FINANCIAL MARKET REVIEWER

Financial Management
Financial management is the business function that deals with investing the available
financial resources in a way that greater business success and return-on-investment
(ROI) is achieved.
Financial Market
Financial markets refer broadly to any marketplace where the trading of securities
occurs, including the stock market, bond market, forex market, and derivatives market,
among others.
Financial markets create securities products that provide a return for those who have
excess funds (Investors/lenders) and make these funds available to those who need
additional money (borrowers).
Types of Financial Markets
1. Stock Markets - refers to several exchanges in which shares of publicly held
companies are bought and sold.
2. Over-the-counter Markets - is a decentralized market in which market
participants trade stocks, commodities, currencies, or other instruments directly
between two parties and without a central exchange or broker.
3. Bond Markets - often called the debt market, fixed-income market, or credit
market—is the collective name given to all trades and issues of debt securities.
4. Money Markets - refers to trading in very short-term debt investments.
5. Derivative Markets - is the financial market for derivatives, financial
instruments like futures contracts or options, which are derived from other forms
of assets.
6. Foreign Exchange Market - is a global decentralized or over-the-counter market
for the trading of currencies.
Primary Market vs Secondary Market
The primary market is where securities are created, while the secondary market is
where those securities are traded by investors.
Four Key Players in Primary Market

● Corporations

● Institutions

● Investment Banks
 ● Firms that provide public accounting services

Key Players in Secondary Market

● Sellers and Buyers

● Investment Banks

Financial System - a system that allows the exchange of funds between financial
market participants such as lenders, investors, and borrowers.
Financial Institutions - such as banks, provide a range of products and services and
act as a mediator between borrowers and investors.
Financial intermediaries - is an entity that acts as the middleman between two parties
in a financial transaction, such as a commercial bank, investment bank, mutual fund, or
pension fund. Financial intermediaries move funds from parties with excess capital to
parties needing funds.

Circular Flow Diagram

Time Value of Money
The concept that money today is worth more than money tomorrow. The time value of
money is also referred to as the present discounted value. Provides that actual
agreements to receive cash (or to pay cash) in the future will earn (or incur) interest due
to passage of time regardless of whether interests have been agreed upon or not.

Two Types of Interest

Simple interest is calculated on the principal, or original, amount of a loan.
Compound interest is calculated on the principal amount and the accumulated interest
of previous periods, and thus can be regarded as “interest on interest.”

Future Value
The value of a sum of money at a future point in time for a given interest rate. (If I
deposit 1 peso today in a bank, how much will it be worth in the future?)

Present Value
The value today of an amount of money that you expect to receive in the future. (How
much do I have to deposit today to receive 1 peso in the future)

Fair Value of 1 and Present Value of 1

Applicable only when cash flow is on a lump sum basis, meaning, on a “one-time”
basis.

Formula using ordinary calculator (FV of 1)

Given:
Amount deposited today = 10,000
Number of years = 3 years
Interest rate = 10%
Press 1 plus interest ‘1.10’, now press the multiplication sign ‘x’ twice, then press
equal sign ‘=’ (equal to the number of years less 1) the answer is then multiplied
to the amount deposited

Example:
FV of 1 = (1.10 x x = = )
= 1.331
= 1.331 x 10,000
= 13,310

Formula using ordinary calculator (PV of 1)

Given:
Amount to be received someday = 10,000
Number of years = 3 years
Interest rate = 10%
Press 1 plus interest ‘1.10’, now press the division sign ‘ ÷ ’ twice, then press equal
sign ‘=’ (equal to the number of years) the answer is then multiplied to the amount
to be received someday
Example:
PV of 1 = (1.10 ÷ ÷ = = = )
= 0.7513
= 0.7513 x 10,000
= 7,513

Future Value of an annuity of 1 and Present Value of ordinary annuity of 1

FV of an annuity of 1
If I make a series of equal deposits over several periods, how much will they
accumulate to in the future?
PV of an annuity of 1
How much do I have to deposit today to be able to make several equal withdrawals of 1
each over equal periods in the future?
FV ANNUITY VS PV ANNUITY
FV = There are several deposits and one withdrawal
PV = There are one deposit and several withdrawals
Two Types of Annuities
Ordinary Annuity – Deposits are made at the end of each interest period
Annuity Due – Deposits are made at the beginning of each interest period. (First
deposit is made immediately or in advance)

Note: Annuity applies only when the cash flow each year is in equal amount. If not
equal the PV of 1 is use.

Formula using ordinary calculator (FV of an annuity)

Given:
Annual deposit = 10,000
Number of years = 10 years
Interest rate = 12%

FV of an ordinary annuity of 1
Press 1 plus interest ‘1.12’, now press the multiplication sign ‘x’ twice, then press
equal sign ‘=’ (equal to the number of years less 1). Now press minus 1 then
press equal sign. Divide the resulting amount by the interest ‘.12’. The answer is
then multiplied to the amount deposited

FV of an annuity due of 1
Press 1 plus interest ‘1.12’, now press the multiplication sign ‘x’ twice, then press
equal sign ‘=’ (equal to the number of years). Now press minus 1 then press equal
sign. Divide the resulting amount by the interest ‘.12’ and then minus 1. The
answer is then multiplied to the amount deposited.

