Republic of the Philippines

President Ramon Magsaysay State University

Zambales
Telefax : 047-8111683/email address: prmsu.edu.ph

College of Accountancy and Business Admnistration

Course Title : Financial Markets

Credit Units : 3 units

Course Description : This course is intended to help students understand the role of financial
institutions and markets play in the business environment that students will face in the future. It
also helps students to develop a series of applications of principles from finance and economics
that explore the connection between financial markets, financial institutions, and the economy.
Students will learn commercial and investment banking, insurance companies, mutual funds, the
Bangko Sentral ng Pilipinas, and their role of in the economy.

Learning Objectives :
This course aims to achieve student learning competencies in Financial Markets. At the end of the
course the students should be able to:

1. Describe the financial systems in both local and international setting.

2. Determine the methodologies to assess the risks involve in financial markets particularly in debt
and equity security trading.

3. Identify the agencies that may affect and drive the continuous development of the financial
market structure.

4. Apply the skills and knowledge obtain in accounting and financial reporting

5. Create strategies on how to handle challenges in entering financial markets

1 | Financial Markets_Alcrobles
Module 1: Introduction to Financial Systems and Financial Market

After studying this chapter, student should be able to:

1. Describe the elements of financial systems, particularly the financial market.

2. Describe the importance of financial market in maximizing firms profit and wealth.
3. Differentiate the different types of financial markets.

Overview.

Financial Market is the marketplace where investors go to raise money to grow their
businesses. It is the avenue where the sale, purchase, creation and trading of financial
instruments occur such as shares, bonds, derivatives, debentures, currencies, and the like. The
trading of the securities occurs in the stock market, forex market, derivative market or bond
market. It plays a crucial role in a country’s economy

Nature and Importance of Financial System

Finance defined.

Basically, finance represents money management and the process of acquiring needed
funds. It is the lifeblood of the business for continuity of business operations. Finance is the
application of economic principles to decision making that involves the allocation of money under
conditions of uncertainty. It is how funds are obtained and then how this will be invested to make
money.

What Is a Financial System?

A financial system is a set of institutions, such as banks, insurance companies, and

stock exchanges that permit the exchange of funds.

Financial systems exist on firm, regional, and global levels. Borrowers, lenders, and
investors exchange current funds to finance projects, either for consumption or productive
investments, and to pursue a return on their financial assets.

The financial system also includes sets of rules and practices that borrowers and lenders
use to decide which projects get financed, who finances projects, and terms of financial deals.

 A financial system is the set of global, regional, or firm-specific institutions and

practices used to facilitate the exchange of funds.
 Financial systems can be organized using market principles, central planning, or a
hybrid of both.
 Institutions within a financial system include everything from banks to stock exchanges
and government treasuries.

Financial system acquires money from people who are keeping it idle and distribute it
among those who uses it for yielding income and generates wealth in country. It aims at efficient

2 | Financial Markets_Alcrobles
allocation of financial resources by channelizing funds between net savers and net spenders.
Financial system has efficient role in minimizing the risk through diversification of funds among
large number of people.

Nature of Financial System

1. Transfer Funds / Allocate capital

Financial system helps in transferring of financial resources from one person to
another person. This system includes financial markets, financial intermediaries,
financial assets and services which facilitates fund movements in an economy.

It allows exchange (flow) of funds between lenders, investors, and borrowers.

Financial systems provide different channels to allocate funds: directly ( via markets)
or indirectly(via intermediaries)

2. Mobilizes Saving
It helps in allocating ideal lying resources with peoples into productive means.
Financial system is the one which obtains funds from savers and provide it to
those who are in need of it for various development purposes. Provides saving
instruments. Pooling funds that can be matched with borrower needs.

3. Risk Allocation
Diversification of risk in an economy is important feature of financial system. Financial
system allocates people’s funds in various sources due to which risk is diversified.

Role of Financial System

1. Facilitates Payment Mechanism

Financial system provides a payment mechanisms for the smooth flow of funds among peoples
in an economy. Buyers and sellers of goods or services are able to perform transactions with each
other due to the presence of a financial system.

2. Reduces Risk
It aims at reducing the risk by diversifying it among a large number of individuals. Financial system
distributes funds among a large number of peoples due to which risk is shared by many peoples.

3. Brings Savers And Investors Together

Financial system serves as a means of bridging the gap between savings and investment. It
acquires money from those with whom it is lying idle and transfers it to those who need it for
investing in productive ventures.

4. Assist In Capital Formation

Financial system has an efficient role in the capital formation of the country. It enables big
corporates and industries to acquire the required funds for performing or expanding their
operations thereby leading to capital formation in the nation.

5. Improves Standard Of Living

It raises the standard of living of peoples by promoting regional and rural development of the
country. The financial system promotes the development of a weaker sections of society through
cooperative societies and rural development banks.

3 | Financial Markets_Alcrobles
 6. Facilitates Economic Development
Financial system influences the pace of economic growth or development of an economy. It aims
at optimum utilization of all financial resources by investing all idle lying resources into useful
means which leads to the creation of wealth.

Elements of Financial System

1. Lenders and Borrowers.

The ultimate lenders (= surplus economic units) and borrowers (= deficit economic units), i.e.
the non-financial economic units that undertake the lending and borrowing process. The ultimate
lenders lend to borrowers either directly or indirectly via financial intermediaries, by buying the
securities they issue.

The ultimate borrowers comprise the four broad sectors of the economy :

- Household sector.
- Corporate (or business) sector.
- Government sector.
- Foreign sector

2. Financial Intermediaries (e.g., banks)

These intermediate the lending and borrowing process. They interpose themselves between
the lenders and borrowers, and earn a margin for the benefits of intermediation (including lower
risk for the lender). They buy the securities of the borrowers and issue their own to fund these
(and thereby become intermediaries).

3. Financial Instruments (cash or derivative)

Financial instruments (or assets), which are created/issued by the ultimate borrowers
and financial intermediaries to satisfy the financial requirements of the various participants.
These instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. retirement
annuities).

4. Financial Markets (money or capital)

Financial markets, i.e. the institutional arrangements and conventions that exist for the
issue and trading (dealing) of the financial instruments.

5. Regulatory Environment -(e.g., Central banks)

6. Money creation.
The creation of money (= bank deposits) by banks when they satisfy the demand for
new bank credit. This is a unique feature of banks. Central banks have the tools to curb money
growth.

7. Price discovery.
Process of determining or valuing the financial instrument in the market. Price discovery,
i.e. the establishment in the financial markets of the price of money, i.e. the rates of interest on
debt (and deposit) instruments and the prices of share instruments.

4 | Financial Markets_Alcrobles
Nature and Importance of Financial Market

In the beginning. The word “market” usually conjures up an image of the bustling, paper
strewn floor of stock exchanges or of traders motioning frantically in the futures pits of big cities
But formal exchanges such as these are only one aspect of the financial markets, and far from
the most important one. There were financial markets long before there were exchanges and, in
fact, long before there was organized trading of any sort.

Financial markets have been around ever since mankind settled down to growing crops
and trading them with others. After a bad harvest, those early farmers would have needed to
obtain seed for the next season’s planting, and perhaps to get food to see their families through.

Both of these transactions would have required them to obtain credit from others with
seed or food to spare. After a good harvest, the farmers would have had to decide whether to
trade away their surplus immediately or to store it, a choice that any 20th-century commodities
trader would find familiar. The amount of fish those early farmers could obtain for a basket of
cassava would have varied day by day, depending upon the catch, the harvest and the weather;
in short, their exchange rates were volatile.

The independent decisions of all of those farmers constituted a basic financial market,
and that market fulfilled many of the same purposes as financial markets do today

What is a Financial Market?

A financial market is a market in which financial assets (securities) such as stocks and
bonds can be purchased or sold. Funds are transferred in financial markets when one party
purchases financial assets previously held by another party. Financial markets facilitate the flow
of funds and thereby allow financing and investing by households, firms, and government
agencies

TYPES OF FINANCIAL MARKET

Based on instruments traded

a. Money Market – this is the sector of the financial market where financial instruments
that will mature or be redeemed in one year or less from issuance date are traded.

Why do companies deal with money market?

- Cash requirements of entities do not coincide with their cash receipts (borrowers)
- Fund providers generates opportunity cost in the form of foregone interests by
investing excess cash in financial instruments that can quickly be converted to cash
when needed with minimal risk (lenders)

b. Capital market – this is the sector in the financial market where financial instruments
issued by government and corporations that will mature beyond one year from issuance date
are traded.
There are two types: (1) equity (share certificate) or (2) debt (PN, bonds)

5 | Financial Markets_Alcrobles
MARKET INSTRUMENTS

Treasury bills —short-term obligations issued by the government.

Repurchase agreements —agreements involving the sale of securities by one party to
another with a promise by the seller to repurchase the same securities from the buyer
at a specified date and price.
Commercial paper —short-term unsecured promissory notes issued by a company to
raise short-term cash.
Negotiable certificate of deposit —bank-issued time deposit that specifies an interest
rate and maturity date and is negotiable, (i.e., can be sold by the holder to another
party).
Banker’s acceptance —time draft payable to a seller of goods, with payment
guaranteed by a bank.

CAPITAL MARKET INSTRUMENTS

Corporate stock —the fundamental ownership claim in a public corporation.

Mortgages —loans to individuals or businesses to purchase a home, land, or other real
property.
Corporate bonds —long-term bonds issued by corporations.
Treasury bonds —long-term bonds issued government treasuries.
State and local government bonds —long-term bonds issued by state and local governments.
Bank and consumer loans —loans to commercial banks and individuals

Based on Market Type

a. Primary Market – this is the financial market wherein fund demanders like
corporation or government agencies raise funds through new issuances of financial
instruments (bonds or stocks).

Why? - Normally to finance new projects or expansions.

How? - Coursed thru investment banks as intermediary.
Who? - Borrowers are fund demanders and lenders are fund providers.

