Compare discount securities to Treasury

bonds with bond equivalent yields (ibey)

MONEY MARKETS
● Liquid funds flow between
short-term borrowers and lenders
through money markets
● Money markets involve debt
instruments with original maturities
of one year or less
● Money market debt issued by
high-quality (i.e., low default risk)
economic units that require Convert bond equivalent yields into effective
short-term funds purchased by annual returns (EAR)
economic units that have excess
short-term funds
● Money market instruments have Money market securities that pay interest
active secondary only at maturity use single-payment yields
MONEY MARKET INSTRUMENTS (ispy) (e.g., jumbo CDs and CB funds)

Treasury bills (T-bills)

Overnight Reverse Repurchase

(RRP)
Facility Repurchase agreements
(repos or RP)
Commercial paper (CP)
Negotiable certificates of deposit
(CD)
MONEY MARKET YIELDS
Some money market instruments are
bought and sold on a discount basis
(e.g.,Treasury bills and commercial paper)
TREASURY BILLS (T-BILLS)
● T-Bills are short-term debt
obligations issued by the
government
● The Central Banks buys and sells
T-bills to implement monetary
policy
● T-bills are virtually default risk free,
are highly liquid, and have little
interest rate risk
T-BILL AUCTIONS
● 13- and 26-weekT-bills are auctioned
weekly
● Bids are submitted by government
securities dealers, financial and
nonfinancial corporations, and
individuals
● Bids can be competitive or
noncompetitive competitive bids
specify the bid price and the desired
quantity of T-bills
 ● noncompetitive bidders get
preferential allocation and agree to
pay the lowest price of the winning
competitive bids
T-BILL AUCTION
THE SECONDARY MARKET FOR
T-BILLS
1. The secondary market forT-bills is
the largest of any money market
instrument
2. 22 primary dealers “make” a market
in T-bills by buying the majority
3. sold at auction and by creating an
active secondary market
4. primary dealers trade for
themselves and for customers
5. T-bill purchases and sales are
book-entry transactions conducted
over Fedwire
6. T-Bills are sold on a discount basis
T-BILL PRICES
T-Bill prices can be calculated from quotes
by rearranging the discount yield equation
P=P−i (dy) h P 0 f T − B i l l 3 6 0 f
Or by rearranging the bond equivalent yield
equation
OVERNIGHT REVERSE
REPURCHASE (RRP) FACILITY
● The discount rate is the target rate in
the conduct of monetary policy
● transactions are short-term (mostly
overnight) unsecured loans
● overnight borrowings between banks
and other entities to maintain their
bank reserves
● Banks with excess reserves lend
funds, while banks with deficient
reserves borrow funds
REPURCHASE AGREEMENT
● A repurchase agreement (repo or
RP) is the sale of a security with an
agreement to buy the security back
at a set price in the future
● Repos are short-term collateralized
loans (typical collateral are Treasury
securities)
● A reverse repurchase agreement is
the opposite side of a repo (i.e., it is
the purchase of a security with an
agreement to sell it back in the
future)
● The yield on repurchase agreements
(iRA) uses a 360-day year like the
discount rate, but uses the current
price in the denominator like the
bond equivalent yield
A COMMERCIAL PAPER
1. Commercial paper (CP) is the largest
money market in terms of dollars
outstanding
2. CP is unsecured short-term
corporate debt issued to raise
short-term funds (e.g., for
working capital)
3. Generally sold in large
denominations (e.g., $100,000 to $1
million) with maturities between 1
and 270 days
 4. CP is usually sold to investors
indirectly through brokers and
dealers (approximately 85% of the
time)
5. CP is usually held by investors until
maturity and has no active
secondary market
6. Yields are quoted on a discount
basis (like T-bills)
CERTIFICATE OF DEPOSIT
● is defined as a “written
acknowledgement by a bank of the
receipt of money on deposit which
the bank promises to pay to the
depositor, bearer or to some other
person or order.
● No particular form is necessary to
constitute a certificate of deposit.
● The clear and unmistakable
language of Section 180 of the Tax
Code imposes a tax on certificates of
deposits drawing interest, orders for
the payment of any sum of money
otherwise than at sight or on
demand
THE ESSENTIAL ELEMENTS OF A
