FINANCIAL MARKETS REVIEWER
LESSON #1 - 10
BY PRINCESS NICOLE M. ESIO
LESSON 1: FUNDAMENTALS (Introduction)
Financial Markets
- refer broadly to any marketplace where the trading of securities occurs.
- a market where buyers and sellers trade commodities, financial securities,
foreign exchange, and other freely exchangeable items (fungible items) and
derivatives of value at low transaction costs and at prices that are
determined by market forces.
Four categories of Trade Commodities:
1.​ Metals (such as gold, silver, platinum, and copper)
2.​ Energy (such as crude oil, heating oil, natural gas, and gasoline)
3.​ Livestock and Meat (including lean hogs, pork bellies, live cattle and
feeder cattle)
4.​ Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee,
cotton, and sugar)
PRIMARY MARKETS VS SECONDARY MARKETS
●​ Primary Markets - markets in which users of funds (e.g.
corporations, governments) raise funds by issuing financial
instruments (e.g. Stocks and bonds)
●​ Secondary Markets - markets where financial instruments are
traded among investors.
MONEY MARKETS VS CAPITAL MARKETS
●​ Money Markets - markets that trade debt securities with maturities
of one year or less (e.g. Treasury bills).
●​ Capital Markets - markets that trade debt (bonds) and equity
(stock) instruments with maturities of more than one year.
Foreign Exchange Markets “FX Markets”
-​ “FX” markets deal in trading one currency for another (e.g. dollar for
yen).
-​ The “spot” FX transaction involves the immediate exchange of
currencies at the current exchange rate.
-​ The “forward” FX transaction involves the exchange of currencies at
a specified date in the future and at a specified exchange rate.
Derivatives Security Markets
-​ The markets in which derivative securities trade.
Derivative Security
➢​ An agreement between two parties to exchange a standard
quantity of an asset at a predetermined price on a specified
date in the future.
Financial Institutions
-​ Institutions that perform the essential function of channeling funds
from those with surplus funds to those with shortages of funds (e.g.
banks, thrifts, insurance companies, securities firms and investment
banks, finance companies, mutual funds, pension funds).
-​ Companies engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and
currency exchange.
Types of Financial Institutions
1.​ Commercial banks - depository institutions whose major assets are
loans and major liabilities are deposits
2.​ Thrifts - depository institutions in the form of savings and loans,
credit unions
3.​ Insurance companies - financial institutions that protect individuals
and corporations from adverse events.
4.​ Securities firms and investment banks - financial institutions that
underwrite securities brokerage and trading.
5.​ Finance Companies - financial institutions that make loans to
individuals and businesses
6.​ Mutual Funds - financial institutions that pool financial resources
and invest in diversified portfolios
7.​ Pension Funds - financial institutions that offer savings plans for
retirement.
Risks Faced by Financial Institutions
●​ Interest rate Risk
●​ Foreign Exchange Risk
●​ Market Risk
●​ Credit Risk
●​ Liquidity Risk
●​ Off-Balance-Sheet Risk
●​ Technology Risk
●​ Operational Risk
●​ Country or Sovereign Risk
●​ Insolvency Risk
Regulation of Financial Institutions
●​ FIs provide vital financial services to all sectors of the economy;
therefore, their regulation is in the public interest
●​ To prevent their failure and the failure of financial markets overall.
Globalization of Financial Markets and Financial Institutions
●​ Financial Markets became more global as the value of stocks traded
in foreign markets soared
●​ Foreign bond markets have served as a major source of international
capital
●​ Globalization also evident in the derivative securities market
Factors Leading to Significant Growth in Foreign Markets
-​ The pool of savings from foreign investors has increased
-​ International investors have turned to other markets to expand their
investment opportunities
-​ Information on foreign investments and markets is now more
accessible (e.g. internet)
-​ Some mutual funds allow ability to invest in foreign securities with
low transaction costs
-​ Deregulation has enhanced globalization of capital flows
Why study Financial Markets and Institutions?
★​ They are the cornerstones of the overall financial system in which
financial managers operate - Individuals use both for investing
★​ Corporations and governments use both for financing
The need to study Financial Markets
-​ Financial markets involve enormous flows of funds affecting
business profits.
➔​ Exchange rates, interest rates, derivatives, inflation, source
of funds/capital, i.e., bonds, shares of stocks, bank loans.
-​ The study will help you understand the issues concerning the flow of
funds
➔​ Transfer from sources to destinations,
➔​ Effects on national and world economy,
➔​ Effects on personal wealth
-​ Interactions
➔​ Individual (borrower, investor)
➔​ Employee (treasury functions)
-​
➔​ Employer or business owner (need to source funds)
Possible employment in the institution
Levels of Framework in the Study
-​ Understand
➢​ Economic analysis to be able to organize concepts and facts.
-​ Evaluate
➢​ Current developments to learn how to use financial data
and economic analysis to properly interpret current events.
-​ Predict
➢​ Likely changes in the economy and financial system.
LESSON 2: MONEY AND INTEREST RATES
Money
-​ An economic unit that functions as a generally recognized medium
of exchange for transactional.
-​ A means of payment for goods and services or repayment of debts,
serves as an asset to the holder.
-​ In modern economy, it is not directly backed by intrinsic (underlying)
value.
➢​ Hence, the financial system works on an entirely fiduciary
basis.
Role/Function of Money in the Economy
1.​ Medium of Exchange
-​ it is accepted freely in exchange for all other goods.
-​ barter system is very inconvenient so the introduction of
money has got over the difficulty of barter.
2.​ Measure of Value
-​ Money acts as a common measure of value; it is a unit of
account and a standard of measurement.
-​ When we buy a good in the market, we pay a price for it in
money; and price is nothing but value expressed in terms of
money.
3.​ Store of value
-​ money is a convenient form to store wealth.
4.​ Standard of deferred payments
-​ It forms the basis for credit transactions.
-​ If credit transactions were to be carried on the basis of
commodities, there would be a lot of difficulties and it will
affect trade.
Money Supply (Money Stock)
-​ the total value of money available in an economy at a point of time.
-​ consists mostly of currency and demand deposits.
➢​ Currency includes all coins and paper money issued by the
government and the banks.
Key Measures for the Money Supply
M1: Narrow Measure -​ includes all currency (i.e., cash) in circulation, traveler’s checks,
demand deposits at commercial banks (or other depository
institutions) held by the public, and other checkable deposits.
-​ it is often referred to as the narrowest measure of money supply or
narrow money.
-​ It refers primarily to money used as a medium of exchange.
M2: Intermediate Measure
-​ includes everything in M1 as well as savings deposits and balances
in retail money market funds.
-​ it refers primarily to money used as a store of value.
M3: Broad Measure
-​ includes everything in M2 as well as large time deposits, balances in
institutional money market funds, and term repurchase agreements.
➢​ a contract in which the vendor of a security agrees to
repurchase it from the buyer at an agreed price.
M4 (L): Broadest Measure
-​ in addition to everything in M3, this includes liquid and near liquid
assets such as:
➢​ short-term treasury bills,
➢​ high grade commercial paper,
➢​ and bank acceptance notes.
Treasury bills, notes and bonds
-​ Marketable government debt securities.
➢​ Treasury bills have maturities of a year or less.
➢​ Treasury notes are issued with maturities from two to ten
years.
➢​ Treasury bonds are long-term investments that have
maturities of 10 to 30 years from their issue date.
High grade commercial papers
-​ an unsecured, short-term debt instrument issued by a corporation,
typically for the financing of accounts payable and inventories or
meeting short-term liabilities. Maturities on commercial paper
rarely range longer than 270 days. -​ The most fundamental type of commercial paper is a promissory
note, a written pledge to pay money. A promissory note is a
two-party paper.
Bank acceptance note
-​ an instrument representing a promised future payment by a bank.
The payment is accepted and guaranteed by the bank as a time draft
to be drawn on a deposit. The draft specifies the amount of funds,
the date of the payment, and the entity to which the payment is
owed.
The Demand for Money
-​ In monetary economics, the demand for money is the desired
holding of financial assets in the form of money, that is, cash or bank
deposits rather than investments.
-​
It can refer to the demand for money narrowly defined as M1
(directly spendable holdings) , or for money in the broader sense of
M2 or M3.
-​ The demand for money is affected by several factors such as:
➢​ level of income
➢​ interest rates and inflation
➢​ uncertainty about the future.
-​ The way in which these factors affect money demand is usually
explained in terms of the three motives for demanding money.
Three Motives for Demanding Money (sources of demand)
1.​ Transaction demand - People prefer to be liquid for day-today
expenses. The amount of liquidity desired depends on the level of
income, the higher the income, the more money is required for
increased spending. This is called transaction demand.
2.​ Precautionary demand - Precautionary demand is the demand for
liquidity to cover unforeseen expenditure such as an accident or
health emergency. The demand for this type of money increases as
the income level increases.
