INTRODUCTION

The International Monetary Fund (IMF) and the World Bank (WB) conduct financial
sector assessments of countries that they help. It is imperative that the IMF and WB monitor
the financial standing of country borrowers. A study of the country's financial system is crucial
in the study of capital markets because the financial market is central to the financial system.
The following report shows the standing of the Philippine financial sector.
The financial Sector Stability Assessment (FSSA) was based on the joint work of IMF
and World Bank Financial Sector Assessment program (FSAP) Update Mission to Manila from
November 4 to 17, 2009. The initial FSAP took place in 2002. The Update team comprised of
World Bank staff including Pamela Madrid, the main author of the report. The FSSA Update on
the Philippines was prepared as background documentation for the periodic IMF consultation
with the member country. It was based on the information available at the time it was
completed last January 11, 2010. The views expressed in the document are those of the staff
team and do not necessarily reflect the views of the government of the Philippines or the
Executive Board of the IMF. (Madrid 2010)
FSAP assessments are designed to assess the stability of the financial system as a whole
and not that of individual institutions. It has been developed to help countries identify and
remedy weaknesses in their financial sector structure, thereby enhancing their resilience to
macroeconomic shocks and cross-border contagion. FSAP assessments do not cover risks that
are specific to individual institutions such as asset quality, operational or legal risks, or fraud.
The main findings Of this assessment are:
The banking sector has been strengthened considerably since the Asian crisis of the
late 1990s and today appears generally resilient to a broad range of macroeconomic
risks. The impact of the ongoing global crisis has thus far been milder than originally
feared and the macroeconomic outlook is improving, although risks remain
elevated in the near term,
Considerable progress has been made toward implementing the recommendations
Of the initial FSAP, particularly in banking supervision, but also in strengthening the
bank resolution framework and nonbank supervision.
Further strengthening of supervisory powers and practices is needed to bring
supervision and bank safety nets to the best international standards and practices.
In particular,' it is critical to ensure adequate legal protection for supervisors and
eliminate bank secrecy with respect to supervisory duties.
Development of the nonbank financial sectors would help growth and risk
diversification. Capital markets and the insurance sector would benefit from
harmonizing various taxes and lowering the regulatory burden on some products
and services. In the housing finance sector, the multitude of government
interventions and institutions need to be rationalized.
All members of society—households, businesses, non-profit organizations, the church,
and the government—are affected by the financial system Of the country to which they belong,
The government is primarily responsible for defining and regulating the financial system itself,
The central bank and its Monetary Board determine the rules, regulations, and monetary
policies that need to be implemented to ensure a stable and healthy financial system for the
country. Business firms, households, and governments play a wide variety of roles in our
modern financial system. All of us, one way or the Other, are involved in the financial system
either as a borrower or a lender or both.
A country's financial system is not however solely determined by the country itself
because other worldwide organizations like WB, IMF, Asian Development Bank, New York
Stock Exchange (NYSE), Osaka Securities Exchange (OSE), Australian Stock Exchange (ASX),
Bats Global Markets (Bats), and Shenzen Stock Exchange, among others and the transnational
banks affect the financial system of the country. Our modern world has a Complex and
sophisticated financial system that has been and will always be affected by globalization.
This chapter will discuss what a financial system is and its role in the economy. It will also
tackle the roles the different participants in a financial system play. The monetary system, the
monetary policy and its effect in the economic system of a country, and the tools of monetary
policy and how they affect money supply and interest rates will also be dealt with in this
chapter. Lastly, the role of the Bangko Sentral ng Pilipinas (BSP) in the economic development
Of the Philippines Will be elaborated.
FINANCIAL SYSTEM: DEFINITION
Financial system describes collectively the financial markets, the financial system
participants, and the financial instruments and securities that are traded in the financial
markets. The functions of the financial system are:
• to channel the funds from the savings units (lenders) to the deficit units (borrowers);
to provide a medium of exchange;
to provide a mechanism for risk sharing; and
• to provide a channel through which the central bank can influence the economy, in
general and the financial system, in particular.
With the advent of globalization, we have a multinational financial system. Multinational
financial system refers to the collective financial transfer mechanisms that facilitate the
movement of money and profits between and among financial system participants throughout
the world. These mechanisms include transfer of prices on goods and services traded internally
and internationally; intercompany loans and leading (speeding up) and lagging (slowing down)
payments, fees, and royalty charges wherever they are located in the world; and dividend
payments. Together, they lead to a "pattern of profits and movements of funds that would be
impossible in the world of Adam Smith" (Shapiro 2003).
Kidwell et al. (2013) cited the inferences that can draw about the financial system:
If the financial system is competitive, the interest rate that the bank pays on
certificates of deposit (CDs) will bear at or near the highest rate that you can earn on
CDs of similar maturity and risk. At the same time, borrowers will have borrowed at
or near the lowest possible interest cost, given their risk class. Competition among
banks for deposits will drive CD rates up and loan rates down.
Banks and other depository institutions, such as insurance companies, gather
money from consumers in small dollar amounts, aggregate it, and then make loans
in much larger dollar amounts.
One important function of the financial system is to allocate money to the most
productive investment projects in the economy. If the financial ‘system is working
properly, only projects with high-risk adjusted rates of return are funded, and those
with low rates are rejected.
Finally, banks are profit-making organizations, and the bank and other lenders earn
much of their profits from the spread between lending and borrowing rates.
From the foregoing discussion, we can see that financial system performs four basic
functions, which are also the functions of finance and financial managers.
Fund acquisition — a way of getting deposits and necessary funds to finance projects
and investments
Fund allocation — determining to which uses, projects, or investments the acquired
funds will be used
Fund distribution — the process by which necessary funds are given to the uses,
projects, or investments that need funds
• Fund utilization — using the funds for its intended purpose
FINANCIAL SYSTEM PARTICIPANTS
There are six participants or sectors in the financial system:

1.households or consumers
2.financial institutions/intermediaries
3.non-financial institutions
4.government
5.central bank
6.foreign participants
Households or Consumers
Households or consumers are generally described as the group that receives income,
majority of which typically comes from wages and salaries. Such income is spent on goods and
services, and a part is saved. Gross savings is equal to current income less current expenditures.
What is spent is termed consumption. Goods that are consumed within a current period are
termed non-durable consumer goods or non-durables. Goods that will last for more than a
year are termed durable consumer goods or durables.
according to the Hadjimichalakises
(1995), "the standard definition of consumer durables, however, is that they are consumption
goods with a life of three or more years. The assumption is that all consumer goods with
shorter lives are used up in the year in which they are purchased." Typically, consumers or
households purchase non-durables from current income and borrow for the durables like cars,
washing machines, air conditioners, or houses.
Financial Institutions/lntermediaries
Financial institutions/intermediaries are the firms that bridge the gap between surplus
units (SUS) or investors/lenders and deficit units (DIJs) or borrowers. They channel funds from
lenders to borrowers. They include depository institutions and non-depository institutions.
Other than being channels, they are lenders and borrowers at times. When they underwrite
securities or acts as brokers or dealers, they are intermediaries. If they buy securities, they are
investors or lenders, and when they are the ones issuing the securities, they are borrowers.
Non-Financial Institutions
Nonfinancial institutions are businesses other than financial institutions or
intermediaries. They include trading, manufacturing, extractive industries, construction,
genetic industries, and all firms other than the financial ones. Just like households and financial
institutions, these are also borrowers or lenders or both at one time or another. When these
non-financial institutions buy securities, they are lenders, investors, or savers; when they issue
the securities, they are the borrowers.
Government
The government means the national, provincial, municipal or city governments, and
barangays or towns comprising the Philippines as a whole. Each division has its heads and
agencies that help in running the division they are responsible for. The president is responsible
for the entire country, the governor is responsible for his own province, the mayor is responsible
for his own city, and the barangay captain is responsible for his own barangay. Each of them
has his own agencies. The Bureau of the Treasury (BTR) is part of the government that is a
participant in the financial system. When BTR or any other subdivisions of government issue
their own securities, they act as borrowers/deficit units, and when the BTR or any other
subdivisions of government buy securities, they act as investors or savers/surplus units.
Central Bank
The Bangko Sentral ng Pilipinas and all the other central banks of the different countries
are mandated to ensure that their respective countries have a stable and financial
system. They oversee the operations of their entire financial system and mandate the rules,
regulations, and monetary policies that will help them maintain a healthy and stable economy.
Central bank is the "banker" to banks. It provides various services to banks such as helping
CAPITAL MARKETS
them collect and clear checks and loaning them funds as needed. As a lender and a regulator,
central bank oversees the health of the banking system. Central banks are the monetary
policymakers of their respective countries.
Foreign Participants
Foreign participants refer to the participants from the rest of the world—households,
governments, financial and non-financial firms, and central banks. Goods and services and
financial instruments/securities are exchanged across national boundaries, as well as within
these boundaries. International trade and finance are parts of globalization. As globalization
affects the entire world, the role of foreign participants in the financial system has become
more important.
BANGKO SENTRAL NG PILIPINAS AND THE PHILIPPINE FINANCIAL SYSTEM
The details in this section about BSP and the different organizational structures come
from BSP.gov.ph. Banko Sentral ng Pilipinas (BSP) is the Central Bank of the Republic of the
Philippines. It was established on January 3, 1949 as the country's central monetary authority.
The Bangk6 Sentra' ng Pilipinas (BSP) was established on July 3, 1993 pursuant tothe provisions
of the 1987 Philippine Constitution and Republic Act No. 7653, the New Central Bank Act
of 1993 to replace the Central Bank of the Philippines. BSP enjoys fiscal and administrative
autonomy in the pursuit of its mandated responsibilities.
New Logo
The new 89 logo is a perfect round shape in blue that
features three gold stars and a stylized Philippine eagle rendered
in white strokes. These main elements are framed on the left side
with the text inscription "Bangko Sentral ng Pilipinas" underscored
by a gold line drawn in half circle. The right side remains open,
signifying freedom, openness, and readiness of BSP as represented
by the Philippine eagle (signifying strength, clear vision, and
freedom) to soar and fly toward its goal. Putting all these elements
together in a solid blue background signifies stability. The stars are
rendered in gold to symbolize wisdom, wealth, idealism, and high quality. The white color of
the eagle and the text for BSP represent purity, neutrality, and mental clarity.
Principal Elements:
The Philippine eagle, our national bird, is the world's largest eagle and a symbol of
strength, clear vision, and freedom, the qualities we aspire for as a central bank.
The three stars represent the three pillars of central banking: price stability,
stable banking system, and a safe and reliable payments system. It may also be
interpreted as a geographical representation of BSP's equal concern for the impact
of its policies and programs on all Filipinos, whether they are in Luzon, Visayas, or
Mindanao.
History
3. Colors
-The blue background signifies stability.
-The stars are rendered in gold to symbolize wisdom, wealth, idealism. and
high quality.
-The white color of the eagle and the text for BSP represent purity, neutrality,
and mental clarity.

4. Font or typeface, Non-serif, bold for "BANGKO SENTRAL NG PILIPINAS" to suggest

solidity, strength, and stability. The use of Non-serif font characterized by clean
lines portrays the no-nonsense professional manner of doing business at BSR

5. Round shape to symbolize the continuing and unending quest to become an

excellent monetary authority committed to improve the quality of life of Filipinos.
This round shape is also evocative of our coins, the basic units of our currency.

A group of Filipinos had conceptualized a central bank for the Philippines as early as
1933. It came up with the rudiments of a bill for the establishment of a central bank for the
country after a careful study of the economic provisions of the Hare-Hawes Cutting Bill, the
Philippine Independence Bill approved by the US Congress. According to Fajardo (1994),
Miguel Cuadernö, the first governor of the Central Bank of the Philippines (the former name
of the now Bangko Sentra/ ng Pilipinas) initiated the development of the concept of a central
bank in 1933 (For thirteen years, he conducted a research on the various central banks of
many countries). In 1939, as required by the Tydings-McDuffie Act, the Philippine legislature
passed a law establishing a central bank. As it was a monetary law, it required the approval of
the United States President. However, President Franklin D. Roosevelt disapproved it due to
strong opposition from vested interests. A second law was passed in 1944 during the Japanese
occupation, but the arrival of the American liberalization forces aborted its implementation.
Shortly after President Manuel Roxas assumed office in 1946, he instructed the then Finance
Secretary Miguel Cuaderno, Sr. to draw up a charter for a central bank. As governor, he chose
the charter of the Central Bank of Guatemala as the model for the charter of the Central Bank
of the Philippines because of the similar economic and social conditions of Guatemala and the
Philippines.
The establishment of a monetary authority became imperative a year later as a result of
the findings of the Joint Philippine-American Finance Commission chaired by Mr. Cuaderno.
The Commission, which studied Philippine financial, monetary, and fiscal problems in 1947,
recommended a shift from the dollar exchange standard to a managed currency system. A
central bank was necessary to implement the proposed shift to the new system.
Immediately, the Central Bank Council, which was created by President Manuel Roxas to
prepare the charter of a proposed monetary authority, produced a draft. It was submitted to
Congress in February 1948. By June of the same year, the newly proclaimed president Elpidio
Quirino, who succeeded President Roxas, affixed his signature on Republic Act No. 265, the
Central Bank Act of 1948. The establishment of the Central Bank of the Philippines was a
definite step toward national sovereignty. Over years changes were introduced to make
the charter more responsive to the needs of the economy.
Organizational Structure

By organization, the basic structure of the Bangko Sentral ng Pilipinas includes:

The Monetary Board exercises the powers and functions of BSP, such as the conduct
of monetary policy and supervision of the financial system. Its chairman is the BSP
Governor, with five full-time members from the private sector and one member
from the Cabinet. The Governor is the Chief Executive Officer of BSP and is required
to direct and supervise the operations and internal administration of BSP. A deputy ,
governor heads each of the BSP's operating sectors.
Executive Management Services is the functional grouping of all units directly
reporting to the Monetary Board or to the Governor.
Functional Sectors:
Monetary Stability Sector takes charge of the formulation and
implementation of the BSP's monetary policy, including serving the
banking needs of all banks through accepting deposits, servicing
withdrawals, and extending credit through the rediscounting facility.
Supervision and Examination Sector enforces and monitors compliance
to banking laws to promote a sound and healthy banking system.
Resource Management Sector serves the human, financial, and physical
resource needs of BSP.
Security Plant Complex is responsible for the production of
Philippine currency, security documents, and commemorative
medals and medallions.
The Monetary Board
The Board that governs the Central Bank is called the Monetary Board. Hence, the
powers and functions of Bangko Sentral are exercised by its Monetary Board, which has seven
members appointed by the President of the Philippines. The Chairman is the Governor of
BSP. Under Republic Act No. 7653, the New Central Bank Act, one of the government sector
members of the Monetary Board must also be a member of the Cabinet designated by the
President. Five other members come from the private sector. The New Central Bank Act
took effect on June 14, 1993, during the reign of then President Fidel Ramos. It established
an independent Cenval Monetary Authority, which is .now known as the Bangko Sentral ng
Pilipinas (BSP) with a capital of PSO billion.
The New Central Bank Act established certain qualifications for the members of the
Monetary Board and also prohibited members from holding certain positions with other
governmental agencies and private institutions that may give rise to conflicts of interest. With
the exception of the members of the Cabinet, the Governor and the other members of the
Monetary Board serve terms of six years and may only be removed for cause.
The Monetary Board meets at least once a week. The Board may be called to a meeting
by the Governor of the Bangko Sentral or by two other members of the Board. Usually, the
Board meets every Thursday but on some occasions, it convenes to discuss urgent issues.
The major functions of the Monetary Board include the power to:
Issue rules and regulations it considers necessary for the effective discharge of the
responsibilities and exercise of the powers vested in it.
Direct the management, operations, and administration of Bangko Sentral, organize its
personnel, and issue such rules and regulations as it may deem necessary or desirable
for this purpose.
Establish a human resource management system which governs the selection, hiring,
appointment, transfer, promotion, or dismissal of all personnel. Such system shall aim to
establish professionalism and excellence at all levels of the Bangko Sentral in acco ance
with sound principles of management.

4. Adopt an annual budget for and authorize such expenditures by Bangko Sentral in the
interest of the effective administration and operations of Bangko Sentral in accordance
with applicable laws and regulations.

5. Indemnify its members and other offcials of Bangko Sentral, including personnel of the
departments performing supervision and examination functions, against all costs and
expenses reasonably incurred by such persons in connection with any civil or criminal
action, suit, or proceeding, to which any of them may be made a party by reason of the
performance of his functions or duties, unless such members or other officials are found
to be liable for negligence or misconduct.

The figures on the succeeding -pages show the Bangko Sentral ng Pilipinas and the
Philippine Financial System. The Bangko Sentral ng Pilipinas is at the top of the structure being
mandated to oversee the financial system of the country. It is the agency that is to ensure that
the country has a healthy financial system and a stable economy. It is the central monetary
Figure 6 shows BSP in relation to the different banking and non•bank financial institutions
and Figure 7 details the different non-bank financial institutions under BSP. The Bangko Sentra'
ng Pilipinas is primarily responsible for regulating the flow of money and credit into the whole
economy in order to attain monetary stability and sustainable economic growth. Its major task
is to mobilize and direct the resources of the Philippine Financial System toward the social
and economic growth of the economy, in particular and the country, in general. Its paramount
importance is the improvement of the life of the masses by alleviating poverty. Through its
different monetary instruments, the Bangko Sentral ng Pilipinas is able to fashion a desirable
level of prices, investments, production, incomes, and consumptions (Fajardo et al. 1994). The
Bangko Sentral ng Pilipinas has the ultimate social responsibility of uplifting the economy and
fostering growth and development of the country.
Under the Bangko Sentral are the different banking institutions, both private and
government, and the non-bank financial institutions, also both private and government. The
private banking institutions are composed of the commercial banking institutions, the thrift
banks, and the rural banks. This is depicted in the chart representation as derived from the
descriptive narration in Fajardo and Manansala's Money, Credit and Banking (1993).
The government banking institutions include the Philippine National Bank, the
Development Bank of the Philippines, the Land Bank of the Philippines, and the Philippine
Amanah Bank. Under the non-bank financial institutions are the private non-bank financial
institutions and the government non-bank financial institutions. under the private non-
bank financial institutions are the investment banks/houses, investment companies, finance
companies, securities dealers and brokers, non-stock savings and loan associations, building
and loan associations, pawnshops, lending investors, fund managers, trust companies/
departments, insurance companies, and venture capital corporations. Under the government
non-bank financial institutions are the Government Service Insurance System (GSIS) for
the government employees and the Social Security System (SSS) for the private company
employees.
Also under the Bangko Sentral ng Pilipinas are the, cooperatives that are handled
directly by the Cooperative Development Authority under the Office of the president. Private
insurance companies are under the Insurance Commission. These organizations are however
mandated to submit reports to the Bangko Sentral ng Pilipinas so that BSP can monitor their
operations and the effects on the financial and monetary system of the country. Other financial
institutions are by the Securities and Exchange Commission (SEC).
BSP Vision and Mission
Vision:
Mission:
BSP aims to be a world-class monetary authority and a catalyst for a globally
competitive economy and financial system that delivers a high quality of life
for all Filipinos.
BSP is commited to promote and maintain price stability and provide
proactive leadership in bringing about a strong financial system conducive
to a balanced and sustainable growth of the economy. Towards this end, it
shall conduct sound monetary policy and effective supervision over firåancial
institutions under its jurisdiction.
Objectives of BSP
ESP, as the central monetary authority of the country, is expected to provide the country
with a safer, more flexible, and more stable and healthy monetary and financial system that
will support a stronger economy. It is enjoined to:
2.
maintain monetary policies conducive to a balanced and sustainable growth of the
economy;
maintain price stability in the country;
promote and maintain monetary stability and the convertibility of the peso;
4.
5.
6.
maintain stability of the financial system;
provide payment and other financial services to the government, the public,
financial institutions, and foreign official institutions; and
supervise and regulate depository institutions.
To attain its objectives, the monetary and fiscal policies of the country need to be closely
and efficiently coordinated.
The different agencies of the government, both financial and fiscal, need to Cooperate
with one another. Moreover, it is important that there would be coordination and cooperation
between the government and the private sectors. These sectors are partners in nation-
building.
Functions of BSP
Being the primary monetary authority, BSP performs the following functions:
1.
2.
3.
Bank of issue
BSP has the monopoly of printing money bills and minting money coins. This
monopoly is designed to:
ensure the uniformity of design and content of money;
effect government supervision over money supply;
give prestige and honor to the central bank; and
• become a good source Of income for the government.
Government's banker. agent. and adviser
BSP handles the banking accounts of government agencies and
instrumentalities. All government agencies deposit their funds with BSP It provides
foreign exchange to the government for the importation Of goods and services and
for payment of foreign loans. If funds are not sufficient for the needs of the country,
BSP borrows from international financial institutions like WB and 'ME
Custodian Of the cash reserves Of banks
All banks are regulated to have adequate reserves in proportion to their
deposit liabilities with BSP to ensure availability of cash to depositors who wish
to withdraw deposits. These resen,'e requirements Create the interbank call loans,
that is. when one bank lacks funds to comply with the reserve requirement Of
BSP, it borrows money from other banks' reserves with BSP for say, overnight. The
interest rate on these interbank call loans is called the reverse repo rate (RRP).
which is the overnight borrowing rate, the official interest rate in the Philippines.
In the Philippines, interest rate decisions are taken by the Monetary Board of BSP
In case Of oversupply of money creating inflation, the legal reserve requirement is
made higher to cut down liquidity or too much money in circulation. The reserve
requirement, say 20%, means that for every peso of deposit, the bank can only
4.
5.
6.
lend 80 centavos because the 20 centavos is deposited with BSP. The reserves
deposited at BSP only earn minimal interest, unlike the loans granted by the banks
to borrowers. This is the reason the banks do not like a high reserve requirement,
that is, they are unable to earn more because the amount they can lend is limited
by the reserve requirement. The cash reserves, aside from regula6ng money supply,
are able to help the government in times of financial crises.
Of the nation's reserves of international currency
The early years of central banking required central banks to maintain a
minimum reserve of gold, and later of international currency, as a guarantee
for its issuance of currency bills or notes and deposit liabilities (cash reserves
of commercial banks). This is designed to meet problems relevant to balance of
payments and maintaining the external value of the local currency. A central bank
must meet its domestic and international payments to create confidence in the
people it serves and the countries it deals with abroad. The US dollar, Swiss franc,
Japanese yen, German mark, British pound and more recently, the euro are among
the currencies accepted as international currency.
Bank of rediscount and lender of last resort
The rediscounting function Of the central bank means the central bank lends
money to banks in distress on the basis of their promissory notes or the promissory
notes of the bank borrowers. When banks grant loans to borrowers, borrowers
execute a promissory note, which the bank discounts. Interest is immediately
deducted from the proceeds of the loans, for example, if the interest is P200 on
a loan, the net proceeds that the borrower gets is 91,000 — P200 = "00.
The process is known as discounting. These notes are presented by these banks to
obtain a loan from the central bank, that is why it is termed rediscounting, that is,
the discounted notes are again discounted.
Bank of central clearance and settlement
The central bank acts as a sort of clearing house. This means that banks
send representatives to the clearing house at the central bank where claims are
demanded by one bank against another. Banks have their own boxes at the clearing
house. All checks placed in the boxes are payable to banks that cashed them. For
example, a representative of Bank A has the check of Bank B. The representative
places the check of Bank B in the box of Bank B. This means that Bank A demands
payment from Bank B. Through the process of bookkeeping (debits and credits),
banks' claims against other banks are settled and cleared. These settlements are
done through the reserves that all the banks have with the central bank.
For checks issued and cashed in Metro Manila, the clearing of checks is
conducted by the Philippine Clearing House Corporation (PCHC)_ Trusted as a neutral
service bureau of banks, PCHC extended its operating outfit by implementing
several electronic-based payment system services for the banking community such
as the Electronic Peso Clearing System (EPCS), Philippine Domestic Dollar Transfer
System (PDDTS), and Project Abstract Secure System (PASS). Sorting, processing,
is
7.
and clearing of checks are done by computers. Clearing of checks for provincial
checks and Metro Manila checks is done manually at the Manila Clearing/Regional
Clearing units of Cebu, Davao, and Bacolod have their own clearing units.
Controller of credit
Controlling money supply requires controlling credit. The higher the money
supply in circulation, the higher the prices of goods and services. Limited supply
of money means lower prices, which do not encourage production. Hence, it is
imperative for the central bank to limit, not only the money supply, but also credit.
This is because credit is in addition to the money supply in circulation. The more
credit there is available, the more production is encouraged because the consumers
can also spend more if they are also able to obtain credit.
BSP can control credit by:
b.
c.
d.
e.
f]
g.
h.
increasing or decreasing interest rates;
increasing or decreasing the legal reserve requirement of banks;
regulating the margin requirements of Stock exchange securities;
open market operations (buying or selling government securities);
imposing ceilings on total amounts bank can lend;
rationing central bank credit;
restricting imports;
selecting projects for funding; and
moral suasion (i.e., encouraging people and businesses to support and
cooperate with central bank policies and regulations).
MONETARY POLICY AND FINANCIAL SYSTEM
Monetary policy refers to the manipulation of money supply to affect the economy
of a country as a whole. It largely impacts interest rates. Increases in the money supply
lower short-term interest rates and will encourage investments and consumption. On the
long run, however, an abundance of money supply leads to increased prices or inflation
and is undesirable. This is where BSP plays its role as the balancer. Generally speaking,
expansionary monetary policies and contractionary monetary policies involve changing the
level of the money supply in a country. Expansionary monetary policy is simply a policy
which "pands (increases) the supply of money, whereas contractionary monetary policy
contracts (decreases) the supply of a countrvs currency. Money supply is the total of
currency and coins and demand deposits in the economy.
Moffat (2016) discussed the effects of monetary policy in his article "What Effects Does
Monetary Policy Have?" Expansionary monetary policy that increases the money supply
causes an increase in bond prices and a reduction in interest rates. Lower interest rates lead to
higher levels of capital investment. They make domestic bonds less attractive, so the demand
for domestic bonds falls and the demand for foreign bonds rises. All else being equal, a larger
money supply lowers market interest rates. Conversely, smaller rnoney supplies tend to raise
market interest rates.
When central bank wishes to increase money supply, it can do a combination Of three
things:
1. Purchase securities in the open market, known as open market operations.
2. Lower the government discount rate.
3. Lower reserve requirement on banks.
These directly impact the interest rate. When the national treasury buys securities in the
open market, the price of those securities rises. Bond prices and interest rates are inversely
related. Government discount rate is an interest rate, so lowering it is essentially lowering
interest rates. If the national treasury decides instead to lower reserve requirements, this will
cause banks to have an increase in the amount of money they can invest or lend. This causes
the price of investments such as bonds to rise, so interest rates must fall. No matter what tool
the central bank uses to expand the money supply, interest rates will decline and bond prices
will rise. Increases in bond prices will affect the exchange market.
Assuming an increase in Philippine bond prices, investors would want sell those bonds in
exchange for other lower-priced bonds. Investors will sell the Philippine bonds because they
will receive higher proceeds. So an investor will sell his Philippine bond, exchange his peso
for dollar, and buy a US bond. This causes the supply of peso in foreign exchange markets to
increase and the supply of dollar in the foreign exchange markets to decrease. This will cause
peso to become less valuable relative to the dollar. The lower exchange rate makes Philippine-
produced goods cheaper in the US and US-produced goods more expensive in the Philippines.
Therefore, exports will increase and imports will decrease causing the balance of trade to
increase. When interest rates are lower, the cost of financing capital projects is less. So all else
being equal, lower interest rates lead to higher rates of capital investment.
We can observe the following relative to contractionary monetary policy:
1.
2.
3.
4.
5.
Contractionary monetary policy causes an increase in bond prices and a reduction
in interest rates,
Lower interest rates lead to higher levels Of capital investment.
The lower interest rates make domestic bonds less attractive, so the demand for
domestic bonds falls and the demand for foreign bonds rises.
The demand for domestic currency falls and the demand for foreign currency rises,
causing a decrease in the exchange rate. The value of the domestic currency is now
lower relative to foreign currencies.
Lower exchange rate causes exports to increase, imports to decrease, and balance
of trade to increase.
The effects of a contractionary monetary policy are precisely the opposite of an
expansionary monetary policy. When the central bank wishes to decrease money supply, it
can do a combination ofthree things:
Sell securities in the open market, known as open market operations.
Raise the discount rate.
Raise the reserve requirements.
These cause interest rates to rise, either directly or through the increase in the supply of
bonds in the open market through sales by the national treasury or by banks. This increase in
supply of bonds reduces the price for bonds. These bonds will be bought by foreign investors,
so the demand for domestic currency will rise and the demand for foreign currency will fall.
Thus, the domestic currency will appreciate in value relative to the foreign currency. The
higher exchange rate makes domestically produced goods more expensive in foreign markets
and foreign goods cheaper in the domestic market. Since this causes more foreign goods to be
sold domestically and less domestic goods sold abroad, the balance Of trade decreases. The
interest rates cause the cost of financing capital projects to go higher, so capital investment
will be reduced.
We can observe the following relative to contractionary monetary policy:
2.
3.
4.
S.
Contractionary monetary policy causes a decrease in bond prices and an increase
in interest rates.
Higher interest rates lead to lower levels of capital investment.
Higher interest rates make domestic bonds more attractive, so the demand for
domestic bonds rises and the demand for foreign bonds falls.
The demand for domestic currency rises and the demand for foreign currency falls,
causing an increase in the exchange rate. The value of the domestic currency is
higher relative to foreign currencies.
Higher exchange rate causes exports to decrease, imports to increase, and balahce
of trade to decrease,
The primary objective of the BSP's monetary policy is "to promote price stability Cond ucive
to a balanced and sustainable growth of the economy" (Republic Act 7653). The adoption
of inflation targeting framework of monetary policy in January 2002 is aimed at achieving
this objective. Inflation targeting is focused mainly on achieving a low and stable inflation,
supportive of the economy's growth objective. This approach entails the announcement of an
explicit inflation target that BSP promises to achieve over a given time period.
The government's inflation target is defined in terms of the average year-on-year
change in the consumer price index (CPI) over the calendar year. In line with the infiation
targeting approach to the conduct of monetary policy, the Development Budget Coordination
Committee (DBCC) through its Resolution No. 2015-7 dated 29 December 2015, maintained
the current inflation target at 3.0 percent ± 1.0 percentage point for 2016—2018.
The highlights of the meeting of the Monetary Board on monetary policy stance held on
23 March 2016 approved by the Monetary Board during its regular meeting held on 7 April
2016 include the following:
2.
4.
The Monetary Board (MB) decided to:
a. maintain the BSP's key policy interest rates at 4.00 percent for the overnight
RRP (borrowing) facility and 6.00 percent for the overnight RP (lending)
facility;
b. maintain the current interest rates on term RRPs, RPs. and SDAs; and
C. maintain the current reserve requirement ratios.
The Monetary Board's assessment of a manageable inflation outlook and robust
growth conditions continues to support keeping monetary policy settings
unchanged. Average inflation is projected to settle within the target range of 3.0
percent ± 1 percentage point for 2016—2018, while inflation expectations continue
to be firmly anchored within the inflation target band over the policy horizon.
The risks surrounding the inflation outlook have remained tilted to the downside.
Downward pressures on inflation could arise from slower-than-expected global
economic activity and potential second-round effects from lower international
oil prices, while upside risks could come from the impact of El Niho dry weather
conditions on food prices and utility rates as well as pending petitions for power
rate adjustments.
At the same time, the Monetary Board observed that domestic demand conditions
continue to be buoyant, supported by solid private household and capital spending,
positive business sentiment, and adequate credit and domestic liquidity.
The Monetary Board also recognized that uncertainty over economic growth
prospects across the globe could condnue to drive volatility in global financial
markets in the months ahead.
BSP uses several tools to implement its monetary policies other than controlling interest
rates. Among these tools are its open market operations (buying and selling government
securities), reserve requirements on banks, discount rate, credit control, money supply, etc.
Moneta policy seeks to influence either the demand for or supply of excess reserves resulting
from the implementation of monetary policy triggering a sequence of events that affect such
economic factors as short-term interest rates, long-term interest rates, foreign exchange rates,
the amount of money and credit in the economy, and the levels of employment, output, and
prices.
Depository institutions trade excess reserves held at the central bank among themselves.
Those with excess reserves earn by lending them to banks with deficit as explained under
interbank call loan. The rate of interest on these interbank transactions becomes a benchmark
interest rate to guide monetary policy. This rate is a function of the supply and demand for
central bank funds among banks and the effects of the central bank trading in its open market
operations.
The open market operations of BSP influence money supply because when it sells
securities, it siphons off the funds or money supply in the economy, thereby decreasing money
supply. When it buys back securities, gives back to the economy the money supply.
When BSP increases the reserve requirement on banks, it reduces the amount available
to banks for lending to borrowers, thus limiting the credit and ultimately the money supply.
When this reserve requirement is lowered, loans that banks can grant are increased ultimately
increasing the money supply.
Monetary policy works largely through its impact on interest rates. Increases in money
supply lower interest rates, which stimulate demand. As money supply increases, investors
will be encouraged to buy more securities (stocks or bonds) forcing securities prices up and
interest rates down. In the long run, investors may increase their holdings of securities and
ultimately buy tangible assets, which stimulate consumption demand directly.
In implementing monetary policy, BSp can take one of two basic approaches to affect the
market for bank excess reserves:
1. Target the quantity of reservesin the marketbasedon BS%open marketoperations'
objectives for growth in the monetary base (the sum of money in circulation and
reserves) and in turn, the money supply; or
2. Target the interest rate on those reserves that BSP is granting.
The approach taken varies according to the need to combat inflation and the desire to
encourage sustainable economic growth.
CHAPTER SUMMARY
Financial system encompasses the financial markets, participants, and instruments dealt
with in said markets.
The functions of the financial system include channeling funds from saviqg units to
deficit units, providing a medium of exchange, providing a mechani>m for risk-sharing,
and providing a channel through which the central bank can influence the economy in
general and the financial system in particular.
There are six participants or sectors in the financial system. They are households, financial
institutions, non-financial firms, government, central bank, and foreign participants.
Households or consumers are the wage/salary-earners whose income is spent on goods
and services and if there is something left to save, they save it.
Financial institutions/intermediaries are the firms that act as bridge between surplus
units/lenders and deficit units/borrowers.
Non-financial institutions are businesses other than the financial institutions/
intermediaries like trading, manufacturing, mining, and other businesses.
Government includes all levels of government from barangays up to the national
government. All government units act as either lenders or borrowers at one time or
another.
The central bank of any country is in charge of the financial system of any country. The
Bangko Sentral ng Pilipinas is the agency that is in charge of the Philippine monetary and
financial system.
The Philippine Monetary System organization is classified in the following:
Bangko Sentral ng Pilipinas
Banking Institutions
A.
Private Banking Institutions
3.
Commercial Banking Institutions
a. Ordinary Commercial Banks
b. Universal Banks
Thrift Banks
a. Savings and Mortgage Banks
b. • private Development Banks
c. Savings and Loan Associatons
Rural Banks
Government Banking Institutions
1. Philippine National Bank
2. Development Bank of the Philippines
3. Land Bank of the Philippines
Philippine Amanah Bank
4.
Non-Bank Financial Institutions
A.
private Non-Bank Financial Institutions
2.
3.
4.
5.
6.
8.
Investment Banks/Companies
Finance Companies
Securities Dealers/Brokers
Pawnshops
Lending Investors
Fund Managers
Trust Companies/Departments
Insurance Companies
Government Non-Bank Financial Institutions
1. Government Service Insurance System
2. Social Security System

\
Internally, BSP is structured as follows:
a. The Monetary Board
b. The Monetary Stability Sector
c. The Supervision and Examination Sector
d. The Resource Management Sector
Objectives of the BSP include (a) maintaining the monetary policies conducive to
a balanced and sustainable growth of the economy; (b) maintaining price stability in
the country; (c) promoting and maintaining monetary stability and convertibility of
peso; (d) maintaining stability of the financial system; (e) providing payment and other
financial services to the government, the public, financial institutions, and foreign official
institutions; and (f) supervising and regulating depository institutions.
Functions of the BSP include (a) bank of issue; (b) government's banker, agent, and
adviser; (c) custodian of the cash reserves of banks; (d) custodian Of the nation's reserves
of international currency; (e) bank of rediscount and lender Of last resort; (f) bank of
central clearance and settlement; and (g) controller of credit.
Monetary policy refers to regulations that will affect money supply to benefit the economy.
Among the tools of monetary policy are money supply. open market operations, reserve
requirements on banks, discount rate, interest rate, and credit control, among others.

