FINANCIAL MARKET PRE-FINALS
BOND MARKET
CAPITAL MARKET- part of financial system which is
concerned with raising capital funds by dealing in shares,
bonds, and other long term investments.
Purpose: Firms and individuals use the money markets
primarily to warehouse funds for short periods of time until a
more important need or a more productive use for the funds
arises.
Participants:
1. Federal Local Government
Issues: long-term notes and bonds to fund the
national debt
Purpose: to finance capital projects, such as school
and prison construction.
Pros: free of default risk since the govnt can print
money to pay off debt.
2. Corporation
Issues: Bonds and Stocks
Purpose: do not have sufficient capital to fund their
investment opportunities
Capital Market Trading:
Primary Market: new issues of stocks and bonds are
introduced
Secondary Market: the sale of previously issued securities
takes place
Bonds - securities that represent a debt owed by the issuer
to the investor. They are typically issued for a specific
amount of money, usually at a given date, and generally with
a particular interest rate.
Coupon Rate - rate of interest that the issuer must pay, and
this periodic interest payment is often called the coupon
payment. This rate is usually fixed for the duration of the
bond and does not fluctuate with market interest rates
TYPES OF BONDS
1. Long Term Government Bonds - They are generally
considered to be very safe investments, because the
government is unlikely to default on its debt.
2. Municipal Bonds – often exempt from federal taxes,
and may also be exempt from state and local taxes
depending on the issuer.
a. General Obligations Bonds - do not have
specific assets pledged as security or a
specific source of revenue allocated for their
repayment. backed by the "full faith and
credit" of the issuer
b. Revenue Bonds - backed by the cash flow of
a particular revenue-generating project.
Revenue bonds tend to be issued more
frequently than general obligation bonds
Issuer: State & Local Govts
3. Corporate Bonds - generally considered to be riskier
than government bonds, but they also offer the
potential for higher returns.
a. Secured Bonds - with collateral attached
b. Unsecured Bonds – No specific collateral is
pledged to repay the debt. In the event of
default, the bondholders must go to court to
seize assets.
c. Junk Bonds - A bond with a rating of AAA has
the highest grade possible.
Treasury Securities
1. Treasury Bill - short-term investments with
maturities less than one year. Sold at a discount rate
to their face value.
2. Treasury Note - medium-term investments with
maturities ranging from one to ten years. Treasury
notes pay less interest than T-bonds since T-notes
have shorter maturities.
3. Treasury Bonds - A long-term investments with
maturities of 10 or 30 years. Offer the highest
interest rate to compensate for the longer
commitment
Have no default risk and interest rate risk.
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are a
type of Treasury security issued by the U.S. government in
1997. TIPS are indexed to inflation to protect investors from
a decline in the purchasing power of their money.
TIPS have a fixed interest rate throughout the term
of security. However, the principal amount used to compute
the interest payment does change based on the consumer
price index. It matures 5, 10, or 30 years.
Treasury (Separate Trading of Registered Interest and
Principal Securities) STRIPS
 Known as zero-coupon securities
 A STRIPS separates the periodic interest payments from
the final principal repayment. The investor does not
receive interest payments but is repaid the full-face
value when the bonds mature. Sold at discount value.
 Treasury STRIPS are created when a bond' s coupons are
separated from the bond. The bond, minus its coupons,
is then sold to an investor at a discount price. The
difference between that price and the bond' s face value
at maturity is the investor ' s profit.
Agency Bonds
An agency bond is a bond that' s issued by or
guaranteed by U.S. federal agencies or governmentsponsored enterprises (GSEs). These bonds are typically
used to fund specific public purposes that are deemed
to be in the national interest.
 Low risk
 Higher return
 Highly liquid
 Issuers of agency bonds include the Student Loan
Marketing Association (Sallie Mae), the Farmers
Home Administration, the Federal, Housing
Administration, the Veterans Administrations, and
the Federal Land Banks
RISK OF MUNICIPAL BONDS
1. Municipal bonds are not default-free.
2. They are not backed by the federal government and
can default from time-totime.
