CHAPTER 1.

INTRODUCTION TO FINANCIAL SYSTEM AND FINANCIAL MARKET OBJECTIVES

After successful completion of this module, you should be able to:

 Describe the elements of financial systems, particularly the financial market

 Describe the importance of financial market in maximizing firms profit and wealth

 Differentiate the different types of financial markets

NATURE AND IMPORTANCE OF FINANCIAL SYSTEM

Finance

Basically, finance represents money management and the process of acquiring needed

funds. It is the lifeblood of the business for continuity of business operations. Finance

is the application of economic principles to decision making that involves the

allocation of money under conditions of uncertainty. It is how funds are obtained and

then how this will be invested to make money.

There are two functions in a financial management:

1. Accounting – this is the goal of employees to maximize profit for their benefits,

driven my rewards and promotions

2. Finance – the goal is to maximize wealth of the owners. The OWNERS ultimate goal

Is to maximize wealth that is why they enter into the financial markets.
Sources of wealth:

1. Capital assets which may be money to earn interest

2. Capital assets which can be land or building to earn rent

3. Labor/profession in order to earn wages/salaries/fees

Flow of funds:

1. Direct financing – where borrowers/spenders deals directly from lenders thru

financial instruments or securities.

2. Indirect financing – where borrowers and lenders transact thru intermediaries.

ELEMENTS OF FINANCIAL SYSTEM

1. Lenders and borrowers – the players

2. Financial intermediaries – how it will occur

 - Special type of financial entity that acts as the third party to facilitate the

borrowing activities between borrowers and lenders.

3. Financial instruments - what will be used

- Medium of exchange of contractual obligation which can be traded (tangible of

intangible)

- Can be:

 cash or

 derivative (A derivative is a financial security with a value that is reliant upon

or derived from, an underlying asset or group of assets—a benchmark. The

derivative itself is a contract between two or more parties, and the derivative

derives its price from fluctuations in the underlying asset. The most common

underlying assets for derivatives are stocks, bonds, commodities, currencies,

interest rates, and market indexes. These assets are commonly purchased

through brokerages.

4. Financial markets – the place of trading

- Money market for cash financial instruments

- Capital market for derivative financial instruments

5. Regulatory control environment – controller of trading activities

- Involves different businesses and financial risks

- Regulated by the central bank

6. Money creation – the value created

7. Price discovery- how much is created

- It is the process of determining or valuing the financial instrument in the

market. The price is driven by risks, high risk high return, low risk low return.

Financial Market refers to channels or places where funds and financial instruments

such as stocks, bonds and other securities are exchanged between willing individuals

or entities.

TYPES OF FINANCIAL MARKET

Based on instruments traded

a. Money Market – this is the sector of the financial market where financial

instruments that will mature or be redeemed in one year or less from issuance

date are traded.

Why do companies deal with money market?

 Cash requirements of entities do not coincide with their cash receipts

(borrowers)

 Fund providers generates opportunity cost in the form of foregone interests by

investing excess cash in financial instruments that can quickly be converted to

cash when needed with minimal risk (lenders)

b. Capital market – this is the sector in the financial market where financial

instruments issued by government and corporations that will mature beyond

one year from issuance date are traded.

There are two types: (1) equity (share certificate) or (2) debt (PN, bonds)

Based on Market Type

 a. Primary Market – this is the financial market wherein fund demanders like

corporation or government agencies raise funds through new issuances of

financial instruments (bonds or stocks).

Why?

- normally to finance new projects or expansions.

How?

- Coursed thru investment banks as intermediary.

Who?

- Borrowers are fund demanders and lenders are fund providers.

Four types of issue methods

1. Public offering – the issuer offers for subscription or sale to general public

2. Private placement -the issuer looks for single investor to purchase the whole

securities issuance than to general public

3. Auction – this is another offering to general public on treasury bills, bonds and

other securities issued by the govt.

