TOPIC II: Financial Assets and Interest Rates

Instructor: Joshua F. Orobia

Course code and title: FM 102 – Monetary Policy and Central Banking
Schedule for Instruction: BSBA-FM 3A: MW, 9:30-11:00 AM
BSBA-FM 3B: MW, 12:30-2:00 PM
BSBA-FM 3C: MW, 2:00-3:30 PM

TOPIC II: FINANCIAL ASSETS AND INTEREST RATES

Learning Objectives
• Explain the concept of Investments in their own words.
• Differentiate the risks in Money Market, Stocks and Bonds and how they work.
• Have a brief understanding about VUL, UITF, and MF and how it earns interests.
• Define Interest Rate
• Enumerate the different Interest Rates monitored by BSP and what affects it.

WHAT IS A FINANCIAL ASSET?

A financial asset is a liquid asset that gets its value from a contractual right or ownership claim. Cash,
stocks, bonds, mutual funds, and bank deposits are all are examples of financial assets. Unlike
land, property, commodities, or other tangible physical assets, financial assets do not necessarily have
inherent physical worth or even a physical form. Rather, their value reflects factors of supply and
demand in the marketplace in which they trade, as well as the degree of risk they carry.

In this graph we will see that the relationship of Risk and Potential Return is directly proportionate. It
means that, the higher the risk the higher the potential return is, the lower the risk the lower the
potential return. These Financial assets earns depending on their risk, they may earn through interests
or capital valuation. Now, let us look at each category starting from Money Market

MONEY MARKET – These are short term investments that mature less than a year. It earns through
Interest Payments. It has Low Risk, Low Income Potential, and are Short-term debt Instruments.

Examples of Money Market:

Certificate of Deposits – these are Time Deposits commonly sold by banks. CD’s differs from savings
account for CD’s has a specific, fixed term (from one, three, 6 months, and 365 days). If you invest
your money in Time Deposits, there will be a holding period and the interest is fixed. This is a low risk
investment since the interest is fixed.
Treasury Bills – are zero-coupon bonds that mature in one year or less. They are bought at a discount
of the par value and, instead of paying a coupon interest, are eventually redeemed at that par value

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to create a positive yield to maturity. TBills is practically risk free since there is a low probability that
the Philippine government will default on its own local currency debt.
Commercial Paper – is a money-market security issued (sold) by large corporations to obtain funds
to meet short-term debt obligations (for example, payroll) and is backed only by an issuing bank or
company promise to pay face amount on the maturity date specified on the note. Since it is not backed
by any collateral, only firms with excellent credit ratings from a recognized credit rating agency will be
able to sell their commercial paper at a reasonable price. Commercial Paper is usually sold at a
discount.
Bills of Exchange – is a binding agreement by one party to pay a fixed amount of cash to another
party as of a predetermined date or on demand.
Repurchase Agreements – also known as repo, RP, or sale and repurchase agreement, is a form of
short-term borrowing, mainly in government securities. The dealer sells the underlying security to
investors and, by agreement between the two parties, buys them back shortly afterwards, usually the
following day, at a slightly higher price.
Banker’s Acceptance – is an instrument representing a promised future payment by a bank. The
payment is accepted and guaranteed by the bank as a time draft to be drawn on a deposit. The draft
specifies the amount of funds, the date of payment (or maturity), and the entity to which the payments
owed. After the acceptances are distinguished from ordinary time drafts in that ownership is
transferable prior to maturity, allowing them to be traded in the secondary market.

BONDS – are fixed income instruments that represents a loan made by an investor to a borrower
(typically corporate or governmental). A bond could be thought of as an I.O.U between the lender and
borrower that includes the details of the loan and its payment. Bonds are used by companies or
government to finance projects and operations. It earns through interest payment and possible trading
gains. Moderate Risk with Moderate Income Potential and is Medium to Long-term Debt
Instruments.

Types of Bonds:
Government Bonds – Bonds that are issued by the government, although when issued by the
government the risk is moderate since bonds may change its interest rates. The Original Tenors is 2
years up to 25 years.
Corporate Bonds – Bonds that are issued by private companies or corporations to finance their
projects.