Four types of issue methods

1. Public offering – the issuer offers for subscription or sale to general public
2. Private placement -the issuer looks for single investor to purchase the whole
securities issuance than to general public
3. Auction – this is another offering to general public on treasury bills, bonds and other
securities issued by the govt.
4. Tap issue – this happens when issuer is open to receive bids for their securities at all
times. Issuers maintain the right to accept or reject the bid prices.

b. Secondary Market – this is where securities issued in the primary market are
subsequently traded (resold and repurchased – second hand).

Who are the players? - Securities brokers are facilitators - Sellers are demanders and
buyers are funds providers

6 | Financial Markets_Alcrobles
7 | Financial Markets_Alcrobles
Sources and references:

Guide to Financial Markets by Marc Levinson

Financial Market by Jeff Madura
https://www.investopedia.com/terms/f/financial-system.asp
https://commercemates.com/nature-and-role-of-financial-system/
https://ebrary.net/16/business_finance/six_elements_the_financial_system

Review Questions:

Multiple Choice: Select the correct answer.

1. This is a type of financial market wherein fund demanders like corporation or government
agencies raise funds through new issuances of financial instruments

a. Secondary Market
b. Primary Market
c. Money Market
d. Capital Market

2. These are short-term obligations issued by the government.

a. Treasury bills
b. Repurchase agreements
c. Commercial paper
d. Bankers’ Acceptance

8 | Financial Markets_Alcrobles
3. It is a bank-issued time deposit that specifies an interest rate and maturity date and is
negotiable.
a. Banker’s acceptance
b. Negotiable certificate of deposit
c. Repurchase agreements
d. Commercial paper

4. This is where securities issued in the primary market are subsequently traded (resold and
repurchased – second hand).
a. Primary Market
b. Secondary Market
c. Capital Market
d. Money Market

5. A type of issuance method for primary markets that happens when the issuer is open to
receive bids for their securities at all times. Issuers maintain the right to accept or reject the
bid prices.
a. Public offering
b. Private placement
c. Auction
d. Tap issue

6. Short-term unsecured promissory notes issued by a company to raise short-term cash.

a. Commercial paper
b. Treasury bills
c. Repurchase agreements
d. Banker’s acceptance

7. These are long-term bonds issued by corporations

a. Corporate stock
b. Corporate bonds
c. Treasury bonds
d. State and local government bonds

8. These are loans to commercial banks and individuals

a. Bank and consumer loans
b. Corporate bonds
c. Treasury bonds
d. Corporate stock

9 | Financial Markets_Alcrobles
9. It is a market in which financial assets (securities) such as stocks and bonds can be purchased
or sold.
a. Financial Market
b. Financial System
c. Financial Resources
d. Financial Institutions

10. This is the sector of the financial market where financial instruments that will mature
or be redeemed in one year or less from issuance date are traded.
a. Money Market
b. Capital Market
c. Market
d. Public Market

11. A financial system.

a. Is a set of institutions, such as banks, insurance companies, and stock exchanges
that permit the exchange of funds.
b. Acquires money from people who are keeping it idle and distribute it among those
who uses it for yielding income and generates wealth in country
c. Includes sets of rules and practices that borrowers and lenders use to decide which
projects get financed, who finances projects, and terms of financial deals.
d. All of the above

12. Financial system helps in allocating ideal lying resources with peoples into productive
means.
a. True
b. False

13. Finance represents money management and the process of acquiring needed funds. It is the
lifeblood of the business for continuity of business operations,
a. True
b. False

14. Financial system does not need to acquire money from people who are keeping it idle and
distribute it among those who uses it for yielding income and generates wealth in country.
a. True
b. False

15. Financial system avoids bridging the gap between savings and investment.
a. True
b. False

10 | Financial Markets_Alcrobles
Module 2: Philippine Financial System

After studying this chapter, student should be able to:

1. Describe the role of Bangko Sentral ng Pilipinas
2. Describe the evolution of currency.
3. Correlate the roles of the BSP to the Philippine financial system

The Philippine Financial System.

A vital element in securing sustained economic growth and stability is a strong and
progressive financial system. Such a system stimulates the effective transformation of savings
into investments and serves as a financial intermediary between savers and spenders. It likewise
facilitates the channeling of loanable funds from surplus spending units to deficit spending units
to fuel production and boost economic growth. As of 2010, the Philippine financial system is
composed of banks, of which were commercial banks, thrift banks and rural banks.

Central Banking

The central bank touches the lives of all residents in the country. First, the central bank
takes care of the country's payment system. Every day, billions of transactions are made using
peso bills or coins, printed or minted by the central bank. The central bank also facilitates the
transfer of high-valued goods and services among economic agents by providing the necessary
infrastructure for alternative modes of payment, such as checks and electronic transfer.

Business enterprises are not only busy producing and marketing their products. They also
exert extra effort to look for the best lending rate a bank can offer them. They know very well
that a few percentage points added to the interest rate can have large implications on the

11 | Financial Markets_Alcrobles
profitability, if not viability, of their enterprises. Likewise, depositors are looking for safe and
sound banks that can give them the most attractive deposit rate. Although interest rates are
freely determined in the market, still they are very much influenced by monetary policy.

The discussions merely highlight the two major functions that have been performed by
the central bank ever since central banking was introduced in the country in 1948, namely,

1) monetary policy
2) bank supervision functions.

These are the same functions performed by central banks in many countries. Although
these have remained the core functions of the country's central bank,

Another major force for change is the liberalization of financial markets and banking
system, which provides financial institutions with more opportunities for financial innovations.
The rapid development and deepening of a variety of financial markets and instruments as well
as the greater diversification of financial institutions have challenged the central bank to rethink
its monetary policy and bank supervision framework.

Still another major force for change is the globalization of financial intermediation and
the need to manage new types of risks arising from such development. Indeed, the opportunities
and risk arising from the globalization of financial intermediation have been clearly illustrated in
the Philippines as well as in other emerging markets before and after the East Asian financial
crisis (1997-1998, started in Thailand.)

The Bangko Sentral ng Pilipinas (BSP)

The BSP is the central bank of the Republic of the Philippines. It was established on 3 July
1993 pursuant to the provisions of the 1987 Philippine Constitution and the New Central Bank
Act of 1993. The BSP took over from Central Bank of Philippines, which was established on 3
January 1949, as the country’s central monetary authority. The BSP enjoys fiscal and
administrative autonomy from the National Government in the pursuit of its mandated
responsibilities.

The BSP's main responsibility is to formulate and implement policy in the areas of money,
banking and credit with the primary objective of preserving price stability. Price stability refers
to a condition of low and stable inflation. By keeping price stable, the BSP helps ensure strong
and sustainable economic growth and better living standards.

12 | Financial Markets_Alcrobles
Mandate, Functions & Responsibilities

13 | Financial Markets_Alcrobles
14 | Financial Markets_Alcrobles
15 | Financial Markets_Alcrobles
History of Currency and Notes

Pre-Hispanic Era

Long before the Spaniards came to the Philippines, trade among the early Filipinos and
with traders from the neighboring lands like China, Java, Borneo, and Thailand was
conducted through barter. The inconvenience of the barter system led to the adoption of a
specific medium of exchange – the cowry shells. Cowries produced in gold, jade, quartz and
wood became the most common and acceptable form of money through many centuries.

Since the Philippines is naturally rich in gold, it was used in ancient times for barter rings,
personal adornment, jewelry, and the first local form of coinage called Piloncitos. These had
a flat base that bore an embossed inscription of the letters “MA” or “M” similar to the
Javanese script of the 11th century. It is believed that this inscription was the name by which
the Philippines was known to Chinese traders during the pre-Spanish time.

16 | Financial Markets_Alcrobles
Spanish Era (1521-1897)

The cobs or macuquinas of colonial mints were the earliest coins brought in by the
galleons from Mexico and other Spanish colonies. These silver coins usually bore a cross on one
side and the Spanish royal coat-of-arms on the other.

The Spanish dos mundos were circulated extensively not only in the Philippines but the
world over from 1732-1772. Treasured for its beauty of design, the coin features twin crowned
globes representing Spanish rule over the Old and the New World, hence the name “two
worlds.” It is also known as the Mexican Pillar Dollar or the Columnarias due to the two
columns flanking the globes.

Due to the shortage of fractional coins, the barrillas, were struck in the Philippines as
ordered by the Royalty of Spain. The barrilla, a crude bronze or copper coin worth about one
centavo, was the first coin struck in the country. The Filipino term “barya”, referring to small
change, had its origin in barrilla.

Different types of Barrillas. Top left is a bronze, uniface specimen

dated 1728. The piece below is made of lead dated 1733
Above right is a copper piece dated 1743

Coins from other Spanish colonies also reached the Philippines and were
counterstamped to legalize their circulation in the country. Gold coins with the portrait of Queen
Isabela were minted in Manila. Silver pesos with the profile of young Alfonso XIII were the last
coins minted in Spain. The pesos fuertes, issued by the country’s first bank, the El Banco Espanol
Filipino de Isabel II, were the first paper money circulated in the country.

17 | Financial Markets_Alcrobles
Revolutionary Period (1898-1899)

Asserting its independence, the Philippine Republic of 1898 under General Emilio
Aguinaldo issued its own coins and paper currency backed by the country’s natural resources. At
the Malolos arsenal, two types of two-centavo copper coins were struck. One peso and five peso
revolutionary notes printed as Republika Filipina Papel Moneda de Un Peso and Cinco Pesos were
freely circulated. These were handsigned by Pedro Paterno, Mariano Limjap and Telesforo
Chuidian. With the surrender of General Aguinaldo to the Americans, the currencies were
withdrawn from circulation and declared illegal currency.

American Period ( 1900-1941 )

With the coming of the Americans 1898, modern banking, currency and credit systems
were instituted making the Philippines one of the most prosperous countries in East Asia.
The Americans instituted a monetary system for the Philippine based on gold and pegged the
Philippine peso to the American dollar at the ratio of 2:1. The US Congress approved the
Coinage Act for the Philippines in 1903.

The coins issued under the system bore the designs of Filipino engraver and artist,
Melecio Figueroa. Coins in denomination of one-half centavo to one peso were minted. The
renaming of El Banco Espanol Filipino to Bank of the Philippine Islands in 1912 paved the way
for the use of English from Spanish in all notes and coins issued up to 1933. Beginning May
1918, treasury certificates replaced the silver certificates series, and a one-peso note was
added.