3.​ Speculative demand - The demand to take advantage of future
changes in the interest rate or bond prices. The higher the rate of
interest, the lower the speculative demand for money. And lower
the rate of interest, the higher the speculative demand for money.
The Impact of Money
-​ Higher interest rates will decrease investments
➢​ it becomes more expensive to borrow money.
➢​ consumption will decrease because consumers will tend to
save.
-​
Higher peso will decrease exports resulting in slower GDP growth.
The Quantity Theory of Money
-​ Quantity theory of money states that money supply and price level
in an economy are in direct proportion to one another.
➢​ When there is a change in the supply of money, there is a
proportional change in the price level and vice-versa.
➢​ Other things remaining unchanged, as the quantity of
money in circulation increases, the price level also increases
in direct proportion and the value of money decreases and
vice versa.
The Equation of Exchange
-​ It is the mathematical expression of the quantity theory of money.
In its basic form, the equation says that:
➢​ the total amount of money that changes hands in an
economy equals the total money value of goods that change
hands, or that nominal spending equals nominal income.
The Equation of Exchange
M x V= P x Y
where, M = Money supply
V = Velocity of money
P = Price level
Y = volume of the transactions (real GDP)
❖​ The velocity of money is a measure of the number of times that the
average unit of currency is used to purchase goods and services
within a given time period.
❖​ The equation states the fact that the actual total value of all money
expenditures (MV) always equals the actual total value of all items
sold (PY).
Assumptions Used in the Quantity Theory of Money
1.​ Constant Velocity of Money
➢​ not influenced by the changes in the quantity of money.
➢​ the velocity depends upon exogenous factors like
population, trade activities, habits of the people, interest
rate, etc. These factors are relatively stable and change very
slowly over time.
2.​ Constant Volume of Trade or Transactions
➢​ Total volume is viewed as independently determined by
factors like natural resources, technological development,
population, etc., which are outside the equation and change
slowly over time. Thus, any change in the supply of money
(M) will have no effect on the total volume.
3.​ Price Level is a Passive Factor
➢​ the price level is affected by other factors of equation, but it
does not affect them.
➢​ P is the effect and not the cause in the equation. An
increase in M and V will raise the price level. Similarly, an
increase in Y (T) will reduce the price level.
4.​ Money is a Medium of Exchange
➢​ The quantity theory of money assumed money only as a
medium of exchange. Money facilitates the transactions. It
is not hoarded or held for speculative purposes.
5.​ Constant Proportional Relation Between Currency Money and
Bank Money
➢​ Bank money depends upon the credit creation by the
commercial banks which, in turn, are a function of the
currency money, thus, the ratio remains constant.
6.​ Long Period
➢​ Over a long period of time, V and volume of transactions
(GDP) are assumed to be constant.
➢​ As P is a passive factor, it becomes clear, that a change in the
money supply (M) will lead to a direct and proportionate
change in the price level (P).
➢​ it is distinct from a fee which the borrower may pay the
lender or some third party.
➢​ typically expressed as annual percentage rate (APR).
Broad Conclusions of Fisher’s Quantity Theory
(i) The general price level in a country is determined by the supply of and
the demand for money.
(ii) Given the demand for money, changes in money supply lead to
proportional changes in the price level.
(iii) Since money is only a medium of exchange, changes in the money
supply, change absolute and not relative prices and thus leave the real
variables such as employment and output unaltered. Money is neutral.
(iv) Under the equilibrium conditions of full employment, the role of
monetary policy is limited.
(v) During the temporary disequilibrium period of adjustment, an
appropriate monetary policy can stabilize the economy.
(vi) The monetary authorities, by changing the supply of money, can
influence and control the price level and the level of economic activity of the
country.
Interest Rates
-​ is the amount a lender charges for the use of assets expressed as a
percentage of the principal.
➢​ the assets borrowed could include cash, consumer goods, or
large assets such as a vehicle or building.
-​ is the cost of debt for the borrower and the rate of return for the
lender.
-​ While interest rates represent interest income to the lender, they
constitute a cost of debt to the borrower.
-​ Companies weigh the cost of borrowing against the cost of equity,
such as dividend payments, to determine which source of funding
will be the least expensive, hence, the cost of capital is evaluated to
achieve an optimal capital structure.
Time Value of Money
-​ The value of money changes over time. Money invested in a bank
today will be worth much more in 10 year’s time.
➔​ Money can be invested and will grow.
➔​ The future value of Php1 increases by the yield % each year
Interest
-​ the cost of using money.
➢​ when you borrow, you pay interest.
➢​ when you lend or deposit funds in bank accounts, you can
earn interest.
-​ money paid regularly at a particular rate for the use of money lent,
or for delaying the repayment of a debt.
Cost of Capital
-​ the cost of a company's funds: either debt or equity, or both.
-​ it is the minimum return that investors expect for providing capital
to the company, thus setting a benchmark that a business has to
meet.
-​ if expectations are not met, they should have placed their money in
another venture.
-​ the two main sources of funds:
❖​ cost of the equity (capital from the shareholders) and
❖​ cost of the loans (borrowings - banks or other sources)
Cost of Share Funds (Equity)
= EXPECTATION OF THE SHAREHOLDERS
Shareholders Expect Return:
➢​ Dividends and
➢​ Share Price Appreciation
WACC (Weighted Average Cost of Capital)
The weighted average of:
cost of the equity (capital from the shareholders)
and
cost of the loans (borrowings - banks or other sources)
How Interest Rates are Determined
-​ The interest rate is determined by a number of factors such as the
state of the economy, demand and supply of loanable funds, and
inflation.
➢​ A country’s central bank sets the interest rate. When the
central bank sets interest rates at a high level the cost of
debt rises. When the cost of debt is high, people are
discouraged from borrowing and slows consumer demand.
-​ A loan that is considered low risk by the lender will have a lower
interest rate. A loan that is considered high risk will have a higher
interest rate.
-​ Higher interest rates will induce people to save more, so loanable
funds will increase.
➢​ Interest rate functions as the price in the money market.
How Interest Rates are Determined Keynesian Theory
The rate of interest is determined as a price in two markets:
1. Investment funds
➢​ the rate balances the demand for funds (required for investment)
and the supply of funds (from savings).
2. Liquid assets
➢​ Holding assets as readily available money.
Equilibrium Interest Rates
-​ the rate at which the quantity of money demanded is equal to the
quantity of money supplied.
-​ this result to Money Market Equilibrium.
-​ the Central bank can alter the equilibrium interest rate by adjusting
the supply of money.
Nominal Rate vs Real Rate
-​ Nominal interest rate refers to the interest rate before taking
inflation into account.
Real interest rate is the rate of interest an investor, saver or lender
receives (or expects to receive) after allowing for inflation.
have an intrinsic value, people are willing to use it as a medium of
exchange
Components of Money Interest
1.​ Pure interest or real interest - the compensation, over and above
inflation, that a lender demands to lend his money.
2.​ Inflation - change in the level of prices.
3.​ Risk Premium
➢​ liquidity risk: the compensation that a lender receives for
investing funds in something that is difficult to sell.
➢​ credit risk: the risk that the loan or bond won’t be repaid as
scheduled, or not at all
What are Checks?
-​ A check is a negotiable instrument in the form of a bill of exchange.
A bill of exchange is an unconditional order in writing addressed by
one person to another; signed by the person giving it; requiring the
person to whom it is addressed to pay on demand or at a fixed
determinable future time, a sum certain in money, to order or to
bearer.
-​
LESSON 3: THE PAYMENT SYSTEM
Commodity Money vs Fiat Money
-​ Commodity money is money whose value comes from a
commodity* of which it is made; it consists of objects having value
or use in themselves (intrinsic value) as well as their value in buying
goods.
*coins minted from precious metals
-​ Fiat money is a currency without intrinsic value that has been
established as money, often by government regulation. It does not
have intrinsic value, and has value only because a government
designed it as a legal tender*.
➢​ recognized by law as a means to settle a public or private
debt or meet a financial obligation.
The Philippine Payment System
-​ A fiat money system, wherein the BSP has the sole authority to issue
paper currency.
-​ Paper money is valued because it is the legal tender authorized to
be used as a form of payment, hence, even if paper money does not
Original Parties of a Bill of Exchange
- drawer: the one who issues and draws the order bill
> he does not pay directly.
- drawee: the party to whom the bill is addressed and who is ordered and
expected to pay
> in the case of a check, the drawee is a bank.
- payee: the one in whose favor the bill is originally issued or is payable
The Importance of Checks
Since checks are negotiable instruments*:
1. they can be used as substitute for money.
*negotiable instruments - a formal document that is able to be
transferred or assigned to the legal ownership of another person,
thereby, facilitating trade.
