Republic of the Philippines

Laguna State Polytechnic University

ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

LSPU Self-Paced Learning Module (SLM)

Course Financial Market
Sem/AY First Semester/2023-2024
Module No. 3
Lesson Title Financial Market (2)
Week
12-14
Duration
Date
Description 1. Foreign Exchange Market
of the 2. Mortgage Markets and Derivatives
Lesson

Learning Outcomes
Intended Students should be able to meet the following intended learning outcomes:
Learning
● understand factors that influence the currency exchange rates of a country
Outcomes
● -understand what exchange rate is

● -Know the significance of foreign exchange risks

● -explain what mortgage markets are

● -differentiate between stock and bond markets and mortgage

● -describe what are mortgages, and its different types

● - describe the different types of derivatives

Targets/ At the end of the lesson, students should be able to:

Objectives
● Describe and explain the nature of Foreign Exchange Market

● Explain and describe Mortgage Market and Derivatives

Student Learning Strategies

Online A. Online Discussion via Google Meet/Zoom
Activities You will be directed to attend in a __________class discussion on Financial System.
(Synchrono To have access to the Online Discussion, refer to this link: ____________________.
us/ The online discussion will happen ______, and ___, 2022, from ____________ AM./PM.
Asynchron (For further instructions, refer to your Google Classroom and see the schedule of
ous) activities for this module)
B. Learning Guide Questions:

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

1. What is Foreign Exchange Market?

2. What is Mortgage Market and Derivatives?

Note: The insight that you will post on online discussion forum using Learning Management System (LMS)
will receive additional scores in class participation.

Offline
Activities Lecture Guide
(e- Read chapter nine and ten of Elenita Cabrera’s book on Financial Market and
Institutions, 2020 edition.
Learning/
Self- 1. Foreign Exchange Market – An entity has to buy raw materials for his product operation
Paced) from other country, and that seller required him to pay his purchases in their local currency. The
system to which that entity should undergo to meet the seller’s requirement is a typical example
of which the entity should exchange his local currency to the sellers pay requirement.
Foreign Exchange Market or FX (forex) – A place or market in which people or firms use
one currency to purchase another currency. Mostly international transactions such as selling,
buying, travelling, borrowing and investing requires partakers to convert one currency to
another. The trading of currency and bank deposits denominated in particular takes place in the
foreign exchange market.
International Monetary Fund (IMF) administered the world exchange rate system from the
end of world war II until the early 70’s. All countries were required to set a specific parity rate for
their currency in measured with US dollar. Adjustments in the exchange rate through changing
the parity rate with respect to the dollar, such as it made the currency cheaper thereby
devaluation occurs. An upvaluation or revaluation resulted when a currency become more
expensive with respect to the dollar. (Cabrera)
The FX market provides service to individuals, businesses and governments who need to
buy or sell currencies, other than that used in their country. It is also a market place in which
currencies are bought and sold purely to make profit via speculation. It also provides mechanism
for the transfer of purchasing power from one currency to another .

The foreign exchange market (also known as forex (FX), or the currency market) is
global marketplace that determines the exchange rate for currencies around the world. Like any
other market, foreign exchange market is a system, not a place where foreign money is bought
and sold. Participants include individuals, firms, foreign exchange broker, commercial banks,
and the central bank are able to buy, sell, exchange, and speculate on currencies. The transaction
in this market is not confined to only one or few foreign currencies. In fact, there are large
number of foreign currencies which are traded, converted, and exchange in the foreign exchange
market

A Foreign Exchange Rates - the value of one currency for the purpose of conversion to
another. It is the price of one’s country currency expressed in terms of another country’s

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
currency. Exchange Rates are important because they affect the relative price of domestic and
foreign goods. When a country’s currency appreciates (rises in value relative to other
currencies), the country’s goods abroad become more expensive and foreign goods in that
country become cheaper, in reverse, when a country’s currency depreciates, its goods abroad
become cheaper and foreign goods in that country become expensive. (Cabrera)