CAPITAL MARKETS
them collect and clear checks and loaning them funds as needed. As a lender and a regulator,
central bank oversees the health of the banking system. Central banks are the monetary
policymakers of their respective countries.
Foreign Participants
Foreign participants refer to the participants from the rest of the world—households,
governments, financial and non-financial firms, and central banks. Goods and services and
financial instruments/securities are exchanged across national boundaries, as well as within
these boundaries. International trade and finance are parts of globalization. As globalization
affects the entire world, the role of foreign participants in the financial system has become
more important.
BANGKO SENTRAL NG PILIPINAS AND THE PHILIPPINE FINANCIAL SYSTEM
The details in this section about BSP and the different organizational structures come
from BSP.gov.ph. Banko Sentral ng Pilipinas (BSP) is the Central Bank of the Republic of the
Philippines. It was established on January 3, 1949 as the country's central monetary authority.
The Bangk6 Sentra' ng Pilipinas (BSP) was established on July 3, 1993 pursuant to the provisions
of the 1987 Philippine Constitution and Republic Act No. 7653, the New Central Bank Act
of 1993 to replace the Central Bank of the Philippines. BSP enjoys fiscal and administrative
autonomy in the pursuit of its mandated responsibilities.
New Logo
The new 89 logo is a perfect round shape in blue that
features three gold stars and a stylized Philippine eagle rendered
in white strokes. These main elements are framed on the left side
with the text inscription "Bangko Sentral ng Pilipinas" underscored
by a gold line drawn in half circle. The right side remains open,
signifying freedom, openness, and readiness of BSP as represented
by the Philippine eagle (signifying strength, clear vision, and
freedom) to soar and fly toward its goal. Putting all these elements
together in a solid blue background signifies stability. The stars are
rendered in gold to symbolize wisdom, wealth, idealism, and high quality. The white color of
the eagle and the text for BSP represent purity, neutrality, and mental clarity.
Principal Elements:
The Philippine eagle, our national bird, is the world's largest eagle and a symbol of
strength, clear vision, and freedom, the qualities we aspire for as a central bank.
The three stars represent the three pillars of central banking: price stability,
stable banking system, and a safe and reliable payments system. It may also be
interpreted as a geographical representation of BSP's equal concern for the impact
of its policies and programs on all Filipinos, whether they are in Luzon, Visayas, or
Mindanao.
Chapter 2

At the forefront of secondary securities transactions in the Philippines is the Philippine

Stock Exchange (PSE). PSE was formed from the country's two former stock exchanges, the
Manila Stock Exchange (MSE), established on August 8, 1927 and the Makati Stock Exchange
(MKSE), established on May 27, 1963. Although both MSE and MKSE traded the same stocks
of the same companies, the bourses were separate stock exchanges for nearly 30 years until
December 23, 1992 when both exchanges were unified to become the present-day PSE.
• In June 1998, SEC granted PSE a self-regulatory organization (SRO) status, which means
that the bourse can implement its own rules and establish penalties on erring trading
participants (TPs) and listed companies. In 2001, one year after the enactment of the
Securities Regulation Code, PSE was transformed from a non-profit, non-stock, member-
goVerned organization into a shareholder-based, revenue-earning corporation headed by a
President and a Board of Directors. (PSE.com.ph 2016)
In the advent of increased trade and globalization, the need for facilities, like PSE, and
systems that will enhance availability of funds are of utmost importance. Individuals and
business institutions need funds to finance their needs. These needs give rise to the clamor
for sources to fund financial activities. On the other hand, those with excess funds need to
find ways and means to make their savings earn. Money in one's hand does not earn anything.
This need required the facilities and system that will help them make profitable investments.
It is in this light that financial markets evolved.
In this chapter, students will learn about financial markets, primary markets, secondary
markets, money markets, and capital markets. They will be acquainted with the different money
markets and the different capital markets. In addition, market for government securities (GS)
will be discussed. Market offerings and private placements will be differentiated. The students
will also have a preview of the different money market and capital market instruments dealt
with in these markets, which will be discussed fully in the next chapter.
FINANCIAL MARKETS: DEFINITION
Financial markets are structures through which funds flow. They are the institutions and
systems that facilitate transactions in all types of financial claim. A financial claim entitles a
creditor to receive payment from a debtor in circumstances specified in a contract between
them, oral or written. Depositors have financial claims on banks where they hold their deposits;
bondholders have financial claims on companies issuing the bonds they hold. Financial markets
are the meeting place for those with excess funds (investors or lenders referred to as surplus/
savings units) and those who need funds (borrowers or issuers of securities referred to as
deficit units). Savings from households and businesses are channeled to those individuals
and businesses which need the funds. The needs of deficit units and surplus units gave rise
to financial markets. Financial markets are at the heart of financial system determining the
volume of credit available, attracting savings, and setting interest rates and security prices
Financial markets are classified as either (1) primary or secondary market or (2) money
or capital market. Although we have other classifications of financial markets, these two are
the basic classifications of financial markets.
PRIMARY MARKETS
Financial claims are initially sold by deficit units in primary markets. Primary markets
are markets in which users of funds (e.g., corporations) raise funds, through new issues of
financial instruments such as stocks and bonds (Saunders and Cornett 2011). They consist of
underwriters, issuers, and instruments involved in buying and selling original or new issues of
securities referred to as primary securities. In other words, primary markets are markets for
primary securities (new issues of financial instruments like stocks and bonds). They raise cash
for the issuing company, which acts as borrower by increasing its current capital stock when
it issues stocks, or outstanding liabilities when it issues bonds. The government also acts as
a borrower when it issues bonds or Treasury bills. The primary market trånsaction involves
either equity security (stock) or debt security (bond). These new issues are issued to initial
suppliers of funds or investors.
The following figures depict primary market transactions. The corporation needing funds
issues new or original issues of either stocks or bonds directly to the investors (Figure 8) or
to underwriters/financial interrnediaries (Figure 9) who in turn sell them to the investors.
Financial intermediary atts as the middleman or bridge that will satisfy the needs of the deficit
units and the surplus units.
Most primary market transactions are done through investment banks, also called
merchant banks, which help the corporations issuing the stocks Or bonds sell these stocks
or bonds to interested investors. Investment or merchant banks purchase shares issued by
the issuing company in an underwriting transaction and then sell these issues to the public.
An underwriter guarantees the sale of the issues, but does not intend to hold the shares or
bonds in his own account. However, if the issue is unsuccessful and public investors refuse to
purchase the issues, the underwriter carries the issues as its own investment, while waiting
for more favorable market conditions.
Investment banks provide the following services:
1.
2.
3.
4.
5.
Provide funds in advance (giving cash to the issuer based on the agreed price Of the
security, usually a certain percentage Of the total agreed price)
Give advice to issuing corporations as to the price and number of securities to issue
Attract the initial public purchasers of the securities
Act as a market analyst and advisor to the issuing company
Absorb the risk and cost Of creating a market for the securities
Primary market issues are generally for public offerings or publicly traded securities like
stocks of cömpanies already selling stocks in the stock market or stock exchanges. If these
companies need additional funds, they create new issues to raise the firm's capitalization or
create new issues of bonds or debt instruments, thereby increasing its outstanding liabilities
to meet the need for the funds. First-time issues for the public are called initial public offerings
(IPOs). At times, it takes several investment banks to undertake such issues. Primary market
securities also include the issue of additional equity or debt instruments of an already publicly
traded firm.
SEC requires 'corporate borrowers in the money market to register their issues unless
they are specifically exempted from doing so (Chapter Ill, Sections 9 and 10 of the Securities
Regulation Code). Prior to registering with the SEC, a company seeks a credit rating from the
Credit Information Bureau.
Rather than public offering, primary market sale can also take the form Of private
placement, particularly for closed corporations, that is, corporations whose stocks are Only
sold to family or a few close friends, relatives, and Other private individuals. In addition, in
private placement, the corporation issuing the stocks or bonds may seek to find an institutional
buyer—such as a pension fund or group of buyers to purchase the whole issue. Merchant
banks conduct private sale of shares to a few individuals or institutions but a vigorous and
broad-based secondary market requires an efficiently operating securities exchange. Stocks
of closed companies are not publicly traded. These banks remain under the management and
control of private companies and individuals. Larger companies, on the other hand, like the
San Miguel Corporation, PLDT, Petron, Yahoo, and Google are publicly traded in large volumes.
SECONDARY MARKETS
Once financial instruments are issued in primary markets, they are then traded in
secondary markets. Secondary markets are like used car markets. Secondary markets are
markets for currently outstanding securities, referred to as secondary securities. These
securities were previously bought and owned and now being resold either by the initial
investors or those who have purchased securities in the secondary market. Secondary markets
provide liquidity for investors as they sell their financial securities when they need cash.
All transactions after the initial issue in the primary market are done in the secondary
markets. For instance, A owns stocks initially issued by Co. X and later on sells these Co. X
stocks to B; the sale of A to B or anyone else is done in the secondary market. Transactions in
the stock and bond market exchanges are secondary market transactions. Shares held by the
public are termed outstanding shares or securities. They do not increase the capital stock of
the original issuing company or its outstanding liabilities unlike in primary market transactions.
Secondary markets only transfer ownership, but do not affect the total outstanding shares or
securities in the market. Onlywhen the issuing corporations redeem bonds or retire stocks will
outstanding shares or securities be reduced. Redemption of bonds decreases total outstanding
debt securities in the market and at the same time reduces the outstanding liabilities of the
issuing company. Retirement of stocks reduces the total outstanding equity securities in the
market and the outstanding capital of the issuing corporaF0n.
Transfer of ownership does not affect the volume of these securities in the market. The
securities simply change hands. Secondary markets transfer shares, but do not raise funds
for companies which issued the securities. They do not affect the issuing company, except
to transfer ownership of the stocks or bonds in its books for purposes of dividend or interest
payments. respectively.
Secondary markets exist for the purpose of marketability or easy selling/transfer of
ownership and liquidity or easy convertibility to cash of securities. Marketable securities are
classified in the balance sheet as cash equivalents because of these characteristics. The role of
the secondary market is to assure that a holder can sell and convert to cash his security at any
time.
Commercial banks have trust departments and treasury departments that are major
players in the secondary market. Trust departments recommend money market and capital
market securities for their clients. Treasury departments carry inventories of market securities
as part of the bank's trading portfolio. Investment houses, finance companies, insurance
companies, and other financial institutions are also leading participants in the secondary
market.
Other than the financial institutions mentioned, securities brokers and securities dealers
are included among the ones dealing in secondary markets. Securities dealer is a financial
institution organized usually as a corporation or a partnership, which principal business is to
buy and sell securities, whether registered or exempt from registration for the dealer's own
account or the client's. Before dealing in securities, a securities dealer is required to obtain a
license from SEC pursuant to the Revised Securities Act. Security dealers buy the securities as
their assets and resell them. They earn from the difference of the cost and the selling price
of the sold securities. Securities brokers do not buy for their own account. Their eamings are
mere commissions. Security brokers find the purchasers for the securities that others wish to
sell. These are done in the secondary markets.
The securities exchange serves the following purposes:
provides marketability by allowing savers to sell their securities immediately
1.
2. Provides liquidity by raising cash any time
3. Provides valuation by serving as a means for determining current values of shares
and ultimately of companies
The value of the companies' shares reflects the companies' own value or worth. It
generally reflects the value of stockholders' holdings/wealth. The higher the value•of the
shares in the exchange, the better the companies will be in the eyes of investors, reflecting
good company performance. This is the reason investors follow the values of stocks listed in
the exchanges.

MONEY MARKETS
Money markets cover markets for short-term debt instruments, usually issued by
companies with high credit standing. They consist of a network of institutions and facilities for
trading debt securities with a maturity of one year or less (Saldana 1997). They are markets
in which commercial banks and other businesses adjust their liquidity position by borrowing,
lending, or investing for short periods of time (Kidwell et al. 2013). The government treasury
uses money markets to finance its day-to-day operations. Business and households also
use money markets to borrow and lend. Money market instruments that generally have
short maturities are highly liquid and have low default risk. There is no formally organized
exchange for money markets such as PSE. Dealers and brokers are at the core of money
market transactions. At the trading room of dealers and brokers, when the market is open,
these rooms are characterized by tension and a frenzy of activities. Each trader sits in front of
phones and computers that link the dealer/broker to other dealers/broker> and their major
customers.
Only debt securities are short-term. Stocks or equity securities are long-term and
therefore dealt with in the capital market. Short-term means a period of one year or
less. These securities usually comprise of short-term Treasury bills (T-bills) issued by the
government, bankers' acceptances, negotiable certificates of deposit, money market deposit
accounts (MMDAs), money market mutual funds (MMMFs), and commercial papers (cps).
These are often termed marketable securities because they are highly marketable and highly
liquid. They are issued by companies needing short-term funds and bought by investors with
short-term excess funds. Those who buy these securities have excess funds in the short-term
needing to convert the same quickly to cash as the need arises. These securities give higher
yields than cash in the bank and have relatively low risk of default, particularly those issued
by the government. Individual investors deal with these securities indirectly through the help
Of financial intermediaries. Being short-term, these securities are at low risk of interest rate
changes. Money market securities are traded in massive quantities. Working capital needs like
purchase Of inventories, payment of operating expenses, and among others are met in the
money markets. Major participants are electronically linked all over the United States and in
major European and Asian financial centers.
Money markets are also distinct from Other financial markets because they are
wholesale markets and because there are large transactions involved. Although some small
transactions do take place, most involve $1 million or more (Kidwell et al. 2013). Most money
market transactions are referred to as open market transactions due to their impersonal
and competitive nature. Open market transaction is an order placed by an insider after all
appropriate documentation has been filed, to buy or sell restricted securities openly in an
exchange.

The Philippine money market started in 1965 primarily as a facility for trading excess
funds among commercial banks (Saldana 1997). The Bangko Sentra! ng Pilipinas (BSP) requires
banks to maintain a daily minimum cash reserve with them set as a percentage of deposit
liabilities. Other than the level Of cash reserves, BSP has certain strict requirements on banks.
Banks with temporary cash Surpluses led commercial banks to set up the money market as
an auction house for excess reserves. It is called the interbank call market, a money market.
Similarly, small bank deficits are funded through the money market. This allows banks to
correct their reserve position in the interbank call loan market. Interbank call loans are credits
Of one bank to another for a period not exceeding 4 days. The a-day limit is based on the
BSP regulation and beyond this period, BSP presumes that a bank could not fund its assets
from its deposit, that is, the bank is in trouble. Interbank call loans are treated as deposit
substitutes. Deposit substitutes are alternative ways of getting money from the public other
than traditional bank deposits. They are borrowings by commercial banks from the public
through other banks or money market. Later on, other companies learned to borrow through
the market for their temporary cash requirements.
The International Monetary Market (IMM) Was opehed in May 1972 by the Chicago
Mercantile Exchange (CME) pioneering. the trading of international financial derivatives,
most notably futures. It later expanded into trading derivatives on interest rates and stock
indexes before fully mergingwith the CME in 1986. Today, the IMM trade derivatives on the
London Interbank Qffered Rate (LIBOR), the 10-year Japanese government bond, and the U.S.
Consumer Price Index (CPI). It has developed an index to price interest-rate futures, This index
has become a standard for pricing all interest-based financial futures and is known as the IMM
Index. It gives a price to securities that were previously quoted only by yield into price-quoted,
and vice-versa. The IMM Index has since become a standard for pricing all interest-based
financial futures.
In financial crisis situations, it is the duty ofthe country's central bank to provide liquidity
to stabilize markets. This is because risk may trade at premiums to a bank's target rates,
called money rates that central bankers cannot control. These are called repo rates, and they
are traded through the IMM. Repo rate is the rate at which the central bank of a country
lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by
monetary authorities to control inflation. Repo markets allow participants to undertake rapid
refinancing in the interbank market independent of credit limits to stabilize the system. A
repurchase agreement (repo) is a sale of securities for cash with a commitment to repurchase
them at a specified price at a future date. A borrower pledges securitized assets such as stocks
in exchange for cash to allow its operations to continue.

Asian governments, banks, and businesses need to facilitate business and trade in
a faster way rather than borrowing US dollar deposits from European banks; hence, Asian
money markets linked up with the IMM. Asian banks, like European banks, were saddled with
dollar-denominated deposits because all trades were dollar-denominated as a result of the
US dollar's dominance. So, extra trades were needed to facilitate trade in other currencies,
particularly euros. Asia and the EU would go on to share not only an explosion of trade
but also two of the most widely traded world currencies on the IMM. For this reason, the
Japanese yen is quoted in US dollars, while eurodollar futures are quoted based on the IMM
Index, a function of the three-month LIBOR. The IMM Index base of 100 is subtracted from the
3-month LIBOR to ensure that bid prices are below the ask price. These are normal procedures
used in other yvidely traded instruments on the IMM to insure market stabilization.
LIBOR is the benchmark interest rate that banks in the London money market are
prepared to lend to one another for overnight, I-month, 3•month, 6-month, and I-year loans.
It is the benchmark for bank rates all over the world. It is also the most common of benchmark
interest rate indexes used to make adjustments to adjustable rate loans, including interest-
only mortgages and credit card debt, as well as for interest rate swaps and credit default
swaps. These are a form of insurance against the default of loans. Lenders typically add a point
or two to create a profit.
LIBOR is calculated and published by ICE Benchmark Administration and published by
Reuters each day at 11 a.m. in five currencies—the Swiss franc, euro, pound sterling, Japanese
yen, and US dollar. Rises and falls in the LIBOR interest rates can have consequences for the
interest rates in all sorts of banking products such as savings accounts, mortgages, and loans.
As of June 2000, IMM switched from a non-profit to a profit, membership and shareholder-
owned entity. It opens for trading at 8:20 EST to reflect major US economic releases reported
at 8:30 a.m. Banks, central bankers, multinational corporations, traders, speculators, and
other institutions all use its various products to borrow, lend, trade, profit, finance, speculate,
and hedge risks. (Twomey 2009)
In the Philippine money market, trading of government securities is regularly observed.
The following discussion relative to govemment securities is from the Bureau of the Treasury's
official website.
The Philippine Government issues two kinds of government securities: Treasury bills
(T-bills) and Treasury bonds (T-bonds), so-called because it is the Bureau of the Treasury
which originates their sale tg the investing public through a network of licensed dealers.
Government agencies, local governments, and govemment-owned or controlled corporations
may float securities but these are not labeled as treasuries. Government securities are no
longer certificated; they are known as "scripless," just like in USA, Canada, China, and Korea.
GS discounts or coupons are subject to 20 percent final income tax which is withheld upon
floatation of T-bills or upon payment of the coupon for T-bonds. No other tax is imposed on
the secondary market buyer.
T-bills are government securities which mature in less than a year. There are three tenors
Of T-bills: (1) 91-day, (2) 182-day, and (3) 364-day bills. The number of days is based on the
universal practice around the world of ensuring that the bills mature on a business day. T-bills
are quoted either by their yield rate, which is the discount, or by their price based on 100
points per unit.

T-bonds are government securities which mature beyond one year. At present, there are
five maturities of bonds: (1) 2-year, (2) 5-year, (3) 7•year, (4) 10-year, and (5) 20-year. These
are sold at its face value on origination. The yield is represented by the coupons, expressed as
a percentage of the face value on per annum basis, payable semi-annually.
T-bills are sold at a discount (less than the principal); hence, the yield to the investor
is the difference between the purchase price and the principal. On the other hand, T-bonds
are sold at face value (the amount of the principal) and are coupon bonds; that is, they bear
coupons, which represent the interest on the principal and are presented when claiming
interest payments.on interest payment dates.
The Automated Debt Auction Processing System (ADAPS) is an electronic mode by which
the national government sells government securities to a network of government securities
eligible dealers (GSEDs) which are •linked to BTR using Bridge Information Systems (BIS),
every Monday for T-bills and every second and fourth Tuesday for T-bonds, whereby GSEDS
tender their bids (both competitive and non-competitive) by keying-in the amount (minimum
of PIOM) and yield of their choice for a maximum of seven competitive bids and one non-
competitive bid per tenor for any amount above PIOM using a BIS terminal in the GSED office.
Within seconds, the bids are arrayed by the System in the terminals of the BTR. After the cut-
Off time Of 1:00 PM, the array is viewed by the Aucton Committee, which then decides on the
award. The award is keyed-back to the respective terminals of GSEDs.
GSED is a SEC-Iicensed securities dealer belonging to a service industry supervised/
regulated by Government (SEC, Bangko Sentral ng Pilipinas, or Insurance Commission) which
has met the (1) PIOOM unimpaired capital and surplus account, (2) the statutory ratios
prescribed for the industry, and (3) has the infrastructure for an electronic interface. Two days
after the auction, the government securities are credited to the Securities Principal Account of
the GSED in the Registry of Scripless Securities (ROSS) and the Demand Deposit Account of the
GSED at the Bangko Sentral ng Pilipinas is debited in favor of the Treasurer of the Philippines
for the cost of the government securities awarded to the GSED concerned. This completes the
trade in the primary market. This is also known as origination of GS as shown in Figure 11.
Over-the-counter (OTC) non-formally organized markets are another mode of originating
GS for specific investors, namely, the government-owned or controlled corporations (GOCCs);
the local government units (LGUs), and the tax-exempt institutions (TEIS), such as pension
funds, GSIS, SSS, etc. It is non-competitive. OTC is open every day, The applicable yield rates
for T-bills issued to GOCCs/LGUs/TEls shall be priced based on the rate of the immediately
preceding TB auction. For GOCCs, the rate shall be the lowest accepted yield rate; for LGUs,
the weighted average yield rate; and for TEIs, the yield shall be 90% of the weighted average
yield rate. T-bonds issued to GOCCs/LGUs/TEls shall be priced based on the current market
yield. The coupon rate for GOCCs and LGlJs shall be based on the rate corresponding to the
auctioned T-bonds. The applicable coupon rate for TEIS shall be based on the 90% of the
coupon rate.
ROSS is the official registry of absolute ownership, legal, or beneficial titles or interest in
GS (T-bills and T-bonds). Upon award of GS to GSEDs at the auction, the securities awards are
electronically downloaded to the ROSS system. On issue date, the Principal Securities Accounts
of the GSEDs are credited of the winning bids.
The GS trades are entered by both parties in their respective trading terminals using
their confidential identification and password and to activate the system and authorize every
transfer instruction between 9:30 a.m. to 1:30 p.m. The ROSS system checks the securities
in the seller's securities account and earmarks these for transfer. The system then sends
an electronic settlement file to BSP containing the amount to be debited and credited to
the Regular Demand Deposit Account (RDDA) of the buyer and seller. Once settlement is
processed, the BSP Philippine Payment and Settlement System (PhilPASS) will send back a
file message that settlement was done and the ROSS system will now transfer the earmarked
securities from the seller securities account to the buyer securities account. A posted message
will then be sent back by ROSS to the system provider.

Securities and cash settlement of GS transaction to the secondary market is done via
delivery-versus-payment (DVP) mechanism on a Real Time Gross trade for trade basis. Cut-
off time for peso funding in the PhilPASS is until 2:00 p.m. All transactions which have been
unsettled after the 2:00 p.m. cut-off time will be declared failed transaction and the earmarking
on the company securities at ROSS will be lifted.
Yield is the increment or interest on an investment in GS. It is the discount earned on
Treasury bills or the coupon paid to the holder of Treasury bonds. Both the discount and
the coupon are expressed as a percentage of the value of the GS on a per annum basis.
Conventionally, the yields on longer-dated GS are higher than the yields of shorter-dated GS.
Competitive bid is a tender to buy an amount of GS at an indicated yield rate per annum
that a GSED believes will wrest an award for the GSED by out-bidding other GSEDs in the
primary market auction of GS. A non-competitive bid is a tender to buy a specified amount
of GS by a GSED in the primary auction of GS, without indicating any yield rate, on the
understanding that the award shall be at the weighted average yield rate of the competitive
bids awarded at the same auction.
Price discrimination or English auction is a method in which successful competitive
bidders pay the price they have bid, and all the winning bidders may pay different prices.
Uniform- price or Dutch auction is a method of pegging a uniform coupon rate of a T-bond
at the stop-out level of arrayed amounts of bid with the corresponding yield rate tendered.
Conventionally, the rate must be divisible by one-eighth of 1%.
Settlement of trades iS the payment process both in the primary and secondary markets
for GS traded. Settlement of trades is undertaken by BSP being authorized by GSEDs to debit
their respective demand deposit accounts with BSP in favor of the demand deposit account of
the Treasurer of the Philippines or their counterparty GSED also with BSP or vice-versa.
Price ofa GS is the value based on 100 points per unit. T-bills are conventionally in terms
of the discount rate, while T-bonds are quoted in terms of the coupon rate or the price. If a
T-bond is quoted in terms of its price, the price is either at a discount, at par, or at a premium
and the coupon is a rate in relation to the maturity date of the bond. Withholding tax is equal
to 20% on the discount.
Other than government securities, investors also place their money in Eurodollar
certificates of deposits, primarily for the big commercial banks, insurance companies, and
other financial institutions. Because of the importance of the dollar as an international medium
of exchange, foreign governments and financial institutions, like banks, hold a store of funds
denominated in dollars outside of the united States. Moreover, US corporations conducting
international trade often hold US dollar deposits in foreign banks overseas as Eurodollar
deposits or Eurodollar CDs. Eurodollar certificates of deposits are US-dollar-denominated CDs
in foreign banks. Maturities of Eurodollar CDs are less than 1 year, and most have a maturity
of 1 week to 6 months. The market in which these Eurodollar deposits are traded is called
the Eurodollar market, a type of money market. Eurodollars may be held by governments,
corporations, and other investors from anywhere in the world. These Eurodollar deposits
are not subject to US bank regulations because they are not in the US. As a result, the rates
paid on Eurodollar CDs are generally higher than that paid on US-domiciled CDs (Sanders and
Cornett 2007).
The rate for Eurodollar funds is known as the London Interbank Offered Rate or LIBOR.
Funds traded in the Eurodollar market are an alternative to the federal funds in the United
States and the interbank call loan in the Philippines used as a source of overnight funding for
banks. As such, the federal funds rate and LIBOR are closely associated. If the LIBOR rate is
lower than the federal rate, institutions borrow from the LIBOR market than the federal fund.
These changes in interest rates make one market desired over the other. Investors go to the
market with the higher interest rates. In fact, the LIBOR rate is often used by US financial
institutions and other worldwide institutions in their commercial and industrial loans. The
LIBOR rate has been widely used as a reference rate. However, because US bank deposits are
less risky than foreign bank deposits and are covered by deposit insurance up to a certain
level, US financial institutions still prefer the federal funds over Eurodollar CDs. Maturities on
Eurodollar CDs are less than one year mostly 1 week to 6 months. These CDs, because they
are in foreign banks and outside the US, are not subject to the reserve requirements as the
regular deposit accounts in the US. Adjustable rate loans in the US are generally tied up to
the US federal funds rate. However, the vigorous growth of the Eurodollar market has caused
LIBOR to become the standard rate by which loan rates are now priced.

CAPITAL MARKETS
Capital markets are markets for long-term securities. Long-term securities are either
debt securities (notes, bonds, mortgages, leases) or equity securities (stocks). Major suppliers
Of capital market securities are corporations for stocks and corporation and governments for
bonds. Long-term securities have maturities of more than a year. These instruments often
carry greater default and market risks than money market instruments generally because they
are long-term. In return, they carry a higher return yield. They suffer wider price fluctuations
than money market instruments.
Capital markets are composed of stock market for equity or stock securities, bond
markets for debt securities, mortgage market for mortgages, foreign exchange markets,
derivative securities markets, direct loan market, and lease market, among others.
The need for long-term assets or capital goods as purchase of land or building or plant
expansion will resort to the capital market as a source of funds. Capital goods are used to
produce goods and services to generate revenues. It is in the capital market that long-term
users of funds and those with long-term excess funds meet. These long-term securities
include long-term loans, mortgages, and financial leases; corporate stocks and bonds; and
government long-term Treasury notes and bonds. Security exchanges, over-the-counter
markets, investment banks, mortgage banks, insurance companies, and other financial
institutions deal with the capital markets, Over-the-counter transactions are done through a
loose network of security traders known as broker-dealer, dealers, and brokers.
The capital market consists of:
1. securities market; and
2. negotiated (or non-securities) market.
Securities Market
In securities market, companies issue common stocks or bonds, which are marketable/
negotiable, to obtain long-term funds. An instrument that is transferable by endorsement or
delivery is negotiable. Negotiability allows securities to be traded anonymously, The identity
of the seller need not be known. Negotiability improves liquidity because anyone who holds
the security can immediately sell the security when the holder needs cash. The holder can
even sell the security prior to maturity.
Securities market is composed of:
1.
2.
3.
stock market for equity or stock securities;
bond market for debt securities; and
derivative securities market for securities deriving their value from another security.

Stock Market
Stock market serves as the medium or agent Of exchange transactions dealing with equity
securities. It involves institutions and analysts who review the performance of listed companies.
When companies are successful in their operations and investments, analysts recommend
buying of their stocks creating demand and increasing share prices and shareholders' wealth.
Shareholders can penalize poor management of companies by selling off their holdings driving
share prices down. All markets follow the basic economic law of supply and demand. If there
are a lot of shares Of any one company in the market, its prices go down. The scarcity Of the
shares drives the share prices up. If many are buying the stocks, it creates demand and raises
prices up.
Classifying stocks into boards enabled PSE to calculate stock indexes (indices) for each
group. A stock index is a measure of the price level Of the shares listed in the exchange by the
indicated category. Index reflects the prices of selected stocks. It is useful as a track record
of changes in stock prices over time. PSE tracks four indices: commercial and industrial,
property, mining, and oil. The overall index, which is called the Philippine stock index (Phisix),
is a composite Of the four indices. (Saldana 1997)
Saldana (1997) listed the following prices in a trading day:
1,
2.
3.
4.
Open — the stock price for the first transaction at the start of trading day
Low — the lowest stock price for transactions during the day
High — the highest stock price for transactions during the day
Close — the stock price for the last transaction of the day

If the closing price is higher than the opening price, therewill be an upward trend in the
price of the stock. This is especially•when the opening price coincides with the low price and
the high price with the closing price. A wide difference in the low and high price indicates high
volatility and therefore, risk in investment in the stock, that is, the more volatile a stock is, the
more risky it will be.
Index also reports price movements of groups and the entire market. Other indicators of
the market are changes in averages and price movements of stocks according to the number
of stocks that increased in price (advances) or decreased in price (declines).
PSE also reports the volume of shares traded. Other reported data are the price range
during the year, earnings per share, and dividends per share. Earnings per share and dividends
per share are important to stockholders and potential stockholders because they depict the
return that stockholders will get in investing in a particular stock. The higher they are, the
more enticing the stocks will be to current and potential stockholders. However, a company's
stock price does not represent the value of the stock as an investment. The value of the stock
is the relationship between the benefits and the cost of the stock. The value of a stock is
determined by various methods, but generally based on the return on equity Or return on
invested capital. The benefits are in terms of cash or stock dividends and the relationship of
these benefits to the cost is the Value of the stock. The benefits of investing in stocks are the
income in terms of dividends, and increases in prices of the stock, called capital gain. The yield
or cash yield of the stock is the ratio of cash dividends to stock price. Price-eamings (PE) ratio
is the ratio Of stock price to earnings per share.

