UNIT VII.

FINANCIAL ASSETS
I. FINANCIAL ASSETS

Financial Assets
 a liquid asset that gets its value from a contractual right or ownership claim.
Cash, stocks, bonds, mutual funds, and bank deposits are all are examples of
financial assets.
 do not necessarily have inherent physical worth or even a physical form rather,
their value reflects factors of supply and demand in the marketplace in which
they trade, as well as the degree of risk they carry.
 A financial asset's worth may be based on an underlying tangible or real asset,
but market supply and demand influence its value as well.

Interest Rates
 is the amount charged on top of the principal by a lender to a borrower for the
use of assets. In the case of a large asset, such as a vehicle or building, the lease
rate may serve as the interest rate.
 typically noted on an annual basis known as the annual percentage rate (APR).
Borrowed money is repaid either in a lump sum by a pre-determined date or in
periodic installments.
 Most mortgages use simple interest. However, some loans use compound
interest, which is applied to the principal but also to the accumulated interest of
previous periods.
 A loan that is considered low risk by the lender will have a lower interest rate. A
loan that is considered high risk will have a higher interest rate.
 Consumer loans typically use an APR, which does not use compound interest.
 The APY is the interest rate that is earned at a bank or credit union from a
savings account or certificate of deposit (CD). Savings accounts and CDs use
compounded interest.

EXAMPLES:
1. An individual takes out a P300,000 mortgage from a bank. The loan agreement
stipulates that the interest rate on the loan is 15%. How much will the borrower will
have to pay the bank?
P300,000 + (15% x P300,000) = P300,000 + P45,000
= P345,000

2. A company secures a P1.5 million loan from a lending institution with a 12%
interest. How much the company must repay from the lending institution?
P1,500,000.00 + (12% x P1,500,000.00) = P1,500,000.00 + P180,000
= P1,680,000.00
SIMPLE INTEREST RATE

Simple interest is the method of calculating interest charged on the amount invested in a
fixed deposit.

Formula:
Simple interest= Principal × Interest Rate × Time

EXAMPLE:
1. An individual takes out a P300,000 mortgage from a bank. The loan agreement
stipulates that the interest rate on the loan is 15%. If the term of the loan was for
20 years, how much will the individual pay for the interest?

Simple interest = Prt

= P300,00.00 x 15% x 20 yrs
= P900,000.00

COMPOUND INTEREST RATE

Compound interest method means that the borrower pays even more in interest.
Compound interest also called interest on interest, is applied to the principal but also on the
accumulated interest of previous periods. The bank assumes that at the end of the first year
the borrower owes the principal plus interest for that year. The bank also assumes that at
the end of the second year, the borrower owes the principal plus the interest for the first
year plus the interest on interest for the first year.

Formula:
EXAMPLE:
1. An individual takes out a P3,000 mortgage from a bank. The loan agreement
stipulates that the compound interest rate on the loan is 15%. If the term of the
loan was for 20 years, compounded monthly, how much will the individual pay for
the interest?
Given:
P = 3,000
r = 5% = 0.05
n = 12
t = 10

Solution:

A = P3,000 (1 + 0.15 / 12) (12 * 20)

= P59,146.48

2. If an amount of P5,000 is deposited into a savings account at an annual interest rate

of 5%, compounded monthly, what is the value of the investment after 10 years?
Given:
P = 5000
r = 5% = 0.05
n = 12
t = 10

Solution:
A = P5,000 (1 + 0.05 / 12) (12 * 10)
= P8,235.05
THE COST OF MONEY

Cost of money is the opportunity cost of holding money instead of investing it, depending
on the rate of interest.

The concept of the cost of money has its basis, as does the subject of finance in
general, in the time value of money. The time value of money is the value of money,
taking into consideration the interest earned over a given amount of time. If offered a
choice between P1,000 today or P1,000 in a year’s time – and there is a positive real
interest rate throughout the year. This is described by economists as time preference. Time
preference can be measured by auctioning off a risk free security–like a Treasury bill. If a
P100 note, payable in one year, sells for P80 now, then P80 is the present value of the note
that will be worth P100 a year from now. This fee paid as compensation for the current use
of assets is known as interest. In other words, the concept of interest describes the cost of
having funds tied up in investments or savings.

