CA51021: Financial Markets

PRELIMINARY EXAM

I. LECTURE

MODULE 1: Financial Markets

Financial Environment
● Factors and situations that primarily affect the financial aspects of the corporation.
● The main source of funds used for investments and operations comes from the savings of the
investors.
● Financing transactions take place in financial markets with the intervention of the different
financial intermediaries and institutions.

Sources of Financing
1. Financial Market
2. Financial Intermediaries

Capital Allocation Process

● in a well-functioning economy, capital flows efficiently from those who supply the capital to those
who demand it.
➔ Suppliers of Capital - individuals and institutions with “excess funds.” These groups are
saving money and looking for a rate of return on their investment.
➔ Demanders or users of capital - individuals, and institutions who need to raise funds to
finance their investment opportunities. These groups are willing to pay a rate of return on
the capital they borrow.
Market
● a venue where goods and services are exchanged.

Different types of Markets

1. Financial Markets
➔ a place where individuals and organizations wanting to borrow funds are brought together
with those having a surplus of funds.
2. Stock Market
➔ equity securities are being issued and traded.
➔ stockholders may sell their stock investments or the firm may issue additional stocks if the
stock price is overvalued or may purchase stocks if undervalued.
3. Bond Market
➔ debt securities are being issued and traded.
➔ referred as the fixed-income market because the investors or bondholders receive fixed
interest payments from their investments.
➔ for example, if the firm has to raise funds but the stock price is undervalued, the firm may
issue debt securities rather than equity securities.
4. Money Market
➔ short-term debts with maturities of one year or less are used as a source of financing (for
example, treasury bills)
5. Capital Market

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 ➔ long-term debt and equity securities are involved in financing.
➔ for example, treasury note (more than one year but not more than 10 years) and treasury
bond (more than 10 years)

A. Other Markets
a. Physical Market
➔ real asset or tangible markets
➔ products involved are real estate, property plants, and equipment, inventories, etc.
➔ assets that do not qualify as financial assets are sold in this type of market.
➔ for example, acquisition of raw materials to be used for manufacturing of products.
b. Spot Market
➔ assets or goods are sold for and delivered on the spot or today.
➔ the determination of price and delivery of goods is on the same date.
➔ for example, a rice dealer went to the farm during harvest to purchase all the harvest at
an agreed price and to be delivered on the same day.
c. Future Market
i. Future Contract
➔ a contract that gives the purchaser an obligation to buy an asset and the seller an
obligation to trade an asset at a predetermined price at a future date.
➔ for example, a rice dealer went to the farm a month before the harvest to purchase
all the future harvest at an agreed price and to be delivered on the day of the
harvest.
➔ for example, investing in a forward contract and option contract to hedge foreign
currency transactions.
ii. Forward Contract
➔ the exchange rate used to value the purchase or sale of foreign currency is a
forward rate. Hence, the forward rate is determined today but the delivery of
investment in foreign currency is in the future.
iii. Option Contract
➔ a derivative whose value is derived from the price of an “underlying” asset.
d. Private Market
➔ negotiation and agreement take place personally between two parties.
➔ makes the contract unique or tailor made.
➔ for example, investing in life insurance, when a depositor opens a savings or checking
account in a bank.
e. Public Market
➔ security or contracts with standardized features are being traded or held by individuals.

Financial Intermediaries
● Organizations that provide financing to the individuals, corporation or other organizations by
raising funds or money from investors.

1. Mutual Funds
➔ The investment company pools money from the investors then invests these accumulated
amounts in a portfolio of securities where equity, debt, or money market.
➔ The investors purchase shares of the investment company thereby giving the former the

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 right to receive dividends.
➔ SEC - body that regulates these mutual funds
2. Unit Investment Trust Fund
➔ The investment company sells units of investment to the investors to accumulate a trust
fund.
➔ The investors own units of investments not shares of stock.
➔ BSP - regulatory body that supervises these UITF
3. Pension Fund
➔ Pooled contribution from the employees or from the employers that serves as the investment
plans for the retirement benefits of the employees.
➔ These may be invested in shares of stocks or in a mutual fund in order to increase the
amount of pensions received by the retirees.
4. Financial Institutions
➔ Provides additional financial services other than pooling and investing of funds.

Unique Economic Functions Performed by Financial Institutions

1. Monitoring Costs - aggregation of funds in financial institutions provides greater incentive to
collect a firm’s information and monitor actions. The relatively large size of the financial
institutions allows this collection of information to be accomplished at a lower average cost.
2. Liquidity Costs and Price Risk - financial institutions provide financial claims to household
savers with superior liquidity attributes with lower price risk.
3. Reduced Transaction Cost - a financial institution can result in economies of scale in
transaction costs.
4. Maturity Intermediation - financial institutions can better bear the risk of mismatching the
maturities of their assets and liabilities.
5. Denomination Intermediation - financial institutions such as mutual funds allow small
investors to overcome constraints to buying assets imposed by large minimum denomination
size

Services Benefiting the Overall Economy

1. Money Supply Transmission - depository institutions are the conduit through which monetary
policy actions impact the rest of the financial system and the economy.
2. Credit Allocation - viewed as a major, and sometimes only, source of financing for a particular
sector of the economy.
3. Intergenerational wealth transfers - life insurance companies and pension funds provide
savers with the ability to transfer wealth from one generation to the next.
4. Payment Services - the efficiency with which depository institutions provide payment services
directly benefits the economy.

Transfer of Securities
1. Direct Transfer
➔ the equity securities evidenced by stock certificates and debt securities evidenced by
bond securities are issued directly to the investors.
➔ these securities do not pass through the possession of any financial intermediaries.
2. Indirect Transfer
➔ the issuing company seeks the aid of the financial institution to easily issue their

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 securities to the investors, thus there is meditation between the issuer and the investor.
➔ the investor may acquire securities from an intermediary that is different from what has
been issued by the corporation.
a. Indirect transfer through Investment Bank
● The securities of the company are bought by the investment bank or the
underwriter with the intention of reselling them to a prospective investor.
● the securities of the issuing company will be in the hands of the investors.
● no new form of capital is created.
b. Indirect transfer through Financial Intermediary
● the securities of the company are bought by these financial intermediaries
without the intention of reselling it rather they will sell their own securities to
new investors.
● the securities of the issuing company are in the possession of the financial
intermediaries while the new investors will get the securities issued by the
financial intermediaries.
● for example, investors will receive the insurance policies issued by the
insurance companies.
● a new form of capital is created.