CERTIFICATE OF DEPOSIT
1. The bank receives money for deposit
2. The bank acknowledges the receipt of the
deposit
through the issuance of a gwritten
document
3. The bank promises to pay to the depositor
or bearer or to some other person or order
the deposit upon maturity
4. The bank imposes an early withdrawal
penalty in case of withdrawal prior to
maturity which comes in the form of
reduced interest.
CERTIFICATE OF DEPOSIT
HASTHE FOLLOWING DISTINCT
FEATURES:
1. Minimum deposit requirement;
2. Stated maturity period
3. Interest rate is higher than the ordinary
savings account
4. Not payable on sight or demand, but
upon maturity or in case of
pre-termination,prior notice is required
5. Early withdrawal penalty in the form of
partial loss or total loss of interest in case of
pre-termination.
EXAMPLE
BDO and Union Bank will offer long-term
negotiable certificates of deposits (LTNCDs)
to raise P5 billion each, according to
separate disclosures to the Philippine Stock
Exchange.
BDO is offering P5 billion worth of
seven-year LTNCDs at an indicative interest
rate range of 3 to 3.25 percent a year until
Aug. 27. It has tapped ING Bank and
Standard Chartered Bank as joint lead
arrangers and selling agents.
BANKER’S ACCEPTANCE
A Banker’s Acceptance (BA) is a time draft
payable to a seller of goods with payment
guaranteed by a bank
Used in international trade transactions to
finance trade in goods that have yet to be
shipped from a foreign exporter (seller) to a
domestic importer (buyer)
Foreign exporters prefer that banks act as
payment guarantors before sending goods to
importers
Banker’s acceptances are bearer
instruments and thus
are salable in secondary markets
Money market funds
mutual funds that invest shareholder’s
funds in money market securities.
BASIC FEATURES OF MONEY
MARKET FUNDS IN THE
PHILIPPINES
 Initial capital, or the minimum investment
to open a money market fund.
Additional investment,or the amount you
want to add to your investment that may
range anywhere from PHP 25 PHP to at
least PHP 100,000, depending on your
fund.
Sales load, which is charged to you
whenever you make an additional
investment.
Trust fee, usually at .05% to 1% to cover
operations, management or
administrative expenses.
Holding period, or the period of time you
are supposed to keep your investment in
your money market fund.
Exit fee, which is computed when you
redeem your investment before the end of
your holdout period.
EXAMPLE
Sun Life Prosperity Money Market Fund
Minimum investment amount: PHP 100
Minimum subsequent: PHP 100 Minimum
holding period: 7 days
Fee: 0.15%
Early redemption fee: 0.25% Launch date:
July 1, 2004
MCGRAW-HILL/IRWIN 5-24
©2009, The McGraw-Hill Companies, All
Rights Reserved
BPI MONEY MARKET FUND:
LOW-RISK INVESTMENT FOR
SHORT-TERM GOALS
WHAT ARE THE ADVANTAGES OF
MONEY MARKET FUNDS?
Money market funds are good alternatives
to a bank savings account.They keep your
money somewhere safe while earning
passive income in a short period of time.
They are less risky for your short-term
financial goals because they mature in just 6
to 12 months.And they are highly liquid,
which means you can easily and quickly
convert your investment to cash.
Any investment still carries even a tiny
amount of risk. Money market funds are not
insured by the Philippine Deposit Insurance
Commission, unlike your savings account or
time deposits.
They may also not pay more than savings
accounts or time deposits, especially when
you factor in all the fees and charges. Some
banks or mutual fund companies have a
high initial amount of investment, so this
can be a problem for people who want to
invest but don’t have the required amount.
MONEY MARKET PARTICIPANTS
● The Government Treasury
● The Central Banks
● Commercial banks
● Money market mutual funds
● Brokers and dealers
● Corporations
● Other financial institutions
● Individuals
INTERNATIONAL MONEY
MARKETS
● U.S. dollars held outside the U.S. are
tracked among multinational banks
in the Eurodollar market
● The rate offered for sale on
Eurodollar funds is the London
Interbank Offered Rate
(LIBOR)
● Eurodollar Certificates of Deposits
are U.S. dollar denominated CDs
held in foreign banks
● Eurocommercial paper
(Euro-CP) is issued in Europe and
can be in local currencies or U.S.
dollars
BOND MARKETS
PREMYO BONDS