Bond Market
Bond market is the market where bonds are issued and traded. It is generally classified
into:
1. Treasury notes and bonds market;
2. municipal bonds market; and
3. corporate bonds market.
Treasury notes and bonds are issued by the government's treasury. Like T-bills, T-notes
and T-bonds are backed by the full faith and credit of the government and are therefore free
from risks. As a result, they pay relatively low rates of interest (yields to maturity) to investors.
However, because of longer maturity, they are subject to wider price fluctuation than money
market instruments and therefore subject to interest rate risk. In contrast to T-bills that sell at
a discount, T-notes and T-bonds pay coupon interest semi-annually. They have maturities of
over 1 to 10 years.
Municipal bond (LGU) is an important financial instrument for development. In the
Philippines, LGU bonds have only recently been acknowledged as a potential tool for
development. LGU bond reduces the dependence of LGUs on the national government in
implementing their development programs, and most importantly, encourages and rewards
transparent good governance among local government executives. LGU bond does all these
while attracting private institutional capital and providing the investing public with an
alternative long-term investment instrument.

Corporate bonds are long-term bonds issued by private corporations. Bond indenture
is the legal contract that specifies the rights and obligations of bond issuer and bondholders
(investors), term of the bond, interest rate, and interest payment dates. It may include such
term as the ability of the issuer to call the bond or redeem bonds prior to maturity, and
restrictions on the issuer's dividend payments, among others.
Derivative Securities Market
The term "derivative" is commonly used to describe a type of security which market value
is directly related to or derived from another traded security. Derivative securities market
refers to the market where derivative securities are traded. Derivative securities are financial
instruments which payoffs are linked to another, previously issued securities. They represent
agreements between two parties to exchange a standard quantity of an asset or cash flow at
a predetermined price at a specified date in the future, As the value of the underlying security
to be exchanged changes, the value of the derivative security changes. Option, futures, and
forward contracts are examples of derivatives as well as stock warrants, swap agreements,
mortgage-backed securities, and other more exotic variations. While derivative securities have
been in existence for centuries, the growth in derivative security markets occurred mainly in
the 1990s and 20005 (Saunders and Cornett 2011).
An example Of a derivative would be a call option on a company's stock. The most
important determinant of the price of the option is the current price Of the company's shares
(the underlying asset) in the open market. Futures contracts would also allow a farmer to
keep his product (e.g., rice) until some time in the future, Vet remain in the current price at
the time of harvest, The contract would, in effect, sell off the price uncertainty to someone
in the market who is willing to hold it. In this case, the farmer has hedged his risk of a price
drop, The person who accepts the risk is engaged in the practice Of speculation. It was the
need for this type of transaction that spawned the first derivative securities markets. Another
example would be the mortgage-backed securities, which are instruments that are-secured/
guaranteed by mortgages.

Capital markets and money markets include the exchanges where securities or financial
instruments are traded or sold. These exchanges can be formally organized or informally
organized (OTC). Organized security exchanges are like the PSE and other international stock
exchanges, including ASX, SZSE, National Stock Exchange of India (NSE), OSE, American Stock
Exchange (AMEX), and Nasdaq Stock Market of the United States. There are also electronic
exchanges like the US Futures Exchange (USFE), Bats, and Boston Equities Exchange.
Negotiated/Non-Securities Market
Negotiated or non-securities market does not involve securities, thus called non-
securities market. This is so-called negotiated because it results from negotiation between
a borrower and a lender. It includes a direct loan by a company or a person from a lending
institution, like a bank. Also, a personal loan that someone asks from a parent or a relative is a
negotiated loan occurring in a negotiated market. A negotiated market is where the buyer and
the seller deal with each other, either directly or indirectly through a broker or dealer, with
regard to both price and volume. Buyers and sellers are given sufficient time to locate one

another to do the trade. Borrowing transactions that are large in volume may not be easily
traded in the auction market, instead these are done in the negotiated market.
If a company needs P3M to expand its manufacturing facilities, it can go to its bank
where it maintains its current or checking account. Generally, banks grant their depositors,
especially companies and big individual depositors, lines of credit up to a certain limit, for
example P5M or PIOM, depending on the average amount of deposits they have with the
bank. The larger the average amount of deposit a depositor has with a bank, the higher the
line of credit the depositor is granted.
Suppose the company needing P3M has a line of credit with its bank. It can borrow P3M
from that bank if the amount is within its line of credit. If its line of credit is only P2M, then it
can only borrow P2M maximum. The loan agreement is called term loan agreement. A term
loan agreement is an agreement between a borrower and a lender for a definite period Of
time, hence the word "term." Term of the loan is the length of period from the date the loan
is taken to its maturity date, the date the loan is to be repaid. The loan is non-negotiable and
therefore less liquid than capital issues like shares and bonds that can be merely endorsed and
transferred because they are negotiable. The loan is a negotiated loan, but non-negotiable.
When the company needs more than its credit line, the resort it can have is to issue
additional shares of stocks or bonds in the capital market if the company is big and prominent
or well known. While all corporations are empowered to sell stocks and bonds in the open
market, not all are able to do So. Only corporations of high credit standing and are well known
in the business community can sell their stocks and bonds in the open market. It would be
very difficult for a small company to do this. A small company does not have the capital, credit
ndin , and connections that big companies have.
A direct loan from a bank is part of the capital market and still the predominant means
Of financing, especially for a developing country like the Philippines. This is because only
prominent and outstanding and well-known companies can issue securities. Small companies
and individuals cannot issue these securities. Consequently, smaller companies still borrow
directly from banks and other financial institutions. The disadvantage of a term loan agreement
is the higher cost of financing borne by the borrowing Company as compared to borrowing in
the open markets. A direct loan has a higher cost because only one borrower shoulders the
cost. In the open market, costs are shared by several participants.
If the amount of financing or funds needed is large, instead of borrowing from a single
bank, a syndicated loan can be obtained from a group of banks called a syndicate. The SM
Megamall in Pasig was financed by a Pl billion loan from a bank syndicate headed by PNB
(Saldana 1997). Long-term loans usually require stockholders to personally guarantee the
loan. When these companies become in default and the stockholders are personally liable,
the lender(s) can run after the personal assets Of the stockholders.
The negotiated or non-securities market includes, but is not limited to, the following:
1. loan market
2. mortgage market
3. lease market

Loan Market
Loan market is where a one-on-one transaction takes place between a borrower and a
lender. As in the foregoing example, a loan by an individual or company from a bank is a direct
loan transaction and an example of a loan market. Even the government negotiates with the
World Bank for certain types of loans.
Mortgage Market
Mortgage market is where a real property (property with more or less permanent life,
like land (residential, agricultural, or industrial), building (residential, commercial, etc.), and
big machineries, among others are used to guarantee or secure big loans. It is also a type of
loan, but a secured loan guaranteed by the mortgage on the property. At times, a mortgage
is used as a means of buying properties. Those who want to own properties go to a bank
or mortgage company and get the loan to buy the property then use the property as the
collateral for the loan, that is, the company mortgages the property. TKe mortgage market
also includes the market for foreclosed properties. These are the properties that are taken by
lenders because the borrowers were unable to pay their loan and since the property is used
as the collateral for the loan, the property is taken over by the lender.
Other than banks and other financial institutions, government agencies like the National
Home Mortgage Finance Corporation (NHMFC), Government Service Insurance System, Social
Security System, and Pag-lBlG HDMF grant mortgage loans that belong to the capital market.
Lease Market
Lease market is where equipment, building, or other property is being leased/rented out
to another party. The one who owns the property and who is renting the property out is the
lessor and the party who is to use the property in exchange of the rent or lease is the lessee.
The lease could be an operating lease or a capital lease.

OTHER MARKETS
Other markets are a combination of the money and capital markets, because they deal
with both short- and long-term loans and securities. These may include the following:
1. Consumer Credit Market
Consumer credit market involves parties and transactions related to loans granted
to households who desire to buy properties, such_ as cars or appliances, travel, obtain
education for themselves or their loved ones, or other similar needs. It is called consumer
credit market because the borrowers are the consumers.
Consumer credit usually takes the form of character loan, car loan, appliance loan,
educational loan, and among others. They can be short-term, like character loans, or
longer-term like car loans (usually five years), or appliance loans (usually three years).
These can also include pawnshops, SSS pension lending companies, and other small
consumer loan companies.
When the loans involved are short-term, they belong to the money market. If long,
they belong to the capital market. Mortgage loans, leases, real estate loans could extend
up to five or ten years or even up to 15 or 30 years, thus belonging to the capital market.
These loans are usually granted by banks, credit unions, savings and loan
associations, and even lending agencies like the SSS lending agencies, which lend out
money to SSS pensioners. These lending agencies get the ATM cards of the pensioners,
which the pensioners use to get their pensions (directly deposited by the Social Security
System to their deposit accounts). The lending agencies then get the payment for the
loan Obtained by the pensioners directly from their ATM accounts. The ATM card is
returned to the pensioner upon full payment of the loan. These are safe (default-free)
loans, as far as the lending agencies are concerned, because they get direct access to the
pensioner's money for payment of the loan obtained.
Pawnshops also belong to this market. They are, in effect, granting short-term
loans to people who pawn their jewelry and other items the pawnshops would accept
as security for the loan. If the pawned item is not redeemed within usually one year, the
pawned item is taken by the pawnshop and then resold in an auction or sale that the
pawnshop generally does on a yearly basis.

2.
3.
Organized Market
Organized markets are the exchanges. Exchanges, whether stock markets or
derivatives exchanges, started as physical places where trading took place. Some of the
best-known organized markets are NYSE, which was formed in 1792, and the Chicago
Board of Trade (now part of the CME Group), which has been trading futures contracts
since 1851. Today, there are more than a hundred stock and derivatives exchanges
throughout the developed and developing world (Dodd 2016). Exchanges are situated
in a certain location with definite rules of trading. Exchanges have members and a
governing board. Members have seats in the exchange and seat gives the member the
right to trade in the exchange. Non-members cannot trade in the exchange.
Over-the-Counter (OTC) Market
Unlike exchanges, OTC markets have never been a "place." They are less formal,
although often well-organized networks of trading relationships centered on one or
more dealers. Dealers act as market makers by quoting prices at which they will sell
or buy to other dealers and to their clients or customers. It does not mean the dealers
may quote the same prices to other dealers as they post to customers, and they do not
necessarily quote the same prices to all customers. Moreover, dealers in an OTC security
can withdraw from market making at any time, which can cause liquidity to dry up,
disrupting the ability of market participants to buy or sell. Exchanges are far more liquid
because all buy and sell orders as well as execution prices are exposed to one another.

4.
OTC markets are less transparent and operate with fewer rules than do exchanges. All
of the securities and derivatives involved in the financial turmoil that began with a 2007
breakdown in the US mortgage market were traded in OTC markets. (Dodd 2016)
There a re a few dealers who hold inventories of OTC securities that act as a securities
market. Included in theOTCs are brokers who act as agents in bringing together dealers
and investors. OTCs cannot function without the computers, terminals, and electronic
networks that facilitate transaction or trade between and among dealers, brokers, and
investors.
Auction Market
Auction market is where the trading is done by an independent third party
matching prices •on orders received to buy and sell a particular security. Stocks are sold
to the highest bidder on the trading floors. The highest bidder is the one who offered the
highest price for a particular security. It is where buyers and sellers are brought together
directly, announcing the prices at which they are willing to buy or sell securities.
PSE is an example. At the PSE, buyers of securities make their bid and sellers make
their offer. Each one makes counter-offers. Bids and offers stipulate both prices and
volume and are handled by the third party, called the trader, an agent of the auction
market. Counter-offers are matched with one another. If there is a match, the trade
or sale is consummated. Buyers and sellers do not directly trade with each other, but
all trades are done through the trader. The exchange is a noisy place as the offers are
"shouted" by the participants.

5.
Foreign Exchange Markets
Foreign exchange market provides the physical and institutional structure through
which the money of one country is exchanged for that of another country, the rate of
exchange between currencies is determined, and foreign exchange transactions are
physically completed.
A foreign exchange transaction is an agreement between a buyer and a seller that
a given amount of one currency is to be delivered at a specified rate for some other
currency. In April 1992, the Bank of International Settlements (BIS) estimated the daily
volume of trading on the foreign exchange market and its satellites (futures, options,
and swaps) at more than USDI trillion. This is about five to ten times the daily volume of
international trade in goods and services. The foreign exchange market consists of two
tiers: interbank or wholesale market and client or retail market. Individual transactions
in the interbank market usually involve large sums that are multiples of a million USD
or the equivalent value in other currencies. This is the interbank or wholesale market.
By contrast, contracts between a bank and its client are usually for specific amounts,
sometimes down to the last penny (Colorado.edu). This is the client or retail market.
There a re spot, forward, and future foreign exchange transactions in the foreign exchange
markets.

6.
Spot Market
Spot markets are called such because buying and selling is done "on the spot,"
that is, for immediate delivery and payment. The buyer pays immediately and the seller
delivers immediately. If you pick up your phone and ask your trader to buy you a certain
stock, say PLDT stocks at today's prices, that is a spot market transaction. You expect to
acquire ownership of the PLDT stocks within minutes or hours (Rose 1994). On the spot,
however, may mean one or two days to one week, depending on the practice in the
particular place where the spot market is located/conducted.
In the foreign exchange market, where spot and forward transactions are done, spot
foreign exchange transactions involve the exchange rate at the date of the transaction
that is why it is called spot exchange transaction. If the exchange rate of dollar to peso
is $1 = P47, the spot transaction will compute it at that exchange rate. Therefore, if the
transaction is for $20,000, the one buying the exchange contract will need 9940,000 to
consummate the contract. The spot market is the exact opposite of the futures market
and forward market.

7.
Futures Market
Unlike the spot market, futures market is where contracts are originated and
traded that give the holder right to buy something in the future at a price specified
in the contract. It is an agreement to transact involving the future exchange of a set
amount of assets for a price that is settled daily. This is the difference between a futures
contract and a forward contract. In futures contract, the contract's price is adjusted each
day as the price of the asset underlying futures contract changes and as the contract
approaches expiration. While the value of the forward contract can change daily when
the buyer and seller agree on the deal and the maturity date of the forward contract,
cash payment from buyer to seller occurs only at the end of the contract period.
In futures contract, because price is adjusted daily, actual daily cash settlements/
funds transfers occur between the buyer and seller in response to these price changes
(called marking to market), but the final payoff is done when the contract matures. In
essence; marking futures contracts to market ensures that both parties to the futures
contract maintain sufficient funds in their account to guarantee the eventual final payoff
actually done when the contract matures (Saunders and Cornett 2011). For the buyers
of the futures contract, marking to market can result in unexpected payments from their
account if the price of the futures contract moves against them (therefore loses). The
opposite will happen if the price of the futures contract goes lower (i.e., the buyer gains).
This is what happens in the foreign exchange futures market.
Other than foreign exchange, a commodity such as wheat or a financial asset
such as a T-bond may be purchased for future delivery. A futures contract like this is a
formal agreement executed through a commodity exchange for the delivery of goods
or securities in the future. One party agrees to accept a specific commodity that meets
a specified quality in a specified month. The other party agrees to deliver the specified

commodity during the designated month. Each contract has a standardized expiration,
and transactions occur in a centralized market. Futures contracts are entered into
through brokers, like stocks and bonds. Brokerage firms own seats on the commodity
exchange. Membership on each exchange is limited and only members are allowed to
execute contracts. They are paid a commission. The price of the futures contract changes
daily as the market value of the asset underlying the futures fluctuates. The price at the
time of delivery will be the one to prevail. As previously explained, this is where the
difference between the futures market and the fonuard market lies. In a forward market,
the price is fixed at the time of entering into the forward contract. Price changes do not
affect the price specified in the contract. In the futures market, the price prevailing at the
contract maturity will be the settlement price, whether it goes higher or lower since the
time the futures contract was entered into.
There are two participants in the futures markets: the speculators who establish
anticipation of a price change and hedgers who employ futures to reduce the risk from
price changes. By hedging, the hedgers pass the risk to the speculators. Hedging involves
taking an offsetting position in a derivative in order to balance any gains and losses to the
underlying asset. Hedgers enter into offsetting contracts. The buyer (speculator) takes
the risk of market price change. Speculators are willing to accept substantial risk for
the possibility of a large return. Speculation profits from betting on the direction where
an asset will be moving. Speculators make bets or guesses on where they believe the
market is headed. For example, if a speculator believes that a stock is overpriced, he
may short sell the stock and wait for the price of the stock to decline, at which point he
will buy back the stock and receive a profit. Unfavorable or adverse movements in prices
can result in increased costs and lower profits and, in the case of financial instruments,
reduced value and yield. Even modest changes in prices or interest rates can lead to
signified changes in their net earnings. The hedger creates a situation in which any
change in the market price of a commodity, security, or currency is exactly offset by a
profit or loss on the futures contract. This enables the hedger to lock in the price or yield
what he wishes to earn.

Hedging is similar to insurance. Insurance protects against risk to life and property.
Hedging protects against the risk of fluctuations in market price of securities, commodity,
or currency. The basic difference, however, is that insurance rests on the principle of risk
distribution over a large group of policyholders; whereas, hedging does not reduce risk.
It transfers the risk of unwanted changes in prices or interest rates from one investor to
another. Insurance distributes risk; hedging transfers risk,
Futures contracts are normally traded in organized markets like the New York
Futures Exchange (NYFE), CBT, and Chicago Mercantile Exchange (CME). There are five
major exchanges in the United States and several exchanges in other parts of the globe.
Types of futures include T-bonds, T-notes, federal funds, Eurodollars, short sterling; Euro
LIBOR, Canadian bankers' acceptances, Euroyen, and German Euro-government bonds.
Currencies like the Japanese yen, Canadian dollar, British pound, Swiss franc, Australian
dollar, Euro, and US dollars are the ones frequently dealt with in the foreign exchange
futures market.

Trading on the largest exchanges such as the CBT takes place in trading "pits." Trading
pit consists of circular steps leading down to the center of the pit, where traders for each
delivery date on a futures contract informally group together. Futures trading occurs
using an open-outcry auction method, where traders face each other and "cry out" their
offers to buy or sell a stated number of futures contracts at a stated price. Only futures
exchange members are allowed to transact on the floor of futures exchanges. Traders
from the public (non-members) are placed with a floor broker (exchange member), who
is the one authorized to trade with another floor broker or with a professional trader.
This is also what happens in any exchange, not only in the futures exchanges.
professional traders are also position traders, day traders, or scalpers who are
specialists on the stock exchanges where they trade for their own account. Position
traders take a position in the futures market based on their expectations about the
future direction of prices of the underlying assets. Day traders generally take a position
within a day and liquidate it before the day's end. Scalpers take positions for very
short period of time, sometimes only minutes, in an attempt to profit from this active
trading. They do not have obligation to provide liquidity to futures markets, but do so in
expectation of earning a profit. Scalpers' profits are related to the bid-ask spread and the
length of time a position is held. Specifically, it has been found that scalper trades held
longer than 3 minutes, and on average, produce losses to scalpers. Thus, this need for a
quick turnover of a scalper's position enhances futures market liquidity and is therefore
valuable (Saunders and Cornett 2007).

Futures trades may be placed as market orders (instructing the floor broker to
transact at the best price available) or limit orders (instructing the floor broker to transact
at a specified price). The order may be for a purchase of the futures contract, in which
the futures holder takes a long position in the futures contract, or the order may be for
a sale of the futures contract in which the futures holder takes a short position in the
futures contract.
A long position means that the dealers purchase securities outright, take title to
them, and will hold them in their portfolios as an investment, or until a customer comes
along in the hope that prices will rise. In the context of an option, the buying of an
options contract constitutes a long position. For example, an owner of shares in Jollibee
Corporation is said to be "long Jollibee's" or has a "long position in Jollibee's." Another
example would be buying all or put options contract from an options writer entitled
someone the right, not the obligation to buy a specific commodity or asset for a specified
amount at a specified date.
The sale of a borrowed security, commodity, or currency, with the expectation
that the asset wilt fall in value, is taking a short position. In the context of options, it is
the sale (also known as "writing") of an options contract. A short position means that
dealers sell securities they do not presently own to make future delivery to a customer.
In doing so, the dealer hopes the prices of those securities will fall, before they must
acquire the securities and make the delivery. Obviously, if interest rates fall, the dealer
will experience capital gains on a long position but loses on a short position. On the
other hand, if interest rate rises, the dealer's long position Will experience capital losses,
and the short position will post a gain.

8.
Once a futures price is agreed upon in a trading pit, the buyer and *Iler do not
complete the deal with each other, but rather with the clearing house overseeing the
exchange. The exchange's clearing house guarantees all trades made by exchange
traders.
Clearing houses break up every trade into a buy and sell transaction and take the
opposite side of the transaction, that is, become the buyer for every futures contract
seller, and the seller for every futures contract buyer. Thus, the clearing house ensures
that all trading obligations are met. Clearing houses are able to perform their function
as guarantor in an exchange's futures contracts by requiring all member firms to deposit
sufficient funds to ensure that the firm's customer will meet the term of any futures
contract entered into the exchange.
Forward Market
Both the futures market and the forward market involve trading contracts calling
for the future delivery of financial instruments, commodities, or currencies. If you call
your broker today and ask him to purchase a contract for you from another investor
calling for delivery to you of P500,OOO T-bonds 6 months from today, that could either
be a futures contract or a forward contract.
If the contract calls for a fixed price for delivery, for example in 6 months, it is a
forward contract: You pay 9500,000 for the T-bonds you wish to pürchase, irrespective
of the price of the T-bonds on the date of delivery, that is, whether it goes up to, say
P550,OOO or down to P450,OOO. The buyer still pays P500,000. Forward contracts are
contractual agreements between a buyer and a seller at time zero (O) to exchange a
pre-specified, non-standardized asset for cash at some later date. The forward contract
guarantees a future price for the asset today, that is, the price of the forward contract is
fixed over the life of the contract unlike the futures contract. The buyer simply wants to
be assured that he will have the investment in his own time frame, say 6 months, with
the amount of money that he has. Perhaps, he does not have the money right now, but
will receive the amount in his time frame, that is, 6 months.

Forward markets can be in the commodity market (gold, copper, Oil, copra, and
among others), the foreign currency market, and even in the interest rate (forward rate
agreements or FRAS). Forward contracts involve non-standardized underlying assets,
such that the terms of each market contract are negotiated individually between the
buyer and the seller. The details of each forward contract, for example, price, expiration,
size, and delivery date are unique.
An example of a forward contract in the interest rate market would be as-month
FRA written today with a notional value of Pl million and a contract rate of 6.5%. This
means that the buyer of the FRA agrees to the seller to pay 6.5% in borrowing Pl million
starting 3 months from now. The seller of the FRA agrees to lend Pl million to the buyer
at the 6.5% indicated in the contract starting 3 months from now.

9.
If interest rates rise in the next 3 months, the FRA buyer gains from it. The FRA
buyer can still borrow the Pl million at the indicated 6.5% rate rather than the higher,
say 7% or 7.5% rate prevailing 3 months from now. If the rate goes down, however, the
buyer pays the higher 6.5% interest instead of the lower, say 5% or 5.5% interest rate on
the PI million heis borrowing.
Options Market
Options market is where stock options are traded. This is the formal market where
the options are bought and sold, and not when a stockholder is given the option or pre-
emptive right to buy additional shares of stock to maintain his proportionate share or
ownership in a corporation. These options, given by the corporation to the stockholders,
can be sold by the stockholders if they do not want to exercise the same. This gives rise
to the options market.
Options market offers investors an opportunity to reduce risk by making the trading
of Options possible on selected stocks and bonds. These agreements give investors the
right to buy from the writer of the option designated securities at a guaranteed price at
any time during the life'of the contract. Options are called warrants if they are issued by
corporations, and calls if they are issued by individuals (Brown and Mayo 2015). These
are rights, but they are not obligation, meaning, they can be exercised or not. Warrants
and calls are the rights to buy, while put is the right to sell an underlying asset at a pre-
specified price, called the exercise or strike price for a specified time period. In American-
style option, the option can be exercised at any time prior and including the expiration
date. In European-style option, the option can be exercised only on the expiration date
(Kidwell et al. 2013).

Options are derivatives; hence, the options market is a derivative market. Most
frequently, the underlying investment on which an option is based is the equity shares
in a publicly listed company. There are other underlying investments on which options
can be based. This includes the stock indexes, exchange traded funds (ETFs), government
securities, and foreign currencies or commodities like agricultural or industrial products.
Stock options contracts are for 100 shares of the underlying stock—an exception would
be when there are adjustments for stock splits or mergers. Options protect from interest
rate risks,
Options are traded in securities marketplaces among institutional investors,
individual investors, and professional traders, and trades can be for one contract or for
many. Fractional contracts are not traded. An option contract is defined by the following
elements:
a.
b.
d.
e.
type (put or call)
underlying security
unit of trade (number of shares)
strike price
expiration date

All option contracts that are of the same type and style and cover the same
underlying security are referred to as a class of options. All options of the same class that
also have the same unit of trade at the same strike priceand expiration date are referred
to as an option series. (Nasdaq.com)
Options can be call options or put options. Call option gives the buyer the right to
buy an underlying security or futures contract at a strike price. The writer of a call option
agrees to sell the security or futures contract if the buyer exercises the option. The writer
is the seller of the security. In return, the buyer of the call option must pay the writer an
upfront fee known as a call premium of the call option. The call premium can be offset
against any profit the buyer makes on the exercise of the option. Since the option is a
right and not an obligation, the buyer can either exercise or not exercise the option. If
the buyer is sure, he will make a profit—he exercises the option; if unsure, he does not
exercise it and just lose in terms of the call premium that he initially paid. If you buy an
option, you are buying a call option. The buyer of a call option is theinvestor.
For example, a call option on X Corp. stocks with an exercise or strike price of PIOO
entitling the holder of the option to buy 100 shares on or before October 10, 201X. If
he buys the shares, it will cost him 100 shares x PIOO PIO,OOO. However, the buyer
has to pay a call premium, say PI,OOO, to the agent immediately. His cost for•the shares
will go up by PI,OOO. The total cost for the 100 shares will then be (PIO,OOO + PI,OOO)
PII,OOO, or PIIO/share. In other words, the call premium becomes the price for the
option that is added to the cost of the shares at the strike price. If on or before the said
date, the X Corp. shares are selling at P120, the buyer of the call option already makes
a profit of PIO/share (P120 current price and PIIO cost) and should make the buy. If
the price of the shares had gone down below the strike price of PIOO all the time until
October 10, 201X, say P90, the buyer of the call option has the right to refuse to buy and
loses the 91,000 call premium he paid to the agent. It is because, as previously stated,
the option is a right and not an obligation. Apparently, he will not buy if the market price
of the shares goes below the strike price of 9100. At any time on or before October 10,
201X, the buyer will feel the market and buy at the exact time within the time frame
when he feels that the price of the shares is at its highest, say P122 or P125. If he buys
at a time when the price of the stocks is at P115, he still makes a profit ofP5/share. If he
buys at a time that the price of the stocks is at P125, he makes a profit of P15. Option
buyers only buy when it is profitable to do so.
The following shows the difference between the parties in a call option and a put
option:
10.
Options are not only for stocks. Like the futures market, options may involve
commodities like gold or copperand securities like T-bills or T-bonds. Options are traded
in organized securities exchanges.
Options not exercised expire and become worthless. Call options provide greater
profits when stock prices are rising and so represent bullish investment vehicles. A
market is bullish when stock prices are rising and bearish when stock prices are going
down.
Swap Market
Swaps are agreements between two parties (counterparties) in exchanging
specified periodic cash flows in the future based on an underlying instrument or price
(e.g., a fixed Or floating rate on a bond or a note). Like forward, futures, and options,
swaps allow firms to better manage their interest rate, foreign exchange, and credit risks.
The swap market is where swaps are traded.
There are five general types Of swaps:
• a. interest rate swaps
b. Currency swaps
c. Credit risk swaps
d. Commodity swaps
e. Equity swaps
The asset or instrument underlying the swap may change, but the basic principle
of a swap agreement is the same in that it involves the transacting parties restructuring
their asset or liability cash flows in a preferred direction.
To be specific, in an interest rate swap, two parties independently borrow the same
amount of money from two different lenders, and then exchange interest payments with
each other for a stipulated period of time. In effect, each party helps to pay off all Or a
portion of the interest cost owed by the other firm. The result is usually lower interest
expense for both parties and a better balance between cash inflows and outflows for
both firms.
Result:
Both companies save on interest costs and better match the maturity
structure of their assets and their liabilities. In reality, the two parties in the
swap exchange only the net difference in their borroWing rates, with the party
owing the highest rate in the market on the payment date paying the other
party the rate difference.
11.
Third and Fourth Markets
When securities that are listed in organized exchanges as NYSE, AMEX, and London
Stock Exchange Group, among others are sold in over-the-counter market, they are
referred to as the third market and fourth market. Third market refers to transactions
between broker-dealers and large institutions, Fourth market refers to transactions
that take place between securities firms and large institutional investors like pension
funds and investment companies. These transactions involve large block trades. These
markets have grown along with the growth of electronic communication networks
(ECNs). Advantages of trading in these markets include speed, reduced trading costs,
and anonymity. Third and fourth market transactions occur to avoid placing the orders
through the main exchange and do away with the commissions that are paid to floor
brokers, which can greatly affect the price Of the security.

TYPES OF INVESTORS
Having studied the different types of markets, let us now study the different types of investors:
1.
2.
3.
Risk-averse investors (bulls and chicken). They are the type of investors who, when
faced with two investment alternatives with equal returns but one is riskier than
the other, will choose the less risky investment. They prefer risk-free assets than
risky assets as long as the expected returns on each asset are the same. In order for
them to invest in a risky asset, they will require a higher return.
Risk-taker investors (bears and pigs). They are the investors who are ready to pay a
higher price for an investment regardless of the risks involved.
Risk-neutral investors. They are investors who do not take into account the risks
involved in the investment and who are focused only on the expected returns.
In the stock market, there are what we call "bulls" and "bears." When the market is
showing confidence, that is, stock prices are going up and market indices like the Nasdaq go
up, we have a bull market. The number of shares traded is also high and even the number
of companies entering the stock market rises showing that the market is confident. Bull
markets are most common in an expanding economy with low unemployment and inflation
is somewhat constant. Technically, a bull market is a rise in the value of the market of at least
20%. The huge rise of the Dow and Nasdaq during the tech boom is a good example of a bull
market.
A bear market is the opposite of a bull market. It is when the economy is bad, recession
is looming, and stock prices are falling. If a person is pessimistic and believes that stocks are
going to drop, he is called a bear and said to have a "bearish outlook." Bear markets make it

tough for investors to pick profitable stocks. However, this is the time to make money using
a technique called short selling. Short selling is technique used by people who try to profit
from the falling price of'a stock. Short selling is a very risky technique as it involves precise
timing and goes contrary to the overall direction of the market. Assume you want to sell short
100 shares of a company because you believe sales are slowing and its earnings will droÅ.
Your broker will borrow the shares from someone with the promise that you will return them
later. You immediately sell the borrowed shares at the current market price. When the price of
the shares drops, you "cover your short position" by buying back the shares, and your broker
returns them to the lender. Your profit is the difference of the price at which you sold the stock
and your cost to buy it back, minus the commissions and expenses in borrowing the stock. But
if you were wrong, and the price Of the shares increases, your potential losses are unlimited.
Another strategy is to wait on the sidelines until you feel that the bear market is nearing
its end, only starting to buy in anticipation of a bull market (Investorguide.com). Actually, it
makes sense to buy when prices are low so your cost is low. Then, you wait until prices go up
and that is the time for you to sell.
When people say you are a chicken, it means you are scared easily. For investors, chickens
are risk-averse investors whose fear overrides their need to make profits and so they turn only
to money market securities or get out of the markets entirely. While it is true that you should
never invest in something over which you lose sleep, avoiding the market completely and
never taking any risk will not give you any return.
Pigs are the opposite of risk-averse investors or chicken. They are high-risk investors
looking for the one big score in a short period Of time. Pigs buy on hot tips and invest in
compaoies without doing their due diligence. They get impatient, greedy, and emotional
about their investments, and they are drawn to high-risk securities without putting in the
proper time or money to learn about these investment vehicles. Professional traders love the
pigs, as they are often from their losses that the bulls and bears reap their profits,
CHAPTER SUMMARY
Financial markets are structures through which funds flow. They are the institutions and
systems that facilitate transactions in all types of financial claims.
A financial claim entitles a creditor to receive payment from a debtor in circumstances
specified in a contract between them, oral or written.
Primary inarkets are markets in which users of funds (e.g., corporations) raise funds
through new issues of financial instruments such as stocks and bonds. They consist of
underwriters, issuers, and instruments involved in buying and selling original or new
issues of securities referred to as primary securities.
Primary market issues are generally for public offerings or publicly traded securities like
stocks Of companies already selling stocks in the stock market or stock exchanges. First-
time issues for the public are called initial public offerings or IPOs.
Rather than a public offering, primary market sales Can take the form of a private
placement, particularly for closed corporations, that is, corporations whose stocks are
only sold to family or a few close friends, relatives, and some Other private individuals.
Secondary markets are markets for currently Outstanding securities referred to as
secondary securities. All transactions after the initial issue in the primary market are
done in the secondary markets. Secondary markets only transfer ownership, but do not
affect the total outstanding shares or securities in the market.
Money markets cover markets for short-term debt instruments usually issued by
companies with high credit standing. They consist of a network of institutions and
facilities for trading debt securities only with a maturity of one year or less.
Banks with temporary cash surpluses led commercial banks to set up the money market
as an auction house for excess reserves. It is called the interbank call market, a money
market.
The Philippine Government issues four kinds of government securities (GS): cash
management bills, Treasury bills, Treasury notes, and Treasury bonds.
Treasury bills (T-bills) are government securities which mature in less than a year. There
are three tenors Of T-bills: 91-day, 182-day, and 364-day bills.
Capital markets are markets for long-term securities. Long-term securities are either
debt securities (notes, bonds, mortgages, or leases) or equity securities (stocks).
Securities market is where companies issue common stocks or bonds that are
marketable/negotiable to obtain long-term funds. An instrument which is transferable
by endorsement or delivery is negotiable.