How do Bonds Work?

Supposed this is a bond issued by the Philippine Government. The Original Bond tenors are:

There are no fluctuations when Bond is held until maturity the said terms will apply and you will get the
annual interest of 40K (4% of 1M), and at the end of the term you will get back your 1M and another
40k. all in all your 1M has earned 200K. But when you sell it at the secondary market (where you sell
previously issued financial instruments) two things will happen depending on the current market
interest rates.

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 TOPIC II: Financial Assets and Interest Rates

When you sell it at a discount: When you sell it at a premium:

When you sell at a discount, it means you are selling your bonds at a lower price because the prevailing
market interest rates are higher. And that’s where the risk lies. For the example above (left), the market
interest rates are higher (5% compared to your 4% Bond), so normally people will chose to buy the
higher interest rates, so in order for you to sell your bond, you will lower the selling price so that people
will prefer it than buying the new bond.
When you sell at a premium, it means you are selling your bonds at a higher price because the
prevailing market interest rates are lower. Ad that’s another way you earn through bonds, by trading
it. For the example above (right), the market interest rates are lower (3% compared to your 4%), so
normally people will choose to buy your bond because of the higher interest rate so you can increase
your selling price to earn from trading.

The Graph shows the inverse relationship

between prevailing market interest rates of
bonds to the prices of Bonds.

EQUITIES – it represents ownership in a corporation. When you buy stocks or shares you become
part owner of the company issuing the stocks or shares. You earn here through Cash Dividends
(portion of earnings paid out to shareholders) and Price Appreciation (when the value of your stocks
increases and you traded it for a higher price than the price you originally bought it for). These are
High Risk with Higher Potential Return and Long-term Investment/Ownership of a corporation.

Types of shares/stocks/equities:
Preferred shares – the main difference between preferred and common stock is that preferred stock
gives no voting rights to shareholders while common stock does. But it has priority over a company’s
income, meaning they are paid dividends before common shareholders.
Common shares – gives voting rights to the shareholders. It is the last in line when it comes to
company assets, which means they will be paid out after creditors, bondholders, and preferred
shares.

Equities are volatile investments, meaning that the price of security can changed dramatically over a
short time period in either directions. That’s why these types of investment have a high risk.

RISK PROFILING
When we become financial advisor or even in managing our own finances, we must know how to
categorized an individual according to their risk profile to match it with the risks involved in the
financial assets. The risk profiles are Conservative, Moderately Conservative, Moderately

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Aggressive, Aggressive. If your client has a moderate conservative risk tolerance or appetite, what
we can advise to them are the investments with moderate risks like the Money Markets and the
Government Bonds. When their risk profile is Aggressive, you may suggest to them the High-Risk
Investments which are the Equities.
But remember, do not put all your eggs in one basket. Diversification is the best way to earn and
shift risks. For example, if you have money market funds and equities, and the price of equities goes
higher resulting to gains in your investments you may want to pull some of it and place it in your
money market funds and wait until the equities prices goes down so that you can buy more
shares/units.
Another tip is that, when your investment goes down, resulting to a net loss, don’t pull it out because
it is only paper loss, wait until your investment recovers or earns then you pull it out.
Last tip, when the price is lower or down, it is better to invest in this times because you can buy
more units/shares/bonds. Example. During the 1st months of the pandemic, the prices went down,
now it is slowly moving up. When you buy during the down time, you have earned already since the
prices now are slowly recovering. Do not buy when the prices are too high.

THREE TYPES OF INVESTMENT FUNDS:

http://myfinancemd.com/difference-uitf-mutual-
fund-vul/

https://onepesos.com/wp-content/uploads/2018/03/comparison-of-mutual-fund-and-uitf-1.png

VUL – Variable Universal Life Insurance is a type of insurance that builds a cash value. In a VUL,
the cash value can be invested in a wide variety of separate accounts similar to mutual funds, and
the choice of which of the available separate accounts to use is entirely up to the contract owner. It is
Insurance + Investments.
UITF – Unit Investment Trust Fund is a pool of investments funded by various investors. You can
think of it as as a basket with different fruits – one basket may contain mangoes, the other with
pineapples, and a third basket contains a combination of two fruits. In the case of a trust fund,
various holdings, instead of fruits, make up the investment. As with a fruit basket wherein you can
decide which fruits to buy, professional fund managers handle and manage the holdings of UITFs.
Since these professionals actively manage the fund, once you have set them up, you can sit back,
relax, and make your money work for you.