2. Constitute the media of exchange for most commercial transactions.
- increase the purchasing medium in circulation.
- eliminate the need to count coins and bills physically and remove the risk
of dealing in cash
3. Serves as a medium of credit transactions.
- when cash is not available, a check can be issued payable until a future
date.
Constraint on the Use of Checks
- Requires more trust on the part of the seller as compared with accepting
bills.
➢​ The fundamental idea, is that the drawer has funds in the hands of
the drawee.
Other Forms of Payment
1.​ Debit card - a card issued by a bank allowing the holder to transfer
money electronically to another bank account when making a
purchase. When used the bank immediately credits the seller’s
account and debits the buyer’s account.
2.​ Credit Card - a card issued by a bank allowing the holder to
purchase goods or services against a line of credit, known as the
card’s credit limit.
Debit Card vs Credit Card
❖​ debit cards are attached to a bank account and allow you to
spend existing funds.
❖​ credit cards allow you to spend on credit that you then pay
back at a later date.
3.​ Proximity mobile payments
-​ payments to a merchant that are initiated from a mobile
phone, using apps linked to a debit or credit card.
-​ these payments are made by simply waving a mobile phone
that uses Near Field Communication (NFC) technology near
a merchant's pointof-sale device.
4.​ Automated Clearing House
-​ the electronic clearing and settlement system used for
financial transactions by commercial banks and other
institutions. - examples: employers pay wages through
direct deposit to their accounts or consumers pay bills
electronically out of checking accounts.
5.​ E-Money
-​ an electronic store of monetary value on a technical device
that may be widely used for making payments to entities
other than the e-money issuer.
-​ It can be accessed remotely via a device like mobile phones
or prepaid cards.
-​ the device acts as a prepaid bearer instrument which does
not necessarily involve bank accounts in transactions.
-​ essentially a private payment system.
6.​ Bitcoin
-​ a digital currency (also called cryptocurrency) that is not
backed by any country's central bank or government. -​ can be traded for goods or services with vendors who
accept Bitcoins as payment.
-​ The P2P network monitors and verifies the transfer of
Bitcoins between users.
Blockchain is the underlying technology behind the bitcoin.
➢​ technically a digital ledger in which transactions are
recorded chronologically and publicly.
➢​ it can allow individuals and companies to make
instantaneous transactions on a network without any
middlemen if they are decentralized.
Cashless Society
-​ an economic state whereby financial transactions are not conducted
with money in the form of physical banknotes or coins, but rather
through the transfer of digital information, usually an electronic
representation of money between the transacting parties.
Cashless Society: Benefits
●​ Lower crime because there's no tangible money to steal
●​ Less money laundering because there's always a paper trail
●​ Less time and costs associated with handling paper money as well as
storing and depositing it
●​ Easier currency exchange while traveling internationally
Cashless Society: Disadvantages
●​ Exposes your personal information to a possible data breach
●​ If hackers drain your bank account, you'll have no alternative source
of money
●​ Technology problems can leave you with no access to your money
●​ The poor and those without bank accounts will have difficulty
paying and receiving payments
●​ Some may find it harder to control spending when they don't see
physical cash leaving their hands
●​ Banks may start charging fees to compensate for possible negative
interest rates
-​
unlike land, property, commodities, or other tangible physical assets,
financial assets do not necessarily have inherent physical worth or
even a physical form.
What Is a Financial Liability?
-​ a contractual obligation to deliver cash or similar financial assets to
another entity, or
-​ a potentially unfavorable exchange of financial assets or liabilities
with another entity.
LESSON 4: FINANCIAL INSTRUMENTS
Financial Instruments
-​ A financial instrument is any contract that gives rise to a financial
asset of one entity and a financial liability or equity instrument of
another entity.
-​ They can be created, traded, modified and settled. They can be cash,
evidence of an ownership interest in an entity, or a contractual right
to receive or deliver.
What Is a Financial Asset?
-​ a liquid asset that gets its value from a contractual right or
ownership claim
-​ e.g. Cash, stocks, bonds, mutual funds, and bank deposits
Derivatives
-​ a financial instrument with a value that is reliant upon or derived
from, an underlying asset or group of assets.
-​ the derivative itself is a contract between two or more parties, and
the derivative derives its price from fluctuations in the underlying
asset.
-​ a contract that “derives” its value from the performance of an
underlying asset. Derivatives
-​ An underlying asset of the derivative contract is the one that is to
be bought or sold on a future date.
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The most common underlying assets for derivatives are stocks,
bonds, commodities, currencies, interest rates, and market indexes.
Futures Contracts
an agreement traded on an organized exchange to buy or sell assets,
especially commodities or shares, at a fixed price but to be delivered
and paid for later.
the existence of futures contracts allows sellers or buyers to hedge
against risk.
can be a commodity futures contract or a financial futures contract.
It is a standardized legal agreement.
Functions similarly with a futures contracts, but it is a
non-standardized contract, i.e., an informal agreement traded
through a broker-dealer network to buy and sell specified assets,
typically currency, at a specified price at a certain future date.
Futures vs Forward
Clearing House
-​ a financial institution formed to facilitate the exchange of payments,
securities, or derivatives transactions; the clearing house stands
between two clearing firms; its purpose is to reduce the risk of a
member firm failing to honor its trade settlement obligations.
Philippine Clearing House Corporation
-​ incorporated in July 1977, as a private corporation co-equally owned
by all commercial banks enlisted as members of the Bankers
Association of the Philippines (BAP).
Derivatives
Call Options
-​ financial contracts that give the option buyer the right, but not the
obligation, to buy a stock, bond, commodity or other asset or
instrument at a specified price (strike price) within a specific time
period (expiration or time to maturity).
-​ the stock, bond, or commodity is called the underlying asset; a call
buyer profits when the underlying asset increases in price.
Foreign Currency Futures
-​ a futures contract to exchange one currency for another at a
specified date in the future at a rate that is fixed on the purchase
date.
-​ the financial derivative’s payoff depends on the foreign exchange
rate(s) of two (or more) currencies.
-​ these instruments are commonly used for currency speculation and
arbitrage or for hedging foreign exchange risk.
Swaps
-​ an agreement between two counterparties to exchange financial
instruments or cash flows or payments for a certain time; the
instruments can be almost anything but most swaps involve cash
based on a notional principal amount.
• interest rate swap
➢​ a type of a derivative contract through which two
counterparties agree to exchange one stream of future
interest payments for another, based on a specified principal
amount; in most cases, interest rate swaps include the
exchange of a fixed interest rate for a floating or variable
rate.
• currency swap
➢​ involves exchanging principal and fixed rate interest
payments on a loan in one currency for principal and fixed
rate interest payments on an equal loan in another currency.
• other types
➢​ Inflation, commodity, credit fault
Caps and collars
• used in connection with interest rates.
➢​ a Cap is an upper limit, or maximum interest rate that will
apply.
➢​ the actual interest rate charged can vary between the Cap
and the Collar, but will never exceed the Cap, or fall below
the Collar (lower limit).
Financial Guarantees
-​ a contract by a third party (guarantor) to back the debt of a second
party (the creditor) for its payments to the ultimate debtholder
(investor).
-​ essentially insurance policies that guarantee that a particular debt
issue will be paid if the debt issuer experiences financial difficulties.
-​ typically issued by insurance companies or other large, extremely
stable financial companies, frequently a parent company for the
benefit of a subsidiary.
Letters of Credit
-​ letter from a bank guaranteeing that a buyer's payment to a seller
will be received on time and for the correct amount.
-​ in the event that the buyer is unable to make a payment on the
purchase, the bank will be required to cover the full or remaining
amount of the purchase.
LESSON 5: OVERVIEW OF THE FINANCIAL SYSTEM
Financial System
-​ a system that allows the exchange of funds between lenders,
investors, and borrowers.
-​ is a set of institutions, such as banks, insurance companies, and
stock exchanges, that permit the exchange of funds.
-​ it exists on firm, regional, and global levels.
-​ borrowers, lenders, and investors exchange current funds to finance
projects, either for consumption or productive investments, and to
pursue a return on their financial assets.
-​ the financial system also includes sets of rules and practices that
borrowers and lenders use to decide which projects get financed,
who finances projects, and terms of financial deals.
Key Components of the Financial System
●​ Financial instruments
●​ Financial markets
●​ Financial institutions
●​ Government regulatory bodies, e.g. BSP
Functions of Financial System
●​ Pooling of Funds
●​ Capital Formation
●​ Facilitates Payment
●​ Provides Liquidity
●​ Short and Long Term Needs
●​ Risk Function
●​ Better Decisions
●​ Finances Government Needs
●​ Economic Development
Flows of Funds through the Financial System
➢​ Imposing restrictions, e.g.,
• “to be used exclusively for”
• “in case of default, the total amount becomes due and
demandable”
Transaction and Information Costs
Transaction Costs:
➢​ are cost in making any economic trade when participating in a
market.
