MODULE 3

OVERVIEW of FINANCIAL MARKETS

FINANCIAL MARKETS
➢ physical or electronic forums that facilitate the flow of funds (transfer of financial assets)
among investors, businesses and government. It provides the mechanism for allocating
financial resources or funds from savers to demanders of funds.
➢ institutions and procedures that facilitate transactions in all types of financial claims.
FINANCIAL CLAIMS – money or acquired rights to receive money that arises from the
process of borrowing and lending.

MARKET MAKER
➢ a dealer in securities or other assets who undertakes to buy or sell at specified prices at all
times. They serve as coordinators who link the buyers and sellers of financial securities, and
sometimes take positions in the securities. While a broker simply arranges trades between
buyers and sellers for a fee, a dealer, in addition to making the arrangement, stands ready
to be a principal in the transaction.
➢ an individual or organization that takes on the risk of holding a particular security in order
to allow investors to trade that security. They quote both a buy and a sell price of this
product in the hope of getting investors to trade it.
INSTITUTIONAL market makers can be banks or other large corporations who usually offer
a bid/ask quote to other banks, institutions, Electronic Communication Networks, or even
retail market makers.
RETAIL market makers are usually companies dedicated to offering retail forex trading
services to individual traders.

ROLE of Market Makers

Market makers help to maintain a smooth functioning, orderly financial market. For example,
200,000 ordinary shares of ABC Co. are being offered at P100 per share to the public thru the
financial market. If only 170,000 shares are bought by the public investors, a market dealer
may buy the 30,000 shares and hold it for a period of time, to keep the price from falling. A
market dealer may also alter the price until all the shares will be sold. If the demand for
ordinary shares of ABC Co. exceed the number of shares being sold, a market dealer may
sell the ordinary shares of ABC Co. that it holds. These actions of market dealers enhance
market efficiency and contribute to a balanced financial system.

Market makers also receive, process, interpret and disseminate information to public
investors. Such information includes the outlook for monetary and fiscal policy, newly
published data about inflation, unemployment and output, assessment of economic
conditions, analysis of trends and market shares in various industries and of specific
businesses. As public investors digest these informations and integrate them in their decision,
it impacts the prices of stocks and bonds as well as the current interest rates.

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 MAJOR Financial Markets
1. SECURITIES Markets – where debt and equity securities are traded
2. DERIVATIVES Market - where derivative securities are traded
3. MORTGAGE market – where mortgage loans, backed by real properties are originated
and traded
4. CURRENCY Exchange Market – where banks & other institutional traders buy and sell
various currencies on behalf of business and other clients.

SECURITIES Markets - securities markets can be further classified according to:

A. MATURITY of securities issued
1. MONEY Market – where short term securities are traded. Funds are given by SSU’s which
don’t have temporary use of their funds, to DSU’s with temporary shortages in financing
their working capital, to meet their liquidity needs. These are usually short term debt
securities issued by companies with very high credit standing.

2. CAPITAL market - where long term securities (maturity > 1 year) are traded.

B. TIMING of issuance – either first time (primary) or subsequent (secondary) issuance.

1. PRIMARY Market – where new securities are traded (issued for the first time) in public. It
is mainly done thru an Initial Public Offering (IPO) where the privately owned company
sells its stock to the public. A company must first register to the Securities and Exchange
Commission (SEC)* before it can make public offering.
➢ It can also be done thru the following:
a. RIGHTS OFFERING (pre –emptive right of stockholders) – where the new (additional)
shares of stocks are offered first to existing stockholders on a pro rata basis.

b. PRIVATE PLACEMENT – where new shares of stocks are sold directly to a selected investor.

➢ Most public offerings are made with the assistance of an investment banker – a
financial intermediary that buys new securities from the issuing firm at an agreed
price and resells them to the public at a price (satisfactory price) that will generate
a profit. Such activity is called UNDERWRITING, where the investment banker takes
the risks or responsibility of reselling the securities at a profit to the public.