18 | Financial Markets_Alcrobles
 The Japanese Occupation 1942-1945

The outbreak of World War II caused serious disturbances in the Philippine monetary
system. Two kinds of notes circulated in the country during this period. The Japanese Occupation
Forces issued war notes in high denominations. These war notes had no back up reserves, thus,
Filipinos dubbed it “Mickey Mouse” money. During the worst inflation in Philippine history,
Filipinos would go to the market laden with bayongs of Mickey Mouse bills, since one duck egg
cost 75 pesos, and a box of matches more than 100 pesos.

On the other hand, Guerrilla Notes or Resistance Currencies which are in low
denominations, were issued by different provinces and, in some instances, municipalities
through their local currency boards to show resistance against the Japanese occupation.

The Philippine Republic

19 | Financial Markets_Alcrobles
 A nation in command of its destiny is the message reflected in the evolution of Philippine
money under the Philippine Republic. Having gained independence from the United States
following the end of World War II, the country used as currency old treasury certificates
overprinted with the word “Victory”.

With the establishment of the Central Bank of the Philippines in 1949, the first currencies
issued were the English series notes printed by the Thomas de la Rue & Co., Ltd. in England
and the coins minted at the US Bureau of Mint. The “Filipinization” of the Republic coins and
notes began in the late 60’s and is carried through to the present. In the 70’s, the Ang Bagong
Lipunan (ABL) series notes were circulated, which were printed at the Security Printing Plant
starting 1978. A new wave of change swept through the Philippine coinage system with the
Flora and Fauna Coin Series initially issued in 1983. The New Design Series of banknotes
issued in 1985 replaced the ABL series. Ten years later, a new set of coins and notes were
issued carrying the logo of the Bangko Sentral ng Pilipinas.

Reporting and Regulations

1. Supervisory Frame work

The Bangko Sentral has supervision over the operations of banks and exercises regulatory
powers as provided in the New Central Bank Act and other pertinent laws over the operations
of finance companies and non-bank financial institutions performing quasi-banking
functions.

2. Regulations

Contains relevant economic and financial regulations issued by the BSP.

a. BSP issuances/ circulars

20 | Financial Markets_Alcrobles
 b. Banking Laws
 Republic Acts (RA) and Implementing Rules and Regulations (IRR) of RAs
Some examples below:
R.A. No. Date Description
R.A. 3765 22 Jun 1963 An Act to Require the Disclosure
of Finance Charges in Connection
with Extensions of Credit ( "Truth
in Lending Act.")
R.A. 3591, as amended An act establishing the Philippine
Deposit Insurance Corporation
(PDIC Charter) (Deposits are
insured by PDIC up to P500,000
per depositor )
R.A. 7653 10 Jun 1993 The New Central Bank Act
R.A. 9160 29 Sep 2001 Anti-Money Laundering Act of
2001
R.A. 11211 14 Feb 2019 An Act Amending Republic Act
Number 7653, Otherwise Known
As "The New Central Bank Act",
And for the Purposes

 Presidential Decrees (PDs)

Some examples below :
P.D. No. Date Description
P.D. 114 29 Jan 1973 Regulating the establishment and
operation of pawnshops
P.D. 129 15 Feb 1973 Governing the establishment,
operation and regulation of
Investment Houses
P.D. 1034 30 Sep 1976 Authorizing the establishment of an
offshore banking system in the
Philippines
P.D. 1797 06 Jan 1981 Amending further Presidential
Decree No. 129, as amended,
otherwise known as “The
Investment Houses Law.”

c. Guidelines and other regulations

 Foreign Exchange Regulations

In line with the thrust of the Bangko Sentral ng Pilipinas (BSP) to

promote a policy environment that is market-oriented and supportive of the
Philippine economy’s sustained expansion, the BSP, through the International
Operations Department (IOD), ensures that the country’s foreign exchange (FX)
regulatory framework remains appropriate for the needs of a dynamic and
expanding economy.

The BSP has undertaken various liberalization measures to ease FX rules to

facilitate the FX transactions by banks, public and private corporates/entities,
small and medium enterprises, overseas Filipinos, and the public in general.

21 | Financial Markets_Alcrobles
 The liberalization is being undertaken in a well-calibrated manner, giving due
consideration to prevailing domestic and international economic and financial
conditions, while ensuring that timely prudential mechanisms (e.g.,
documentary/reportorial requirements) and safeguard measures remain in
place to allow the BSP to:

a. adopt necessary measures to address any perceived emerging

concern/problem; and
b. maintain its ability to capture timely, reliable and comprehensive data for
its various needs, such as policy review and formulation, analysis of trends
and developments (e.g., volatility in capital flows), statistics and report
generation.

 Guidelines on the Establishment of Banks

The BSP, as part of its chartering process, puts emphasis on the suitability of
shareholders, adequacy of financial strength and sufficient expertise and
integrity of management, among others, in ensuring that the proposed bank will
be operated in a secure and prudent manner.

The application for authority to establish a bank shall be submitted to the

Supervisory Policy and Research Department (SPRD). Following are the relevant
guidelines and forms for the establishment of banks:

Domestic Banks

Guidelines:
Basic Guidelines in Establishing Banks (Appendix 33)
Circular 902 - Phased Lifting of the Moratorium on the Grant of New
Banking License or Establishment of New Domestic Banks
Circular 854 - Minimum Capitalization of Banks
Forms:
Agreement to Organize a Bank
Biographical Data
Articles of Incorporation and By-Laws
Projected Balance Sheet

Foreign Banks

In the case of foreign banks, they may operate in the Philippines

through any one (1) of the following modes of entry:

Mode 1: By acquiring, purchasing or owning up to 100% of the voting

stock of an existing domestic bank.
Mode 2: By investing in up to 100% of the voting stock of a new
banking subsidiary incorporated in the Philippines.
Mode 3: By establishing branches with full banking authority.

Guidelines:
Application Guide in Establishing Foreign Banks

22 | Financial Markets_Alcrobles
 Circular 858 - Amendments to Relevant Provisions of the Manual of
Regulations for Banks Implementing Republic Act No. 10641
Circular 858 FAQ
Circular 854 - Minimum Capitalization of Banks

Forms:
Agreement to Organize a Bank (Mode 2)
Head Office Guarantee (Mode 3)

 Compliance with PFRS/PAS

The Philippine Financial Reporting Standards (PFRS)/Philippine Accounting
Standards (PAS) are the new set of Generally Accepted Accounting Principles
(GAAP) issued by the Accounting Standards Council (ASC) to govern the
preparation of financial statements. These standards are patterned after the
revised International Financial Reporting Standards (IFRS) and International
Accounting Standards (IAS) issued by the International Accounting Standards
Board (IASB).

The Bangko Sentral ng Pilipinas (BSP) pronounced its adoption of the PFRS/PAS
effective the annual financial statements beginning 1 January 2005 in its
Memorandum to All Banks and Other BSP Supervised Financial Institutions
(BSFIs) dated 11 January 2005. The adoption of the new set of standards is
aimed at promoting fairness, transparency and accuracy in financial reporting.

 Other Regulations
Registration of Pawnshops and Money Service Businesses (MSBs)

d. Manual of Regulations

The Manual of Regulations for Banks (MORB) is the primary source of regulations
governing entities supervised by the Bangko Sentral ng Pilipinas. It provides the rules and
policy issuances that implement the broader provisions of Republic Act No. 8791, also
known as the General Banking Law of 2000, as wella s other pertinent banking laws.
Monetary Policy

1. Manual of Regulations for Banks (MORB) (updated as of December 2020)

2. Manual of Regulations for Non-Bank Financial Institutions (MORNBFI)
(updated as of December 2020)
3. Manual of Regulations on Foreign Exchange Transactions (updated as
of September 2021)

Monetary Policy

The primary objective of the BSP's monetary policy is to promote a low and stable
inflation conducive to a balanced and sustainable economic growth. The adoption of inflation
targeting framework of monetary policy in January 2002 is aimed at achieving this objective.

Inflation targeting is focused mainly on achieving a low and stable inflation, supportive
of the economy’s growth objective. This approach entails the announcement of an explicit
inflation target that the BSP promises to achieve over a given time period.

23 | Financial Markets_Alcrobles
 To achieve the inflation target, the BSP uses a suite of monetary policy instruments in
implementing the desired monetary policy stance, depending on its assessment of the outlook
for inflation. If the BSP perceives the inflation forecast to exceed the target, then it implements
contractionary monetary policy to bring down inflation to its target path. On the other hand, if
the BSP sees the inflation forecast to be lower than the target or there is need to increase liquidity
in the financial system, then it can implement expansionary monetary policy. The reverse
repurchase (RRP) or borrowing rate is the primary monetary policy instrument of the BSP.

Open Market Operations

Raising or lowering the overnight RRP rate (policy rate) or rate at which BSP borrows
from banks and eligible financial institutions using its holdings of government securities as
collateral Issuance of BSP securities to absorb excess liquidity from the financial system by locking
funds in longer-term monetary instruments Outright sale or purchase of government securities

Acceptance of Term Deposits

Offering term deposits to absorb liquidity

Standing Liquidity Facilities

Offering standing liquidity (deposit and lending) windows to absorb or provide liquidity
at the initiative of the counterparty

Other Liquidity Management Facilities

Increasing/decreasing the reserve requirement or the percentage of bank deposits and
deposit substitute liabilities that banks must set aside in deposits with the BSP which they cannot
lend out, or where available through reserve-eligible government securities.
Adjusting the rediscount rate on loans extended to financial institutions on a short-term
basis against eligible collateral of banks' borrowers

Sources and references:

https://prezi.com/7sov0z9xwm5z/structure-of-the-philippine-financial-system/
https://www.statista.com/statistics/1194941/philippines-number-of-banks-by-
https://www.bsp.gov.ph/SitePages/AboutTheBank/AboutTheBank.aspx
https://www.bsp.gov.ph/Pages/CoinsAndNotes/HistoryOfPhilippineMoney/HistoryOfPhilippine
Money.aspx#:~:text=The%20US%20Congress%20approved%20the,to%20one%20peso%20were
%20minted.