3. Many municipal bonds carry call provisions, allowing
the issuer to redeem the bond prior to the maturity
date
CORPORATE BONDS
Callable – the issuer may redeem the bonds prior to maturity
after a specified date
Bond Indenture - contract that states the lender’s rights and
privileges and the borrower’s obligations. Any collateral
offered as security to the bondholders is also described in
the indenture
Bearer Bonds - payments were made to whoever had
physical possession of the bonds. Replaced by Registered
bonds
Characteristics:
1. Restrictive Covenants - they must impose rules and
restrictions on managers designed to protect the
bondholders’ interests. These are known as
restrictive covenants. They usually limit the amount
of dividends the firm can pay (to conserve cash for
interest payments to bondholders) and the ability of
the firm to issue additional debt. The interest rate is
lower the more restrictions are placed on
management through these covenants because the
bonds will be considered safer by investors.
2. Call Provision- states the issuer (company) has the
right to force the bondholder to sell the bond back.
The price bondholders are paid for the bond is
usually set at the bond’s par price or slightly higher
a. Sinking Fund - requirement in the bond
indenture that the firm pay off a portion of
the bond issue each year
b. Reasons: when rates fall they can reissue
cheaper debt
-Help manage sinking funds where company
gradually buys back some bonds each year
-Allows the company to retire bonds that can
restrict their actions or adjust their debt
levels as needs
3. Conversion- bonds can be converted into shares of
common stock. Can be converted into a certain
number of common shares at the discretion of the
bondholder.
Types of CORPORATE BONDS
1. Secured Bonds - with collateral attached.
a. Mortgage bonds are used to finance a
specific project.
b. Equipment trust certificates are bonds
secured by tangible non-real-estate
property, such as heavy equipment and
airplanes.
c. Collateral Trust Bonds - backed by financial
assets, such as stocks or bonds, which are
pledged as collateral to secure the bonds.
2. Unsecured Bonds - without having any specific assets
serve as collateral
a. Debentures - long-term unsecured bonds
that are backed only by the general
creditworthiness
b. Subordinated Debentures - they have a
lower priority claim. holders are paid only
after nonsubordinated bondholders have
been paid in full.
 subordinated debenture holders are paid only after
non Subordinated bondholders have been paid in
full. As a result, subordinated debenture holders are
at greater risk of loss.
3. Junk Bonds - issued by the government to raise loans
or debts, risk of default and timely repayment is high
in the case of junk bonds
Junk bonds are also known as high-yield bonds
because the interest payments are higher than for the
average corporate bond
Financial Guarantees for Bonds - ensures that the lender will
be paid both the principal and the interest in the event the
issuer defaults.
Credit Default Swap by J.P Morgan (1995) - provides
insurance against default in the principal and interest
payments of a credit instrument.
OVERSIGHT THE BOND MARKETS
Trade Reporting and Compliance Engine (TRACE)
1. Rules that say which bond transactions must be
publicly reported.
2. The establishment of a trading platform that makes
transaction data readily available to the public.

Under Financial Industry Regulatory Authority
(FINRA)
Current Yield - an approximation of the yield to maturity on
coupon bonds that is often reported because it is easily
calculated; yearly coupon payment / price of the security
MORTGAGE MARKET
HISTORY OF MORTGAGE
1863 – National Banking Act of 1863 that restricts mortgage
lending.
1880s-1890s - Selling bonds to raise the long-term funds they
lent
Agricultural recession resulted in many defaults.
Post-World War I - National banks were authorized to make
mortgage loans.
Great Depression (1930s) - Led to foreclosures and caused
property values to collapse
MORTGAGE - It is long-term loan secured by real estate used
to purchase or maintain a home, plot of land, or other types
of real estate.
Collateral - This lending institution will place a lien against
the property, and this remain in effect until the loan is paid.
A lien is a public record that attaches to the title of
the property, advising that the property is security for a loan,
and it gives the lender the right to sell the property if the
underlying loan defaults.
Down Payments - Are intended to make the borrower less
likely to default on the loan. a borrower who does not make
the borrower less likely to default on the loan
PRIVATE MORTAGE INSURANCE - PMI is an insurance policy
that guarantees to make up any discrepancy between the
value of the property and the loan amount, should a default
occur .