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MF – Mutual Funds is a type of financial vehicle made up of a pool of money collected from many
investors to invest in securities like stocks, bonds, money market instruments, and other assets.
Mutual funds are operated by professional money managers, who allocate the fund's assets and
attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is
structured and maintained to match the investment objectives stated in its prospectus.

CREDIT is generally defined as an agreement between a lender and a borrower, who promises to
repay the lender at a later date—generally with interest. Credit also refers to an individual or business'
creditworthiness or credit history. The word ‘credit’ came from the Latin creditum which means trust.

Classes and Kinds of Credit

1. According to its PURPOSE

a. Commercial Credit – which includes the promise to pay off businessmen for the funds they
borrowed in the purchase of goods for productive or profitable ventures. These are merchants,
distributors and manufacturers.
b. Agricultural Credit – which includes the promise to pay off farmers and farm organization
for the funds they borrowed in the acquisition of farm inputs.
c. Investment Credit – the promise to pay off individuals or business firms for the loans they
obtained in buying capital goods. This is also called Industrial Credit.
d. Consumer Credit – constitutes all the obligations to pay off people for the money they
borrowed for consumption purposes.
e. Speculative Credit – a type of credit, which is used for dealing in securities or goods with
the intention of making a profit through favorable price changes.
f. Export Credit – in some form and to some extent is always involved in all sorts of transactions
for which cash is not paid on or before shipment of goods out of country.
g. Industrial Credit – is intended for financing the needs of industries like logging, fishing,
manufacturing and others, and which involves big amounts of money.
h. Real Estate Credit – when credit is secured purposely for construction, acquisition,
expansion or improvement of real estate properties, it is termed as real estate credit.

2. As to terms
a. Short-term Credit – a loan in which is payable in less than one year
b. Intermediate-term Credit – a loan in which matures only in more than a year but less than
5 years.
c. Long-term Credit – a loan whose maturity is from 5 years or more.

3. According to Security
a. Secured Credit – It is a loan in which the borrower pledges some assets as collateral for the
loan.
Collateral: land, stocks, bonds, machines, houses, crops, and other valuable properties
b. Unsecured Credit – It is obtained without the use of property as collateral for the loan.
Borrowers generally must have high credit ratings to be approved.

4. According to sectors of society

a. Public credit – includes all grants of credit to government whether national, provincial,
municipal and its instrumentalities
b. Private credit – all grants of credits to non-government.

LOAN AND DISCOUNT FUNCTIONS

Loans means money lent at interest. Banks do not only accept deposits but also extended loans. It is
Important that the bank will be able to collect the amount needed to pay the interest to their depositor.
While most on the customers of commercial bank are businessmen. Their need is mostly short term.

Types of Loans
a. Demand Loans – repayable at a short notice
b. Term Loans - granted for more than one year and repayment of such loans is spread over
a longer period. The repayment is generally made in suitable instalments of fixed amount.

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 TOPIC II: Financial Assets and Interest Rates