4. Tap issue – this happens when issuer is open to receive bids for their

securities at all times. Issuers maintain the right to accept or reject the bid

prices.

b. Secondary Market – this is where securities issued in the primary market are

subsequently traded (resold and repurchased – second hand).

Who are the players?

- Securities brokers are facilitators

- Sellers are demanders and buyers are funds providers

MODULE 2

PHILIPPINE FINANCIAL SYSTEM

OBJECTIVES

After successful completion of this module, you should be able to:

1. Describe the role of Bangko Sentral ng Pilipinas in the Financial Market

2. Describe the evolution of currency and instruments used in financial markets

3. Set their personal target of inflation based on the information made available to

them

4. Correlate the roles of different agencies in the financial market environment

COURSE MATERIALS

Financial regulation is a type of regulation whereby rules and standards (controls

over the market factors) were set to oversight the ability of the companies to establish

and maintain appropriate level of capital to sustain its operations.

Market Drivers being regulated

1. Competitiveness

2. Market behavior (integrity on companies’ activities and representation)

3. Consistency (information disclosures and policies)

4. Stability (govt mitigate market risks to protect the interests of the clients)

Financial activity regulation is the setting up of standards, control and order on the

financial activities regardless of the source.

Regulatory Bodies

These regulatory bodies correlate each role in the financial environment.

I. Bangko Sentral ng Pilipinas

Its function is to:

1. Liquidity management

2. Currency issues

3. Lender of last resort

4. Financial supervision

5. Management of foreign currency reserves

6. Determination of exchange rate policy

The BSP Law establishes the Bangko Sentral ng Pilipinas (“BSP”), its

organizational setup, responsibilities, corporate authorities, key operational

procedures, and special powers over banks. It then defines the key roles of the BSP,

namely:

(a) as a central monetary authority with the sole power to issue currency and legal

tender and to regulate the supply of money and credit in the system;

(b) as government banker with the power to represent the national government in

all dealings with international financial institutions; and

(c) as a central bank with regulatory and supervisory power over all banks and

financial institutions exercising quasi-banking functions.

To provide the BSP with the reports they need, you need to have detailed

information about your operations and your portfolio. The reports you must submit
 range from your balance sheet to more specific reports like an ageing analysis of

your non-performing loans (NPLs) by economic activity. For many of the required

reports, you must provide detailed classification.

I. Insurance Commission This is mandated by Exec Order 192 s. 2015 to

ensure enforcement of Republic Act 10607 – Insurance Code Its function is

to regulate and supervise the insurance, pre-need and health maintenance

organization industry.

II. Securities and Exchange Commission (SEC) This agency is tasked to

administer oversight on the corporate sector, capital market participants

and securities and investment instruments and promote corporate

governance.

III. IV. Bureau of Investment (BOI) This is the lead agency to promote

investment in country and thereby generate local and foreign investment in

the country. This is an attached agency of the DTI. It provides advisory,

actualization and post services to the investors.

MONETARY POLICY

Monetary policy is the monitoring and control of money supply by a central bank –

this is undertaken by the Bangko Sentral ng Pilipinas in the Philippines. This is used

by the government to be able to control inflation and stabilize currency.

Monetary Policy is considered to be one of the two ways that the government can

influence the economy – the other one being Fiscal Policy (which makes use of

government spending, and taxes).

Monetary Policy is generally the process by which the central bank, or government

controls the supply and availability of money, the cost of money, and the rate of

interest.

Money Supply and Payment System

The financial system is an interrelated financial process which fueled by money.

Money supply is the availability of financial resources for deployment in the financial

system. The monetary demand in the market is managed by BSP. Money will take the

form of the following:

 Cash (coins and bills)

 Demand deposits

 Other financial instruments

Money is expected to be regulated to enable the sovereign to have control to its

economy. For a monetary policy to be appropriate or effective, the BSP must ensure

the following are present:

 Alignment to the target goals

 Access to information

 Responsiveness of the variable set

The BSP under RA 7653 has the sole power to issue currencies. The management of

the note and coins rests with the local banks. The local banks must observe the

following:

 Banks shall classify their cash deposits and sort by series and by

denomination, by being fir or clean notes or dirty or unclean notes.