B. Factors Influencing Exchange Rates - As with any other market the currency
exchange rate between two currencies is determined by the supply of the demand for those
currencies. Factors that tend to increase the supply or decrease the demand schedule for a given
currency will bring down the value of that currency in foreign exchange matters. Similarly, the
factors that tend to decrease the supply or increase the demand for a currency will raise the
value of that currency.
Major reasons for exchange rate movements are:
1. Inflation - a general increase in prices and fall in the purchasing value of money.
Inflation tends to deflate the value of a currency because holding the currency results in reduced
purchasing power.
2. Interest Rates - if interest returns in a particular country are higher relative to other
countries, individuals and companies will be enticed to invest in that country. As a result, there
will be an increased demand for the country's currency.
3. Balance of Payments - is used to refer to a system of accounts that catalogs the flow
of goods between the residents of two countries.
4. Government Intervention - Through intervention (e.g., buying or selling the
currency in the foreign exchange markets) the central bank of a country may support or depress
the value of its currency.
5. Other factors - Other factors that may affect exchange rates are political and
economic stability, extended stock market rallies and significant declines in the demand for
major exports.

C. Forex trading always involves selling one currency in order to buy another, which is why
it is quoted in pairs – the price of a forex pair is how much one unit of the base currency is worth
in the quote currency. Foreign exchange market is organized as an over-the-counter market in
which several hundred dealers (mostly bank) stand ready to buy and sell deposits denominated
in foreign currencies.
D. Theory of Purchasing Power Parity - Purchasing power parity (PPP) is an economic
theory that allows the comparison of the purchasing power of various world currencies to one
another. It is a theoretical exchange rate that allows you to buy the same amount of goods and
services in every country. Government agencies use PPP to compare the output of countries that
use different exchange rates. You could use it to find out where to get the cheapest hamburger in
the world. Retrieved from: https://www.thebalance.com/purchasing-power-parity-3305953
E. Foreign Currency Exchange Rate Transactions:
1.Spot transactions -are those which involve(two-day) exchange of bank deposits.
The spot exchange rate is the exchange rate for the spot transactions.
2.Forward Transactions - involve the exchange of bank deposits at some specified
future date. The forward exchange rate is the exchange rate for the forward transaction.

SPOT EXCHANGE RATES If we are exchanging currency for another one immediately, we
participate in a spot transaction. A typical spot transaction may involve a Philippine firm buying
foreign currency from its bank and paying it in Philippine pesos.

DIRECT AND INDIRECT QUOTES - A direct quote indicates the number of units of the home

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

currency require to buy one unit of foreign currency. Direct quote is the peso/foreign currency
rate: 1 US dollar = P48.0530
1 UK pound = P65.1938
1 HK dollar= P6.1977
1 Japan Yen = P0.4629

- An Indirect quote indicates the number of units of foreign currency

that can be bought for one unit of the home currency. An Indirect quote is the foreign currency
/peso rate.
Illustrative case:
Compute the indirect quotes from the Philippine direct quotes of spot rates for US
dollars, UK pound, Hong Kong dollar and Japanese Yen as of January 08, 2021.

1 US dollar = P48.0530

1 UK pound = P65.1938

1 HK dollar= P6.1977

1 Japan Yen = P0.4629

Indirect quote = 1/Direct quote

Thus: US dollars = 1/48.0530 = 0.02081 (US dollar/P1)

UK pounds = 1/65.1983 = 0.01533 (pound/P1)

HK dollars = 1/6.1977 = 0.16135 (HK dollar/P1)

Japan Yen = 1/0.4629 =2.16029 (yen/P1)

CROSS RATE is the indirect computation of the exchange rate of one currency from the
exchange rates of two other currencies.
For instance: The peso/pound and the US dollar/peso rates are given in the figure. From this
information, we could determine that US dollar/pound and pound/US dollar exchange rates.
P65.1983 = £1
P48.0530 = $1
P65.1983/P48.0530 = 1.35679 US dollar per 1 pound
Thus, the pound/US dollar exchange rate is:
P48. 0530/65.1983 = 0.73702 pound per 1 US dollar

F. Arbitrage - the simultaneous buying and selling of securities, currency, or commodities

in different markets or in derivative forms in order to take advantage of differing prices for the
same asset. Arbitrage is the process of a simultaneous sale and purchase of currencies in two or
more foreign exchange markets with an objective to make profits by capitalizing on
the exchange-rate differentials in various markets.
Retrieved from: https://businessjargons.com/arbitrage-in-foreign-exchange-market.html
Arbitrage is the process of buying and selling currency in more than one market to make

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
a riskless profit. The person behind this strategy is the arbitrageur.