INTEREST RATES

1. What are interest rates?

Generally, interest rates are prices. These are the price paid for the use of money for a period of
time and are expressed as a percentage of the total outstanding balance that is either fixed or
variable. There are two ways by which interest rate can be defined: first, from the point of view of a
borrower, it is the cost of borrowing money (borrowing rate); and second, from a lender’s point of
view, it is the fee charged for lending money (lending rate).
2. How are interest rates classified?
The interest rates charged on borrowed funds are generally classified according to the tenor or the
maturity period: short‐term (less than one year); medium‐term (more than one year but less than
five years); and long‐term (more than five years).
Interest rates differ, depending on the type of instruments (e.g., traditional deposit instruments like
savings deposit, time deposit, and some demand or current accounts, and investment instruments
like bonds, securities) and on the tenor of investment.
3. What are real interest rates?
Real interest rates are interest rates adjusted for the expected erosion of purchasing power resulting
from inflation. Real interest rates are what matter to households’ consumption and firms’
investment decisions, which collectively constitute aggregate demand. Demand for goods and
services cannot be directly controlled by nominal interest rate. Instead, demand is also affected by
expected inflation.
Being the main supplier of bank reserves, a central bank can only set the short‐run nominal policy
rate, which serves as the benchmark for market interest rates. A central bank cannot set the real
interest rates because it cannot set inflation expectations. One may therefore wonder how an
adjustment in short‐run nominal interest rate can affect consumption and investment decisions,
which are carried out over a longer horizon. The answer lies in the fact that central bank’s policy
action can influence not only the market rates but also inflation expectations. Thus, by signaling its
policy intent through nominal policy rate adjustment, the central bank can affect the real return on
funds faced by households and firms.
For example, a P1,000,000 investment with nominal 10 percent annual return will give the investor
at the end of the year P1,100,000, i.e., 1,000,000(1+.010). With 5 percent annual inflation, the real
value of the investment is P1,047,617, i.e., 1,100,000/(1+0.05). The real return is therefore 4.8
percent. This is given by r = (i‐π)/(1+π) (where r is real interest rate, i is nominal interest rate and π
is inflation rate). At low rates of inflation, this can be approximated by r=i‐π.
4. What is the yield curve?
The yield curve is what economists use to capture the overall movement of interest rates (which is
also known as “yields” in Wall Street parlance). Plot the day’s yield for various maturities of Treasury
bills (T‐bills) and bonds on a graph and you have the day’s yield curve. As can be seen from the chart
under the secondary market, the line begins on the left with the 3month T‐bills and ends on the right
with the 25‐year T‐bonds.
Government T‐bills and bonds are issued through yield auctions of new issues to generate cash for
the National Government (NG). This is referred to as the primary auction market. Secondary trading,
on the other hand, is carried out in over‐the‐counter (OTC) market. In the secondary market, the
most recently auctioned Treasury issue is considered current or on‐the‐run. Current issues are more
actively traded and more liquid, hence, they typically trade at lower yields.
As of end‐March 2020, the yields for government securities (GS) in the secondary market rose
generally (except for the 10‐year and 20‐year GS) relative to the end‐December 2019 levels, given
the increase in market uncertainties over (i) the economic impact of the coronavirus pandemic and
the corresponding quarantine measures imposed by governments around the world; (ii) the
eruption of Taal volcano in January; and (iii) geopolitical concerns between the US and Iran at the
beginning of the quarter. Debt paper yields were higher by a range of 5.8 bps for the 6‐month GS
to 73.1 bps for the 2‐year GS compared to end‐December 2019 levels. Meanwhile, secondary
market yields for the 10‐year and 20‐year GS declined by 15.0 bps and 9.8 bps, respectively.

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 TOPIC II: Financial Assets and Interest Rates