BOND AND BOND MARKETS

Capital markets involve equity and debt

instruments with maturities of more than
one year
Bonds are long-term debt obligations
issued by corporations and government
units
Bond markets are markets in which
bonds are issued and traded
-Treasury notes (T-notes) and bonds
(T-bonds)
-Municipal bonds (Munis)
-Corporate bonds

TYPES OF SECURITIES
ISSUED BY THE NATIONAL
GOVERNMENT THROUGH THE
BUREAU OF THE TREASURY (BTR)
• Treasury bills (fixed-rate)
• Treasury bonds (fixed-rate
coupon-bearing and zeroes)
• Retail treasury bonds (RTBs,
fixed-rate coupon-bearing)
• Multi-currency retail treasury bonds
(MRTBs, fixed-rate coupon-bearing)
• Dollar-linked peso notes (fixed-rate)

Issued by the National Government

through Other Entities
• Debt securities issued by
government-owned and -controlled
corporations (GOCCs)
• Debt securities issued by government
agencies
TREASURY NOTES AND
TREASURY NOTES AND BONDS BONDS
Treasury notes and bonds (T-notes and ● T-notes have original maturities
T- bonds) are issued by the Government from over 1 to 10 years
Treasury to finance the national debt and ● T-bonds have original maturities
other government expenditures from over 10 years
The annual budget deficit is equal to ● Issued in minimum denominations
annual expenditures (G) less taxes (T) (multiples) of $1,000
received
● May be either fixed principal or
annual federal deficits:
inflation- indexed
MCGRAW-HILL/IRWIN
● inflation-indexed bonds are called
The national debt (ND) is the sum of
Treasury Inflation Protection
historical
Securities (TIPS)
● the principal value of TIPS is
adjusted by the percentage change in
the Consumer Price Index (CPI)
every six months
TREASURY NOTES AND BONDS ● Trade in very active secondary
markets
● Prices are quoted as percentages of
Default risk free: Low returns: low facevalue,
backed by the full interest rates
faith and credit of (yields to maturity)
the governmentb reflect low default
risk TREASURY STRIPS
Separate Trading of Registered
Interest rate Liquidity risk: Interest and Principal Securities
risk: because of older issued T- (STRIPS), a.k.a.Treasury zero bonds or
their long bonds and T-notes Treasury zero-coupon bonds
maturity,T-notes trade less Financial institutions and government
and T-bonds frequently than securities brokers and dealers create
experience wider newly issued T- STRIPS from T-notes and T-bonds
price fluctuations bonds and T-notes STRIPS have the periodic interest
than money market payments separated from each other and
securities when from the principal payment
interest rates one set of securities reflects interest
change payments one set of securities reflects
principal payments
 STRIPS are used to immunize against
interest rate risk MCGRAW-HILL/IRWIN
6-11
©2009, The McGraw-Hill Companies, All
Rights Reserved
TREASURY NOTES AND BONDS
“Clean” prices are calculated as:
V = INT (PVIFA )+M(PVIF )
Vb = the present value of the bond
M = the par value of the bond
INT = annual interest payment (in dollars)
N = the number of years until the bond
matures m = the number of times per year
interest is paid
id = interest rate used to discount cash flows
on the bond MCGRAW-HILL/IRWIN
b m id/m,Nm
id/m,Nm
©2009, The McGraw-Hill Companies, All
Rights Reserved
6-12
TREASURY NOTES AND
BONDS
Accrued interest on T-notes and T-bonds is
calculated as:
Accrued interest = INT Actual number of
days since last coupon payment 2 Actual
number of days in coupon period
The full (or dirty) price of a T-note or T-
bond is the sum of the clean price (Vb) and
the accrued interest
TREASURY NOTES AND BONDS
● The primary market of T-notes n
T-bonds is similar to that of
T-bills; the Treasury sells T-notes
and T-bonds through competitive
and noncompetitive single-bid
auctions
● 2-year notes are auctioned
monthly
● 3, 5, and 10-year notes are
auctioned quarterly (Feb,
● May,Aug, and Nov)
● 30-year bonds are auctioned
semi-annually (Feb and Aug)
● Most secondary trading occurs
directly through brokers and
dealers
MUNICIPAL BONDS
● Municipal bonds (Munis) are
securities issued by state and local
governments
-to fund imbalances between expenditures
and receipts
-to finance long-term capital outlays
Attractive to household investors because
interest is exempt from federal and most
local income taxes
General obligation (GO) bonds are
backed by the full faith and credit of the
issuing municipality
Revenue bonds are sold to finance
specific revenue
generating projects
MUNICIPAL BONDS IN THE
PHILIPPINES
● Our local government units are
expressly authorized to issue bonds,
debentures, securities, collateral
notes and other obligations to
finance self-liquidating, income-
 producing development and
livelihood projects.
● As early as 1998, the Bankers
Association of the Philippines and
the Development Bank of the
Philippines created the Local
Government Unit Guarantee
Corporation (LGUGC) to facilitate
LGU bond floatation. Even before
the creation of the LGUGC,there
were municipal bond
flotation—although very few—in the market.
● The LGUGC was the first privately
managed local government
guarantee corporation set up in a
developing country in Asia.
Among the
● LGUGC-guaranteed LGU bonds
were those issued by the cities of
Caloocan and Tagaytay; Puerto
Princesa and the
● But while we were the first in
Asia to come up with this initiative,
our municipal bond market has not
been fully developed and utilized as
a tool of economic development at
the local level.
● As a matter of fact, the records of
the LGUGC
would readily indicate that there have only
been a handful of LGU bond issuances.The
LGUGC guarantees more bank loans than
bond
floatation by our LGUs.
MUNICIPAL BONDS
● Compare Muni returns with fully
taxable corporate bonds by finding
the after-tax return for corporate
bonds: ia = ib(1 – t)
ia = after-tax rate of return on a taxable
corporate bond ib = before-tax rate of
return on a taxable bond
t = marginal total income tax rate of the
bond holder
Alternately, convert Muni interest rates to
tax equivalent rates of return: ib = ia/(1 – t)
MUNICIPAL BONDS
> Primary markets
● firm commitment
underwriting:a public offering of
Munis made through an investment
bank,where the investment bank
guarantees a price for the newly
issued bonds by buying the entire
issue and then reselling it to the
public
● best efforts offering: a public
offering in which the investment
bank does not guarantee a firm price
● private placement:bonds are sold on
a semi-private basis to qualified
investors (generally FIs)
> Secondary markets: Munis trade
infrequently due mainly to a lack of
information on bond issuers
CORPORATE BONDS
● Corporate bonds are
long-term bonds issued by
corporations
● A bond indenture is the
legal contract that specifies
the rights and obligations
of the issuer and the
holders
● Bearer versus registered
bonds
● Term versus serial bonds
 ● Mortgage bonds are required coupon
secured debt issues to payment
submit s to the
● the correct
coupons person.
to a
CORPORATE BONDS bank for
BEARER VERSUS REGISTERED payment
BONDS and then
redeem
Bearer bonds the
● physical
certificat
Bearer REGISTERE e when
bonds D BONDS the bond
reaches
● fixed-inc ● debt the
ome instrum maturity
security ent date.
that is whose
owned bondhol
by the der's TERM VERSUS SERIAL BONDS
holder, informat
or ion is
bearer, kept on
rather record
than by with the
a issuing
registere party. TERM SERIAL
d owner. ● By BONDS
● The archivin
coupons g the
notes issued by ● a bond issue
for owner's
companies to the that is
interest name,
public or investors structured
payment address,
with so that a
s are and
scheduled maturity portion of
physicall other
dates. the
y details,
outstanding bonds
attached issuers
mature at regular
to the ensure
intervals until all of
security. they're
the bonds have
● The making
matured.
bondhol the
der is bond's
 incvb = rate of return on a nonconvertible
● Because the
bond opcvb = value of the conversion option
bonds
Stock warrants give bondholders the
mature
opportunity to purchase common stock at a
gradually
prespecified price
over a
period of
years, these
bonds are
used to
finance
projects that
provide a
consistent
income
stream for
bond
repayment. Debentures ● a type of
bond or
other debt
instrument
that is
unsecured
by
collateral.