2. SECONDARY Market – where securities are traded after they have been issued.
➢ Provides LIQUIDITY and a mechanism for continuous pricing of securities to reflect
their values at each point in time based on information available. It includes:
a. ORGANIZED SECURITIES EXCHANGE* – a centralized institution where transactions of
already outstanding securities are made. They are auction markets where order
system is used and price is determined by the flow of buy and sell orders. Securities
traded are called “LISTED SECURITIES”

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 b. OVER THE COUNTER (OTC) market - not an institution but a widely scattered
telecommunications network thru which buyers & sellers of certain securities are
brought together.
* SEC – the primary regulator of the securities (capital) markets. It confirms the adequacy and
accuracy of information provided to potential investors before public offering is made.

* PSE (Philippine Stock Exchange) Inc. – a private entity delegated with the authority to
ensure compliance with relevant laws regarding trading of securities in the capital market.
➢ PSE is authorized to penalize and fine its member brokers for violation of its rules.

MAJOR Financial Market INSTRUMENTS

1. MONEY MARKET Instruments
A. COMMERCIAL PAPERS – an instrument issued, sold or endorsed to another person or
entity with or without recourse. It refers to the negotiable instruments such as:
1. PROMISSORY NOTES (also called dealer papers) – short term indebtedness issued by
an individual or institution as direct obligor (debtor).

2. DRAFTS
a. BANKER’S ACCEPTANCE – a bill of exchange (draft) drawn (issued) by a commercial
firm upon a bank, payable to a designated third party, and is accepted by bank. The
bank’s acceptance means that the bank is guaranteeing the availability of funds at
the maturity date, generally 30 -180 days from date of acceptance.
b. TRADE ACCEPTANCE – if another commercial entity, instead of bank, made the
acceptance.

3. NEGOTIABLE CERTIFICATE OF DEPOSIT – a document evidencing a time deposit

placed with depository institution (banks). It states the amount of deposit, its maturity
date, the interest rate and the method under which the interest is calculated.

B. TREASURY BILL – a short term debt instrument issued by the National Government to be
paid thru the National Treasury. They are issued at various denominations like P100,
P1,000 and P10, 000 and maturity dates such as 91, 182 and 364 days.

C. REPURCHASE AGREEMENTS – an instrument sold by a dealer of securities to a buyer

(investor) wherein the dealer promises to buy the same instrument (securities) from the
buyer, in a future date and price specified (fixed) in the agreement.

D. INTERBANK LOANS - an overnight loan granted by a bank to another bank to meet the
daily bank reserve required by the central bank (BSP).

2. CAPITAL MARKET Instruments

a. EQUITY Securities – ordinary or preference shares of different corporations
b. DEBT securities – bonds and other debt instruments maturing more than 1 year.
1. corporate bonds
2. government (treasury) bonds and notes. In USA, it can be state or municipal bonds.
3. mortgage bonds of homeowners, businesses or government entities

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 Characteristics of Money Market Instruments (MMI)
1. Low default risk – MMI are issued by economic units with the highest credit standing.
2. Low price risk – short term maturity of the MMI makes it less susceptible to price changes
due to fluctuations of interest rates in the market.

3. High marketability (liquidity) – MMI can be bought or sold quickly due to the presence of
active secondary markets (for most MMI), standardized features and low default risks.

4. Sold in large denominations – to reduce transaction costs per unit or peso of instrument.

➢ Money market instruments share many common characteristics and therefore, they serve
as close substitute for one another. For this reason, the yields (interest rates) on money
market instruments are highly correlated with one another.

DERIVATIVES Market - where trading of derivative securities takes place.

DERIVATIVE security – a financial instrument (FI) or other contract that derives its value from the
movement of the price, foreign exchange rate or interest rate on some underlying asset.

CHARACTERISTICS of Derivatives
1. BILATERAL - there is an agreement between two parties in which one does something for
the other.
2. EXECUTORY - the execution of the contract is on a future date.
3. Serves as a way to HEDGE against risks - the contract fixes the price of the asset or the
cost of another transaction regardless of future changes in its price.