• e.g. legal fees, commissions
Information Cost:
➢​ are expenditures of time and money that are required to obtain
intelligent information normally related to due diligence, decision
making, problem solving and research.
Problems from Asymmetric Information
1.​ Adverse selection: results when one party makes a decision based
on limited or incorrect information, which leads to an undesirable
result.
2.​ Moral hazard: when an individual takes more risks because he
knows that he is protected due to another individual bearing the
cost of those risks
Minimizing the Problems
Adverse selection:
➢​ Disclosure of material information.
➢​ Collecting information on firms and providing the information to
investors.
●​ this may be done through trade organizations like chambers
of commerce, credit management associations.
➢​ Collateral or mortgage requirements.
Moral Hazards:
➢​ Monitoring changes or progress of the borrower’s use of the loaned
funds.
Reduction of Transaction Costs
1.​ Economies of scale
2.​ Process standardizations
3.​ Technology
4.​ Use of software to evaluate credit worthiness
LESSON 6: THE PHILIPPINE FINANCIAL SYSTEM
Functions of a Commercial Bank
Commercial Bank
1. Depositories of funds and sources of credit
2. Accepting drafts (bills of exchange)
3. Issuing letters of credit
4. Discounting and negotiating promissory notes, drafts and bills of
exchange and other evidences of debt
5. Accepting and / or creating demand deposits
6. Receiving other types of deposits and deposit substitutes refers to a form
of obtaining funds from the public, other than deposits, through the
issuance, endorsement or acceptance of debt instruments for the purpose
of relending or purchase of other receivables and obligations.
7. Buying and selling foreign exchange
8. Accepting deposits and trust accounts from residents and nonresidents
9. Maintaining deposits with foreign banks abroad, Offshore Banking Units
and Foreign Currency Deposit Units
10. Investing in debt and equity instruments denominated in foreign
currency and other activities that may be necessary or incidental to carry on
the business of commercial banking.
Functions of a Universal Bank
Universal Bank
All the functions of a commercial bank. In addition it is also empowered
➢​ to engage in the activities of an investment house or bank such as
underwriting, securities dealership and equity investment and to
invest in other industries other than those allied to the banking
industry.
FINANCIAL MARKETS REVIEWER
LESSON #7 - 16
BY PRINCESS NICOLE M. ESIO & KHATE GUINZBURG CANDAZA
LESSON #7: FINANCIAL MARKETS (A BROADER VIEW)
FINANCIAL MARKETS
➔​ Financial markets refer broadly to any marketplace where the
trading of securities occurs.
➔​ including the stock market, bond market, forex market, and
derivatives market, among others.
Functions of Financial Markets
1.​ Price Determination (Price Setting)
-​ the financial market performs the function of price
discovery of the different financial instruments which are
traded between the buyers and the sellers on the financial
market.
-​ the prices are determined by the market forces i.e., demand
and supply in the market.
2.​ Funds Mobilization (Raising Capital)
-​ funds available from the lenders or the investors of the
funds will get allocated among the persons who are in need
of the funds (business expansion, purchases)
3.​ Liquidity
-​ this function provides an opportunity for the investors to
sell their financial instruments at its fair value prevailing in
the market at any time during the working hours of the
market.
4.​ Risk Sharing (Risk Management)
-​ derivatives transfer part of the risk from the party who
agrees to the contract to the party accepting the
instrument.
5.​ Easy Access
-​ the industries require the investors for raising the funds and
the investors require the industries for investing its money
and earning the returns from them.
6.​ Reduction in Transaction Costs and Provision of the Information
-​ the trader requires various types of information while doing
the transaction of buying and selling the securities.
-​ the financial market helps in providing every type of
information to the traders without the requirement of
spending any money by them; in this way, the financial
market reduces the cost of the transactions
7.​ Capital Formation
-​ financial markets provide the channel through which the
new savings of the investors flow in the country which aid in
the capital formation of the country
Methods of Obtaining Funds
1. Debt instrument
- a tool that an individual, government entity, or business entity can utilize
for the purpose of obtaining funds.
- it is a documented, binding obligation that provides funds to an entity in
return for a promise from the entity to repay a lender or investor in
accordance with terms of a contract.
Debt instrument
- the contract includes detailed provisions on the deal such as collateral
involved, the rate of interest, the schedule of payments for interest and
principal, and the date of maturity which can be:
➢​ short term = less than 1 year
➢​ intermediate term = 1-10 years
➢​ long term = 10 years or more
2. Equity instrument
- a document which serves as a legally applicable evidence of the ownership
right in a firm, like a share certificate.
- issued to company shareholders and are used to fund the business. shareholders are entitled to a proportionate share in the net earnings and
assets of the company.
Primary Markets Vs Secondary Markets
Primary Markets
- markets in which users of funds (e.g. corporations, governments) raise
funds by issuing financial instruments (e.g. stocks and bonds).
- new stocks and bonds are sold to the public for the first time through an
initial public offering or through an investment bank.
Secondary Markets
- markets where financial instruments that have been sold previously are
traded among investors.
Broad Segments of the Stock Market or Exchange
★​ Organized Stock Exchange
★​ Over-the-Counter Exchange
1. Organized Stock Exchange
➔​ organized secondary market
➔​ with a physical location where trading takes place
Stock Exchange
●​ a facility where stockbrokers and traders can buy and sell securities,
such as shares of stock and bonds and other financial instruments.
Listing of Securities on Stock Exchange
Listing
- the admission of securities of a company to trading on a stock exchange.
- provides an exclusive privilege to securities on the stock exchange.
➢​ only listed shares are quoted on the stock exchange.
➢​ stock exchange provides transparency in transactions of listed
securities and equality and competitive conditions.
Objectives of Listing
1. To provide liquidity to securities.
2. To provide a mechanism for effective control and supervision of trading.
3. To mobilize savings for economic development.
4. To provide free negotiability to stocks.
5. To support ability to raise further capital.
2. Over-the-Counter Exchange
➔​ a decentralized market in which market participants trade stocks,
commodities, currencies or other instruments directly between two
parties and without a central exchange.
➔​ over-the-counter markets do not have physical locations; instead,
trading is conducted electronically.
Day Trading
➔​ speculation in securities, specifically buying and selling financial
instruments within the same trading day, such that all positions are
closed before the market closes for the trading day.
➔​ traders who trade in this capacity with the motive of profit are
therefore speculators.
How Day Trading Works?
●​ shares are held momentarily, buying at one price and selling when
the price rises even by a few cents after some minutes later.
●​ profits are gained by trading large volume of shares in one
transaction or making several trades during the day.
●​ trades are “close out” at the end of the day to guard from off-hours
movements
What Day Traders Should Be Familiar With
1.​ Market data and news playing
- is to buy a stock which has just announced good news, or short sell
on bad news.
- such events provide enormous volatility in a stock and therefore
the greatest chance for quick profits (or losses).
- day traders pay a premium for access to real-time data.
2.​ Trend following or trend trading
- is a strategy according to which one should buy an asset when its
price trend goes up, and sell when its trend goes down, expecting
price movements to continue.
3.​ Contrarian investing
- an investment strategy that is characterized by purchasing and
selling in contrast to the prevailing sentiment of the time.
- it assumes that financial instruments that have been rising steadily
will reverse and start to fall, and vice versa.
4.​ Range trading
- a trading style in which stocks are watched that have either been
rising off a support price or falling off a resistance price
➢​ that is, every time the stock hits a high, it falls back to the
low, and vice versa.
➢​ such a stock is said to be "trading in a range", which is the
opposite of trending
- a related approach to range trading is looking for moves outside of
an established range, called a breakout (price moves up) or a
breakdown (price moves down), and assume that once the range
has been broken prices will continue in that direction for some time.
5.​ Swing trading
- a speculative trading strategy in financial markets where a tradable
asset is held for between one and several days in an effort to profit
from price changes or ‘swings’
- a swing trading position is typically held longer than a day trading
position, but shorter than buy and hold investment strategies that
can be held for months or years.
6.​ Scalping
- the shortest time frame in trading and it exploits small changes in
currency prices;
- it normally involves establishing and liquidating a position quickly,
usually within minutes or even seconds.
7.​ Bid-offer spread
- is simply the difference between the price at which you can buy a
share and the price at which you can sell it.
- to make the spread means to buy at the Bid price and sell at the
Ask price, in order to gain the bid/ask difference.
- The bid price is what buyers are willing to pay for it. The ask price
is what sellers are willing to take for it.
➢​ If you are selling a stock, you are going to get the bid price, if
you are buying a stock you are going to get the ask price.
8.​ Margin trading
- the buying of securities with cash borrowed from a broker, using
the bought securities as collateral.
