BALIUAG UNIVERSITY

College of Business Administration and Accountancy

APC 8: Valuation Concepts and Methods
2nd Trimester AY 2020 – 2021
Luisito V. Correa Jr. CPA, CAT, MBA

Lesson 1: Financial Instruments and Markets LVC

I. Overview of Financial Instruments and Markets

✓ Financial Markets
• Financial markets consist of exchanges where buyers and sellers of financial instruments are
brought together to execute transactions. The exchanges may be physical locations, such as
trading floors where auctions take place; or they may be electronic exchanges that exist in
cyberspace.

✓ Types of Financial Markets

• Financial markets are diverse. They include stock exchanges such as the New York Stock Exchange,
corporate bond markets, government securities markets, money markets, the federal funds market
(which is open only to banks), over-the-counter (OTC) markets, foreign exchange markets, and
derivatives (futures and options) exchanges.

A. Capital markets refers to markets where long-term debt and equity instruments are traded. These
include stock market and bond market.

B. Money markets refers to markets where short-term debt instruments with maturities of less than one
year are traded.

C. Financial intermediaries such as commercial banks or mortgage companies facilitate transactions in

financial markets. Other financial intermediaries include thrift institutions, pension funds, mutual
funds, insurance companies, credit unions, and investment banks.

D. Primary markets – markets where either securities from initial public offering or a subsequent
offering are first issued through investment bank. They facilitate the issuance of new securities. The
issuer of the security receives the proceeds of the sale, less fees that go to the investment banker.

E. Secondary markets – markets where issued securities are traded after the initial issue of securities.
Secondary markets can be auction markets, dealer markets, or electronic communications networks.

F. Stock Market and Securities Exchanges

• Physical Exchanges – physical location where buyers and sellers of stocks come together. They
uses designated market makers (DMMs) to accomplish stock trades. The designated market
makers have replaced the “specialists” formerly used.

• A market maker in general is a firm (or an individual) that holds securities in its own inventory
and posts both bid and offer prices on them. When an investor wants to sell a security, the
market maker buys it from the investor at the bid price. When an investor wants to buy a security,
the market maker sells the security to the investor at the offer price, which is higher than the bid
price.

• A designated market maker serves as a market maker for specific securities. The DMM oversees
the trading in its assigned securities. It maintains quotes on the bid and offer prices for those
specific securities for which it serves as designated market maker. It operates both manually and
electronically, managing a physical auction and providing algorithmic (computerized) quotes to
the automated auction. The designated market maker is the only market participant that has an
obligation to buy and sell for its own inventory in order to maintain fair and orderly markets for its
assigned securities.

• Other major market participants

- Floor brokers represent clients on the exchange floor. They do not trade for their own
accounts the way market makers do. A floor broker’s clients are institutional clients such as
broker-dealers, banks, mutual funds, and pension funds, as well as day traders and some high

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net worth individual investors. The floor broker earns a commission on each trade he or she
executes for a client.
- Supplemental liquidity providers (SLPs) were introduced to the NYSE in 2008. The SLP
program was initially a pilot program intended to last for 6 months but it has been renewed
multiple times and expanded. Supplemental liquidity providers are exchange member
organizations that are each assigned a group of listed securities and use computerized trading
in those securities to create high volumes of trading on the exchange. The purpose of these
high trading volumes is to add liquidity to the market (to ensure that anyone who wants to
sell can sell and anyone who wants to buy can buy). SLPs are not located on the trading floor.
They are upstairs and connected electronically to the markets.
- Electronic Exchanges. The NASDAQ (National Association of Securities Dealers Automated
Quotations) is an electronic stock exchange without a physical location. The NASDAQ is an
electronic network operated by the National Association of Securities Dealers. The NASDAQ is
capable of executing trades in stocks that are listed on other exchanges as well as in NASDAQ
listed stocks.
- Electronic Communications Networks (ECNs) are automated stock trading systems that are
separate from stock exchanges, though they may be owned by major stock exchanges. ECNs
act as passive order matching systems. They do not utilize market makers but simply match
buy and sell orders that have the same prices for the same number of shares.