Subordinated ● is an
debentures unsecured
loan or
bond that
MORTGAGE BONDS ranks below
mortgage bond is secured by a other, more
mortgage, or a pool of mortgages, that senior loans
are typically backed by real estate or securities
holdings and real property, such as with respect
equipment. to claims on
assets or
Debentures and subordinated earnings.
debentures ●
Convertible bonds versus Subordinate
non-convertible bonds d
icvb = incvb − opcvb icvb = rate of return on debentures
a convertible bond are thus also
known as
 junior issuer of a
securities. non-callable bond
In the case can’t call the
of borrower bond prior to its
default, date of maturity.
creditors
who own
subordinate
d debt will A Sinking fund ● provision is
not be paid a
out until requirement
after senior that the
bondholders issuer retire
are paid in a certain
full. amount of
the bond
issue early
Callable bonds ● also known as the bonds
as a approach
redeemable maturity.
bond, is a
bond that
the issuer
may redeem
before it
reaches the
stated
maturity Primary markets are identical to that
date.
of Munis
● A callable
Secondary markets the exchange
bond allows
the issuing
market (e.g., PSE, NYSE) the
company to over-the-counter (OTC) market
pay off their Bond ratings
debt early the two major bond rating agencies are
Moody’s and
Standard & Poor’s (S&P)
Non-callable ● Bond that is
bonds are rated by perceived default
bonds only paid
risk
out at
maturity. bonds may be either investment or
The speculative (i.e., junk) grade
MCGRAW-HILL/IRWIN
6-29
©2009, The McGraw-Hill Companies,
All Rights Reserved
BOND MARKET INDEXES
Managed by major investment banks
Reflect both the monthly capital gain
and loss on
bonds plus any interest (coupon) income
earned
Changes in values of bond indexes can
be used by bond traders to evaluate
changes in the investment attractiveness
of bonds of different types and
maturities
BOND MARKET
PARTICIPANTS
The major issuers of debt market
securities are federal, state and local
governments, and corporations
The major purchasers of capital market
securities are households, businesses,
government units, and foreign investors
businessesandfinancialfirms(e.g.,banks,i
nsurancecompanies,and mutual funds)
are the major suppliers of funds for
Munis and corporate bonds
foreign investors and governments are
the major suppliers of funds for T-notes
and T-bonds
MCGRAW-HILL/IRWIN
6-31
©2009, The McGraw-Hill Companies, All
Rights Reserved
INTERNATIONAL BONDS AND
MARKETS
● International bond markets involve
unregistered bonds that are
internationally syndicated,offered
simultaneously to investors in
several countries,and issued outside
of the jurisdiction of any single
country
● Eurobonds are long-term bonds
issued outside the country of the
currency in which they are
denominated
● Foreign Bonds are long-term bonds
issued outside of the issuer’s home
country
● Brady Bonds are bonds swapped for
an outstanding loan to a less
developed country
● Sovereign Bonds are Brady Bonds
that have had their underlying
collateral removed and the
creditworthiness of the country is
substituted instead
MORTGAGE
MARKETS
MORTGAGES AND MORTGAGE-
BACKED SECURITIES
● Mortgages are loans to individuals or
businesses to purchase homes, land,
or other real property
MORTGAGE-BACKED SECURITIES
(MBS)
● Many mortgages are securitized
● mortgages are packaged and sold as
assets backing publicly traded or
privately held debt instruments (i.e.,
mortgage-backed securities (MBSs))
 MORTGAGES DIFFER FROM
BONDS AND STOCKS
mortgages are backed by a specific piece of
real property
primary mortgages have no set size or
denomination
primary mortgages generally involve only a
single investor
comparatively little information exists on
mortgage borrowers
PRIMARY MORTGAGE
MARKET
Four basic types of mortgages are
issued by financial institutions
● home mortgages are used to
purchase one- to four- family
dwellings
● multifamily dwellings mortgages are
used to purchase apartment
complexes, townhouses, and
condominiums
● commercial mortgages are used to
finance the purchase of real estate
for business purposes
● farm mortgages are used to finance
the purchase of farms
MORTGAGE CHARACTERISTICS
● Collateral: lenders place liens
against properties that remain in
place until loans are fully paid off
● A down payment is a portion of the
purchase price of the property a
financial institution requires the
borrower to pay up front
● private mortgage insurance (PMI) is
generally required when the
loan-to-value ratio is more than 80%
HOUSING LOANS PHILIPPINES
MORTGAGE CHARACTERISTICS
● Conventional mortgages are
mortgages that are not government
insured
● Amortized mortgages have fixed
principal and interest payments that
fully pay off the mortgage by its
maturity date
● fully amortized mortgage maturities
are usually either 15 or 30 years
● Balloon payment mortgages require
fixed monthly
● interest payments for 3 to 5 years
whereupon full payment
● of the mortgage principal is due
MORTGAGE CHARACTERISTICS
● Fixed-rate mortgages lock in the
borrower’s interest rate required
monthly payments are fixed over the
life of the mortgage lenders assume
interest rate risk
● Adjustable-rate mortgages
(ARMs) tie the borrower’s interest
rate to some market interest rate or
interest rate index
● required monthly payments can
change over the life of the mortgage
yearly interest rate changes are often
capped
● borrowers assume interest rate risk
● ARMs can increase default risk
MORTGAGE
CHARACTERISTICS
Discount points are fees or payments
made when a mortgage loan is issued
● each point costs the borrower 1
percent of the principal value
● the lender reduces the interest rate
used to determine the payments
on the mortgage in exchange for points paid
Other fees MORTGAGE PAYMENTS
● application fee The present value of a mortgage can be
● title search written as:
● title insurance PV = principal amount borrowed
● appraisal fee PMT = monthly mortgage payment
● loan origination fee PVIFA = present value interest factor of an
● closing agent and review fees other annuity
fees r = monthly interest rate on the mortgage
MCGRAW-HILL/IRWIN t = number of monthly payments over the
7-11 life of the mortgage
©2009, The McGraw-Hill Companies, All Rearrange to isolate the payment:
Rights Reserved MCGRAW-HILL/IRWIN
1j
MORTGAGE CHARACTERISTICS j=11+r PrM,tT=(PVIFA )
Mortgage refinancing t
when a borrower takes out a new mortgage PV = PMT = PMT(PVIFA ) PV
and uses r,t
the proceeds to pay off an existing mortgage ©2009, The McGraw-Hill Companies, All
mortgages are most often refinanced when Rights Reserved
an existing mortgage has a higher interest 7-14
rate than prevailing rates
borrowers must balance the savings of a OTHER TYPES OF
lower monthly payment with the costs (fees) MORTGAGES
of refinancing ● Automatic rate-reduction mortgages
an often-cited rule of thumb is that the new ● Graduated-payment mortgages
interest (GPMs)
rate should be 2 percentage points less than ● Growing-equity mortgages (GEMs)
the ● Second mortgages and home equity
refinanced mortgage rate loans Shared-appreciation
MCGRAW-HILL/IRWIN mortgages (SAMs)
7-12 ● Equity-participation mortgages
©2009, The McGraw-Hill Companies, All (EPMs)
Rights Reserved Reverse-annuity mortgages (RAMs)

