(1) FUNDAMENTALS (introduction)

Financial Markets
- Refers broadly to any marketplace where the trading of securities occurs.
> Including the stock market, bond market, forex market, and derivatives market,
among others.
- A financial market is a market where buyers and sellers trade commodities,
financial securities, foreign exchange, and other freely exchangeable items (fungible
items) and derivatives of value at low transaction costs and at prices that are
determined by market forces.

Tradable commodities fall into the following four categories:

1. Metal (such as gold, silver, platinum, and copper)
2. Energy (such as crude oil, heating oil, natural gas, and gasoline)
3. Livestock and Meat (including lean hogs, pork bellies, live cattle, and feeder cattle)
4. Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar)

Primary Markets versus Secondary Markets

Primary Markets
- Markets in which users of funds (e.g. corporations, governments) raise funds by
issuing financial instruments (e.g. stocks and bonds).
Secondary Markets
- Markets where financial instruments are traded among investors.

Money Markets versus Capital Markets

Money Markets
- Markets that trade debt securities with maturities of one year or less (e.g. Treasury
bills).
Capital Markets
- Markets that trade debt (bonds) and equity (stock) instruments with maturities of
more than one year.

Foreign Exchange Markets

- “FX” markets deal in trading one currency for another (e.g. dollar for yen).
- The “spot” FX transaction involves the immediate exchange of currencies at the
current exchange rate.
- The “forward” FX transaction involves the exchange of currencies at a specified date
in the future and at a specified exchange rate.

Derivative Security Markets

- The markets in which derivative securities trade.
Derivative Security
> An agreement between two parties to exchange a standard quantity of an asset at
a predetermined price on a specified date in the future.

Overview of Financial Institutions

● Institutions that perform the essential function of channeling funds from those with
surplus funds to those with shortages of funds to those with shortages of funds (e.g.
 banks, thrifts, insurance companies, securities firms and investment banks, finance
companies, mutual funds, pension funds)
Financial Institutions
- Companies engaged in the business of dealing with financial and monetary
transactions such as deposits, loans, investments, and currency exchange.

Types of FIs
Commercial banks
- Depository institutions whose major assets are loans and major liabilities are
deposits
Thrifts
- Depository institutions in the form of savings and loans, credit unions
Insurance Companies
- Financial institutions that protect individuals and corporations from adverse events.
Securities firms and investment banks
- Financial institutions that underwrite securities and engage in securities brokerage
and trading
Finance Companies
- Financial institutions that make loans to individuals and businesses
Mutual Funds
- Financial institutions that pool financial resources and invest in diversified portfolios
Pension Funds
- Financial institutions that offer savings plans for retirement

Risks Faced by Financial Institutions

● Interest Rate Risk
● Foreign Exchange Risk
● Market Risk
● Credit Risk
● Liquidity Risk
● Off-Balance-Sheet Risk
● Technology Risk
● Operational Risk
● Country or Sovereign Risk
● Insolvency Risk

Regulation of Financial Institutions

● FIs provide vital financial services to all sectors of the economy; therefore, their
regulation is in the public interest
● To prevent their failure and the failure of financial markets overall

Globalization of Financial Markets and FIs

● Financial Markets became more global as the value of stocks traded in foreign
markets soared
● Foreign bond markets have served as a major source of international capital
 ● Globalization also evident in the derivative securities market

Factors leading to Significant Growth in Foreign Markets

- The pool of savings from foreign investors has increased
- International investors have turned to other markets to expand their investment
opportunities
- Information on foreign investments and markets is now more accessible (e.g.
internet)
- Some mutual funds allow ability to invest in foreign securities with low transaction
costs
- Deregulation has enhanced globalization of capital flows

The Need to Study Financial Markets

Financial Markets involve enormous flows of funds* affecting business profits.
- Exchange rates, interest rates, derivatives, inflation, source of funds/capital, i.e.,
bonds, shares of stocks, bank loans.
The study will help you understand the issues concerning the flow of funds*
- Transfer from sources to destinations,
- Effects on national and world economy,
- Effects on personal wealth.

