FM201

Financial Market#
 LEARNING MODULE INFORMATION
I. Course Code FM201
II. Course Title Financial Market
III. Module Number 02
IV. Module Title The Classifications of Markets
V. Overview of the Module This module will discuss the basics of financial markets. Topics to be covered
are overview of financial markets, debt and equity markets, money markets and
capital markets, and foreign exchange.

VI. Module Outcomes After the study of all the lessons, you are expected to:
• Explain the function of financial markets
• Describe the different classifications of markets:
o Primary and secondary markets
o Debt and equity markets
o Money markets and capital market
• Understand the different concepts under foreign exchange markets

Lesson 1: Overview of Financial Markets

Lesson Objectives:
After studying this lesson, you should be able to:
a. Describe what a financial market is
b. Distinguish between:

• Primary market and secondary market

• Debt market and equity market

c. Explain the main function of financial markets
d. Enumerate and describe the activities of financial markets
Getting Started:
Please read through the following article:

LandBank to list bonds for environmental projects

By: Tyrone Jasper C. Paid (Business Mirror)
Date posted: October 6, 2020

The Land Bank of the Philippines is set to list its P3-billion bond offering with the Philippine Dealing and
Exchange Corp. next month.

In a recent statement, the state-run bank announced the launch of its sustainability bonds aimed at raising funds for
environment and social projects. The peso-denominated fixed-rate bonds due in 2024 have tenor of two years. The
offering will be issued in minimum denominations of P50,000 and in multiples of P10,000 thereafter. The offer
period runs from October 26 to November 6.

LandBank tapped Standard Chartered Bank to be the sole lead arranger and bookrunner of the transaction. Both banks
are the selling agents.

“With the pandemic posing both as a pressing challenge and opportunity, it strengthens LandBank’s commitment all the
more, with a sharpened focus in supporting sectors and activities for sustainable recovery,” LandBank President and
CEO Cecilia C. Borromeo said.

The proceeds from the transaction will finance loan programs supporting green and social projects identified in the
bank’s Sustainable Finance Framework.

Among the green projects are climate change mitigation and adaptation, natural resource and biodiversity
conservation and pollution prevention and control.

Meanwhile, LandBank cited programs for basic infrastructure, food security, essential services, affordable
housing, employment generation, and food security as some of the social projects.

Recently, the state-owned bank stated that it will be providing a 60-day grace period on loan and credit- card payments
following the passage of Republic Act 11494, a law aiming “to accelerate the recovery and bolster the resiliency of the
Philippine economy.”

The one-time moratorium covers all existing, current and outstanding loans falling due from September 15 to December
31.
“LandBank understands how providing loan relief can significantly support our clients during these difficult times,”
Borromeo said. “We look to ease their financial concerns as we continue navigating the challenges of this pandemic.”

Discussion/Application:

Financial market is a market where financial instruments are traded. It is a meeting place for people, corporations,
and institutions that either need money or have money to lend or invest.
The flow of money around the world is essential for businesses to operate and grow. Stock markets are places where
individual investors and corporations can trade currencies, invest in companies, and arrange loans. Without the global
financial markets, governments would not be able to borrow money, companies would not have access to the capital
they need to expand, and investors and individuals would be unable to buy and sell foreign currencies.
Function of Financial Markets

Financial markets and financial intermediaries have the basic function of getting people together by moving funds
from those who have surplus of funds to those who have shortage of funds.
To understand the general structure and operation of financial markets, please refer to the diagram below.

Those who have savings and are lending funds (the lender-savers), are at the left and those who must borrow funds
to finance their spending (the borrower-spenders), are at the right.

The principal lender-savers are households, but business enterprises and the government as well as foreigners and their
government, sometimes also find themselves with excess funds and so lend them out. The most important borrowers-
spenders are business and the government but households and foreigners also borrow to finance their purchases of cars,
furniture and houses.

The arrow shows what funds flow from lender-savers to borrower-spenders, both directly and indirectly. Funds flow from
lenders to borrowers indirectly through financial intermediaries such as banks or directly through financial markets such
as the Philippines Stock Exchange
What Financial Markets Do

• Raising capital – Firms often require funds to build new facilities, replace machinery or expand their business in
other ways. Shares, bonds, and other types of financial instruments make this possible. The financial markets are
also an important source capital for individuals who wish to buy homes or cars, or even to make credit card
purchases.