Stock Market Transactions

1. Stock Market
➔ shares of stocks of a corporation are sold to new investors and/or existing stockholders.
★ The Philippines had two stock markets:
a. Manila Stock Exchange (MSE)
b. Makati Stock Exchange (MkSE)
★ These two markets were unified from the Philippine Stock Exchange with 8
constituent indices such as:
● PSE Composite Index (PSEi)
● PSE All Shares Index (ALL)
● PSE Holding Firms Index (HDG)
● PSE Industrial Index (IND)
● PSE Financial Index (FIN)
● PSE Mining and Oil Index (M-O)
● PSE Property Index (PRO)
● PSE Services Index (SVC)
2. Initial Public Offering (IPO) Markets
➔ markets where the stocks of a closely held corporation, going public, are offered to the
public for the first time.
➔ closely held corporations undergo IPO in order to raise additional capital to finance their
operating and investing activities.
➔ this is in the form of indirect transfer through an investment bank.
➔ however, the corporation may also undergo an IPO through direct transfer where
individual investors may place their respective bid prices and the corporation selling
directly to them.
➔ generally, the IPO transaction is classified as a primary market transaction.
➔ an exception is when the outstanding stocks of the corporation owned by the existing

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 shareholders were sold to the public, the IPO transaction is under a secondary market
transaction.
3. Seasoned Offering
➔ the issuance of additional shares of stocks of the company after its first time offering in
order to finance the capital budget or to improve its capital structure.
➔ this may be done by family corporations or public listed corporations.
4. Primary Markets
➔ involved with the issuance or selling of new shares of stocks to the investors through the
aid of investment bankers.
➔ the cash proceeds from primary market transactions goes to the corporation.
➔ the transaction in this market changes the size of the capital structure of the company.
5. Secondary Markets
➔ involved with the sale of the outstanding shares of stocks to the existing shareholders or
to new investors.
➔ the cash proceeds from secondary market transactions go to the selling shareholders,
not the corporation.
➔ the capital structure is not affected by secondary market transactions.

Stock Market Efficiency

1. Market Efficiency
➔ if the stock market shows that the market prices of the stocks are about equal or close to
intrinsic values.
◆ in this situation, the stock price reflects all publicly available information hence, is
fairly priced.
◆ investors’ returns or losses under an efficient market are relatively low.
2. Market Inefficiency
➔ stock prices are considered to be highly overvalued or undervalued. Hence, the
investors are not confident to invest unless they know some information about the other.
➔ securities are normally in equilibrium and are “fairly priced.”
➔ investors cannot “beat the market” except through good luck or better information.

Three Levels of Efficiency in Efficient Market Hypothesis

1. Weak form
➔ the information regarding past or historical prices of a particular stock is not conclusive
in predicting stock prices.
➔ an investor cannot beat the market by simply analyzing the past performances of the
stock.
2. Semi-strong form
➔ all public information is already incorporated in the stock prices.
➔ investors cannot beat the market solely by analyzing the published financial reports of
the company unless they have information from company insiders.
3. Strong Form
➔ investors cannot beat the market even with insider information.
➔ investors in this market cannot earn high returns.

Classification of Stock Prices

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 1. Market Value
➔ also known as perceived value.
➔ price of stock which is currently traded in the market.
2. Intrinsic Value
➔ the true value of the stock
➔ the price that the willing buyer will bid and a willing seller will ask provided that all
necessary information about the stock is available.
➔ it can be estimated through the following:
a. Dividend Discount Model
b. Corporate Valuation Model
NOTE:
● If the market value is equal to the intrinsic value, the stock price is at equilibrium.
● If the market value is higher than the intrinsic value, the stock price is deemed as
overvalued. Stockholders are expected to sell rather than to buy shares.
● If the market value is lower than the intrinsic value, the stock price is undervalued.
Investors are expected to purchase more shares to take advantage of the lower price.

MODULE 2: Determinants of Interest Rates

Interest Rates

● They are essential as they are commonly used as benchmarks for other types of securities in
determining an acceptable level of required return.
● They depict certain macroeconomic factors.

Nominal Interest Rate

● Also known as stated or coupon rate

● Used to compute the interest payment received by the investors from debt securities
● Does not consider compounding effect

a. Annual Percentage Rate - cost of source of financing that considers simple interest

𝐼
𝐴𝑃𝑅 = 𝑃𝑋𝑇

Where:
● I - interest amount
● P - principal
● T - time period

Effective Interest Rate

● Also known as the discount rate

● Interest rate used to compute the present value factors
● Considers the compounding effect

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 a. Annual Percentage Yield - cost of source of fund that considers the effect of compounding. Also
known as Effective Annual Rate

𝑖 𝑚
𝐴𝑃𝑌 𝑜𝑟 𝐸𝐴𝑅 𝑜𝑟 𝐸𝑓𝑓% = {[1 + 𝑚
] − 1}

Where:
● APY - annual percentage yield
● i - nominal interest rate per year
● m - number of compounding periods within a year

Components of Nominal Interest Rates

Simple Format Cross Term Format

𝑟 = 𝑟* + 𝐼𝑃 𝑅𝑓𝑟 = 𝑟 * + 𝐼𝑃 + (𝑟 * 𝑥 𝐼𝑃)

a. Real risk-free interest rate (r*)

● Represents the actual yield of risk-free debt security
● “True” risk-free rate assuming there is no expected inflation

b. Risk-free interest rate (rf or r* + IP)

● Component of the Capital Asset Pricing Model (CAPM)
● Imputed with inflation premium to protect the investors from the effects of inflation

c. Inflation Premium (IP)

● Protects the lender from the effects of inflation

d. Default Risk Premium (DRP)

● Originated from the risk where the borrower is unable to make timely interest or principal
payments
● Closely inherent to corporate-issued debt securities where the possibility of default is
present
● The lower the credit score or rating, the higher will the DRP be

e. Liquidity Premium (LP)

● Additional interest provided for debt securities that are fairly more difficult to convert to
cash
● Securities that are easier to be converted into cash have low liquidity premium as they
have less risk of not being convertible into cash

f. Maturity Risk Premium

● To offset the losses that could be encountered by the decreasing price of debt
instruments, a maturity risk premium is imputed on long-term debt securities

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 𝑁𝐼𝑅 = [𝑟 * + 𝐼𝑃] + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃
𝑁𝐼𝑅 = 𝑟𝑟 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃

Interest Rates Components Of The Government And Corporate Issued Securities

Government issued security:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟 * + 𝐼𝑃
Short-term debt security
Corporate issued security:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟 * + 𝐼𝑃 + 𝐷𝑅𝑃 + 𝐿𝑃

Government issued security:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟 * + 𝐼𝑃 + 𝑀𝑅𝑃
Long term debt security
Corporate issued security:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟 * + 𝐼𝑃 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃

Term Structure of Interest Rates

1. Unbiased Expectations Theory
➔ At any given point in time, the yield curve reflects the market’s current expectations of
future short-term rates.
➔ According to the unbiased expectations theory, the return for holding a 4-year bond to
maturity should equal the expected return for investing in four successive 1-year bonds
(as long as the market is in equilibrium).
2. Liquidity Premium Theory
➔ Long-term rates are equal to geometric averages of current and expected short-term
rates, plus liquidity risk premiums that increase with the security’s maturity.
➔ Longer maturities on securities mean greater market and liquidity risk.
◆ Investors will hold long-term maturities only when they are offered at a premium to
compensate for future uncertainty in the security’s value. The liquidity premium
increases as maturity increases.
3. Market Segmentation Theory
➔ Assumes that investors do not consider securities with different maturities as perfect
substitutes. Rather, individual investors and FIs have preferred investment horizons
dictated by the nature of the liabilities they hold.
➔ Interest rates are determined by distinct supply and demand conditions within a
particular maturity segment (e.g., the short end and long end of the bond market).