Day trading is
●​ High risk
●​ Stressful
●​ Expensive
Some Attributes of Financial Markets
●​ Liquidity
●​ Transparency
●​ Reliability
●​ Legal procedures
●​ Suitable investor protection and regulation
●​ Low transaction cost
●​ Technology
●​
●​
●​
●​
Deregulation
Liberalization
Consolidations
Globalization
LESSON #8: MONEY AND CAPITAL MARKETS PART 1
Money Markets versus Capital Markets
Money Markets - markets that trade debt securities with maturities of one
year or less (e.g. Treasury bills).
Capital Markets - markets that trade debt (bonds) and equity (stock)
instruments with maturities of more than one year.
Users of Money Market
➢​ Companies - sourcing cash for operational requirements; investing
excess cash in short-term instruments.
➢​ Banks - as the acceptor of short-term commercial papers; issuer of
certificates of deposit.
➢​ Investors / individuals - as savers in the form of bank deposits or
short term financial instruments.
➢​ Users of Money Market Economic development - providing funds
to public and private institution to finance their needs; liquidity help
to promote trade, commerce and industry.
What Money Markets Do
➢​ Borrowing by the government - avoids deficit financing or printing
more notes increasing the money supply and price level.
➢​ Mobilization of funds - transferring of funds from one sector to
another, thus mobilizing the resources for the country’s
development.
Types of Money Market Instruments
●​ Commercial paper
●​ Bankers’ acceptances
●​ Treasury bills
●​ Government agency notes
●​ Local government notes
●​ Interbank loans (non-affiliated banks)
●​ Time deposits
●​ Repurchase agreements
High grade commercial papers
- an unsecured, short-term debt instrument issued by a corporation,
typically for the financing of accounts payable and inventories or meeting
short-term liabilities. Maturities on commercial paper rarely range longer
than 270 days.
- The most fundamental type of commercial paper is a promissory note, a
written pledge to pay money. A promissory note is a two-party paper.
Bank acceptance note
- an instrument representing a promised future payment by a bank. The
payment is accepted and guaranteed by the bank as a time draft to be
drawn on a deposit. The draft specifies the amount of funds, the date of the
payment, and the entity to which the payment is owed.
Treasury bills, notes and bonds
- Marketable government debt securities.
➢​ Treasury bills have maturities of a year or less.
Term repurchase agreements
➢​ a contract in which the vendor of a security agrees to repurchase it
from the buyer at an agreed price.
LESSON #8: MONEY AND CAPITAL MARKETS PART 2
Money Markets versus Capital Markets
Money Markets - markets that trade debt securities with maturities of one
year or less (e.g. Treasury bills).
Capital Markets - markets that trade debt (bonds) and equity (stock)
instruments with maturities of more than one year.
Primary Issuers of Capital Market Securities
➔​ National and local government - for funding national debt (issued
by national government) and to finance capital projects (national
and local)
➔​ Corporations - to finance capital expenditures and other investment
opportunities.
Capital Market Trading
Covers both Primary Market and Secondary Market
- Primary market
➢​ new issues of stocks and bonds wherein the issuer actually receives
the proceeds of the sale.
➢​ the selling of securities for the first time is referred to as initial
public offering (IPO).
Secondary Market
➢​ venue for the sale of previously issued securities.
➢​ two types of secondary market:
•Organized Stock Exchange
•Over-the-Counter Exchange
Bonds
●​ Cash flows received by the investor or paid by the issuer:
1. periodic interest payments,
2. principal (par value or face value) returned at maturity.
Bonds Trading Process
1. Private placement to a small group of investors which are frequently
financial institutions.
2. Public offering using an investment bank as a security underwriter:
➢​ the bank guarantees the firm a price for the whole lot of newly
issued bonds by paying the bid price at a discount from par and
reselling to investors at an offer price which is a higher price
Firm Commitment Underwriting
- the underwriter guarantees to purchase all the securities offered for sale
by the issuer regardless of whether they can sell them to investors.
- it is the most desirable agreement because it guarantees all of the issuer's
money right away.
Bonds Trading Process
Aside from using a Firm Commitment Underwriting, the following
arrangements can be made:
- Competitive sale
- Negotiated sale
- Best effort underwriting basis
Competitive Sale
- Any broker dealer or dealer bank may bid on the bonds at the designated
date and time.
- The bonds are awarded to the bidder offering the lowest interest cost.
Negotiated Sale
- the terms of the bonds and the terms of the sale are negotiated by the
issuer and the bond purchaser.
➢​ the issuer should have sufficient knowledge of debt financing to take
an active role in establishing the terms of the issue and sale.
➢​ an independent financial advisor can serve as a third party
negotiator.
Best Effort Underlying Basis
●​ a legal agreement between an underwriter and a bond issuer,
whereby the underwriter agrees to do the best it can to sell as many
as possible to the public.
●​ does not guarantee that all of the securities in the issue must be
sold.
Advantages of Using Bonds (Borrower’s View)
1. Lower interest payment.
2. Interest expense is tax deductible.
3. Holders do not share in the company’s huge profit.
4. Holders do not have a hand in managing the business.
5. The total cost incurred by a company in offering its bonds to the public is
generally lower than those of common equity shares.
Disadvantages of Using Bonds (Borrower’s View)
1. Debt and interest payments should be met.
2. Debt and interest payments are fixed.
3. At maturity date, payment of debt requires a huge cash outflow.
4. Holders do not have a hand in managing the business.
5. Restrictive covenants may restrict the company’s financial flexibility.
LESSON #9: FOREIGN EXCHANGE MARKET
Foreign Exchange Market
➔​ The foreign exchange market (Forex, FX, or currency market) is a
global decentralized or over-the-counter (OTC) market for the
trading of currencies.
➔​ This market determines foreign exchange rates for every currency.
➔​ It includes all aspects of buying, selling and exchanging currencies at
current or determined prices.
➔​ The foreign exchange market assists international trade and
investments by enabling currency conversion.
➔​ It serves individuals, businesses and governments who need to buy
or sell foreign currencies
➔​ It also supports direct speculation and evaluation relative to the
value of currencies.
Exchange Rate
➔​ the price of one country’s currency expressed in terms of another
country’s currency.
Factors Affecting Exchange Rates
1. Inflation Rates
●​ A country with a lower inflation rate than another's will see an
appreciation in the value of its currency.
●​ A country with a consistently lower inflation rate exhibits a rising
currency value while a country with higher inflation typically sees
depreciation in its currency and is usually accompanied by higher
interest rates.
2. Interest Rates
●​ Increases in interest rates cause a country's currency to appreciate
because higher interest rates provide higher rates to lenders,
thereby attracting more foreign capital, which causes a rise in
exchange rates.
3. Country’s Current Account / Balance of Payments
●​ A country’s current account reflects balance of trade and earnings
on foreign investment. It consists of total number of transactions
including its exports, imports, debt, etc.
●​ A deficit in current account due to spending more of its currency on
importing products than it is earning through sale of exports causes
depreciation.
4. Government Debt
●​ Government debt is public debt or national debt owned by the
central government.
●​ A country with government debt is less likely to acquire foreign
capital, leading to inflation.
5. Terms of Trade
●​ Related to current accounts and balance of payments, the terms of
trade is the ratio of export prices to import prices.
6. Political Stability & Performance
●​ A country with less risk for political turmoil is more attractive to
foreign investors, as a result, drawing m0re investments from other
countries.
●​ Sound financial and trade policy strengthen the value of a country’s
currency but a country prone to political confusions may see a
depreciation in exchange rates.
7. Recession
●​ When a country experiences a recession, its interest rates are likely
to fall, decreasing its chances to acquire foreign capital.
8. Speculation
●​ If a country's currency value is expected to rise, investors will
demand more of that currency in order to make a profit in the near
future.
●​ As a result, the value of the currency will rise due to the increase in
demand. With this increase in currency value comes a rise in the
exchange rate as well.
9. Government Intervention
●​ Monetary Policy is generally the process by which the central bank,
or government controls the supply and availability of money, the
cost of money, and the rate of interest.
Exchange Rate Determination
➔​ Currency prices can be determined in two main ways:
➢​ a floating rate or
➢​ a fixed rate.
Floating rate
- determined by the market forces of supply and demand on the global
currency markets.
- rates fluctuate freely and may result to either devaluation or revaluation
or upvaluation
➢​ Therefore, if the demand for the currency is high, the value will
increase. If demand is low, this will drive that currency price lower.
Managed Float
➔​ A floating exchange rate doesn't mean countries don't try to
intervene and manipulate their currency's price, since governments
and central banks regularly attempt to keep their currency price
favorable for international trade.
➔​ Short-term moves in a floating exchange rate currency reflect
speculation, rumors, disasters, and everyday supply and demand for
the currency.