The Need to Study Financial Institutions

- Interactions:
> Individual (borrower, investor)
> Employee (treasury functions)
> Employer or business owner (need to source funds)
- Possible employment in the institution

Levels of Framework in the Study

- Understand
> economic analysis to be able to organize concepts and facts.
- Evaluate
> current developments to learn how to use financial data and economic analysis to
properly interpret current events.
- Predict
> likely changes in the economy and financial system

(2) MONEY AND INTEREST RATES

Money
- An economic unit that functions as a generally recognized medium of exchange for
transactional purposes in an economy.
- A means of payment for goods and services or repayment of debts, serves as an
asset to the holder.
- In modern economy, it is not directly backed by intrinsic (underlying) value.
> hence, the financial system works on an entirely fiduciary basis.
Role/Function of Money in the Economy
1. Medium of exchange
- It is accepted freely in exchange for all other goods
- Barter system is very inconvenient so the introduction of money has got over
the difficulty of barter.
2. Measure of value
- Money acts as a common measure of value; it is a unit of account and a
standard of measurement
- When we buy a good in the market, we pay a price for it in money; and price
is nothing but value expressed in terms of money.
3. Store of value
- Money is a convenient form to store wealth
Example: Suppose the wealth of a man consists of a thousand cattle. He
cannot preserve his wealth in the form of cattle. But if there is money, he can
sell his cattle, get money for that and can store his wealth in the form of
money.
4. Standard of deferred payments
- It forms the basis for credit transactions
- If credit transactions were to be carried on the basis of commodities, there
would be a lot of difficulties and it will affect trade.

Money Supply (Money Stock)

- The total value of money available in an economy at a point of time
- Consists mostly of currency and demand deposits.
> Currency includes all coins and paper money issued by the government and the
banks

Key Measures for the Money Supply

M1: Narrow Measure
- Includes all currency (i.e., cash) in circulation, traveler’s checks, demand deposits at
commercial banks (or other depository institutions) held by the public, and other
checkable deposits
- It is often referred to as the narrowest measure of money supply or narrow money.
- It refers primarily to money used as a medium of exchange.

M2: Intermediate Measure

- Includes everything in M1 as well as savings deposits and balances in retail money
market funds
- It refers primarily to money used as a store of value

M3: Broad Measure

- Includes everything in M2 as well as large time deposits, balances in institutional
money market funds, and term repurchase agreements.
> a contract in which the vendor of a security agrees to repurchase it from the buyer
at an agreed price.
M4 (L): Broadest Measure
- In addition to everything in M3, this includes liquid and near liquid assets such as:
> short-term treasury bills,
> high grade commercial paper,
> and bank acceptance notes
M4 (L)
Treasury bills, notes and bonds
- Marketable government debt securities.
> Treasury bills have maturities of a year or less
> Treasury notes are issued with maturities from two to ten years
> Treasury bonds are long-term investments that have maturities of 10 to 30 years from
their issue date

High grade commercial papers

- An unsecured, short-term debt instrument issued by a corporation, typically for the
financing of accounts payable and inventories or meeting short-term liabilities.
Maturities on commercial paper rarely range longer than 270 days.
- The most fundamental type of commercial paper is a promissory note, a written
pledge to pay money. A promissory note is a two-party paper.

Bank acceptance note

- 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 the payment, and the entity to which
the payment is owed.

The Demand for Money

- In monetary economics, the demand for money is the desired holding of financial
assets in the form of money, that is, cash or bank deposits rather than
investments.
- It can refer to the demand for money narrowly defined as M1 (directly spendable
holdings), or for money in the broader sense of M2 or M3.
- The demand for money is affected by several factors such as:
 Level of Income
 Interest rates and inflation
 Uncertainty about the future
- The way in which these factors affect money demand is usually explained in terms of
the three motives for demanding money.