 Banks should provide securely sealed bags or containers for fit and dirty notes

which should be properly labelled.

  Banks’ deposits shall be packed ins sealed bags or containers in standard

quantity of twenty (20) full bundles per denomination.

 Banks located in the provinces may make direct deposits of currencies to the

nearest BSP regional/branch or shipped to the BSP in Manila if none.

 Coins shall also be sorted as the notes and must be free from adhesive tapes

Purchasing Power

The purchasing power is practically based on the consumer price index. The

Consumer Price Index (CPI) is the weighted average value of the basket of prices of all

commodities representing the market. The degree of movement of the CPI from a

period to another is called inflation rate. There are two types of inflation rate:

Core inflation – used for most of the economic estimates where it excludes in the

equation the movement of the commodities or incidents with very volatile

movements.

Headline inflation – captures the changes of the cost of living based on the

movement of the basket or commodities as a whole.

Payment System

The payment system is a set of interrelated processes of settlement of goods or

services rendered in exchange for a set of instruments that will undergo either a

banking or non-banking procedures. This requires the following:

 Standard methods of transmitting payment messages within the system

 Agreed means of settlement

  Common operating procedures and rules, e.g. admission, fees and operating

MODULE 3.

MANAGING THE CREDIT RISK IN MONEY MARKET

OBJECTIVES

After successful completion of this module, you should be able to:

 Identify the different levels and methods of rating entities

 Make recommendation on the results of liquidity and solvency

 Understand how to improve value of collaterals

COURSE MATERIALS

Credit risk is a business risk that a lender bears when a borrower fails to pay his

obligations.

Credit Information Systems is dedicated to providing the best credit reporting,

appraisal management and lending risk mitigation products with unequaled service.

Credit Information Systems brings Information, Technology, and Compliance together

to serve the customers in this rapidly changing regulatory environment.

In the Philippines, RA No. 9510 was enacted in Oct. 31, 2008 establishing the

credit information system.

CREDIT RATING

This is a driver of the interest rate or risk consideration that affects the confidence

level of the investors.

These are determined by companies that are recognized globally that objectively

assigns or evaluates countries and companies based on the riskiness of doing

business with them.

The riskiness is primarily driven by the ability of the country or company to

manage their liquidity and solvency in the long run. The higher the grade is, the lower

is the default risk.

The following are the three major rating companies:

a). Standard and Poor’s Corporation (S&P) – founded in 1941 by Henry Varnum Poor

to assess credit worthiness of an industry

b). Moody’s Investors Service (Moody) – founded in 1909 is aimed to provide credit

rating on debt securities.

c). Fitch Ratings – founded in 1914 and owned by Hearst, provides credit opinions

based on the credit expectations on certain quantitative and qualitative factors that

drive a company.

Interest Rates

Economic Theories That Affect the Term Structure of Interest Rates

1). Expectation theories > interest rates are driven by the expectation of the lenders or

borrowers in the risks of the market in the future.

- Pure expectation theory based in statistical and current data analysis

- Biased expectation theory – considers other factors that affect the term structure of

the loans as well as the interest rates to be perceived. (biased estimate over the market

behavior in the future).

2). Market segmentation theory > assumes that the driver of the interest rates are the

saving and investment flows.

BSP defines interest rates to be a type of price which will compensate the risk of

allowing the finances to flow into the financial system. For lender – investment return

for borrower – cost of debt

Cost of Debt

Cost of debt refers to the effective rate a company pays on its current debt. It

refers to after-tax cost of debt, but it also means the company's cost of debt before

taking taxes into account. The difference in cost of debt before and after taxes lies in

the fact that interest expenses are deductible.