TYPES of Derivatives
A. FORWARD COMMITMENTS which are ABSOLUTE contracts
1. FORWARDS – a contract that guarantees the delivery of certain amount of goods, such
as foreign currency, for exchange into a specific amount of another currency, on a
specific day in the future.

2. FUTURES – a contract to buy or sell a particular type of security or commodity from or

to the futures exchange during a predetermined future time period.
3. SWAPS - an exchange of assets or income streams for equivalent assets or income
streams with slightly different characteristics.
B. CONTINGENT CLAIMS which are CONDITIONAL contracts
4. OPTIONS – a contract which gives the owner the right, but not the obligation, to buy
(CALL option) or sell (PUT option) an asset at a specified price any time during a
specified period in the future.

FORWARD Market – where forward contracts (instruments) are traded. It is opposite of the spot
market in which securities are traded for immediate delivery and payment.

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 SPOT price (rate) – the observed price (rate) at which current transactions take place
FORWARD price (rate) –the price (rate) at which the purchaser will buy a specified amount of asset
from the seller at a fixed date sometime in the future. It is the price at which the forward contract
has zero net present value.
➢ The buyer of a forward contract is said to be in LONG position and is obligated to pay the
forward price for the asset. The seller of a forward contract is said to be in SHORT position
and is obligated to sell the asset in exchange for the forward price.

➢ Forward contracts let importers and exporters offset the price risk inherent in future
dealings by guaranteeing future exchange rates and prices.

FUTURES Market - where future contracts (instruments) are traded. It is where people trade
contracts for future delivery of securities, cash goods or the value of securities sold in the market.

➢ Futures contract are very similar to forward contracts in that it involves two parties
agreeing today on price at which the buyer will pay a commodity or financial instrument
from a seller at a fixed date in the future.
➢ However, there are differences between the two contracts, which are as follows:
FUTURES contracts FORWARD contracts
1. TRADING of contracts Organized exchange market Over the counter market
happen in the (Ex. Chicago Board of Trade)
(Chicago Mercantile Exchange)
2. DISTINCT features Standardized in quantities, Customized by buyer and
(FORM) delivery period, and grades of seller.
deliverable items.
3. PARTIES to the contract Buyer – futures exchange – Buyer – seller
seller (counterparty)
4. SETTLEMENT Can be on a daily basis, through Upon maturity, through
delivery or offsetting. delivery only.
5. LIQUIDITY HIGH LOW
6. REGULATION Regulated by Stock Exchange Self-regulated
7. degree of DEFAULT RISK Low. Daily cash settlement of HIGH. It depends on the
(usually when price fluctuates) contract from date of contract Creditworthiness of both
to termination of contract. parties entering the contract.
8. Marked to Market? YES, on a daily basis. NO
Mark to market (MTM) is a method of measuring the fair value of accounts that can fluctuate over time, such as assets and
liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation
based on current market conditions.

Common Objects of forward Contract: Investment in stocks, Investment in bonds, Commodities,

Currencies, Equipment and other assets.

Sample Transactions
1. Company T agrees to buy 1,000 shares of stock in ABC Corporation at P80 per share from
Broker K one month from now.
Analysis:
Case 1: If the prices of the share increases to P90 one month from now: The buyer will purchase at
the agreed price of P80 per share, making him earn a gain of P10 per share. The seller incurs a loss

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 of P10. From the point of view of Company T, the value of forward contract is P10,000 (1,000shares
x P10 per share gain).

Case 2: If the prices of the share decreases to P75: The buyer is required to purchase on the agreed
price of P80, making him lose P5 per share. The seller accrues a gain of P5 per share.
2. Person H agrees to sell 800 tons of rice to Rice Miller Q at P10,000 per ton once Person H
harvests his rice production.
Analysis:
Case 1: If the market price of rice per ton is P11,000 on the agreed date: Person H incurs a loss of
P1,000 per ton while Miller Q earns a gain of P1,000 per ton.

Case 2: If the market price of rice per ton is P8,500 on the agreed date: Person H was able to sell
his rice P1,500 higher than the market price while Miller Q incurred a loss when he paid P1,500 higher
than the market price.