G. Bond and Fixed Income Securities Markets

• Bonds may be of many different types. Bonds are medium to long-term negotiable debt securities
that have been issued by governments, government agencies, states or other government bodies,
international organizations such as the World Bank, and companies. Most (though not all) bonds
are fixed-income securities, meaning they have a set interest rate and they pay interest based on
that rate regularly, and they repay principal at maturity. The term negotiable means they can be
traded in the secondary market after issuance without any reference to the issuer. After issuance,
they are traded in the secondary bond markets.
• The bond market is a virtual network consisting primarily of dealers. A dealer is a firm that buys
and sells securities for its own account. In other words, if an investor wants to buy a bond, the
seller of the bond will be a dealer; and if an investor wants to sell a bond, the buyer of the bond
will be a dealer. A bond dealer will make a market in particular bonds, meaning the dealer is
prepared to quote a price to buy or sell those specific issues of bonds. The dealers making a
market in specific bonds provide liquidity for investors who want to buy or sell those bonds
• As with stocks, when an investor wants to sell a bond, the dealer/market maker buys it from the
investor at the bid price. When an investor wants to buy a bond, the dealer/market maker sells
the security to the investor at the offer price, which is higher than the bid price.
• The various bond dealers are connected electronically to enable trades in bond issues in which
they do not make a market. Software through which investors and dealers can buy and sell bonds
or other securities is called a trading platform. Many brokers have bond trading platforms for
their clients to use.

H. Government Securities Markets

• Government securities are initially issued in government auctions. Short-term Treasury bills are
auctioned every Monday, while longer-term bills, notes and bonds are auctioned at intervals as
necessary. Treasury bills are discounted, which means they are purchased at a discount to their
face value, and on their maturity date, the government pays the face value. The difference is
interest income and it is not received until the maturity date.
• Treasury Notes and Treasury Bonds are longer-term securities. T-notes have maturities of from 1-
10 years, while T-bonds mature in 10 to 30 or 40 years from their original issue date. Both
Treasury notes and Treasury bonds pay a stated rate of interest semi-annually and are redeemed
at their face value at maturity.

I. Over the Counter (OTC) Markets

• Over-the-counter (OTC) markets are dealer markets where transactions are completed by
computer or over the telephone. They are decentralized markets without any physical location.
Dealers act as market makers and quote the prices at which they will buy and sell an investment
or a currency. Trades can be executed in the over-the-counter market without other market
participants knowing the price, making OTC markets less transparent than exchanges where
prices are published.

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Lesson 1: Financial Instruments and Markets LVC
• Over-the-counter markets are used primarily for bonds, Government securities, money market
instruments, very small company stocks, and derivatives. They include both a customer market,
where dealers trade with investors, and an interdealer market, where dealers trade with one
another.

J. Money Markets
• The money market is a subset of the fixed income market. Money market instruments, though,
have very short maturities (less than one year), whereas fixed income securities are considered to
be medium and long-term (longer than one-year maturities). Money market instruments are
short-term borrowings by governments, financial institutions, and large corporations.
• Money market instruments are usually traded in high denominations. Individual investors can
gain access to the money market through money market mutual funds, where the assets of
investors are pooled and the securities are bought on their behalf by the fund.
• Like the bond market, the money market is a dealer market, with dealer firms buying and selling
securities in their own accounts and making money on the spread when they sell them. Deals are
transacted over the telephone or through electronic networks.
• Money market securities include negotiable short-term securities such as Treasury bills,
commercial paper, bankers’ acceptances, negotiable CDs and repurchase agreements.

K. Derivatives Markets
• Though derivatives are not a source of capital for a company, no discussion of markets would be
complete without at least mentioning the derivatives markets. Derivatives include futures and
options.
• Futures and options based on interest rates, equity indexes, foreign exchange, energy, precious
metals, agricultural commodities, and even the weather are traded on the four exchanges. A few
trades are still accomplished by means of open outcry auction on the trading floors, but
approximately 80% of the trades are now made electronically.
• The exchanges guarantee each trade, ultimately acting as the seller to every buyer and the buyer
to every seller. Trades are accomplished through a group of member firms called clearing
members, who include some of the largest and best capitalized names in the banking and
financial services industries.
• Market participants must post deposits called margin through these clearing members. The
margin requirement assures the exchange that the participants have sufficient funds to handle
losses they may experience in the market. As soon as anyone buys or sells a futures contract, they
must deposit with their clearing member an amount of money that the exchange determines is
sufficient to cover any one-day price move. As long as that person or firm holds on to the
contract, the contract holder must maintain minimum margin funds for that position and deposit
additional funds whenever the market moves against him.

