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BAP 4 Capital Market L1-3
BAP 4 Capital Market L1-3
BAP 4 Capital Market L1-3
HANDOUT 1
ROLE OF FINANCIAL MARKET AND INSTITUTIONS AND THE CAPITAL MARKET
Financial Markets
-Financial Markets are structures through which funds flow. They are the institutions and systems that
-Financial Claims entitles a creditor to receive payment from a debtor in circumstances specified in a
-Financial Instruments are monetary contracts between parties. They can be created, traded, modified
and settled. They can be cash, evidence of an ownership interest in an entity or a contractual right to
receive or deliver in the form of currency; debt; equity; or derivatives.
Financial Markets are the meeting place for those with excess funds, it may be
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. Different Financial
Markets serve different types of customers. Financial Markets also vary depending on the maturity of
the securities being traded and the types of assets used to back the securities. For these reasons, it is
useful to classify markets along the following dimensions:
✓ Primary Markets – it is where a capital is actually raised by the company, selling stocks directly to the
investors, typically through an Initial Public Offering.
Initial Public Offering (IPO) - When a private company first sells shares of stock to the public, this
process is known as an initial public offering (IPO). In essence, an IPO means that a company's ownership
is transitioning from private ownership to public ownership. For that reason, the IPO process is
sometimes referred to as "going public."
✓ Secondary Markets – it is where securities can be bought and sold after they have been issued to the
public in the Primary Market.
✓ Money Markets – are for short term, because the assets that are bought and sold are short term—
with maturities ranging from a day to a year—and normally are easily convertible into cash.
✓ Capital Markets – are for intermediate or for long term, because bring buyers and sellers together to
trade stocks, bonds, currencies, and other financial assets. Capital markets include the stock market and
the bond market.
✓ Physical Asset Market - also known as tangible assets, refer to things that may be liquidated in the
event of default in order to pay off debts.
✓ Financial Asset Market - is a liquid asset that represents—and derives value from—a claim of
ownership of an entity or contractual rights to future payments from an entity.
Everywhere around the world, financial markets operate around six (6) main role and functions:
• Facilitating Savings - financial markets provide a means for people to transfer their money power from
the present to the future. For example, you can put aside some money for savings or invest in bonds and
shares to earn future interest.
• Providing Loans - in the capital market, corporations or the government can issue loans and bonds in
exchange for public money. Bonds, in the case of a corporation, are loans made by an investor to a
business in need of cash for operations and growth.
• Allocating Capital to more Productive Use - people can invest their extra cash in a business function to
collect interests instead of sitting idle in a bank account.
• Facilitating Transactions - financial markets provide a way for buyers and sellers to interact and
exchange
funds for their transactions.
• Providing Forward Markets - in forward markets, you can offer to buy a product in the future at a
predetermined price to avoid price volatility.
• Providing a Market for Equities - an equity market is a market of shares. A company can sell shares to
the public in exchange for capital to grow. An individual investing in the company’s shares can also earn a
return on investment, usually in the form of dividends - a fixed amount of money paid at a certain period
provided the business performs well.
• A medium of exchange;
• A unit of account;
• A store of value; and
• A standard of deferred payment.
Financial Institutions play an important role in capital markets, directing capital to where it is most
useful. Essential because they provide a marketplace for money and assets so that capital can be
efficiently allocated to where it is most useful. For example, a bank takes in customer deposits and lends
the money
to borrowers. Without the bank as an intermediary, any individual is unlikely to find a qualified borrower
or know how to service the loan. Via the bank, the depositor can earn interest as a result. Likewise,
investment banks find investors to market a company's shares or bonds to.
A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the
normal process of cash movement that underpins any economy. A bank shortage of cash available for
lending is just one in a series of cascading events that occur in a credit crisis.
HANDOUT 2
DETERMINATION OF INTEREST RATES
The Loanable Funds Market Theory is a fundamental concept in economics that explains how the supply
and demand for loanable funds affect interest rates in an economy. It is an economic model used to
analyze the market equilibrium for interest rates. It involves the interaction of borrowers and lenders
where the supply of loanable funds (from savers) and demand for loanable funds (from borrowers)
determine the market interest rate.
Interest Rate- or cost of money. The cost of borrowing money, expressed as a percentage of the amount
of the loan, is called the interest rate. In other words, the interest rate is the amount paid by the
borrower to the lender for the use of the borrowed money, expressed as a percentage of the principal
amount.
People borrow money for various reasons, like buying a house, starting a business, or leasing a car.