MORTGAGE AMORTIZATION
Each fixed monthly payment consists partly
of repayment of the principal and partly of
the interest on the outstanding mortgage
balance
An amortization schedule shows how the
fixed monthly payments are split between
principal and interest
SECONDARY MORTGAGE
MARKETS
FIs remove mortgages from their
balance sheets through one of two
mechanisms
● by pooling recently originated
mortgages together and selling them
in the secondary market
 ● by securitizing mortgages (i.e.,
by issuing securities backed by
newly originated mortgages)
Advantages of securitization
● FIs can reduce the liquidity risk,
interest rate risk, and
● credit risk of their loan portfolios
● FIs generate income from
origination and service fees
SECONDARY MORTGAGE MARKETS
● The U.S. government established
the Federal National Mortgage
Association (FNMA or Fannie
Mae) in the 1930s to buy mortgages
from thrifts so they could make more
mortgage loans
● FHA and VA insured loans make
securitization easier
● Government National
Mortgage Association (GNMA or
“Ginnie Mae”) and Federal Home
Loan Mortgage Corp. (FHLMC or
“Freddie Mac”) created in the 1960s
● encouraged continued expansion of
the housing market
● provided direct and indirect
guarantees that allow for the
creation of mortgage-backed
securities
MORTGAGE SALES
FIs have sold mortgages among themselves
for over 100 years
A large part of correspondent banking
involves small banks selling parts of large
loans to larger banks
Large banks often sell parts of their loans
(i.e., participations) to smaller banks
Mortgage sales occur when an FI
originates a mortgage and sells it to an
outside buyer
a loan sale is made with recourse if the loan
buyer can sell the loan back to the originator
should it go bad
MORTGAGE SALES
Mortgage sellers: money center banks,
smaller banks, foreign banks, investment
banks
Mortgage sales allow FIs to manage credit
risk, achieve better asset diversification, and
improve their liquidity and interest rate risk
positions
FIs are encouraged to sell loans for
economic and regulatory reasons
sold mortgages can still generate fee
income for the bank
sold mortgages reduce the cost of reserve
and capital requirements
Mortgage buyers: foreign and domestic
banks, insurance companies, pension funds,
closed-end bank loan mutual funds, and
nonfinancial corporations
MORTGAGE BACKED SECURITIES
● Pass-through securities “pass
through” promised principal and
interest payments to investors
● Three agencies are directly involved
in the creation of pass-through
securities
Ginnie Mae Fannie Mae Freddie Mac
Private mortgage pass-through issuers
create pass-throughs from nonconforming
mortgages
MORTGAGE BACKED SECURITIES
Collateralized mortgage obligations
(CMOs) are multiclass pass-throughs with
multiple bond holder classes or tranches
each bond holder class has a different
guaranteed coupon
mortgage prepayments retire only one
tranche at a time, so all
other trances are sequentially prepayment
protected
Mortgage-backed bonds (MBBs)
MBBs allow FIs to raise long-term low-cost
funds without removing
 a group of mortgage assets is pledged as
collateral against a MBB issue, but there is
no direct link between the cash flows of the
mortgages and the cash flows on the MBB
mortgages from their balance sheets
MCGRAW-HILL/IRWIN
7-21
©2009, The McGraw-Hill Companies, All
Rights Reserved
INTERNATIONALTRENDS IN
SECURITIZATION
Foreign investors participate in U.S.
mortgage and MBS markets, but the value
held has decreased since 1992
Europe is the world’s second largest and
most developed securitization market
the United Kingdom is the biggest MBS
issuer in the European market, followed by
Germany
the advent of the Euro has accentuated the
increased trend in securitization in Europe
Mortgage lending has grown in Russia since
the early
2000s because of changes in property
ownership laws
MCGRAW-HILL/IRWIN
7-22
©2009, The McGraw-Hill Companies, All
Rights Reserved
FINANCIAL CRISIS OF 2007-2008
MCGRAW-HILL/IRWIN 7-23
©2009, The McGraw-Hill Companies, All
Rights Reserved
STOCK MARKET Common
stocks
● Common stock is the fundamental
ownership claim in a public or
private corporation
● Dividends are discretionary and
are thus not guaranteed
● Common stockholders have the
lowest priority claim in the event
of bankruptcy (ex. residual claim)
● Limited liability implies that
common stockholders can lose no
more than their original
investment
● Common stockholders control the
firm’s activities indirectly by
exercising their voting rights in
the election of the board of directors
Dual-class firms have two classes of
common shares outstanding, with different
voting rights assigned to each class.
- With cumulative voting, the
number of votes assigned to each
stockholder equals the number of
shares held multiplied by the
number of directors to be elected
A proxy vote allows stockholders to vote by
absentee ballot (e.g., by mail)
PREFERRED STOCK
- Preferred stock is a hybrid
security that has characteristics of
both bonds and common stock
Generally has fixed dividends that
are paid quarterly
- Generally does not have voting
rights unless dividend payments
are missed
- Nonparticipating versus
participating
- Cumulative versus
noncumulative
- Primary markets are markets
where corporations raise funds
through new issues of stock, most
 of the time through investment
banks
- Investment banks act as
distribution agents in best efforts
underwriting
- act as principals in firm
commitment underwriting
GROSS PROCEEDS – NET PROCEEDS
= UNDERWRITER”S SPREAD
A syndicate is a group of investment
banks working in concert to issue
stock; the lead underwriter is the
originating house
PRIMARY STOCK MARKETS
An initial public offering (IPO) is the
first public issue of financial instruments by
a firm
Seasoned offering
- is the sale of additional
securities by a firm whose
securities are already publicly traded
- pre-emptive rights give existing
stockholders the ability to maintain
their proportional ownership
- A red herring prospectus is a
preliminary version of the
prospectus that describes a new
security issue