II. Financial Instruments

✓ Classification of financial instruments/securities

1. Debt securities - fixed-income securities which represent money that is borrowed and must be repaid
with terms outlining the amount of the borrowed funds, interest rate, and maturity date. In other
words, debt securities are debt instruments, such as bonds (e.g., a government or municipal bond) or
a certificate of deposit (CD) that can be traded between parties.
2. Equity securities – May be variable income securities (i.e., common stocks) or fixed-income (i.e.,
preferred stocks). These represent ownership interest held by shareholders in a company. In other
words, it is an investment in an organization’s equity stock to become a shareholder of the
organization. The difference between holders of equity securities and holders of debt securities is that
the former is not entitled to a regular payment, but they can profit from capital gains by selling the
stocks. Another difference is that equity securities provide ownership rights to the holder so that he
becomes one of the owners of the company, owning a stake proportionate to the number of acquired
shares.
3. Hybrid securities - A broad group of securities that combine the characteristics of the two broader
groups of securities, debt and equity. Hybrid securities pay a predictable (fixed or floating) rate of
return or dividend until a certain date, at which point the holder has a number of options, including
converting the securities into the underlying share.
4. Derivative instruments – Instruments whose value changes in relation to changes in a variable, such
as an interest rate, commodity price, credit rating, or foreign exchange rate. It requires either a small

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or no initial investment, and is settled at a future date. A derivative allows an entity to speculate on or
hedge against future changes in market factors at minimal initial cost.

✓ Short-term debt securities

Type Description
Treasury bills Short-term debt securities issued by the government. They do not have
stated interest rate but are sold by the government at a discounted amount
and redeemed at maturity at face or par value.
Treasury notes* Long-term debt securities issued by the government. Similar to its short-
term counterparts, it is issued by the Philippine Government through the
Bureau of the Treasury.
Certificate of deposits Savings deposits with a bank that may not be withdrawn before their
maturity without a high penalty. Usually have a higher rate of interest when
compared with other savings instruments because they are for fixed,
usually long-term periods.
Commercial papers Unsecured short-term debt securities issued to the public by large
creditworthy corporations.
Banker acceptance Drafts (or checks) drawn on a bank for payment when presented to the
bank. Generally arise from payments for goods by corporations in foreign
countries. Because the bank is writing and guaranteeing the check, the
check carries less risk than a corporate or personal check.
Money market accounts
Similar to savings accounts, individual or business investors deposit idle
funds in the accounts and the funds are used to invest in higher-yielding
bank certificate of deposits (CDs), commercial papers, etc. They pay
higher interest rates than ordinary savings accounts but less than on
CDs.
Money market mutual Shares in a fund that purchases higher-yielding bank CDs, commercial
funds paper, and other large-denomination, higher-yielding securities. Each
investor owns a portion of the mutual fund. These allow many more
investors access to more of the money market instruments.
Repurchase agreements Sales of governmental securities by a dealer who also has agreed to
repurchase them at a specific time in the future at a specific price.

✓ Bonds
A. Classification of bonds based on their security provisions:
Type Description
Mortgage bond A bond secured with the pledge of specific property. The securing property
is typically property or plant assets
Collateral trust bond A bond secured by financial assets of the firm.
Debenture bond A bond that is not secured by the pledge of specific property. It is a general
obligation of the firm.
Subordinated A bond with claims subordinated to other general creditors in the event of
debenture bankruptcy of the firm. That is, the bondholders receive distributions only
after general creditors and senior debt holders have been paid. As you would
expect, subordinated debentures have higher yields than senior unsecured
debt.
Income Bond A bond with interest payments that are contingent on the firm’s earnings.
Obviously, these bonds also have a high degree of risk and carry even higher
yields.

B. Classification of bonds based on their methods of payment:

Type Description
Term bonds Bonds paid in single maturity.
Serial bonds Bonds paid off in installments over the life of the issue. May be desirable to
bondholders because they can choose their maturity date.

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Type Description
Bonds with sinking The firm makes payments into a sinking fund which is used to retire bonds
fund provisions by purchase.
Convertible bonds The bonds may be convertible into common stock and this may provide the
method of payment.
Redeemable bond A bondholder may have the right to redeem the bonds for cash under certain
circumstances (e.g., if the firm is acquired by another firm).
Callable bond The bonds may have a call provision allowing the firm to force the
bondholders to redeem the bonds before maturity.