Yields of Government Securities in the Secondary Market

In percent

5. How are interest rates determined?

Today, the level of interest rates is determined by the interaction of the supply and demand for
funds in the money market. Interest rates, prior to their full liberalization in 1983, were fixed by the
Bangko Sentral ng Pilipinas (BSP). In 1981, the Central Bank of the Philippines deregulated all bank
rates except short‐term lending rates. In 1983, the deregulation of bank rates was completed with
the removal of the remaining ceilings on short‐term lending rates.
6. What is the BSP’s policy on interest rates? Does the BSP regulate the interest rate charged by banks,
lending investors and pawnshops?
Since 1983, the BSP has followed a market‐oriented interest rate policy. That is, it allows the market
to set its own rates. Thus, the BSP does not regulate the interest rate charged by banks, lending
investors and pawnshops. However, for transparency purposes, the BSP requires that the interest
rates applied must be duly indicated on the pawn ticket in case of pawnshops, the promissory note
in the case of lending investors, and loan agreements in the case of bank loans. The Monetary Board
only sets rates for the BSP’s overnight borrowing and lending facility to influence the timing, cost
and availability of money and credit, for the purpose of stabilizing the price level.
7. Can the BSP intervene so that banks will not charge very high lending rates?
The BSP’s past experience with rate‐setting made apparent the limitations of an administratively
fixed interest rate. For this reason, the BSP shifted to a market‐oriented interest rate policy in 1983.
The re‐imposition of rate ceilings or limits on the spread between the T‐bill rate and lending rate will
only introduce distortions in the credit market, including: a) the pricing of credit outside of the
fundamental issue of risk; b) the exclusion of certain segments of the economy from the market; c)
the need to also regulate other banking products and services; and d) the increased burden on bank
supervision.
After the Asian crisis, however, the Banker’s Association of the Philippines (BAP) decided to
implement a gentleman’s agreement to maintain a cap on the spread of bank lending rate of up to
a maximum of five (5) percent over the 91‐day T‐bill rate in the secondary market. A review of the
spread between the average monthly bank lending rate charged by commercial banks (both high‐
and low‐end) and the 91‐day T‐bill rate showed that banks are generally in compliance with the 500‐
basis point cap.
8. Can the BSP set interest rate levels?
Yes, by law, the BSP can effectively set interest rates. Under the Usury Law (Act No. 2655, as
amended by P.D. 116), the Monetary Board can prescribe the maximum interest rates for loans
made by banks, pawnshops, finance companies and similar credit institutions, and to change such
rates whenever warranted by prevailing economic conditions. Moreover, the BSP charter (R.A. No.
7653) allows the Monetary Board to take appropriate remedial measures whenever abnormal
movements in monetary aggregates, in credit or in prices endanger the stability of the Philippine
economy. Nevertheless, since 1983, the BSP has followed a market‐oriented interest rate policy.

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9. What factors influence the rise and fall in interest rates?

Interest rate movements in the Philippines are affected generally by the price level or inflation rate,
fiscal policy stance, and intermediation cost which could impact the demand and supply for money.
• Inflation rate. The BSP’s policy direction to achieve its mandate of maintaining price stability
has a marked influence on the interest rate level. When there is too much liquidity in the
system, there is more pressure for inflation to rise. To curb inflationary pressures arising from
excess liquidity in the system, the BSP will have to increase its key policy rates, i.e., overnight
borrowing rate or reverse repurchase rate (RRP) and overnight lending rate or repurchase
rate (RP). By increasing its key policy rates, the BSP is sending a signal to the market that the
general level of interest rates will be on an uptrend. In mirroring the movement of the BSP’s
policy rates, the benchmark 91‐day Tbill rate also sets the direction for other rates,
specifically, bank lending rates.
• Fiscal policy stance. The fiscal policy stance may also influence the direction of interest rates.
A government that incurs a fiscal deficit needs to finance its existing budgetary requirements
by borrowing from the domestic market or from abroad. The higher is the fiscal deficit, the
stronger the demand to borrow to finance the gap. This exerts upward pressure on domestic
interest rates, particularly if the government borrows from a relatively less liquid domestic
market.
• Intermediation cost. Financial institutions incur costs in extending their services. Interest
rates will tend to be high when intermediation cost is high. Included in the intermediation
costs are administrative costs and the BSP’s reserve requirements.
Other factors that could influence the interest rates include the maturity period of the financial
instrument and the perception of risks associated with the instrument. Those with longer‐term
maturity and with higher probability of incurring loss carry higher interest rates. The lack of
intermediation could also affect interest rate movement. For instance, with their larger holdings of
non‐performing assets (NPAs), banks are more cautious in their lending activities. This would tend
to induce an increase in interest rates.
10. What is an interest rate corridor (IRC) and how does it promote more stable interest rates?
An IRC is a system for guiding money market rates towards central bank (CB) target/policy rate. It
consists of a rate at which the CB lends reserves to banks and a rate at which it takes deposits from
them, with the CB policy/target rate set in the middle.
The IRC system consists of the following instruments: standing liquidity facilities, namely, the
overnight lending facility (OLF) and the overnight deposit facility (ODF); the overnight reverse
repurchase (RRP) facility; and a term deposit auction facility (TDF). The interest rates for the standing
liquidity facilities form the upper and lower bounds of the corridor, while the overnight RRP rate is
currently set in the middle of the corridor. The repurchase (RP) and Special Deposit Account (SDA)
windows were replaced by standing OLF and ODF, respectively. Meanwhile, the RRP facility was
modified to a purely overnight RRP. In addition, the TDF serves as the main tool for absorbing
liquidity.
The key benefit of the adoption of an IRC system in the Philippines is the strengthening of monetary
policy transmission by ensuring that money market interest rates move within a reasonable range
around the BSP’s policy rate. Upon the implementation of the IRC, the BSP narrowed the width of
the corridor from 350 basis points to 100 basis points (+ 50 basis points). This narrower corridor will
help limit potential interest rate volatility.
The new IRC system is also seen to confer other benefits over time. It is expected to promote greater
interbank market activity by encouraging banks to undertake their day‐to‐day liquidity management
more actively as BSP monetary operations gradually exert a stronger influence on short‐term
liquidity conditions. Moreover, the offering of the TDF is expected to promote the establishment of
benchmarks for short‐term interest rates. Increased activity and better pricing in money market
rates, in turn, are seen to help add depth to money markets and help develop the domestic capital
market. Over time, the implementation of the IRC system will also allow possible adjustments in
reserve requirements in line with international norms.