Cost of debt formula is:

Cost of Debt = Interest Expense (1 – Tax Rate)

Example:

A company named Vin Paul Ltd. took loan of $100,000 from a Bank at the rate of

interest of 8% to issue company bond of $100,000. Based on the loan amount and

rate of interest, interest expense will be $8,000 and the tax rate is 30%.
 Cost of Debt = $8,000(1-30%)

Cost of Debt = $8000(0.7)

Cost of Debt = $5,600

Cost of debt of the company is $5,600.

Risk-free rate of return

The risk-free rate of return is the theoretical rate of return of an investment with

zero risk. The risk-free rate represents the interest an investor would expect from an

absolutely risk-free investment over a specified period of time.

Formula: Rfr = Rf less inflation rate

Example: Mr. A wants to borrow funds from B. The risk free rate is 6% and current

inflation is 2%. It is expected that the inflation is expected to grow at 3%. B finds a

relevant margin of 4% on the loan.

Risk free rate is 6% - 2% = 4%

New nominal risk free rate is 4% + 3% = 7%

Interest rate for the loan will be 7% + 4% = 11%

It’s up for Mr. A to evaluate whether to borrow or source another financing institution

that offers lower interest rate.

Risks

In commerce, risk is a very important factor to consider that may drives the

business up or down. Risks relate to the volatility patterns in the business.

There are risks that are inherent in every financing transaction:

1. Default risk. This arises on the inability to make consistent payments. This type of

risk may be quantified by determining the probability of the borrower to default in

their payments in the duration of the loan.

2. Liquidity risk. This risk focuses on the entire liquidity of the company or its ability

to service its current portion of their debt as it becomes due.

3. Legal risk. This risk will arise only upon the ability of any of the parties (lender or

borrower) to comply with the covenants in the contract.

4. Market risk. Market risk is the impact of the market drivers to the ability of the

borrowers to settle the obligation. This is classified as a systematic risk because it

arises from external forces or based on the movement of the industry.

Mitigating the Interest Rate

Risks Since the interest rate is dependent on the inflation, tenor and other market

risks, companies should consider and make reasonable estimat4s to mitigate these

risks.

Some measures to mitigate risks maybe considered:

1. Spot rates. This is an interest rate that is available or applicable for a particular

time. Spot rate maybe used to mitigate the risk by referring to historical yield vis-à-vis

the forces that occur in those times.

2. Forward rates. These are normally contracted rates that fixed the rates and allow

the party to assume such risk on the difference between the contracted rate and the

spot rate.

3. Swap rate. This is another contract rate where a fixed rate exchanges for a certain

market rate at a certain maturity.

Basis Points (BPS)

In finance, Basis Points (BPS) are a unit of measurement equal to 1/100th of 1

percent. BPS are used for measuring interest rates, the yield of a fixed-income

security, and other percentages or rates used in finance.

This metric is commonly used for loans and bonds to signify percentage changes

or yield spreads in financial instruments, especially when the difference in material

interest rates is less than one percent per year.

One basis point is equal to .01 percent or 1/100th of 1 percent. The succeeding

points move up gradually to 100%, which equals 10000 basis points, as illustrated in

the diagram below.

Percentage Basis Points

0.01% 1

0.1% 10

0.5% 50
 1% 100

10% 1000

100% 10000

Examples:

 The difference between bond interest rates of 9.85 percent and 9.35 percent is 0.5

percent, equivalent to 50 basis points.

 The Federal Reserve boosts the interest rates at 100 BPS, signaling an increase from

10 percent to 11 percent.

 Due to the growth of iPhone sales, Apple Inc. reported high earnings, more than

what was estimated; the stock increased 330 BPS, or 3.3 percent, in one day

Why do investors and analysts use BPS?

The main reasons investor use BPS points are:

1. To describe incremental interest rate changes for securities and interest rate

reporting.