3. Bank P agrees to buy USD 5,000 from Bank L at an exchange rate of P55 per dollar on
January 6, 2025.
Analysis:
Case 1: If a dollar costs P60 on January 6, 2025, Bank P was able to lower its cost from the spot
price of P60 to the derivative’s transaction price of P55 for one USD. Bank L incurred the P5 per
one USD loss because of the contract.

Case 2: If a dollar costs P54 on January 6, 2025, Bank P and Bank L incurs a loss and a gain,
respectively, both in the amount of P1 per one USD.

NOTE: Always make sure that when analyzing gains and losses from derivative contracts, check from
whose perspective you are analyzing.

SWAPS – usually have the following descriptions:

1. Traded over-the-counter,
2. Almost always created between the parties with what they want to exchange.
3. Both the parties are buyers and sellers of each other.

Common Objects of the Contract

1. Currencies (series of cash flows in different currencies are swapped, making the currency
swap equivalent to multiple currency forward/futures contracts)
➢ The purpose is to lower interest rate on borrowed cash. Note that it is generally cheaper to
borrow in one’s own local currency.

2. Interest rates (fixed versus variable rates are exchanged. Cash flows are of the same
currency.) option

Sample Transaction:
ABC Phil. Corporation needs ₤100,000 or an equivalent of P6,000,000 today. Phil. Bank will
charge ABC an interest rate of 14% on loans denominated in pounds and an interest rate on
10% on loan denominated in pesos.
XYZ UK Corporation needs P6,000,000. If it goes to UK Bank, the interest rate would be 12%.
However, XYZ UK Corporation can borrow ₤100,000 at an interest rate of 8%.

WHAT SHOULD THEY DO?

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 ABC Phil. Corporation should borrow P6,000,000 with the interest rate of 10% and XYZ UK Corporation
should borrow ₤100,000 at the lower 8% rate offered by UK Bank.
Alternative 1: ABC receives the P6,000,000 and immediately converts the amount to pounds with its
bank or other foreign exchange trader. XYZ converts the amount in pounds to the needed P6,000,000
pesos. ABC and XYZ then exchange their interest rates requiring ABC to pay 8% on the ₤100,000 and
XYZ to pay 10% on the P6,000,000.
ABC pays 8% instead of 14% while XYZ pays 10% instead of 12%.

Alternative 2: ABC and XYZ exchange both the principal amounts and interest rates between
themselves.

OPTIONS – has the following descriptions

1. May be traded on an exchange or over-the-counter.
2. May be further classified according to when the option can be exercised.
a. European option – on a specified date, usually terminal date. Most common type.
b. American option – at any time between the agreement date until its terminal date.
c. Bermuda option – on selected dates between the agreement date until its terminal date.

3. The position of the holder of the contract may be classified according to whether the
option will provide a gain or not.
a. OUT-the-money – contract holder will incur loss if the contract is exercised.
b. ON-the-money – contract holder will not incur loss nor gain from exercising the option.
c. IN-the-money – contract holder will earn a gain from the exercise of the option.

Common Objects of the Contract: Right to buy (Call option) or Right to sell (Put option) the following:
Investment in stocks, Investment in bonds, Commodities, Currencies, Equipment and other assets

Sample Transactions
1. Company T agrees into an option contract to buy 1,000 shares of stock in ABC Corporation
at P80 per share from Broker K one month from now.
Analysis:
Case 1: If the prices of the share increases to P90 one month from now: The buyer should exercise
the call option. Company T will purchase from Broker K the shares at the agreed price of P80 per
share, making the former earn a gain of P10 per share. The seller has no choice to incur the loss of
P10 once Company T exercises the option. The contract is in-the-money for Company T.

Case 2: If the prices of the share decreases to P75: Company T should not exercise the option so
that it will not incur a loss of P5 per share. The contract is out-the-money for Company T.

Case 3: The price of the share is P80 per share: Company may or may not exercise the option
contract because the contract is at-the-money.

2. Person H agrees into an option contract to sell 800 tons of rice to Rice Miller Q at P10,000
per ton once Person H harvests his rice production.
Analysis:
Case 1: If the market price of rice per ton is P11,000 on the agreed date: Person H should not
exercise the option to avoid incurring a loss of P1,000 per ton.