Stock market serves as the medium or agent Of exchange transactions that deals with
equity securities or stocks.
Bond market is the market where bonds are issued and traded. Bond markets are
generally classified into Treasury notes and bonds market, municipal bonds market, and
corporate bonds market.

•
Derivative securities market refers to the market where derivative securities are traded.
Capital markets and money markets include the exchanges where the securities or
financial instruments are traded or sold. These exchanges can be formally organized or
informally organized.
The negotiated or non-securities market includes, but is not limited to loan market,
mortgage market, and lease market. Loan market is where a one-on-one transaction
takes place between a borrower and a lender. Mortgage market is where a real property,
building, and big machineries, are used to guarantee or secure big loans. Lease market
is where equipment, building, or other property is being leased/rented out to another
party.
Auction market is where the trading is done by an independent third party matching
prices on orders received to buy and sell a particular security.
Foreign exchange market provides the physical and institutional structure through which
the money of one country is exchanged to the' money of another country, the rate of
exchange between currencies is determined, and foreign exchange transactions are
physically completed.
Futures market is where contractsare originated and traded that give the holder right
to buy something in the future at a price specified in the contract.
Forward contracts are contractual agreements between a buyer and a seller at time O to
exchange a pre-specified, non-standardized asset for cash at some later date.
Options market is where stock options, the right to buy stocks, are traded. Options
are called warrants if they are issued by corporations, and calls if they are issued by
individuals.
Swaps are agreements between two parties in exchanging specified periodic cash flows
in the future based on an underlying instrument or price.
The third market comprises OTC transactions between broker-dealers and large
institutions. The fourth market is made up of transactions that take place between large
institutions.
Investors are generally classified as bulls, bears, chickens, or pigs.

NTRODUCTION
In Chapter I, we learned about the different types Of financial markets. In this chapter,
we will study the financial instruments that they deal with. Prior to that, let us learn something
about the Capital Market Institute of the Philippines (CMIP).
CMIP is a bullish organization that stokes and develops the investment character of
Filipinos in the Philippine financial/capital market. It is committed to promoting, developing,
and advancing awareness and knowledge on capital market and its role in the development
Of the national economy through developing, organizing, and conducting programs, projects,
researches, and other activities to upgrade competencies of members, practitoners,
entrepreneurs, professionals, teachers, and students in dealing with the Philippine capital
market. It further aims to:
•
inculcate in the Filipino people a lasting investment consciousness and a strong
desire to save and invest and to become active participants in the Philippine capital
ma rket;
work jointly or in coordination with concerned organizations and agencies toward
a lasting investment culture in the country;
coordinate With educational, business, financial institutions, and other relevant
agencies nationwide in formulating programs, strategies, and methodologies
that will facilitate teaching and learning about financial markets and investment
concepts, principles, and practices; and
conduct national seminars, briefings, and workshops on current trends and issues
related to investments and the financial market. (Capitalmarketinstitute.com)
In this chapter, you will learn about the different money market instruments and the
different capital market instruments. You will be familiarized with the different govemment-
issued securities dealt with in the money market. You will also be knowledgeable about
the negotiated (non-marketable) capital market and the instruments dealt with in the said
market. Similarly, the instruments dealt with in the negotiable/marketable securities market
will be discussed. As preview to accounting, the students will be introduced to the different
types of corporation-issued stocks and the different types of corporation-declared dividends
to stockholders.

In finance, financial instruments are classified as to their term or maturity date. They
can either be short-term (with maturity of one year or less) or long-term (with maturity of
more than one year). Short-term instruments belong to the money market, while long-term
instruments belong to the capital market.
However, in accounting, it is not the term that determines the classification of securities
as short-term or long-term. Current assets are assets that will be converted to cash within
a period of one year. Non-current assets have lives longer than a year. Both finance and
accounting classify short-term securities as short-term. But for long-term securities, what
finance treats as long-term can be treated in accounting as short-term or current if the
intention of the holder or owner of the securities is to sell them when the need for cash
arises. They do not need to wait for the maturity date to convert it to cash. This means that

even if the security is a 10-year bond, but the intention of the company is to sell it as the
need arises and not Wait for its maturity, the security is classified as current or short-term.
On the other hand, if the intention of the company is to hold the securities until the maturity
or to hold on to them for regular dividend income or interest income, then the securities are
reported under non-current assets as long-term investment. For the purposes of this book,
we will follow the classification in finance. The clarification in the foregoing is intended to help
accounting students in studying finance.
MONEY MARKET INSTRUMENTS
Money market instruments are short-term securities. They are paper or electronic
evidences of debt dealt in the money markets. Only debt securities are short-term. Equity
securities are long-term and belong to the capital market. Money market instruments are
issued by the government and corporations needing short-term funds. Government securities
are generally issued by the Bureau of the Treasury. The details on the securities issued by the
Philippine government discussed in this book are all from the Treasury.gov.ph, the official
website Of the Philippine Treasury.
Cash Management Bills
Cash management bills are government-issued securities with maturities of less than 91
days, Specifically 35 days or 42 days. They have shorter maturities than T-bills. Government
securities (GS) are unconditional obligations of the government issuing them, backed up by
the full taxing power of the issuing government. As such, they are theoretically default-free.
Investing in these bills affords security and liquidity to investors.

Treasury Bills (T-Bills)

Treasury bills (T-bills) are issued by the Bureau of the Treasury with 91-day, 182-day,
and 364-day maturities. The odd number of days is to generally ensure that they mature on a
business day. Like Treasury bonds (T-bonds), they are sold only through government securities
eligible dealers (GSEDs), dealers authorized by the government to sell T-bills. Transactions are
done through bidding online.
The Philippine government issues two types of government securities: Treasury bills,
which are short-term, and T-bonds, which are long-term. T-bills are zero coupon securities
because they have no coupon payments (interest payment) and only have face values. They
are sold at a discount, which means that their purchase price is less than their face value. This
difference between their purchase price and their face value is the sole source of their return
generally referred to as discount yield (dy) or margin. They do not earn interest.
They are generally quoted either by their yield rate, which is the discount or by their
price based on 100 points per unit. The yield is the increment or interest on an investment.
Relative to government securities, it is the discount earned on T-bills or the coupon paid to
the holder of T-bonds. Both the discount and the coupon are expressed as a percentage of the
value of the GS on a per annum basis. Conventionally, the yields in longer-dated or termed GS
are higher than the yields in shorter-termed GS. The image on the next page is a sample of the
Philippine government's latest offerings of T-bills dated April 6, 2016.

Banker's Acceptances
Banker's acceptance is a time draft issued by a bank payable to a seller of goods. It is
drawn on and accepted by the bank. Before acceptance, the draft is not an obligation of the
bank; it is merely an order by the drawer to the bank to pay a specified sum of money on a
specified date to a named person or to the bearer of the draft just like an ordinary check. Upon
acceptance, which occurs when an authorized bank employee stamps the draft "accepted"
and signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is
well known and enjoys a good reputation, the accepted draft may be readily sold in an active
market (LaRoche 1998). The bank substitutes its own creditworthiness for that of the drawer
that makes banker's acceptances marketable instruments.
Time draft issued by a bank is an order forthe bank to pay a specified amount of money
to the bearer of the time draft on a given date. It is different from sight draft, which is an order
to pay immediately. A bank check is a sight draft.
Letters of Credit
Banker's acceptances are generally used with the purchase of goods or services either
domestically or internationally. In these cases, the buyer has its bank issue a letter of credit
(L/C) on its behalf in favor of the seller. For imports, an international letter of credit is opened',
for local purchase, a domestic letter of credit is opened. A commercial letter of credit is a
contractual agreement between a bank, known as the issuing bank, on behalf of the buyer
(drawer), authorizing another bank, the correspondent bank known as the advising or
confirming bank, to make payment to the beneficiary, the seller. The issuing bank, on the
request of the buyer; opens the letter of credit. The issuing bank makes a commitment to
honor drawings made under the credit. The beneficiary is the seller of goods or services.
Essentially, the issuing bank replaces the buyer as the payor.
The letter of credit states that the bank will accept the seller's time draft if the seller
presents the bank with shipping documents that transfer title on the goods to the bank. The
bank notifies the seller of the letter of credit through a correspondent bank in the case of
exports in the exporter's country. When the goods have been shipped, the seller presents
its time draft and the specified documents to the accepting bank's correspondent, which
forwards them to the accepting bank. Ifthe documents are in order, the accepting bank takes
them, accepts the draft, and discounts it for the exporter. At this point, the transaction is
complete from the exporter's point of view; it has shipped the goods, turned over title to
them, and received payment. The responsibility of the buyer is to the issuing bank, which the
buyer has to pay for the entire amount of the transaction including any necessary charges and
Through a letter of credit, the bank substitutes its own promise to pay for the promise of
one Of its customers. By substituting its promise, the bank reduces the seller's risk, facilitating
the flow of goods and services through international markets. If the seller becomes concerned
about the soundness of the bank issuing the letter of credit, the seller may ask his own bank
to issue a confirmation letter in which that bank guarantees against foreign bank default. A
confirmation letter transfers the payment obligation to the guaranteeing/confirming bank
from the originating/issuing bank.

Negotiable Certificates of Deposit

Certificate of deposit (CD) is a receipt issued by a commercial bank for the deposit of
money. It is a time deposit with a definite maturity date (of uø to one year) and a definite rate
of interest. CD stipulates that the bearer is entitled to receive annual interest payments at the
rate indicated in the certificate, together with the principal upon maturity of the certificate.
They are not ordinarily redeemed prior to maturity, but in the early 1960s, a secondary market
was established in which CDs in denominations of $100,000 or more can be traded prior to
maturity. That was when the so-called negotiable certificates of deposit were born (Thomas
1997). They are not the regular certificates of deposits or time deposits held by depositors in
banks, which are not marketable.
Negotiable certificate of deposit is a bank-issued time deposit that specifies an interest
rate and maturity date and is negotiable. It is a short-term, 2 to 52 weeks, and of a large
denomination, PIOO,OOO, P500,OOO, and 91M. The normal 'round lot trading unit among
dealers is PI million. It is a bearer instrument, that is, payable to whoever holds the CD when
it matures. Therefore, it is important that the owners must take good care of them because
when lost, the one who found it can claim payment. Negotiable CDs are more risky than T-bills.
When CDs mature, the owner receives the full amount deposited plus the earned interest.

Secondary markets for CDs exist. In Asia, CDs market has grown rapidly in the past
decade, despite that it is relatively small and illiquid compared to its counterparts in Europe
and the United States. In the Philippines, banks like Union Bank, BOO, and HSBC offer CDs. In
the US, the heart is found in New York City. CDs are more heterogeneous than T-bills. T-bills
have similar rates, maturity periods, and denominations; more variety is found in CDs. This
makes it harder to liquidate large blocks of CDs because a more specialized investor is much
needed. Securities dealer who "makes" the secondary market in CDs mainly trades in million
units. Smaller denominations can be traded, but will bring a relatively lower price. Income
received from CDs is subject to taxation at all government levels. In recent years, CD yields
have been above those available on bankers' acceptances. (Keown et al. 1998)
Banks issue negotiable CDs to attract additional funds to make additional loans or to
counteract the restrictive effect of deposit withdrawals. Banks began issuing negotiable CDs,
which were not subject to statutory interest rate ceilings, in an effort to halt the withdrawal
of deposits. When central banks adopt restrictive policies, commercial banks issue negotiable
CDs increasing the outstanding supply of these marketable securities. Negotiable CDs are held
by lenders with a need for temporary investment outlets for large amounts of fund typically at
PIM or more. The .primary buyers of negotiable CDs are corporations, money market mutual
funds, government institutions, charitable organizations like PCSO, and foreign buyers.

Repurchase Agreements
Repurchase agreements are legal contracts that involve the actual sale of securities by
a borrower to a lender with a commitment on the part of the borrower to repurchase the
securities at the contract price plus a stated interest charge at a later date. A repurchase
agreement is' usually a short-term loan (often overnight) from a corporation, state or local
government, or other large entity that has idle funds to a commercial bank, securities dealer,
or other financial institution. They were created by brokerage houses and popularized by
commercial banks. A reverse repurchase agreement or reverse repo is an agreement involving
the purchase of securities by one party to another with the promise to sell them back at a
given date in the future. Therefore, from the point of view of the seller of the security, the
transaction is a repurchase agreement and from the point of view of the buyer, the transaction
is a reverse repo.
Repurchase agreements are closely associated with the functioning of the interbank cali
loan market in the Philippines and the federal funds market in the US. In an interbank loan
market or Fed funds transaction, the bank with excess reserves sells fed/reserve funds for
one day to the purchasing bank. The next day, the purchasing bank returns the fed/reserve
funds plus one day's interest reflecting the fed/reserve funds rate. Since there is a credit risk
exposure to the selling bank in that the purchasing bank may not be able to repay the fed/
reserve funds the next day, the selling bank may seek collateral backing for the one-day loan of
fed/reserve funds. In a repo transaction, the funds-selling bank receives government securities
as collateral from the funds-purchasing bank. That is, the funds-purchasing bank temporarily
exchanges securities for cash. The next day, this transaction is reversed; the funds-purchasing
bank sends back the fed/reserve funds borrowed plus interest at the repo rate; in return, it
receives or repurchases its securities used as collateral in the transaction.

RPs are free from interest rate ceilings and are not subject to reserve requirements as long
as the collateral are GS. The contract price of the securities that makes up the arrangement is
fixed for the duration ofthe transaction. Anyone who buys an RP is protected from market price
fluctuations throughout the contract period. This makes it a sound alternative investment for
funds that are freed up for only very short periods of time. The collateral used most frequently
in these transactions is a government-issued security like a T-bill. The borrower provides
the lender collateral in the form of GS making the loan free of default. However, it has poor
marketability because it is a two-party agreement, but it is self-liquidating within a few days.
RPs can be overnight RPs or term RPs. Overnight RPs mature in a day. Term RPs have a
maturity greater than 1 day. The difference between overnight RPs and term RPs is the same
difference between demand deposits and time deposits. Term RPs are one way of avoiding the
interest rate ceilings on time deposits. Assume that an investor invests overnight or over the
weekend. The investor is concerned that T-bill prices will fall before they are sold. The investor
can always find a bank or dealer willing to sell the desired number of T-bills and commit to
buying them back later at a specified price. The purchase and sale prices are set to guarantee
the investor a profit.
If the interest rates fall or remain unchanged during the day(s) the investor holds the
T-bills, the rate of profit on the repo will be slightly less than the rate that the investor could
have earned by buying and selling T-bills in the open market. This difference and the fee
charged for the transaction constitute the bank's or dealer's profit. However, if interest rates
rise, the investor still gets the guaranteed profit and the bank or dealer absorbs the loss. This
change in the interest rates constitutes the risk in repos. (Shetty et al. 1995)
In another case, a large corporation with a million or more in funds that is not needed
for a few days "buys" a large block of GS from a major bank. The bank agrees to repurchase
the securities on the date the corporation needs the funds at a price sufficiently above the
price the company paid for the securities to provide a rate of return about one-quarter of one
percent below the current federal funds rate. Thus, rather than holding large checking account
balances, which earn no interest, the corporation makes a safe, convenient investment at a
competitive yield. Banks, dealers, and others who borrow in this market find it a useful source
of funds. Because aggressive management of cash positions by corporations, state, and local
governments, and other large organization has become widespread, RP market has grown
dramatically in the past 25 years.

Money Market Deposit Accounts

Money market deposit accounts (MMDAs) are PDlC-insured deposit accounts that are
usually managed by banks or brokerages and can be a convenient place to store money that is
to be used for upcoming investments or has been received from the sale of recent investments.
They are very safe and highly liquid investments, typically paying higher interest than regular
savings accounts but lower than money market mutual funds. They are also called. money
market accounts. MMDAs usually offer check-writing privileges. MMDAs are insured by the
Philippine Deposit Insurance Corporation (PDIC) up to P500,OOO per person, per bank. As long
as the balance in the account remains below the insurance limit, every bit of principal and
interest earned on the account is 100% guaranteed.

The growth of MMDA market retarded the growth of MMMF market. MMDA was
actually designed by the government as a step to save small depository institutions that
were threatened by the fast development of MMMF market. There is always a very close
competition between these two markets.
Money Market Mutual Funds
Money market mutual funds .(MMMFs) are investment funds that pool funds from
numerous investors and invest in money market instruments offered by investment
companies. A mutual fund is an investment company that pools the funds of many individual
and institutional investors to form a massive asset base. The assets are then entrusted to a
full-time professional fund manager who develops and maintains a diversified portfolio of
security investments. In the Philippines, there are currently four basic types of mutual funds—
stock, balanced, bond, and money market funds. Stock funds/Equity funds invest primarily in
shares of stock. Balanced funds invest both in shares of stock and debt instruments combining
the features of both the growth funds and the income funds. Bond funds invest in long-term
debt instruments of governments or corporations. Money marketfunds invest purely in short-
term debt instruments. As of September 30, 2010, there are a total of 43 mutual funds in the
country. (PIFA.com)

More comprehensively, mutual funds can be classified as:

1,
2.
3.
4.
5.
6.
Growth funds — invest in assets that are expected to reap large capital gains
(generally equity securities)
Income funds — invest in stocks that regularly pay dividends and in notes and bonds
that regularly pay interest
Balanced funds — combine the features of both growth funds and income funds
Sector funds — invest in specific industries as health care, financial services, utilities,
extractive industries
Index funds — invest in a basket of securities that make up some market index as
the 500 index of stocks
Global funds — invest in securities issued in many countries providing diversification
People who buy shares of a mutual fund are its owners or shareholders. They are pdrtfolios
of liquid investment with low default risk. They are investment pools that buy safe, short-
term securities, such as T-bills, CDs, and commercial papers. MMMFs allow small investors to
invest in money market instruments. MMMFs provide investors with check-writing capacities,
just like MMDAs and thus may be viewed as an alternative to bank deposits. Unlike MMDAs,
MMMFs are not insured by the government.
Wholesale MMMFs cater to institutional investors setting high minimum investment
levels, for instance, P50,OOO. Others are known as retail MMMFs with minimum investments
within the reach of most individuals. Some MMMFs specialize in investing in T-bills only, while
• others invest in a variety of money market instruments.

The income earned in money market mutual funds varies based on the performance of
the underlying investments. However, because these investments are fairly safe, they do not
pay high returns although the yields are a bit higher than on money market deposit accounts.
Both money market deposit accounts and money market mutual funds are simply places
to keep your money for the short term. They are not good places to put your money for the
long-term. Because they earn so little, parking long-term assets in a money market guarantees
that you will lose buying power to inflation. If you are parking cash while you figure out where
to better invest it, a money market mutual fund might be the better choice because you could
then easily transfer those assets into a fund with the same company with a single phone call
or click of the mouse.
MMMFs are open-ended mutual fund that invest in commercial paper, bankeris
acceptances, repurchase agreements, government securities, certificates of deposit, and
other highly liquid and safe securities, and pay money market rates of interest. Open-end
mutuål fund shares are bought and sold on demand at their net asset value (NAV), which is
based on the value of the fund's underlying securities and is calculated at the end of every
trading day. Investors buy shares directly from a fund. Closed-end mutual funds (CEFs) have a
fixed number Of shares and are traded among investors on an exchange. CEFs may trade at a
discount or premium to their NAV. If the market price of a CEF is greater than its NAV, it will be
traded at a premium. If the market price is less than its NAV, it will be traded at a discount. A
CEF is not required to buy back its shares from investors upon request (Wellsfargofunds.com).
Like stocks, their share prices are determined according to supply and demand, and they often
trade at a wide discount or premium to their NAV.

Launched in the middle 1970s, MMMFs became popular in the early 1980s when interest
rates and inflation soared. Management's fee was less than 1% of an investor's assets; interest
over and above that amount was credited to shareholders monthly. In the US, the fund's NAV
normally remained a constant $1 per share—only the interest rate went up or down. Such
funds, like MMDAs usually offered check-writing privileges. In 2008, the government created
a temporary money fund insurance program, guaranteeing share prices if the fund's NAV fell
below $1 a share. In additiom, some funds were covered by private insurance.
Many money market funds are part of fund families. This means that investors can
switch their money from one fund to another and back again without charge. Money in an
asset management account usually is automatically swept into a money market fund until the
account holder decides where to invest it next.
MMMFs sell their shares to raise cash, and by pooling the funds of large numbers of
small savers, they can build their liquid assets portfolios. In the US, one can start an account
with merely $1,000, which makes it suited for small businesses and even individuals. These
funds offer liquidity and offer return the same way as purchasing the marketable securities
directly.

Certificate of Assignment
Certificate of assignment is an agreement that transfers the right of the seller over a
security in favor of the buyer. The underlying security carries a promise to pay a certain sum
of money on a fixed date like a promissory note. The arrangement allows the buyer to hold
the security as a guaranteed source of repayment. The buyer has the option to force the
liquidation of the underlying security to ensure repayment.
For example, ABC Corporation owns certain securities, say T-bills worth •100,000.
ABC Corporation goes to a bank and borrows money corresponding to the amount of the
T-bills, that is, PIOO,OOO. ABC Corporation executes a certificate of assignment assigning the
right over of the T-bills to the bank. The maturity and amount of the loan need to match the
maturity and amount of T-bills. When the maturity date comes, ABC Corporation will pay the
bank PIOO,OOO that it borrowed and get back the cancelled certificate of assignment.
Certificate of Participation
Certificate of participation is an instrument that entitles the holder to a proportionate
equitable interest in the securities held by the issuing firm or an entitlement to a pro rata
share in a pledged revenue stream, usually lease payments. The lessor assigns the lease and
the payments to a trustee, which then distributes the payments to the certificate holders.
The transaction is between the buyer and the original issuer of the security. A dealer issues
the certificate of participation. The dealer's liability is to vouch for the integrity of the original
security rather than to repay the loan if the issuer defaults. The certificate of participation is a
useful instrument when the original security is in a large denomination and when there are a
few buyers.
For example, DEF Corporation issued a promissory note for 9300 million to a bank.
The bank later sold P5 million of this instrument to RST Company, Inc. The bank will issue a
certificate of participation in DEF'S promissory note to RST Company, Inc. The bank's certificate
of participation does not make the bank liable in case DEF Corporation defaults on its note.

Eurodollar CDs and Eurocommercial Papers

The US dollar has been an international medium of exchange. Foreign governments and
financial institutions, like banks, hold a store of funds denominated in US dollars outside of the
United States. Moreover, US corporations conducting international trade often hold US dollar
deposits in foreign banks overseas to facilitate expenditures of their companies and branches
or offices in these foreign countries. These dollar-denominated deposits held offshore in US
bank branches overseas and in other foreign banks are called Eurodollar deposits and the
market in which they trade is called the Eurodollar market. Eurodollar certificate of deposits
or Eurodollar CDs are dollar-denominated, negotiable, large-time deposits in banks outside
the United States. Similarly, Eurocommercial papers (EurocPs) are issued in Europe by dealers
of commercial papers without involving a bank. They are negotiable commercial papers dealt
with in the European markets. The Eurocommercial rate is generally about one-half to one
percent above the LIBOR rate. Foreign commercial paper markets are new and small relative

to the US commercial paper markets. Eurocommercial papers are issued in local currencies
as well as in US dollars. With the introduction of the Euro as the official currency in most
European countries, EuroCPs denominated in Euros are now common in Europe. The Euro
market potential is essentially bright. Eurodollars may be held by governments, corporations
from anywhere in the world not directly subject to US bank regulation. As a result, the rates
paid on Eurodollar CDs are generally higher than that paid on US-domiciled CDs (Sanders and
Cornett 2007).
CAPITAL MARKET INSTRUMENTS
After gaining knowledge in examining the different money market instruments, we are
now ready to learn the different capital market instruments available to investors.
As stated, these long-term instruments are basically-either equity securities or debt
securities. Capital market instruments include corporate stocks, mortgages, corporate bonds,
treasury securities, state and local government bonds, US government agency securities, and
non-negotiable bank, and consumer loans and leases.
Capital market instruments, just like capital markets, can be classified as:
1. Non-negotiable/non-marketable instruments
2. Negotiable/marketable instruments

Non-Negotiable/Non-Marketable Instruments
Non-negotiable or non-marketable instruments in the capital markets are the following:
1. Loans
Loans are direct borrowings of deficit units from surplus units like banks. They can
be short-term or long-term. Companies needing large amounts of funds to finance special
projects like purchase of land or building, plant expansion, or even bond retirement
usually resort to borrowing from capital markets. They do one-on-one transaction with
the lenders. Stockholders usually guarantee these loans. The amount of loan granted
depends on how well the lenders know the borrowers,and generally on their deposits
with said banks or with the amount of transactions they do with the said banks. Long-
time, established companies can really borrow large amounts of funds to finance their
capital needs.
2. Leases
Leases are rent agreements. The owner of the property is called the lessor and the
one who is renting and using the property is the lessee. The lease can be an operating
lease, where the lessor shoulders all expenses including insurance and taxes related to
the property leased out and the lessee pays a fixed regular amount usually On a monthly
basis. It can also be a financing or capital lease, where the lessee shoulders all expenses of
the property as insurance and taxes. Generally, capital leases are lease-to-own contracts
where the lessee pays a big initial down payment, pays a fixed regular amount, and later
pays a minimal amount to finally own the asset or property being leased.

Companies who want to buy capital equipment or machinery can arrange for a
lease-to-own contract with a financial institution. They initially lease equipment or
machinery and have-the option to •buy the leased equipment or machinery at the end Of
the program. This is a convenient way to own equipment and machinery. Even buildings
are sometimes purchased in this manner.
3. Mortgages
Mortgages are agreements where a property owner borrows money from a
financial institution using the property as a security or collateral for the loan. The assets
covered by mortgages are non-current assets or permanent assets as land, building,
and other real estate properties. Land, building, and machineries are usually mortgaged
upon purchase. The companies borrow money from banks and other lending institutions
to buy the land, building or machinery and such land, building, or machinery are used as
collateral for the loan thus obtained. Lending institutions are more secure knowing that
something of value guarantees the loan. In essence, mortgages are secured loans.
4. Lines of Credit
Line of credit is a bank's commitment to make loans to regular depositors up to a
specific amount. The line of credit includes letters of credit, standby letters of credit, and
revolving credit arrangements, under which borrowings can be made up to a maximum
amount as of any point in time conditional on satisfaction of specified terms, befOre, as
of, and after the date of drawdowns on the line. Lines of credit provide the convenience of
a readily available source of money that can be used anytime and for whatever purpose.
Personal lines of gedit are for households and can be used for home renovation, buying
a car, vacation, or any major purchase. Commercial lines of credit are for businesses and
can be used for current or short-term purposes like purchase of merchandise and pay
operating expenses or for capital expenditures. But since the credit is ongoing and has no
termination, it is considered long-term. It is flexible providing ongoing access to funds.
Generally, it is secured against home equity. Borrowers only pay interest on the funds
used with flexible repayment options, sometimes including the ability to pay as little as
interest only. It can also have the option to combine with a mortgage to benefit from
automatic rebalancing; therefore, available credit increases automatically as payment is
made (revolving line of credit). It is a great option if you are looking for flexibility.

Negotiable/Marketable Instruments
The following are specific marketable or negotiable instruments dealt with in the capital
markets:
Corporate Stocks
Corporate stocks are the largest capital market instruments. Stocks are evidences
of ownership in a corporation. The holders are called shareholders or stockholders. Shares
of stocks are actually intangible while the stock Certificates are the tangible evidence of

ownership. While there are stocks held for short-term use, classified as current assets Linder
marketable securities or temporary investments, stocks are by nature long-term. They do not
have maturity dates, although redeemable preferred shares, like callable bonds, can be called
for redemption at the option of the issuing company.
The capital stock of a company is divided into shares and each share is denominated
in Philippine peso or in the currency of the country where the company is located. Domestic
companies are incorporated in the countries where they are located. Any other company is
considered as foreign corporation as far as that country is concerned. An American company
doing business in the Philippines is foreign in the Philippines, while considered domestic in
the United States. Foreign companies with offices in the country are called resident foreign
corporations. Stocks can therefore be stocks of domestic companies or stocks Of foreign
companies.
Shares of stock may be classified as:
A.
B.
1.
2.
1.
2.
Par value shares
NO par value shares
a. With stated value
b. Without stated value
Common shares
Preferred shares
a. As to assets
c b. As to dividends
iii,
Cumulative
Non-cumulative
Participating
Non-participating

Par value shares are shares where the speqific money value is shown on the face of the
stock certificate and fixed in the Articles of Incorporation. The primary purpose Of par value is
to fix the minimum issue price Of the shares. The par value shares may be issued at a premium
(above par value), but may not be sold at a discount (below par value).
No par value shares are shares Without any money value appearing on the face Of the
stock certificate. Our Corporation Code provides that no par value shares may not be issued
for less than five pesos per share (P5.OO). NO par value shares may be assigned a stated value
in the Articles of Incorporation in a Board of Resolution made by the Board Of Directors if
authorized, Or by a majority of the stockholders at a meeting called for that purpose. The
assignment of stated value for no par value shares defeats the purpose of no par value shares.
True no par value shares should not have a stated value.

If a corporation issues only one class of stock, it is called common stock (or ordinary
shares) and each share has equal rights. To attract investors, corporations may issue more
than one class of stock, onewith preferential rights over the common stock. Such shares with
preferential rights are called preferred shares or preference shares. In cases where there is
more than one class of stock—preferred stock and common stock—common stock is referred
to as residual being subordinate to preferred stocks and therefore is entitled to an equal pro
rata division of profits without any preference or advantage over any other stockholder or
class of stockholders.
Preferred shares as to assets upon liquidation mean that the shares shall be given
preference over common shares in the distribution of the assets of the corporation in case of
liquidation. Preferred shares as to dividends refer to shares with preferential rights to share in
the earnings of the corporation, that is, the owners thereof are entitled to receive dividends
before payment of any dividend to the common stockis made. The dividend preference may
be on a cumulative or non-cumulative basis and on a participating or non-participating basis.
Payment of dividends cannot be made if the Board of Directors has not declared the
same. All dividends not declared by the Board of Directors in a given period are called passed
dividends. Unpaid passed dividends are called dividends in arrears.
Cumulative preferred shares are entitled to receive all passed dividends in arrears. Non-
cumulative preferred shares are not entitled to passed dividends or which are called dividends
in arrears for cumulative shares. They receive only dividends that are currently declared.
Participating preferred shares are entitled hot only to the stipulated dividend, but also to the
share with the common stock in the dividends that may remain after the common shares have
received dividends at the same rate as the preferred for the current year. Non-participating
preferred shares are entitled to a fixed amount or rate of dividend only, say 10% or 8% or 12%.
Preferred shares can be a combination of the foregoing characteristics, that is, non-
cumulative, non-participating; non-cumulative, participating; cumulative, non-participating;
and cumulative, participating.

The authority to declare dividends rests with the Board of Directors. As previously stated,
unlike debt instruments, stocks do not have maturity dates. They remain outstanding so long
as the issuing corporation is in business and is not retired or called in by the issuing company.
Therefore, while there are stocks held for short-term use, classified as current assets under
marketable securities, stocks are long-term.
Secondary markets provide liquidity and enhance the marketability of stocks reducing
the real costs of financing to business firms and expanding the possibilities for raising funds.
Stocks were traded by brokers in organized stock exchanges and over-the-counter or OTC
markets. Any corporation with more than 300 stockholders may have its stock traded over-
the-counter. Large corporations that meet certain standards of size and stability may apply
with SEC for listing in an prganized stock exchange, such as PSE.