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11. Why are interest rates not the same in all banks?
The cost of doing business varies from bank to bank and this is reflected in the different lending rates
charged by the banks.
12. What interest rates are monitored by the BSP?
Interest rates monitored by the BSP include:1
• Overnight Lending Facility (OLF) Rate ‐ the interest rate on the standing overnight lending
(i.e. Repurchase) facility at which the BSP lends reserves to commercial banks.
• Overnight Deposit Facility (ODF) Rate ‐ the interest rate on the overnight/term deposit (i.e.
Special Deposit Account) facilities at which the BSP takes deposits from commercial banks.
• Term Deposit Facility (TDF) Rate ‐ the interest rate on the term deposit (i.e. 7‐day and 28‐
days term deposits auctioned using variable‐rate with multiple price tenders) facilities at
which the BSP takes deposits from commercial banks.
• Overnight Reverse Repurchase (RRP) Facility Rate – the interest rate on the RRP facility at
which overnight RRP agreements are offered to banks. The offering involves a fixed rate and
full‐allotment method where individual bidders are awarded a portion of the total offer
depending on their bid size.
• Treasury bill (T‐bill) Rate ‐ the rate on short‐term debt instruments issued by the NG for the
purpose of generating funds needed to finance outstanding obligations. T‐bills come in
maturities of 91, 182 and 364 days. Auction is usually held on Mondays at the Bureau of the
Treasury.
• Interbank Call Loan Rate ‐ the rate on loans among banks for periods not exceeding 24 hours
primarily for the purpose of covering reserve deficiencies.
• Philippine Interbank Offered Rate (PHIBOR) ‐ represents the simple average of the interest
rate offers submitted by participating banks on a daily basis, under the auspices of the BAP.
The participants consist of 20 local and foreign banks, which post their bid and offer rates
between 10:30 – 11:30 A.M. on an electronic monitor where lending rates in pesos are
determined. The rates given by the banks are used as their dealing rates or the rates at
which they will be able to borrow from or lend to the market during the day. Launched by
the BAP on 1 February 1996, PHIBOR serves as an indicator of the banking system’s level of
liquidity.2
• Philippine Interbank Reference Rate (PHIREF) ‐ the implied interest rate on the peso derived
from all done USD/PHP swap and forward transactions. The rate is a firm price, not an
indicative quote, transacted among financial institutions. The PHIREF rate is estimated
through a “fixing” arrangement wherein an average rate is calculated from rates contributed
by a panel of banks.
• PHP BVAL Reference Rates‐ are benchmark rates for the Philippine peso in the GS market.
The PHP BVAL Reference Rates are calculated by Bloomberg Finance Singapore L.P. and/or
its affiliates in an agreement with the BAP. 3
• Time Deposit Rate ‐ the weighted average interest rate charged on interest‐bearing deposits
with fixed‐maturity dates and evidenced by certificates issued by banks.
• Savings Deposit Rate ‐ the rate charged on all interest‐bearing deposits of banks, which can
be withdrawn anytime. It is derived as the ratio of interest expense on peso deposits of
sample banks to the total outstanding level of these deposits.
• Bank Average Lending Rate ‐ the weighted average interest rate charged by commercial
banks on loans granted during a given period of time. Monthly data are computed as the
ratio of actual interest income of sample banks on their peso‐denominated loans to the total
outstanding level of these loans.