2. To avoid ambiguity and confusion when discussing relative and absolute interest

rates, especially when the rate difference is less than 1 percent, but the amount has

material importance to discuss.

For example, when discussing an interest rate that has increased from 11% to

12%, some may use the absolute method stating there is a 1% increase in the interest
rate, while some may use the relative method stating a 9.09% increase in in the

interest rate. Using basis points eliminates this confusion by stating that there is an

increase in the interest rate by 100 basis points.

What instruments do BPS apply to?

The usage of basis points is primarily applied to yields and interest rates, but they

may also apply to the change in the value of an asset, such as, the percentage changes

of stock values.

Other examples are:

 Treasury bonds

 Corporate bonds

 Interest rate derivatives

 Credit derivatives

 Equity securities such as common stock

 Debt securities such as mortgage loans

 Options, futures

Managing Solvency and Liquidity

 Liquidity is often a more involved strategy than solvency due to it being a short-

term measurement of business. Managing risk associated with liquidity is a necessary

component of a broader business-wide risk management system that should be in

place to help maintain operations.

Assessing prospective funding needs and ensuring enough money is available at

the right times to handle debt helps keep risk low. Because liquidity is associated with

the short term, regular tasks that can be done to manage risk include:

1. Monitoring and assessing current and future debt obligations

2. Planning for unexpected funding needs

3. Addressing daily liquidity obligations

4. Preparing to withstand any periods of liquidity stress

Ratios that are used to measure Solvency and Liquidity:

1. Current Ratio. The current ratio expresses the capability of current assets to cover

its current liabilities without resorting to selling long-term assets to cover its

current obligations.

Formula: Current Ratio = Current Assets/Current Liabilities

2. Quick Ratio. Higher liquidity ratio using quick assets should reveal a very liquid

company in terms of financial health. It should show that a business have more funds

to be used for other purposes.

Formula: Quick Ratio = Current Assets less Inventories & Prepayments Current

Liabilities
3. Debt Ratio. This ratio measures the business total liabilities as a percentage of its

total assets. It is the business ability to pay its liabilities with its existing assets; which

means that when a business sells all its assets, this ratio will determine whether all

liabilities can be paid off or not. The higher the ratio, the riskier the business is for the

lenders.

Formula: Debt Ratio = Total Liabilities /Total Assets

A lower ratio implies for a very favorable climate for the business as it means a

longer period of existence. Most businesses have benchmarks for this ratio but a ratio

of 0.5 is reasonable as it is considered less risky. It means that the business has twice

amount of assets than its liabilities.

4. Debt to Equity Ratio. This ratio compares a business total debt total equity. A

higher debt to equity ratio means that the financing aspect of the business comes from

creditors than from its owners.

A lower debt to equity ratio means the other way around. In a debt to equity ratio

of 0.5, this means that the business assets are funded by 2 to 1 by owners to

creditors. In simple terms, the owners owned the assets of the business by 2/3 while

creditors owned the assets by 1/3.

Formula: Debt to Equity Ratio = Total Liabilities/Total Equity

Collateral Valuation Methods

Collaterals are normally required by financial institutions when acquiring large

loans – the higher their value are, the bigger a loan can be with minimal interest rate.
The following are the most common valuation methods used:

a. Cost approach. The value of an asset can be determined by the cost to replace

or reproduce it. Under this approach is the appraisers factor in functional and

operational obsolescence.

When valuing investments in private company stock using this approach, an

appraiser would subtract liabilities from the combined fair market values of the

company’s assets.

b. Market approach. An asset is worth as much as other assets with similar utility

in the marketplace under this approach.

With investments in private company stock, for example, an appraiser might look

at recent transactions involving other companies in the same industry and compute

pricing multiples from those comparables.

c. Income approach Investors pay for the expected cash they’ll receive every year

from an asset and when the asset is eventually sold (or salvaged) in the future. Often

appraisers “discount” future earnings based on the asset’s risk, using a discounted

cash flow analysis.