• Commercial transactions - As well as long-term capital, the financial markets provide the grease that makes
many commercial transactions possible. This includes such things ask arranging payment for the sale of a product
abroad and providing working capital so that a firm can pay employees if payment from customers run late.

• Price setting - The value of an ounce of gold or a share of stock is no more and no less than what someone is
willing to pay for to own it. Markets provide price discovery, a way to determine the relative values of
different items, based upon the prices at which individuals are willing to buy and sell them.

• Asset valuation - Market prices offer the best way to determine the value of a firm or of the firm's assets or
property. This is important not only to those buying and selling businesses, but also to regulators. An insurer for
example, may appear strong if it values the securities it owns at the prices it paid for them years ago, but the
relevant question for judging its solvency is white prices those securities could be sold for if it needed cash to
pay claims today.

• Arbitrage – In countries with poorly developed financial markets, commodities, and currencies may trade
at vastly different prices in different locations. As traders in financial markets attempt to profit from these
divergences, prices move towards a uniform level, making the entire economy more efficient.
This also means buying low and selling high.

• Investing – The stock, bond and money markets provide an opportunity to earn a return on funds that are
not needed immediately, and to accumulate assets that will provide an income in future.

• Risk management – Features, options and other derivatives contracts can provide protection against many
types of risk, such as the possibility that a foreign currency will lose value against the domestic currency before
an export payment is received. They also enable the markets to attach a price to risk, allowing firms and
individuals to trade risks so they can reduce their exposure to some while retaining exposure to others.

Different Classifications of Financial Markets

Primary Markets vs. Secondary Markets

Primary market is where new funds are raised. This is where the funds transfer from savers to users. In this case,
the savers here are called the investors. They are the ones who buy the stocks and bonds.

In a primary market, the one who sells is called the issuer and the process of selling a financial instrument is called
an issue.
Example: For a corporation that wants to sell bonds, we say that they issue bonds. The corporation is the issuer.
Secondary market is where the financial instruments are traded from one investor to another.

Scenario: The only way to take profit from the stocks purchased from the primary market is to sell it to another
investor willing to pay for it. This is where secondary markets come into play. Hence, they serve two functions:

a. They make it easier to sell financial instruments to raise cash; that is, they make the financial instruments more
liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing
firm to sell in the primary market.

b. They determine the price of the security that the issuing firm sells in the primary market. The firms that buy
securities in the primary market will pay the issuing corporation no more than the price that they think the
secondary market will set for this security.

Debt Market vs. Equity Market

Funds in a financial market can be obtained by a firm or an individual in two ways:

The most common is to issue debt, which is a financial obligation for specific payments at specific time. In other words, it
is also an agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and
principal payments) until a specified date (maturity date).

Maturity – a period for which a financial instrument must be paid in full. A debt instrument is short-term if its maturity
is less than a year and long-term if its maturity is ten years or longer. Debt instruments with a maturity between one and
ten years are said to be intermediate term.
The second method of raising funds is by issuing equity instruments, such as common or ordinary stock, which are
residual claims on assets. Residual claim is a claim on assets after all other obligations have been fully and completely
satisfied (example: after all workers’ salaries and taxes are paid off). If you own one share of common stock in a company
that has issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the
firm’s assets. Equities often make periodic payments (dividends) to their holders and are considered long term securities
because they have no maturity date. In additional, owning a stock means that you own a portion of the firm and have the
right to vote on issues important to the firm and to elect its directors.

Summary of the Lesson:

• Financial market is a meeting place for people, corporations, and institutions that either need money or
have money to lend or invest.

• The basic function of financial market is to get people together by moving funds from those who have surplus of
funds to those who have shortage of funds.