Review Questions:

24 | Financial Markets_Alcrobles
Module 3. Managing Credit Risk in Money Market

After studying this chapter, student should be able to:

1. Identify the different levels and methods of rating entities

2. Make recommendation on the results of liquidity and solvency
3. Understand how to improve value of collaterals

The main task of the financial system is to ensure the flow of resources from sectors with
an excess of funds to those with a gap in funds. Developments brought about by globalization,
have paved the way for new turnovers in the field of finance. The foreign capital flows are
transported rapidly to the farthest corners of the world. More complex market structures have
emerged on the agenda with various financial tools that have brought the dimensions of the
global financial markets into a higher level. As a result, solutions to ‘risk management in the
financial markets’ and ‘credit risk management’ and its application, gained importance.

As a result, Financial Institution (FI) managers must devote significant time to

understanding and managing the various risks to which their FIs are exposed.

RISKS FACED BY FINANCIAL INSITUTIONS.

25 | Financial Markets_Alcrobles
CREDIT RISK

Credit risk is the risk that the promised cash flows from loans and securities held by FIs
may not be paid in full. These financial claims refers to loans and bonds.

However, in general, FIs that make loans or buy bonds with long maturities are more
exposed than are FIs that make loans or buy bonds with short maturities. This means, for example,
that depository institutions and life insurers are more exposed to credit risk than are money
market mutual funds and property–casualty insurers, since depository institutions and life
insurers tend to hold longer maturity assets in their portfolios than mutual funds and property–
casualty insurers. Should a borrower default, however, both the principal loaned and the interest
payments expected to be received are at risk.

Many financial claims issued by individuals or corporations and held by FIs promise a
limited or fixed upside return (principal and interest payments to the lender) with a high
probability, but they also may result in a large downside risk (loss of loan principal and promised
interest) with a much smaller probability.

Impact of Credit Risk on an FI’s Equity Value

Credit Process, Credit Ratings and Credit Information System

THE CREDIT PROCESS

Below is an illustration of the CREDIT PROCESS in Philippine Financial Institutions.

There are 3 PHASES:

1. Initiation Stage- Covers marketing the loan product, prospecting, discussing loan
packages, negotiation of loan terms and conditions, credit investigation, property
appraisal, credit evaluation and loan approval.

26 | Financial Markets_Alcrobles
 2. Documentation and Closing - After approval is obtained, the terms and conditions
agreed with the borrower is documented into a Loan Agreement.

3. Portfolio Management - These phase includes credit administration, regular credit

review, billing and collection, loan restructuring or remedial. If client with a collateral
mortgaged defaults on payment and collection is impossible, the account ends up in
foreclosure or “dacion en pago” or the voluntary surrender of the property mortgaged.

What Is a Credit Rating?

The term credit rating refers to a quantified assessment of a borrower's creditworthiness

in general terms or with respect to a particular debt or financial obligation. A credit rating can be
assigned to any entity that seeks to borrow money—an individual, a corporation, a state or
provincial authority, or a sovereign government.

Credit ratings determine whether a borrower is approved for credit as well as the interest
rate at which it will be repaid. Bonds issued by businesses and governments are rated by credit
agencies on a letter-based system.

Understanding Credit Ratings

A loan is a debt—essentially a promise, often contractual. A credit rating determines

the likelihood that the borrower will be willing and able to pay back a loan within the confines
of the agreement without defaulting.

An individual's credit rating affects their chances of approval for a given loan and
favorable terms for that loan. A high credit rating indicates a strong possibility of paying back

27 | Financial Markets_Alcrobles
the loan in its entirety without any issues while a poor credit rating suggests that the borrower
has had trouble paying back loans in the past and might follow the same pattern in the future.

Credit Ratings and Credit Scores

Credit ratings apply to businesses and governments as well as individuals. For example,
sovereign credit ratings apply to national governments while corporate credit ratings apply
solely to corporations. Credit scores, on the other hand, apply only to individuals.

Credit Information System

REPUBLIC ACT No. 9510 (October 31, 2008)

Section 1. Title. - This Act shall be known as the "Credit Information System Act"

Section 2. Declaration of Policy. - The State recognizes the need to establish a

comprehensive and centralized credit information system for the collection and
dissemination of fair and accurate information relevant to, or arising from, credit and
credit-related activities of all entities participating in the financial system. A credit
information system will directly address the need for reliable credit information
concerning the credit standing and track record of borrowers.

The operations and services of a credit information system can be expected to: greatly
improve the overall availability of credit especially to micro, small and medium-scale
enterprises; provide mechanisms to make credit more cost-effective; and reduce the
excessive dependence on collateral to secure credit facilities.

The State shall endeavor to have credit information provided at the least cost to all
participants and shall ensure the protection of consumer rights and the existence of fair
competition in the industry at all times.

An efficient credit information system will also enable financial institutions to reduce
their over-all credit risk, contributing to a healthier and more stable financial system.

Section 4. Establishment of the Credit Information System. - In furtherance of the policy

set forth in Section 2 of this Act, a credit information system is hereby established.

(a) Banks, quasi-banks, their subsidiaries and affiliates, life insurance

companies, credit card companies and other entities that provide credit facilities are
required to submit basic credit data and updates thereon on a regular basis to the
Corporation.

Credit Analysis

This section discusses credit analysis for real estate lending, consumer and small-
business lending, mid-market commercial and industrial lending, and large commercial and
industrial lending. It also provides insights into the credit risk evaluation process from the
perspective of a credit officer (or an FI manager) evaluating a loan application

28 | Financial Markets_Alcrobles
Real Estate Lending

Because of the importance of residential mortgages to banks, savings institutions, credit

unions, and insurance companies, residential mortgage loan applications are among the most
standardized of all credit applications. In this topic, we look at the evaluation process that FIs
(such as commercial banks, savings institutions, and finance companies) use to determine
whether a real estate loan application should be approved.

Two considerations dominate an FI’s decision to approve a mortgage loan application:

(1) The applicant’s ability and willingness to make timely interest and principal
repayments
(2) The value of the borrower’s collateral.

Ability and willingness of the borrower to repay debt outstanding is usually established
by application of qualitative and quantitative models.

 The character of the applicant is also extremely important. Stability of residence,

occupation, family status (e.g., married, single), previous history of savings, and
credit (or bill payment) history are frequently used in assessing character.
 The loan officer must also establish whether the applicant has sufficient
income. In particular, the loan amortization (i.e., principal and interest
payments) should be reasonable when compared with the applicant’s income
and age.
 The loan officer should also consider the applicant’s monthly expenditures.
 Family responsibilities and marital stability are also important.
 Monthly financial obligations relating to auto, personal, and credit card loans
should be ascertained, and an applicant’s personal balance sheet and income
statement should be constructed.

Two ratios are very useful in determining a customer’s ability to maintain mortgage
payments:
a. GDS (gross debt service) ratio – The gross debt service ratio is the customer’s
total annual accommodation expenses (mortgage, lease, condominium
management fees, real estate taxes, etc.) divided by annual gross income.

b. TDS (total debt service) ratio. - The total debt service ratio is the customer’s
total annual accommodation expenses plus all other debt service payments
divided by annual gross income.

As a general rule, for an FI to consider an applicant, the GDS and TDS ratios must be less
than an acceptable threshold. The threshold is commonly 25 to 30 percent for the GDS ratio
and 35 to 40 percent for the TDS ratio.

29 | Financial Markets_Alcrobles
Calculation of the GDS and TDS Ratios

Despite a higher level of gross income, Customer 1 does not meet the GDS or TDS
thresholds because of relatively high mortgage, tax, and other debt payments.
Customer 2, while earning less, has fewer required payments and meets both the FI’s GDS
and TDS thresholds.

Cost of Debt

What Is the Cost of Debt?

The cost of debt is the effective interest rate that a company pays on its debts, such as
bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the
company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key
difference in the cost of debt before and after taxes lies in the fact that interest expenses are
tax-deductible.

How the Cost of Debt Works

Debt is one part of a company’s capital structure, which also includes equity. Capital
structure deals with how a firm finances its overall operations and growth through different
sources of funds, which may include debt such as bonds or loans.

The cost of debt measure is helpful in understanding the overall rate being paid by a
company to use these types of debt financing. The measure can also give investors an idea of
the company’s risk level compared to others because riskier companies generally have a higher
cost of debt.

Examples of Cost of Debt

There are a couple of different ways to calculate a company’s cost of debt, depending
on the information available.

30 | Financial Markets_Alcrobles
 The formula (risk-free rate of return + credit spread) multiplied by (1 - tax rate) is one
way to calculate the after-tax cost of debt.

This formula is useful because it takes into account fluctuations in the economy, as well
as company-specific debt usage and credit rating. If the company has more debt or a low credit
rating, then its credit spread will be higher.

For example, say the risk-free rate of return is 1.5% and the company’s credit spread is
3%. Its pretax cost of debt is 4.5%. If its tax rate is 30%, then the after-tax cost of debt is 3.15%
= [(0.015 + 0.03) × (1 - 0.3)].

As an alternative way to calculate the after-tax cost of debt, a company could

determine the total amount of interest that it is paying on each of its debts for the year. The
interest rate that a company pays on its debts is inclusive of both the risk-free rate of return
and the credit spread from the formula above because the lender(s) will take both into account
when initially determining an interest rate.

Once the company has its total interest paid for the year, it divides this number by the
total of all of its debt. This is the company’s average interest rate on all of its debt. The after-tax
cost of debt formula is the average interest rate multiplied by (1 - tax rate).

For example, say a company has a $1 million loan with a 5% interest rate and a
$200,000 loan with a 6% rate.

The average interest rate, and its pretax cost of debt, is 5.17% = [($1 million × 0.05) +
($200,000 × 0.06)] ÷ $1,200,000. The company’s tax rate is 30%.

Thus, its after-tax cost of debt is 3.62% = [0.0517 × (1 - 0.30)].

Why Does Debt Have a Cost?