Appraisers always consider all three approaches, but one or two may be more

relevant than the rest. For example, the cost and market approaches might be more

relevant when valuing vacant land. Conversely, the market and income approaches

might be more relevant when valuing a rental property with an established rent roll.

MODULE 4.
 FINANCIAL INSTRUMENTS

OBJECTIVES

After successful completion of this module, you should be able to:

 Describe the different financial instrument

 Identify the limitations or risk in using each financial instrument

 Describe how financial instruments are valued and treated in financial reports

COURSE MATERIALS

Financial instruments are monetary contracts between parties. ...

International Accounting Standards IAS 32 and 39 define a financial instrument as

"any contract that gives rise to a financial asset of one entity and a financial liability or

equity instrument of another entity".

Financial instruments or assets or securities are intangible as future economic

benefits takes a claim in the form of cash that will be received in the future.

Two parties involved: the issuer and the investor

Issuer is the party that issues the financial instruments and promises to make

future cash payments to the investor. Normally, issuer has requirements for the

business when issuing financial liabilities/obligations.

Investor is the party who owns the financial instruments issued by the

borrower which bears the promise to pay for the principal + interests. This is normally

traded in the financial market by investors to persons willing to pay for the proceeds

and willing to take (inherent) risks.

MONEY MARKET

In the money market, financial instruments are traded and not cash/currency
- Short term and highly liquid

- Sold in large denominations

- Low default risk and matures within one year or less

- Classified in the financial statements as cash equivalents (redeemable within three

months or less from the date of purchase)

TYPES OF FINANCIAL INSTRUMENTS

Money market instruments took the form of short-term deposits, government

securities, commercial papers and certificates of deposit which form part of the

Philippine interest rate market.

Treasury Bills

- Government securities issued by the Bureau of Treasury which mature in less than a

year

- Three tenors: 91-day, 182-day and 364-day (# of days is a universal practice

ensuring that the bills mature in a business day)

- Quoted either by their yield date (a discount) or by their price based on 100 points

per unit.

- T-bills which will mature in less that 91-day are called Cash management Bills (35

day or 42 day)

- Banks bid for the t-bills held by the Bureau of Treasury and resell these to investors.

- Have zero default risk (safest investment instrument) since the government can

always print more money that they can use to redeem these securities at maturity.

- Can be traded easily in the secondary market.

- Interest not stated but sold at a discount (lower purchase price than the maturity

value

Repurchase Agreement

What Is a Repurchase Agreement?

A repurchase agreement (repo) is a form of short-term borrowing for dealers in

government securities. In the case of a repo, a dealer sells government securities to

investors, usually on an overnight basis, and buys them back the following day.

For the party selling the security and agreeing to repurchase it in the future, it is a

repo; for the party on the other end of the transaction, buying the security and

agreeing to sell in the future, it is a reverse repurchase agreement.

Repos are typically used to raise short-term capital.

Think of a repurchase agreement as a loan with securities as collateral. For

example, a bank sells bonds (collateral) to another bank and agrees to buy the bonds

back later at a higher price

Negotiable Certificates of Deposits

These are securities issued by banks which record a deposit made indicating

the interest rate and the maturity date. This can’t be easily withdrawn since this is

different from a demand deposit. The CD restricts the holder from withdrawing the

fund until maturity date for a promise of high return than a regular demand deposit.

Commercial Paper

- Unsecured promissory notes that are only issued by large and credit worthy

enterprises
- Maturity can be short-term or long term

- Directly issued to the buyer, no secondary market

- Issuers maintain credit lines with banks to back-up the commercial papers when it

falls due and no funds are available to pay for the lenders (reduces the risk).