MODULE 3: Macroeconomics

MONETARY POLICY

● Changing the money supply to influence the nation’s economy

➔ Usually performed by the central bank of a country (Ex. Bangko Sentral ng Pilipinas)

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 ● It would utilize the following in order to accomplish the desired impact on GDP, Employment,
and Price levels.
➔ Open Market Operations
➔ Changing Reserve Ratio
➔ Changing Discount Rate
● Relationship between interest and the quantity of money demanded: Interest is the price to
be paid for the use of money

TWO TYPES OF DEMAND FOR MONEY

1. Transaction Demand
● Demand for money for use in the exchange of goods and services such as buying and
selling
● It is not influenced by the change in interest rates.

2. Asset Demand
● Use of money as a storage of value
● Has an inverse relationship between the quantity of the money demanded and the
interest rate.
➔ The higher the interest rates, the lower the quantity demanded for money
➔ Reason: We would rather pay off our debts if interest rates are high or we would
lend our money

OVERVIEW ON SOME OF THE ITEMS IN THE BALANCE SHEET OF THE CENTRAL BANK
● Treasury Securities - debt instruments that represent government obligations
● Loans to Commercial Banks - amount lent to commercial banks
● Other assets
● Treasury deposits - government’s financing in the central bank; amounts contributed by the
government of the country
● Reserves of Commercial Banks - cash amounts kept on hand by banks in order to meet
central bank requirements
➔ Any amount of cash in circulation in the economy is an obligation of the central bank of
the country.
➔ To be appreciated together with the required reserve ratio

EXAMPLE: We have an initial deposit in any bank 100,000. The required reserve ratio is 20%. How
will the bank account for these transactions?
Bank A

Reserve 20,000

Loan Requirement 80,000

Deposits payable by the commercial bank 100,000

● 20% of the 100,000 (20,000) is required to be kept by the bank because it is the reserve
requirement ratio provided.

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 ● The remaining 80,000 can be lent to the general public. Loan receivable would be found on the
balance sheet of the bank if the amount is successfully lent.
● If someone would borrow 80,000, he can deposit it to another bank. Thus, creating Bank B.

Bank B

Reserve 16,000

Loan Requirement 64,000

Deposits payable by the commercial bank 80,000

● There would be an additional deposit of 80,000.

● Banks create money out of thin air. If we deposit an amount, the bank can multiply that money
through this system:
➔ If someone would borrow 80,000 and deposit it to another bank, that bank will have to
maintain 20% (16,000) as reserves.
➔ The bank can then lend the remaining amount (60,000) and then whoever borrows can
also deposit it in another bank.
● If this trend would continue ad infinitum, how much with our initial 100,000 will be circulated?
➔ Initial Deposit divided by Required Reserve Ratio
➔ 100,000 / 20% = 500,000 : Amount that will be in circulation throughout the banking
system

MONETARY POLICY
● Open Market Operations
➔ Central bank would buy or sell treasury or government securities from commercial banks
or the general public

Assume a 40% reserve requirement

1. Buy Securities
Central Bank

Treasury Securities 1,000,000 Reserves of Commercial Banks 1,000,000

● If the central bank buys treasury securities for 1,000,000, Treasury Securities and Reserve
of Commercial Banks will go up by the same amount.

Commercial Banks

Treasury Securities 1,000,000 Reserves of Commercial Banks 1,000,000

(Decrease)

If RR = 40%; Then, money supply will increase by 2,500,000

● Treasury Securities of the commercial bank will be decreased by 1,000,000 if the central
bank buys it.

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 ● 2,500,000 (1,000,000 / 40%)
● By buying Treasury Securities, the central bank can increase the money supply.

Companies

Treasury Securities 1,000,000 Cash 1,000,000

(Decrease) (Increase)

● If a central bank would buy it from a company, the company’s balance sheet will experience
a decrease in treasury securities by 1 million and an increase in cash by 1 million
● Considering that most cash is deposited in banks, this would pave a way to an increase by
1.5 Million in the total cash if we’re going to follow the system
● As a result, we’ll also find a 2.5 Million increase in the money supply.

If RR = 40%
Money Supply
Increase by 1,000,000
+ Increase by 1,500,000
2,500,000 - Money that will be circulating to banks
2. Sell Securities
Central Bank

Treasury Securities 1,000,000 Reserves of Commercial Banks 1,000,000

(Decrease) (Decrease)

Commercial Banks

Treasury Securities 1,000,000 Reserves of Commercial Banks 1,000,000

(Increase) (Decrease)

If RR = 40%; Then, money supply will decrease by 2,500,000

● The balance sheet of the commercial banks 1 million peso increase in Treasury securities
and a 1 million decrease in the reserves of the commercial bank.

Companies

Treasury Securities 1,000,000 Reserves of Commercial Banks 1,000,000

(Increase) (Decrease)

● Considering that cash is generally maintained in a bank account, a decrease in cash by 1

million.
● Given a reserve requirement ratio of 40%, there will also be a decrease of 1.5 million in the
bank's ability to create money.
● When the central bank buys or sell Treasury Securities from or to banks and companies the
money supply can be altered (Open Market Operations)

If RR = 40%

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 Money Supply
Decrease by 1,000,000
+ Decrease by 1,500,000
2,500,000

CHANGING OF THE DISCOUNT RATE

● Discount rate - interest charged by the Central Bank to Commercial Banks

Central Bank

Change L to C. Banks Change of Reserves of Commercial Banks Change of

1,000,000 1,000,000

Commercial Bank

Reserves of Commercial Banks Change of L to C. Banks Change of

1,000,000 1,000,000

● If the central bank decreases the discount rate, the commercial banks would be motivated to
borrow more. Hence, increasing the overall money supply.
● If the discount rate would be increased, they would be discouraged from taking a loan,
thereby decreasing the reserves of commercial banks.

EXPANSIONARY MONETARY POLICY

● Also called easy money.
● Utilized when the economy is under the threat of a recession
● Has the intention to increase the money supply
● Can be accomplished when the central bank does the following:
➔ Buys treasury securities
➔ Decreases the reserve ratio
➔ Decreases the discount rate
● IMPACT TO THE ECONOMY
➔ The increase in money supply would translate to lower interest rates (more money in
circulation, the lower will be the price of borrowing such)
➔ Lower interest rates would translate to a lower cost of capital for private firms
★ If the cost of capital is lower → more investments will be made by the private
sector
➔ If there is more investments → this will increase the aggregate demand through the
multiplier effect thereby increasing a GDP

CONTRACTIONARY MONETARY POLICY

● Used when we are under the threat of a demand pull inflation
● Has the intention of decreasing the money supply
● Can be accomplished when the central bank does the following:
➔ Sells treasury securities

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 ➔ Increases the reserve ratio
➔ Increases the discount rate
● IMPACT TO THE ECONOMY
➔ The reduction in the money supply would increase the interest rates
➔ If interest rates would go up, the cost of capital for private businesses would also go up
thus, the private sector would reduce their investment
➔ Lower investment would decrease the aggregate demand through the multiplier effect
further. As a result if ever there is a demand pull inflation that would be mitigated through
this system.