Lenders require that borrowers pay back the principal amount of a debt, as well as
interest in addition to that amount. The interest rate, or yield, demanded by creditors is the cost
of debt—it is demanded to account for the time value of money, inflation, and the risk that the
loan will not be repaid. It also involves the opportunity costs associated with the money used for
the loan not being put to use elsewhere.

Managing Liquidity and Solvency

Solvency and liquidity are both terms that refer to an enterprise's state of financial
health, but with some notable differences.

Liquidity Ratio
Liquidity refers to an enterprise's ability to pay short-term obligations—the term also
refers to a company's capability to sell assets quickly to raise cash.

Current Ratio
Current ratio = Current assets / Current liabilities

31 | Financial Markets_Alcrobles
 The current ratio measures a company's ability to pay off its current liabilities (payable
within one year) with its current assets such as cash, accounts receivable, and
inventories. The higher the ratio, the better the company's liquidity position.

Quick Ratio
Quick ratio = (Current assets – Inventories) / Current liabilities

OR

Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable) /

Current liabilities

The quick ratio measures a company's ability to meet its short-term obligations with its
most liquid assets and therefore excludes inventories from its current assets. It is also
known as the "acid-test ratio."

Days Sales Outstanding (DSO)

Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x Number of
days in sales

Days sales outstanding, or DSO, refers to the average number of days it takes a
company to collect payment after it makes a sale. A higher DSO means that a company
is taking unduly long to collect payment and is tying up capital in receivables. DSOs are
generally calculated quarterly or annually.

Solvency Ratio
Solvency refers to an enterprise's capacity to meet its long-term financial commitments

Debt-to-Equity (D/E)
Debt to equity = Total debt / Total equity
The debt-to-equity (D/E) ratio indicates the degree of financial leverage (DFL) being
used by the business and includes both short-term and long-term debt. A rising debt-
to-equity ratio implies higher interest expenses, and beyond a certain point, it may
affect a company's credit rating, making it more expensive to raise more debt.

Debt-to-Assets
Debt to assets = Total debt / Total assets
Another leverage measure, the debt-to-assets ratio measures the percentage of a
company's assets that have been financed with debt (short-term and long-term). A
higher ratio indicates a greater degree of leverage, and consequently, financial risk.

Interest Coverage Ratio

Interest coverage ratio = Operating income (or EBIT) / Interest expense
The interest coverage ratio measures the company's ability to meet the interest
expense on its debt, which is equivalent to its earnings before interest and taxes (EBIT).
The higher the ratio, the better the company's ability to cover its interest expense.

32 | Financial Markets_Alcrobles
Valuation of Collaterals

What Is Collateral?

The term collateral refers to an asset that a lender accepts as security for a loan.
Collateral may take the form of real estate or other kinds of assets, depending on the purpose of
the loan. The collateral acts as a form of protection for the lender. That is, if the borrower defaults
on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its
losses

What Is Collateral Value?

The term collateral value refers to the fair market value of the assets used to secure a
loan. Collateral value is typically determined by looking at the recent sale prices of similar assets
or having the asset appraised by a qualified expert.

Understanding Collateral Value

Collateral value is one of the key aspects considered by lenders when reviewing
applications for secured loans. In a secured loan, the lender has the right to obtain ownership of
a particular asset—called the "collateral" of the loan—if the borrower defaults on their
obligation. In theory, the lender should recover all or most of their investment by selling the
collateral. Therefore, estimating the value of that collateral is a key step before any secured loan
is approved.

Home Mortgage and Collateral Value

Secured loans can be made against all types of property. One of the most common types
of secured loans is the home mortgage, in which the house is given as collateral to secure the
mortgage loan. In this situation, if the borrower fails to make their mortgage payments, the
mortgage lender can sell the house to recuperate their investment.

Example of Collateral Value

Depending on the type of asset being used as collateral, the collateral value methods
may differ. For instance, if a loan is secured by publicly-traded stock, then the current
market price of those securities can be used when estimating its collateral value.

In other cases, the collateral being used may be rarely traded on the market. For instance, a
borrower might pledge collateral in the form of privately held shares or alternative assets, such
as fine art or rare collector's items. In these situations, an appraiser may need to use specialized
valuation methods, such as calculating the value of the private shares by using discounted cash-
flow analysis (DCF). Meanwhile, fine art and other rare items may need to be appraised by
specialists who are familiar with the private collector and auction markets for those types of
assets.

33 | Financial Markets_Alcrobles
Source

http://www.pinoymoneybankingandcredit.com/2011/05/credit-process.html
Financial Markets and Institutions by Sanders
https://www.creditinfo.gov.ph/republic-act-no-9510-credit-information-system-act-cisa-0
https://www.investopedia.com/terms/c/costofdebt.asp#:~:text=Key%20Takeaways,such%20as
%20bonds%20and%20loans.&text=Debt%20is%20one%20part%20of,all%20of%20a%20compan
y's%20debts.
https://www.investopedia.com/terms/collateral-
value.asp#:~:text=The%20term%20collateral%20value%20refers,appraised%20by%20a%20qual
ified%20expert.

34 | Financial Markets_Alcrobles
Module 4. Financial Instruments

After studying this chapter, student should be able to:

1. Describe the different financial instrument

2. Identify the limitations or risk in using each financial instrument
3. Describe how financial instruments be valued

What Is a Financial Instrument?

Financial instruments are assets that can be traded, or they can also be seen as packages
of capital that may be traded. Most types of financial instruments provide efficient flow and
transfer of capital all throughout the world's investors. These assets can be cash, a contractual
right to deliver or receive cash or another type of financial instrument, or evidence of one's
ownership of an entity.

Types of Asset Classes of Financial Instruments

Financial instruments may also be divided according to an asset class, which depends
on whether they are debt-based or equity-based.

1. Debt-Based Financial Instruments

Debt-based financial instruments represent a loan made by an investor to the owner of

the asset.

Short-term debt-based financial instruments last for one year or less. Securities of this
kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and
certificates of deposit (CDs).

Exchange-traded derivatives under short-term, debt-based financial instruments can be

short-term interest rate futures. OTC derivatives are forward rate agreements.

Long-term debt-based financial instruments last for more than a year. Under securities,
these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and
options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors,
interest rate options, and exotic derivatives.

2. Equity-Based Financial Instruments

Equity-based financial instruments represent ownership of an asset.

Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in
this category include stock options and equity futures. The OTC derivatives are stock options
and exotic derivatives.

35 | Financial Markets_Alcrobles
Examples of Financial Instruments

1. Long Term Negotiable Certificates of Deposit

2. Short-Term and Long-Term Commercial Papers
3. Banker’s Acceptances
4. Treasury Bills, Notes and Bonds
5. Repurchase Agreement

Long Term Negotiable Certificate of Deposits

An LTNCD, or Long-Term Negotiable Certificate of Deposit, is a bank product offered to

investors looking for a relatively safe investment, but with higher interest rates than a
regular savings account or short-term time deposit.

As mandated by the BSP, LTNCDs are to be denominated in Philippines Pesos, have a

minimum maturity of 5 years, and registered with a third party Registry Bank maintaining
an Electronic Registry Book

Long-term: maturity date usually comes after 5 years or so.

Negotiable: can be sold in the secondary market, even before maturity date.

Certificate of Deposit: like a Certificate of Deposit (CD), LTNCDs also earn interest, and
is a debt instrument.

Deposit: as a bank deposit product, it is insured by the PDIC. It is a hybrid product (high-
yielding) in a sense that much like a time deposit, it is issued by a bank and is covered by the
PDIC up to Php500,000.00. Like a bond, it is negotiable, long-term, and has quarterly interest
payments. The tenor is typically five years.

Example :

Land Bank of the Philippines LTNCD Issuance

PESO LONG-TERM NEGOTIABLE CERTIFICATES OF TIME DEPOSIT (LTNCD)

LANDBANK LTNCD Due 2021

Issuer Land Bank of the Philippines
PDIC Coverage Yes
Issue Date 09 October 2015
Maturity Date / Original Tenor 09 April 2021 (5 ½ years)
Interest/Coupon on Issue Date (Gross)3.750%
Taxation Tax exempt for qualified individuals if held for
at least 5 years
Interest Payment Period Quarterly
Minimum Investment Requirement (Secondary Market) P 50,000
Tradable via Market Maker Yes

36 | Financial Markets_Alcrobles
 Example of NCD ( 1980)

Short Term Commercial Papers

"Commercial paper" shall be defined as an instrument evidencing indebtedness of any

person or entity, including banks and non-banks performing quasi-banking functions, which
is issued, endorsed, sold, transferred or in any manner conveyed to another person or entity,
either with or without recourse and irrespective of maturity. Principally, commercial papers
are promissory notes and/or similar instruments issued in the primary market and shall not
include repurchase agreements, certificates of assignments, certificates of participations,
and such other debt instruments issued in the secondary market

Commercial paper is a commonly used type of unsecured, short-term debt instrument

issued by corporations, typically used for the financing of payroll, accounts payable and
inventories, and meeting other short-term liabilities. Maturities on commercial paper
typically last several days, and rarely range longer than 270 days

The issuance of commercial paper is an alternative to short-term bank loans. Some large
firms prefer to issue commercial paper rather than borrow from a bank because it is usually
a cheaper source of funds. Tenor varies from 30, 60, 90, 180 (and so on) but has a maximum
tenor of 360/365 days.

Issuer SEC-Registered Philippine Corporations

Tenor 30 days to 1 year
Redemption Price Discount to par (Less than 100% of face value) (Pay
less than the principal amount received at maturity)

37 | Financial Markets_Alcrobles
 Interest Rate Prevailing Market Rate (Subject to 20% final
withholding tax except for tax-exempt institutions)
Interest Payment At maturity
Minimum Investment Php 50,000 with increments of Php 10,000 thereafter

Tradable in the open market Yes

STCPs are sold at a discount to par but are redeemable by the issuer at par come maturity
date. Instead of earning periodic coupons or interests, you can earn by buying the instrument
at a discount, with a promise to redeem the instrument at 100% of the target principal
investment amount. The difference between the discount and par is considered the return
on investment.