G. Forward Rates - The forward exchange rate is the rate of exchange, agreed upon now,
for a foreign exchange market transaction that will occur at a specified date in the future. The
agreement to make such an exchange in the future at a rate agreed upon now is called a forward
contract. In making a forward contract---purchasing yen forward in this case---our Japanese
exporter and Canadian importer hedge or cover themselves against a future rise in the dollar
price of the yen. They shift the risk from future exchange rate changes onto the party who sells
them yen forward. That seller of forward yen has to deliver yen for dollars at an exchange rate of
355 yen for one Canadian dollar in 90 days. When the forward contract matures in 90 days, the
forward seller has to purchase yen for Canadian dollars spot at the going market price---that is,
the spot exchange rate---at that time in order to deliver them at the agreed-upon forward price.
Retrieved from https://www.economics.utoronto.ca/jfloyd/modules/ffxm.html

FORWARD RATES The forward rate for a currency is the exchange rate at which the currency
for future delivery is quoted. The trading of currencies for future delivery is called a forward
market transaction. In an instance Aquarius Corporation expects to pay US$ 5 million to US
supplier 30 days from now. It is not certain however, what these dollars will be worth in
Philippine pesos 30 days from today.
FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN
1. Relative Price Levels - Arise in a country’s price level causes its currency to depreciate, and a
fall in the country’s relative price level causes its currency to appreciate.
2.Trade Barriers - Increasing trade barriers causes a country’s currency to appreciate.
3. Preferences for Domestic Versus Foreign Goods - Increased demand for a country’s experts
causes currency to appreciate in the long run, conversely increased demand for imports causes
the domestic currency to depreciate.
4. Productivity – As a country becomes productive relative to other countries, its currency
appreciates in the long run.

EXCHANGE RATE IN THE SHORT RUN The key to understanding the short-term behavior of
exchange rates is to recognize that an exchange rate is the price of domestic bank deposits in
terms of foreign bank deposits. Earlier approaches to exchange rate determination emphasized
the role of import and export demand.
MANAGING FOREIGN EXCHANGE RISK Foreign exchange risk refers to the possibility of a drop
in revenue or an increase in cost in an international transaction due to a change in foreign
exchange rates. International business transactions are denominated in foreign currencies. The
rate at which one currency unit is converted into another is called the exchange rate.

AVOIDANCE OF EXCHANGE RATE RISK IN FOREIGN CURRENCY MARKETS

1. The firm may hedge its risk by purchasing or selling forward exchange contracts.

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
2. The firm may choose to minimize receivables and liabilities.
3. Maintaining a monetary balance between receivables and payable denominated in a particular
foreign currency avoids a net receivable or net liability position in that currency.
4. Another means of managing exchange rate risk is by the use of trigger pricing.
5. A firm may seek to minimize its exchange rate risk by diversification.
6. A speculative forward contract does not hedge any exposure to foreign currency fluctuations.

2. MORTGAGE MARKET- Mortgage market forms a subcategory of the capital markets

because it involves long-term funds. Mortgage Market differs from the stock and bond markets in
a number of ways.
• Usual borrowers in capital markets are businesses and government entities while in mortgage
markets are individuals.
• Mortgage loans are made for varying amounts and maturities depending on the borrower’s
needs, features that cause problems for developing a secondary market.
Mortgages are long-term funds secured by a real estate. Both individuals and businesses
obtain mortgage loans to finance real estate purchases. A family may obtain a mortgage loan to
finance the purchase of a home; in this case, the loan is amortized. The borrower pays it over
time in some combination of principal and interest payments that result in full payment of the
debt by maturity.

Characteristics of Mortgage:
A. Mortgage Interest Rates - It is the interest charged on a loan used to purchase a
property. The amount of interest owed is calculated as a percentage of the total amount of the
mortgage issued by the lender. Mortgage interest rates may either be fixed or variable
(adjustable)
Factors that Affect Interest Rates:
1. Current Long-Term Market Rates – occurs due to the Central Bank trying to keep
prices stable and to encourage job creations.
2. Term or Life of the Mortgage – the usual mortgage lifetime is 15 or 30 years. A
mortgage with a longer term has higher interest rate than shorter-term mortgages
3. Number of Discount Points Paid – refers to interest payments made at the
beginning of a loan, also called as “buying down the rate”. A loan with one discount point means
that the borrower pays 1% of the loan amount which lowers the rate by 0.25%.