- May have stated interest rate or sold at discounted basis

Banker’s Acceptance

This refers to an order to pay a specified amount of money to the bearer on a

specified date. This is often used to finance the purchase of goods that have yet to be

delivered to the buyer. This type of instrument is used by importers and exporters of

goods where buyer and seller have no established credit with each other. This is

directly payable to the buyer.

EVALUATING MONEY MARKET SECURITIES

In evaluating money market securities, interest and tenor of the securities

before maturity are the large factors to consider. As the interest increases, the value

of the securities reduces.

As a finance person, one must have to understand which money market to

invest on which can be evaluated based on the interest rates and liquidity. Interest

rates dictate the potential return that can be received from an investment. Interest

rate on money market is relatively low as a result the low risks associated with them

and the short maturity period.

Money market securities have a deep market so that these are competitively

priced; they carry the same risks profile and attributes making each instrument a

close substitute for each other.

VALUATION ON MONEY MARKET SECURITIES

Valuation of money market securities is important to determine at what

amount an investor is willing to pay in exchange of a security. This can be valued

using the present value approach where the interest rate used in the valuation shall

reflect the required return from the instrument based on the investors’ perceived risk.

The formula for present value is:

PV = CF/(1+r)ⁿ

Where: CF = cashflow in future period

r = the periodic rate of return or interest (also called the discount rate or the required

rate of return)

n = number of periods

Let's have an example.

Assume that you would like to put money in an account today so that you have

enough money in 10 years. If you would like to invest P10,000 in 10 years, and you

know you can get 5% interest per year from a savings account during that time, how

much should you put in the account now?

To compute:

PV = P10,000/ (1 + .05)¹⁰ = P6,139.13

a. On ordinary calculator, you divide P10,000 by 1.05 then press equals (=) ten times.

b. Using the PV table, locate the period of 10 years, then rate of 5%. Using the

equivalent factor, multiply it to the P10,000 amount.

 Hence, P6,139.13 will be worth P10,000 in 10 years if you can earn 5% each year.

In other words, the present value of P10,000 in this scenario is P6,139.13. It is

important to note that the three most influential components of present value are

time, expected rate of return, and the size of the future cash flow.

Why Does Present Value (PV) Matter?

The concept of present value is one of the most fundamental and prevalent

in the world of finance. It is the basis bond pricing, stock pricing financial modeling,

banking, insurance, and pension fund valuation. It accounts that money we receive

today can be invested to earn a return. Present value accounts for the time value of

money.
MODULE 5.

DEBT SECURITIES MARKET

OBJECTIVES

After successful completion of this module, you should be able to:

 Identify different types of bonds

 Select the bond or debt security investments that will yield higher value

COURSE MATERIALS

Debt market or debt securities market is the financial market where the debt

instruments or securities are transacted by suppliers and demanders of funds.

This is the:

- Money market for short term debts

- Capital market for long term debts, like equity in the stock market

DEBT INSTRUMENTS

What are debt instruments?

 A paper or electronic obligation that enables the issuer to raise funds by promising

to repay lender in accordance to terms of the contract

 Provide a way to market participants to easily transfer the ownership of debt

obligations from one party to another.

 A legally enforceable evidence of a financial debt, and the promise to timely repay

the principal and interest.

Importance of Debt Instruments

1. It makes the repayment of the debt instrument legally enforceable

2. It increases transferability of the obligation by way of increased liquidity and a

means to trade this in the financial market.

Types of Debt Instruments

a. Short-term debt instruments – obligations both personal and corporate that are

paid within one year. Examples are: credit card bills, payday loans, car title loans,

consumer loans, revolving credit lines, treasury bills

b. Long term debt instruments – obligations due for payment for over a year through

periodic installment payments. Examples are: mortgage, car loans

DEBT SECURITY

What is a debt security?

 refers to a debt instrument that has defined basic terms and can be bought or sold

between two parties.

 Also known as fixed-income securities that are traded over the counter

 Interest rate is largely determined by the perceived repayment ability of the

borrower.