Furthermore, the time value of money is related to the concept of opportunity cost.
The cost of any decision includes the cost of the most forgone alternative. The cost of
money is the opportunity cost of holding money in hands instead of investing it. The trade-
off between money now (holding money) and money later (investing) depends on the rate
of interest that can be earned by investing. An investor with money has two options: to
spend it right now or to save it. The financial compensation for saving it as against spending
it is that the money value will accrue through the compound interest that he will receive
from a borrower (the bank account or investment in which he has the money).

INTEREST RATE LEVELS

1. Supply and Demand: Interest rate levels are a factor of the supply and demand of
credit: an increase in the demand for money or credit will raise interest rates, while a
decrease in the demand for credit will decrease them. Conversely, an increase in the
supply of credit will reduce interest rates while a decrease in the supply of credit will
increase them.
2. Inflation: Inflation will also affect interest rate levels. The higher the inflation rate,
the more interest rates are likely to rise. This occurs because lenders will demand
higher interest rates as compensation for the decrease in purchasing power of the
money they are paid in the future.
3. Government. The government has a say in how interest rates are affected. The
U.S. Federal Reserve (the Fed) often makes announcements about how monetary
policy will affect interest rates.
FACTORS/DETERMINANTS OF MARKET INTEREST RATES

Market interest rates is the rate at which interest is paid by a borrower for the use
of money that they borrow from a lender in the market. They are mostly driven by
inflationary expectations, alternative investments, risk of investment, and liquidity
preference.

Factors Influencing Market Interest Rates:

1. Deferred consumption: When money is loaned the lender delays spending the
money on consumption goods. According to time preference theory, people prefer
goods now to goods later. In a free market there will be a positive interest rate.
2. Inflationary expectations: Most economies generally exhibit inflation, meaning a
given amount of money buys fewer goods in the future than it will now. The
borrower needs to compensate the lender for this. If the inflationary expectation
goes up, then so does the market interest rate and vice versa.
3. Alternative investments: The lender has a choice between using his money in
different investments. If he chooses one, he forgoes the returns from all the others.
Different investments effectively compete for funds, boosting the market interest
rate up.
4. Risks of investment: There is always a risk that the borrower will go bankruptcy,
abscond, die, or otherwise default on the loan. This means that a lender generally
charges a risk premium to ensure that, across his investments, he is compensated
for those that fail. The greater the risk is, the higher the market interest rate will get.
5. Liquidity preference: People prefer to have their resources available in a form that
can immediately be exchanged, rather than a form that takes time or money to
realize. If people are willing to hold more money in hands for convenience, the
money supply will contract, increasing the market interest rate.
II. BONDS AND THEIR VALUATION

Bonds
 Bonds are issued by organizations generally for a period of more than one year to
raise money by borrowing.
 Bonds generally have a fixed maturity date.
 All bonds repay the principal amount after the maturity date; however some
bonds do pay the interest along with the principal to the bond holders.
 Bonds are debt securities issued by corporations, governments, or other
organizations and sold to investors.
 Backing for bonds is typically the payment ability of the issuer to generate
revenue, although physical assets may also be used as collateral.
 Because corporate bonds are typically seen as riskier than government bonds,
they usually have higher interest rates.
 Bonds have different features than stocks and their prices tend to be less
correlated, making bonds a good diversifier for investment portfolios.
 Bonds also tend to pay regular and stable interest, making them well-suited for
those on a fixed-income.