Formula using ordinary calculator (PV of an annuity)

Given:
Annual Installment = 10,000
Number of years = 10 years
Interest rate = 12%
PV of an ordinary annuity of 1
Press 1 plus interest ‘1.12’, now press the multiplication sign ‘ ÷ ’ twice, then press
equal sign ‘=’ (equal to the number of years). Now press minus 1 then press equal
sign. Divide the resulting amount by the interest ‘.12’. Press equal sign. Disregard
the negative sign by pressing +/- . The answer is then multiplied to the amount of
installment.

PV of an annuity due of 1
Press 1 plus interest ‘1.12’, now press the multiplication sign ‘ ÷ ’ twice, then press
equal sign ‘=’ (equal to the number of years). Now press minus 1 then press equal
sign. Divide the resulting amount by the interest ‘.12’. Press equal sign. Disregard
the negative sign by pressing +/- . Multiply by 1 plus interest ‘1.12’.The answer is
then multiplied to the amount of installment.

When cash flows are not due annually

● Change the interest rate. Divide the rate by the number of installments in a year.
(Semiannual = 2 installments, Quarterly = 4 installments, Monthly = 12
installments, and so on)
● Change the period. Multiply the number of years by the number of installments in
a year. (Semiannual = 2 installments, Quarterly = 4 installments, Monthly = 12
installments, and so on)

Example:
Annual rate = 12%
Cash flow = Semiannual installment
Number of years = 3 years

New rate to be used in equation = 6% (12% / 2 )

New period to be used in equation = 6 years ( 3 x 2)

Periodic payment for amortized loans = PV / PV factor of an annuity of 1

Present Value of a Perpetuity

The present value of a perpetuity is determined by simply dividing the amount of the
regular cash flows by the discount rate.

Annual Percentage Rate/ Effective Rate of Interest

APR = (1 + R/M) ^M -1.0
Where:
R = nominal rate
M = number of compounded period in a year (semiannual, quarterly, monthly, and so
on)
Using Ordinary Calculator
Step 1: Divide the rate by compounded period
Step 2: Get the FV factor of 1 (Period use is the compounded period)
Step 3: FV factor of 1 minus 1.0
Step 4: Turn the resulting answer in step 4 in %

Example:
Nominal rate = 12%
Compounded period = Quarterly
Step 1: 12% ÷ 4 = 3%
Step 2: (1.03 x x = = = ) = 1.1255 (Go back to the formula for ordinary calculator)
Step 3: 1.1255 – 1.0 = .1255
Step 4: 12.55%

Risk and Rates of Return

Risk and the required rate of return are directly related by the simple fact that as risk
increases, the required rate of return increases

Risk implies future uncertainty about deviation from expected earnings or expected
outcome. Risk measures the uncertainty that an investor is willing to take to realize a
gain from an investment
Required rate of return (RRR) is the minimum amount of profit (return) an investor will
seek or receive for assuming the risk of investing in a stock or another type of security.

Portfolio investment is a modern investment method that involves asset allocation and
diversification to construct a collection of investments. It is about reducing risk rather
than increasing return.

Low Risk Low Return

High Risk High Return

Average Return
An average return is calculated the same way that a simple average is calculated for
any set of numbers. The numbers are added together into a single sum, then the
sum is divided by the count of the numbers in the set.

Standard Deviation
Standard deviation is a statistical measurement of how far a variable, such as an
investment's return, moves above or below its average (mean) return. An
investment with high volatility is considered riskier than an investment with low volatility;
the higher the standard deviation, the higher the risk.

Coefficient of Variation
Investors use it to determine whether the expected return of the investment is worth the
degree of volatility, or the downside risk, that it may experience over time. the higher
the COV, the higher the risk.

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship
between the expected return and risk of investing in a security. It shows that the
expected return (RRR) on a security is equal to the risk-free return plus a risk premium,
which is based on the beta of that security

Long-term Financing: Debts

Debts
When a company borrows money to be paid back at a future date with interest it is
known as debt financing. It could be in the form of a secured as well as an unsecured
loan. A firm takes up a loan to either finance a working capital or an acquisition.
Bonds
Bonds are investment securities where an investor lends money to a company or a
government for a set period of time, in exchange for regular interest payments.
Call Provision
A call provision refers to a clause in a bond purchase contract that gives the bond’s
issuer the right to redeem the bond early, before its maturity date.
Callable bonds usually pay a higher coupon rate than non-callable bonds
Nominal Interest Rate
The nominal interest rate is the stated interest rate of a bond or loan, which signifies the
actual monetary price borrowers pay lenders to use their money
Effective Interest Rate
The effective interest rate is the true rate of interest earned. It can also mean the
market interest rate, the yield to maturity, the discount rate, the internal rate of
return, the annual percentage rate (APR), and the targeted or required interest
rate.

Note: Related computation is the same with Intermediate Accounting 2 -Bonds payable.

Sample Problem:
Angel recently issued bonds that mature in 5 years. They have a par value of
P1,000 and an annual coupon of 5%. If the effective interest rate is 8%, at what price
should the bonds sell?
PV of 1 for P1,000
PV of ordinary annuity for coupon interest (P50)
Get the sum of two PVs to get the price of bonds.
Answer: P880