➔​ Extreme short-term moves can result in intervention by central
banks, even in a floating rate environment. Because of this, while
most major global currencies are considered floating, central banks
and governments may step in if a nation's currency becomes too
high or too low, hence, the term “managed float”.
Fixed Exchange Rate
●​ A country's decision to tie the value of its currency to another
country's currency, gold (or another commodity), or a basket of
currencies.
●​ A fixed or pegged rate is determined by the government through its
central bank. The rate is set against another major world currency
(such as the U.S. dollar, euro, or yen).
The “Law of One Price”
❖​ an economic concept that states that the price of an identical asset
or commodity will have the same price globally, regardless of
location, when certain factors are considered.
❖​ the law of one price is the foundation of purchasing power parity
➢​ PPP states that the value of two currencies is equal when a
basket of identical goods is priced the same in both
countries. It ensures that buyers have the same purchasing
power across global markets.
Kinds of Foreign Currency Exchange Transactions
1. Spot Transactions - an agreement between two parties to buy one
currency against selling another currency at an agreed price for settlement
on the spot date. Spot or Settlement date
●​ exchange is done immediately; the standard settlement
timeframe for foreign exchange spot transactions is two
business days from the trade date (T+2).
Spot exchange rate - the exchange rate at which the transaction is done.
Spot Exchange Rate
1. Direct Quote - one unit of foreign currency is expressed in terms
of domestic currency.
e.g. US$ 1 = Php 48.67
2. Indirect Quote - one unit of domestic currency is expressed in
terms of foreign currency.
e.g. Php 1 = US$ 0.0205
3. Cross Rate - a foreign currency exchange transaction between
two currencies that are both valued against a third currency.
e.g.
1 Swiss Franc = 1.08 United States Dollar
1 Swiss Franc = 0.90 Euro
1.08 / 0.90 = 1.20 US Dollar = 1 Euro
0.90/ 1.08 = 0.83 Euro = 1 US Dollar
2. Forward Transactions - an agreement with the bank to purchase one
currency against selling another currency at a fixed price for delivery on an
agreed date in the future.
Forward Rates
➔​ the exchange rate at which a bank agrees to exchange one currency
for another at a future date when it enters into a forward contract
with an investor.
➢​ spot rate refers to the immediate exchange rate.
➢​ forward rate refers to the future exchange rate agreed upon
in forward contracts.
Factors Affecting Exchange Rates in the Future
In the long run, exchange rates are determined by:
1. Relative price levels
2. Trade barriers
3. Preference for domestic against foreign goods
4. Productivity
Foreign Exchange Risk
➔​ is a financial risk that exists when a financial transaction is
denominated in a currency other than the domestic currency of a
business entity.
➢​ It may lead to a decrease in revenue or an increase in cost in an
international transaction due to a change in foreign exchange rates.
Preventing Exchange rate Risk in Foreign Currency Markets
1. Hedging, not speculation
2.Establishment of netting centers, particularly for large multinational
companies.
3.Trigger pricing
4.Diversification
LESSON #10: MORTGAGE AND DERIVATIVES MARKET PART 1
Mortgage
-​ a legal agreement by which a bank or other creditor lends money at
interest in exchange for taking title of the debtor's property, with
the condition that the conveyance of title becomes void upon the
payment of the debt.
-​ a debt instrument that is secured by real estate.
➢​ Because of the presence of collateral, mortgage loans are
considered to be relatively safe for lenders; therefore, the
interest rates on mortgage loans tend to be lower than for
unsecured debt.
Mortgage Market
●​ Primary Mortgage Market - the market where borrowers can obtain
a mortgage loan from a primary lender. Banks, mortgage brokers,
mortgage bankers, and credit unions are all primary lenders and are
part of the primary mortgage market.
●​ Secondary Mortgage Market - where lenders and investors buy and
sell mortgages and their servicing rights. Its purpose is to give
lenders a steady source of money to lend, while also alleviating the
risk of owning the mortgage.
Features that Borrowers Should Know
1. Mortgage interest rates
2. Loan terms
a. Collateral
b. Down payment
c. Private mortgage insurance
d. Amortization
3. Borrower qualifications
Types of Mortgage Loans
1. Conventional mortgages - a type of mortgage loan that is not insured or
guaranteed by the government; it is backed by private lenders, and its
insurance is usually paid by the borrower.
➢​ can be harder to qualify for and require that the borrower have a
higher credit score.
2. Insured mortgages - protected by mortgage default insurance; the
insurance protects the lender, not the borrower, against losses in the event
of failure of mortgage payments or default on the loan.
3. Fixed Rate Mortgages - the mortgage carries a constant interest rate
from beginning to end.
4. Adjustable Rate Mortgages - the interest rate applied on the outstanding
balance varies throughout the life of the loan; the interest rate for is reset
based on a benchmark or index.
5. Graduated Payment Mortgages - the payments increase gradually from
an initial low base level to a higher final level; the payment starts out low
and then gradually rises.
6. Growing Equity Mortgages - monthly payments increase over time
according to a set schedule, rather than remaining fixed and equal over the
loan term. The interest rate on the loan does not change, and there is never
any negative amortization.
7. Shared Appreciation Mortgages - the borrower or purchaser of a home
shares a percentage of the appreciation in the home's value with the lender;
in return for this additional compensation, the lender agrees to charge an
interest rate which is below the prevailing market interest rate.
8. Equity Participating Mortgages - the lender and the borrower undertake
a joint investment and agree to a future division of profit (or losses)
according to specified shares.
9. Second Mortgages - A second mortgage or junior-lien is a loan you take
out using your house as collateral while you still have another loan secured
by your house.
10. Reverse Annuity Mortgages - the lender advances funds to the owner,
secured against the value of the property; it allows you to cash in some of
your home's equity, without having to sell or move out.
Mortgage Securitization
❖​ Securitization - the financial practice of pooling various types of
contractual debt such as residential mortgages, commercial
mortgages, or other debt obligations and selling their related cash
flows to third party investors as securities.
❖​ Mortgage- backed security - a type of asset-backed security which
is secured by a mortgage or collection of mortgages; a common type
is the mortgage pass through.
LESSON #10: MORTGAGE AND DERIVATIVES MARKET PART 1
Participants in a Derivatives Market
●​ Hedgers - persons or entities investing in financial markets to reduce
the risk of price volatility, i.e., eliminate the risk of future price
movements.
●​ Speculators - Investors engaged in the purchase of any financial
instrument or an asset that an investor speculates to become
significantly valuable in the future.
➢​ Speculation is the buying of an asset or financial instrument
with the hope that the price of the asset or financial
instrument will increase in the future. It is a risky activity
that investors engage in. Speculation is driven by the motive
of potentially earning lucrative profits in the future.
●​ Arbitrageurs - investors who make profit from buying a commodity
or shares, or currency in one place and sells them in another where
they can get a higher price at the same time.
➢​ Arbitrage is the practice of taking advantage of a price
difference between two or more markets.
●​ Margin traders - investors who are trading assets using funds
provided by a third party.
➢​ margin is the collateral deposited by an investor investing in
a financial instrument to the counterparty to cover the
credit risk associated with the investment.
Derivatives Market
●​ the financial market for financial instruments such as futures
contracts or options.
●​ there are four kinds of participants in a derivatives market:
1. Hedgers
2. Speculators
3. Arbitrageurs
4. Margin traders
LESSON #11: GLOBALIZATION OF FINANCIAL MARKETS
International / Global Financial Markets
➢​ the place where financial wealth is traded between individuals and
between countries ; it can be seen as a wide set of rules and
institutions where assets are traded between agents in surplus and
agents in deficit and where institutions lay down the rules.
➢​ include the market for foreign exchange, the Eurocurrency and
related money markets, the international capital markets, notably
the Eurobond and global equity markets, the commodity market and
last but not least, the markets for forward contracts, options, swaps
and other derivatives.
IMPORTANCE OF INTERNATIONAL / GLOBAL FINANCIAL MARKETS
❖​ offer access to foreign capital needed for expansion.
❖​ facilitate trading in foreign currencies.
❖​ allow investors to channel funds to other countries.
❖​ create policies for good governance and control.
➢​ governance in the financial market can be defined as a set
of rules useful in interconnecting the agents who operate
within it and the institutions; these rules define the market.
World’s Largest Financial Markets
●​ The New York Stock Exchange (NYSE) is the largest in the world
○​ there are more than 500 non-U.S. stocks from 46 countries
○​ non-U.S. companies must comply with SEC and accounting
regulations, thus providing a more overall transparent
process to investors.
Cross-Border Financing
●​ any financial arrangement that originates in one country for the
benefit of someone in another country.
○​ It can include loans, letters of credit, and bank acceptances.
○​ Constraints:
■​ laws, collection of money, tax, transaction cost are
different in different countries.