 The total dollar value of traded debt securities that are conducted daily is much

larger than the traded stocks.

Examples are: collateralized securities, collateralized debt obligations (CDO),

collateralized mortgage obligations (CMO), mortgage backed securities issued by the

Government National Mortgage Association, zero-coupon rate.

Basic terms of a debt security

- Notional (estimated/theoretical) amount or amount borrowed

- Interest rate

- Maturity and renewal date

Types of debt securities

1. Money market debt securities – debt securities with maturities of less than one

year like treasury bills and certificate of deposits

2. Capital debt securities – debt securities with maturities of more than one year

like notes, bonds and mortgage backed securities

Debt Security vs Debt Instrument

What is the difference between debt security and debt instrument?

Debt security

 refers to money borrowed that must be repaid and has a fixed amount, a

maturity date and interest rate.

 Can be bought or sold between two parties

 Some are discounted in the original market price.

 Examples are treasury bills, bonds, preferred stock and commercial paper
Debt instrument

 Can be paper or electronic form; a tool that an entity can utilize to raise capital

 Gives market participants the option to transfer the ownership of the debt

obligation from one party to another

 Primary focuses on debt capital raised by institutional entities.

 Examples are bonds, debentures (unsecured loans), leases, certificates, bills of

exchange and promissory notes, credit cards, loans, credit lines

A bond is a typical example of a debt instrument as it is an instrument of

indebtedness of the bond issuer to the holders. It is also a debt security, under which

the issuer owes the holders a debt and is obliged to pay them interest (the coupon) or

to repay the principal at maturity date.

Debt securities have implicit level of safety because they ensure that the principal

amount is returned to the lender at maturity date or upon the sale of the security.

They are classified by their level of default risk, the type of issuer and income payment

cycles. The riskier the bond, the higher is its interest rate or return yield.

Types of bonds

1. Corporate bonds – these are bonds issued by corporations to finance operations

or expansions.
 2. Government bonds – these are bonds issued by government that provides the

face value on the agreed maturity date with periodic interest payments. This type of

bond attracts conservative investors.

3. Municipal bonds- these are bonds issued by the local government and their

agencies purposely to fund special projects.

4. Mortgage bonds – these are pooled mortgages on real estate properties which are

locked in by the pledge of particular assets. Payments may be monthly, quarterly or

semiannually.

5. Asset-backed bonds (Asset-backed Securities ABS) – this is a financial security

collateralized by pool of assets such as loans, leases, credit card debt, royalties or

receivables.

6. Collateralized Debt Obligation (CDO) - this is a structured financial product that

pools together cash flow generating assets and repackages this asset pool into

discrete tranches (which vary substantially in their risk profile) that can be sold to

investors. Like the senior tranches are generally safer because they have first

priority on payback from the collateral in the event of default.

Characteristics of Bond

 Coupon rate – this is the fixed interest rate or return of the bond which is paid to

the bondholders semi-annually.

 Maturity date – this is the period when the bond issuer pays the investor at full-

faced value of the bond. This may be short-term or long-term.

 Current or market price – bonds can be purchased at par, below par or above par.

The market price depends on the level of interest rate in the market.
Bond Valuation

This is a technique in determining the theoretical fair value of a bond. Bond

valuation includes calculating the present value of the bond’s future interest

payments, also known as its cash flows, and the bond’s value upon maturity, also

known as the face value or par value.

Approach in Bond Valuation

a. Traditional approach – where valuation is to discount every cash flow of a bond

by the same interest rate or discount rate for each period.

b. Arbitrage Free Valuation approach – this value the bond as a package of cash

flows, with each cash flow viewed as a zero-coupon bond and each cash flow

discounted at its unique discount rate.

Valuation of bonds with embedded options

There are two models:

a. The lattice model which is used to value callable bonds and putable bonds

b. The Monte Carlo simulation model which is used to value mortgage-backed

securities and certain types of asset-backed securities.