long Quiz
Q & A from ULOs a-p
4th Formative Assessment
Date
Where to Submit
October 6,2020
October 6,2020
October 6,2020
October 9,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
October 13,2020
October 13,2020
October 13,2020
October 15,2020
Any day
October 16,2020
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
Blackboard LMS
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Online Code of Conduct
1.
2.
3.
4.
5.
6.
7.
Students are expected to abide by and honor code of conduct, and thus, everyone
and all are exhorted to exercise self-management and self-regulation.
All students are guided by professional conduct as learners in attending On-Line
Blended Delivery (OBD) course. Any breach and violation shall be dealt with
properly under existing guidelines, specifically in Section 7 (Student Discipline) in
the Student Handbook.
Professional conduct refers to the embodiment and exercise of the University’s
Core Values, specifically in the adherence to intellectual honesty and integrity;
academic excellence by giving due diligence in virtual class participation in all
lectures and activities, as well as fidelity in doing and submitting performance tasks
and assignments; personal discipline in complying with all deadlines; and
observance of data privacy.
Plagiarism is a serious intellectual crime and shall be dealt with accordingly. The
University shall institute monitoring mechanisms online to detect and penalize
plagiarism.
Students shall independently and honestly take examinations and do assignments
unless collaboration is clearly required or permitted. Students shall not resort to
dishonesty to improve the result of their assessments (e.g. examinations,
assignments).
Students shall not allow anyone else to access their personal LMS account.
Students shall not post or share their answers, assignments or examinations to
others to further academic fraudulence online.
By enrolling in OBD course, students agree and abide by all the provisions of the
Online Code of Conduct, as well as all the requirements and protocols in handling
online courses.
Course prepared by:
QUEENIE P. TENEDERO
KHEN O. ENRIQUEZ
Authors
Course reviewed by:
DEVZON U. PORRAS
PH-BSAIS/BSIA
JADE D. SOLAÑA
PH-BSA/BSMA
MARY GRACE S. SOMBILON
AD
Approved by:
LORD EDDIE I. AGUILAR
Dean
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