Why should you invest in STCPs?

Liquidity- You can easily buy and sell it in the secondary market through selling agents
like banks, subject to prevailing market prices.

Short term commitment- A viable option for investors looking to lock in their funds for
a short period of.

Low risk- Given the tenor of the instrument. investors are exposed to a relatively low-
risk than a longer-tenored corporate bond.

Thus, STCPs can be a viable alternative for retail fixed-income investors who are looking
for a short term investment that yields return higher than traditional bank products such as
time deposits.

Banker’s Acceptances

A banker's acceptance is a short-term issuance by a bank that guarantees payment at a

later time.
A banker's acceptance is often used in importing and exporting, with the importer's
bank guaranteeing payment to the exporter.

38 | Financial Markets_Alcrobles
 A banker's acceptance differs from a post-dated check in that it is seen as an
investment and can be traded on a secondary market.

Applying for a banker's acceptance is similar to applying for a short-term, fixed-rate

loan; the borrower goes through a credit check and sometimes extra underwriting
processes.

Similar to buying a Treasury bill, an investor on the secondary market might buy the
acceptance at a discounted price, but still get the full value at the time of maturity.

How it works

A banker’s acceptance works much like a post-dated check, which is simply an order for
a bank to pay a specified party at a later date. If today is Jan. 1, and a check is written with
the date "Feb. 1," then the payee cannot cash or deposit the check for an entire month.
This can be thought of as a maturity date for a claim on another's assets.

Critical Distinctions

Perhaps the most critical distinction between a banker's acceptance and a post-dated
check is a real secondary market for banker's acceptances; post-dated checks don't have such
a market. For this reason, banker's acceptances are considered to be investments, whereas
checks are not. The holder may choose to sell the BA for a discounted price on a secondary
market, giving investors a relatively safe, short-term investment.

Steps Involved in Banker’s Acceptances

39 | Financial Markets_Alcrobles
To understand these steps, consider the example of a U.S. importer of Japanese goods.

First, the importer places a purchase order for the goods (Step 1). If the Japanese
exporter is unfamiliar with the U.S. importer, it may demand payment before delivery of
goods, which the U.S. importer may be unwilling to make. A compromise can be reached
by creating a banker’s acceptance.

The importer asks its bank to issue a letter of credit (L/C) on its behalf (Step 2).
The L/C represents a commitment by that bank to back the payment owed to the
Japanese exporter.

Then the L/C is presented to the exporter’s bank (Step 3),

Exporter’s Bank informs the exporter that the L/C has been received (Step 4).

The exporter then sends the goods to the importer (Step 5)

Exporter sends the shipping documents to its bank (Step 6),

Exporter’s bank passes them along to the importer’s bank (Step 7).

At this point, the banker’s acceptance (B/A) is created, which obligates the importer’s
bank to make payment to the holder of the banker’s acceptance at a specified future
date. The banker’s acceptance may be sold to a money market investor at a discount.
Potential purchasers of acceptances are short term investors. When the acceptance
matures, the importer pays its bank, which in turn pays the money market investor who
presents the acceptance.

Treasury Bills, Notes and Bonds

Treasury Bills

Treasury Bills or popularly known as T-Bills are peso-denominated short-term fixed

income securities issued by the Republic of the Philippines through its Bureau of Treasury.

Why invest in Treasury Bills?

You get the interest in advance.

Investing in Tbills is practically risk free since there is a low probability that the
Philippine government will default on its own local currency debt.

Features

Issued by the Republic of the Philippines and thus carries its obligation to pay investors
on maturity dates.

Original tenors are 91, 182 and 364 days. All maturity dates traditionally fall on a
Wednesday (unless said day is a holiday). Computation of selling price is based on
number of days remaining till the maturity of a series.

40 | Financial Markets_Alcrobles
 Sold at a discount, with the interest paid in advance.

Interest given to client is based on prevailing market rates and is subject to withholding
tax (currently at 20% except for tax-exempt institutions).

Minimum placement: Php 200,000.00 face value, subject to the availability of the
security. ( Land Bank of the Philippines)

Tradable via Organized Exchange : Yes

Treasury Notes (Fixed rate)

Fixed Rate Treasury Notes (“FXTN”) are medium to long-term investments issued
by the Philippine government

Issuer Republic of the Philippines

Status/Credit Fully guaranteed by the National Government
Issue Size Various
Issue Date Various
Maturity Date Various
Original Tenor Up to 25 years (3, 5, 7, 10, 15, 20, 25 years)
Interest/Coupon on Issue Date (Gross)
Various
Taxation (subject to 20% withholding tax, except for tax-
exempt institutions)
Interest Payment Period Semi-annually
Minimum Investment Requirement (Secondary Market)
PHP 200,000 ( LBP)
Php 50,000 ( Security Bank)
Tradable via Organized Exchange Yes

Why Invest?

Liquidity - You can buy and sell your fixed income securities on any banking day.

Fixed Rates - Your income stream is fixed regardless of market changes.

Lower Risk - Lessen your risk by investing in the Philippine government

Retail Treasury Bonds

Treasury Bonds are obligations with maturities ranging from 3 years to 25 years, typically
issued at par with periodic coupon payments to be made up to final maturity.

Issuer Republic of the Philippines

Status/Credit Fully guaranteed by the National Government
Issue Date Various
Maturity Date Various
Original Tenor Up to 25 years (3, 5, 7, 10, 15, 20, 25 years)
Interest/Coupon on Issue Date (Gross) Various
Taxation (subject to 20% withholding tax, except for tax-exempt institutions)
Interest Payment Period Quarterly

41 | Financial Markets_Alcrobles
 Minimum Investment Requirement Primary Market: P 5,000
Secondary Market: P 200,000
Tradable via Organized Exchange Yes

Repurchase Agreement

With a repurchase agreement (or repo), one party sells securities to another with an
agreement to repurchase the securities at a specified date and price. In essence, the repo
transaction represents a loan backed by the securities. If the borrower defaults on the loan, the
lender has claim to the securities. Most repo transactions use government securities, although
some involve other securities such as commercial paper or NCDs.

A repurchase agreement (Repo) is a contract whereby the seller of securities agrees to

buy them back at a specified future date and price usually on a short-term basis. The difference
between the original price and the repurchase price implies the cost of the repo otherwise known
as the repo rate. This transaction is generally used for securities financing.

Example of a Repurchase agreement ( Page 1)

42 | Financial Markets_Alcrobles
 Risks in Trading Financial Instruments

General risk factors

Financial instruments involve various risks, but several risk factors apply to any type of
financial instrument and are discussed below:

a) Market risk: The risk that changes in market prices have adverse effect on financial
instruments.

b) Interest rate risk: The risk that changes in interest rates have adverse effect on the
value of a financial instrument.

c) Currency risk: Exchange rates fluctuate and financial instruments that are registered
in foreign currency can entail currency risk. Changes in currency rates can cause profit or
loss although the currency value in which the underlying instrument is registered does
not change.

d) Liquidity risk: The risk that an investor cannot easily sell or buy a specific financial
instrument at a certain point in time, or is only able to do so on terms that are
considerably poorer than the norm in an active market at any time. This can be
caused by various factors, such as inactive market with a particular instrument, contract
size and other factors that may affect the supply and demand and market participants’
behaviour.

e) Economic risk: Economic fluctuations often affect the prices of financial instruments.
The fluctuations are variable, they can variate in time and magnitude and can affect
different industries in various ways. When deciding on an investment an investor must
be aware of the general impact of economic fluctuations, including between countries
and different economies, on the value of financial instruments.

f) Country risk: The risk includes, among other things, political risk, currency risk,
economic risk and risk relating to capital transfers. This refers to the economic factors
that could have a significant impact on the business environment in the country in which
the financial instrument is registered.

g) Legal risk: The risk that the government makes changes to existing laws or regulations
that can have adverse effect on financial instruments, for example changes in tax laws or
laws regarding capital transfers across borders.

h) Inflation risk: When investors assess the yield of a specific financial instrument, it is
necessary to do so with regard to inflation and inflation outlook to estimate the expected
real return on investment and current asset value.

i) Counterparty risk: The risk that a counterparty will not meet his contractual obligations
in full.

j) Settlement risk: The risk related to a counterparty not meeting the contractual
obligations on the settlement date. Settlement loss may occur due to default or due to
the different timings of the settlement between relevant parties.

43 | Financial Markets_Alcrobles
 Sources : https://www.landbank.com/treasury/treasury-products/landbank-issues
https://ebrary.net/411/business_finance/deposit_instruments
https://www.securitybank.com/personal/investments/fixed-income-securities/short-term-
commercial-paper/#:~:text=Overview,30%20days%20to%201%20year.
https://www.securitybank.com/blog/short-term-commercial-paper-101/
https://www.investopedia.com/articles/investing/062013/bankers-acceptance-101.asp
https://www.pds.com.ph/wp-content/uploads/2019/07/GS-REPO-RULES-UPDATED-AS-OF-AUGUST-
2018-.pdf
https://morb.bsp.gov.ph/repurchase-agreement/
https://cdn.islandsbanki.is/image/upload/v1/documents/financial_instruments_and_associated_risk
s.pdf

44 | Financial Markets_Alcrobles
Module 5 Debt Securities Market

After the sessions, the student is expected to:

1. Identify different types of bonds

2. Select the bond or debt security investments that will yield higher value

Investments are a great way to increase your sources of income. Investments like stocks
and mutual funds are popular investment options that many finance-savvy Filipinos are adding
to their portfolio. While there is always some amount of risk in investing, many find the chance
of getting higher returns as worth the risk.

But it’s that same risk that makes many other Filipinos hesitant about investing. After all,
when you have a family to look after, or a financial goal to aim for, you don’t want to put these
on the line for income that isn’t a hundred percent guaranteed.

Many Filipinos may not know about Philippine Bonds, which are one of the safest
investment instruments in the financial markets. If you’re interested in low-risk but high-return
investments, here’s a guide to bond investments and why it may be the best investment option
for the shrewd investor who wants to play it safe.

What Is a Debt Security?