• The two ways to source funds are to issue financial instruments such as debt and equity.
References:
1. Financial Markets and Institutions by Ma. Elenita Balatbat Cabrera, 2020 Edition
Lesson 2: Money Markets and Capital Markets

Lesson Objectives:
At the end of this lesson, you should be able to:
Money Markets:
1. Describe what a money market is
2. Explain how a money market works
3. Identify the users of money markets

4. Enumerate and describe the features of money market instruments

Capital Markets
5. Describe what capital market is
6. Explain the various capital market participants
7. Describe capital market trading
8. Explain the nature of capital market instruments:
a. Bonds
b. Ordinary Equity Shares
c. Preferred Shares

Getting Started:

The term “money market” refers to the network of corporations, financial institutions, investors and governments which
deal with the flow of short-term capital. When a business needs cash for a couple of months until a big payment arrives, or
when the bank wants to invest money that depositors may withdraw at any moment, or when a government tries to meet
its payroll in the face of big seasonal fluctuations in tax receipts, the short term liquidity transactions occur in the money
market.

The money markets have expanded significantly in recent years as a result of the general outflow of money in the banking
industry, a process referred to as disintermediation. Until the start of the 1980s, financial markets in almost all countries
were centered on commercial banks. Savers and investors kept most of their assets on deposits with banks, either as short-
term demand deposits such as cheque-writing accounts, paying little or no interest, or in the form of certificates of
deposits that tied up the money for years. Drawing on this reliable supply of low-cost money, banks were the main source
of credit for both business and consumers.
Discussion:

Money Markets - In addition to the definition above, these are markets that trade debt securities or instruments
with maturities of one year or less (short-term instruments).
Characteristics:

• Large Denomination.
Denomination is the amount of money related to one particular instrument. Money market instruments
generally have large denominations.

• Low Risk
The money market instruments are usually considered to be of low risk only in terms of the default risk. This is a
risk that the obligation will not be paid on time and in full. However, other risks are still present such as
currency risk and inflation risk.

• Short Maturity
Money market instruments traded have maturities of one year or less.
How it works

The money market exists to provide the loans that financial institutions and governments need to carry out their day-to-
day operations. For instance, banks may sometimes need to borrow in the short term two fulfill their obligations to
their customers, and they use the money market to do so.

For example, most deposit accounts have a relatively short notice period and allow customers access to their money
either immediately, or within a few days or weeks. Because of the short notice period, Banks cannot make long-term
commitments with all of the money they hold on deposit. They need to ensure that a proportion of it is liquid (easily
accessible) in market terms. Otherwise, if a large number of customers wish to withdraw their money at the same time,
There may be a shortfall between the money the bank has lent and the cash deposits it needs to return to savers.

Banks may also find that they have greater demand for mortgages or loans than they do for savings accounts at certain
times. This creates a mismatch between the money they have available and the money they have loaned out, so the bank
will need to borrow in order to be able to fulfill the demand for loans.

The money markets are the mechanisms that bring these borrowers and investors together without the comparatively
costly intermediation of banks. They make it possible for borrowers to meet short-run liquidity need and deal with
irregular cash flows without resorting to more costly means of raising money.
There is an identifiable money market for each currency, because interest rates vary from one currency to another. These
markets are not independent, and both investors and borrowers will shift from one currency to another depending upon
relative interest rates. However, regulations limit the ability of some money market investors to hold foreign currency
instruments, and most money market investors are concerned to minimize any risk of loss as a result of exchange rate
fluctuations. For these reasons, most money market transactions occur in the investor’s home currency.
Who uses the money market?
Companies

• When companies need to raise money to cover their payroll or running costs, they may issue commercial paper
– short-term, unsecured loans for PhP100,000 or more that mature within one to nine months.

• a company that has cash surplus may “park” money for a time in short-term, debt-based financial instruments
such as Treasury bills and commercial paper, certificates of deposit, or bank deposits.
Banks

• If demand for long-term loans and mortgages is not covered by deposits from savings accounts, banks may
then issue certificates of deposit, with a separate and fixed-term maturity of up to five years.

• Individuals seeking to invest large sums of money at relatively low risk may invest in financial instruments. Sums
of less than PhP50,000 can be invested in money market funds.

Types of Money Market Instruments

Commercial Paper

• Commercial paper is an unsecured short-term promissory note issued by a corporation to raise short-term
cash, often to finance working capital requirements.

• It is generally held by investors from the time of issue until maturity. Thus, there is no active secondary
market for commercial paper.

• Companies with high credit ratings can issue commercial papers. This is because commercial papers are
not actively traded and because it is also unsecured debt.
o Credit rating is an evaluation of the risk of default for a particular borrower.