Three Motives for Demanding Money (Sources of Demand)

1. Transaction Demand
- People prefer to be liquid for day-to-day expenses. The amount of liquidity
desired depends on the level of income, the higher the income, the more
money is required for increased spending. This is called transaction demand.
 2. Precautionary Demand
- Precautionary demand is the demand for liquidity to cover unforeseen
expenditure such as an accident or health emergency. The demand for this
type of money increases as the income level increases.
3. Speculative Demand
- The demand to take advantage of future changes in the interest rate or bond
prices.
- The higher the rate of interest, the lower the speculative demand for money.
And lower the rate of interest, the higher the speculative demand for money.

The Impact of Money

- Higher interest rates will decrease investments
 It becomes more expensive to borrow money.
 Consumption will decrease because consumers will tend to save.
- Higher peso will decrease exports resulting in slower GDP growth.

The Quantity Theory of Money

- Quantity theory of money states that money supply and price level in an economy are
in direct proportion to one another.
- Other things remaining unchanged, as the quantity of money in circulation increases,
the price level also increases in direct proportion and the value of money decreases
and vice versa.

Assumption Used in the Quantity Theory of Money

1. Constant Velocity of Money
 Not influenced by the changes in the quantity of money.
 The velocity depends upon exogenous factors like population, trade activities,
habits of the people, interest rate, etc. These factors are relatively stable and
change very slowly over time.
2. Constant Volume of Trade or Transactions
 Total volume is viewed as independently determined factors like natural
resources, technological development, population, etc., which are outside the
equation and change slowly over time. Thus, any change in the supply of
money (M) will have no effect on the total volume.
3. Price Level is a Passive Factor
 The price level is affected by other factors of equation, but it does not affect
them.
 P is the effect and not the cause in the equation. An increase in M and V will
raise the price level. Similarity, an increase in Y (T) will reduce the price level.
4. Money is a Medium of Exchange
 The quantity theory of money assumed money only as a medium of
exchange. Money facilitates the transaction. It is not hoarded or held for
speculative purposes.
5. Constant Proportional Relation Between Currency Money and Bank Money
 Bank money depends upon the credit creation by the commercial banks
which, in turn, are a function of the currency money, thus, the ratio remains
constant.
 6. Long Period
 Over a long period of time, V and volume of transactions (GDP) are assumed
to be constant.
 As P is a passive factor, it becomes clear, that a change in the money supply
(M) will lead to a direct and proportionate change in the price level (P).

Broad Conclusions of Fisher’s Quantity Theory

i. The general price level in a country is determined by the supply of and the
demand for money.
ii. Given the demand for money, changes in money supply lead to proportional
changes in the price level.
iii. Since money is only a medium of exchange, changes in the money supply,
change absolute and not relative prices and thus leave the real variables such as
employment and output unaltered. Money is neutral.
iv. Under the equilibrium conditions of full employment, the role of monetary policy is
limited.
v. During the temporary disequilibrium period of adjustment, an appropriate
monetary policy can stabilize the economy.
vi. The monetary authorities, by changing the supply of money, can influence and
control the price level and the level of economic activity of the country.

The Equation of Exchange

- It is the mathematical expression of the quantity theory of money. In its basic form,
the equation says that:
 The total amount of money that changes hands in an economy equals the
total money value of goods that change hands, or that nominal spending
equals nominal income.

MxV=PxY
Where, M = Money supply
V = Velocity of money
P = Price Level
Y = Volume of the transactions (Real GDP)

- The velocity of money is a measure of the number of times that the average unit of
currency is used to purchase goods and services within a given time period.
- The equation states the fact that the actual total value of all money expenditures
(MV) always equals the actual total value of all items sold (PY).