Shelf registration allows firms to offer
multiple issues of stock over a two-year
period with only one registration statement
SECONDARY STOCK MARKETS
- are the markets in which stocks,
once issued, are traded among
investors
- EXCHANGE vs. Over the
Counter(OTC)
BASIS FOR COMPARISON
EXCHANGE
- is an organized and regulated
market, wherein trading of stocks
takes place between buyers and
sellers in a safe, transparent and
systematic manner.
- Exchange itself
- Well established companies
- Has Physical location
- Exchange hours
- Listed Stocks
- High transparency
- Standardized contracts
OTC (OVER THE COUNTER)
- is a decentralized dealer market
wherein brokers and dealers transact
directly via computer networks and
phone.
- Dealer
- Small companies
- No physical location
- 24×7
- Unlisted Stocks Low Customized
- Low transparency
- Customized contracts
EXCHANGES EXAMPLES
The U.S. has three major stock markets:
- New York Stock Exchange Euronext
(NYSE Euronext)
- National Association of Securities
Dealers Automated Quotation
(NASDAQ)
- American Stock Exchange (AMEX)
The Philippine Stock exchange
NYSE EURONEXT
- Created by the merger of NYSE
Group, Inc. and Euronext N.V. on
April 4, 2007 to become the first
truly global stock market
- Over 3,200 different stocks trade on
NYSE Euronext
 - Trading occurs at a specific place on
the floor of the exchange called a
trading post
- Each stock has a special market
maker called a specialist that
maintains liquidity for the stock at
all times
NYSE EURONEXT
- Three types of transactions occur at
trading posts
- a market order is an order to
transact at the best price available
when the order reaches the trading
post
- a limit order is an order to transact
at a specified price
- specialists transact for their own
account
Program trading is the simultaneous
buying and selling of a portfolio of at least
15 different stocks valued at more than $1
million using computer programs to initiate
the trades
Circuit breakers give investors time to
make informed choices during periods of
high market volatility
TRADING ON NYSE EURONEXT AND
AMEX
STOCK MARKET QUOTES
● Name
● Symbol Open
● High
● Low
● Close
● Net Chg % Chg
● Volume
● 52 Wk High 52 Wk Low Div
● Yield
● P/E
● YTD % Chg
AMEX
- lists smaller firms than NYSE
Euronext
- Operates as a broker-specialist
market-maker system like NYSE
Euronext
- Pioneered exchange traded funds
(ETFs)
- ETFs are index funds that are listed
on an exchange and can be traded
intraday
NASDAQ AND OTC MARKETS
- is the world’s first electronic market
and has no physical trading floor
- Provides continuous trading for the
most active stocks traded over the
counter (OTC)
- Primarily a dealer market in which
often more than 20 dealers act as
market makers
- A small order execution system
(SOES) provides automatic order
execution for orders of less than or
equal to 1,000 shares
- The NASD maintains an electronic
“OTC bulletin board” and “pink
sheets” for small firms that are not
part of the NASDAQ
SECONDARY STOCK MARKETS
Choice of market listings
NYSE has extensive listing requirements
(e.g.,firm market value
and trading volume)
AMEX listing requirements are less
stringent than NYSE and NASDAQ
requirements are even less so
Electronic communication networks
(ECNs)
normal trading occurs between 9:30 a.m.
and 4:00 p.m. eastern
standard time
extended-hours trading occurs through
computerized
alternative trading systems (ATSs) a.k.a.
ECNs
Online trading via the internet is becoming
increasingly
popular to both individual and professional
investors
STOCK MARKET INDEXES
A stock market index is the composite value
of a group of secondary market-traded
stocks
Price-weighted index
the Dow Jones Industrial Average (DJIA),
composed of 30 companies, is the most
widely know stock market index
Value-weighted indexes NYSE Composite
Standard & Poor’s 500 NASDAQ
Composite
Wilshire 5000
THE PSEI
- is the main index of the Exchange. It
is composed of the 30 largest and
most active common stocks listed at
the PSE.
- By gauging changes in the stock
prices of select listed companies, the
PSEi provides a snapshot of the
market’s overall condition.
- In the past, various names were used
to refer to the Exchange’s main
index, such as the Phisix and the
PSE Composite Index.
● Households, mutual funds, and
private pension funds are the largest
holders of corporate stock
● Market efficiency is the speed with
which financial security prices adjust
to unexpected news
• weak form market efficiency
• semistrong form market efficiency
• strong form market efficiency
Stock Market Regulation:
- The Securities and Exchange
Commission (SEC) is the primary
regulator of stock markets
- The SEC delegates certain regulatory
responsibilities to the exchanges for
the day-to-day surveillance of
activity
- The main emphasis of SEC
regulation is on full and fair
disclosure of information on
securities
- Recently imposed regulations aim to
reduce excessive price fluctuations
and increase auditing oversight
INTERNATIONAL ASPECTS OF STOCK
MARKETS
- U.S. stock markets are the world’s
largest
- European markets have increased
their share of the global market with
the advent of a common
currency,the Euro
- Growth has recently strengthened in
the U.K., Canada, Japan, and Pacific
Basin countries
 - International stock markets allow Market for Foreign Currency (Pounds)
investors to diversify by holding Depreciation is a decrease in the value of a
stocks issued by corporations in currency relative to another currency.
foreign countries P
- International diversification can Dollar Price of 1 Pound
increase risk due to incomplete 0
information about foreign stocks as LO: 12-3
well as foreign exchange and Sl
political risk $3
Dollar Depreciates (Pound Appreciates)
$2
Dollar Appreciates (Pound Depreciates)
$1
Exchange Rate: $2 = £1
Foreign Exchange Markets
Q see picture
Appreciation is an increase in the value of
a currency relative to another currency.
Foreign Exchange Markets Quantity of Pounds
Foreign exchange markets are markets in l
which cash flows from the sale of products Dl
or assets denominated in a foreign Q
currency are transacted 12-11