ISSUES IN THE MONETARY POLICY

a. Fast and Flexible
● Compared to fiscal policy, monetary policy is fast and flexible with no political pressures
considering that monetary policy is being done in the central bank, congress or the office
of the president.
b. Recognition Lag
● There is a delay when an event, such as a recession, happens before we recognize it
c. Operational Lag
● For the policy to work, it would take time.
d. Cyclical Asymmetry
● Usually contractionary approach works: pulling a string
➔ Depress spending in the economy: higher interest rates, lower money supply
● Usually expansionary monetary policy is pushing a string, cannot happen but you can
make it loose so that the producers and consumers will be able to respond
➔ No guarantee that it works

FISCAL POLICY
● The use of government action to influence a nation’s economy
● It is attained through the use of:
➔ Government spending - an injection to the economy
➔ Taxation - a leakage from the economy

CLASSICAL VS. KEYNESIAN VIEW

A. Classical View
● Government Revenue = Government Expenditure : Balanced
● The role of the government is passive when it comes to dealing with the economy
B. Keynesian View
● Government Revenue > Government Expenditure: Surplus
● Government Revenue < Government Expenditure: Deficit
● The duty of the government is to intervene in case the economy is not functioning well

IMPACT OF CHANGES IN AGGREGATE DEMAND

● Aggregate Demand - Downward sloping line
➔ If aggregate demand increases or it shifts to the right: both price levels and GDP
goes up

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 ➔ If the aggregate demand decreases or shifts to the left: both price level and GDP
goes down
● Business cycle - fluctuations in the economic activity
➔ Peaks - Period of prosperity, where the inflation will be an issue
➔ Throws - Periods of depression work
➔ To minimize these fluctuations, Keynesian economics believes that governments should
intervene through spending and taxation,
★ If periods of depression happen, we want to boost the economy
★ In periods of inflation, we want to reduce economic activity.

FISCAL POLICY TOOLS

● To stimulate the demand for goods, expansionary fiscal policy is necessary. It can be
accomplished through:
➔ Increased government spending
➔ Decrease taxes
● To stop the demand-pull inflation, a contractionary fiscal policy would be prescribed:
➔ Decrease government spending
➔ Increase taxes

EXAMPLE 1: Given an economy’s marginal propensity to consume 0.75, and the real GDP being
P200M, which is at equilibrium. If the potential GDP is 260M, how much is the increase in
government spending and decrease in taxes?

1 1
Multiplier Effect: 1 − 𝑀𝑃𝐶
= 1 − 0.75
= 4𝑥
260𝑀 − 200𝑀
Increase in Government Spending needed = 4
= 15𝑀
260𝑀 − 200𝑀
Decrease in Taxes Needed = 4 𝑥 0.75
= 20𝑀

NOTES:
● Consumers and producers will not necessarily increase their spending by the same amount as
reduction in taxes
● As the marginal propensity consumer suggests only 0.75 of an increase in income would
translate to additional spending as such we have the difference in calculation

EXAMPLE 2: Given an economy’s marginal propensity to consume 0.75, and the real GDP being
P400M, which is at equilibrium. If the potential GDP is 280M, how much is the decrease in
government spending and increase in taxes?
1 1
Multiplier Effect: 1 − 𝑀𝑃𝐶
= 1 − 0.75
= 4𝑥
280𝑀 − 400𝑀
Increase in Government Spending needed = 4
= 30𝑀
280𝑀 − 400𝑀
Decrease in Taxes Needed = 4 𝑥 0.75
= 40𝑀

NOTES:

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 ● Real GDP is way above full employment GDP or potential GDP, this translates to inflation
rather than the real increase in productive capacity
● We want to contract the economy

ISSUES IN FISCAL POLICY

a. Timing problem
i. Recognition lag - there is a timing difference between an economic event (e.g. inflation
or recession) before it will be known.
ii. Administrative lag - delay in the government bureaucracy. It will take time for a problem
to be solved by Malacañang and Congress.
iii. Operational lag - it will take time for the fiscal policy action to work.
b. Political consideration - If the candidates can run for reelection, they would influence the
economy in such a way that would make them win again.
c. Future reversal - if there would be a decrease in taxes, we will not necessarily increase our
spending because it is something temporary.
d. Crowding out effect - when the government spends, it usually borrows and by borrowing the
cost of funds increases for private businesses. As a result the government increases spending
at the expense of decreasing spending by the private sector, canceling out the fiscal policy.
e. Built in Stabilizers - acts automatically without the need for fiscal policy.
● Progressive income taxes - everyone becoming wealthy.
● Tax tables will automatically tax more rather than the need for additional policies to be
set by the government

MODULE 4: Money Markets

Money Markets
● Markets where debt securities or instruments with maturities of less than one year are traded
● In money markets, short-term debt instruments (those with an original maturity of one year or
less) are issued by agencies and organizations requiring short-term funds and are purchased by
agencies and organizations with excess short-term funds.
● Once issued, money market instruments will then be actively traded in the secondary markets.
● Why is it important?
➔ Cash collection and cash disbursement patterns do not necessarily coincide with each
other. There will be times of deficit of cash and times of excess cash.
● Keeping unneeded cash is costly because it incurs a lot of opportunity cost
➔ Opportunity cost - forgone benefit for choosing one alternative over another
➔ If you leave cash as it is instead of investing it in the money markets, you are foregoing
the interest you could have earned from investing in such instruments.
● Why does the money market exist?
➔ There is an immediate cash need for individuals and companies and governments that
need to be addressed

TYPES OF MONEY MARKET SECURITIES

● Treasury Bills ● Negotiable certificates of deposit
● Federal Funds (CDs)
● Repurchase agreements ● Banker’s acceptances
● Commercial papers ● Commercial papers

15
 ● Time deposits ● Long-term negotiable certificates of
● Retail treasury bonds and corporate deposit (LTNCD)
bonds

CHARACTERISTICS OF MONEY MARKET SECURITIES

● Money market instruments are sold in large denominations
● These securities have low default risk or the risk of late or non-payment of principal or interest
● The securities sold in the money market must have an original maturity of one year or less.

MONEY MARKET PARTICIPANTS

● The money market players and other parties involved

1. The Bureau of Treasury

● As principal custodian of government funds, the Bureau of the Treasury (BTr) is
responsible for ensuring the sufficiency of Government financial resources including the
active management and investment of excess funds. (from the BTr ISO Certification)
● They are also the agency responsible for the issuance of the money market securities
in the Philippines

2. Commercial Banks
● They participate as issuers and or investors of almost all money market instruments.
● This is because in part, they need to meet reserve requirements imposed by the Central
Bank.

3. Money Market Mutual Funds

● These pooled funds purchase large amounts of money market securities and sell them
based on the instrument's underlying value.
● Money market mutual funds allow individuals and other small investors to invest in
money market securities

4. Brokers and Dealers

● Brokers and dealers play a key role in marketing new issues of treasury bills and other
securities.
● They link buyers and sellers in the fed funds market and assist in secondary trading in
other money market securities as well.
● Brokers and dealers also act as intermediaries by linking buyers and sellers of money
market instruments, usually for smaller investors who do not have sufficient funds to
invest in primary issues of money market securities or those who simply would like to
invest in money market securities.

5. Corporations
● Financial and other non-financial corporations raise large amount of funds in the money
market because their cash inflows rarely equal their business needs, they will often
invest their excess cash in money market securities or borrow from other parties in the
money market to raise cash to meet their short-term needs.

16
 6. Other Financial Institutions
● Other financial institutions, such as insurance companies are players in the money
market, because of the unpredictable nature of their liabilities. They are therefore
required to maintain a large amount of liquid assets. To achieve this, they invest in
money market securities.