C. Bonds issued by government

Type Description
Treasury notes Issued by the national government
Municipal bonds Issued by the local government (Not applicable in the Philippines)

D. Other types on bonds:

Type Description
Zero-coupon rate These types of bonds do not pay interest. Instead they sell at a deep discount
bonds from the face or maturity value. The return to the investor is the difference
between the cost and the bond’s maturity value.
Floating rate bonds The rate of interest paid on this type of bond floats with changes in the
market rate (usually monthly or quarterly). Therefore the market price of the
bond does not fluctuate as widely. Reverse floaters are floating rate bonds
that pay a higher rate of interest when other interest rates fall and a lower
rate when other rates rise. Reverse floaters are riskier than normal bonds.
Registered bonds These bonds are registered in the name of the bondholder. Interest
payments are sent directly to the registered owners.
Junk bonds These bonds carry very high-risk premiums. They often have resulted from
leveraged buyouts or are issued by large firms that are in troubled
circumstances. They may appeal to investors who feel they can diversify the
risk by purchasing a portfolio of the bonds in different industries.
Foreign bonds These bonds are international bonds that are denominated in the currency
of the nation in which they are sold.

✓ Equity securities
Type
Common stock/
Ordinary share
Preferred stocks/
Preference share
Description
The ultimate owners of the firm are the common shareholders. They
generally have control of the business and are entitled to a residual claim to
income of the firm after the creditors and preferred shareholders are paid.
Common stock ownership involves a higher degree of risk compared with
preferred stock and has higher cost of capital than the latter. The investor is
the last in line to receive earnings and distributions upon liquidation of the
firm. On the other hand, common stockholders have the potential
opportunity to receive very high returns. The return of the common
stockholder includes dividends and appreciation in the value of the stock.
Stock warrants are sometimes issued with bonds to increase their
marketability. A stock warrant is an option to buy common stock at a fixed
price for some period of time. Once the bond is sold, the stock warrants often
may be sold separately and are traded on the market.
Preferred shareholders are entitled to receive a stipulated dividend and,
generally, must receive the stipulated amount before the payment of
dividends to common shareholders (preferred as to dividends). In addition
preferred stockholders have a priority over common stockholders in the
event of liquidation of the firm (preferred as to assets).

✓ Classes of preference shares

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Type Description
Cumulative preference Most issues are cumulative preferred stock and have a cumulative claim to
shares dividends. That is, if dividends are not declared in a particular year, the
amount becomes in arrears and the amount must be paid in addition to
current dividends before common shareholders can receive a dividend.
Participating preference It gives the holder the right to receive dividends equal to the customarily
shares specified rate of preferred dividends as well as an additional dividends.
Redeemable preference Some preferred stock is redeemable at a specified date or redeemable at the
shares option of the holder. This makes the stock very similar to debt. Per PFRS 9,
redeemable preference shares are presented in the statement of financial
position as a financial liability.
Convertible preference Preferred stock may be convertible into common stock.
shares
Callable preference Can be called in at the option of the issuing corporation.
shares
Preference shares with A small percentage of preferred shares have a floating rather than fixed
floating rate dividend rate.

✓ Hybrid securities
a. Convertible bonds
b. Convertible preference shares

✓ Derivative instruments
Type Description
Futures contracts Represent agreement between two parties for the purchase and delivery of
an asset at an agreed upon price at a future date. Futures trade on an
exchange, and the contracts are standardized. Traders will use a futures
contract to hedge their risk or speculate on the price of an underlying asset.
The parties involved in the futures transaction are obligated to fulfill a
commitment to buy or sell the underlying asset.
Forward contracts Similar to futures, but do not trade on an exchange, only over-the-counter.
When a forward contract is created, the buyer and seller may have customized
the terms, size and settlement process for the derivative. As OTC products,
forward contracts carry a greater degree of counterparty risk for both buyers
and sellers.
Options contract Are similar to a futures contract, as it involves the purchase or sale of an asset
between two parties at a predetermined date in the future for a specific price.
The key difference between the two types of contracts is that, with an option,
the buyer is not required to complete the action of buying or selling.
Swaps Involve the exchange of one kind of cash flow with another. For example, an
interest rate swap enables a trader to switch to a variable interest rate loan
from a fixed interest rate loan, or vice versa.

References:
Corporate Finance Institute. (n.d.). Types of Security. https://corporatefinanceinstitute.com/resources
/knowledge/trading-investing/types-of-security/

Hock, B., & Roden, L. (2014). CMA Preparatory Program Part 2 Volume 1: Financial Decision Making (6th ed.). Hock
International, LLC.

Whittington, R. O. (2013). CPA Exam Review: Business Environment and Concepts. John Wiley& Sons, Inc.

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