CATEGORIES OF INVESTORS
★​ Retail or Individual Investor
○​ someone who invests in securities and assets, such as
stocks, bonds, securities, mutual funds, on their own,
usually in smaller quantities.
★​ Institutional Investor
○​ an entity which pools money to purchase securities, real
property, and other investment assets or originate loans.
○​ an organization that invests money on behalf of other
people.
International Credit Markets
➢​ a marketplace for the exchange of debt securities and short-term
commercial paper.
➢​ a form for the movement of loan capital between countries
TYPES OF INTERNATIONAL CREDIT MARKETS
1.​ Eurocredit Market
➢​ comprises banks that accept deposits and provide loans in
large denominations and in a variety of currencies different
from the lender's national money; the loans carry variable
or floating rates.
2.​ Eurobond Market
➢​ a MARKET based in Europe, comprising a web of
international banks and money brokers, which is engaged in
the borrowing and lending of FOREIGN CURRENCIES such as
US dollars OUTSIDE their countries of origin, as a means of
financing trade and investment transactions.
○​ the main instrument used in the Eurocurrency
market to finance long-term investment is the
Eurobond , a debt instrument that's denominated in
a currency other than the home currency of the
country or market in which it is issued.
3.​ Foreign Bond Market
➢​ where international (foreign) bonds are issued by foreign
issuers in a foreign national market and are denominated in
the currency of that market.
○​ foreign bond issuance is regulated by the rules of
the host national market.
○​ an example of a foreign bond is a bond
denominated in US dollars issued by a German
company in the United States.
FINANCIAL INTERMEDIARIES
●​ are financial institutions such as banks, building societies, credit
unions, insurance companies, pension funds or mutual funds.
●​ they are entities that act as the middleman between two parties in
a financial transaction.
FLOW OF FUNDS THROUGH THE FINANCIAL SYSTEM
LESSON #12: FINANCIAL INSTITUTIONS AND INTERMEDIARIES
Overview of Financial Institutions
●​ Institutions that perform the essential function of channeling funds
from those with surplus funds to those with shortages
of funds (e.g. banks, thrifts, insurance companies, securities firms
and investment banks, finance companies, mutual funds, pension
funds)
FINANCIAL INSTITUTIONS
●​ companies engaged in the business of dealing with financial and
monetary transactions such as deposits, loans, investments, and
currency exchange.
LESSON #13: FUNDAMENTALS OF COMMERCIAL BANKING
Commercial Banks
★​ depository institutions whose major assets are loans and major
liabilities are deposits.
THE BANK BALANCE SHEET
(1) Bank Assets
➢​ Reserves and Other Cash Assets
➢​ Securities
➢​ Loans Receivable
➢​ Other Assets
(2) Bank Liabilities
➢​ Demand or Current Account Deposits
➢​ Non Demand Deposits
➢​ Borrowings
(3) Bank Capital or Net Worth
RISK MANAGEMENT IN BANKING
➔​ theoretically defined as “the logical development and execution of a
plan to deal with potential losses” .
Liquidity Risk
●​ refers to the ability of a bank to access cash to meet funding
obligations which include allowing customers to take out their
deposits.
○​ bank run occurs when many customers withdraw all their
money simultaneously from their deposit accounts with a
banking institution for fear that the institution is, or might
become, insolvent.
●​ can be managed by not having a balance sheet concentrated in
illiquid assets.
○​ proper management of asset-liability duration can ease
funding difficulties, e.g., balancing short term liabilities with
sufficient short-term assets.
○​ regulations exist to lessen liquidity problems e.g. the
requirement to hold sufficient reserves to survive for a
period of time even without the inflow of outside funds.
Credit Risk
●​ occurs when borrowers or counterparties fail to meet contractual
obligations.
●​ banks can lower their exposure through diversification ,, credit risk
analysis, imposing collateral requirements, rationing , restrictive
covenants and relationship banking
Market Risk
●​ mostly occurs from a bank’s activities in capital markets due to the
unpredictability of equity markets, commodity prices, interest rates,
and credit spreads.
○​ to decrease market risk
■​ diversification of investments is important,
■​ hedging e.g., interest rate swaps,
■​ use of floating interest rates for loans.
Operational Risk
●​ the risk of loss due to errors, breaches or fraud, interruptions, or
damages caused by people, failed internal systems or processes, or
any external event that disrupts a financial institution’s operations.
○​ operational loss becomes prevalent if internal control is
weak.
○​ In general, the risk can be mitigated by having an excellent
or strong internal control .
INTERNAL CONTROL
❖​ Comprises the plan of the organization and all of the methods and
procedures adopted by a business to:
➢​ Safeguard its assets
➢​ Check the accuracy and reliability of its accounting data
➢​ Promote operational efficiency
➢​ Encourage adherence to prescribed managerial policies
LESSON #14: OTHER BANKING ACTIVITIES
Off-Balance-Sheet Activities
❖​ Off-balance sheet (OBS), or incognito leverage, usually means an
asset or debt or financing activity not on the company's balance
sheet.
1. Loan commitment - a lender's promise to offer a loan or credit of
a specified amount to a borrower.
➢​ A commitment fee is charged by a lender to a borrower as a
way of guaranteeing that the bank will keep the funds
available.
2. Standby letters of credit - a legal document that guarantees a
bank's commitment of payment to a seller in the event that the
buyer – or the bank's client– defaults on the agreement.
3. Loan sale - a sale by a bank, under contract of all or part of the
cash stream from a specific loan, thereby removing the loan from
the bank's balance sheet.
4. Trading Activities - cover transactions for hedge instruments like
futures, options, and interest rate swaps; it includes hedging
services provided to bank customers.
Shadow Banking
➔​ a term for the collection of nonbank financial intermediaries that
provide services similar to traditional commercial banks but
outside normal banking regulations.
Investment banks - a special segment of banking operation whose areas of
business helps individuals or organizations raise capital and provide financial
consultancy services to them.
Division Within Investments Banks
●​ Industry coverage groups
-​ Differentiated by what types of clients the groups serve,
e.g., Healthcare, Technology, Media, Telecom, Financial
Institutions, Natural Resources, Consumer & Retail,
Industrials, Real Estate, Gaming and Lodging, and Financial
Sponsors.
●​ Product groups
-​ Differentiated by what types of services the groups provide.
e.g., Mergers and Acquisitions (M&A), Leveraged Finance,
Equity Capital Markets, Debt Capital Markets, and
Restructuring. These groups focus only on their specific
products/services and can work across all industry groups.
LESSON #15: INTRODUCTION TO BANKING LAWS AND THE PDIC LAW
★​ Declaration of Policy from the General Banking Law (RA 8791)
General Banking Law (RA 8791)
➔​ an act providing for the regulation of the organization and
operations of banks, quasi-banks, trust entities and for other
purposes. (The General Banking Law of 2000)
Declaration Policy
●​ The State recognizes the vital role of banks in providing an
environment conducive to the sustained development of the
national economy and the fiduciary nature of banking that requires
high standards of integrity and performance.
●​ In furtherance thereof, the State shall promote and maintain a
stable and efficient banking and financial system that is globally
competitive, dynamic and responsive to the demands of a
developing economy.
Quasi-banks
➢​ refer to entities engaged in the borrowing of funds through the
issuance, endorsement or assignment with recourse or acceptance
of deposit substitutes for purposes of relending or purchasing of
receivables and other obligations.
Deposit Substitutes
➢​ an alternative form of obtaining funds from the public, other than
deposits, through the issuance, endorsement, or acceptance of debt
instruments for the borrower’s own account, for the purpose of
relending or purchasing of receivables and other obligations.
Restriction on Bank Exposure to DOSRI
➢​ Dealings of a bank with any of its Directors, Officers, Stockholders
and their Related Interests (DOSRI) should be in the regular course
of business and upon terms not less favorable to the bank than
those offered to others.
➢​ No director or officer of any bank shall, directly or indirectly, for
himself or as the representative or agent of others, borrow from
such bank nor shall he become a guarantor, indorser or surety for
loans from such bank to others, or in any manner be an obligor or
incur any contractual liability to the bank except with the written
approval of the majority of all the directors of the bank, excluding
the director concerned.
★​ The New Central Bank Act (RA 7653 amended by RA 11211)
Declaration of Policy
●​ The State shall maintain a central monetary authority that shall
function and operate as an independent and accountable body
corporate in the discharge of its mandated responsibilities
concerning money, banking and credit. In line with this policy, and
considering its unique functions and responsibilities, the central
monetary authority established under this Act, while being a
government-owned corporation, shall enjoy fiscal and
administrative autonomy.
Creation of the Bangko Sentral
-​ The capital of the Bangko Sentral shall be two hundred billion pesos
(₱200,000,000,000) to be fully subscribed by the Government of the
Republic.
Currency
-​ all Philippine notes and coins issued or circulating in accordance
with the provisions of this Act.