CHARACTERISTICS OF BONDS

 Face value is the money amount the bond will be worth at maturity; it is also the
reference amount the bond issuer uses when calculating interest payments.
 The coupon rate is the rate of interest the bond issuer will pay on the face value of
the bond, expressed as a percentage. The coupon rate is the fixed return that an
investor earns periodically until it matures.
 Coupon dates are the dates on which the bond issuer will make interest payments.
Payments can be made in any interval, but the standard is semiannual payments.
 The maturity date is the date on which the bond will mature and the bond issuer
will pay the bondholder the face value of the bond. When a bond matures, the bond
issuer repays the investor the full face value of the bond. The face value is not
necessarily the invested principal or purchase price of the bond.
 The issue price is the price at which the bond issuer originally sells the bonds.

TYPES OF BONDS AND THEIR KEY CHARACTERISTICS

MAIN TYPES OF BONDS:

1. Corporate bonds. These are debt securities issued by private and public
corporations.
2. Investment-grade bonds. These bonds have a higher credit rating, implying less
credit risk, than high-yield corporate bonds.
 3. Agency bonds are those issued by government-affiliated organizations such as
Fannie Mae or Freddie Mac.
4. High-yield bonds. These bonds have a lower credit rating, implying higher credit
risk, than investment-grade bonds and, therefore, offer higher interest rates in return
for the increased risk.
5. Municipal bonds, called “munis,” are debt securities issued by states, cities, counties
and other government entities. Types of “munis” include:

o General obligation bonds. These bonds are not secured by any assets;
instead, they are backed by the “full faith and credit” of the issuer, which
has the power to tax residents to pay bondholders.
o Revenue bonds. Instead of taxes, these bonds are backed by revenues
from a specific project or source, such as highway tolls or lease fees.
Some revenue bonds are “non-recourse,” meaning that if the revenue
stream dries up, the bondholders do not have a claim on the underlying
revenue source.
o Conduit bonds. Governments sometimes issue municipal bonds on
behalf of private entities such as non-profit colleges or hospitals. These
“conduit” borrowers typically agree to repay the issuer, who pays the
interest and principal on the bonds. If the conduit borrower fails to make
a payment, the issuer usually is not required to pay the bondholders.
6. U.S. Treasuries are issued by the U.S. Department of the Treasury on behalf of the
federal government. They carry the full faith and credit of the U.S. government,
making them a safe and popular investment. Types of U.S. Treasury debt include:
o Treasury Bills. Short-term securities maturing in a few days to 52 weeks
o Notes. Longer-term securities maturing within ten years
o Bonds. Long-term securities that typically mature in 30 years and pay
interest every six months
o TIPS. Treasury Inflation-Protected Securities are notes and bonds whose
principal is adjusted based on changes in the Consumer Price Index. TIPS
pay interest every six months and are issued with maturities of five, ten,
and 30 years.

OTHER TYPES OF BONDS:

1. Fixed Rate Bonds. In Fixed Rate Bonds, the interest remains fixed throughout the
tenure of the bond. Owing to a constant interest rate, fixed rate bonds are resistant
to changes and fluctuations in the market.
2. Floating Rate Bonds. Floating rate bonds have a fluctuating interest rate
(coupons) as per the current market reference rate.
3. Zero Interest Rate Bonds. Bonds that do not pay any regular interest to the
investors. In such types of bonds, issuers only pay the principal amount to the bond
holders.
4. Inflation Linked Bonds. Bonds linked to inflation are called inflation linked bonds.
The interest rate of Inflation linked bonds is generally lower than fixed rate bonds.
 5. Perpetual Bonds. Bonds with no maturity dates are called perpetual bonds. Holders
of perpetual bonds enjoy interest throughout.
6. Subordinated Bonds. Bonds which are given less priority as compared to other
bonds of the company in cases of a close down are called subordinated bonds. In
cases of liquidation, subordinated bonds are given less importance as compared to
senior bonds which are paid first.
7. Bearer Bonds. Bearer Bonds do not carry the name of the bond holder and anyone
who possesses the bond certificate can claim the amount. If the bond certificate gets
stolen or misplaced by the bond holder, anyone else with the paper can claim the
bond amount.
8. War Bonds. War Bonds are issued by any government to raise funds in cases of
war.
9. Serial Bonds. Bonds maturing over a period of time in installments.
10. Climate Bonds. Climate Bonds are issued by any government to raise funds when
the country concerned faces any adverse changes in climatic conditions.