Lenders charge interest on these as the cost of borrowing. People also save their money in banks, which
pay interest for allowing them to use the depositor’s money. Interest rates are calculated by taking into
account the principal loan amount and any applicable fees or charges. The interest rate determines how
much money you will have to pay back during the life of your loan. Higher interest rates are charged
when the risk of default is greater.
• Fiscal Policy Stance – how the government’s level of spending and taxation impact aggregate demand
and economic growth.
• Intermediation Cost – the cost incurred by financial institutions in extending their services. Inclusions
are Administrative Costs and the BSP’s Reserve Requirements.
• Other Factors – those with longer-term maturity and with higher probability of incurring loss carry
higher
interest rates. Moreover, banks with larger holdings of non-performing assets (NPAs) are more cautious
in their lending activities. This would tend to induce an increase in interest rates.
The term structure of interest rates, commonly known as the yield curve, depicts the interest rates of
similar quality bonds at different maturities. It reflects expectations of market participants about future
changes in interest rates and their assessment of monetary policy conditions.
where,
I = Interest Amount
P = Present Value or Principal
r = Simple Interest Rate
t = Time Period
The principal amount, in the context of a loan, refers to the initial sum of money borrowed from a
lender.
where,
FV = Future Value
PV = Present Value FV
r = Interest Rate
n = Number of Periods
t = number of time periods elapsed
HANDOUT 3
DEBT SECURITY MARKET: MONEY MARKETS
The Money Market refers to trading in very short-term debt investments. At the wholesale level,
it involves large-volume trades between institutions and traders. At the retail level, it includes money
market mutual funds bought by individual investors and money market accounts opened by bank
customers. The money market involves the purchase and sale of large volumes of very short-term debt
products, such as overnight reserves or commercial paper. An individual may invest in the money market
by purchasing a money market mutual fund, buying a Treasury bill, or opening a money market account
at a bank. Money market accounts offer higher interest rates than a normal savings account, but there
are higher account minimums and limits on withdrawals. In all of these cases, the money market is
characterized by a high degree of safety and relatively low rates of return.
Overnight Reserves - Overnight rates are the rates at which banks lend funds to each other at the end of
the day in the overnight market.
Commercial Paper - is an unsecured, short-term debt instrument issued by corporations. It's typically
used to finance short-term liabilities such as payroll, accounts payable, and inventories. Commercial
paper is usually issued at a discount from face value. It reflects prevailing market interest rates.
The interbank call money market is an overnight market that mainly assists commercial banks in
meeting their immediate liquidity requirements by facilitating lending and borrowing among banks.
In the wholesale market, commercial paper is a popular borrowing mechanism because the interest
rates are higher than for bank time deposits or Treasury bills, and a greater range of maturities is
available, from overnight to 270 days. However, the risk of default is significantly higher for commercial
paper than for bank or government instruments.
The Philippine Money Market started in 1965 primarily as a facility for trading excess funds among
commercial banks. The Banko Sentral ng Pilipinas (BSP) requires banks to maintain a daily minimum cash
reserve with them set as percentage of deposit liabilities. Other than the level of cash reserves, BSP has
certain strict requirements on banks. Banks with temporary cash surplus led commercial banks to set up
the money market as an auction house for excess reserves.
• The market helps to bring a balance between the demand and supply of short-term funds, bringing a
monetary equilibrium.
• By making funds available to various different participants in the market, the market promotes
economic growth of the economy.
• Governments can keep a check on the liquidity in the country by influencing the money supply. In
addition, as explained above it helps keep a control on deflation or inflation.
• Also, the market promotes saving and investment by giving a platform to wholesale as well as retail
investors for investing/borrowing of funds.
Types of Bonds
• Government Bonds – a debt security issued by a government and sold to investors to support
government
spending and obligations.
• Corporate Bonds – are a debt securities issued by corporations to raise capital.
• Municipal Bonds – refers to the type of debt security issued by local, county, and state governments.
They are commonly offered to pay for capital expenditures, including infrastructure projects.
• Convertible Bonds – these bonds give investors the option to convert their bond holdings into a
specific
number of the company’s common shares at a predetermined conversion ratio. They offer the potential
for capital appreciation if the company’s stock price rises significantly.
• Accrual Bonds – has a stated interest rate but are not paid until maturity. Investors don’t receive
interest
prior to maturity but they accrue and compound and are paid during the maturity period.
• Step-up Bonds – pays an initial interest rate for the period then a higher rate after that period. For
example, a 10-year maturity bond may offer 5% fixed interest for the first four (4) years, then 7% starting
on the 5th year.
Participants
• Issuers – entities issuing bonds to raise funds.
• Investors – individuals, institutions, and funds purchasing bonds.
• Underwriters – financial institutions facilitating bond sales.