Stocks are entitled to dividends. Dividends can be:

1. Dividends out of earnings (share of stockholders in the profit of the company)
2. Liquidating dividends
a. Dividends in case of liquidation/bankruptcy
b. Dividends representing return of capital in case of extractive industries or
mining companies
Dividends out of earnings can be in the form of:
1, Cash dividend
2. Stock dividend
3. Property dividend
4. Scrip dividend
Cash dividends are dividends distributed in the form of cash, say PIO/share cash dividend,
which means the company will pay those who own shares in the company at the rate of 910/
share. If you own 1,000 shares, you will receive PIO,OOO (1,000 shares x PIO dividend per
share) in cash dividend. Cash dividends can also be a certain percent, say 10% or 5%. In terms
of share, if the par value or stated value of a stock is P20, a 10% cash dividend will mean 10%
of 920 or P2/share, and if you own 1,000 shares, you will receive 1,000 shares x P2 or P2,OOO,
Stock dividends are dividends given out to stockholders in the form of the company's
own shares. If a company declares a 10% stock dividend, it wili be 10% of the shares owned
by the stockholder. If you own 1,000 shares of stock in a corporation, a 10% stock dividend
will mean that you will receive 10% of 1,000 shares or 100 shares of the company's own stock
as stock dividend. Stock dividends are like "paper transactions" because they do not involve
any asset on the part of the company declaring the dividend. All that the company needs is
enough unissued common stock, enough retained earnings, and a board declaration.
Unissued common stock refers to that part of the authorized capital stock that has not
been fully paid, meaning, stock certificates have not been issued, hence unissued. Retained
earnings refer to the profits of the company that have not been declared as dividends and
retained by the business to help in its operations. A board declaration means a resolution
issued by the Board of Directors to the effect that dividends are being declared.
Property dividends are in the form of non-cash assets of the Company distributed as
dividends to stockholders. A company can declare property dividends and then distribute its
own holdings of government securities, or marketable securities or even inventories. Instead
of selling the securities or inventories and giving cash dividends, the company distributes the
government securities, marketable securities, or inventories as property dividends.
Scrip dividends are deferred cash dividends. Scrips are promissory notes that will be paid
by the company in cash at a certain future date.
Unlike dividends out of earnings, liquidating dividends (return of capital) are given by
companies who are in the process of liquidation (going out of business) or by companies in

the extractive industry. Natural resources are depleted ahd stockholders of these companies
receive what is known as liquidating dividends, which are in effect return of capital.
Bonds
Bonds are debt instruments issued by private companies and government entities to
borrow large sums of money that no single financial institution may be willing or able to lend.
A government bond is issued by a national government and is denominated in the country's
own currency. Bonds issued by the Bureau of the Treasury are called T-bonds. Bonds issued
by national governments in foreign currencies are normally referred to as sovereign bonds.
These bonds are certificates of indebtedness with definite maturity dates, that is, the date
when the bond issuers need to redeem the bonds (redemption dates). They also pay interest
at regular intervals (monthly, quarterly, every six months, or even yearly) and the holders are
the creditors or investors (surplus units or SUS), while the issuer is the debtor or borrower
(deficit units or DUs). They earn a fixed rate of interest, which issuers pay at regular intervals
(monthly, quarterly, every six months, or even yearly). The earnings on bonds, therefore, are
in the form of interest or coupons (hence, coupon bonds).
Corporate Bonds
Corporate bonds are certificates of indebtedness issued by corporations who need large
amount of cash. Bond agreements are called bond indentures. At times, it is impossible to
borrow a large amount from a single institution. This is the time corporations decide to issue
bonds instead. In the case of bonds, the investors are the lenders; therefore, we have several
lenders for a single amount borrowed, say 95 million. Bonds have specific interest rates and
maturity dates. While there might be short-term bonds, most corporate bonds are long-term
bonds because they mature in more than a year.
Bonds can be classified as follows:
I, As to security:
a,
b.
Secured bonds
Secured bonds are collateralized either by mortgages or other assets.
Securitized mortgages (mortgage-backed securities) are mortgages packaged
together by financial institutions and sold as bonds backed by mortgage cash
flows such as interest and principal repayments on these mortgages.
Unsecured bonds
Unsecured bonds, also called debenture bonds, do not have any sort
of guarantee. They do not provide any lien against any specific property or
security for the obligation, that is, there is no collateral. This is the reason why
debenture bonds are generally issued by companies with a steady high credit
rating. Companies such as large mail-order houses and commercial banks are
some of these companies.

2.
3.
As to interest rate:
a. Variable rate bonds
Variable rate bonds are bonds whose interest rate fluctuates and
changes when the market rates change.
b. Fixed rate bonds
Fixed rate bonds have rates that are fixed as stated in the bond indenture.
As to retirement:
a. Putable bonds
Putable bonds are bonds that can be turned in and exchanged for cash
at the holder's option. The put option can only be exerci?ed if the issuer takes
some specified action as being acquired by a weaker company or increasing
its outstanding debt by a large amount. A putable bond allows the investor
to sell the bond back to the issuer, prior to maturity, at a price specified at
the time the bond is issued. This type of bond protects investors: if interest
rates rise after bond purchase, the future value of coupon payments will
become less valuable. Therefore, investors sell bonds back to the issuer and
may lend proceeds elsewhere at a higher rate. Bondholders are ready to pay
for such protection by accepting a lower yield relative to that of a straight
bond. Putable bonds have not been used to a large extent. The holder of a
putable bond is essentially long the bond and long the embedded put option.
This has the effect of increasing the convexity of the price-yield relationship
associated with this security, thus reducing the downside risk to the investor.
This has the effect of increasing the price of the security, hence reducing
the potential return to the investor. As the price of the bond increases, you
get longer. As the price of the bond decreases, you are naturally somewhat
hedged because you get less long.

is
b.
Callable/redeemable bonds
Callable/redeemab/e bond is bond in which the issuer has the right to
call the bond for retirement for a price determined at the time the bond is
issued. This amount will typically be greater than the principal amount of the
bond. In the case of a callable bond, the individual with a long position in this
security will essentially be long the bond and short the embedded call option.
The call feature is positive for the issuer of the bond as it allows the issuer to
essentially refinance debt at more favorable terms when interest rates fall.
For the investor, on the other hand, this represents a drawback as it causes
the price behavior of this security to exhibit negative convexity when interest
rate levels fall. This limits the capital appreciation potential of the bonds
when interest rates fall. Investors are usually compensated for this drawback
through a greater return potential as callable bonds are usually priced at a
discount to other comparable non-callable fixed income securities.

c.
When callable/putable bonds are issued, the terms governing the bond
(frequency, coupon, maturity) and the terms governing the embedded option
such as thestrike schedule are defined. The terms of the bond component
are virtuaily identical to those of other bonds. The embedded call/put option,
on the other hand, may have a lockout period associated with it (i.e„ an initial
period during which it cannot be called). (PNB.com.ph)
Convertible bonds
Convertible bonds can be exchanged for common stocks. This feature
attracts investors, but these convertible bonds usually carry lower interest
rates. Usually, these bonds come with warrants, which are options to buy
common stock at a stated price.
4.
Other classification
a. Income bonds
Income bonds are bonds that pay interest only when the interest is
earned by the issuing company. If the issuing company incurs a loss, it is not
required to pay interest on the income bonds. These bonds cannot put issuing
companies into bankruptcy, but from the point of view of the investor, these
bonds are more risky than the ordinary bonds.

b.
c.
Indexed or purchasing power bond
Popular in Brazil, Israel, Mexico, and a few other countries plagued by
high rates of inflation is the indexed or purchasing power bond. The interest
rate paid on these bonds is based on an inflation index such as the consumer
price index (Cpl). Therefore, the interest paid rises automatically when the
inflation rate rises protecting the bondholders against inflation. This is similar .
to the variable rate bond. The British government has issued an indexed
bond whose interest rate is set equal to the British inflation rate plus 3%.
These bonds, as such, provide a "real return" of 3%. Mexico has also used
indexed bonds whose interest rate is pegged to the price of oil to finance
the development of its huge petroleum reserves since oil prices and inflation
are correlated offering some protection to investors against inflation (Weston
and Brigham 1993). An increase in the inflation rates increases the return on
these bonds, which are favorable to investors. Inflation-indexed bonds in the
United States bear coupons indexed to reflect inflation and even the final
principal payment is an inflation-adjusted principal.
Junk bonds
Junk bonds are speculative, below-investment grade, high-yielding
bonds. They are a big default risk investment; hence, these bonds are high-
yielding. High-yield bond mutual funds and other institutional investors,
like energy-related firms, cable TV companies, airlines, and other industrial
companies, buy these bonds. These bonds are usually used to finance
corporate restructuring or company buy-outs. Investors are generally large

companies involved in multibillion dollar takeovers. These bonds are not

attractiVe to individual investors.
Interest payments on bonds are regular, unlike dividends, which depend on the company's
profits and discretion of the Board of Directors. Moreover, most companies redeem bonds
prior to maturity or can be rolled over. Each year, new corporate bond issues exceed new stock
issues substantially despite the total value of corporate bonds outstanding is less than one-
third the value of stocks (Thomas 1997).
The behavior of the bond market is important in companies' financing decisions. When
bond yields are high, many investment projects are postponed because the cost of borrowing
is high and the cost of borrowing is very important in every financial decision. The rate of
return of a particular project should always be higher than the cost of borrowing to finance
the project. If the cost of financing is high, the project is generally postponed until the bond
market becomes favorable for borrowers. Clearly, what is desirable for borrowers and bond
issuers is unfavorable to investors who need higher returns on their investments. They will not
invest in bonds that will give lower yields.
Corporate bonds generally have original maturities of 10 to 30 years and are traded
over the counter in a market that is "thin" compared to the major stock exchanges and the
US government securities market. Buyers of corporate bonds are primarily institutions that
do not require highly liquid financial assets. These include life insurance companies, private
pension funds, state and local government retirement funds, and nonprofit organizations.
Treasury Bonds
Similar to T-bills, Treasury notes and bonds are issued by the treasury of the country
concerned. T-bones are government securities which mature beyond one year. At present,
the following are the tenor or term of bonds: 2, 3, 4, 5, 7, 10, 15, 20, a;nd 25 years. These are
sold at its face value on origination. The yield is represented by the coupons, expressed as a
percentage of the face value on per annum basis, payable semi-annually (Infest.cfo.gov.ph).
T-notes could be over 1- to 10-year notes.

Retail treasury bonds (RTBs) are like T-notes, but are usually longer in maturity (10 years
and above). They are direct and unconditional obligations of the national government that
primarily cater to the retail market or the end-users. RTBs are safe, liquid, and offer attractive
return* to investors. The interest coupons of I-bonds are paid to the investor quarterly.
Furthermore, RTBs serve as a critical part of the government's program to make government
securities available to small investors. They are issued to mobilize savings and encourage retail
investors to purchase long-term papers. In the retail market, the minimum placement of RTBs
is P5,OOO in contrast to P500,OOO in the wholesale market. (Infest.cfo.gouph)
Floating rate notes (FRNs) in which interest payments rise and fall are based on discount
rates for 13-week T-bills. FRNs are issued for a term of 2 years and pay interest quarterly.
Savings bonds are low-risk savings product that earns interest while protecting you from
inflation. They are sold at face value. EE and E Savings Bonds are secure savings product that
pay interest based on current market rates for up to 30 years. Electronic EE Savings Bonds are
sold at face value in treasuryDiréct (Treasurydirect.gov). Fixed raie treasury notes (FXTNs) are
direct and unconditional obligations of the national government. The Bureau of the Treasury

(BTR) issues them. They are interest-bearing and carry a term of more than one year and can
be traded in the secondary market before maturity. The tenors for these debt instruments can
vary.
The interest rate on the T-notes and T-bonds are generally higher than the interest rates
on T-bills because of the longer maturity period. Like T-bills, they are almost default-free being
backed by the government, but are subject to interest rate fluctuations and changes. Unlike
T-bills, T-notes and T-bonds are not discounted. They pay coupon interest semi-annually. They
come in denominations of PI,OOO and multiples of PI,OOO. These T-notes and T-bonds are
registered issues, which means the Treasury records the name and address of the current
holder of each security and credits the bank account of the owner of record for accrued
interest every 6 months. Like stocks, their ask and bid prices are reported in major business
newspapers and journals like The Wall Street Journal in the United States or business sections
of regular newspapers. T-notes and T-bonds are actively traded in secondary markets.
T-notes and T-bonds are usually issued to fund the national debt and other national
expenditures. While default-risk-free, they are not entirely risk-free. These instruments
experience a wider price fluctuation than money market instruments as interest rates change,
and therefore are subject to interest rate risk. Also, many of the older issued bonds and notes
("off the run" issues) may be less liquid than newly issued bonds and notes ("on the run"
issues) and therefore, subject to liquidity risk.

Municipal Bonds
State and local governments and other political subdivisions must finance their own
capital investment projects like roads, schools, bridges, sewage plants, and airports. These
projects need financing and these local governments usually issue municipal bonds or
local government unit (LGU) bonds. New issues of municipal bonds are generally bought
by investment bankers and resold to commercial banks, insurance firms, and high-income
individuals. They are not, however, as saleable as corporate bonds. Municipal/LGlJ bonds
come in the following two varieties:
1. General obligation bonds (GO)
2. Revenue bonds
General obligation bonds are issued to raise immediate capital to cover expenses and
are supported by the taxing power of the issuer. Revenue bonds, on the other hand, are issued
to fund infrastructure projects and are supported by the income generated by those projects.
Both types of bonds are tax exempt and particularly attractive to risk-averse investors because
they are default-risk-free.
Long-Term Negotiable Certificates of Deposit
Long-term negotiable certificates of deposit (LTNCDs) are negotiable certificates of
deposit with a designated maturity or tenor beyond 1 year, representing a bank's obligat-ion
to pay the face value upon maturity, as well as periodic coupon or interest payments during
the life of the deposit. It is exactly the same as the short-term negotiable CDs, but is long-
term. LTNCDs are covered by deposit insurance with the Philippine Deposit Insurance Corp.

(PDIC) up to a maximum amount of P500,OOO per depositor. The minimum denomination is

PIOO,OOO to P500,OOO depending on the issuer, with increments of 950,000. The interest is
paid quarterly and is tax exempt for qualified individuals if they are held for at least 5 years.
Majority of the country's commercial banks engage in capital-raising activities in accordance
with Bangko Sentral ng Pilipinas (BSP) requirements by issuing LTNCDs. Instead of issuing more
shares or launching a new debt instrument, banks are resorting to LTNCDs, which consumers
find more attractive because they are relatively safe yet high-yielding compared to traditional
deposits. These certificates form part of a bank's deposits and rank senior to all unsecured
and subordinated debts, and all classes of equity securities. A long-term time deposit cannot
be transferred during its life, while there is a market for LTNCDs should the holder wish to
sell it prior to maturity date. Big commercial banks like Hong Kong and Shanghai Banking
Corp. Ltd. (HSBC), ING Bank NV Manila Branch, and Standard Chartered Bank, PNB, First Metro
Investment Corp., and Multinational Investment Bancoiporation are leading arrangers, book
runners, and selling agents.
Mortgage-Backed Securities
Individual mortgages are non-negotiable and as such are neither liquid nor suited tb
trading on secondary markets. As a result, an instrument that came as a result of mortgage
companies and banks grouping mortgages into a standard million block group and issuing
securities backed up by these mortgages, called mortgage-backed securities, came to evolve.
These are the mortgage-backed securities, which are usually in the form of bonds. These are
usually sold to pension funds or life insurance companies. The mortgage houses or banks
continue to collect the payments on the mortgages and pass them on to the owner of the
security in the form of interest on the bonds held. This has resulted in a more efficient
mortgage market contributing to lower mortgage rates for homeowners.

Chapter summary

CMIP is committed to promote, develop, and advance awareness and knowledge of capital
market and its role in the development of the national economy through developing,
organizing, and conducting programs, projects, researches, and other activities to
upgrade competencies of members, practitioners, entrepreneurs, professionals,
teachers, and students in dealing with the Philippine capital market.
Money market instruments are short-term securities (maturing in one year or less).
Treasury bills (T-bills) are issued by the national treasury with 91-day, 182-day, and 364'
day maturities. They are zero-coupon securities because they have no coupon payments
and only have face values.
A banker's acceptance is a time draft issued by a bank payable to a seller of goods. A time
draft issued by a bank is an order for the bank to pay a specified amount of money to
the bearer of the time draft on a given date. It is different from a sight draft, which is an
order to pay immediately.
A commercial letter of credit is a contractual agreement between a bank, known
as the issuing bank, on behalf of the buyer (drawer), authorizing another bank, the
correspondent bank known as the advising or confirming bank, to make payment to the
beneficiary, the seller.
Negotiable certificate of deposit is a bank-issued time deposit that specifies an interest
rate and maturity date and is negotiable (salable/saleable).
Repurchase agreements are legal contracts that involve the actual sale of securities by
a borrower to the lender with a commitment on the part of the borrower to repurchase
the securities at the contract price plus a stated interest charge at a later date. A reverse
repurchase agreement or reverse repo is an agreement involving the purchase of
securities by one party to another with the promise to sell them back at a given date in
the future.
Money market deposit accounts (MMDAs) are PDlC-insured deposit accounts that are
usually managed by banks or brokerages also called money market accounts.
Money market mutual funds (MMMFs) are investment funds that pool funds from
numerous investors and invest in money market instruments offered by investment
companies.
Mutual funds can be classified as growth funds, income funds, balanced funds, sector
funds, index funds, and global funds.

Certificate of assignment is an agreement that transfers the right of the seller over a
security in favor of the buyer,
Certificate of participation is an instrument that gives the buyer a share in a security that
promises to pay a certain sum of money ona fixed date or a type of financing where an
investor purchases a share in the lease revenues of a program or municipality.
Eurodollar certificate of deposits or Eurodollar CDs are dollar-denominated, negotiable,
large time deposits in banks outside the United States.

Capital market instruments can be classified as non-negotiable/non-marketable

instruments and negotiable/marketable instruments.
Non-negotiable instruments in the capital markets are loans, leases, mortgages, and
lines of credit.
Loans are direct borrowings of deficit units from surplus units.
Leases are rent agreements. The owner of the property is called the lessor and the one
who is renting and using the property is the lessee.
Mortgages are agreements where a property owner borrows money from a financial
institution using the property as a security or collateral for the loan.
Line of credit is a bank's commitment to make loans to regular depositors up to a specific
amount. Personal lines of credit are for households. Commercial lines of credit are for
businesses.
Marketable/negotiable securities include stocks, bonds, notes, long-term negotiable
CDs, and mortgage-backed securities.
Corporate stocks are the largest capital market instruments. Stocks are evidence of
ownership in a corporation. The holders are called shareholders or stockholders.

Shares of stock may be classified as:

A.
1.
2.
B.
1.
2.
Par value shares
No par value share
a. With stated value
b. Without stated value
Common shares
Preferred shares
a. As to assets
b. As to dividends
11.
iii.
iv.
Cumulative
Non-cumulative
Participating
Non-participating
•
Par value shares are shares where the specific money value is shown in the face of the
stock certificate.
If a corporation issues only one class of stock, it is called common stock and each share
has equal rights. Shares with preferential rights are called preferred shares. Preferred

shares as to assets upon liquidation mean that such shares shall be given preference over
common shares in the distribution of the assets of the corporation in case of liquidation.
Preferred shares as dividends refer to shares with preferential rights to share in the
earnings of the corporation.
Cumulative preferred shares are entitled to receive all passed dividends in arrears. Non-
cumulative preferred shares are not entitled to passed dividends. Participating preferred
shares are entitled not only to the stipulated dividend, but also to the share with the
common stock in the dividends that may remain after the common shares have received
dividends at the same rate as the preferred for the current year. Non-participating
preferred shares are entitled to a fixed amount or rate of dividend only.
Cash dividends are dividends distributed in the form Of cash. Stock dividends are
dividends given out to stockholders in the form of the company's own shares. Property
dividends are in the form of non-cash assets of the company distributed as dividends.
Scrip dividends are deferred cash dividends.
Bonds are debt instruments issued by private companies and government entities to
borrow large sums Of money. Bonds issued by the natiOnal treasury are called Treasury
Bon ds (T-bonds). Bonds issued by national governments in foreign currencies are normally
referred to as sovereign bonds. Corporate bonds are certificates of indebtedness issued
by corporations.
Secured bonds are collateralized either by mortgages or other assets. Securitized
mortgages are mortgages packaged together by financiai institutions and sold as bond'
backed by mortgage cash flows such as interest and principal repayments on these
mortgages. Unsecured bonds, also called debenture bonds, do not have any sort of
guarantee.
Variable rate bonds are bonds which interest rate fluctuates and changes when the
market rates change. Fixed rate bonds have rates that are fixed as stated in the bond
indenture'.

Putable bonds are bonds that can be turned in and exchanged for cash at the holder's
option. A callable/redeemable bond is bond in which the issuer has the right to call the
bond for retirement. Convertible bonds can be exchanged for common stocks.
Income bonds are bonds that only pay interest when the interest is earned by the issuing
company. Indexed or purchasing power bonds are bonds which interest rate paid on
these bonds is based on an inflation index. Junk bonds are speculative, below-investment
grade, high-yielding bonds.
Treasury Bonds (T-bonds) are government securities which mature beyond one year.
Municipal bonds or local government unit (LGU) bonds are issued by municipalities or
local government units.
Long-term negotiable certificates of deposit (LTNCDs) are negotiable certificates of
deposit with a designated maturity or tenor beyond one year, representing a bank's
obligation to pay the face value upon maturity, as well as periodic coupon or interest
payments during the life of the deposit.

Chapter 4

INTRODUCTION

The previous chapter discussed that the role of financial intermediaries is to make

the needs of surplus units and deficit units meet. Financial intermediaries are the bridges

that enable meeting of investors or surplus units and borrowers or deficit units. Financial

intermediaries are also instrumental in bringing about the different types of financial

instruments or securities that we find in the financial markets.

The National Statistical Coordination Board of the Philippine Statistics Authority (PSA)

reports that the national accounts of the Philippines highlight financial intermediation. Tables

2 and 3 show the annual gross value added in the financial intermediation by industry group

in the Philippines for the years 2013 and 2014 and their corresponding growth rates.

Table 2: Gross Value Added in Financial Intermediation by Industry Group (2013 and 2014
Annual at Constant 2000 Prices)

Table 2 shows that all sectors of the industry group (financial intermediation)
experienced growth—7.83% for banking institutions, 7.23% for non-bank financial
intermediation, 7.40% for insurance, and 2.23% for activities auxiliary to financial
intermediation. The total gross value added in financial intermediation experienced a 7.24%
overall growth rate.
Table 3 shows the gross value added growth rates in financial intermediation by industry
group for the year 2012 compared to 2013, and for the year 2013 compared to 2014,
Table 3: Gross Value Added in Financial Intermediation by Industry Group (Annual 2012
Compared to 2013 and 2013 Compared to 2014)

Table 3 shows that banking institutions grew by 15.4% in 2013 and 12.3% in 2014; non-
bank financial intermediation grew by 14.3% in 2013 and 11.7% in 2014. Insurance grew by
20% in 2013 and 11.9% in 2014. Activities auxiliary to financial intermediation grew by 16.5%
in 2013 and 6.5% ih 2014. However, this also shows that the growth rates in 2013 were higher
than in 2014, Overall, the industry grew 15.9% in 2013 and 11.7% in 2014.
In this chapter, the students will learn how deficit units, savings units, and intermediaries
interplay in the business world. Financial intermediation and the role of the different
financial intermediaries play in the business world will be discussed. Similarly, the role that
savings units and deficit units play in the economy will be explored. Students will also learn
what disintermediation is, how it takes place, and its effect on financial intermediaries.
Furthermore, mismatching of securities and how it works to the advantage and disadvantage
of financial intermediaries will be explained. In addition, the different types of risks faced by
financial intermediaries and investors will be discussed. Bank supervision and bank regulation
will be explained and differentiated, and how the CAMELS rating is applied relative to bank
supervision and regulation.
FINANCIAL INTERMEDIARIES: DEFINITION
Financial intermediaries are the financial institutions that act as a bridge between
investors or savers (surplus units or SUS) and borrowers or security issuers (deficit units
or DUS). They may simply act as a bridge between deficit units and surplus units without
owning the securities issued by the deficit units. However, they can transfer them directly to
the surplus units or investors, just like market specialists or brokers, or in certain instances,
like investment banks/merchant banks which underwrite certain original issues. Generally,
financial intermediaries buy the securities issued by the deficit units for their own account.
What they do is issue their own financial instruments called secondary securities, which they
sell directly to investors or surplus units. Financial intermediaries can therefore either help sell
the primary securities issued by the original issuers or issue their own financial instruments as
secondary securities.
A bank gets deposits from the depositors. In this case, the depositor is the lender and
the bank is the borrower. Original borrowers issue primary securities. In this case, the primary
security is the deposit account, that is, the checking account. The check (primary security) is
an asset (e.g., marketable securities) that the buyer of the security can use to pay his account.
The bank depositor who bought the primary security can now use it—in this cage, the check—
to pay his account, if the lender is willing to accept the check. This is the same with the buyers
of marketable securities who can sell their marketable securities or use them to pay his
account if the len
 the bank, as a financial intermediary, can create secondary securities that it can sell. It
can pool deposits to avail a bigger amount that can be transformed or created into a secondary
security like loans, commercial papers, or negotiable certificate of deposits, which they can
sell to interested investors or simply lend accumulated deposits to borrowers as a loan. The
asset transformation role of financial intermediaries is clearly seen through their issuance of secondary
securities. The primary securities they buy are transformed into secondary
securities that they issue.
Commercial papers (CPS) Or negotiable certificates of deposits (NCDs) that a bank issues
are secondary securities. Loan is a secondary security. The primary security (check or checking
account) is now transformed into a secondary security (CPS or NCDs). Borrowers do not need
to contact the savers directly. In the process, banks earn through the interest spread between
what these banks pay to depositors as interest and the interest that these banks charge to their
borrowers. For example, a bank gives 6% interest to depositors, but charges the borrowers,
12%. The spread is 6%, which is the difference between the two rates (12% — 6% = 6%).
Aside from pension funds, which are usually issued by insurance companies, other financial
intermediaries issue securities as NCDs, MMMFs, MMDAs, mortgage-backed securities, and
the like. Financial intermediaries have brought into existence several of the financial products
or securities now available in the financial markets. Financial intermediaries are generally
large and have economies of scale in terms of operation, and specifically, in analyzing the
creditworthiness of borrowers to ensure that securities issued by these borrowers are worth
investing into or purchasing for the buyers/investors. As Weston and Brigham (1993) stated:
A system of specialized intermediaries can enable savings to do more than just draw
interest. For example, individuals can put money in banks and get both interest income
and a convenient way of making payments (checking), or put money into life insurance
companies and get both interest income and protection for their beneficiaries.
Financial intermediaries do not only sell securities issued by other companies; they also
issue their own securities to raise funds to purchase securities of other corporations they
wish to buy either as their own investment or for resale in cases where selling them will
give them better profits. These secondary securities issued by financial intermediaries includé
savings deposits, life insurance policies, MMMFs, pensions, and pre-need plans, etc. Financial
intermediaries use these secondary securities to attract funds from surplus units, the same
funds they use to buy the primary securities issued by deficit units.
Financial intermediaries are different from other businesses in that their assets and
liabilities are overwhelmingly financial. They have very small amounts of tangible assets. This
is because intermediaries simply move funds from one sector to •another (Bodie et al. 1995).
Compared with non-financial firms, the deposits they accept from both financial and non-
financial firms are their liabilities while these deposits are the assets of the non-financial and
financial firms doing the deposit. The loans the depository institutions grant to non-financial
and financial firms are the assets of the depository institutions, which are, in turn, the liabilities
of the borrower non-financial and financial firms. This is explained further by the following
illustration:

In short, the deposits made by the non-financial and financial institutions are their assets
and these deposits they place with the depository institutions become the liabilities of the
depository institutions. On the other hand, the loans that the depository institutions grant the
non-financial and financial institutions are the assets of the depository institutions and the
liabilities of the non-financial and other financial institutions.
DIRECT AND INDIRECT FINANCE
A borrower-lender relationship is the typical direct finance relationship or transaction. A
bank and a bank depositor are engaged in direct finance; similarly, a bank and a bank borrower
are engaged in direct finance. If you borrow money from your aunt, that is direct finance.
An incorporator buying shares from the issuing corporation also engages in direct finance.
There is no need for any financial intermediary. The checking account, savings account, or
time deposit certificate is originally issued by the bank to the depositor that acts as the buyer
of the security. The depositor "pays" for the checking, savings, or time certificate of deposit
issued by the bank. The claims arising from a direct finance transaction, in our example: the
deposit, loan, and stock, are all primary or direct securities. A direct security/primary security
flows directly from the borrowing unit to the lending or investing unit.
Likewise, when someone Or a company borrows from a bank, he or the company issues
a promissory note, which is the primary security for the funds given by the bank in exchange.
In essence, the borrower "sells" his promissory note and he is "paid" by the bank through the
funds given to him that he borrowed. The relationship between the borrower and the bank
is direct, hence, direct finance. However, the relationship between the depositors, where the
funds lent to borrowers came from, and the borrower from the bank, is indirect finance. The
borrowers do not even know who the depositors are.
Figure 13 shows direct finance without the use of a market specialist.

Figure 14 shows direct finance using a market specialist as a transfer agent like brokers.
.The primary or direct security goes directly from the issuer/borrower to the investor/saver.
This is exactly what Kidwell et al. (2013) explained when they said that direct financing is
one "where funds flow directly through financial markets." The market specialist still transfers
the original issue/primary security (same issue issued by the issuing company), which is the
direct security, and does not create a new or secondary issue. These financial institutions
that channel funds directly to deficit units from the surplus units but do not issue their own
financial instruments or securities are called market specialists. Direct securities or primary

Securities such as stocks and bonds sold in the open market through market specialists are
termed as open market securities. Market specialists are a special type of financial intermediary
in the sense that they provide the connection between surplus and deficit units but do not
issue their own securities. Market specialists help move funds through financial markets. A
market specialist does not acquire the securities that he helps to sell. For instance, a broker,
who is a market specialist, simply facilitates the sale Of original or primary security issued by
corporations by looking for investors willing to buy the securities. They simply find buyers for
the primary/original securities and they are paid commissions.
Indirect finance is like the relationship between the depositor of a bank and the
borrowers of the same bank. The funds lent to the borrowers came from the deposits of
the bank's depositors. The relationship between the bank and the depositors is direct like
the relationship between the bank and the borrowers, while that between the depositors
and the borrowers is indirect and therefore, indirect finance. The foregoing relationships are
illustrated in Figure 15.

Another transaction that involves indirect finance is the use of a middleman or an

intermediary, which generally happens in the secondary financial market. When intermediaries
pool deposits and transform them into secondary securities which they sell to investors, it is
called indirect finance. That is exactly what banks do when they pool deposits and then grant
loans to borrowers.