BORROWER QUALIFICATIONS - Qualifying for a mortgage
loan was different from qualifying for a bunk loan because
most lender sold their mortgage loans to one a few federal
agencies in the secodary mortgage market.
Mortgage Interest Rates
1. Market rates. Long-term market rates are
determined by the supply of and demand for long-
term funds, which are in turn influenced by a
number of global, national, and regional factors.
2. Term. Longer-term mortgages have higher interest
rates than shorter-term mortgages. The usual
mortgage lifetime is either 15 or 30 years. Lenders
also offer 20-year loans, though they are not as
popular.
3. Discount points. Discount points (or simply points)
are interest payments made at the beginning of a
loan. A loan with one discount point means that the
borrower pays 1% of the loan amount at closing, the
moment when the borrower signs the loan paper
and receives the proceeds of the loan
LOAN AMORTIZATION - Mortgage loan borrowers agree to
pay a monthly amount of principal and interest that will fully
amortize the loan by its maturity. “Fully amortize” means
that the payments will pay off the outstanding indebtedness
by the time the loan matures.
TYPES OF MORTGAGE LOANS
 Insured Mortgages - are originated by banks or other
mortgage lenders but are guaranteed by either the
Federal Housing Administration (FHA) or the Veterans
Administration (VA).
 Conventional Mortgages - are originated by the same
sources as insured loans but are not guaranteed.
 Fixed-rate mortgages - the interest rate and the
monthly payment do not vary over the life of the
mortgage
 Adjustable-rate mortgages (ARMs) - is tied to some
market interest rate and therefore changes over time.
OTHER TYPE OF MORTGAGES
 Graduated-Payment Mortgages (GPMs) Graduatedpayment mortgages are useful for home buyers who
expect their incomes to rise. The GPM has lower
payments in the first few years; then the payments
rise. Early payments may not even be sufficient to
cover the interest due, in which case the principal
balance increases.
 Growing-Equity Mortgages (GEMs) - Lenders
designed the growing-equity mortgage loan to help
the borrower pay off the loan in a shorter period of
time. With a GEM, the payments will initially be the
same as on a conventional mortgage.
 Second Mortgages (Piggyback) – are loans that are
secured by the same real estate that is used to
secure the first mortgage. The second mortgage is
junior to the original loan
 Reverse Annuity Mortgages (RAMs) - The reverse
annuity mortgage is an innovative method for retired
people to live on the equity they have in their
homes. The contract for a RAM has the bank
advancing funds on a monthly schedule. This
increasing-balance loan is secured by the real estate.
Mortgage-Lending Institutions
 Originally established with a mandate from Congress
to provide mortgage loans to families.
 Thrift institutions attracted depositors by offering
slightly higher interest rates on deposits.
 Played a crucial role in the early growth of the
housing industry by raising short-term funds through
deposits for long-term mortgage loans.
Reserve accounts are established for most mortgage loans to
permit the lender to make tax and insurance payments for
the borrower.
mortgages have unknown default risk. Investors in
mortgages do not want to expend energy evaluating the
credit of borrowers. These problems inspired the creation of
the mortgage-backed security, also known as a securitized
mortgage
 Mortgage Pool - large number of mortgages assembled
into
 Securitization - A trustee, such as a bank or a
government agency, holds the mortgage pool, which
serves as collateral for the new security.
 mortgage pass-through, a security that has the
borrower’s mortgage payments pass through the
trustee before being disbursed to the investors in the
mortgage pass-through.
 Prepayment Risk - The possibility that mortgages will
prepay and force investors to seek alternative
investments, usually with lower returns
Types of Pass-Through Securities
 Government National Mortgage Association (GNMA) PassThroughs Ginnie Mae began guaranteeing pass-through
securities in 1968
 Federal Home Loan Mortgage Corporation (FHLMC) PassThroughs Freddie Mac was created to assist savings and
loan associations, which are not eligible to originate Ginnie
Mae–guaranteed loans
 Private Pass-Throughs (PIPs) In addition to the agency passthroughs, intermediaries in the private sector have offered
privately issued pass-through securities. The first of these
PIPs was offered by BankAmerica in 1977
 Collateralized Mortgage Obligation (CMO). CMOs are
securities classified by when prepayment is likely to occur.