7. Individuals
● Individual investors participate in the money markets through direct and indirect
investments in money market securities via banks or money market mutual funds.

DIFFERENT MONEY MARKETS

a. Treasury Bill Market - the government is the debtor
b. Commercial Paper Markets - markets where businesses borrow

BASIC CHARACTERISTICS
1. Low default risk - the probability of non-payment is little to none, thus low returns is expected
2. Sold in large denominations - denominates the securities in large sums (millions)
➔ This is to make the most of the transaction costs that will be incurred again considering
that the returns here are usually low
3. Short term maturity - market for instruments with short-term maturities.
➔ Lenders intend to get their money back in a short period, borrowers also intend to settle
them in the same length.

YIELDS ON MONEY MARKET SECURITIES

a. Bond Yield Equivalent - 365 days
➔ Simple rate of return stated on an annual basis
➔ Effect of compounding is not accounted
➔ t is the nominal or stated rate earned on a security over a one-year period. It is used to
calculate the present value of an investment.
➔ The formula for bond equivalent yield is as follows:

Where:
Pf = Face Value
P0 = Purchase price of the security
n = Number of days until maturity

b. Effective Annual Return - 365 days

➔ Used when the investment horizon or the maturity on a security is less than a year.
➔ This accounts for the compounding of interest for certain money market securities.

17
 Where:
ibe = Bond equivalent yield
n = Number of days until maturity

c. Discount Yield - 360 days

➔ Return expressed as a percentage discount of the face value
➔ For securities that are sold on a discount basis, there is no explicit interest rate.
★ Interest is hidden or imputed in the face value since they are issued at below face
value amount
➔ This is used to calculate the interest rates on discount securities

➔ To properly compare returns of discount and non discount securities, the yield on the
discount securities can be adjusted to reflect its bond equivalent yield by using the
formula below:

d. Single Payment Yield - 360

➔ For securities with an explicit interest rate
➔ Effects of compounding is not accounted
➔ This is used to calculate returns on money market securities that pay interest only at
maturity. Securities that have single payment yields will receive a final payment at
maturity consisting of interest plus face value of the security.
★ Date of Investment: Invest P5,000,000 → Maturity Date: Receive P5,000,000 + interest
➔ To properly compare the interest rates on single-pay securities with other types that pay
using a 365- day year, the interest received on single pay securities should be converted
to the bond equivalent yield as follows:
365
𝑖𝑏𝑒 = 𝑖𝑠𝑝 ( 360 )

DISCOUNT YIELD, BOND EQUIVALENT YIELD AND EFFECTIVE ANNUAL RETURN: A

COMPARISON
Suppose you can purchase P 1Million Treasury Bill that is currently selling on a discount basis at
98.5% of its face value. The T-Bill is 140 days from maturity.

18
 Discount Yield

Bond Equivalent Yield

Effective Annual Return

TYPES OF MONEY MARKET SECURITIES

A. Treasury Bills
● Short-term, negotiable and transferable fixed income securities issued by the Bureau of
Treasury on behalf of the Philippine government.
● Often used by the Philippine government to finance public expenditures.
● In the Philippines, T-Bills have 3 different tenors: 91-day, 182-day and 364- day T-Bills
● Often sold at a discount and redeemed at face value upon maturity. Investor earns the
spread in exchange for allowing the government to borrow your money.

TERMS
● Face Value - the face value of the T-Bill is the nominal value or the peso value of the
T-Bill
● Maturity date - the date when the face value of the T-Bill must be paid back.
● Settlement date - the date when the trade on the T-Bill becomes final. The day when the
buyer must pay for the securities being acquired.
● Bid Price - the price at which the buyer is willing to purchase the security.
● Ask price - the price is the price being sought by the seller for security.
● Ask yield - the return the investors would receive if they paid the ask price and held the
T-Bill to maturity
● As a rule, “BUY AT ASK, SELL AT BID”

HOW DO YOU EARN FROM T-BILLS?

19
 A P1,000.00 91-day T-Bill was sold for P900.00 on Jan 1, 2021. On Apr 2, 2021, it is redeemed
at P1,000.00.
● The investor earns the spread of P 100.00 for allowing the government to borrow his/her
money.

TREASURY BILLS: CALCULATING THE ASK OR DISCOUNT YIELD

Suppose you bought a T-bill maturing Sep 15, 2016 for P9,991.362. The T-Bill matures 122 days
after the settlement date on May 17, 2016 and has face value of P10,000.00
𝑃𝑓 − 𝑃0 360 10,000 − 9,991.362 360
𝑖𝑡−𝑏𝑖𝑙𝑙,𝑑 = 𝑃𝑓
𝑥 𝑛
→ 𝑖𝑡−𝑏𝑖𝑙𝑙,𝑑 = 10,000
𝑥 122
= 0. 2549%

𝑃𝑓 − 𝑃0 365 10,000 − 9,991.362 365

𝑖𝑡−𝑏𝑖𝑙𝑙,𝑏𝑒 = 𝑃0
𝑥 𝑛
→ 𝑖𝑡−𝑏𝑖𝑙𝑙,𝑏𝑒 = 9,991.362
𝑥 122
= 0. 2587%

365/𝑛
𝑖𝑏𝑒 0.002587 365/122
𝐸𝐴𝑅 = (1 + 365/𝑛
) − 1 → 𝐸𝐴𝑅 = (1 + 365/122
) − 1 = 0. 2589%

B. Federal Funds
● Short- term unsecured loans between financial institutions usually for a period of one day
by trading their excess reserves at their local federal reserve to other banks that need to
borrow funds because they are short of reserves.
● The overnight interest rate in the interbank lending market is the federal fund rate. It is the
interest rate for borrowing federal funds
● Federal funds are considered single- payment loans. Since the borrowing bank will pay the
lending bank the face value of the loan and the interest at the prevailing federal fund rate.

EXAMPLE
The overnight federal funds rate for Aug 2021 was 0.09%. To convert this to bond equivalent
yield, we use the single payment yield formula:

365 365
𝑖𝑏𝑒 = 𝑖𝑠𝑝 ( 360 ) = 0. 09%( 360 ) = 0. 09125%

Because fed funds are loaned only for a day, we can calculate the EAR as well:
0.09125% 365/1
𝐸𝐴𝑅 = (1 + 365/1
) − 1 = 0. 09129%

C. Repurchase Agreements
● Agreements involving the sale of securities to one party by another with a promise to
repurchase the same securities at a specific price on a specific date in the future.
● Basically a collateralized federal fund loan, The collateral being the securities.
● These have very short-term maturity, usually from 1-14 days.
● The loans are slightly smaller than the market securities pledged as collateral to account for
the underlying risk of the collateral security.

20
 REPURCHASE AGREEMENT YIELDS
● Repurchase agreements are backed by treasury securities, the risk on these
agreements are low and the interest rates are lower than the uncollateralized fed funds.
The repurchase agreement yields are computed at an annualized percentage between
the initial selling price of the securities and the agreed repurchase price using. A
360-day year.