Foreign exchange markets

● facilitate foreign trade
● facilitate raising capital in foreign
markets
● facilitate the transfer of risk between
market participants
● facilitate speculation in currency
values
Foreign Exchange Risk
Foreign exchange risk is the risk that cash
flows will vary as the actual amount of
LOCAL CURRENCY received on a foreign
investment changes due to a change in
foreign exchange rates
9- 12

A foreign exchange rate is the price at Currency depreciation occurs when a

which one currency can be exchanged for
another currency
McGraw-Hill/Irwin
9-7
In the market for foreign currency, the
intersection of the demand for
foreign currency and the supply of
foreign currency determine the exchange
rate.
country’s currency falls in value relative to
other currencies
domestic goods become cheaper for foreign
buyers
foreign goods become more expensive for
domestic purchasers
McGraw-Hill/Irwin
Currency appreciation occurs when a
country’s currency rises in value relative to
other currencies

Determinants of Exchange Rates
Factors that cause a country’s currency to
appreciate or depreciate are:
Tastes
Relative Income
Relative Price Levels (INFLATION) Relative
Interest Rates
Speculation LO: 12-3
12-14
Determinants of Exchange Rates
Factors that cause a country’s currency to
appreciate or depreciate are:
● Tastes
● Relative Income
● Relative Price Levels
(INFLATION)
● Relative Interest Rates
● Speculation LO: 12-3
12-17
Foreign Exchange History
McGra
Foreign exchange markets
w-Hill/Irwin
operated under the gold standard through
most of the 1800s
U.K. was the dominant international trading
country until WWII forced it to deplete its
gold reserves to purchase arms and
munitions from the U.S.
9- 23
1944: Bretton Woods Agreement fixed
exchange rates within 1% bands
1971: Smithsonian Agreement increased
bands to 2 1⁄4%
1973: Smithsonian Agreement II
introduced “managed” free float
McGraw-Hill/Irwin
9- 24
Foreign Exchange Markets
Foreign exchange25 markets are the largest
of all financial markets: turnover averaged
$3.2 trillion per day in 2007
London accounts for 42.5%
New York accounts for 23.8%
France accounts for 7.1%
● Prior to 1972, the only channel
through which foreign exchange
occurred was through banks
● twenty-four hours a day
over-the-counter (OTC) market
among major banks
● electronic trading of spot and
forward contracts
● over 90% of contracts are settled
with delivery of currency
9- 26
Foreign Exchange Markets
Organized markets have existed since
1972
9- 27
● International Money Market (IMM)
(a subsidiary of the Chicago
Mercantile Exchange (CME)) is
based in Chicago
● derivative trading in foreign
currency futures and options
● less than 1% of contracts are
completed with delivery of the
underlying currency
In 1982 the Philadelphia Stock
Exchange (PHLX) became the first
exchange to offer around-the-clock trading
of currency options
 National currency Unless interfered by BSP (Central Bank)
>> PEGGED (FIXED)
Money of a country is its symbol and
Price or exchange rate is determined by
identity
market forces of demand and supply
USA= dollar ($)
Increase in exchange rate $ to PHP
Germany=Deutschmark (DM)
• Dollar appreciated
Great Britain= British Pound (α)
• Peso depreciated (also called devaluation)
Japan= Yen (Y)
European Union= Euro (€)

Forex Peeged fixed

BSP buys and sells dollars to maintain a
certain exchange rate

Over valued: BSP rate < market rate

EXCHANGE RATE
Price of one currency expressed in terms of
another currency
Direct quote= local /foreign Indirect
quote= 1/ direct
quote
Ask rate= selling rate by banks
Bid rate= buying rate by banks
Cross rate= computation of exchange rate
for a currency from the exchange rate of
two other currencies
Undervalued:
BSP rate > market rate
Managed float exchange rate
BSP interferes during disorderly or erratic
fluctuations of exchange rates
Dirt vs clean float
CLEAN FLOAT= interferences only due to
erratic rates
DIRTY FLOAT=Interference to achieve
objectives other than erratic rates

Floating. Pegged
Foreign Exchange. Transactions External economic ● Decline in
spot foreign exchan transactions disturbance investments
1. involve the immediate exchange of Effect on Big ● Internal
currencies at current exchange rates exports economic
forward foreign exchange transactions ● Business disturbance
involve the exchange of currencies at a uncertaintie ● Open
specified exchange rate at a specific date in s economy (
the future ● big Imports)
9- g3e2 Fluctuations ● Product
in diversificati
TYPES OF EXCHANGE RATES commodity on Similar
Determined by market forces of demand prices rate of
and supply ● Cost push inflation
>> FLOATING RATE inflation
 DERIVATIVE SECURITIES
● Increase in ● with trading
MARKET
foreign debt partner
● Decline in Requires
investments High DERIVATIVES
reserves ● A derivative security is an agreement
Inelastic between two parties to exchange a
demand or standard quantity of an asset at a
● supply predetermined price at a specific
date in the future
● Derivative securities markets are the
markets in which derivative
Alternative policy proposals securities trade
● Dollar exchange control Selective Derivatives involve the buying and
imports selling (i.e., the transfer of) risk,
● Tight credit policy which results in a positive impact on
● Sound fiscal policies ( expenditures, the economic system
taxes , balanced budget Derivatives are used for hedging and
for speculation MCGRAW-HILL/IRWIN
10-7

BACKGROUND
Derivative securities are securities that are
neither debt nor equity and whose values
are derived from the values of other,
related securities.
Derivative securities are not used by
corporations to raise funds.
Rather, they serve as a useful tool for
managing certain aspects of firm risk.
Two of the most popular types of derivative
securities are options and financial futures.