A debt security is a debt instrument that can be bought or sold between two parties and
has basic terms defined, such as the notional amount (the amount borrowed), interest rate, and
maturity and renewal date.

Examples of debt securities include a government bond, corporate bond, certificate of

deposit (CD), municipal bond, or preferred stock. Debt securities can also come in the form
of collateralized securities, such as collateralized debt obligations (CDOs), collateralized
mortgage obligations (CMOs), mortgage-backed securities issued by the Government
National Mortgage Association (GNMA), and zero-coupon securities.

How Debt Securities Work

A debt security is a type of financial asset that is created when one party lends money to
another. For example, corporate bonds are debt securities issued by corporations and sold to
investors. Investors lend money to corporations in return for a pre-established number of
interest payments, along with the return of their principal upon the bond's maturity date.

Government bonds, on the other hand, are debt securities issued by governments and
sold to investors. Investors lend money to the government in return for interest payments (called
coupon payments) and a return of their principal upon the bond's maturity.

Debt securities are also known as fixed-income securities because they generate a fixed
stream of income from their interest payments. Unlike equity investments, in which the return
earned by the investor is dependent on the market performance of the equity issuer, debt
instruments guarantee that the investor will receive repayment of their initial principal, plus a
predetermined stream of interest payments.

45 | Financial Markets_Alcrobles
What are bonds?

Bonds are long-term debt securities that are issued by government agencies or
corporations. The issuer of a bond is obligated to pay interest (or coupon) payments periodically
(such as annually or semiannually) and the par value (principal) at maturity. An issuer must be
able to show that its future cash flows will be sufficient to enable it to make its coupon and
principal payments to bondholders. Investors will consider buying bonds for which the
repayment is questionable only if the expected return from investing in the bonds is sufficient to
compensate for the risk.

Bonds are a passive investment asset. It serves as proof that its issuer (either the
government or a private corporation) has borrowed money from you and they will pay you what
you’re owed plus periodic interest payments over the period indicated on your bonds’ terms.

Let’s say that the government has an infrastructure project that will cost them 50 billion
pesos. After the government exercises all their possible options for funding, they may find that
they’re still short of 5 billion pesos. One solution is to issue multiple bonds totaling to that
amount, but promising to pay it back after several years plus interest.

Individuals, organizations, and even foreign governments can buy these bonds in
exchange for the money the government needs, and will be known as creditors or debt-holders.
After the specified bond tenor has passed, the bond matures, and creditors can claim their debt
plus the interest that they’re entitled to.

Types of bonds

Two types of bonds according to maturity

1. Treasury Bills (T-Bills). Debt investments with short term maturity of less than a year. According
to the Bureau of Treasury, there are currently three tenors (maturity period) of Treasury Bills:

• 91-day
• 182-day
• 364-day

2. Treasury Bonds (T-Bonds). Debt investments with long term maturity of more than one year.
According to the Bureau of Treasury, there are currently five (5) maturities of Treasury Bonds:

• 2-year
• 5–year
• 7–year
• 10–year
• 20-year
 25-year

46 | Financial Markets_Alcrobles
Four types of bonds according to issuer

1. Treasury Securities. Issued by the Bureau of Treasury. This is ideal for big corporations.

2. Government Bonds. Government bonds, also known as sovereign bonds, are either placed up
for auction with institutions that have the capacity to distribute it further to the retail investors,
or sold directly to the general public. Issued by government agencies, e.g. PAG-IBIG or the
Home Development Mutual Fund. The bonds offered by PAG-IBIG are also ideal for individual
investments because of their competitive interest rates.

3. Municipal Bonds. Issued and announced by local government

4. Corporate Bonds. Corporate bonds are those issued by private corporations listed on the stock
exchange. Corporations may issue bonds to investors to expand their business or sustain their
operations. Issued by large corporations. For instance, Ayala Land, Inc.’s announcement to
raise P8B from fixed-rate bonds.

Bond investment risks

Compared to investments like stocks and mutual funds where you risk incurring a loss
depending on market conditions, sovereign bonds are considered as relatively risk-free, as the
risk of the government defaulting is relatively low.

With the country’s steady economic growth, it’s unlikely that the Philippine government
would be unable to pay its bonds when the time comes.

However, take note that this isn’t an investment that guarantees 100% safety from risk.
Major events like a revolution or a country defaulting due to its huge foreign debt is possible.
However, this is unlikely to happen in the Philippines where growth is relatively stable.

47 | Financial Markets_Alcrobles
 As for corporate bonds, if the issuing company ever goes bankrupt, it will be liquidated
to pay off any remaining debt. Because bonds are considered debt, holders of its corporate bonds
will be prioritized – even put ahead of those holding its stocks.

Advantages of buying bonds in the Philippines

1. Relatively less risk.

Whether you buy Philippine sovereign bonds or corporate bonds, it is a relatively safer
option, because it is much less volatile compared to other forms of investments that
can fluctuate depending on the market trends.

2. Portfolio diversification. As the saying goes, don’t put all your eggs in one basket. If
you’re planning on investing in multiple investment products, the low-risk features of
bonds can offset potential losses that high-risk investments may incur.

3. Fixed income. Depending on the type of bonds you buy, interest can be paid
periodically, giving you fixed passive income on top of your other sources of income or
revenue.

4. Better interest income. Other low-risk, interest-based options like savings accounts
and time deposits offer lower interest rates. The income you receive from bonds is
much higher compared to the other two.

Disadvantages of buying bonds

1. There is still risk of default.

As mentioned earlier, buying bonds is not 100% risk-free. It’s unlikely that the
Philippines may undergo a scenario wherein economic growth suddenly plummets and
it defaults due to its debts, but the chance of it happening exists, albeit being remote at
this point. As for corporate bonds, creditors are prioritized over stockholders, but that
doesn’t guarantee that you’ll be paid in full depending on the corporation’s amount of
debt upon liquidation.

2. Opportunity costs. Bonds are the relatively safer option, but there’s no guarantee that
it will do better than the high-risk, high-reward investments. In many cases, the gamble
investors take on stocks can greatly pay off. For bonds, the smaller profits (interest
payments) are steadier as committed by the issuer. Typically in normal markets, stocks
generally perform better in the long run. But in case of a recession or a decline in the
market, bonds are the better option for those who want to play it safe.

How do bonds work?

To start investing, you will need a tax identification number (all profits from your bonds
are subject to 20% tax), a bank account, and at least P10,000 in capital to buy bonds. You can
buy bonds through different means:

48 | Financial Markets_Alcrobles
 Directly from the Bureau of Treasury’s authorized selling agents (you can find
announcements of new bond offerings within the business sections of newspapers when they
are issued or announced)

Through brokers in the secondary market (this will entail additional brokerage fees on
top of your withholding tax)

Bond funds.

These aren’t exactly bonds, but pooled investment funds by authorized financial
institutions and companies. Your profits come from bond investments, where the investors’
pooled money was invested in. Examples of these funds include mutual funds and unit
investment trust funds.

Should I invest in bonds?

Bonds are the best choice for conservative Filipinos who want safe investments, as
opposed to taking a gamble on the stock market. Bonds are not directly affected by the highs and
lows of the stock market, so it’s less likely that you will incur losses. It is the better option for
people who prefer the predictable passive income from the periodic interest that their bonds
receive. This makes it a good investment option for.

First-time investors who want to start safe

 Investors looking to add safe long-term options to offset their riskier investments
 People who want periodic income to help their household’s expenses
 Retired individuals who want additional periodic income

Advantages of buying bonds in the Philippines

5. Relatively less risk.

Whether you buy Philippine sovereign bonds or corporate bonds, it is a relatively safer
option, because it is much less volatile compared to other forms of investments that
can fluctuate depending on the market trends.

6. Portfolio diversification. As the saying goes, don’t put all your eggs in one basket. If
you’re planning on investing in multiple investment products, the low-risk features of
bonds can offset potential losses that high-risk investments may incur.

7. Fixed income. Depending on the type of bonds you buy, interest can be paid
periodically, giving you fixed passive income on top of your other sources of income or
revenue.

8. Better interest income. Other low-risk, interest-based options like savings accounts
and time deposits offer lower interest rates. The income you receive from bonds is
much higher compared to the other two.

49 | Financial Markets_Alcrobles
Disadvantages of buying bonds

3. There is still risk of default.

As mentioned earlier, buying bonds is not 100% risk-free. It’s unlikely that the
Philippines may undergo a scenario wherein economic growth suddenly plummets and
it defaults due to its debts, but the chance of it happening exists, albeit being remote at
this point. As for corporate bonds, creditors are prioritized over stockholders, but that
doesn’t guarantee that you’ll be paid in full depending on the corporation’s amount of
debt upon liquidation.

4. Opportunity costs. Bonds are the relatively safer option, but there’s no guarantee that
it will do better than the high-risk, high-reward investments. In many cases, the gamble
investors take on stocks can greatly pay off. For bonds, the smaller profits (interest
payments) are steadier as committed by the issuer. Typically in normal markets, stocks
generally perform better in the long run. But in case of a recession or a decline in the
market, bonds are the better option for those who want to play it safe.

Strategies and Challenges in Bond Market

The returns of bonds are influenced by a number of factors: changes in interest rates,
changes in the credit ratings of the issuers, and changes in the yield curve. A bond strategy is
the management of a bond portfolio either to increase returns based on anticipated changes in
these bond-pricing factors or to maintain a certain return regardless of changes in those factors.
Bond strategies can be classified as active, passive, hybrid.

 Active strategies usually involve bond swaps, liquidating one group of bonds to
purchase another group, to take advantage of expected changes in the bond
market, either to seek higher returns or to maintain the value of a portfolio.
Active strategies are used to take advantage of expected changes in interest
rates, yield curve shifts, and changes in the credit ratings of individual issuers.

 Passive strategies are used, not so much to maximize returns, but to earn a good
return while matching cash flows to expected liabilities or, as in indexing, to
minimize transaction and management costs. Pension funds, banks, and
insurance companies use passive strategies extensively to match their income
with their expected payouts, especially bond immunization strategies and cash
flow matching. Generally, the bonds are purchased to achieve a specific
investment objective; thereafter, the bond portfolio is monitored and adjusted
as needed.