• Secondary Market - where securities can be bought and sold after they have been issued to the public
in the primary market.
• A global bond, sometimes referred to as a Eurobond, is a type of bond issued and traded outside the
country where the currency of the bond is denominated.
• Global bonds may have a fixed or floating rate with maturities ranging from one to 30 years.
• Global bonds are grouped into developed country bonds and emerging market bonds.
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.
✓ Present Value (PV) Method – calculates the present value of all expected future cash flows associated
with the bond, including the periodic coupon of payments and the principal repayment at maturity. The
present value is determined by discounting these cash flows back to their present value using a discount
rate that reflects the market interest rate.
✓ Yield to Maturity (YTM) – is it the rate of return an investor can expect to earn on a bond if it is held
until maturity, assuming that all coupon payments are reinvested at the YTM rate. The YTM is the
interest rate that equates the present value of the bond’s cash flows to its current market price.
✓ Interest rates - When the interest rates change, it affects the discount rate of the bonds issued. In this
scenario, the bond prices fall when the interest rates rise and vice-versa.
✓ Inflation - The expected inflation influences the market in a huge way. The same happens to the bond
market. The high expectations of inflation lead to increased rates of interest, thereby lowering the bond
prices. However, when the expectations of inflation are low, it’s an opposite scenario, i.e., lower interest
rates and higher bond prices.
✓ Economic conditions - Whether it is the Gross Domestic Product (GDP) or market or customer
sentiments, an economy is highly affected. When the economy is towards progress and growth, the
interest rates are high and bond prices are low. On the contrary, if the economy is weak, the interest rate
is low, and the price of the bond is high.
✓ Credit rating - The change in the credit rating affects the risk factor associated with an investment.
When there is an increase in the credit rating, the credit spread lessens, thereby increasing the price of
the bond, while a decrease in the credit rating means a wider credit spread and lower bond price.
✓ Market Liquidity - A liquid bond market will mean lower volatility in bond value, while an illiquid
market will lead to higher volatility in the prices of the bonds.
✓ Financial state of the issuer - It is one of the most important factors to be taken into consideration.
The issuer is the one who requires fulfilling their bond obligations. Hence, their financial status must be
assessed. For the issuer of the bond with a well-performing business and fewer debt obligations, the
bond price is higher than the issuers with high debt obligations and poorly-performing business.
The advantages of using different bond valuation models to assess the price of the bonds are as follows:
✓ It helps investors figure out the expected return from the bond they hold.
✓ In addition, they can also assess the risk associated with these bonds.
✓ When investors are aware of the returns expected and risks associated with the bonds they are issued,
they make well-informed investment decisions.
Based on this valuation, companies can determine the cost of capital to be utilized for debt financing.
• Inflation Risk/Purchasing Power Risk - refers to the effect of inflation on investments. When inflation
rises, the purchasing power of bond returns (principal plus coupons) declines.
• Interest Rate Risk - refers to the impact of the movement in interest rates on bond returns. As rates
rise, bond prices decline. In the event of rising rates, the attractiveness of existing bonds with lower
returns declines, and hence the price of such bonds falls. The reverse is also true. Short-term bonds are
less exposed to this risk, while long-term bonds have a high probability of getting affected.
• Call Risk - specifically associated with the bonds that come with an embedded call option.
• Reinvestment Risk - probability that investors will not be able to reinvest the cash flows at a rate
comparable to the bond’s current return, tends to happen when market rates are lower than the bond’s
coupon rate.
• Credit Risk - results from the bond issuer’s inability to make timely payments to the lenders. This leads
to interrupted cash flow for the lender, where losses might range from moderate to severe. Credit
history and capacity to repay are the two most important factors determining credit risk.
• Liquidity Risk - arises when bonds become difficult to liquidate in a narrow market with very few
buyers and sellers. Narrow markets are characterized by low liquidity and high volatility.
• Market Risk/Systematic Risk - is the probability of losses due to market reasons like slowdown and
rate changes. It affects the entire market together. In a bond market, no matter how good an investment
is, it is bound to lose value when the market declines.
• Default Risk - is the bond issuing company’s inability to make required payments. It is seen as other
variants of credit risk where the borrowing company fails to meet the agreed terms of the issue.
During the life of a bond, its price or valuation may change depending on various factors which include
the following:
• Change in Interest Rates - The price of a bond moves inversely to market interest rates. This
relationship is due to the fact that the discount rate used to compute the net present value of cash flows
from a bond is based on prevailing market interest rates. When market interest rates move up, the
discount rate of a bond rises, causing the value of the bond to fall as the cash flows are discounted at a
higher discount rate. Conversely, a bond’s value rises when market interest rates decline as the
corresponding cash flows are discounted at a lower discount rate.