These differ from traditional mortgage-backed securities in
that they are offered in different maturity groups.
 Jumbo Mortgages are often bundled into pools to back
private pass-through.
 SUBPRIME LOANS - are those made to borrowers who do
not qualify for loans at the going market rate of interest
because of a poor credit rating or because the loan is larger
than justified by their income.
THE FOREIGN EXCHANGE MARKET
Foreign Exchange Market - trade between countries involves
the mutual exchange of different currencies (or, more
usually, bank deposits denominated in different currencies)
A. Spot Transactions - Involve the immediate (two day)
exchange of bank deposits.
B. Forward Transactions - involve the exchange of bank
deposits at some specified future date
Importance:
 They affect the relative price of domestic and foreign
goods.
The dollar price of French goods to an
American is determined by interaction of two
factors: The price of French goods in euros, and the
euro-dollar exchange rate
COUNTRY’S CURRENCY APPRECIATES
Domestic goods – cheaper
Foreign goods – expensive
COUNTRY’S CURRENCY DEPPRECIATES
Domestic goods – Expensive
Foreign goods – Cheaper
Law of One Price
If two countries produce an identical good, and
transportation costs and trade barriers are very low, the
price of the good should be the same throughout the world
no matter which country produces it

Exchange rate is determined by the law of supply and
demand
THEORY OF PURCHASING POWER PARITY
 It is an economic theory that compares the purchasing
power of various world currencies to one another.
 It states that exchange rates between any two
currencies will adjust to reflect changes in the price
levels of the two countries.
 The theory of PPP is simply an application of the law of
one price to national price levels
 PPP is an important metric because it provides a way to
compare levels of growth and standards of living in
various nations, each of which has its own currency.
 it provides a framework for understanding the relative
value of currencies and predicting exchange rate
movements
Real Exchange Rate - the rate at which domestic goods can
be exchanged for foreign goods
Why the Theory of Purchasing Power Parity
Cannot Fully Explain Exchange Rates

Assumption of Identical Goods- PPP assumes that all
goods are identical between countries, meaning their
prices should be equal when converted into a common
currency.

Non-Traded Goods and Services- PPP overlooks nontraded goods and services, such as housing, local amenities,
and certain services, which can significantly impact a
country's price level but aren't subject to international
trade
 Transportation Costs and Trade Barriers- PPP
assumes that transportation costs and trade barriers
are very low or non existent
 Short-Term Fluctuations- While PPP holds true in the
long run, it often fails to predict short-term exchange
rate movements accurately. Short-term fluctuations
can be influenced by various factors such as
speculative trading, market sentiments, and
unexpected economic events, which PPP doesn't
account for comprehensively.
Factors That Affect Exchange Rates in the Long Run
- If a factor increases the demand for domestic goods
relative to foreign goods, the domestic currency will
appreciate; if a factor decreases the relative demand
for domestic goods, the domestic currency will
depreciate.
1. Relative Price Levels - comparison of the prices of
goods and services between countries
Appreciate – a fall in the country’s relative level
Depreciates - a rise in the country’s relative level
2. Trade Barriers – government-imposed restrictions
increasing trade barriers will causes a country’s
currency to appreciate in the long run.
3. Productivity - crucial aspect as it can significantly
influence a country’s economic growth and
competitiveness.
4. Preferences for Domestic vs Foreign Goods
Appreciate - Increased demand for a country’s
exports
Depreciate - increased demand for imports causes
FACTORS THAT AFFECT EXCHANGE RATES IN THE SHORT
RUN
1. Investor sentiment: feelings and attitudes of
investors that impact buying and selling decisions in
markets.
2. Geopolitical events: events involving nations and
governments that influence global markets and
economies, such as wars, trade disputes, and
political tensions.
3. Economic data releases: reports providing
information on economic performance, like
unemployment rates, GDP growth, and inflation
figures, which guide investment decisions.