B. Loan Terms - Mortgage loan contracts contain many legal and financial terms, most of
which protect the lender from financial loss. Conditions involved include the number of
years to pay on the loan, the interest rate and the monthly payment.
C. Collateral - One characteristic common to mortgage loans is the requirement that
collateral, usually the real estate being financed, be pledged as security.

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
D. Down Payment - The lender requires the borrower to make a down payment on the
property, that is, to pay a portion of purchase price. Some lenders require the borrower
to pay 5% to 20% as down payment.
E. Private Mortgage Insurance (PMI) - It is an insurance policy that protects the lender
from losses in the event that the borrower defaults on the primary mortgage and the
property goes into foreclosure. PMI is applied when the down payment is less than 20%.
PMI costs between 0.5% and 1% of the mortgage annually.

F. Borrower Qualification- Before granting a mortgage loan, the lender will determine
whether the borrower qualifies for it. If the lender gives a mortgage loan to a borrower
who does not fit the guidelines, the lender may not be able to resell the loan to the few
government agencies in the secondary market.
AMORTIZATION OF MORTGAGE LOAN Mortgage loan borrowers generally agrees to pay a
monthly amount of principal and interest that will be fully amortized by its maturity. Fully
amortized- means that the payments will pay off the outstanding indebtedness by the time loan
matures. Look on Figure 10-1: Amortization of a 30-year, P130,000 loan at 8.5%. (Cabrera, page
64)
TYPES OF MORTGAGE LOANS:
Conventional Mortgages- These are originated by banks or other mortgage lenders but are not
guaranteed by government or government-controlled entities, most lenders though now insure
many conventional loans against default or they require the borrower to obtain private mortgage
insurance on loans.
Insured Mortgages- These mortgages are originated by banks or other mortgage lenders but are
guaranteed by either the government or government-controlled entities.
Fixed-rate Mortgages -In fixed-rate mortgages, the interest rate and the monthly payment do
not vary over the life of the mortgage.
Adjustable-Rate Mortgages (ARMs)- The interest rate on adjustable-rate mortgage (ARMs) is
tied to some market interest rate, (e.g., Treasury bill rate) and therefore changes over time. ARMs
usually have limits, called caps, on how high (or low) the interest rate can move in one year and
during the term of the loan.
Graduated-Payment Mortgages (GPMs)-These mortgages are useful for home buyers who
expect their incomes to rise. The GPM has lower payments in the first few years then the
payment rises. The early payment may not even be sufficient to cover the interest due, in which
case the principal balance inreases.as time passes, the borrower expects income to increase so
that higher payment will not be too much of burden.
Growing Equity Mortgage (GEMs)- With a GEM, the payments will initially be the same as on a
conventional mortgage. Over time, however, the payment will increase. This increase will reduce
the principal more quickly than the conventional payment stream would.
Shared Appreciation Mortgages (SAMs) -In a SAM, the lender lowers the interest rate in the
mortgage in exchange for a share of any appreciation in the real estate (if the property sells more
than a stated amount, the lender is entitled to a portion of the gain).
Equity Participating Mortgage (EPM)-In EPM, an outsider investor share in the appreciation of

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
the property. This investor will either provide a portion of the purchase price of the property or
supplement the monthly payment. In return the investor receives a portion of any appreciation
of the property. As with the SAM, the borrower benefits by being able to qualify for a larger loan
than without such help.
Second Mortgages -These are loans that are secured by the same real estate that is used to
secure the first mortgage. The second mortgage is junior to the original loan which means that
should a default occur, the second mortgage holder will be paid only after the original loan has
paid off, if sufficient funds remain.
Reverse Annuity Mortgage (RAMs) -In a RAM, the bank advances funds to the owner on a
monthly schedule to enable him to meet living expenses he thereby increasing the balance of the
loan which in secured by the real estate. The borrower does not make payments against the loan
and continues to live in his home. When the borrower dies, the estate sells the property to pay
the debt. Look on Fig 10-2 Summary of Mortgage types (Cabrera, page 166).