BOND VALUATION
 Bond valuation is a technique for determining the theoretical fair value of a
particular bond. Bond valuation includes calculating the present value of a bond's
future interest payments, also known as its cash flow, and the bond's value upon
maturity, also known as its face value or par value. Because a bond's par value
and interest payments are fixed, an investor uses bond valuation to determine
what rate of return is required for a bond investment to be worthwhile.
 Bond valuation is a way to determine the theoretical fair value (or par value) of a
particular bond.
 It involves calculating the present value of a bond's expected future coupon
payments, or cash flow, and the bond's value upon maturity, or face value.
 As a bond's par value and interest payments are set, bond valuation helps
investors figure out what rate of return would make a bond investment worth the
cost.

CHANGES IN BOND VALUES OVER TIME

Bond prices fluctuate with changing market sentiments and economic environments,
but bond prices are affected in a much different way than stocks. The following are some of
the reasons for the change in Bond price/ value over time:

1. The yield is the discount rate of the cash flows. Therefore, a bond's price reflects
the value of the yield left within the bond. The higher the coupon total remaining,
the higher the price.
2. Changes in Interest Rates, Inflation. Changes in interest rates affect bond
prices by influencing the discount rate. Inflation produces higher interest rates,
which in turn requires a higher discount rate, thereby decreasing a bond's price.
 Bonds with a longer maturity see a more drastic lowering in price in this event
because, additionally, these bonds face inflation and interest rate risks over a longer
period of time, increasing the discount rate needed to value the future cash flows.
Meanwhile, falling interest rates cause bond yields to also fall, thereby increasing a
bond's price.
3. Credit Ratings. Bonds are rated by independent credit rating agencies. Bonds with
higher risk and lower credit ratings are considered speculative and come with higher
yields and lower prices. If a credit rating agency lowers a particular bond's rating to
reflect more risk, the bond's yield must increase and its price should drop.

BOND RISKS

Bonds can be a great tool to generate income and are widely considered to be a safe
investment, especially compared with stocks. However, investors should be aware of the
potential pitfalls to holding bonds.

1. Credit risk. The issuer may fail to timely make interest or principal payments
and thus default on its bonds.
2. Interest rate risk. Interest rate changes can affect a bond’s value. If bonds are
held to maturity the investor will receive the face value, plus interest. If sold
before maturity, the bond may be worth more or less than the face value. Rising
interest rates will make newly issued bonds more appealing to investors because
the newer bonds will have a higher rate of interest than older ones. To sell an
older bond with a lower interest rate, you might have to sell it at a discount.
3. Inflation risk. Inflation is a general upward movement in prices. Inflation
reduces purchasing power, which is a risk for investors receiving a fixed rate of
interest.

4. Liquidity risk. This refers to the risk that investors won’t find a market for the
bond, potentially preventing them from buying or selling when they want.
5. Call risk. The possibility that a bond issuer retires a bond before its maturity
date, something an issuer might do if interest rates decline, much like a
homeowner might refinance a mortgage to benefit from lower interest rates.
6. Price risk is the risk that the market price of a bond will fall, usually due to a
rise in the market interest rate. Price risk is the uncertainty associated with
potential changes in the price of an asset caused by changes in interest rate
levels in the economy.
7. Reinvestment risk is the risk that a bond is repaid early, and an investor has to
find a new place to invest with the risk of lower returns. Reinvestment risk is the
risk that a particular investment might be canceled or stopped somehow, and
that one may have to find a new place to invest their money with the risk that
there might not be a similarly attractive investment available.
References:
https://www.investopedia.com/
Interest Rate by CAROLINE BANTON May 17, 2020