4. Shifts in monetary policy: changes in central bank
policies, such as interest rates and money supply,
aimed at achieving economic goals like controlling
inflation or stimulating growth
ASSET MARKET APPROACH
This approach is rooted in a theory called portfolio
choice.
THE INTERNATIONAL FINANCIAL SYSTEM
foreign exchange interventions - central banks regularly
engage in international financial transactions. Conducted by
monetary authorities to influence foreign exchange rates by
buying and selling currency in foreign exchange markets.
a. Unsterilized Intervention – a direct intervention in the
foreign exchange market by the central bank which
directly impact the economy.
b. Sterilized Intervention – involve simultaneously buying
and selling foreign currency and securities offset any
impact to the money supply
International reserves - holdings of assets denominated in
foreign currency
Balance of Payments - a bookkeeping system for recording
all receipts and payments that have a direct bearing on the
movement of funds between a nation (private sector and
government) and foreign countries.
Current account shows international transactions that
involve current flows of funds into and out of a country.
 The difference between merchandise exports and
imports, the net receipts from trade, is called the
trade balance, but more accurately is referred to as
the merchandise trade balance
Exchange of Rate Regime
A. Fixed exchange rate regime, the value of a currency
is pegged relative to the value of another currency
(called the anchor currency) so that the exchange
rate is fixed in terms of the anchor currency
B. Floating exchange rate regime, the value of a
currency is allowed to fluctuate against all other
currencies.
 managed float regime or dirty float - countries
intervene in foreign exchange markets in an attempt
to influence their exchange rates by buying and
selling foreign assets
International Monetary Fund (IMF)
- During Fixes Exchange Regime
- Bretton Woods Agreement
task of promoting the growth of world trade by
setting rules for the maintenance of fixed exchange
rates and by making loans to countries that were
experiencing balance-of-payments difficulties.
FIXED EXCHNAGE RATE REGIME
 When the domestic currency is overvalued, the central
bank must purchase domestic currency to keep the
exchange rate fixed, but as a result it loses international
reserves. KNOWN AS DEVALUATION
 When the domestic currency is undervalued, the central
bank must sell domestic currency to keep the exchange
rate fixed, but as a result, it gains international reserves.
KNOWN AS REVALUATION
Perfect Capital Mobility - if there are no barriers to domestic
residents purchasing foreign assets or foreigners purchasing
domestic assets
Policy trilemma (impossible trinity) – It states that three
objectives is not possible, therefore needed to choose 2
options only.
a. Free movement of capital
b. Independent (autonomous) monetary policy
c. Fixed (managed) exchange rates
Monetary Unions - A variant of a fixed exchange rate regime
in which a group of countries decide to adopt a common
currency, thereby fixing their exchange rates vis-à-vis each
other
Currency Boards and Dollarization
Currency board - which the domestic currency is backed
100% by a foreign currency (say, dollars) and in which the
note-issuing authority, whether the central bank or the
government, establishes a fixed exchange rate to this foreign
currency and stands ready to exchange domestic currency
for the foreign currency at this rate whenever the public
requests it
Dollarization - which a country abandons its currency
altogether and adopts that of another country.
Speculative Attack – economic scenario where speculators
aggressively trade a nation’s currency anticipating its
depreciation in the near future.
Managed Float (Dirty Float) – exchange rate regime in which
the exchange rate is neither entirely float nor fixed.
Capital Controls – measures that are taken by either the
government or the central bank to regulate the outflow and
inflow of the foreign capital in the country.
a. Taxes
b. Tariffs
c. Volume restrictions
d. Outright legislation
Emerging market countries are countries that have recently
opened up to flows of goods, services, and capital from the
rest of the world.
Controls on Capital Outflows
Capital outflows can promote financial instability in emerging
market countries because when domestic residents and
foreigners pull their capital out of a country, the resulting
capital outflow forces a country to devalue its currency
Controls on Capital Inflows
Controls on capital inflows receive more support. It can lead
to lending boom and excessive risk taking on the part of the
banks. They may block those funds from entering a country
that would be used for productive investment opportunities