• Commercial papers can also be backed by a line of credit (promise by a commercial bank to make a
particular loan to a borrower).
Bankers’ Acceptances

• Issued by corporations, usually used in international trade. These are used to Finance trade in goods that have
yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer).

o foreign exporters often prefer that banks act as guarantors for payment before sending goods to
domestic importers.

• It is a promise to pay or a promissory note by a corporation and the bank guarantees that it will pay.

• To “Accept” means to assumer responsibility in case of default.

• Low-risk instrument – both the corporation and bank promise to pay

• A bankers’ acceptance is a time draft payable to a seller of goods, with payment guaranteed by a bank. Time
drafts issued by a bank are orders for the bank to pay a specified amount of money to the better of the time draft
on a given date.

Treasury Bills

• Often referred to as T-bills, are securities with a maturity of one year or less, issued by national governments.

• Generally considered the safest of all possible investments because it is default-free.

A default can occur when a borrower is unable to make timely payments, misses payments, or avoids or
stops making payments.

Government Agency Notes

National government agencies and government-sponsored corporations are heavy borrowers in the money markets
in many countries. These include entities such as development banks, housing finance corporations, education
lending agencies and agricultural finance agencies.

Local government notes are issued by provincial or local governments, and by agencies of these governments such as
schools, authorities and transport commissions. The ability of governments at this level to issue money market
securities varies greatly from country to country. In some cases, the approval of national authorities is required; in
others, local agencies are allowed to borrow only from banks and cannot enter the money markets.

Interbank Loans

These are loans extended from one bank to another with which it has no affiliation. Many of these loans are across
international boundaries and are used by the borrowing institution to re-lend to its own customers.
Overnight loans are short term unsecured loans from one bank do another. They may be used to help the borrowing bank
finance loans to customers, but often the borrowing bank adds the money to its reserves in order to meet regulatory
requirements and to balance assets and liabilities.

Negotiable Certificates of Deposit

• Negotiable certificate of deposit is a bank-issued time deposit that specifies an interest rate and maturity date and
is negotiable (salable) in the secondary market.

• A negotiable CD is a bearer instrument - whoever holds The CD when it matures receives the principal
and interest.

Repurchase Agreements

• A repurchase agreement (repo or RP) is an agreement involving the sale of securities by one party to another
with a promise to repurchase the securities at a specified price and on a specified date in the future.

• Simply put, it is the sale of the security and buying back.

• A repo Is a combination of two transactions. In the first a securities dealer, such as a bank, sells securities it owns
to an investor, Agreeing to repurchase the securities at a specified higher price at a future date. in the second
transaction, days or months later, the repo is unwound as the dealer buys back the securities from the investor.
the amount the investor lends is less than the market value all the securities a difference called the spread or
haircut, to ensure that it still has sufficient collateral is the value of the securities should fall before the dealer
repurchases them.

Capital Markets

The capital market is a financial market in which longer-term debt (original maturity of one year or greater) and equity
instruments are traded. Capital market securities include bonds, stocks and mortgages. Capital market securities are
often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty
about the amount of funds they will have available in the future.

The national government issues long-term notes and bonds to fund the national debt while local governments issued notes
and bonds to finance capital projects.

Corporations issue both bonds and stock to finance capital investment expenditures and fund other
investment opportunities.
Capital Market Trading

Capital market trading occurs in either the primary market or the secondary market. The primary market is where new
issues are stocks and bonds are introduced. Investment funds, corporations and individual investors can all purchase
securities offered in the primary market. You can think of a primary market transaction as one where the issuer of the
security actually receives the proceeds of the sale. When firms sell securities for the Very first time, the issue is an initial
public offering (IPO). subsequent sales of a firm’s new stocks or bonds to the public are simply primary market
transactions (as opposed to an initial one).

The capital markets have well-developed secondary markets. A secondary market is where the sale of previously issued
securities take place, and it is important that because most investors plan to sell long-term bonds before they reach
maturity and eventually to sell their holdings of stock as well. There are two types of exchanges in the secondary
market for capital securities: organized exchanges and over-the-counter exchanges. Whereas most money market
transactions originate over the phone, most capital market transactions, measured by volume, occur in organized
exchanges. An organized exchange has a building where securities (including stocks, bonds and options) trade.
Exchange rules govern trading to ensure the efficient and legal operation of the exchange, and the exchange’s board
constantly reviews these rules to ensure that they result in competitive trading.