MORTGAGE LENDING INSTITUTIONS The institutions that provide mortgage loans to familiar
and business and their share in the mortgage market are as follows

Mortgage tools and trusts 49% Life insurance companies 9%

Commercial banks 24% Savings and loans associates 9%
Government agencies and others 15%
Source: Federal Revenue Bulletin, 2018
Many of the institutions making mortgage loans do not want to hold large portfolios of long-term
securities. Commercial loans, thrifts and most other loan organization do make money through the
fees that they earn for packaging loans for other investors to hold. Loans organization fees are
typically 1% of the loan amount, through this varies with the market.

SECURITIZATION OF MORTGAGES Intermediaries face several problems when trying to sell

mortgages to the secondary market; that is lenders selling the loans to another investor. These
problems are:
a) Mortgages are usually too small to be wholesale instruments
b) Mortgages are not standardized. They have different terms to maturity, interest rates
and contract terms. Thus, it is difficult to bundle a large number of mortgages together and
c) Mortgage loans are relatively costly to service. The lenders must collect monthly
payments, often advances payment of properly taxes and insurance premiums and service
reserve accounts
d) Mortgages have unknown default risk. Investors in mortgages do not want to spend a
lot of time and effort in evaluating the credit of borrowers. The above problems inspired the
creation of mortgage-backed security Mortgage-backed security is a security that is collateralized
by a pool of mortgage loans. This is also known as securitized mortgage. Securitization is the
process of transforming illiquid financial assets into marketable capital market instruments. The
most common type of mortgage-backed security is the mortgage pass through the trustee before
being disbursed to the investors in the mortgage-pass through. If borrowers pre-pay their loans,
investors receive more principal than expected.
Impact of Securitized Mortgage on the Mortgage Market Mortgage-backed securities (also
called securitized mortgages) have been growing in popularity in recent years as institutional
investors look for appreciative investment opportunities that compete for funds with
government notes bonds, corporate bonds and stock. Securitized mortgage are low-risk
securities that have higher yield than comparable government bond and attract funds from
around the world.

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

DERIVATIVES A derivative is a financial security with a value that is reliant upon or derived
from, an underlying asset or group of assets a benchmark. The derivative itself is a contract
between two or more parties, and the derivative derives its price from fluctuations in the
underlying asset. The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes. These assets are commonly
purchased through brokerages

CHARACTERISTICS OF DERIVATIVES A derivative is a financial instrument

1.Whose value changes in response to the change in a specified interest rate, security
price, commodity price, foreign exchange rate, index of prices or rates credit rating o credit
index, or similar variable.
2.That requires no initial net investment or title net investment relative to other types of
contracts that have a similar response to changes in market and conditions; and
3.That is settled at a future date.
Derivative for Hedging Companies use derivatives to protect against cost fluctuations by
fixing a price for a future deal in advance. By setting costs in this way, buyers gain protection-
known as a hedge against unexpected rises or falls in, for example, the foreign market, interest
rates, or the value of the commodity or product they are buying. Derivative for Speculation
Investors may buy or sell an asset in the hope of generating a profit from the asset’s price
fluctuations. Usually this is done on a short-term basis in assets that are liquid or easily traded.
The most commonly used derivatives are future contracts, forward contracts, options, foreign
currency futures and interest rate swaps.
Note that all discussions above were taken form Financial Markets and Institutions,
2020 edition, by Ma. Elenita Balatbat Cabrera and Gilbert Anthony B. Cabrera.

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

LSPU SELF-PACED LEARNING MODULE: FINANCIAL MARKET

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

Learning Resources
Cabrera, Ma. E. B. and Cabrera, G. A., (2020) Financial Markets and
Institutions, 2020 edition, GIC Enterprises,2017 C. M. Recto Avenue, Manila
Philippines
https://www.thebalance.com/purchasing-power-parity-3305953

https://businessjargons.com/arbitrage-in-foreign-exchange-market.html

https://www.economics.utoronto.ca/jfloyd/modules/ffxm.html

https://www.frbsf.org/education/publications/doctor-econ/2001/june/money-
market-foreign-exchange/#:~:text=The%20foreign%20exchange%20markets
%20play,currencies%20or%20deposits%20they%20want.

https://www.yourarticlelibrary.com/foreign-trade/foreign-exchange-market-and-
its-important-functions/26067

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