CHANGING NATURE OF FINANCIAL INTERMEDIARIES

financial intermediaries have changed over time not only in structure but also in its
functions. Old simple financial intermediaries, which specialized in a single function like getting
deposits and granting loans, had become complex in structure with different departments
performing several specialized functions.
The Old Financial Environment
Thomas (1997) described the changing nature of financial intermediation. According to
him, the US Congress, after the Great Depression of the 1930s, devised a host of measures to
promote a highly specialized financial system. Banks were set up to take in deposits and grant
only short-term loans. Creation of branches was limited and interest rates were duly regulated.
Thrift institutions, to protect banks, were prohibited to grant consumer and commercial loans
and issue checking accounts and were forced to specialize in long-term fixed-rate mortgages.
Life insurance companies were allowed only to issue policies and purchase corporate bonds,
not stocks. In 1933, the Banking Act of 1933 (Glass Steagall Act) separated commercial and
investment banking. Commercial banks were no longer allowed to underwrite corporate
stocks and bonds, which function became the dominion of investment banks, and they
were not allowed to hold common stocks in their investment portfolios. On the other hand,
investment banks were not allowed to accept household deposits or grant commercial loans,
which became the domain of commercial banks. Financial institutions therefore became highly
specialized. Households can no longer go to one financial institution and transact all their
businesses there. They have to go to banks to open checking accounts, go to an insurance
company to purchase insurance policies, go to a thrift institution to mortgage their house
and lot, etc. Companies who issue stocks and bonds have to go to an investment bank for
underwriting of their issues and go to a commercial bank for a loan. Severe restrictions were
placed on the portfolios of depository institutions, especially thrifts. This was known as the old
financial environment (OFE).
The New Financial Environment
OFE began to' change in the mid-1970s when the increase in market rates of interest
accompanied by high and rising rates of inflation clashed with the existing regulatory
structures. The Hadjimichalakises (1995) described the new financial environment as being
characterized by market-determined or deregulated rates on assets and liabilities of financial
intermediaries and by greater homogeneity among financial institutions, which emerged
in the 1980s. Financial institutions can now perform various financial functions, which
enable households and companies to go to a single financial institution to transact various
financial businesses. Thereupon emerged the new financial/ environment (NFE) characterized
by financial innovations. New practices apti new products emerged. Laws, regulations,
institutional arrangements, and technological innovations were introduced. These innovations
sprung from attempts by households, firms, and banks to circumvent existing regulations to
maximize profit/wealth. The governments were left with no other choice but to simply protect
the health of their respective economic and financial systems. The Hadjimichalakises (1995)
opined that the proximate cause for the demise of the regulated deposit rates in the 1930s

until the early 1970s was the high and rising rate of inflation in the late 1960s, the 1970s,
and the early 1980s. According to them, inflation rate rose from 4.7% in 1972 to 9.7% (an
increase of 5%) in 1981 (in a span of 9 years). This inflation rate embedded in the double-
digit rate of interest pushed interest rates to go up. As the spread between deposit rates and
interest rates widened, wealthy households and firms withdrew their funds from the regular-
rate deposit accounts and placed them in higher-earning financial instruments like T-bills,
which pay market-determined rates. Small savers were unable to take advantage of these
financial instruments because of denominations they could not afford. The outflow of funds
from financial intermediaries is termed disintermediation, which plagued the depository
institutions, especially thrifts. Moreover, financial technology developed and paved the way
for those who can afford said technology to circumvent existing regulatory structures. As such,
the old structures became less effective and less useful, and ultimately became obsolete.
In the early 1970s, MMMFs were first introduced and households and small businesses
began to have access to a saving tool better than deposits. In 1977, Merrill Lynch created
the cash management account (CMA) by combining MMMF features with securities account
and credit line (Hadjimichalakises 1995). CMA is an MMMF in which deposited funds can be
used to purchase securities or can be withdrawn by check or credit card. It has no limit on the
number of checks that can be issued against the account or the size of the check. Credit cards
also grew secondary to advances in computer technology, making it profitable for banks to
mass market the same. Private pension funds and state and local government retirementfunds
also grew. This dramatic increase in pension funds and mutual funds hurt commercial banks,
thrift institutions, and investment banks benefiting life insurance companies, which moved
into management of pension fund assets. It also raised interest rates on deposit to prevent
withdrawal of deposits, boosted the commercial paper market, and allowed small businesses
to borrow from finance companies which, in turn, issue commercial papers to obtain loanable
funds. It also increased the demand for high-yielding mortgage-backed securities that led to
the securitization of consumer loans in the mid-1980s (Thomas 1997). Securitization means
loans made by banks and finance companies were transformed into securities sold in large
blocks.
In the advent of the new financial environment, credit cards replaced money in the
wallets of individuals and business executives. Even companies opened their own credit card
accounts. Corporate credit cards are a distinct group within the greater credit card universe,
separate from both personal and small business credit cards. Companies may provide their
employees with corporate cards for the payment of approved, business-related expenses,
most often travel-related. Usually issued in the company's name, corporate cards also display
the name of the individual employee cardholder. Unlike personal and small business cards,
corporate credit cards are offered by only a few issuers. Corporate credit card accounts are
generally established by businesses using a banking relationship or via deal negotiated directly
with a card issuer. In developing such relationship, the company's credit is considered, just as
an individual's credit is considered when applying for a consumer credit card. When it comes
to payment, corporate cards fall into two categories: individual payment cards and company
payment cards. Employees who are issued an individual payment card are responsible for
submitting their own expense reports based on company policy and paying the issuer directly

for any charges. With company-payment cards, the employer picks up the tab for all company-
sanctioned charges. The employee may still pay the issuer directly for any unapproved or
personal charges. (Creditcards.com)
CLASSIFICATION OF FINANCIAL INTERMEDIARIES
Financial intermediaries varied but they have one common characteristic. All of them
issue secondary securities to be able to purchase primary securities issued by deficit units.
They can however be grouped into two basic categories:
1, Depository institutions
2. Non-depository institutions
DEPOSITORY INSTITUTIONS
Depository institutions, as the name implies, refer to financial institutions that accept
deposits from surplus units. They issue checking or current accounts/demand deposits,
savings, time deposits, and help depositors with money market placements. Current or
checking accounts can be withdrawn by issuing checks. Most current accounts do not earn
interest, although due to competition, there are now banks offering interest on these checking
or current accounts. These are called NOW accounts. Savings accounts can be withdrawn
by using the passbooks given by the bank to the depositors when they initially make their
deposits. All the deposits and withdrawals are recorded in the same passbook. It also details
the interest earned and any taxes or charges deducted from the account. Time deposits refer
to deposits that have maturity, like 30 days, 60 days, 180 days, or one year. These deposits
may not be withdrawn without penalty prior to maturity, but they earn more interest than
the savings account. Time deposits are evidenced by certificates of deposits; however, these
are not the negotiable CDs bought and sold in the open markets. These banks or depository
institutions help the depositors if the depositors want to earn more than time deposits, and
do the more risky money market placements.
These depository institutions pool the deposits of the depositors and lend the pooled
funds to deficit units or purchase securities. The deposits that depository instituåons issue
are free of risk as the amount of deposit or principal does not fluctuate like stocks and bonds.
Deposits are only reduced if the depositor makes withdrawals or if there are certain bank
charges, like in cases when deposits go below the allowed minimum balance. The deposits
placed in these institutions, generally, can be withdrawn on demand or in certain cases only a
short notice (if amount to be withdrawn is too large). Individuals and business companies are
depositors and they are also borrowers.
Depository institutions include:
1. Commercial banks
a. Ordinary commercial banks
b. Expanded commercial or universal banks

Thrift banks
a.
b.
e.
Savings and mortgage banks
Savings and loan associations
private development banks
Microfinance thrift banks
Credit unions
3.
Rural banks
Commercial Banks
Commercial banks are perhaps the biggest of the depository institutions. Universal and
commercial banks represent the largest single group of financial institutions, resource-wise, in
the country. They could have been the pioneers in financial intermediation.
Ordinary commercial banks perform the more simple functions of accepting deposits and
granting loans. Thev do not do investment functions. Traditionally, commercial banks grant
only short-term loans. These loans were originally extended to merchants for the transport of
their goods in both the domestic and international markets, as well as to finance the holding of
inventories during the brief period required for their sale. As the industry developed and grew,
producers became the clients of commercial banks. Today, commercial banks are the largest
lenders in commercial and industrial loans. They supply funds to traders, manufacturers,
industries, governments, and other financial institutions. Liabilities of commercial banks
and commercial banks alone (except smaller savings and depository institutions) circulate as
money. Commercial banks have the power to create and destroy money through their savings
and loan operations (Fajardo et al. 1994). Money does not only referto currency and coins but
also includes checking/current accounts or demand deposits, regular savings accounts, and
small time deposits. Bank credit also increases money supply.
For instance, someone deposited P1,OOO in the bank. The bank puts 8% as reserve and
is therefore able to lend the remaining 92% or 9920. The borrower puts the 9920 in the bank.
The reserve is 8% leaving 9846 available for lending. Another borrower puts P846 borrowed
in the bank. The reserve is 8% leaving P778 available for lending. This will continue almost
endlessly. Just at this point, the 91,000 has grown into: 91,000 + 9920 + 9846 9778 93,544.
That is how banks create money through its lending operation.
In 1980, the financial reforms in the Philippines saw the creation of what is now known
as "universal banks" (Fajardo et al. 1994). Universal banks or expanded commercial banks
are a combination of commercial banks and an investment house. They perform expanded
commercial banking functions (domestic and international) and underwriting functions
of an investment house. They offer the widest variety of banking services among financial
institutions. In addition to the function of an ordinary commercial bank, universal banks are
also authorized to engage in underwriting and other functions of investment houses and invest
in equities of non-allied undertakings. In addition, they render financial services, payment
processing, securities transactions, underwriting (like merchant banks), and financial analysis.

The functions of an investment house may be done by the commercial bank: (1) in-
house by establishing a department for the purpose or by (2) the establishment of a subsidiary
which will do the investment function. As an investment house, however, they cannot go into
other finance companies business, such as leasing. As an investment house, they can only do
underwriting of securities, securities dealership, and equity investment. The minimum paid-in
capital of a universal bank is 91.5 billion. Some commercial and universal banks have become
global.
In its website, Thismatter.com expounded on commercial banks citing the following:
The primary business of commercial banks is to serve businesses, although with banking
deregulation, they have entered into the consumer business as well. Commercial banks
provide the widest variety of banking services. In addition to savings accounts, checking
services, consumer loans, commercial and industrial (C&I) loans, and credit cards,
commercial banks may also offer trust services, trade financing, investment banking,
and management for corporations, governments and their agencies, and treasury
services. Community banks, however, are smaller commercial banks with assets of less
than $1 billion that generally serve their immediate community of consumers and small
businesses. Community banks are often called regional and super-regional banks that
cover a much wider geographic area and usually have assets in the hundreds of billions
of dollars. They have many branches that extend into several states and many ATMs
at convenient locations throughout their area. Global banks also offer international
services such as letters of credit and currency exchange. These larger banks use short-
term borrowing, also the most numerous by a large margin. Some commercial banks
borrow in the money markets to supplement their deposits and often require loans from
the smaller community banks. These correspondent banks have accounts at the larger
banks, which facilitate the frequent transfers of funds with the big banks. Some banks
money center banks—borrow for their funding instead of relying on deposits. However,
the recent credit crisis has forced money center banks to become depository institutions
because they could not sell their commercial paper or bonds in financial markets that
have been greatly diminished by investors' fear of defaults.
According to Investorwords.com, universal banking is a system of banking where banks
are allowed to provide a variety of services to their customers. In universal banking, banks are
not limited to just loans, checking and savings accounts, and other similar activities, but are
allowed to offer investment service' as well (Investor words. coml. Also, Thefreedictionary.com
defined "universal banking" as banking services that include savings, loans, and investments.
Universal banking combines both commercial banking and investment banking. The term
universal banking is more common in Europe than in the US because of stricter regulation of
American banks. (Thefreedictionary.com)
Deposits are a significant part of the money supply of a country. Commercial banks
play a key role in using these deposits as do other depository institutions in the economic
development of the country. Also, being in direct contact with the central bank of the country,
they receive all regulations and monetary policies of the central bank, which governs the
financial system in the country. As such, they disseminate these regulations and policies to
their depositors. Just like any other financial intermediaries, they mismatch maturities creating

of securities/instruments as saving tools. Mismatching of securities means that they can turn
short-term instruments like deposits into long-term securities like bonds or long-term loans.
While deposits form a major part of commercial banks' liabilities or source of funding,
commercial banks also have other non-deposit sources of funds, such as subordinated notes
and debentures. Their loans, on the other hand, are a mixture of consumer loans, commercial
loans, real estate loans, and even international loans. Traditionally, commercial banks were
the only depository institutions allowed by law to offer transaction services by providing a
financial instrument—demand deposits (better known as checking accounts)—that serve as a
medium of exchange. Historically, commercial banks served the financial needs of commerce
by providing a substantial portion of short-term credit to non-financial businesses providing
the bulk of the money in the form of checking accounts (Hadjimichalakises 1995).
Commercial banks, like some other smaller depository institutions, have several branches
in the different parts of the country. These enable them to reach a broader base and help the
country in its economic development. Nationwide branching is common among commercial
banks and this has helped not only the country, in general but also the communities where
these branches are located, in particular.
Forming a significant part of the financial system of any country, banks are regulated
by the central bank and the government to protect against any disruption in the provision of
their services and to protect the cost that will be imposed on the economy. However, they are
regulated separately from savings institutions and credit unions.
Bank supervision and bank regulation are essential for the maintenance of a balanced
financial system. Bank supervision deals with ensuring the soundness and safety of banks.
Bank regulation consists of the administration of laws in the form of rules and regulations
that govern the conduct of banking and the structure of the banking industry. There are bank
regulations that govern the establishment of a certain bank in a certain location. There are
also bank regulations that govern mergers or acquisitions affecting banks. Banks and other
financial institutions are supervised and regulated to ensure they engage in healthy practices
to maintain a healthy financial system. They are supervised and regulated to ensure they
perform their functions to benefit not Only their own organizations, but also the people they
serve, in particular, and the economy and the country, in general.
The Philippine Deposit insurance Corporation insures the deposits in the depository
institutions, including commercial banks to help depositors have peace of mind knowing that
their deposits are insured and therefore, safe in the banks. PDIC helps in maintaining a healthy
financial system in the Philippines.
Regulatory agencies in the Philippines include the Bangko Sentral ng Pilipinas, Securities
and Exchange Commission, Bureau of Internal Revenue, and the provincial, city, or local
governments. Onsite reviews are at times made to ensure the healthy operations of these
depository institutions.

Prior to 1994, the MACRO rating was used by regulatory agencies to gauge credit standing
of banks:
M
c
Management
Asset quality
Capital adequacy
Risk management
Operating results
In 1994, the Hadjimichalakises (1995) identified the CAMELS rating:
c
M
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to risk
The CAMELS rating aims to determine a bank's overall condition and identify its strengths
and weaknesses financially, operationally, and managerially. Each element is assigned a
numerical rating based on the five key components (Pdf.usaid.gov). The CAMELS rating is a
comprehensive rating with one signifying the best rating and five the lowest. It provides an
early warning signal to prevent a collapse. A rating of one means most stable, two or three
are average suggesting supervisory attention, and four or five for below average signaling a
problem bank.
Thrift Banks
Thrift banking system is composed of savings and mortgage banks, stock savings and
loan associations, private development banks, microfinance thrift banks, and credit unions.
Credit unions, although not classified as banks, can be considered as a thrift institution in
the sense that they encourage people to save. These different thrift institutions cater to the
needs of households, agriculture, and industry. They encourage the habit of thrift and savings
and provide loans at reasonable rates. Thrift banks are engaged in accumulating savings of
depositors and investing them. They also provide short-term working capital and medium-
and long-term financing to businesses engaged in agriculture, services, industry and housing,
and diversified financial and allied services, and to their chosen markets and constituencies,
especially small- and medium- enterprises and individuals. (BSP.gov.ph)
Thrift banks, at the approval of the Monetary Board, may establish banking offices
(branches and extension offices) nationwide just like commercial banks. A branch is an
independent unit of the head office performing all the functions and offers the service facilities
of the head office. An extension office operates like a branch, but is under the supervision and
administrative control of the nearest branch of the head office, or the head offce if the head
office is the one nearest to it.

Thrift banks are also allowed to grant loans under the Agrarian Reform Credit and
Supervised Credit Programs of the government. They may invest in the equity of allied
undertakings as leasing companies, banks, investment houses, financing companies, credit
card companies, and other financial institutions serving small- and medium-scale industries.
These investments, however, are regulated. A thrift bank may own up to 100% of the equity of
an allied undertaking company.
Savings and mortgage banks are banks specializing in granting mortgage loans other than
the basic function of accepting deposits. They are organized for the purpose of accumulating
savings of depositors and investing the same, together with its capital in highly liquid
marketable bonds and other debt securities, commercial papers, drafts, bills of exchange,
acceptances, or notes arising out of commercial transactions or in loans secured by bonds,
mortgages, and other forms of security or in loans for personal or household finance, secured
or unsecured, and financing for home building and improvement. In addition, they may invest
in such other investments and loans with the approval of the Monetary Board of the Bangko
Sentral ng Pilipinas. The portfolio of savings banks consists mainly of mortgages.
Mortgage banks do not accept deposits but extend loans. They offer first and second
mortgages on commercial property, residential houses, and residential apartments. First
mortgage represents the first time that a property could be mortgaged. If the amount of the
property is a lot bigger than the amount of the first mortgage loan, the property can be used
to secure another loan, called second mortgage. Basically, the first mortgage has priority over
the second mortgage. Mortgage banks are usually privately owned corporations willing to
take risks that other banks reject.
Stock Savings and loan associations (S&Ls) accumulate savings of their depositors/
stockholders and use these accumulated savings, together with their capital for the loans
that they grant and for investments in government and private securities. These associations
provide personal finance and long-term financing for home building and improvement.
Savings and loan associations first appeared in the 1800s so that factory workers could
save money to buy a home. They were loosely regulated until the Great Depression when the
US Congress passed several major laws to shore up the banking industry and to restore the
public's trust in them. Before 1980, SLAS were restricted to mortgages and savings and time
deposits, but the Monetary Control Act extended their permitted activities to commercial
loans, non-mortgage consumer lending, and trust services. Many S&Ls have been owned by
depositors, which was their main source of funding—thus they were called mutual savings
and loans associations or just mutual associations. Mutual S&Ls, like credit unions, used their
earnings to lower future loan rates, raise deposit rates, or reinvest, while corporate S&Ls
either reinvested profits or returned profits to their owners by paying dividends. Nowadays,
most S&Ls are corporations, giving them access to additional capital funding to compete more
successfully and to facilitate mergers and acquisitions (Thismatter.com). They accumulate the
savings of their depositors/stockholders and use these accumulated savings together with
their capital for the loans that they grant and for investments in government and private
securities. These associations provide personal finance and long-term financing for home
building and home improvement.

Private development banks cater to the needs of agriculture and industry providing them
with reasonable rate loans for medium- and long-term purposes. The Philippine government
has asked the assistance of government agencies like the Development Bank of the Philippines
(DBP), Philippine National Bank (PNB), Government Service Insurance System (GSIS), Social
Security System (SSS), and other governmental departments to help the private development
banks in their effort to uplift the economic status of the private development banks' clients.
They are authorized to grant real estate mortgage loans With maturities of not more than
20 years for the purposes of the establishment, rehabilitation, and expansion of, and for
investment in, agricultural, industrial, manufacturing, commercial, and other economic
enterprises (Fajardo et al. 1994).
Micro finance thrift banks are small thrift banks that cater to small, micro, and cottage
industries, hence the term "micro." They grant small loans to small businesses like sari-sari
stores, small bakeries, and cottage industries, among others. They help uplift the standard of
living in most rural areas.
Credits unions are cooperatives organized by people from the same organization (whether
formally or informally organized) like farmers, fishermen, teachers, sailors, employees, and so
on. Credit unions grant loans to these people, who become members of the credit union, and
get deposits from them. Usually, the members avail of loans as a multiple (two or three times)
of their deposits. Cooperatives are under the supervision of the Cooperative Development
Authority under the Office of the President.
In a news release made by the World Council of Credit Unions (WOCCU), December
1, 2010 in Madison, Wisconsin, former President of the Republic of the Philippines Gloria
Macapagal-Arroyo awarded WOCCU a presidential commendation in recognition of its credit
union development work in the island nation. The honor commended WOCCU for "its steadfast
support, vital partnership and full cooperation with the Philippine government... and to the
upliftment of the lives and welfare of the Filipino people." (WOCCU.org 2010)
Today, membership in credit unions is no longer restricted to a certain group. Non-
teachers can now become members of a teachers' credit union just like in the other credit
unions. Their loans granted to members are no longer restricted to short- and medium-term
loans. They also grant long-term loans for home buying or financing new business. Credit
unions nowadays even sell life insurance and offer investment advice. Because they cater only
to members, they are classified as non-profit organization enjoying certain tax benefits.
Rural and Cooperative Bank
Rural and cooperative banks are the more popular type of banks in the rural communities.
Their role is to promote and expand the rural economy in an orderly and effective manner
by providing the people in the rural communities with basic financial services. Rural and
cooperative banks help farmers through the stages of production from buying seedlings to
marketing of their produce. Rural banks and cooperative banks are differentiated from each
other by ownership. While rural banks are privately owned and managed, cooperative banks
are organized/owned by cooperatives or federation of cooperatives. (Thismatter.com)

Dictionary.com equated cooperative banks with savings and loan associations and is
termed building societies in Britain. ICBA.coop defined a cooperative bank as a financial entity
which belongs to its members, who are at the same time the owners and the customers of
their bank. Cooperative banks are often created by persons belonging to the same local or
professional community or sharing a common interest. Cooperative banks generally provide
their members with a wide range of banking and financial services (loans, deposits, banking
accounts, etc.). In most countries, they are supervised and controlled by banking authorities
and have to respect prudential banking regulations, which put them at a level playing field with
stockholder banks. Depending on countries, this control and supervision can be implemented
directly by state entities or delegated to a cooperative federation or central body. (ICBA.coop)
Generally, rural banks and cooperative banks are geared toward the development Of
the countryside, that is, non-urban areas and cities. However, in today's world, we can see
rural banks even in cities in the provinces. Today, a lot of cities in the provinces are already
developed just like the cities in the urban areas. In the Philippines, Valenzuela, Meycauayan,
Marilao, Malolos, and a lot more in Cebu and Davao are already developed and still have rural
and cooperative banks in them.
NON-DEPOSITORY INSTITUTIONS
Non-depository institutions issue contracts that are not deposits. These are pension
funds, life insurance companies, mutual funds, and finance companies like depository
institutions which perform financial intermediation. Pension funds and insurance companies
issue contracts for future payments under certain specified conditions. Mutual funds issue
shares in a portfolio of securities or "basket" securities. Mutual funds differ in accordance
with the types of securities they buy for their portfolios, Money market mutual funds issue
accounts like checking accounts that can be withdrawn by checks. Finance companies raise
funds that they lend to households and firms by selling marketable securities and borrowing
from banks.
Non-depository institutions can be classified into the following:
2.
3.
4,
5.
6.
7.
8.
Insurance companies
Life insurance companies
b. Property/casualty insurance companies
Fund managers
Investment banks/houses/companies
Finance companies
Securities dealers and brokers
pawnshops
Trust companies and departments
Lending investors

Life Insurance Companies

Life insurance companies are financial intermediaries that sell life insurance policies.
Policyholders pay regular insurance premiums. These premiums are used to purchase
investments so that they can pay cash as needed (e.g., when an insured dies). Life insurance
companies provide protection over a contracted period or term, which may be a year, 5 years,
or for a lifetime. If the insured person dies during the term of the policy, the insurance company
pays the beneficiaries the agreed-upon sum, called the face value of the insurance policy.
If the insured person outlives the term of the policy, the insurance company pays nothing.
That is the reason why these policies have what is termed as loan values and cash surrender
values. Loan value of a policy is the amount that can be borrowed against the policy during
the term of the policy. Cash surrender value is the amount that will be given to the insured
or beneficiary if the insured or the beneficiary (whoever is paying the premium) decides to
surrender the policy before the term ends, which means the policy is discontinued.
A special type of life insurance is the accident insurance that insures against death or
disability caused by accidents. Like the ordinary life insurance, it has a term and a face value
and works in exactly the same way as any life insurance. The only difference is the cause—
accidents.
Other than life, some life insurance companies, the biggest ones like Lloyd's of London,
insure body parts like the throat (for singers) or the hands (for pianists and sculptors). Lloyd's
of London has provided some of the most famous celebrity body-part policies like those for
Jimmy Durante's $50,000 nose, Bette Davis's $28,000 waistline, and Michael Flatley's $39
million legs. These arrangements began during the silent film era: Douglas Fairbanks, Sr. had
one of the first "scar policies," but the practice is said to have originated with the cross-eyed
vaudevillian Ben Turpin, who would have collected $20,000 if his eyes had gone straight.
(Slate, corn)
In general, one has to pay higher premiums for surplus lines insurance than he would
for insurance on the regular market. The oddball body-part policies can then become a
means of adding extra coverage for a specially valuable star. An entertainment company will
typically max out on standard life and disability insurance for a given celebrity before turning
to specialty policies. In the United Kingdom, the members of the Derbyshire Whiskers Club
insured their beards against "fire and theft," and a soccer fan insured himself against psychic
trauma if England loses this year's World's Cup. The Explainer even looked into coverage
for the finger he uses to manipulate the track pad on his laptop; it turned out that general
disability insurance would be a better deal. Tabloids reported that pop singer Mariah Carey
recently insured her lower extremities for $l billion, although Carey herself would not confirm
the rumor. (Slate.com) you do not have to be a celebrity to insure your body parts—anyone
can order up some specialty insurance if he thinks he needs it. As long as you are willing to
pay the premium, you can get insurance for the body part of your choice. Premiums for these
types of insurance are higher than the regular life insurance.

Property/Casualty Insurance Companies

Property/casualty insurance companies Offer protection against pure risk. They insure
against injury or property loss resulting from accidents, work-related injuries, malpractice,
natural calamities, and at the extreme, exotic adventures as trips to the wild like the African
safaris. Property and casualty insurance gives protection against property losses to one's
business, home, or car and against legal liability that may result from injury or damage to the
property of others. This type of insurance can protect a person or a business with an interest
in the insured physical property against losses.
The events requiring payment from property/casualty insurance companies are less
predictable than that of life insurance companies; hence, they invest in more liquid, more
marketable, lower-yielding securities so that they will have the cash available when needed
(happening of the event being insured against). Property and casualty insurance is insurance
that protects against property losses to one's business, home, car and against legal liability
that may result from injury or damage to the property of others.
Casualty insurance does not only cover property but also individuals. It provides help if a
person meets an accident and say, loses a body part or becomes paraplegic or quadriplegic. At
times, it is referred to as disability insurance. When it comes to your personal finances, long-
term disability can have a devastating effect if you are not prepared. Disability insurance can
replace a portion of the salary you were making before you became disabled and unable to
work after a serious injury or illness. But before you seek coverage, you should first understand
the different types of disability definitions used by insurers.
The AXA Group, an insurance group of companies, stated that property-casualty business
includes the insurance of personal property and liability. It covers a broad range of products
and services designed for individual and business clients. (AXA.corn)
Allstate Corporation, another insurance company, discussed property casualty insurance
in insurance terms as one that can also be called property liability insurance. It gives
protection against financial losses that come as a result of being held legally liable for an
accident that causes damage to another person or another person's belongings or property.
It may help pay for a person's injuries or any legal costs incurred as a result of the person
being injured on a property due to negligence. This kind of insurance comes mostly into play
with auto; homeowners, and renters insurance. It pays for the repair or replacement of the
other person's car, in addition to any medical bills, if that person suffers physical injury. It also
generally extends to any additional damage done to the other person's personal belongings
that he has with him at the time of the accident. It can also cover damages when one suffers
an accident while on his property at home. Allstate.com cited the following examples of the
sort of damages that property casualty insurance may cover (Allstate.com):
• Medical bills. Whether the injured person has medical insurance or not is beside
the point. If you are found to be at fault, you could be held responsible for the
payment of those medical bills.
Pain and suffering. This is another type of damage people typically claim when in
an accident. Medical bills aside, if someone is seriously injured, he can also seek

to hold you financially responsible for the monetary equivalent of the pain and
suffering he has experienced as a result of the accident.
Loss of wages. If someone gets injured severely at your fault, he may not be able
to work for quite a while. If this happens, you could be held liable for those lost
earnings.
Legal fees. Being sued can cost you to hire lawyer to defend you. Casualty insurance
typically covers your attorney's fees if someone injured in your home sues you for
damages.
Homeowners insurance insures one's house and its contents. Your home and its contents
are your greatest assets. That is why it is imperative that you protect its value.
Auto insurance covers one's, spouse's, and relatives' home and other licensed drivers to
whom the insurer gives permission to drive his car. The policy is "package protection" which
provides coverage for both physical injury and property damage liability, as well as physical
damage to the vehicle. This damage can include both that caused by the collision and damage
caused by things "other than collision" such as flood, fire, wind, and hail, among others.
If your car gets into an accident at your fault, you can claim damages from your insurance
company. In the United States, a damaged car that is insured can be declared as "total loss"
so the maximum amount that can be claimed is obtained by the owner. This does not mean
that you can no longer use your car. You can still have the damaged car repaired at your cost
because the insurance company pays you but does not get the damaged car, and can still be
driven and used.
Flood insurance is a special type of insurance that covers damage to any structure or
the contents therein caused by flood. Coverage could be on a per occurrence sub-limit, an
annual aggregate limit, or as a separate deductible. Flood insurance could be residential flood
insurance or commercial flood insurance. Residential flood insurance applies to residences of
households, while commercial flood insurance applies to businesses. This is a special type of
insurance because regular homeowners or commercial insurance policy do not cover against
flood.
Windstorm insurance is also a special type of insurance that protects homeowners
and business establishments from devastations caused by windstorms and hurricanes. It is
special in the sense that homeowners and business establishments need to secure additional
coverage, either through a separate policy of a rider to their existing homeowners or
commercial insurance policy.
Umbrella liability policy is also a special type of insurance that provides coverage over
and above one's automobile or homeowner's policy. Damages due to an accident or injuries
sustained by somebody else on someone's property may exceed the limit set on one's
automobile or homeowner's property. This is the time an umbrella liability policy will kick in.
Health insurance is a type of insurance that covers the cost of an insured individual's
medical and surgical expenses during an illness. The insured may pay costs out-of-pocket
and is then reimbursed or the insurer makes payments directly to the provider. Usually, the
insurer contracts healthcare providers and hospitals to provide benefits to its members at

a discounted rate. These costs include medical exams, drugs, and treatments referred to as
"covered services" in the insurance policy.
Long-term care (LTC) is defined as a need for assistance with some of the activities of daily
living (often called ADLs). ADLs include functions that most of us perform each day, like eating,
bathing, using the bathroom, dressing, transferring and maintaining continence. The need
for assistance may be due to physical inability or mental impairment, such as memory loss,
Alzheimer's, or dementia. Long-term care insurance is designed to ccnter long-term services
and supports, including personal and custodial care in a variety of settings such as your home,
adult day health centers, hospice care, respite care, assisted living facilities or residential care
facilities, or nursing homes. Long-term care insurance policies reimburse policyholders a daily
amount (up to a pre-selected limit) for services to assist them with activities of daily living
such as bathing, dressing, or eating. These services are usually not covered by traditional
health insurance or Medicare. These policies also ensure that one can make choices about
what long-term care services he receives and where he receives. A great number of people
over 65 will spend some time in a nursing home, assisted living or extended care facility and
the cost of such care can be very substantial.
Professional liability insurance protects professionals, such as doctors, financial advisors,
nursing home administrators, lawyers, etc. against financial losses from lawsuits filed against
them by their clients or patients. While practitioners from different professions are expected
to have extensive technical knowledge and experience, mistakes might happen and they can
be held responsible in a court of law for any harm they cause to another person or business.
These types of policies are often called errors and omissions or malpractice policies. These
policies cover against alleged or actual negligence, defense costs, personal injury (e.g., libel or
slander), copyright infringement, claims arising from services provided in the past, and claims
and damages.
Credit insurance is an optional protection purchased from lenders and often associated
with mortgages, loans, or credit cards. It protects the lender and the borrower on the risk that
he is unable to repay the debt due to death, disability, or involuntary unemployment.
Fund Managers
Included among the fund managers are pension fund companies and mutual fund
companies. Pension fund companies sell contracts to provide income to policyholders during
their retirement years. Pension funds are set up to accumulate funds to provide retirement,
disability, and lump sum death benefit payments to the employees of companies or labor
union members. Pension funds can be funded by employees only or by both employees
and their employers during the policy-holders' income earning years. Contributions to the
fund are made while the policyholders are still employed, and the disbursements from
the fund are made in a series of payments over the retirement years of the policyholders
or in lump sum upon retirement. This ensures that even if retired, the policyholders will be
receiving income from their funds, or will have a lump sum amount that the retiree can use
for whatever purpose he seems fit. Contributions are not taxed, but disbursements are. For
the employers, contributions to the pension funds of their employees are tax-deductible as

Employee benefits. Social security is a form of pension plan. A pension plan places member
contributions in a portfolio of stocks, bonds, and other assets in the expectation of building
an even larger pool of funds as the need arises. It also helps employees to balance planned
consumption upon retirement with the amount of savings set aside today.
Pension plans may be defined as contribution plans or defined benefit plans. Defined
contribution plans are ones where the employees or the employees and the company make
payments to the fund as a fixed percentage of salaries making the size of the retiree's benefit
dependent upon the investment success of the fund manager. Under the defined benefit plans,
a fixed benefit payment to the employee is calculated, which is usually related to the size of
the employee's salary and the number of years of service. Actuaries estimate the interest
that the portfolio will earn and the expected life span of the employee, then they calculate
the sizes of the periodic contribution that the employee or the employee and the company
will make to the fund to ensure that the retiree will receive the benefit that has been pre-
determined. In short, it is a plan that either pays a retired employee so many dollars/pesos per
month or it pays the individual a percentage of his average final salaries (Van Horne 1995).
Mutual fund companies are companies engaged in the mutual funds market. They allow
investors to purchase mutual funds that buy different securities in the securities market like
stocks, long-term bonds, or short-term debt instruments issued by businesses or government
units. Even individuals can invest in mutual funds. Open-end investment companies belong
to this group, They are financial intermediaries that pool relatively small amounts of
investors' money to finance large portfolios of investments that justify the cost of professional
management. By pooling funds, these organizations reduce risks by diversification. They also
achieve economies of scale, which lower the costs of analyzing securities, managing portfolios,
and buying and selling securities (Weston and Brigham 1993).
Mutual funds are open-end investment companies. They issue new shares whenever
one wants to buy them and repurchase shares whenever an investor wants to sell them. The
price of a mutual fund share equals the net value of the portfolio divided by the number of
shares outstanding at that time. This value is calculated twice a day—at noon and at the close
of the market for the day (Shetty et al. 1994). The shareholders become the owners of the
portfolio of the fund. These portfolios of securities could be made up of equity securities or
debt securities or even other mutual funds.
Money market mutual funds invest in high-quality short-term securities. They have
check-writing privileges combining the features of current account and mutual funds. Like in
the case of mutual funds, traditional financial institutions establish their own divisions or buy
or establish a subsidiary that specializes in money market mutual funds. These divisions or
subsidiaries conduct their business mostly by mail or electronic transfer of funds.
Investment Banks/Houses/Companies
Investment companies are financial intermediaries that pool relatively small amounts of
investors' money to finance large portfolios of investments that justify the cost of professional
management. They could be closed-end investment companies that issue a fixed number of
shares and sell to the public to raise money to purchase investments. These shares trade in
the open market like the shares of any corporation and their price varies with the demand.