1 Data on interest rates are available at the BSP website through this link: www.bsp.gov.ph/statistics.online.asp
2
Effective 15 April 2013, the Bankers Association of the Philippines has stopped the setting and publication of PHIBOR rates.
3 On 29 October 2018, the Bankers Association of the Philippines (BAP) replaced the PDST Reference Rates and launched the PHP

BVAL Reference Rates. The BVAL methodology employs a two‐pronged approach or algorithm involving (i) Step One – direct
observations with actual trades, executable levels and indicative quotes; and (ii) when direct market observations are insufficient,
Step Two – direct observations of Comparable Bonds to derive a relative value, prices and rates for the benchmark tenor.

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•Lending Rate ‐ refers to the range (high and low) of lending rates reported by commercial
banks on a daily basis. The low end refers to the prime lending rate.
13. Why is there a gap between the banks’ savings deposit rate and lending rate?
The gap reflects the interest rates charged on loans, covering not only the cost of funds (marginal
cost), but also intermediation and other overhead costs, as well as the spread or profit margin. The
spread represents the risk premium assigned to a particular loan exposure — the higher the risk, the
higher the spread. It should also be noted that the data on lending rates reflect the average interest
rate level and hence, provide only a broad indication of loan tenors and risk exposures.
In Q4 2019, the interest rates on savings and time deposits (all maturities) averaged 0.989 percent
and 3.128 percent, respectively. Bank lending rates (all maturities), meanwhile, averaged 6.796
percent during the same period. These translated to a gap ranging 3.668‐5.807
percent between the lending and deposit rates.
14. What implications do interest rate levels have on the economy?
During normal times, a low‐interest rate environment, which reflects competitive conditions as well
as the actual cost of funds, should impact positively on a bank’s financial performance. Low interest
rates encourage borrowing to finance economic activity. This speeds up economic growth, improving
the borrowers’ ability to repay loans, which, in turn, should affect favorably the bank’s earnings.
Thus, banks gain from low interest rates in two ways: the increased demand for bank loans, and the
reduction in non‐performing loans. The stock market similarly prospers due to prospects of high
corporate profits.
The experience of many countries shows that high interest rates tend to reduce borrowing for
investment activity, ultimately leading to slower economic growth. Slower economic growth, in turn,
reduces corporate profits and, hence, the ability to repay loans, which impacts negatively on banks’
balance sheets. High interest rates also tend to encourage investors to pull out their funds from the
stock market and invest them instead in fixed‐income securities.
An emerging economy that is expected to grow robustly will naturally see higher interest rates to
temper inflationary pressures.
Too low an interest rate can also have serious repercussions. Having very low interest rate for a long
time can lead to sharp and sustained increases in asset prices beyond what can be supported by
long‐term economic fundamentals. Such asset price increases spawn expectations of higher short‐
term trading profits more than the assets’ future earning capacity.
There is also the so called zero lower bound, that is, nominal interest rate cannot go below zero. A
zero nominal interest rate would mean that the real interest is negative, which is a mirror image of
too low aggregate demand. With negative real rates, households will opt not to deposit their cash
in the banks because the real return is eroded. Investors will also postpone planned investment
because returns are negative. Hence, economic activity is stalled and recession sets in. Under this
scenario, interest rates are of no help to the economy.
15. How would you describe interest rate developments since the mid‐1990s?
T‐bill rates have generally been declining since mid‐1998 (Table 1 and Chart 1). The decline in yields
continued until it reached its lowest in 2002, when rates began to inch up anew until 2004. T‐bill
rates eased in 2005 and 2006, reflecting decelerating inflation, improving fiscal performance, and
ample liquidity in the financial system. In addition, average lending rates mirrored the movement in
the yields of government securities. This decline in interest rates was accompanied by a flattening
of the yield curve, which suggests an easing in monetary conditions and relatively well‐contained
inflation expectations.
The downtrend in T‐bill rates continued until April 2007. However, beginning May, T‐bill rates began
to rise on account of the uncertainty brought about by the local elections. Rates continued to
increase gradually until September due to worries over the impact of the US subprime mortgage
market troubles on local markets, despite continued benign inflation. In December, average
domestic interest rates eased following the Government’s announcement of a record‐budget
surplus in November. These rates remained low compared to year‐ago levels but were higher
relative to the rates posted at the start of 2007.
In 2008, T‐bill rates trekked a general uptrend as a result of higher inflation due mainly to rising
commodity prices and later in the year, due to the higher risk premium demanded by the market
players in reaction to the global financial turmoil.

