Financial Markets (Midterms)
Capital Asset Pricing Model (CAPM)
The primary objective of doing business is to earn profit. As with businesses, the primary
objective of investing is to increase the value of your fund, or at the very least preserve the
purchasing value of the fund. With this it is imporatnt to calculate your returns. Simple returns
can be calculated using the following formula:
Current Value - Initial Value = Increase in Value
Increase in Value / Initial Value = Percentage Return
Example:
A has 1 million pesos invested in a security on January 1. On December 31, the value of the security is
now 1,100,000 pesos.
The rate of return is calculated as follows:
Rate of Return = 100,000/1,000,000 --> 10%
Sometimes, such simple calculations cannot consider the movements in the
investments such as additions and withdrawals from the fund. With this situation, you need to
know how to calculate returns based on the Time Weighted Rate of Return.
The time weighted rate of return considers the changes in investments value brought
about by the additions or withdrawals in the investment.
Example:
A invested his 1 million pesos in a security. As of August 1, the value of the security is 1,100,000
pesos. During this date, A decided to add another 50,000 pesos to his investment. As of
December 31, the total value of the investment is 1,080,000 pesos. How much if the rate of
return using weighted rate of return method?
To calculate the return, we need to segregate the transactions based on when there was a change
in cash flow. Each segregated transaction should have its own rate of return.
1.
2.
RR = (1,100,000 - 1,000,000)/1,000,000 --> 10%
RR = (1,080,000 - 1,150,000)/1,150,000 --> -6.08%
The weighted return is calculated as follows:
= ((1+10%)*(1+-6.08%))-1 --> 3.31%
Another way of calculating return of different investments or of the same investments of
different periods is the arithmetic average. the resulting return of arithmetic average does not
tell us much because of its inherent limitation. it simply adds up all the return divided by the
period or number of securities.
Example:
A particular security earned 80%, 10%, 30%, 40%, 5% over a 5-year period. The arithmetic
average is 33%. since the returns are interrelated, such relationship is not manifested by the
arithmetic average.
Capital asset pricing model (CAPM)
It helps us to calculate investment risk and what return on the investment we should expect.
the CAPM formula:
EROI = RF% + B (ERm - RF%)
where:
EROI = expected return of investment
RF% = risk-free rate
B -beta of the investment
(ERm -RF%) = market risk premium
According to Ben Mc Clure, the modern portfolio theory shows that specific risk can be
removed through diversification, but diversification cannot solve the problem of systemic risk.
The CAPM evolved to measure the systematic risk.
The CAPM states that investors are entitled to a risk premium which is directly affected
by the volatility of the market (represented by the beta) plus the risk free rate.
Example:
A corporation has a beta of 1.2. The risk-free rate is 5% and the return on the market portfolio is
at 9%.
Using the formula:
Expected Return = 5% + (1.2 * (9% - 5%) --> 9.8%
From the formula, we can conclude that the higher the beta (volatility of the security in relation
to the market) the higher would be the risk, and therefore, the higher should be the return:
Using the above example:
Beta
1.0
1.2
1.4
1.5
1.7
2.0
2.5
Expected Return (%)
9
9.8
10.6
11
11.8
13
15
Chapter 9: Foreign Exchange Market
The trading of currency and bank deposits denominated in particular currencies takes place
in the foreign exchange market. Transactions conducted in the foreign exchange market determine
the rates at which currencies are exchanged, which in turn determine the cost of purchasing foreign
goods and financial assets.
The constant change in exchange rates causes problems for financial managers as the change
in relative purchasing power between countries affects imports and exports, interest rates and other
economic variables. The relative strength of a particular currency to other currencies changes many
times over a business cycle.
Recent Historical Perspective of Exchange Rates
From the end of World War II until the early 70’s, the world was on a fixed exchange rate
system administered by the International Monetary Fund (IMF). Under this system, all countries were
required to set a specific parity rate for their currency vis-a-vis the United States dollar. A country
could effect a major adjustment in the exchange rate by changing the parity rate with respect to the
dollar. Then the currency was made cheaper with respect to the dollar, this adjustment called
devaluation. An upvaluation or revaluation resulted when a currency became more expensive with
respect to the dollar.
A floating rate international curency system has been operating since 1973. Most major
currencies fluctuate freely depending upon their values as perceived by the traders in foreign
exchange markets. The determination of exchange rates are influenced by such important factors as:
a. country’s economic strengths;
b. level of exports and imports;
c. level of monetary activity; and
d. deficits or surpluses in its balance of payments.