𝑃𝑓 − 𝑃0 360
𝑖𝑟𝑒𝑝𝑜,𝑠𝑝 = 𝑃0
𝑥 𝑛

Where:
Pf = Repurchase price of securities
(selling price + interest paid on the repurchase agreement)
P0 = Selling price of the securities
n = number of days until the repurchase matures

EXAMPLE
Suppose a bank enters a reverse repurchase agreement in which it agrees to buy fed funds
from one of its corresponding banks at a price of 10 million, with a promise to sell these funds
back at 10,000,291.67, including interest, after 5 days. The yield is calculated below:
𝑃𝑓 − 𝑃0 360 10,000,291.67 − 10,000,000 360
𝑖𝑟𝑒𝑝𝑜,𝑠𝑝 = 𝑃0
𝑥 𝑛
→ 𝑖𝑟𝑒𝑝𝑜,𝑠𝑝 = 10,000,000
𝑥 5
= 0. 21%

D. Commercial Papers
● A short-term unsecured, promise to pay (promissory note) issued by a corporation to raise
short-term cash often to finance working capital requirements.
● Single payment securities are often sold at a discount with interest payments made at the
maturity date.
● Companies with a strong credit rating can borrow money at a lower interest rate by issuing
a commercial paper than by directly borrowing money from the bank via a loan.

EXAMPLE
Suppose Mr. Rodriguez purchases a 95-day commercial paper with a par value of 1 million for
the price of P990,023. The discount yield on the commercial paper would be:
1,000,000 − 990, 023 360
𝑖𝑑 = ( 1,000,000
)𝑥 95
= 3. 78%

The bond equivalent yield is:

1,000,000 − 990, 023 365
𝑖𝑏𝑒 = ( 990,023
)𝑥 95
= 3. 87%

The EAR is:

21
 0.0387 365/95
𝐸𝐴𝑅 = (1 + 365/95
) − 1 = 3. 93%

E. Negotiable Certificates of Deposit

● A bank-issued time deposit that specifies interest rate and maturity date and is negotiable
in the secondary market.
● Well-known banks can offer CDs at slightly lower rates than their lesser known
counterparts.
● It is a bearer instrument – meaning, whoever holds the CD at the date of maturity is entitled
to receive the principal and interest.
● These are purchased by money market mutual funds – a pool of funds of individual
investors used to indirectly purchase negotiable CDs.

YIELDS OF NEGOTIABLE CERTIFICATE OF DEPOSIT

A bank has issued a 6-month 1 million CD with a 0.72% quoted annual interest rate. The bond
equivalent yield will be:
365
𝑖𝐶𝐷,𝑏𝑒 = 0. 72% 𝑥 360
= 0. 73%

At maturity (in 6 months), the investor will receive:

0.73%
𝐹𝑉 = 1, 000, 000 (1 + 2
) = 1, 003, 650

The EAR on the CD is:

0.73% 2
𝐸𝐴𝑅 = (1 + 2
) − 1 = 0. 7313%

F. Banker’s Acceptance
● A time draft payable to the seller of goods and services, with the payment guaranteed by a
bank.
● This money market instrument from international trades and letters of credit is used to
finance trade in goods that have yet to be shipped from a foreign exporter to a domestic
buyer where the foreign sellers prefer banks to act as guarantor for payments before
sending the goods to local importers.
● If there is an immediate need for cash, the foreign exporters can sell the acceptance before
the maturity date at a discount. The ultimate bearer will receive the face value of the
acceptance at maturity date.

MODULE 5: Mortgage Markets

What is a Mortgage?
● A loan to borrowers (either individuals or businesses) to purchase a real property such as a
house, lot or building.

22
 ● These properties act as a collateral to protect the financial institution (a bank or finance
company) in the event of non-payment.
● As a result, the mortgage companies can underwrite more loans. Securitization allows these
financial institutions have more liquid assets therefore reducing interest rate risk, and credit risk.
It also provides the FI’s with additional income streams from fees and charges and allow them
reduce the effects of regulatory constraints such as capital requirements, reserve requirements
and others.
● Mortgages are often securitized by the mortgagor, meaning they are combined into one large
portfolio and is then divided into smaller pools based on the mortgage’s inherent risk of default.
These smaller pools are then sold to investors in the form of bonds.
● By buying into these types of securities the mortgagors are taking off these mortgages from their
balance sheets by letting the investors assume their place as lender in exchange for a rate of
return commensurate to their risk tolerance.
● Banks - owe their resources to depositors; carry responsibility to the public
● Central Bank - protects the depositors; by seeing to it that the banks are liquid, solvent and
have enough capital → capital adequacy
● There is a maximum limit as to what ratio of loans the deposits are
➔ Carrying too much loan receivable can be a burden for the bank so they transfer the
mortgage receivables to another party by through selling

Default, credit and interest rate ris

● Default risk - is the risk that a lender takes on in the chance that a borrower will be unable to
make the required payments on their debt obligation.
● Credit risk - is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations.
● Interest rate risk - is the potential for investment losses that result from a change in interest
rates.
● Liquidity risk - refers to how a bank's inability to meet its obligations (whether real or
perceived) threatens its financial position or existence.

Risk and return trade off

● The risk-return tradeoff states that the potential return rises with an increase in risk.
● The higher the risk, the higher the return

Characteristics of Mortgages
a. Customized
● The terms (such as size, fees, and interest rate) of each mortgage held by a bank or
finance company can differ
● A mortgage contract between a financial institution and a borrower must indicate all
of the terms of the mortgage agreement.
b. Collateral
● Mortgage loans are backed by a property that serves as a collateral to the loan.
● The property will be placed with a lien, a public record attached to the title that gives
the bank or finance company the right to sell the property if the borrower defaults.
c. Down Payment

23
 ● The bank or finance company requires the borrower to pay a portion of the
purchase price of the property at the closing date, the date of issuance.

● Federally insured mortgages are usually originated by private originators, but payment is
guaranteed by the federal government (Federal Housing Authority or Veterans Administration)
and is usually subject to a stringent application process. These loans are limited in size that
varies per state and require little to no down payment. Conventional mortgages on the other
hand are not guaranteed by the federal government but by private mortgage insurance. PMIs
are contracts purchased by the borrower guaranteeing to pay the financial institution to pay the
the difference between the value of the property and the balance remaining on the mortgage.
The secondary mortgage will not buy conventional mortgages if the loan to value ratio is more
than 80%.

● Balloon payment mortgage – a type of mortgage that requires a fixed monthly interest rate for
a 3–5-year period. Full payment of the mortgage principal (balloon payment) is required by the
end of the payment term.
d. Interest rates – payment for borrowing money to finance the purchase of real property:
prevailing market rates, fees and others.
e. Discount points – fees or payments made when a mortgage loan is issued at closing. It
effectively reduces the interest rate on the mortgage.
f. Other fees – fees to cover the mortgage issuer’s cost of processing the mortgage.
g. Mortgage refinancing – the borrower takes out a new mortgage and uses the proceeds
to pay the current mortgage.

● Fixed rate mortgage – locks in the borrower’s interest rate and thus requires the borrower to
make monthly payments over the life of the loan.

● Adjustable-rate mortgages – it is tied to a market interest rate or interest rate index. Therefore,
the payments on this type of mortgages can change over the life of the loan.

● Discount point – one discount point is equal to 1% of the principal value of the mortgage. For
instance, in a $100k mortgage principal that requires the borrower to pay 2 discount points at
closing, the borrower needs to pay $2k on the day of the closing.