Time Value of Money

The value of money changes over time. Money invested in a bank today will be worth much
more in 10 year’s time.
- Money can be invested and will grow
- The future value of Php1 increases by the yield % each year.
Interest
- The cost of using money
> when you borrow, you pay interest
> when you lend or deposit funds in bank accounts, you can earn interest
- Money paid regularly at a particular rate for the use of money lent, or for delaying the
repayment of a debt
> it is distinct from a fee which the borrower may pay the lender or some third party
 > typically expressed as annual percentage rate (APR)

Interest Rates
- Is the amount a lender charges for the use of assets expressed as a percentage of
the principal
> the assets borrowed could include cash, consumer goods, or large assets such as
a vehicle or building
- Is the cost of debt for the borrower and the rate of return for the lender.
- While interest rates represent interest income to the lender, they constitute a cost
of debt to the borrower
- Companies weigh the cost of borrowing against the cost of borrowing against the
cost of equity, such as dividend payments, to determine which source of funding will
be the least expensive, hence, the cost of capital is evaluated to achieve an optimal
capital structure.

Cost of Capital
- The cost of a company’s funds: either debt or equity, or both
- It is the minimum return that investors expect for providing capital to the company,
thus setting a benchmark that a business has to meet
- If expectations are not met, they should have placed their money in another venture
- The two main sources of funds:
> Cost of the Equity (capital from the shareholders)
> Cost of the Loans (borrowings- banks or other sources)
Cost of Share Funds (Equity)
= EXPECTATION OF THE SHAREHOLDERS
Shareholders Expect Return:
> Dividends and
> Share Price Appreciation
How Interest Rates are Determined
- The interest rate is determined by a number of factors such as the state of the
economy, demand and supply of loanable funds, and inflation.
> A country’s central bank sets the interest rate. When the central bank sets interest
rates at a high level the cost of debt rises. When the cost of debt is high, people are
discouraged from borrowing and slows consumer demand.
- A loan that is considered low risk by the lender will have a lower interest rate. A loan
that is considered high risk will have a higher interest rate.
- Higher interest rates will induce people to save more, so loanable funds will increase
> interest rate functions as the price in the money market

How Interest Rates are Determined Keynesian Theory

The rate of interest is determined as a price in two markets:
1. Investment Funds
> the rate balances the demand for funds (required for investment) and the supply of
funds (from savings)
2. Liquid Assets
> holding assets as readily available money

Equilibrium Interest Rates

- The rate at which the quantity of money demanded is equal to the quantity of
money supplied
- This result to Money Market Equilibrium
 - The Central Bank can alter the equilibrium interest rate by adjusting the supply of
money

Nominal Rate vs Real Rate

- Nominal interest rate refers to the interest rate before taking inflation into account
- Real interest rate is the rate of interest an investor, saver or lender receives (or
expects to receive) after allowing for inflation.

Components of Money Interest

1. Pure interest or real interest
- The compensation, over and above inflation, that a lender demands to lend
his money
2. Inflation
- Change in the level of prices
3. Risk Premium
> Liquidity Risk: the compensation that a lender receives for investing funds in
something that is difficult to sell
> Credit Risk: the risk that the loan or bond won’t be repaid as scheduled, or not at
all.
 (3) THE PAYMENT SYSTEM
Commodity Money vs Fiat Money
- Commodity money is money whose value comes from a commodity* of which it is
made; it consists of objects having value or use in themselves (intrinsic value) as well
as their value in buying goods.
*coins minted from precious metal
- Fiat money is a currency without intrinsic value that has been established as money,
often by government regulation. It does not have intrinsic value, and has value only
because a government designed it as a legal tender*
> recognized by law as a means to settle a public or private debt or meet a financial
obligation

The Philippine Payment System

- A fiat money system, wherein the BSP has the sole authority to issue paper currency.
- Paper Money is valued because it is the legal tender authorized to be used as a
form of payment, hence, even if paper money does not have an intrinsic value,
people are willing to use it as a medium of exchange

What are Checks?