FORWARDS AND FUTURES

A spot contract is an agreement to
transact involving the immediate exchange
of assets and funds
A forward contract is a
non-standardized agreement to transact
involving the future exchange of a set
amount of assets at a set price
A futures contract is a standardized
exchange traded agreement to transact
involving the future exchange of a set
amount of assets for a price that is
settled daily
MCGRAW-HILL/IRWIN
10-9
FINANCIAL FUTURES
A financial futures contract is a contract
in which one party agrees to deliver a
specified about of a specified financial
instrument to the other party at a specified
price and date.
The buyer of the financial futures contract
receivesw
the financial instrument on the settlement
date.
The seller delivers the financial instrument
and receives payment on the settlement
date.
FUTURES MARKETS
Futures contracts are usually traded on
organized exchanges
Exchanges indemnify counterparties
against credit (i.e., default)
risk
Futures are marked to market daily
marked to market describes the prices on
outstanding futures contracts that are
adjusted each day to reflect current futures
market conditions
The five major U.S. exchanges are the
CBOT, CME, NYFE, MACE, and KCBOT
The principal regulator of futures markets
is the Commodity Futures Trading
Commission (CFTC)
MCGRAW-HILL/IRWIN
10-11
IS THERE A FUTURES MARKET IN
THE PHILIPPINES
Atty. Rafael Padilla, 14 October 2023
The Philippine Stock Exchange (PSE) has
been interested in setting up a futures
exchange (for regulatory reasons, through a
subsidiary or via joint venture) for more
than 20 years—ever since the Securities and
Exchange Commission (SEC) first proposed
the issuance of rules for the reopening of a
futures exchange in the Philippines, only
five years after the MIFEI scandal.
But PSE never actually launched futures
trading partly for regulatory reasons.
It is also doubtful whether the Philippines
is ready to reopen futures trading 25 years
after the country’s first and only futures
exchange was ordered by the SEC to cease
operations.
FUTURES MARKETS
Futures contract trading occurs in trading
“pits” using an open-outcry auction among
exchange members
floor brokers place trades for the public
professional traders trade for their own
accounts
position traders take a position in the
futures market based on their expectations
about the future direction of the prices of
the underlying assets
day traders take a position within a day and
liquidate it before day’s end
scalpers take positions for very short
periods of time, sometimes
only minutes,in an attempt to profit from
active trading
MCGRAW-HILL/IRWIN
10- 13
FINANCIAL FUTURES QUOTATIONS
Figure 21.5
Source: Wall Street Journal, January 20,
2000, p. C22.
OPTIONS
https://www.youtube.com/watch?v=VJgHk
AqohbU&list=RDCMUCFCEuCsyW
P0YkP3CZ3Mr01Q&start_radio=1&rv=VJg
HkAqohbU&t=9
OPTIONS = a right but not a obligation
=exercise price =x
An option is an instrument that provides its
holder with an opportunity to purchase or
sell a specified asset at a stated price on or
before a set expiration date.
Options are probably the most popular type
of derivative security.
Three basic forms of options are rights,
warrants, and calls and puts.
This session will focus on call and put
options.
CALL OPTIONS
A call option is an option to purchase a
specified number of shares of stock
(typically 100) on or before a specified
future date at a stated price.
They usually have initial lives of 1 to 9
months.
The striking price is the price at which the
holder of a call can buy the stock at any time
prior
to the option’s expiration date.
The striking price is usually set at or near
the prevailing market price of the stock at
the time it is issued.
CALL OPTIONS
Executing Call Option Transactions
Investors purchase call options in the same
way
they purchase stocks—by calling their
broker. The price of the call option is called
an option
premium.
American-style call options are call options
that can be exercised at any time throughout
the life of the option.
European-style call options are options that
can be exercised only on the expiration date.
CALL OPTIONS
Figure 21.1
Source: Wall Street Journal, January 21,
2000, p. C13.
CLASSIFYING CALL OPTIONS
Table 21.1
ACTIVITY 1: SPECULATING WITH
CALL OPTIONS
Bill Warden purchased a call option on
Flight stock for $4 per share, with an
exercise price of $60 per share.
He plans to exercise his option at the
expiration date of the stock price at the time
it is above $60.
He plans to sell immediately the stock he
receives from exercising the option.
Bill wants to determine what his profit per
share would be under various possible
outcomes
for the price of Flight stock.
SPECULATING WITH CALL OPTIONS
Table 21.2
SPECULATING WITH CALL OPTIONS
Figure 21.2
SPECULATING WITH CALL OPTIONS
Table 21.3
SPECULATING WITH CALL OPTIONS
Table 21.4
SPECULATING WITH CALL OPTIONS
Figure 21.3
SPECULATING WITH CALL OPTIONS
Factors that Affect the Call Option Premium
Stock price relative to exercise price Time to
expiration
Stock price volatility
PUT OPTIONS
A put option is an option to sell a specified
number of shares of stock (typically 100) on
or before a specified future date at a stated
price.
They usually have initial lives of 1 to 9
months.
The striking price is the price at which the
holder of a put can sell the stock at any time
prior to the option’s expiration date.
The striking price is usually set at or near
the prevailing market price of the stock at
the time the put option
is issued.
CLASSIFYING PUT OPTIONS
Table 21.5
ACTIVITY 2: SPECULATING WITH PUT
OPTIONS
Emma Rivers purchased a put option on
Zector stock for $3 per share, with an
exercise price of $40 per share. She plans to
exercise her option at the expiration date if
the stock price at that time is below $40.
She plans to purchase the stock just before
exercising her put option. Emma wants to
determine what her profit per share would
be under various possible outcomes for the
price of Zector stock.
Factors that Affect the Put Option Premium
Stock price relative to exercise price Time to
expiration
Stock price volatility
CLACK- SCHOLES OPTION PRICING
MODEL
BE REFLECTIVE (ICV/ RV, BIBLE
PASSAGE)
What is the significance of the Bible
passage taken from Ecclesiastes 4:9-12 in
your life as you explore merger, acquisition,
and risk management?
Two are better than one, because they have
a good reward for their toil. For if they fall,
one will lift up his fellow. But woe to him
who is alone when he falls and has not
another to lift him up! Again, if two lie
together, they keep warm, but how can one
keep warm alone? And though a man might
prevail against one who is alone, two will
withstand him—a threefold cord is not
quickly broken.

SPECULATING WITH PUT OPTIONS

Table 21.6

SPECULATING WITH PUT OPTIONS

Figure 21.4

SPECULATING WITH PUT OPTIONS

Table 21.7

SPECULATING WITH PUT OPTIONS

PUT OPTIONS