Mortgage markets: what’s the deal?

Mortgage markets are studied separately from other financial markets because of the following
reasons:
a. A mortgage is specifically related to a real property. The same applies to mortgage bonds.
b. There is no set size or denomination for primary mortgages.
c. Primary mortgages only involve a single investor
d. The issuers in the mortgage markets are individuals

● A mortgage is backed by a a specific piece of real property. In the event of a default, the said
property can be foreclosed and can be resold. Unlike when corporate bonds and stocks are
issued, they give holders a general claim to their assets.

24
 ● Rather, the size of the mortgage depends on the borrower’s needs and ability to repay. Bonds
usually have a preset denomination a which you can purchase, and shares are usually sold at
par value per share.
● You only deal with an investor bank or mortgage company in a mortgage deal. Unlike with
bonds and stocks, they will usually have many different investors.
● The mortgage market is participated largely by individuals, unlike in other financial institutions.
Therefore, the information available on these issuers are less extensive and unaudited. Unlike
in the bond and stock markets, the reliability and extensiveness of available information must
follow rules and regulations.

Primary mortgage markets

BASIC MORTGAGE CATEGORIES
1. Home mortgages – mortgages used to purchase one to four family homes.
2. Multi-family dwelling mortgages – mortgages used to purchase apartment complexes,
condominiums and townhouses.
3. Commercial mortgages – used to purchase real properties for business purposes.
4. Farm mortgages - used to finance the purchase of farms and agricultural lands.

Mortgage amortization

● These are the fixed monthly payments made by the borrower that generally consists of the
partial repayment of the principal and interest on the outstanding balance of the loan.
● An amortization schedule shows how the monthly payments are broken down between principal
and interest.

Amortization Schedule: An Example

25
 Notice the following:

● Payments made are fixed.

● Interest is calculated on a daily basis.
● Excess amortization after interest is deductd in the principal payment.

Mortgage Amortization

● Mortgage payments can be calculated using the time value of money.

𝑡
1 𝑗
𝑃𝑉 = 𝑃𝑀𝑇 ∑ ( 1+𝑟 )
𝑗=1

1 𝑡
( 1+𝑟 )
𝑃𝑉 = 𝑃𝑀𝑇 [ 1 − 𝑟
]

Where:
PV = Principal amount being borrowed
PMT = Monthly mortgage payment
r = monthly interest rate on the mortgage
t = number of monthly payments over the life of the mortgage

Mortgage Amortization: Examples

Problem 1: You plan to purchase a house for $150,000 using a 30-year mortgage obtained from
your local bank. The mortgage rate offered to you was 8%. You decide to make a 20% payment to
forego the purchase of the PMI at closing.

To compute the amount of the loan:

PV = $150,000 - ($150,000 x .20) = $120,000

Problem 2: You plan to purchase a house for $150,000 using a 30-year mortgage obtained from
your local bank. The mortgage rate offered to you was 8%. You decide to make a 20% payment to
forego the purchase of the PMI at closing.

To compute for the monthly payment:

26
Other type of mortgages

● Jumbo Mortgages - these exceed the conventional mortgage conforming limits set by Fannie
Mae or Freddie Mac
● Subprime Mortgages - mortgages from borrowers with weakened credit history
● Alt-A Mortgages - considered riskier than a prime mortgage and less risky than a subprime
mortgage.
➔ Alt A mortgages are riskier than prime mortgages because they have less than full
documentation, lower credit scores and higher loan to value ratios.
● Option ARMs - “pick-a-payment or option” adjustable-rate mortgages; Minimum payment
option, Interest only payment, 30-year fully amortizing payment or 15 year fully amortizing
payment, second mortgages and reverse annuity mortgages
a. Minimum Option Payment: Lowest/ Cheapest among the four options. The monthly
payment on this ARM option is initially set for 12 months at an initial interest rate. The
payment changes annually after that and a payment caps limits dictates how much it can
increase during the year. May result in a negative amortization if the borrower chooses to
continue to pay the minimum amount after the initial period set.
b. The interest only option requires the borrower to pay only interest during the initial
period of the loan. During this time, no principal must be repaid. After this initial period,
the borrower must start amortize so that the mortgage will be paid at the end of its term.
c. 30-year fully amortizing payment – borrower pays principal and interest over a 30-year
period to pay lender the full amount of the mortgage at the end of the term. The payment
is calculated each month based on the prior month’s fully indexed rate, loan balance and
remaining loan term. The same is true for the 15-year fully amortizing payment except
that there is a higher amount of principal payment every month including interest rates on
the loan from the previous month plus principal to pay the loan within 15 years.

27
 d. Second mortgages – loans secured to a piece of real estate property already used to
secure a first mortgage. Interest rates are higher for second mortgages because second
mortgage lenders only get paid after the first mortgage borrower has been paid in case of
a default.
e. Financial institutions often offer home equity loan that let customers borrow a line of credit
secured with a second mortgage on their homes.
f. Reverse annuity mortgage – mortgage borrowers receive regular monthly payments
from a financial institution rather than making them. When the RAM matures or the
borrower dies, the borrower or his estate will sell the property to settle the debt. RAMs
were designed so that retired homeowners will be able to live on the equity they built up
on their homes without necessarily selling their homes.

Mortgages in the Secondary Market

● Secondary Market - market where issued securities are bought and sold
➔ In the case of mortgages, after the loan receivable is issued, the bank or finance
company will sell it to another party
● May include:
1. Sale of mortgages
● Happens when the bank sells the mortgage to another party
● Sale can occur with or without recourse to the issuing bank
2. Issuance of mortgage-backed securities
● Investment security made up of a bundle of mortgage loans bought from the
banks that issued them
● Allow mortgage issuers to separate the credit-risk exposure from the lending
process itself, moving the bank from the traditional “originate and hold” model to
the ”originate and distribute” model
a. Pass-through mortgage securities - Securitization
➔ Mortgage-backed securities that “pass through” promised payments of
principal and interest on pools of mortgages created by banks to
secondary market participants holding interests in the pools
b. Collateralized mortgage obligations - Securitization
➔ Issued in multiple classes or tranches
➔ Tranches - bond holder class associated with a CMO
c. Mortgage backed bonds - Collateralization
➔ Bonds collateralized by a pool of assets

Secondary Mortgage

● How does secondary mortgage market work?