Short term, day-to-day fluctuations in exchange rates are caused by supply and demand
conditions in the foreign exchange market.
The Foreign Currency Exchange Market
The forex market provides a service to individuals, businesses, and governments who need
to buy or sell currencies other than that used in their country. It provides a mechanism for the
transfer of purchasing power from one currency to another. This is where traders convert one foreign
currency into another and is one of the largest financial markets in the world. Currency trading entails
no specific physical location; instead, it is an over-the-counter market whose main participants are
commercial and investment banks, and foreign exhchange dealers and brokers around the world.
Exchange Rates
An exchange rate is simply the price of one country’s currency expressed in terms of another
country’s currency. In practice, almost all trading of currencies takes place in terms of US dollar.
Exchange rates are important because they affect the relative price of domestic and foreign
goods. When a country’s currency appreciates (rises in value relative to other currencies), the
country’s goods abroad becomes more expensive and foreign goods in that country becomes cheaper
(holding domestic prices constant in the two countries). Conversely, when a country’s currency
depreciates, its goods abroad become cheaper and foreign goods in that country become more
expensive.
Factors Influencing Exchange Rates
1. Inflation - because holding the currency results in reduced purchasing power.
2. Interest Rates - If interest rates in a particular country are higher relative to other countries,
individuals and companies will be enticed to invest on that country. As a result, there will
be an increased demand for the country’s currency.
3. Balance of Payments - refer to a system of accounts that catalogs the flow of goods
between the residents of two countries. For instance, if Philippines is a net exporter of
goods and therefore has a surplus balance of trade, countries purchasing the goods must
use the country’s currency. This increases the demand for the currency and its relative
value.
4. Government Intervention
5. Other factors - political and economic stability, extended stock market rallies and significant
declines in the demand for major exports.
Interaction in Foreign Exchange Currency Markets
Exchange Rate Determination
- equilibrium exchange rate in floating markets are determined by the supply of and demand for the
currencies.
Fixed Exchange Rate
- An exchange rate set too high (in foreign currency units per peso) tends to create a deficit Philippine
balance of payments. This deficit must be financed by drawing down foreign reserves or by borrowing
from the central banks of the foreign countries. This effect is short-term because at some time, the
country will deplete its foreign reserves, A major reason for a country's devaluation is to improve its
balance of payments, As an alternative to drawing down its reserves, a country might change its trade
policies or implement exchange controls or exchange rationing. Many developing countries use
currency exchange rationing to avoid a deficit balance of payments.
- An exchange rate set too low (in foreign currency units per peso) tends to create a surplus Philippine
balance of payments. In this case, surplus reserves build up.
At some time, the country will not want any greater reserve balances and will have to raise the value
of its currency.
- An exchange rate A (PA foreign currency units per peso), a greater quantity of peso is supplied by
Philippine interests than demanded by foreign interests (i.e., Philippine imports exceed exports). The
result is a trade deficit. An exchange rate B, a smaller quantity of peso is supplied by Philippine
interests than demanded by foreign interests (i.e., Philippine exports exceed imports). The result is a
trade surplus.
Managed Float
A managed float is the current method of exchange rate determination. During peiods of
extreme fluctuation in the value of a nation’s currency, intervention by governments or central banks
may occur to maintain fairly stable exchange rates. Floating rates permit adjustments to eliminate
balance of payments deficits or surpluses. For example, if the Philippine has a deficit in its trade with
Japan, the Philippine peso will depreciate relative to Japan’s currency. This adjustment should
decrease imports from and increase exports to Japan.
Theory of Purchasing Power Parity
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.
The PPP conclusion that exchange rates are determined solely by changes in relative price
levels rests on the assumption that all goods are identical in both countries. When this assumption is
true, the law of one price states that the relative prices of all these goods (that is, relative price level
between the two countries) will determine the exchange rate.
Two Kinds of Foreign Exchange Rate Transactions are:
a. Spot Transactions - are those which involve immediate (two-day) exchange of bank deposits.
The spot exchange rate is the exchange rate for the spot transactions.
b. Forward Transactions - involve the exchange of bank deposits at some specified future date.
The forward exchange rate is the exchange rate for the forward transaction.