• Bond Coupon Rate - Most bonds have a fixed coupon rate over the tenure of the bond. Coupon
payments are typically paid out semi-annually or annually. If a bond's coupon rate is below the market
yield, the bond will trade below its par value i.e. at a discount. This happens because investors will
require the yield of the bond to be in line with existing market yields. This means the bond price will
decline to the level where its yield is equivalent to current market yields of bonds of similar credit ratings
and maturities. If a bond's coupon rate is above the market yield, the bond will trade above its par value
or at a premium. This occurs as investors are willing to pay a higher price to achieve the additional yield.
Remember that as the yield decreases, the bond’s price increases.
• Bond Maturity - The prices of bonds with a longer term to maturity are more sensitive to changes in
interest rates. Prices of bonds with longer maturities will decline by a larger magnitude as compared to
bonds with shorter maturities when interest rates rise. Similarly, prices of bonds with longer maturities
will rise by a larger magnitude as compared to bonds with shorter maturities when interest rates decline.
• Bond Credit Rating - The bond credit rating system helps investors to determine the issuer’s credit risk
profile. A higher credit rating indicates that the issuer has a stronger capacity to service the bond’s
coupon payments or principal repayment on a timely basis, while a lower credit rating indicates a weaker
capacity of the issuer to service its coupon payments and principal repayment. Hence, bond issuers with
lower credit ratings have to offer higher yields to attract investors given the higher risk involved and vice
versa. A change in a bond’s credit rating can impact a bond’s price. If the bond’s credit rating is lowered,
the value of the bond will decline and its yield increases. Alternatively if the credit rating is raised, the
value of the bond will rise and the yield declines.
Despite changes in a bond’s valuation due to movements in interest rates over the life of a bond, an
investor who holds a bond from issue date to maturity will receive the total amount of coupon and
principal repayment as originally stipulated over the life of a bond. Similarly, long term investors in bond
funds will be able to ride through fluctuations in bond valuations as a result of movements in interest
rates as the fund will receive the coupons and principal repayments held by its bond portfolio in full over
the longer term.
HANDOUT 5
DEBT SECURITY MARKET: MORTGAGE
Overview of Mortgage
A mortgage is a type of loan used to purchase or maintain a home, land, or other types of real estate.
The borrower agrees to pay the lender over time, typically in a series of regular payments that are
divided into principal and interest. The property then serves as collateral to secure the loan.
A borrower must apply for a mortgage through their preferred lender and ensure that they meet several
requirements, including minimum credit scores and down payments. Mortgage applications go through a
rigorous underwriting process before they reach the closing phase. Mortgage types vary based on the
needs of the borrower, such as conventional and fixed-rate loans.
Individuals and businesses use mortgages to buy real estate without paying the entire purchase price up
front. The borrower repays the loan plus interest over a specified number of years until they own the
property free and clear. Most traditional mortgages are fully-amortizing. This means that the regular
payment amount will stay the same, but different proportions of principal vs. interest will be paid over
the life of the loan with each payment. Typical mortgage terms are for 30 or 15 years. Mortgages are also
known as liens against property or claims on property. If the borrower stops paying the mortgage, the
lender can foreclose on the property.
For example, a residential homebuyer pledges their house to their lender, which then has a claim on the
property. This ensures the lender’s interest in the property should the buyer default on their financial
obligation. In the case of a foreclosure, the lender may evict the residents, sell the property, and use the
money from the sale to pay off the mortgage debt.
Advantages Disadvantages
Longer-term mortgages – are becoming available. Debt – By taking out a mortgage, you're taking on
These 30-year mortgages mean although it's a a commitment to pay back a lot of money within
longer commitment, it can be a more affordable a certain time period, including interest. Even
option than before. over 25 years, you'll be paying a lot more back
than you borrowed.
Cost-effective borrowing – The interest rates on a Secured Loan – A mortgage is a secured loan
mortgage are generally lower than for other types against your property so if you can't keep up with
repayments, you could end up losing your home.
of borrowing. Lenders can offer a variety of
mortgages such as fixed-rate, tracker or
discounted deals. It's possible to find a specific
mortgage deal that's ideal for your circumstances
and also make it an affordable option.
Types of Mortgages
• Fixed-rate Mortgages – remains constant throughout the loan term, with the borrower’s monthly
payments.
• Adjustable-rate Mortgage – has an initial fixed interest rate, which can change periodically based on
market rates.
• Interest-only Loans – involves complex repayment schedules and are best for sophisticated borrowers.
• Reverse Mortgages – are a distinct financial product. These types of mortgages can be more affordable
in the short term but may be less so in the long run.