 Hybrid strategies are a combination of both active and passive strategies, often
employing immunization that may require rebalancing if interest rates change
significantly. Hybrid strategies include contingent immunization and
combination matching.

The primary objective of an active strategy is for greater returns, such as buying bonds
with longer durations in anticipation of lower long-term interest rates; buying junk bonds in
anticipation of economic growth; buying Treasuries when the reserve is expected to increase the
money supply, which it usually does by buying Treasuries.

50 | Financial Markets_Alcrobles
Active selection strategies are based on anticipated interest rate changes, credit changes, and
fundamental valuation techniques.

Interest Rate Anticipation Strategies

A rate anticipation strategy involves selecting bonds that will increase the most in value
from an expected drop in interest rates. A rate anticipation swap involves selling a group of bonds
so that others can be purchased based on the expected change in interest rates. A total return
analysis or horizon analysis is conducted to evaluate several strategies using bond portfolios with
different durations to see how they would fare under different interest rate changes, based on
expected market changes during the investment horizon.

If interest rates are expected to drop, then bonds with longer durations would be
purchased, since they would profit most from an interest rate decrease. If rates were expected
to increase, then bonds with shorter durations would be purchased, to minimize interest-rate
risk. One means of shortening duration is buying cushion bonds, which are callable bonds with a
coupon rate that is significantly higher than the current market rate. Cushion bonds generally
have a shorter duration because of their call feature and are cheaper to buy, since they generally
have a lower market price than a similar bond without the call feature. Rate anticipation
strategies generally require a forecast in the yield curve as well since the change in interest rates
may not be parallel.

Yield Curve Shifts

The yield curve risk is the risk of experiencing an adverse shift in market interest rates
associated with investing in a fixed income instrument. When market yields change, this will
impact the price of a fixed-income instrument. When market interest rates, or yields, increase,
the price of a bond will decrease, and vice versa.

Understanding Yield Curve Risk

Investors pay close attention to the yield curve as it provides an indication of where short
term interest rates and economic growth are headed in the future. The yield curve is a graphical
illustration of the relationship between interest rates and bond yields of various maturities,
ranging from 3-month Treasury bills to 30-year Treasury bonds. The graph is plotted with the y-
axis depicting interest rates, and the x-axis showing the increasing time durations.

Since short-term bonds typically have lower yields than longer-term bonds, the curve
slopes upwards from the bottom left to the right. This is a normal or positive yield curve. Interest
rates and bond prices have an inverse relationship in which prices decrease when interest rates
increase, and vice versa. Therefore, when interest rates change, the yield curve will shift,
representing a risk, known as the yield curve risk, to a bond investor.

The yield curve risk is associated with either a flattening or steepening of the yield curve,
which is a result of changing yields among comparable bonds with different maturities. When
the yield curve shifts, the price of the bond, which was initially priced based on the initial yield
curve, will change in price

51 | Financial Markets_Alcrobles
Assessing Bond Value -How To Evaluate Bond Performance

When evaluating the potential performance of a bond, investors need to review certain
variables. The most important aspects are the bond's price, its interest rate and yield, its date to
maturity, and its redemption features. Analyzing these key components allows you to determine
whether a bond is an appropriate investment.

There are four key variables to be considered when evaluating a bond's potential performance.

 The bond's current price vis-a-vis its face value is one.

 The bond's maturity (the number of years or months the issuer is borrowing money for)
is another variable.
 The bond's interest rate and its yield—its effective return, based on its price and face
value—is a third factor.
 A final factor is redemption—whether the issuer can call the bond back in before its
maturity date.

Price

The first consideration is the price of the bond. The yield that you will receive on the
bond impacts the pricing.

Bonds trade at a premium, at a discount or at par. If a bond is trading at a premium to

its face value, then it usually means the prevailing interest rates are lower than the rate
the bond is paying. Hence, the bond trades at a higher amount than its face value, since
you are entitled to a higher interest rate than you could get from comparable
instruments. A bond is trading at a discount if the price is lower than its face value. This
indicates the bond is paying a lower interest rate than the prevailing interest rate in the
market. Since you can obtain a higher interest rate easily by investing in other fixed
income securities, there is less demand for a bond with a lower interest rate.

A bond with a price at par is trading at its face value—the amount at which the issuer
will redeem the bond at maturity. This is also called the par value.

Interest Rate and Yield

A bond pays a certain rate of interest at periodic intervals until it matures. Bonds'
interest rates, also known as the coupon rate, can be fixed, floating or only payable at
maturity. The most common interest rate is a fixed rate until maturity; it's based on the
bond’s face value. Some issuers sell floating rate bonds that reset the interest based on
a benchmark such as Treasury bills or LIBOR. The London Interbank Offered Rate (LIBOR)
is a benchmark interest rate at which major global banks lend to one another in the
international interbank market for short-term loans.

As their name implies, zero-coupon bonds don't pay any interest at all. Rather, they are
sold at steep discounts to their face values. This discount reflects the aggregate sum of
all the interest the bond would've paid until maturity.

Closely related to a bond's interest rate is its yield. The yield is the effective return
earned by the bond, based on the price paid for the bond and the interest it generates.
Yield on bonds is generally quoted as basis points (bps).

52 | Financial Markets_Alcrobles
 What Are Basis Points (BPS)?
Basis points (BPS) refers to a common unit of measure for interest rates and
other percentages in finance. One basis point is equal to 1/100th of 1%, or
0.01%, or 0.0001, and is used to denote the percentage change in a
financial instrument. The relationship between percentage changes and basis
points can be summarized as follows: 1% change = 100 basis points and 0.01% =
1 basis point.

Basis points are typically expressed in the abbreviations "bp," "bps," or "bips."

Two types of yield calculations exist. The current yield is the annual return on the total
amount paid for the bond. It is calculated by dividing the interest rate by the purchase
price. The current yield does not account for the amount you will receive if you hold
bond to maturity. The yield-to-maturity (YTM) is the total amount you will receive by
holding the bond until the end of its lifespan The yield to maturity allows for the
comparison of different bonds with varying maturities and interest rates.

For bonds that have redemption provisions, there is the yield to call, which calculates
the yield until the issuer can call the bond—that is, demand that investors surrender it,
in return for a payoff.

Types of Yield Curve Risk

Flattening Yield Curve

When interest rates converge, the yield curve flattens. A flattening yield curve is
defined as the narrowing of the yield spread between long- and short-term
interest rates. When this happens, the price of the bond will change accordingly.
If the bond is a short-term bond maturing in three years, and the three-year
yield decreases, the price of this bond will increase.

Let’s look at an example of a flattener. Let’s say the Treasury yields on a 2-year
note and a 30-year bond are 1.1% and 3.6%, respectively. If the yield on the
note falls to 0.9%, and the yield on the bond decreases to 3.2%, the yield on
the longer-term asset has a much bigger drop than the yield on the
shorter-term Treasury. This would narrow the yield spread from 250 basis
points to 230 basis points.

A flattening yield curve can indicate economic weakness as it signals that

inflation and interest rates are expected to stay low for a while. Markets
expect little economic growth, and the willingness of banks to lend is weak.

Steepening Yield Curve

If the yield curve steepens, this means that the spread between long- and short-
term interest rates widens. In other words, the yields on long-term bonds are
rising faster than yields on short-term bonds, or short-term bond yields are
falling as long-term bond yields are rising. Therefore, long-term bond prices
will decrease relative to short- term bonds.

53 | Financial Markets_Alcrobles
 A steepening curve typically indicates stronger economic activity and rising
inflation expectations, and thus, higher interest rates. When the yield
curve is steep, banks are able to borrow money at lower interest rates
and lend at higher interest rates. An example of a steepening yield curve can
be seen in a 2-year note with a 1.5% yield and a 20-year bond with a 3.5%
yield. If after a month, both Treasury yields increase to 1.55% and 3.65%,
respectively, the spread increases to 210 basis points, from 200 basis points.

Inverted Yield Curve

On rare occasions, the yield on short-term bonds is higher than the yield on
long-term bonds. When this happens, the curve becomes inverted. An
inverted yield curve indicates that investors will tolerate low rates now if
they believe rates are going to fall even lower later on. So, investors
expect lower inflation rates, and interest rates, in the future.

Maturity

The maturity of a bond is the future date at which your principal will be repaid. Bonds
generally have maturities of anywhere from one to 30 years. Short-term bonds have
maturities of one to five years. Medium-term bonds have maturities of five to 12 years.
Long-term bonds have maturities greater than 12 years.1

The maturity of a bond is important when considering interest rate risk. Interest rate
risk is the amount a bond’s price will rise or fall with a decrease or increase in interest
rates. If a bond has a longer maturity, it also has a greater interest rate risk.

Redemption

Some bonds allow the issuer to redeem the bond prior to the date of maturity. This
allows the issuer to refinance its debt if interest rates fall. A call provision allows the
issuer to redeem the bond at a specific price at a date before maturity. A put provision
allows you to sell it back to the issuer at a specified price prior to maturity.

A call provision often pays a higher interest rate. If you hold such a bond, you are taking
on additional risk that the bond will be redeemed and you will be forced to invest your
money elsewhere, probably at a lower interest rate (a decline in interest rates is usually
what triggers a call provision). To compensate you for taking on this chance, the bond
pays more interest.

54 | Financial Markets_Alcrobles
Sources:
https://www.investopedia.com/terms/d/debtsecurity.asp
https://www.metrobank.com.ph/articles/learn/ph-bond-investments
https://www.ecomparemo.com/info/what-you-need-to-know-about-bonds-in-the-philippines
https://www.ig.com/en/bonds/what-are-government-bonds
https://thismatter.com/money/bonds/bond-
strategies.htm#:~:text=A%20bond%20strategy%20is%20the,as%20active%2C%20passive%2C%
20hybrid.
https://www.investopedia.com/terms/y/yieldcurverisk.asp#:~:text=Therefore%2C%20when%2
0interest%20rates%20change,comparable%20bonds%20with%20different%20maturities.

55 | Financial Markets_Alcrobles