- A check is a negotiable instrument in the form of a bill of exchange
- A bill of exchange is an unconditional order in writing addressed by one person to
another; signed by the person giving it; requiring the person to whom it is addressed
to pay on demand or at a fixed determinable future time, a sum certain in money, to
order or to bearer

Original Parties of a Bill of Exchange

- Drawer: the one who issues and draws the order bill
> he does not pay directly
- Drawee: the party to whom the bill is addressed and who is ordered and expected to
pay
> in the case of a check, the drawee is a bank.
- Payee: the one in whose favor the bill is originally issued or is payable

The Importance of Checks

Since checks are negotiable instruments*
1. They can be used as substitute for money
*Negotiable instruments- a formal document that is able to be transferred or
assigned to the legal ownership of another person, thereby, facilitating trade
2. Constitute the media of exchange for most commercial transactions
- Increase the purchasing medium in circulation
3. Serves as a medium of credit transactions
- When cash is not available, a check can be issued payable until a future date
 4. Requires more trust on the part of the seller as compared with accepting bills
- The fundamental idea, is that the drawer has funds in the hands of the
drawee.

Other Forms of Payment

1. Debit Card
- A card issued by a bank allowing the holder to transfer money electronically
to another bank account when making a purchase.
- When used the bank immediately credits the seller’s account and debits the
buyer’s account

2. Credit Card
- A card issued by a bank allowing the holder to purchase goods or services
against a line of credit, known as the card’s credit limit.

Debit Card vs Credit Card

 Debit Cards are attached to a bank account and allow you to spend existing funds.
Credit Cards allow you to spend on credit that you then pay back at a later date

3. Proximity mobile payments

- Payments to a merchant that are initiated from a mobile phone, using apps
linked to a debit or credit card.
- These payments are made by simply waving a mobile phone that uses Near
Field Communication (NFC) technology near a merchant’s point-of-sale
device
4. Automated Clearing House
- The electronic clearing and settlement system used for financial transactions
by commercial banks and other institutions.
- Examples: employers pay wages through direct deposit to their accounts or
consumers pay bills electronically out of checking accounts.
5. E-Money
- An electronic store of monetary value on a technical device that may be
widely used for making payments to entities other than the e-money issuer
- It can be accessed remotely via a device like mobile phones or prepaid cards
- The device acts as a prepaid bearer instrument which does not necessarily
involve bank accounts in transactions
- Essentially a private payment system
6. Bitcoin
- A digital currency (also called crypto-currency) that is not backed by any
country’s central bank or government
- Can be traded for goods or services with vendors who accept Bitcoins as
payment.
- The P2P network monitors and verifies the transfer of Bitcoins between users.
- 1 Bitcoin equals 2,492,794.04 Philippine Peso 25 Feb, 2021
Blockchain is the underlying technology behind the bitcoin
- Technically a digital ledger in which transactions are recorded chronologically
and publicly
- It can allow individuals and companies to make instantaneous transactions on
a network without any middlemen if they are decentralized.

Cashless Society
- An economic state whereby financial transactions are not conducted with
money in the form of physical banknotes or coins, but rather through the
transfer of digital information, usually an electronic representation of money
between the transacting parties.

Cashless Society: Benefits

 Lower crime because there’s no tangible money to steal
 Less money laundering because there’s always a paper trail
 Less time and costs associated with handling paper money as well as storing and
depositing it
 Easier currency exchange while traveling internationally
Cashless Society: Disadvantages
 Exposes your personal information to a possible data breach
 If hackers drain your bank account, you’ll have no alternative source of money
 Technology problems can leave you with no access to your money
 The poor and those without bank accounts will have difficulty paying and receiving
payments
 Some may find it harder to control spending when they don’t see physical cash
leaving their hands
 Banks may start charging fees to compensate for possible negative interest rates
 On top of the expensive cost of building the infrastructure, the disadvantages make it
difficult to attain an entirely cashless society in the near future.

(4) FINANCIAL INTRUMENTS

Financial Instruments
- A financial instrument is any contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument of another entity.
- They can be created, traded, modified and settled. They can be cash,
evidence of an ownership interest in an entity, or a contractual right to receive
or deliver.