Globalization of Mortgages
Globalization of Mortgage refers to the growing connectivity and integration of mortgage markets
across various nations or regions. It signifies the development of mortgage lending and borrowing
operations beyond international boundaries, facilitating international investment in real estate and
mortgage-backed securities.
• Increases liquidity – integration of mortgage increases liquidity by facilitating the free flow of funds
across borders. It allows for efficient allocation of capital, leading to increased investments.
• Regulatory challenges – present regulatory challenges due to different regulations and supervisions
across countries. Coordination and harmonization of regulations can be complex, requiring international
cooperation and standardization efforts.
• Housing market volatility – globalization can increase housing market volatility, as capital flows can
exacerbate fluctuations in prices and demand.
• Inequality and social implications – globalization can exacerbate income inequality and social
disparities, as access to mortgage financing and housing opportunities may be unequally distributed
across countries.
Mortgage Valuation
A mortgage valuation is a specific type of assessment done by the mortgage lender to help them
confirm the property’s value. It’s also used to see if the property will be a suitable security for the loan
you’ve applied for. Your lender will usually arrange a mortgage valuation.
• The appraisal helps the lender determine how much they are willing to lend the borrower to purchase
the property.
• The appraisal takes into consideration factors such as the property’s location, size, condition, and
comparable sales in the area. The cost of mortgage valuation is typically paid for by the borrower as part
of the mortgage application process.
• Mortgage valuation is primarily carried out for the lender’s benefit to ensure they are making sound
investment.
• Mortgage valuation can vary depending on the lender and local regulations.
• Income Capitalization Approach – commonly used for commercial properties, particularly those
generating rental income. The income approach involves estimating the value of property based on the
income it generates. This is done by analyzing the rental income, expenses, and market capitalization
rates to determine the property’s net operating income (NOI) and applying a capitalization rate to
estimate
its value.
• Cost Approach – estimates the value of a property by considering the cost to replace or reproduce it.
This method is often used for unique properties or when there is limited market data available. It
involves determining the cost constructing a similar property, adjusting for depreciation and
obsolescence, to estimate the property’s value.
Mortgage-Backed Securities
Mortgage-backed securities (MBS) are investment products similar to bonds. Each MBS consists of a
bundle of home loans and other real estate debt bought from the banks that issued them. Investors in
mortgage-backed securities receive periodic payments similar to bond coupon payments. Mortgage-
backed securities (MBS) are variations of asset-backed securities that are formed by pooling together
mortgages exclusively. The investor who buys a mortgage-backed security is essentially lending money to
home buyers. An MBS can be bought and sold through a broker. The minimum investment varies
between issuers.
• Securitization - To spread risk and make profits, financial institutions bundled these subprime
mortgages into complex financial products known as mortgage- backed securities (MBS) and
collateralized debt obligations (CDOs).
• Housing Bubble - Occurred as home prices surged, encouraging more borrowing and lending.
• Deteriorating Loan Quality - As more subprime borrowers defaulted on their mortgages, the quality of
MBS and CDOs declined significantly.
• Financial Institutions' Exposure - Many major banks and financial institutions held substantial amounts
of these risky securities, making the vulnerable to massive losses.
• Global Impact - The crisis had a global reach, affecting financial markets and economies worldwide due
to interconnectedness in the global financial system.
• Housing Bubble Burst - The crisis began when the housing bubble burst, causing home prices to
plummet. This made it difficult for homeowners to sell their homes or refinance their mortgages.
• Mortgage Defaults - As home prices fell, many subprime borrowers found themselves owing more on
their mortgages than their homes were worth. This led to a surge in mortgage defaults and foreclosures.
• Banking Sector Troubles - Banks and financial institutions faced significant losses due to their exposure
to mortgage-backed securities tied to the collapsing housing market.
• Economic Consequences - The crisis had severe economic consequences, including a recession,
widespread job losses, and a significant decrease in consumer spending. It also led to a credit crunch,
making it harder for individuals and businesses to obtain loans.
• Government Interventions - To stabilize the financial system, governments around the world took
various measures, including providing financial support to struggling banks, implementing economic
stimulus packages, and introducing regulatory reforms.
• Lessons Learned - The Mortgage Credit Crisis highlighted the dangers of excessive risk-taking in the
financial industry, the importance of effective regulation, and the need for transparency in complex
financial products.
In summary, the Mortgage Credit Crisis was a financial catastrophe triggered by the bursting of
the housing bubble, widespread mortgage defaults, and the interconnectedness of global financial
markets. It had profound and lasting effects on the global economy, leading to significant changes in
financial regulations and lending practices.