Direct Quote - the spot exchange rate’s quoted exchange rate. It indicates the number of units of
the home currency required to buy one unit of the foreign currency.

Indirect Quote - indicates the number of units of foreign currency that can be bought for one
unit of the home currency.
In summary, a direct quote is the peso/foreign currency rate, and an indirect quote is the foreign
currency quote/peso rate.
Illustrative Case:
Compute the indirect quotes from the Philippine direct quotes of spot rates for US dollars, UK pound,
EU euros, and Japanese yen as of August 27, 2019 given in Figure 9-1. The related indirect quotes are
computed as follows:
Indirect Quote = 1 / Direct Quote
US dollars --> 1 / 52.3260 = .01911 (dollar/P1)
UK pounds --> 1 / 63.9424 = .01564 (pound/P1)
EU euros --> 1 / 58.1028 = .01721 (euro/P1)
Japan yen --> 1 / .4931 = 2.028 (yen/P1)
Example:
A Filipino businessman paid P112,148.20 to an Italian supplier on August 27, 2019. How many euros
did the Italian supplier receive?
P112,148.20 x 0.1721 = 1,930.07 euros

Cross Rates - the indirect computation of the exchange rate of one currency from the exchange
rates of two other currencies.
(1) should have common currency
(2) numerator is equivalent to 1 unit of currency
(3) deonominator should be the unit you’re looking for
1 USD = P55
1 EUR = P60
1 AUD = P35
USD to EURO --> P60 / P55 = 1.09 USD per EURO
EURO to USD --> P55 / P60 = 0.92 EURO per USD
EURO to AUD --> P35 / P60 = 0.58 EURO per AUD
USD to AUD --> P35 / P55 = 0.64 USD per AUD



Arbitrage - the process of buying and selling in exchange market to make a riskless profit.
Arbitrageur - the person/trader doing arbitrage.
Triangular Arbitrage - three exchange rates are necessary to profit from a mispricing. Arbitrage
condition for cross rates.


Foreward Rates - the exchange rate at which the currency for future delivery is quoted.
Forward market transacrion - trading of currencies for future delivery.
Factors that Affect Exchange Rates in the Long Run
1. Relative Price Levels
2. Trade Barriers
3. Preferences for Domestic Versus Foreign Goods
4. Productivity

Foreign Exchange Risk - refers to the possibility of a drop in revenue or an increase in cost in an
international transaction due to a change in foreign exchange rates.
Avoidance of Exchange Rate Risk in Foreign Currency Markets
1.
2.
3.
4.
5.
6.
The firm may hedge its risk by purchasing or selling forward exchange contracts. A
firm may buy or sell forward contracts to cover liabilities or receivables, respectively,
denominated in a foreign currency. Any gain or loss on the foreign payables or
receivables because of changes in exchange rates is offset by the loss or gain on the
forward contract.
The firm may choose to minimize receivables and liabilities denominated in foreign
currencies.
Maintaining a monetary balance between receivables and payables denominated in a
particular foreign currency avoids a net receivable or net liability position in that
currency. Monetary items are those with fixed cash flows. A firm may attempt to
achieve a net monetary debtor (creditor) position in countries with currencies
expected to depreciate (appreciate). Large multinational corporations have
established multinational netting centers as special departments to attempt to
achieve balance between foreign receivables and payables. They also enter into
foreign currency futures contracts when necessary to achieve balance.
Another means of managing exchange rate risk is by the use of trigger pricing. Under
trigger pricing, foreign funds are supplied at an indexed price but with an option to
convert to a future-based fixed price when a specified basis differential exists between
the two prices.
A firm may seek to minimize its exchange-rate risk by diversification. If it has
transactions in both strong and weak currencies, the effects of changes in rates may
he offsetting.
A speculative forward contract does not hedge any exposure to foreign currency
fluctuations, it creates the exposure.
Chapter 10: The Mortgage Markets and Derivatives
What are Mortgages?
Mortgages are long-term loan secured by real estate. Both individuals and businesses obtain
mortgages loanbs to finance real estate purchases.
A. Mortgage Interest Rates
three important factors that affect the interest rate on the loan:
1. Current long-term market rates
2. Term or Life of the mortgage
3. Number of Discount Points Paid
B. Loan Terms
C. Collateral
D. Down Payment
E. Private Mortgage Insurance (PMI)
F. Borrower Qualification
Types of Mortgage Loans
1. Conventional Mortgages - these are originated by banks or other mortgage lenders but are
not guaranteed by government controlled entities. Most lenders though now insure many
conventional loans against default or they require the borrower to obtain private mortgage
insurance on loans.
2. Insured Mortgages - these mortgages are originated by banks or other mortgage lenders but
are guaranteed by either the government or governement-controlled entities.
3. Fixed-rate Mortgages - In fixed-rate mortgages, the interest rate and the monthly payment do
not vary over the life of the mortgage.
4. Adjustable-Rate Mortgages (ARMs) - the interest rate on adjustable-rate mortgage is tied to
some market interest rate, (e.g., Treasury bill rate) and therefore changes over time. ARMs
usually have limits