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 Case 2: If the market price of rice per ton is P8,500 on the agreed date: Person H should exercise
the option to be able to sell his rice P1,500 higher than the market price. Miller Q will incur the loss
of P1,500 per ton once Person H exercises his option.

3. Bank P agrees into a call option contract on USD 5,000 from Bank L at an exchange rate of P55 per
dollar on January 6, 2025.
Analysis:
Case 1: If a dollar costs P60 on January 6, 2025: By exercising the option, Bank P was able to lower
its cost from the spot price of P60 to the derivative’s transaction price of P55 for one USD. Bank L
incurred the P5 per one USD loss because of the contract.

Case 2: If a dollar costs P54 on January 6, 2025. Bank P should not exercise the option, and instead
purchase normally at P54 per one USD.

NOTE: Always make sure to check the kind of option being considered, whether put or call option.
This determines which party has the right to exercise the option. The party who has the right generally
does not incur any losses from the contract.

MORTGAGE Market
MORTGAGE – a collateralized loan that is amortized over time. Periodic amortization includes
payment of interest in unpaid balance and the rest to principal.
CAPS - maximum limit of principal (Principal cap) or interest (interest cap) payment to be
made by the borrower in a mortgage contract. CAPS helps keep the monthly (periodic)
payment from rising to a level that the borrower can’t pay.

UNIQUE CHARACTERISTICS of Mortgage Markets

1. Mortgage loans are always secured by pledge of real property as collateral.
2. Mortgage loans are made for varying amounts and maturities, depending on borrower’s
needs which make it difficult to market in secondary markets
3. Due to #2, Mortgage loans has relatively less active secondary market compared to
stocks and bonds.
4. Issuers (borrowers) of mortgage loans are typically small, relatively unknown financial entities.
5. Mortgage markets are both highly regulated and strongly supported by government policies.

TYPES of Mortgages
1. STANDARD FIXED rate Mortgage (FRM) - characterized by fixed interest rate throughout
the life of loan
➢ Creditor takes a lien on the property which prevents the borrower from selling the property
without the approval of the creditor (repaying the debt or agreement to repay the debt
from proceeds of sale)

➢ In case the borrower defaults in payment, lender may foreclose and thru legal processes,
cause the property to be sold or obtain title to the property.

2. ADJUSTABLE rate mortgage (ARM) - carries fixed interest rate for the first period and
adjustable rate for the rest of the life of the loan. Borrower is taking interest rate risk.

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 ➢ Interest rate adjustment is based on rate index agreed upon like Treasury securities rates,
current Fixed rate mortgage index, savings and loan cost of funds index, bank prime rate
and LIBOR rate.

➢ Method of rate adjustment should be fully disclosed in the mortgage loan agreement, and
not solely on the discretion of the creditor.

➢ Rate index must be readily verifiable to the borrower & beyond the control of creditor.

3. OTHER Mortgages
a. Balloon Payment Mortgage – offers a relatively low fixed rate of interest for a
predetermined period of time, after which the balance will be paid in the form of balloon
payment

b. Rollover Mortgages (ROMs) and Renegotiated Rate Mortgages (RRMs) - similar to ARM
but the number of years between interest rate adjustments is longer than a typical ARM.
➢ like balloon rate mortgage, it protects the lender from being locked into a long term low
rate of interest.

c. Interest only mortgages – a loan on which the borrower pays only interest for the first 10 -
15 years, after which the loan balance will be fully amortized with the remaining 15 years.

d. Construction to permanent Mortgages – loans are used to purchase a land and

construction of a building (house). Borrower pays only interest during the construction phase
and then rolled over into FRM, ARM or other mortgages ones the construction is completed.

e. Reverse annuity mortgages (RAMs) – a relatively low interest loan made by the
borrower against his equity in his/her home. Designed for older people.

f. Home Equity Loans and lines – a second mortgage against the borrower’s home or real
properties. It is often used for debt consolidation, home improvement, education, and
emergencies.