The Philippine Investment Funds Association (PIFA) is an association that contributes

to nation-building through the effective mobilization of long-term savings by increasing the
citizenry's awareness regarding investments. It protects the interests of the investing public
and make them more knowledgeable about their investment options and risk tolerance. It
partners with the government by assisting, coordinating, and cooperating with relevant
regulatory agencies led by the Securities and Exchange Commission. It fosters the growth of
the Philippine Mutual Fund Industry through the institution of standards of excellence in the
operations of Philippine investment companies. (Ehow.com)
Investment banks underwrite new issues of equity and debt securi6es: In an underwriting
transaction, the investment bank, also known as merchant bank, guarantees the sale of the
issues at an agreed price. The investment bank will try to resell all the issues to investors
and any remaining unsold issues will have to be bought by the investment bank for its own
account. Aside from providing the funds in advance, the investment bank also gives advice to
the issuing company as to the price and number of securities to issue. The issuer is spared the
risk and cost of creating a market for its securities on its own. This is, as explained in Chapter
1, what is termed as underwriting. An investment house or investment bank/merchant
bank works primarily for corporations and governments. These banks help raise money for
their clients through debt and stock offerings. They also advise companies on mergers and
acquisitions and help bring prospective buyers together with sellers. Investment banks provide
advisory services to investors, but primarily to larger institutional customers such as pension
and mutual funds. US investment banks are primarily in New York City, with Goldman Sachs, J.
P. Morgan, and Morgan Stanley on top of the heap. (Ehow.com)
Finance Companies
Finance companies are profit-oriented financial institutions that borrow and lend funds
to households and businesses. They are like banks and thrifts. However, finance companies
do not issue checking or savings accounts and time deposits. They raise funds in the open
markets and borrow from banks. Finance companies act as financial intermediaries by issuing
securities in the open markets and borrowing from banks and then relend these funds to
households and businesses.
Finance, companies had been traditionally grouped into three:
1: Sales finance companies
2. Consumer finance companies
3. Commercial finance companies
Sales finance companies provide installment credit to buyers of big-ticket items like
cars and household appliances. Most sales finance companies are subsidiaries of major
manufacturers of these cars and household appliances. They serve as outlets for the
manufacturers; hence, they are captive finance companies because they cannot sell any other
item except those manufactured by the parent company.

Consumer finance companies grant credit to consumers. They grant small loans to
individuals, generally those with low credit ratings and are unable to borrow from the regular
lending institutions like banks and thrifts. Because of the high credit or default risk, the
interests charged on these loans are higher.
Commercial finance companies, also known as business finance companies; grant credit
to businesses. Therefore, while consumer finance companies grant loans to consumers,
commercial finance companies grant loans to commercial enterprises or businesses. Like
consumer finance companies, they grant loans to businesses with difficulty in obtaining loans
from the regular source of these loans because of their low credit rating. Again, interests on
these loans are therefore higher. These loans are usually secured by the businesses' assets like
accounts receivables, inventories, or equipment and other fixed assets that the businesses
may have.
Securities Dealers and Brokers
Securities dealers and brokers can be counted among the other finance companies.
Securities brokers are only compensated by means of commission. They act as financial
intermediaries in the sense that they look for investors or savings units for the benefit of the
borrowers or deficit units. They help in the meeting of these units. They only earn commission
on any sale they make. They do not buy the securities directly. Securities dealers, on the
other hand, buy securities and resell them and make a profit on the difference between their
purchase price and their selling price.
Pawnshops
Pawnshops are the agencies where people and some small businesses "pawn" their assets
as collateral in exchange of an amount much smaller than the value of the asset. Pawnshops
are in the business of lending money on the security of pledged goods left in pawn, or in the
business of purchasing tangible personal property to be left in pawn on the condition that it
may be redeemed or repurchased by the seller for a fixed price within a fixed period of time.
A "pawn transaction" does not include pledge to, or purchase by, a pawnbroker of real or
personal property from a customer followed by the sale or the leasing of that property back
to the customer in the same or a related transaction. (Definitions.uslegal.com)
Pawnshops have been in business for many years and have provided loans to people
who use their assets as collateral. In the Philippines, pawnshop has the highest rate of
return, almost 60% annually and has a payback period of 3.5 years. These are the reasons
pawnshops flourish like mushrooms across the country, even in the cutthroat competition in
the lending business (Expertsonline.com). Cebuana Lhuillier has Over 1,500 branches all over
the Philippines.
The Chamber of Pawnbrokers of the Philippines, Inc. (CPPI) claims it is the first and only
organization to serve and to represent the best interest of the firms and individuals involved in
the aspects of the pawn broking industry (CPPl.com). CPPI keeps its members aware of current
and pending legislation pertaining to the industry and works to represent the interests of
member pawnbrokers to the appropriate agencies like the Bangko Sentral ng Pilipinas and

the Bureau of Interval Revenue (Businesslist.ph). CPPl•offers a wide range of services and
programs which can make a real difference in the success and growth of the pawnshop
business. Membership to the CPPI definitely has its advantages.
In a study, a part of a larger study on the informal credit markets supported by the Asia
Development Bank, made by Mario Lamberto of the Philippine Institute for Development
Studies, Mr. Lamberto stated that pawnshops constitute the smallest group among financial
institutions. According to the study made in 1985, pawnshops' total combined assets was
p808M, which was less than one percent of the total assets of the entire financial system. Mr.
Lamberto concluded that pawnshops have carved out their own niche in the financial market,
servicing small borrowers who could not be accommodated by the banking system. Like the
informal money lenders, pawnshops have provided a safety net to small firms and households
who suffered liquidity problems. The strong demand for the services of pawnshops made
them an attractive business venture. Pawnshops have sprouted in every corner of the country.
In fact, pawnshops stood side by side in almost every commercial place. Pawnshops have,
indeed, become a permanent fixture in the lives of ordinary Filipinos. (Lamberto 1991)
Trust Companies/Departments
Barron's Banking Dictionary defined trust companies as corporations organized for the
purpose of accepting and executing trusts and acting as trustee under wills, as executor, or
as guardian (Barnesandnoble.com). Some trust companies, mostly banks, perform banking
services with a special trust department. They can perform trust functions for companies
issuing bonds to ensure that bondholders are paid as needed. They can act as fiscal agents or
paying agents for the government.
Lending Investors
lending investors are individuals or companies who loan funds to borrowers, generally
consumers or households. Lending investors perform granting loans, but they are not as big
as the regular financial intermediaries. No matter how small they are, they bridge the gap
between lenders and borrowers or the deficit units or the saving units. They also charge a
higher rate of interest on the loans they grant. Individuals that grant loans under the so-called
"5/6" terms are, in effect, lending investors. Companies that grant loan to SSS pensioners are
lending investors.
RISKS OF FINANCIAL INTERMEDIATION
Risk is the possibility that actual returns will deviate or differ from what is expected.
If you expect prices to go up and you buy securities, you are taking a risk because prices
could go either up or down. If prices go up, you gain; if prices go down, you lose. Financial
intermediation is highly market sensitive, that is, it changes with the changes in the market
environment. As such, financial intermediaries face several risks.

Interest Rate/Market price Risk

Financial intermediaries perform what is known as asset transformation in their buying
primary securities and selling secondary securities. They buy one asset (primary security)
and transform this asset into another asset (secondary security) that they sell. They also
perform mismatching of maturities. Short-term liabilities are pooled and converted to long-
term assets. These asset transformation and mismatching of maturities of assets and liabilities
expose financial intermediaries to what is termed interest rate or market price risk. Interest
rate or market value/price risk is the risk that the market value (price) of an asset will decline
(when interest rate rises), resulting in a capital loss when sold. The market value of an asset
or liability is theoretically equal to its discounted future cash flows. Therefore, when interest
rates increase, the discount rate on those cash flows increases and reduces the market value
of the asset or liability. On the other hand, when interest rates fall, the market values of the
assets and liabilities increase. In short, securities decline in price when interest rates rise.
Interest rate risk and market price risk go in opposite direction. When prices rise, interest rates
fall and when prices fall, interest rates rise.
Reinvestment Risk
Reinvestment risk arises as a result of interest rate/market price risk. Reinvestment risk
IS the risk that earnings from a financial asset need to be reinvested in lower-yielding assets or
investment because interest rates have fallen or decreased. Uncertainty about interest rate at
which a company could reinvest funds borrowed for a longer period is also reinvestment risk.
If the cost of borrowing is, say 10%, the financial intermediary should be able to earn more
than 10% when it reinvests the borrowed funds.
Refinancing Risk
Refinancing risk is the risk that the cost of rolling over or re-borrowing funds could be
more than the return earned on asset investments. If the cost of rolling over borrowed funds
is, say 10%, and the return that will be earned on investing the borrowed funds will only result
in a rate of return of, say 9%, the financial intermediary loses 1%,
Default/Credit Risk
Default risk or credit risk is the risk that the borrower will be unable to pay interest on a
loan or principal of a loan or both. If A borrows from the bank and A fails to pay any interest
payment on the loan or fails to pay the principal upon maturity, A is said to be in default. If a
company issues bonds and is unable to pay interest on interest payment dates or fail to pay
the principal on bond redemption date, the company is said to be in default. This is the reason
there are credit investigators who investigate background of borrowers before companies or
banks are able to grant loans requested by borrowers. Suppliers investigate background of
buyers before granting credit to these buyers because of the risk of default.

Inflation/Purchasing Power Risk

Inflation risk or purchasing power risk is the risk of increase in value of goods and services
reducing the purchasing power of money to purchase goods or services. Families struggle
when the prices of staple commodities like rice, fish, meat, and vegetables rise. Their earnings
can only buy less of these commodities making survival difficult. When gas prices increase,
drivers and those owning cars complain because they can buy less gas for their money. As
prices rise, purchasing power decreases. They go in opposite directions just like market prices
and interest rates do.
Political Risk
Political risk is the risk that government laws or regulations will affect the investor's
expected return on investment and recovery of investment adversely or negatively. Even in
extreme cases, this can lead to total loss of invested capital. Increased taxes on petroleum
products will reduce returns on stockholders of petroleum companies. Regulated interest
rates on deposits discourage depositors and motivate them to move their funds to other
higher-earning investments as money market mutual funds or T-bills.
Off-Balance-Sheet Risk
Off-balance-sheet transactions are usually engaged in by financial institutions. Off-
balance-sheet transactions are those transactions that do not appear in the financial
institution's balance sheet but represent transactions that pose contingent assets or
contingent liabilities on the financial institution. Something is contingent if it does not
actually exist currently, but may happen in the future, perhaps upon the happening of a
certain event. Happening of contingent assets is favorable, but happening of a contingent
liability becomes unfavorable and disadvantageous to a financial intermediary. A financial
institution that grants a letter of credit to the company for its issuance of bonds will create a
liability on the part of the financial institution should the company fail to meet its interest and
principal payment on its bonds. The financial institution will be forced to pay such interests
and principal on the bonds issued by the company. The happening of such event is only the
time that such liability will be shown in the balance sheet of the financial institution.
Technology and Operation Risk
Technology and operation risks are related because technological innovations generally
involve and affect operations. Advancement in technology poses an operational risk to all
businesses, including financial institutions. These businesses need to update their own
operations by investing in software and hardware as computer knowledge advances and
international networking and communications become prevalent. Banks have to put up
automated teller machines (ATMs) for the convenience of depositors and improvement of their
own operations. Companies with international operations need to be able to communicate
directly with all their branches and outlets scattered throughout the world. Computer systems
network is needed to connect different accounts at different locations. At times, there is a need
to put up their own satellite system to keep up with the needs of the time. These technological

innovations aim to widen customer base, take advantage of economies of scale, reduce
operating costs, increase Operating efficiency, and ultimately increase profits and improve
owners' wealth. Technology and operation risk arises when these investments in technology
do not produce the desired results, that is, fail to get more customers, unable to produce
economies of scale as desired, and fail to increase profit or reduce costs, among others. These
result when technological innovations produce excess capacity and bureaucratic inefficiencies.
Benefits from technological innovations, however, may result in operating efficiency better
than competition, puffing the Company ahead in the race for superiority in its field. It can also
help develop new products that will help in the firm's survival and earnings potential.
Liquidity Risk
Financial intermediaries also face liquidity risks. Liquidity risk results from withdrawal of
funds by investors or exercise of loan rights or credit lines of clients. Financial intermediaries,
especially banks with a lot of deposit accounts that are supposed to be met daily and
immediately, cause them a problem on how these withdrawals can be met. Financial
intermediaries hold very little cash on hand as most of their assets are in investments in
financial assets, most of which are long-term versus their short-term liabilities. This mismatch
of assets and liabilities poses or causes the liquidity risk faced by financial intermediaries. The
first sign of a liquidity problem faced by a financial intermediary can cause a "run." When bank
depositors demand withdrawals of their funds deposit with a certain bank at the same time, it
will cause a "bank run," which will ultimately result in bank insolvency and bankruptcy. When
depositors use their credit lines with a certain bank at the same time, the bank will be faced
with a funding source problem. Deposit insurance and discount windows were designed to
help with such liquidity problems.
Currency or Foreign Exchange Risk
Currency or foreign exchange risk is the possible loss resulting from an unfavorable change
in the value of foreign currencies. If a Philippine investor buys US securities, in the hope that
the USS will increase in value, the Philippine investor will lose if the US$ falls because his dollar
investment will fall in value because the value of the dollar fell. A US investor who buys Euro
securities will lose if the Euro will fall in value relative to the US dollar. Financial intermediaries
usually do not only own domestic securities. They also own securities denominated in foreign
currencies. Diversification reduces their foreign exchange risk because holding only securities
denominated in one currency will make the financial intermediary at a losing end should the
currency of the securities it is holding fall in value without any security to offset the loss. If it
holds securities in various foreign currency denominations, a loss in one en be offset by a gain
in another.
Country or Sovereign Risk
In general, while investing in securities denominated on other foreign currencies is
advantageous, for a financial intermediary, it is likewise posing a country or sovereign risk
in investing in securities denominated in foreign currency. This is because unlike investing in

domestic-currency-denominated securities, which provide recourse to the country's domestic

bankruptcy courts in case of default, any default in a foreign country is difficult to pursue as
the government of the foreign country may prohibit payment or limit payments secondary
to foreign currency shortages and some other political reasons. Country or sovereign risk
overrides credit risk from a foreign borrower because even if the borrower is in good credit
standing, the government of that foreign country can set up regulations that prohibit debt
repayments to outside or foreign creditors. Even if willing and able to pay, the foreign borrower
cannot pay its obligation because its own government prohibits the repayment. There are
no international bankruptcy courts lenders could resort to. Therefore, lending to a foreign
borrower needs an evaluation of the credit or default risk of the borrower and an evaluation
of the country or sovereign risk of the country where the borrower is located.
ROLE OF FINANCIAL INTERMEDIARIES IN SOCIO-ECONOMIC DEVELOPMENT
In a developing country like the Philippines, financial intermediaries play an important
role in its socio-economic development. While financial intermediaries play an important role
in the urban areas, where a lot of businesses are located and where the financial markets
are very active, they are also very instrumental in the rural areas for the development of
these less developed economies. It is the financial intermediaries that bring the available
funds from the urban areas to the rural areas, which have the most need for such funds.
Rural banks, cooperative banks, and microfinance thrift banks have been a great help in these
disadvantaged areas. They are the ones doing the lending to farmers and other rural residents
that need to develop their status in life. They can borrow from the rural banks, cooperative
banks, and microfinance thrift banks and start their own small businesses or send their
children to school.
In addition to rural banks, cooperative banks, and microfinance thrift banks, the
growth of commercial banks in the rural areas has helped the areas tremendously by making
credit available to the rural residents so they can use the same to advance themselves.
Entrepreneurship and micro and small industries had been pushed in these areas to help these
areas develop and improve not only the economic aspects of the residents' lives but also their
social life. Financial intermediaries had been a great help in the socio-economic development
of these areas. Financial intermediaries had been influential and helpful in the establishment
of schools and businesses in these areas aiding in their socio-economic development. Schools
are needed in these areas to help the residents attain economic sufficiency by academic
achievement. Educated individuals have greater potential to earn more and become
economically self-sufficient. Businesses are similarly necessary in these areas to give jobs or
employment to their residents to help them attain a higher economic status in life. Financial
intermediaries had helped the government in securing funds for infrastructure development
of these areas. Infrastructure is needed to facilitate business growth. Financial intermediaries
had helped individuals pursue education or businesses and livelihood projects for them to
attain economic independence.
The objective of rich countries helping the poor countries is the same objective of
financial intermediaries and the government—to help the poor sectors to alleviate poverty;
encourage individual or personal industry; promote entrepreneurship; and motivate self-
sufficiency (Thomas 1997). These efforts are done through making available the necessary and

much-needed resources from the savings units to the deficit units. These efforts push toward
agricultural development, especially for countries like the Philippines, which is predominantly
agricultural. It promotes the growth of micro and cottage industries and encourages growth
of small businesses. Farmers usually borrow money to buy fertilizers and other products they
need for their farms. Fishermen borrow money to buy bancas or boats and nets for fishing.
Banks, especially the rural and development banks, as financial intermediaries, help a great
deal in this regard. These financial intermediaries are also at times instrumental in buying
the produce from agricultural and rural areas to help farmers get the immediate price or
money for their products. They do not have to wait for their produce to reach the markets.
The financial intermediaries provide financing while they wait for the realization of their sale.
They simply pay interest on the loans they get, generally using their produce as collateral for
their loans. Such interest is generally covered by the sales price of their products, still allowing
them to earn even a little profit. At times, the financial intermediaries, because of their vast
networking, are able to find them a market or a buyer. Helping them ultimately results in their
socio-economic welfare and development.
Moreover, these financial intermediaries have helped a lot of the rural folks escape
usurers. Financial intermediaries had partnered with the government in its effort to develop
these rural areas and uplift the economic and social standing of the rural communities and at
the same, time, get rid of usurers. The usurers will flourish if the rural areas do not have the
banks to help them in their fight against poverty. A financial system mobilizes the financial
resources of society, and, utilizes these for social and economic development.
ECONOMIC BASES FOR FINANCIAL INTERMEDIATION
Imagining a world without financial intermediaries helps explain the role financial
intermediaries play in the economic, if not, social development of a country. Imagine a world
without banks or stock markets. There would be no place to put our money where it would
earn interest. Putting our money in a piggy bank or a house post would not earn us anything. If
there were no financial intermediaries, we would have no place to get help to put our children
to school (if what we earned was not enough) to improve our lives. Similarly, if financial
intermediaries did not exist, we would have no help to start our own business and improve
the life of our family. All of these are impossible without the financial intermediaries in our
midst.
Financial intermediaries help both the surplus units and the deficit units. They help
surplus units by pooling funds of thousands of individuals and entities overcoming obstacles
that stop them from purchasing primary claims directly. Such obstacles include lack of financial
expertise, lack of information, limited access to financial markets, absence of many financial
instruments in small denominations, and a lot more. The spread of risk is made possible only
by the pooling funds. This is generally termed as diversification. Risk is spread by the pooling
of resources. If borrowers default, several lenders suffer the loss, instead of just one lender
shouldering the loss.
Financial intermediaries also help the deficit units by broadening the range of
instruments, denominations, and maturities of financial instruments enabling even small
savers or surplus units to take advantage of the safer and more profitable investment

alternatives. Even governments are helped a lot by these institutions in disposing of

government securities to a broader base. Thomas (1997) stated that financial intermediaries
increase economic efficiency, boost economic activity, and elevate living standards.
Other than helping in the socio-economic development of the nation, financial
intermediaries bear a large part of the cost that individuals and small borrowers should have
shouldered if they themselves had done what the financial intermediaries were doing. It is
costly to do market research and analysis including determining the most profitable and the
safest means of investing our hard-earned savings. The big network and economies of scale
available to these financial intermediaries allow them to shoulder all the costs, including
transaction costs, which the individual and small borrowers should have shouldered. This
makes the existence of financial intermediaries indispensable.
In this connection, let us study the role of two market imperfections—transaction costs
and information gathering. The financial market, just like any other market, is imperfect. An
imperfect market is a market where information is not quickly disclosed to all participants
in it and where buyers and sellers are not matched immediately. Even in the most advanced
financial markets, there are still numerous cases of price corruption, improperly disseminated
information, and other market imperfections.
Transaction Costs
Transaction costs refer to all fees, commissions, and other charges paid when
buying or selling securities including research costs, cost of distribuhng securities
to investors, cost of SEC registration, and the time and hassle of the financial
transaction. In general, the greater the transaction cost, the more likely it is that a
financial intermediary will provide the financial service. Banks and other financial
intermediaries are experts in reducing transaction cost. Much of the cost savings
come from economies of scale and from the use of sophisticated digital technology
(Kidwell et al. 2013).
Information Gathering
Financial intermediaries are major contributors to information production.
They are especially good at selling information about a borrower's credit
standing. The need for information about financial transactions occurs because of
asymmetric information. Asymmetric information occurs when buyers and sellers
do not have access to the same information. Sellers usually have more information
than buyers, especially when the sellers produce or own the asset to be sold. For
financial transactions, issuers of securities know more about investors about the
credit quality of the securities being issued. As can be expected, informational
asymmetry exists more for consumer loans and loans to small businesses because
little information is publicly available.

CHAPTER SUMMARY
Financial intermediaries are financial institutions that act as a bridge between investors
or savers and borrowers or security issuers.
The securities issued by original issuers/borrowers are called primary securities. The
securities issued by financial intermediaries are called secondary securities.
A depositor-bank relationship and a borrower-lender relationship are the typical direct
finance relationships or transactions. A direct security or primary security flows directly
from the lending or investing unit to the borrowing or deficit unit.
The relationship between the depositors, from whom funds came, and the borrowers
who borrowed from the bank is indirect, thus indirect finance.
The asset transformation role of financial intermediaries is evidenced by their issuance
of secondary securities. The primary securities they buy are transformed into secondary
securities that they issue.
The Old Financial Environment (OFE) was a highly specialized financial system where
banks were set up to take in deposits and grant only short-term loans.
The New Financial Environment (NFE) was characterized by market-determined or
deregulated rates on assets and liabilities of financial intermediaries and by greater
homogeneity among financial institutions.
Financial intermediaries are basically classified into depository institutions and non-
depository institutions.
Depository institutions refer to financial institutions that accept deposits from surplus
units. Depository institutions include:
2.
Commercial banks
a. Ordinary commercial banks
b. Expanded commercial or universal banks
Thrift banks
a.
b.
d.
e.
Savings and mortgage banks
Savings and loan associations
private development banks
Microfinance thrift banks
Credit unions
Rural banks

Non-depository institutions issue contracts that are not deposits. They can be classified
into:
1.
2.
4.
6.
7.
8.
Insurance companies
- a. Life insurance companies
b. Property/casualty insurance companies
Fund managers
Investment banks/houses/companies
Finance companies
Securities dealers and brokers
Pawnshops
Trust companies and departments
Lending investor’s
Ordinary commercial banks perform the more simple functions of accepting deposits
and granting loans. Universal banks or expanded commercial banks are a combination of
commercial banks and an investment house.
The thrift banking system is composed of savings and mortgage banks, stock savings
and loan associations, private development banks, microfinance thrift banks, and credit
unions. Thrift banks are engaged in accumulating savings of depositors and investing
them. Savings and mortgage banks are banks specializing in granting mortgage loans
other than the basic function of accepting deposits. Stock savings and loan associations
accumulate savings of their depositors/stockholders and use these accumulated
savings together with their capital for the loans that they grant and for investments in
government and private securities. Private development banks cater to the needs of
agriculture and industry providing them with reasonable rate loans for medium- and
long-term purposes. Micro finance thrift banks are small thrift banks that cater to small
micro, and cottage industries. Credits unions are cooperatives organized by people
from the same organization like farmers of a certain crop, fishermen, teachers, sailors,
employees of one company, etc. and grant loans to these members and get deposits
from them,
Rural and cooperative banks promote and expand the rural economy in an orderly and
effective manner by providing the people in the rural communities with basic financial
services.
Bank supervision deals with ensuring the soundness and safety of banks.
CAMELS rating aims to determine a bank's overall condition and identify its strengths
and weaknesses financially, operationally, and managerially.
Life insurance companies are financial intermediaries that sell life insurance policies.
Property/casualty insurance companies offer protection against pure risk.

Homeowners insurance is insurance for houses and its contents.

Auto insurance covers one's, spouse's, and relatives' home and other licensed drivers to
whom the insurer gives permission to drive his car.
Flood insurance is taken if one considers flood to be a risk for his business or property.
Windstorm insurance is a separate type of coverage that protects one's home or business
against wind damage.
Umbrella liability policy provides coverage over' and above one'? automobile or
homeowner's policy.
Health insurance is a type of insurance that pays for medical expenses in exchange for
premiums.
Long-term care (LTC) is defined as a need for assistance with some of the activities of
daily living.
Professional liability coverage protects professionals, such as doctors, financial advisors,
nursing home administrators, lawyers, etc., against financial losses from lawsuits filed
against them by their clients or patients.
Fund managers are pension fund companies and mutual fund companies. Pension fund
companies sell contracts to provide income to policyholders during their retirement
years. Mutual fund companies are companies that allow investors, including individuals,
to buy into mutual funds that buy different securities in the securities market.
Investment companies are financial intermediaries that pool relatively small amounts
of investors' money to finance large portfolios of investments that justify the cost of
professional management.
Finance companies are profit-oriented financial institutions that borrow and lend
funds to households and businesses. Finance companies are sales finance companies,
consumer finance companies, and commercial finance companies.
Securities brokers are financial intermediaries that look for investors or savings units
for the benefit of the borrowers or deficit units and are compensated by means of
commission.
Pawnshops are the agencies that lend money on the security of pledged goods left in
pawn.
Trust companies are corporations organized for the purpose of accepting and executing
trusts and acting as trustee under wills, as executor, or as guardian.
Lending investors are individuals or companies who loan funds to borrowers, generally
consumers or households.
Risk is the possibility that actual returns will deviate or differ from what is expected.
Financial intermediaries and investors as well have so many risks to face. This includes
market value risk, reinvestment risk, default risk, inflation risk, political riski off-balance
sheet risk, technology and operation risks, liquidity risk, currency risk, and country risk. Homeowners
insurance is insurance for houses and its contents.
Auto insurance covers one's, spouse's, and relatives' home and other licensed drivers to
whom the insurer gives permission to drive his car.
Flood insurance is taken if one considers flood to be a risk for his business or property.
Windstorm insurance is a separate type of coverage that protects one's home or business
against wind damage.
Umbrella liability policy provides coverage over' and above one'? automobile or
homeowner's policy.
Health insurance is a type of insurance that pays for medical expenses in exchange for
premiums.
Long-term care (LTC) is defined as a need for assistance with some of the activities of
daily living.
Professional liability coverage protects professionals, such as doctors, financial advisors,
nursing home administrators, lawyers, etc., against financial losses from lawsuits filed
against them by their clients or patients.
Fund managers are pension fund companies and mutual fund companies. Pension fund
companies sell contracts to provide income to policyholders during their retirement
years. Mutual fund companies are companies that allow investors, including individuals,
to buy into mutual funds that buy different securities in the securities market.
Investment companies are financial intermediaries that pool relatively small amounts
of investors' money to finance large portfolios of investments that justify the cost of
professional management.
Finance companies are profit-oriented financial institutions that borrow and lend
funds to households and businesses. Finance companies are sales finance companies,
consumer finance companies, and commercial finance companies.
Securities brokers are financial intermediaries that look for investors or savings units
for the benefit of the borrowers or deficit units and are compensated by means of
commission.
Pawnshops are the agencies that lend money on the security of pledged goods left in
pawn.
Trust companies are corporations organized for the purpose of accepting and executing
trusts and acting as trustee under wills, as executor, or as guardian.
Lending investors are individuals or companies who loan funds to borrowers, generally
consumers or households.
Risk is the possibility that actual returns will deviate or differ from what is expected.
Financial intermediaries and investors as well have so many risks to face. This includes
market value risk, reinvestment risk, default risk, inflation risk, political risk off-balance
sheet risk, technology and operation risks, liquidity risk, currency risk, and country risk.

Financial intermediaries play an important role in the socio-economic development of a

country in general, and of urban and rural areas, in particular.
The economic bases for financial intermediation deal with the spread of risk made
possible by the pooling funds through diversification through economies of scale
by bearing a large part of the cost that individuals and small borrowers should have
shouldered if they themselves had done what the financial intermediaries are doing.
absorbing transaction costs and gathering information.

INTRODUCTION
Chief Executive James Gorman of Morgan Stanley expressed concern over the firm's
problem of increasing revenue in the weak markets in 2016. Gorman said that this may
prompt management to take further actions to achieve financial goals,
Morgan Stanley had trouble in the fixed-income markets as well as in underwriting of
stocks and bonds due to the sliding commodity and oil prices, worries about the Chinese
economy, and the uncertainty about US interest rates. The firm's return on equity was
6.2% only as opposed to its target of 9% to 11% by the end of 2017. In addition, Gorman
said that Morgan Stanley's shareholder return was "not acceptable" and that the bank
might need to get "much more aggressive" on cost cutting. Even Morgan Stanlevs shares
were down. (Reuters.com)
This news item highlights the importance of return on equity (ROE) or return on
investment (ROI) for firms, particularly firms as big as Morgan Stanley. Morgan Stanley is a
financial holding company engaged in global financial services with offices and employees
around the world, including Jakarta, Indonesia; Bangkok, Thailand; Hanoi, Vietnam; Labuan,
Malaysia; and Manila. Its Southeast Asia hub and main office in the region is in Singapore
(Morganstanley.com). They advise, originate, trade, manage, and distribute capital for
governments, institutions, and individuals, helping them reach long-term financial goals
through wealth management. Corporations, organizations, and governments around the
world rely on Morgan Stanley for their investment banking and capital market needs. Global
institutions, cutting edge hedge funds, industry innovators all turn to Morgan Stanley for sales,
trading, and market-making services.
Accumulation of wealth through return on investment and substantial rewards is
inherent in investments; however, dissipation of resources and disastrous results are inherent
in investments as well. These adverse outcomes are what we call risks in investments.
Investors go through the following process in making an investment decision:
1. Set objectives.
2. Identify available resources.
g. Evaluate various investment alternatives—stocks, bonds, mutual funds, pension
funds, T-notes and T-bonds, T-bills, CPs, security derivatives, MMMFs, CDs, precious
metals, futures, options, and the like.
4. Choose or identify the investment alternative that will provide the best return and
at the same time, serve or attain their objectives.
It is important for an individual or entity to identify their objectives, which generally
include the desired rate of return, before evaluating alternative investment options. The
choice of assets to bold depends on the individual's or the entity's objectives and their risk
tolerance. Some avoid risks and prefer to hold default-free investments, like government
securities, while others go for riskier but better-•yielding investments. Evaluating investment
alternatives involves weighing risks versus returns. Generally, the higher the risks, the higher

the required returns. on an investment. More liquid assets give lower returns than assets that
are less liquid.
Returns are very important to investors and businesses, but returns are often associated
with risks. Therefore, risks should be considered in choosing the best investment alternative.
CONCEPT OF RISK
Risks refer to chances that the outcome of an event is unfavorable Or undesirable.
Returns, on the other hand, refer to yields or earnings on an investment. Generally, the higher
the risks, the higher the required returns on an investment. Risk is a chance or possibility
of danger, loss, injury, and the like. It is the uncertainty of the expected outcome. It is the
consequence or the stake of doing things. It is oftentimes associated with the game of chance.
For students, there is the risk Of failing the exam or a subject. For some, there is the risk
Of losing one's job, the risk of losing one's house due to fire or other natural disasters, or the
risk of inability to meet the payments on the house. There is also the risk of losing a life or limb
due to accident or natural death. Because of these risks, some take precautionary measures
to mitigate their effect, like buying an insurance policy. Some buy fire insurance policy as
financial protection from the ill effects of fire. Others buy flood insurance as financial security
from the hazards of floods.
Investment risks force investors to evaluate the return and risk characteristics of each
investment alternative before making a decision. Investors, however, differ in their attitudes
toward risks. Some like taking risks, while others exert efforts to avoid or minimize risk. Risk-
averse investors include a premium for risk in the return that they desire in their investments,
that is, they use an adjusted rate of return as their discount rate or desired yield.
The risk for short-term investments like 3-month time deposits, bonds purchased 6
months before maturity, I-year T-bills, and other money market instruments is very minimal
since the outcome is more certain due to the shortness of the period or term involved. Risks
for long-term investments, which mature in more than a year, are more likely to be present
due to the length of their term. This is attributed to the different kinds of risks.
Risks are further classified as systematic and unsystematic risk (Fabozzi and Modigliani 2009):
1.
2.
Systematic risk — also called undiversifiable risk or market risk. Systematic risk
results from the general market and economic conditions that cannot be diversified
away.
Unsystematic risk — sometimes called diversifiable risk, residual risk, or compamL
specific risk. This is the risk that is unique to a company such as a strike, the outcome
of unfavorable litigation, or a natural catastrophe.