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 TOPIC II: Financial Assets and Interest Rates

Beginning 2009, short‐term interest rates started to ease following the six rate cuts in the BSP’s key
policy rates since December 2008. In 2010 and 2011 primary interest rates declined further as a
result of the BSP’s previous monetary policy decisions.
In 2012, domestic interest rates in the primary market started to increase on the back of cautious
market sentiment amid the continuing debt crisis in the euro area. The rising T‐bill rates also
reflected investors’ preference for longer‐dated government papers given expectations of a
manageable inflation outlook over the policy horizon. In 2013, domestic interest rates in the primary
market declined significantly due to strong demand for government securities on the back of the
country’s strong macroeconomic fundamentals and ample liquidity in the financial system.
In 2014, the average T‐bill rates in the primary market edged higher as investors sought higher yields
on expectations of an increase in interest rates as the US Federal Reserve’s monthly bond‐buying
program ended in October 2014. In 2015, Treasury bill rates in the primary market rose across tenors
even as domestic inflation remained subdued throughout the year. In 2016, T‐bill rates declined
reflecting strong investor preference for short‐dated tenors amid concerns over slowing economic
growth in Asia and the continued expectation of a US Fed rate hike in the coming months. In 2017,
T‐bills increased due to geopolitical concerns overseas and heightened uncertainty on the direction
of US fiscal and monetary policy. In 2018, T‐bill rates further increased as a result of policy rate hikes
by the BSP and the US Federal Reserve.
The average interest rates for the 91‐, 182‐ and 364‐day T‐bills in the primary market in Q1 2020
rose to 3.161 percent, 3.459 percent, and 3.793 percent from 3.118 percent, 3.229 percent, and
3.528 percent, respectively, in the previous quarter. The results of the auctions reflected market
players’ risk aversion amid geopolitical tensions between the US and Iran as well as concerns over
the impact of Taal Volcano’s eruption during the early part of the quarter. However, a declining
trend was seen mid‐part of the quarter following the 75‐basis point cumulative policy rate cut by
the BSP and due to increased demand for short‐term government securities amid uncertainties
and lingering concerns over the COVID‐19 outbreak.

Table 1

Chart 1

Source: Bureau of Treasury

FM 102 – Monetary Policy and Central Banking 11

 TOPIC II: Financial Assets and Interest Rates

FM 102 – Monetary Policy and Central Banking 12

 TOPIC II: Financial Assets and Interest Rates

References:
Pagoso, C.M. (2010) Money, Credit and Banking.
Aquino et Al (2015) Money, Banking and Financial Market 4/E
Stephen G. Cechetti (2015) Money, Banking and Financial Market
Roberto Medina (2014) Money, Credit and Banking
Croushore, Dean (2012) Money and Banking
https://www.wikipedia.org
https://business.inquirer.net/196107/mutual-funds-vul-uitf-or-
stocks#:~:text=The%20main%20difference%20between%20these,in%20the%20mutual%20fund%2
0company.
https://www.investopedia.com/terms/m/mutualfund.asp
https://www.bsp.gov.ph/Media_and_Research/Primers%20Faqs/intrates.pdf

Prepared by: Reviewed by:

_______________________ _______________________
Joshua F. Orobia Melissa S. Carbonell, MBA
Instructor Chairperson, Business Administration Department

FM 102 – Monetary Policy and Central Banking 13