Mortgage QUALIFYING
➢ A borrower’s ability to qualify for a mortgage depends upon the following factors:
1. Borrower’s income – lenders use the payment (principal + interest) to income ratio to
assess the borrower’s ability to repay a loan. Some conservative rule of thumb regarding
such ratios are as follows:
a. mortgage payment (P& I) should be < 25 % of monthly gross income of borrower
b. sum of mortgage (P & I), property tax (T), home insurance premium (HI) & any mortgage
insurance (MI) payments should be < 25 % of monthly gross income
c. The sum of (P&I), T, HI, MI and other debts services < 33 % of monthly gross income

2. Down payment – the greater the down payment requirement, the greater the possibility that
the borrower may not be able to pay it, thus, the need to purchase mortgage insurance.

3. Mortgage Insurance – allows the borrower to make lower down payment on the mortgage
in exchange of paying insurance premium, in addition to the principal and interest of the loan.

4. Other financial obligations – reduces the creditworthiness of the borrower because it

reduces his/her ability to pay the mortgage he will acquire.

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 Mortgage Backed Securities (MBS) – securities which pass through all or part of the principal
and interest payments on pools of many mortgages to buyers of the MBS’s.

TYPES of Mortgage Backed Securities

1. Pass Through Securities – securities that pass through all payments of principal and interest
on pools of mortgages to holders of securities in the pool.
a. GNMA - Ginnie Mae -- securities pass through all payments of interest and principal
received on a pool of federally insured mortgage loans. It guarantees that payments
of principal & interest will be made on a timely basis.
b. FHLC – Freddie Mac - provide a secondary market for conventional mortgage. Its initial
purpose is to assist savings and loan associations and other mortgage lenders attract
capital market funds.

c. FNMA – Fannie Mae – established for the primary purpose of buying government
guaranteed FHA mortgages in the secondary market.
d. Privately issued pass through (PIP) – issued by private institutions or mortgage bankers,
which pool mortgages, obtain private insurance, obtain ratings for the security issue
and sells the securities using underwriter’s services.
➢ used to securitize nonconforming mortgage loans that do not qualify for FHA insurance, often
because the mortgage exceeds the FNMA’s or FHLMC’s purchase limit or fails to meet their
underwriting standards.

e. CMO’s and REMICs – consists of a series of related debt obligations called tranches,
which divide up the principal and interest payments made on a pool of mortgages and
pay them to various investors according to schedule.
f. Stripped Mortgage Backed Securities (SMBSs)
IO (Interest Only) – securities where the holder of this security receive cash based solely
on the interest payments of the underlying pool of mortgages.

PO (Principal Only) - securities where the holder of this security receive cash based
solely on the principal payments of the underlying pool of mortgages
➢ As interest rates decrease, the value of the IO also decreases & vice versa.
➢ As interest rates increase, the value of the PO decreases & vice versa.

2. Mortgage Backed Bonds

➢ Bonds issued by holders of mortgages. They usually pay interest and have fixed maturity.
a. FHLMC and FNMA debts,
b. Private mortgage backed debt – provides financial institutions with an effective way to
obtain relatively low cost funds by issuing bonds when their other sources of funds are
expensive or inadequate.
c. State and local government housing Revenue bonds.

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 Mortgage Prepayment Risk (Call Risk) – the risk that debtors will obtain another mortgage
having lower interest rate to pay old mortgage earlier than maturity date. It happens when
interest rates declines in time.

Mortgage Extension Risk – the risk that the expected timing of mortgage payments will
extend further into the future. It happens when interest rates declines in time.

Characteristics of Mortgage Backed Securities (MBS)

1. They are issued in standardized denominations, making it more tradable in the primary
and secondary markets.

2. They possess high credit standing – they are either issued by large, well known borrowers
or are insured by well-known institutions, whose credit worthiness can be checked easily.

3. They possess low degree of risk because they are insured and highly collateralized.
4. Their repayment schedules are similar to those offered on government or corporate debt
securities.

➢ the above characteristics encourage liquidity of mortgage securities and make the
mortgage market more active.

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