It is axiomatic that "if it can't be measured, it can't be managed." This is perhaps the
reason why experts try to measure risks. Following are the different standards for risks:
— Risk is an average effect by summing the combined effect of each
BS 25999
possible consequence weighted by the associated likelihood Of each
consequence.
Risk estimation is the process to assign values to the probability and
ISO 27005 -
consequences of a risk.
Risk assessment categorizes threats, hazards, Or perils by both their
NFPA1600 —
relative frequency and severity.
BS 25999-2 specifies requirements for establishing, implementing, operating, monitoring,
reviewing, exercising, maintaining, and improving a documented Business Continuity
Management System (BCMS) within the context of managing an organization's overall
business risks. ISO 22301 superseded the original British Standard, BS 25999-2, and builds on
the success and fundamentals of this standard. BS ISO 22301 specifies the requirements for
setting up and managing an effective BCMS for any organization, regardless of type or size.
British Standards Institution (BSI) recommends that every business has a system in place to
avoid excessive downtime and reduced productivity in the event of an interruption. (BSIgroup.
com)
The IS027k standards are deliberately risk-aligned, meaning, organizations are
encouraged to assess the security risks to their information. Dealing with the' highest risks
first makes sense from the practical implementation and management perspectives. The
standard provides guidelines for information security risk management. ISO 27005 is broader
in scope than merely addressing the risk management requirements identified in ISO/IEC
27001. However, the standard does not specify, recommend, or even name any specific risk
management method. It does however imply a continual process consisting of a structured
sequence of activities, some of which are iterative (IS021001security.com):
Establish the risk management context (e.g., scope, compliance obligations,
approaches/methods to be used, and relevant policies and criteria such as the
organization's risk tolerance Or appetite);
Quantitatively or qualitatively assess (i.e., identify, analyze, and evaluate) relevant
risks, taking into account the information assets, threats, existing controls, and
vulnerabilities to determine the likelihood Of incidents or incident scenarios, and
the predicted business consequences if they were to Occur to determine a level of
risk;
Treat (i.e,. modify [use information security controls], retain [accept], avoid and/
or share (with third parties]) the risks appropriately using those levels of risk to
prioritize them;
Keep stakeholders informed throughout the process; and

• Monitor and review risks, risk treatments, obligations, and criteria on an ongoing
basis, identifying and responding appropriately to significant changes.
The National Fire Protection Association (NFPA) 1600 "Standard on Disaster/Emergency
Management and Business Continuity Programs" is designed to be a description Of the
basic criteria for a comprehensive program that addresses disaster recovery, emergency
management, and business continuity. NFPA is an international body with • over 60,000
members from all Over the world. Less than a quarter of these members are affiliated with
fire departments. The majority of the members are representatives of the private and public
sectors and come from a wide variety of fields. NFPA standards are developed through a
consensus standards development process approved by the American National Standards
Institute.
NFPA 1600 is considered by many to be an excellent benchmark for continuity
and emergency planners in both the public and private Sectors. The standard addresses
methodologies for defining and identifying risks and. vulnerabilities and provides planning
guidelines which address (Davislogic.com):
stabilizing the restoration of the physical infrastructure;
protecting the health and safety of personnel;
crisis communications procedures; and
management structures for both short-term recovery and ongoing long-term
continuity of operations.

Spurred by the financial crisis in late 2008, risk management experienced increased
importance as a function within the financial services industry. Accordingly, familiarity with
the basic methodologies for measuring, assessing, and controlling risk is vital for those wishing
to get ahead in finance. Some of these methods are (Kolakowski 2016):
1.
2.
3.
Loss of principal and/or interest payments
The crudest yet most conservative measurement Of risk is the total sum of
money invested or loaned. The worst possible outcome is that the entire investment
becomes worthless or that the borrower defaults.
Probability
A refinement is the introduction of probabilities to the analysis. The
mathematical theory of probability deals with patterns that occur in random events.
Probability is a set of all possible outcomes like an 80% probability of success and a
20% probability of failure.
Volatility and variability
Volatility is a basic measure for risks associated with a financial market's
instrument. It represents an asset's price fluctuation and is accounted as the
difference between maximum and minimum prices within trading session, trading
day, month, and the like. The wider range of fluctuations (higher volatility) means
higher trading risks involved. Standard deviation is the typical statistic used to

measure volatility. Historical volatility equals to standard deviation Of an asset

values within a specified time frame, calculated from the historical prices. Expected
volatility is calculated from the current prices, on the assumption that the market
price of an asset reflects expected risks (Trading-point.com). Generally, volatility
is shown by plotting the changes in prices of certain investments over a period of
time, as shown in the following graph of Alphabet Inc.'s (NASDAQ:GOOG) shares
over the period March 21—27.

Variability, on the other hand, is the extent to which data points in a statistical
distribution or data Set diverge from the average or mean value. It also refers to the
extent to which these data points differ from each other. There are four commonly
used measures Of variability: range, mean, variance, and standard deviation. Range
is the highest data minus the lowest data. Mean is also known as the arithmetic
average, which is the result when you add up all the numbers, then divide by how
many numbers there are. Variance is a measure of how close the scores in the data
set are to the middle of the distribution. It is mainly used to calculate the standard
deviation. Standard deviation is a measure of how spread out numbers are. It is the
square root of the variance (Mariano 2016). The risk perception of an asset class
is directly proportional to the variability of its returns. The graph on the next page
shows the variance (variability) and the standard deviation (volatility) of Conglomo,
Inc.
Investment prospectuses caution that past performance is no guarantee of
future results. Historical data can be mined to make assessments of possible future
price movements, in light Of past fluctuations in price. Likewise, correlations and
statistical relationships measured in some historical period offer Only imperfect
indications of what the future may hold for the same security or class of securities.
Thus, extrapolating historical trends and relationships into the future should be
done with extreme caution.
Assessments of counterparty risk
Counterparty risk, which includes default risk, is the risk that the other party
to a transaction, such as another firm in the financial services industry, will prove
unable to fulfill its obligations on time. Examples of these obligations include
delivering securities or cash to settle trades, and repaying short-term loans as
scheduled. Assessments of counterparty risk often are made based on the analyses
of companies' financial strengths provided by rating agencies. However, as the
financial crisis of late 2008 demonstrated, the methodologies used by the rating
agencies are deeply flawed (as are consumer Fair Isaac Corporation [FICO] scores)
and subject to grave error. Additionally, in a general financial panic, events can spiral
Out of control very swiftly, and small counterparty failures can rapidly accumulate to
the point where large firms with supposedly ample financial cushions are rendered
insolvent. Lehman Brothers, Merrill Lynch, and Wachovia were such casualties of
the 2008 crisis; the first Went out of business and the others were acquired by
stronger firms. A large part Of the problem in assessing counterparty risk is that
the analyses performed by rating agencies are not dynamic enough. They typically
adjust to new realities only relatively slowly. Furthermore, Once a counterparty
-that was previously considered sound suddenly moves toward insolvency, it is
extremely difficult to get out Of transactions already entered into.

5.
The Role of actuaries
Actuaries are most associated with analyzing mortality tables on behalf of
life insurance companies and any other venture which involves measurement Of
risks. It plays a critical part in setting of premiums on policies and payout schedules
on annuities. Actuarial science, as it is often called, is an application of advanced
statistical techniques to huge data sets which themselves have high degrees of
measurement accuracy. Additionally, the risk assessments made by life insurance
actuaries are based on data that is almost completely uncorrelated with the financial
system and movements in the financial markets. By contrast, measurements of
counterparty risk, the future behavior of investment securities, and the outlook
Tor specific business initiatives are not amenable to such precise scientific analysis.
Thus, risk managers probably will never have the ability to develop predictive
models that have anywhere near the degree of confidence that one can place in
those estimated by a life insurance actuary.
CONCEPT OF RETURNS
Returns are the revenues, earnings, yields, proceeds, income, or profit from some
undertakings made, like financial investment, capital investment, and business operation.
They are measured, based: on the net cash flow realized or expected to be realized from an
investment or based on the net income from business operations. Net cash flows refer to the
difference between the cash flows received from an investment and the cash flows expended
on an investment. Net income from an investment refers to the difference between revenues
from an investment and the expenses spent on an investment. They are normally translated
in the form of percentages, which are called rates of return. Rate of return is used to compare
the outcomes of different investments. It is also used to measure historical performance,
determining future investment and estimating cost of capital for capital investment decision.
It shows the return made on an investment.
Returns, when talking about investments in financial securities, can be in the form of
income' or price appreciation, which is a capital gain or both. For example, for an investment in
a bond of PI,OOO with a maturity period of 10 years, paying P40 interest every 6 months, the
income on the bond would be equal to 980 a year, which is equivalent to 8% of the face value
of the bond (P80/P1,OOO). If, at any time during the life of the bond, the bond sells at 110
(PI,OOO x 110% = PI,IOO), the investor will not only earn the P80/year interest on the bond,
but also the increase in price from 91,000 to PI,IOO or PIOO gain, should he decide to sell
the bond prior to maturity, The same is true for an investment in stocks. The only difference is
that, in stocks, income is in the form of dividends declared by the issuing corporation instead
of interest.
RISK AND RETURN
Risk and return are interrelated because the returns from an investment should equate
the risk involved. As stated earlier, the risk-averse investor, before making investment in a risky
asset, requires a higher return than the risk-free asset. Returns computed from historical data
can be used in measuring future returns; however, the uncertainty of the occurrence or the
risk involved should also be taken into account.
Risk is the possibility that actual returns will deviate or differ from what is expected.
The actual returns Can go up or down depending on the market. If the returns go up, the risk
in investing is worth it; if the returns go down, then the risk is not worth taking. Taking risks
involves knowledge of expected returns, terminal value, present value, and rate of return.
Expected returns are the future cash flows associated with the investment. Terminal value is
the maturity value of an investment. Present values are the discounted value of the future
returns. Rate Of return is the ratio of the net cash flows and the principal or initial investment.
The different risks that financial intermediaries face are the same risks that the public and the
government, as borrowers and lenders, also face.
Return is the profit or earnings and rate of return is the percentage Of profit or earnings
on a particular investment, which is why it is often termed ROI or return on investment.

If you invest PI,OOO and you earned PIOO, your rate Of return is 10% (PIOO/PI,OOO). The
interest rates on your investments, including deposits, are the return that you earn on your
investments or deposits. The yield you get on your investment in government securities is
your return on your investment in those government securities. The dividend that you earn as
a stockholder is the return you earn on your stocks, in addition to any capital gain or increase
in value of said stocks.
TO increase the rate of return of a company, the company has to take certain risks. "Keep
your alpha high and your beta low" is an Old adage related to investment and therefore, to
risk and return. "Alpha" means return and "beta" means risk. Alpha denotes excess return
and beta denotes risk, the latter being a measure of risk. In other words, we have to keep
the return high and the risk low. However, in the business world, "the higher the risk, the
higher the return" is generally presumed. This is the reason why short-term borrowings have
lower interest rates than long-term borrowings because the default risk in long-term loans are
higher than in short-term loans because of the period and the uncertainty involved in the long
run.

METHODS OF CALCULATING RATES OF RETURN

There are several methods of calculating the rate of return on an investment. Some of
these are:
1. Holding period return — rate of return measured for a given period which can be in a
month or in a year. The period covers 1 month to several months or 1 year to several
years. However, if it covers several years, the result from this method no longer presents
realistic rate of return. This is used when the holder Of the security does not hold on
to the security until maturity. The holding period is the time the investor holds the
investment from the time of acquisition to 'time Of sale generally prior to maturity. The
formula is:

where
EV+I-IV
R = Returns for the period
EV = Ending value Of the investment after an interval
I = Income received from investment (Dividend for stock; Interest for bonds)
IV = Initial value Of the investment at the beginning of the interval
c.
Internal rate of return (IRR)/yield to maturity — In computing for the IRR of the
investment, the present value of the expected cash flows is taken into account.
We have to use the present value table (present value of Pl.OO per year for each
of n years) if the future returns are all the same; if they are not the same, we have
to use the discount table (present value of PI.OO to be received after n years).
Internal rate of return ORR) is a metric used in capital budgeting measuring the
profitability of potential investments. Internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows from a particular investment
equal to zero. Net present value is the difference between the present value of
future cash inflows and the present value of the investment or the principal. If the
NPV is positive, the investment is accepted; if negative, the investment is rejected,
However, this method will require trial and error and interpolation. Yield to maturity
is the IRR for bonds. Since it will require trial and error, the computation can start
with finding the estimated yield to maturity (Mejorada 1999). The approximate
yield to maturity (YM) would be:
discount have higher yield than nominal rate because the principal is lower than the face
value; consequently, bonds purchased at premium have a lower yield than the nominal
rate, because the principal is higher than the face value, which is the maturity value.
EXPECTED RETURN, VARIANCE, AND STANDARD DEVIATION OF A PORTFOLIO
When you make a decision, you take risks. There can be positive or negative outcomes of
the choices we make; so with each decision we take a risk. When a lady say "Yes" to someone
courting her, she takes the risk of marrying the wrong guy, which could lead to unfavorable
outcomes. Similarly, when investing, you take the risk of losing some or all of the money you
have invested. You also take the risk of gaining a return on what you have invested. Risks are
measured by calculating the standard deviation of the historical return or average returns of
specific investments. The higher the risk, the greater chances of losses or gains. Returns are
what we receive on.an original investment.
There are two types of returns:
1. expected returns, which is what you expect to get on your investment; and
2. unexpected returns, which are gains or losses caused by unforeseen events.
Expected return is the sum of the products of the weight of each asset and their
forecasted returns. It is calculated as the weighted average of the likely profits of the assets in
the portfolio, weighted by the likely profits of each asset class. Expected return is calculated
by using the following formula:

Variance
Variance (02) is a measure of how spread out numbers are, that is, how far each value in
the data set is from the mean It is the average of the squared differences from the mean.
Variance measures the variability from an average, that is, volatility, which is a measure of risk.
Therefore, this statistic can help determine the risk an investor might take when purchasing a
specific security. To find the variance, we follow three basic steps:
1. Subtract the mean from each value in the data set.
2. Square each difference and add all the squares together.
3. Divide the sum of the squares by the number of values in the data set.
To incorporate expected returns with the concept of variance, we first compute for
the expected returns. Given the probability and the forecasted sales for given scenarios, for
example, we get the expected returns by multiplying each probability by each forecasted sales.
Adding all the expected returns together gives the mean, which we will need in computing the
variance.
Example: Assume that we were given the following assumptions relative to the sales Of a
Company and the related probabilities:
Portfolio Variance
A portfolio is a collection of financial assets or investments such as stocks, bonds, and
cash. Portfolio variance is a measure of the risk of a portfolio, a combination of the return
variance and co-variance Of each security, and its proportion in that portfolio. Therefore, the
variance of a portfolio's return is a function of the variance of the component assets as well
as the covariance between each Of them. Covariance provides diversification reducing the
overall volatility for a portfolio. Covariance is a statistical measure of how two assets mcwe
in relation to each other. A positive covariance indicates that two assets move together in
tandem. A negative covariance indicates two assets move in opposite directions.
Modern portfolio theory (MPT) or mean-variance analysis is a mathematical framework
for assembling a portfolio of assets such that the expected return is maximized for a given
level Of risk, defined as variance. This theory posits that portfolio variance can be reduced by
diversification, choosing asset classes with a low or negative covariance thereby reducing risk.
The fundamental goal of portfolio theory is to optimally allocate your investments between
different assets.
Portfolio variance is calculated by multiplying the squared weight of each security by its
corresponding variance and adding two times the weighted average weight multiplied by the
Standard Deviation
Standard deviation (ox) can be defined in two ways:
1.
2.
Standard deviation is calculated as the square root of variance. It derives from the
variance, a measure of the dispersion of a set of data from its mean. The more
spread apart the data, the higher the deviation.
In finance, standard deviation is also known as historical volatility and used by
investors as a gauge for the amount of expected volatility. It is applied to the annual
rate of return of an investment to measure the investment's volatility. For example,
a volatile stock will have a high standard deviation while a stable blue chip stock
will have a lower standard deviation. The more volatile an investment, the higher
the standard deviation. A large dispersion tells us how much the fund's return is
deviating from the expected normal returns.
STRUCTURE OF RATES OF RETURN
The interest rates on various securities or investments are determined by factors Such as
length of time to maturity, credit or default risk, and liquidity. The difference in interest rates
arising from differences in length Of time to maturity or term of the security is called the term
structure of interest rates. It is the relationship between interest rates and the length of time
to maturity on debt securities, other things being equal.
The difference in interest rates arising from the credit or default risk is termed default
risk or credit risk structure Of interest rates. It is the relationship between the return or yield on
debt securities and the risk that the issuer may default on its obligations to pay the interest or
the principal. Default risk premium is the difference between the interest on the debt security
of a specific issuer and the interest on a government treasury security with the same maturity.
Comparison with a government security is made because government securities are default-
free.

The yield curve is a graphical representation of the term structure of interest rates at a
particular point in time. Constructing the yield curve involves measuring the length of time
to maturity or the term of the instrument on the horizontal axis or x-axis and the yield to
maturity or interest rate on the vertical axis or y-axis. Then, we plot the yields on comparable
debt securities of different maturities. Thus, a yield curve shows the yield to maturity.
An ascending or upward-sloping yield curve, as shown in Figure 16a, means that the
longer the maturity of the security, the higher the interest rate, which is the general trend.
This curve is formed when interest rates are lowest on short-term securities and it rises at a
diminishing rate until the rates begin to level out on longer maturities. This is the yield curve
most commonly observed (Kidwell et al. 2013). A flat yield curve, as shown in Figure 16b,
means that interest rates are the same across the maturity spectrum, that is, among different
maturities that may happen occasionally. This means that the YM is virtually unaffected by the
term to maturity. They are not common, but do occur from time to time. A downward-sloping
or inverted yield as shown in Figure 16c, means that short-term rates are higher than
long-term rates which can happen under certain market conditions. This means that yields
decline as maturity increases. Historically, yield curves have been inverted when interest rates
have been high across the maturity spectrum. Inverted or downward-sloping yield curves
do not generally last very long, but do occur periodically (Saunders and Cornett 2011). The
different yield curves are in response to securities' or asset holders' regard for securities
of different maturities as perfect substitutes for each other, as imperfect substitutes, or as
no substitutes at all (Hadjimichalakises 1995). The shape and level of yield curves do not
remain constant over time. As the general level of interest rates rises and falls, yield curves
correspondingly shift up and down and have different slopes.

TERM STRUCTURE OF INTEREST RATES

The term of a loan (also called term-to-maturity) is the length of time the principal
matures. It is the period from the time the loan is acquired up to its maturity date. The
relationship between a security's yield to maturity (YM) and the term-to-maturity is known as
the term structure of interest rates. The term structure can be graphically shown by plotting
the YM and the maturity for equivalent-grade securities at a point in time, giving us the yield
curve that we have studied under structure of rates of return. It is important to note that for
yield curves to be meaningful, other factors that affect interest rates, such as default risk, tax
treatment, and marketability must be held constant (Kidwell et al. 2013).

An important aspect of the term structure of interest rates is the distinction and the
relationship between spot rates and forward rates, Spot interest rates are the current interest
rates that apply to current or outstanding loans of any term or duration, that is, whether the
loan is short-term or long-term. Forward interest rates are for loans of any term or duration,
but to be executed at some future time. Assume a one-year security to be sold two years
from today. If the one-year security bears interest at 6% and will be sold to an interested
buyer two years from today at 8%, the 8% is the forward interest rate, while the 6% is the
spot interest rate or the current rate. A long-term loan can be broken down into a series of
renewable short-term loans. The 2-year loan can be thought of as a short-term I-year loan
and another I-year loan each of which can be renewed or "rolled over" with the principal and
the earned interest for the succeeding year. Renewing the loan, such that the new principal is
the sum of the original principal and the interest, is what "rolling over" means. If the principal
is 91,000 and the interest is PIOO, the principal for the next year when the loan is rolled over
becomes PI,IOO. This is how compounding is done. The interest earned plus the principal at
the beginning of the period becomes the principal for the next period.
THEORIES OF TERM STRUCTURE
There are four basictheories related to the term structure of interest rates. These are:
1.
3.
4.
pure or unbiased expectations theory
Liquidity/term premium theory
Segmented markets theory
Preferred habitat theory
pure or Unbiased Expectations Theory
Pure or unbiased expectations theory states that for the same holding period (term),
investors should expect to earn the same return, whether they invest in short-term or long-
term securities. This theory points to the role of Current expectations about future interest
rates as the crucial determinant of the current term structure of interest rates. Thomas (1997)
said that market forces dictate that the yield on a long-term security of any particular maturity
is equal to the geometric mean of the current short-term yield and the successive future
short-term yields currently expected to prevail over the life of the long-term security. This
means that an investor expects to earn the same average return over the long run by (1)
purchasing a long-term bond and holding into maturity in the same manner as (2) purchasing
a short-term bond and rolling it over, that is, reinvesting the proceeds each year in a new
short-term security.
As an example, let us assume that today's yield on I-year bonds is 8% and the consensus
of market participants or the investors specifically is that a year from now, the yield on I-year
bonds will rise to 10%. Today's yield on 2-year bonds should be the average of 8% and 10%,
or roughly around 9%. This way, there is market equilibrium because an investor can have an
equal choice between investing for two successive I-year periods at 8% and 10%, respectively,
or for one 2-year period at 9%. This means the investor will be indifferent whether he chooses

alternative 1 or alternative 2 because to him, the return is just the same or equal. Under
this theory, market forces operate to produce a yield curve or term structure that equalizes
expected returns among alternative maturities for any pl«nning or investment horizon.
Thomas (1997) cited the following assumptions as the bases of the pure expectations
theory:
1.
3.
4.
Investors desire to maximize holding period returns, that is, the returns eamed
over their relevant time horizon.
Investors have no institutional preferences for particular maturities. They regard
various maturities as perfect substitutes for one another.
There are no transaction costs associated with buying and selling securities; hence,
investors will always swap maturities in response to perceived yield advantages.
Large numbers of investors form expectations about the future course of interest
rates and act aggressively on those expectations.
With the foregoing assumptions, the term structure of interest rates will reflect only
the expectations about future interest rates. Nothing else will affect the shape of the yield
curve. Therefore, under this theory, the yield curve will slope upward as shown in Figure 16a
if investors expect interest rates to go up in the future. This means that long-term yields are
higher than short-term yields. If investors expect interest rates to go down in the future, the
yield curve will slope downward as shown in Figure 16c. This means that short-term yields
are higher than long-term yields. If, on the other hand, investors expect rates to remain the
same as the yield of today, then the yield curve will tend to be flat as shown in Figure 16b. This
means that the yield on short-term securities will just be the same as the yield on long-term
securities. Therefore, the only determinant of the yield curve is the expectation of the market
participants, particularly the investors. This is the reason this theory is known as the pure
expectations theory. While the yield curve under this theory behaves like the normal yield
curve, it seems unrealistic to assume that there is no shifting between securities of different
maturities, no matter how large the gap in long-term interest rates and expected future short-
term rates is.
Liquidity/Term Premium Theory
The liquidity/term premium theory emanates from the pure expectations theory based
on the idea that investors will hold long-term maturities only if they are offered a premium
to compensate for future uncertainty in a securites value which increases with an asset's
maturity, that is, the longer the term of the security, the riskier the security becomes, relative
to default. Also, a longer maturity security is less liquid and therefore, the liquidity risk
inherent in these longer maturity securities is greater. This increased risk deserves to be paid
a premium, hence the term "liquidity premium." Short-term securities are more liquid and
more marketable than longer-term securities and are less prone to market or interest rate risk.
Therefore, investors prefer the short-term securities over the long-term securities given the
same yield or rate of return. Moreover, longer-term securities are more sensitive to interest
rate changes than short-term securities. Therefore, it follows that the longer the maturity, the
higher the liquidity premium.

This theory is sometimes called "term premium theory" because the premium is placed
on the term of the security. The longer the term, the riskier the security becomes and therefore,
the extra risk arising out of the longer term of the security needs to be compensated by what
is known as "term premium." It can also be referred to as "risk premium theory" because
it names the risks inherent in longer-term securities—market price risk, interest rate risk,
liquidity risk, and default or credit risk.
Sanders and Cornett (2007) explained this theory as long-term rates equal to the
geometric averages of current and expected short-term rates, plus liquidity risk premiums
that increase with the maturity of the security.
The following figures adapted from Thomas (1997) show the behavior of the yield curve
under the pure expectations theory and the liquidity premium theory when interest rates
expectations are (1) expected to rise, (2) expected to remain constant, and (3) expected to fall.

In this theory, the long-term rates exceed the average of current and expected future
short-term rates by a term premium (TP) that is a positive function of the term to maturity
of the longer-term security. Positive means increasing with the length of the term, making
the normal yield curve as upward-sloping or ascending (Figure 17a). Only when market
participants' consensus that interest rates will come down considerably in the future will the
yield curve slope downward (Figure 17c). Inasmuch as a premium is attached to the risk, the
yield under this theory will be higher by the premium as compared to the pure expectations
theory. When yields are expected to remain constant, the liquidity or term premium theory
implies a slightly upward-sloping yield curve (Figure 17b). When yields are expected to fall, the
liquidity or term premium theory implies a more gently downward-sloping curve (Figure 17c).
Take note that the yield curve for the liquidity or term premium theory is always higher
than the yield curve for the pure expecta60ns theory, simply because of the risk premium
added to the expected return, but it does not significantly differ from one another. The higher
yield for the liquidity or term premium theory is due to the liquidity premium or term premium
that is added to the yield under the pure expectations theory. As we have stated, the liquidity
or term premium theory comes from the pure expectations theory, with the addition Of the
liquidity premium or term premium which is evident in the figures presented.
Segmented Markets Theory
The segmented markets theory, also known as the market segmentation theory, is the
total opposite of the pure expectations theory where securities with different maturities are
perfect substitutes for each other. Under this theory, investors do not consider securities with
different maturities as perfect substitutes. under this theory, investors have certain preferred
investment horizon (term of securities they invest in) in accordance with or to agree with
the kinds of assets and the kinds of liabilities they hold. If the assets and liabilities they are
holding are short-term (e.g„ banks), they would prefer short-term securities (e.g„ T-bills) over
long-term securities. If the assets and liabilities they are holding are long-term (e.g., mortgage
houses and pension funds), they would prefer the long-term securities (e.g„ T-bonds or
T-notes) over the short-term securities. Also, from the vantage point of lenders, short-term
securities possess liquidity and greater. Stability of principal (price stability) and have low
market risk. On the other hand, long-term securities provide stability of income over time
and are therefore preferred by those who prefer stability of income (long-term) over time,
versus those who prefer stability of principal (short-term). This theory assumes that investors
and borrowers are generally unwilling to shift from one maturity sector to another Without
adequate compensation in the form of an interest rate premium.

The behavior of the yield curve under this theory has something to do with the supply
of the securities. If the supply of securities decreases in the short-term market and increases
in the long-term market, the slope of the yield curve becomes steeper (Figure 18a). This
shows that investors have a preference for short-term securities. This will result in a higher
demand for short-term securities than for long-term securities, which will ultimately result in
a high price and a low yield for short-term securities. If the supply of short-term securities had
increased while the supply of long-term securities had decreased, the yield curve will have a
natter slope, and might even slope downward (Figure 18b). This means that investors have
a preference for long-term securities increasing its demand and consequently, resulting in a
high price and a low yield for long-term securities.
This supply of and demand for securities are heavily influenced by the open market
operations of the government and the financial institutions. When they issue more securities,
they increase the supply for the securities, and when they buy back those securities, they
decrease the supply for the securities. The government's and the financial institutions'
debt management decisions will significantly influence the shape of the yield curve. If the
government and the financial institutions are principally issuing long-term debt securities
currently, the yield curve will be relatively steep as seen in Figure 17a. If they are issuing
principally short-term debt securities currently, short-term yields will be high relative to long-

term yields, making the yield curve downward-sloping or inverted as in Figure 17c. The yield
curve will be flat as in Figure 17b, if the government and the financial institutons are principally
issuing the same amount of short-term and long-term securities currently. Simultaneously
selling short-term securities and buying long-term securities will twist the yield curve.
The segmented markets theory or the market segmentation theory assumes that
securities of different maturities are imperfect substitutes as opposed to the pure expectations
theory that assumes securities of different maturities are perfect substitutes, so long as the
expected future rates are equal to the current rate.
preferred Habitat Theory
Preferred habitat theory combines the elements of the three other theories of term
structure. Under this theory, borrowers and lenders have strong preferences for particular
maturities, just like the segmented markets theory. The yield curve therefore will not
conform strictly with the predictions of the pure expectations and liquidity premium theories.
However, if the expected additional returns (excess returns) to be gained by deviating from
their preferred maturities (habitats) become large enough, investors will deviate from their
preferred habitats. Assuming expected returns on long-term securities significantly exceed
those on short-term securities, investors will lengthen the maturities of their assets or
investments, that is, they will buy long-term securities. On the other hand, if the excess returns
expected from buying short-term securities significantly exceed long-term returns, investors
will stop limiting themselves to the long-term securities and will make short-term securities a
limited portion of their portfolios.
This theory is based on the notion that investors will accept additional risk in exchange of
additional expected returns. As such, this theory moves closer to what is happening in the real
world. In this theory, both investor expectations and the factors emphasized in the segmented
markets theory come into play to influence the term structure of interest rates.
Thomas (1997) posited the following observations relating the foregoing theories and
yield curves:
2.
3,
upward-sloping yield curve predominates. On the average, long-term yields have
been significantly higher than short-term yields.
The yield curve typically shifts rather than rotates. In other words, when short-term
yields are rising, long-term yields are usually also rising; when short-term yields are
falling, long-term yields are usually falling. Yields very seldom move in opposite
directions; they move in the same direction.
The yield curve exhibits a regular cyclical pattern. 30th short-term and long-term
yields exhibit a pro-cyclical pattern with short-term rates exhibiting much greater
amplitude over the business cycle than long-term yields do. Short-term yields fall
faster than long-term yields in a recession and rise faster than long-term yields
during an economic expansion. Therefore, the yield curve exhibits a regular cyclical
pattern, sloping steeply upward near the low point of the business cycle but
flattening out as the expansion phase proceeds and frequently even inverting as
the economy approaches the peak of the business cycle.

RISK STRUCTURE OF INTEREST RATES

Risk Structure is the relationship of interest rates on' bonds with the same term to
maturity. Embedded in the yields of risky securities is a premium to compensate for the risk
that goes with the security, such as market or interest rate risk, liquidity risk, default or credit
risk, arid the like. The magnitude of this premium varies widely among different securities in
accordance with the risks involved with these different securities. Theoretically, this magnitude
(spread) can be estimated by comparing the yield on the risky security versus the yield on a
similar risk-free security. For example, government securities are generally used as benchmark
yields because government securities are generally default- or risk-free, The spread between
these yields is known as the risk premium.
Investment advisory bodies like Moody's and Standard and Poor's provide ratings Of the
quality of securities in the United States. Bonds with a Moody's rating of Baa or above are
considered to be investment grade; bonds with lower ratings are considered junk bonds.
According to Thomas (1997), the magnitude Of the gap between the yields on these
bonds increases in periods Of recession (depression) and at other times when issuing firms
experience financial distress, making their issues more risky. Therefore, during periods of
expansion or at times when issuing companies experience significant growth, the yield spread
between the yields is less. It is therefore safe to assume that the risk premium fluctuates over
the course Of the business cycle, that is, it is cyclical. During recession, when more companies
go bankrupt, lenders refrain from buying more risky securities and tend to buy safer securities,
particularly government-issued securities. During a period of economic growth, investors are
more leaned toward riskier but higher-yielding securities.

Making an investment decision involves setting objectives, identifying available resources,

evaluating investment alternatives, and choosing the best investment alternative.
Risks refer to chances that the outcome of an event will be negative or undesirable;
returns refer to yields or earnings on an investment.
Types of investors include risk-averse, risk-takers, and risk-neutral.
Measurement Of risk involves methodologies such as loss of principal, probability,
volatility and variability, assessments of counterparty risk, and role of actuaries.
Net cash flows refer to the difference between the cash flows received from an investment
and the cash flows expended on an investment.
The net income from an investment refers to the difference between revenues from an
investment and the expenses Spent on an investment.
There are several methods of calculating the rate of return on an investment. They are
holding period return, average rate of return, and internal rate of return.
Expected return is calculated as the weighted average of the likely profits of the assets
in the portfolio, weighted by the likely profits of each asset class with the following
equation:

Expected return is calculated as the weighted average of the likely profits of the assets
in the portfolio, weighted by the likely profits of each asset class with the following
equation:
Variance (02) is a measure of the dispersion Of a set of data points around their mean
value. Variance measures the variability from an average (volatility).
The variance of a portfolio's return is a function of the variance of the component assets,
as well as the covariance between each of them. Covariance is a measure Of the degree
to which returns on two risky assets move in tandem.
Standard deviation is a measure of the dispersion of a set of data from its mean. The
more spread apart the data, the higher the deviation.
The difference in interest rates arising from differences in length of time to maturity or
term of the security is called the term structure of interest rates. The difference in interest
rates arising from the credit or default risk is termed default-risk or credit-risk structure
of interest rates. The default risk premium is the difference between the interest on the
debt security of a specific issuer and the interest on a government treasury security with
the same maturity.
The yield curve is a graphical representation of the term structure of interest rates at a
particular point in time. An ascending or upward-slopping yield curve means that the
longer the maturity of the security, the higher the interest rate. A fiat-yield curve means
that interest rates are the same among different maturities. A downward-sloping or
inverted yield curve means that short-term rates are higher than long-term rates.
The term of a loan means the period from the time the loan is acquired up to its maturity
date. The relationship between a security's yield-to-maturity (YM) and the term-to-
maturity is known as the term structure of interest rates.
Spot interest rates are the Current interest rates that apply to current or outstanding
loans of any term or duration, that is, whether the loan is short-term Or long-term.
Forward interest rates are for loans of any term or duration, but to be executed at some
future time.
There are four basic theories related to the term structure of interest rates. These
are pure or unbiased expectations theory, liquidity/term premium theory, segmented
markets theory, and preferred habitat theory.
Pure or unbiased expectations theory States that for the same holding period (term),
investors should expect to earn the same return, whether they invest in short-term or
long-term securities.
Liquidity/term premium theory emanates from the pure expectations theory based on
the idea that investors will hold long-term maturities only if they are offered a premium
to compensate for future uncertainty in a security's value.
Under the segmented markets theory, investors have certain preferred investment
horizon in accordance with or to jibe with the kinds of assets and the kinds of liabilities
they hold.
Preferred habitat theory combines the elements of the three other theories Of term
structure.
Risk structure is the relationship between interest rates on bonds with the same term to
maturity. Embedded in the yields of risky securities is a premium to compensate for the
risk that goes with the security. Theoretically, this magnitude (spread) can be estimated
by comparing the yield on the risky security versus the yield on a similar-risk-free security.