Exclusive Issue Power
➢​ The Bangko Sentral shall have the sole power and authority
to issue currency, within the territory of the Philippines.
➢​ No other person or entity, public or private, may put into
circulation notes, coins or any other object or document
which, in the opinion of the Monetary Board, might
circulate as currency, nor reproduce or imitate the facsimiles
of Bangko Sentral notes without prior authority from the
Bangko Sentral.
➢​ Violation of this provision or any regulation issued by the
Bangko Sentral pursuant thereto shall constitute an offense
punishable by imprisonment of not less than five (5) years
but not more than ten (10) years. In case the Revised Penal
Code provides for a greater penalty, then that penalty shall
be imposed.
Legal Tender Power
➢​ means that when the currency is offered in payment of a
debt, public or private, the same must be accepted.
➢​ Philippine currency notes have no limit to their legal tender
power.
➢​ In particular, all notes and coins issued by the BSP shall be
fully guaranteed by the Government of the Republic of the
Philippines and shall be legal tender in the Philippines for all
debts, both public and private.
However, in the case of coins in denomination of:
➔​ 1, 5 and 10 Piso they shall be legal tender in
amounts not exceeding P1,000.00
➔​ coins in denomination of 1, 5, 10 and 25 Sentimo
shall be legal tender in amounts not exceeding
P100.00.
★​ PDIC Law (RA 3591, as Amended by RA 10846)
Declaration of Policy
●​ to strengthen the mandatory deposit insurance coverage system to
generate, preserve, maintain faith and confidence in the country’s
banking system, and protect it from illegal schemes and
machinations.
➢​ the Corporation, while being a government instrumentality
with corporate powers, shall enjoy fiscal and administrative
autonomy.
Insurable Deposits
●​ Deposits of all commercial banks, savings and mortgage banks, rural
banks, private development banks, cooperative banks, savings and
loan associations, as well as branches and agencies in the
Philippines of foreign banks and all other corporations authorized to
perform banking functions in the Philippines, are insured with PDIC
Exclusions:
1.​ Investment products such as bonds, securities and trust
accounts;
2.​ Deposit accounts which are unfunded, fictitious or
fraudulent; Insurable deposits
3.​ Deposit products constituting or emanating from unsafe and
unsound banking practices;
4.​ Deposits that are determined to be proceeds of an unlawful
activity as defined under the AntiMoney Laundering Law
●​ As for Philippine banks with branches outside the country, subject to
the approval of the Board of Directors, any insured bank with branch
outside the Philippines may elect to include for insurance its deposit
obligations payable at such branch.
●​ Foreign currency deposits are also insured by PDIC. Depositors may
receive payment in the same currency in which the insured deposit
is denominated.
Insured Deposits
●​ the amount due to any bona fide depositor for legitimate deposits
in an insured bank net of any obligation of the depositor to the
insured bank as of date of closure, but not to exceed P500,000.00.
Are All Banks Insured or Members of PDIC?
-​ Membership of banks to PDIC is mandatory; hence, all operating
banks are members of PDIC.
Risk Covered by PDIC
●​ only the risk of a bank closure ordered by the Monetary Board.
●​ thus, bank losses due to theft, fire, closure by reason of strike or
existence of public disorder, revolution or civil war, are not covered
by PDIC.
Maximum Liability
●​ In determining the insured amount, the outstanding balance of each
account is adjusted, such that interests are updated, withholding
taxes are deducted, accounts maintained by a depositor in the same
right and capacity are added together; and whenever applicable,
unpaid loans and other obligations of the depositor are deducted;
and in no case shall insured deposit exceed P500,000.
●​ Deposits in different banking institutions are insured separately.
●​ however, if a bank has one or more branches, the main office and all
branch offices are considered as one bank.
●​ The claim for the uninsured portion of the deposit is a claim against
the assets of the closed bank.
●​ The claim may be filed with the Liquidator of the closed bank within
sixty (60) days from publication of notice of closure.
Requirements for Claims
●​ Depositors will be advised through the national and/or local media
and posters at the premises of the closed insured bank & other
public places within the locality on:
1) the schedule of distribution of claim forms by PDIC,
2) receiving of claim forms by PDIC,
3) and the prescriptive date of filing claims by the
depositors.
●​ The depositor of the closed insured bank has 24 months from date
of bank takeover to file his insurance claim.
➢​ Failure to file the claim with PDIC would mean that all rights
of the depositor with respect to the insured deposit shall no
longer be honored. But he may still make a claim against
the assets of the closed bank.
Processing of Claims
●​ Deposit records are subjected to an examination prior to the start of
servicing/settlement of claims. Claims are evaluated and processed
according to PDIC's standard procedures.
●​ The claim for insured deposit should be settled within six (6) months
from the date of filing, provided all requirements are met - but the
claim must be filed within twenty-four (24) months after bank
takeover.
The six-month period shall not apply if:
➔​ the documents of the claimant are incomplete or
➔​ if the validity of the claim requires the resolution of issues of
facts and law by another office, body or agency,
independently or in coordination with PDIC
LESSON #16: REGULATORS OF THE FINANCIAL SYSTEM
Principal Regulatory Agencies
●​ Bangko Sentral ng Pilipinas
●​ Philippine Deposit Insurance Corporation
●​ Securities and Exchange Commission
●​ Insurance Commission
Objectives of Financial Regulations
a. To ensure the soundness of the financial system.
1. Restrictions on entry
2. Stringent reporting requirements
3. Restriction on assets and activities
4. Deposit insurance
5. Limits on competition
6. Restriction on interest rate
b. To increase the information available to investors.
c. To improve control of the financial system.
The Role of BSP in Financial Regulation
Primary objectives
●​ to maintain price stability conducive to a balanced and sustainable
growth of the economy and employment;
●​ it shall also promote and maintain monetary stability and the
convertibility of the peso.
Responsibilities
●​ provide policy directions in the areas of money, banking, and credit.
●​ have supervision over the operations of banks and exercise such
regulatory and examination powers over the quasibanking
operations of non-bank financial institutions.
●​ exercise regulatory and examination powers over money service
businesses, credit granting businesses, and payment system
operators.
➢​ the Monetary Board is empowered to authorize entities or
persons to engage in money service businesses.
The Role of PDIC in Financial Regulation Functions
●​ The Corporation shall promote and safeguard the interests of the
depositing public by providing insurance coverage on all insured
deposits and helping maintain a sound and stable banking system.
Functions
1. Deposit insurance
2. Risk mitigation
3. Receivership and liquidation
The Securities and Exchange Commission
●​ the national government regulatory agency charged with
supervision over the:
➢​ corporate sector,
➢​ capital market participants,
➢​ securities and investment instruments market,
➢​ protection of the investing public.
Main Responsibility
➔​ enforcing all laws affecting corporations and other forms of
associations not otherwise vested in some other government
offices.
➔​ the Commission also implements and acts either as lead or support
agency in administering and enforcing special laws.
VISION
★​ By 2028, the SEC with its driven, highly-trained and customer-centric
team of professionals, equipped with innovative technology and
automated registration and data management systems, is the
premier investor champion and catalyst of a broadened and
informed investor based capital market and business sector
considered among the best in the Southeast Asian Region.
MISSION
★​ We are the gateway to doing business in the Philippines. We provide
a competitive and secure environment for easy company
registration, efficient capital formation, and broad investor
participation.
CORE VALUES
●​ INTEGRITY
●​ PROFESSIONALISM
●​ ACCOUNTABILITY
●​ TEAMWORK
●​ INDEPENDENCE
The Insurance Commission
●​ an attached agency of the Department of Finance (DOF) committed
to protect the interest and welfare of the insuring public and to
develop and strengthen the insurance industry.
➢​ as a regulator, the commission shall provide an opportunity
for every Filipino to secure insurance protection and shall
observe practices at par with regional and global standards.
VISION
★​ We are committed to implement prudent and progressive regulatory
and supervisory policies at par with international standards.
MISSION
★​ Strong, sustainable and globally competitive regulated entities, as
pillars of the economy, to serve every Filipino.
Mandate
➔​ To regulate and supervise the insurance and pre-need industries in
accordance with the provisions of the Insurance Code, as amended,
the Pre-Need Code of the Philippines and Executive Order No. 192
(s. 2015).
Major functions
➔​ to promulgate and implement policies, rules and regulations
governing the operations of entities engaged in insurance and
pre-need activities.
➔​ to handle licensing of insurance, reinsurance companies, its
intermediate, mutual benefit associations, trusts for charitable uses
and pre-need companies and its intermediaries.
Is PDIC Under the Insurance Commission?
➔​ the Philippine Deposit Insurance Corporation (PDIC) is a government
instrumentality created to insure bank deposits.
➔​ the Insurance Commission supervises and regulates the insurance
industry