What Is a Financial Asset?

- A liquid asset that gets its value from a contractual right or ownership claim
- E.g. Cash, stocks, bonds, mutual funds, and bank deposits
- Unlike land, property, commodities, or other tangible physical assets, financial
assets do not necessarily have inherent physical worth or even a physical
form.

What Is a Financial Liability?

- A contractual obligation to deliver cash or similar financial assets to another
entity, or
- A potentially unfavorable exchange of financial assets or liabilities with
another entity.
Derivatives
- A financial instrument with a value that is reliant upon or derived from, an
underlying asset or group of assets.
- The derivative itself is a contract between two or more parties, and the
derivative derives its price from fluctuations in the underlying asset.
- A contract that “derives” its value from the performance of an underlying asset
- An underlying asset of the derivative is the one that is to be bought or sold
on a future date
- The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes
Futures Contracts
- An agreement traded on an organized exchange to buy or sell assets,
especially commodities or shares, at a fixed price but to be delivered and paid
for later
- The existence of futures contracts allows sellers or buyers to hedge against
risk
- Can be a commodity futures contract or a financial futures contract
- It is a standardized legal agreement
Forward Contracts
- Functions similarly with a futures contracts, but it is a non-standardized
contract, i.e., an informal agreement traded through a broker-dealer network
to buy and sell specified assets, typically currency, at a specified price at a
certain future date

Future Forward
Marked-to-market daily, which means that daily Settles at the end of the agreement
changes are settled day by day until the end of
the contract.
Because they are traded on an exchange, they An arrangement made and traded over-the-
have clearing houses that guarantee the counter (OTC) between two counterparties that
transactions negotiate and arrive on the exact terms of the
contract
Has standardized terms Forward contract is a private and customizable
agreement

Clearing House
- A financial institution formed to facilitate the exchange of payments,
securities, or derivatives transactions; the clearing house stands between two
clearing firms; its purpose is to reduce the risk of a member firm failing to
honor its trade settlement obligations.

Philippine Clearing House Corporation

- Incorporated in July 1977, as a private corporation co-equally owned by all
commercial banks enlisted as members of the Bankers Association of the
Philippines (BAP).

Derivatives
Call Options
- Financial contracts that give the option buyer the right, but not the
obligation, to buy a stock, bond, commodity or other asset or instrument at a
specified price (strike price) within a specific time period (expiration or time
to maturity)
- The stock, bond, or commodity is called the underlying asset; a call buyer
profits when the underlying asset increases in price
Foreign Currency Futures
- A future contract to exchange one currency for another at a specified date in
the future at a rate that is fixed on the purchase date
- The financial derivative’s payoff depends on the foreign exchange rate(s) of
two (or more) currencies
- These instruments are commonly used for currency speculation and arbitrage
or for hedging foreign exchange risk.
Swaps
- An agreement between two counterparties to exchange financial instruments
or cash flows or payments for a certain time; the instruments can be almost
anything but most swaps involve cash based on a notional principal amount.
 Interest Rate Swap
 A type of a derivative contract through which two counterparties agree to
exchange one stream of future interest payments for another, based on a
specified principal amount; in most cases, interest rate swaps include the
exchange of a fixed interest rate for a floating or variable rate
 Currency Swap
 Involves exchanging principal and fixed rate interest payments on a loan in
one currency for principal and fixed rate interest payments on an equal loan in
another currency
 Other Types
 Inflation, commodity, credit fault
Caps and Collars
 Used in connection with interest rates
 A Cap is an upper limit, or maximum interest rate that will apply
 The actual interest rate charged can vary between the Cap and the Collar, but
will never exceed the Cap, or fall below the Collar (lower limit)
Financial Guarantees
- A contract by a third party (guarantor) to back the debt of a second party (the
creditor) for its payments to the ultimate debt holder (investor).