● Loan originators such as banks and other mortgage companies operate in the secondary
mortgage markets through these two ways:
● Pooling of mortgages. Grouping of recently originated mortgages and selling them in the
secondary market.
● Securitization of mortgages. Discussed earlier.
● Both methods allow for the reduction of liquidity risk, interest rate risk, default risk and credit risk
than keeping these originated mortgages in their books. As discussed in the previous chapter,

28
 banks make money out of mostly short-term deposits. If they keep these long-term mortgages in
their books exposes them to interest rate risk.
● Mortgage companies then become servicers, collecting payments on behalf of the secondary
investors.
● Financial institutions have sold mortgages and real estate property loans among themselves for
a long time. A large part of correspondent banking, meaning a large bank provides a small bank
a number of deposit, lending and other services.
● In the secondary market, mortgage sales happen. It is when a financial institution sells an
originated loan with or without recourse to an outside buyer. Recourse is the ability of a loan
buyer to sell back the loan to the originator should it go bad. If the loan is sold without recourse,
the originator removes the loan entirely from their books and no longer has the liability to these
mortgages. In comparison, when the loan is sold with recourse, the originator retains a
contingent risk credit liability.
● The secondary mortgage was created to boost the economy during the great depression to
increase liquidity in the mortgage markets and the availability of affordable housing, the Federal
National Mortgage Association or Fannie Mae was established to buy mortgages from financial
institutions so they could lend to other mortgage borrowers. Its mandate was to act as a
secondary mortgage facility that could purchase, hold and sell mortgage loans.
● Fannie Mae grew very large over the years and had acquired a lot of debt, for the large debt to
be removed from the balance sheet, it was converted into a publicly-traded company.
● In the 1960s, the US government created the Government National Mortgage Association
(GNMA or Ginnie Mae) to address the decline of availed VA guaranteed home mortgages as
well as the Federal Home Loan Mortgage Corporation. The GNMA is a government owned
enterprise while Fannie Mae and Freddie Mac are government sponsored enterprises.
● The FHA or the VA was also established to insure certain mortgages against default risk thus
making it easier to sell/securitize securities.

II. PRACTICE EXERCISE: THEORETICAL

1. Financing transactions take place in financial markets with the intervention of the different
financial intermediaries and institutions.
a. True
b. False
2. Forward Contract is one that gives the purchaser an obligation to buy an asset and the seller an
obligation to trade an asset at a predetermined price at a future date.
a. True
b. False
3. There is market efficiency if the stock market shows that the market prices of the stocks are
about equal or close to intrinsic values.
a. True
b. False
4. Market value is the price of stock which is currently traded in the market.
a. True
b. False
5. If the market value is higher than the intrinsic value, the stock price is deemed as undervalued.
Investors are expected to purchase more shares to take advantage of the lower price.

29
 a. True
b. False
6. The date when the face value of the treasury bill must be paid back.
a. Maturity Date
b. Settlement Date
c. Acquisition Date
7. Short- term unsecured loans between financial institutions usually for a period of one day by
trading their excess reserves at their local federal reserve to other banks that need to borrow
funds because they are short of reserves.
a. Federal Funds
b. Repurchase Agreements
c. Commercial Papers
8. A bank-issued time deposit that specifies interest rate and maturity date and is negotiable in the
secondary market.
a. Certificates of Deposit
b. Certificate of No Marriage
c. Certificate of Registration
9. A place where individuals and organizations wanting to borrow funds are brought together with
those having a surplus of funds.
a. Stock Market
b. Bond Market
c. Financial Market
10. Pooled contribution from the employees or from the employers that serves as the investment
plans for the retirement benefits of the employees.
a. Mutual Fund
b. Pension Fund
c. Unit Investment Trust Fund

III. PRACTICE EXERCISE: PROBLEM SOLVING

PROBLEM 1
Given an economy’s marginal propensity to consume 0.45, and the real GDP being P600M, which is
at equilibrium. If the potential GDP is 800M, how much is the decrease in government spending and
increase in taxes?
1. Increase in government spending
2. Decrease in taxes needed

PROBLEM 2
Suppose Jihyo purchases a 120-day commercial paper with a par value of 2 million for the price of
1.5M. Compute for the following.
3. Discount Yield
4. Bond Equivalent Yield
5. Effective Annual Return

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PROBLEM 3
Emmylyn plans to buy a house worth PHP 40,000,000 using a 15-year mortgage. The mortgage rate
offered to her was 8% annually. Emmylyn decides to make a 20% down payment to forego the
purchase of the PMI at closing.
6. How much is the amortization payment at the end of year 1?

PROBLEM 4
Mr. LJS, an investor, plans to buy a house worth PHP 50,000,000 using a 25-year mortgage. The
mortgage rate offered to him was 5% annually. Mr. LJS decides to make a $15,000,000 down
payment to forego the purchase of the PMI at closing.
7. If Mr. LJS decides to pay 2,483,336 annually, at year 23, how much of the loan balance would
he still have to pay?

PROBLEM 5
Dawn Stephanie bought a 3-storey townhouse for PHP 45,000,000.00. Assuming she paid a 25%
down payment at closing. She financed the rest by taking out a 30-year mortgage with a 8% interest
rate from her depository bank and decided she would pay for the amortization yearly at P
2,997,925.87 a year.
8. Calculate how much interest she will pay over the life of the loan to the nearest peso.
9. How much of the annual amortization payment is allocated to the principal at year 15? Round off
to the nearest peso.
10. How much is her loan balance at the end of year 8? Round off to the nearest peso.
11. How much of the annual amortization payment is allocated to the principal at year 29? Round off
to the nearest peso.
12. Calculate how much interest she will pay at the end of year 12. Round off to the nearest peso.

PROBLEM 6
Ramon Gino took out a loan for PHP 24,000,000 payable in 20 years at 7% annual interest to buy a
new house after a 25% down payment.
13. How much is his principal balance at the end of month 9 if he pays 500,000 in monthly
amortization? Round off to the nearest peso.
14. How much is his loan balance at the end of month 15 if he pays 500,000 in monthly
amortization? Round off to the nearest peso.
15. How much is his interest balance at the end of month 15 if he pays 500,000 in monthly
amortization? Round off to the nearest peso.

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 ANSWER KEY
THEORETICAL

1. A. 6. A.

2. B. 7. A.

3. A. 8. A.

4. A. 9. C.

5. B. 10. B.

PROBLEM SOLVING

1. 109,890,109.9 11. 2,570,238

2. 244,200,244.2 12. 2,303,270

3. 75% 13. 377,147

4. 101.38% 14. 18,373,827

5. 139.88% 15. 109,459

6. 3,738,545

7. 4,617,541

8. 56,187,766

9. 875,066

10. 30,581,073

PROBLEM SOLVING: SOLUTIONS

PROBLEM 1
Increase in government spending needed 800𝑀 − 600𝑀
= 109, 890, 109. 9
1.82

Decrease in taxes needed 800𝑀 − 600𝑀

= 244, 200, 244. 2
1.82 𝑥 0.45

PROBLEM 2
Discount Yield 𝑖𝑑 = (
2,000,000 − 1,500,000
) 𝑥
360
= 75%
2,000,000 120

Bond Equivalent Yield 𝑖𝑏𝑒 = (

2,000,000 − 1,500,000
) 𝑥
365
= 101. 38%
1,500,000 120

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Effective Annual Return 𝐸𝐴𝑅 = (1 +
1.0138
)
365/120
− 1 = 139. 88%
365/120

PROBLEM 3

6. 3,738,545

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PROBLEM 4

7. 4,617,541

34
PROBLEM 5

8. 56,187,776

9. 875,066

10. 30,581,073

11. 2,570,238

12. 2,303,270

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PROBLEM 6

13. 377,147
Explanation: Note that the question states that the 24M loan was taken out after paying a 25%
DP. Meaning, the loan amount is 24M itself.

14. 18,373,827

15. 109,459

REFERENCES
Bagayao, I. et al. (2018). Financial Management Volume 1
Saunders, A. & Cornett, M. (n.d). Financial Market and Institutions Sixth Edition

Prepared by:

DIAMLA, Shireen
FORONDA, Aisha Kyle
GAN, Alexsandra Noelle

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