Capital Market Instruments: (Bonds, Ordinary Equity Shares, Preferred Shares)

Bonds

As we all know, some individuals who want a loan borrow money from banks. However, for a large corporation,
borrowing money would be available through another type of financial intermediary: the bond market. A bond is any
long-term promissory note issued by the firm in order to raise funds. It documents who owes, how much and when the
payment must be made. Unlike stocks, if you buy a bond from a well-known corporation like Ayala Land, you don't own
a part of the company. Rather, you simply lend money to Ayala Land. In exchange, the firm promises to pay back a
specific sum at a particular point in time. In addition, some bonds pay out regular installments called coupon payments
according to a pre-ordained schedule. By issuing bonds, Companies can raise big capital and make big investments.
They can repay that debt over a long timeline. Governments also raise funds this way.

Bonds are not as risky as stocks because the bondholders must be paid before any profits are distributed to
shareholders. But bonds also have risk, and this is called default risk, which means that the bond issuer will not be able
to pay when it becomes due. If investors think that the firm issuing a bond has a significant default risk, they are likely
to demand a higher interest rate for lending money. Bonds are rated by agencies such as the S&P which can go from:

• AAA – the rating for safest bonds; low-risk

• D – the lowest rating for bonds that carry the highest risk, highest likelihood of default
From the image above, you will notice that anything below B rating are considered “junk bonds”. These bonds are
considered higher risk investments that are able to attract attention through their higher yields. The ones that possess
higher ratings (BBB and above in the S&P’s rating) are known as “investment-grade bonds” and seen as safer and more
stable investments.

Characteristics of Bonds
Most bonds share some common basic characteristics including:

• Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond
issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium
$1,090 and another investor buys the same bond later when it is trading at a discount for $980. When the bond
matures, both investors will receive the $1,000 face value of the bond.

• The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a
percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50
every year.

o However, note that there are instances when bonds do not have interest. Instead, they are sold at a
discounted price from the face value. Example: A bonds with a face value of PhP1000 was sold at
PhP950. Upon maturity, the bond will be paid back at full price (PhP1000). You derive the income from
the difference between the face value and discounted price. This is called spread.

Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any
interval, but the standard is semiannual payments.

The maturity date is the date on which the bond will mature, and the bond issuer will pay the bondholder the face value
of the bond.
The issue price is the price at which the bond issuer originally sells the bonds.
Additional important concepts relating to bonds:

• Current Yield - Is the interest that it pays annually divided by its current price. This calculation tells
investors what they will earn from a bond and holding it for one year.
Example: A PhP1000 bond with an annual coupon of PhP100. The current yield is 10%.

• Yield to Maturity – The anticipated return on a bond which is held until maturity (that is, the bond is not
sold before the maturity date).

Types of Bonds:
Bonds may either be secured or unsecured:
1. Unsecured Long-term Bonds
These are unsecured long-term debt and backed only by reputation and financial stability of the corporation or
backed by the “full faith and credit” of the issuer. Because these bonds are unsecured, the earning ability of the
issuing corporation is of great concern to the bondholder. To provide some protection to the bondholder, the issuing
firm may be prohibited from issuing future secured long term debt that would create additional burden.

2. Secured Long-term Bonds

Secured bonds are those that are collateralized by an asset, such as real estate/property, equipment (as in the case
of airlines, manufacturing, or railroad companies). The purpose of collateralizing a bond is so if the issuer
defaults and fails to make interest or principal payments, the investors have a claim on the issuer’s assets that will
enable them to get their money back.

In the case of mortgage bonds, for example, the market value of real property is greater than that of the mortgage
bonds issued. This provides the mortgage bondholders with a margin of safety in the event the market value of the
secured property declines. Should the should the issuing firm fail to pay the bonds at maturity, the trustees can
foreclose or sell the mortgaged property and use the proceeds to pay the bondholders.
In the Philippines, there are two general types of bonds that you can acquire: government bonds and corporate bonds.

Government bonds

Government bonds are issued by the Philippine government through the Bureau of the Treasury, and that explains that
they are also known as treasury bonds. They are offered in two different ways: through auction and directly to the
investing public. In auctions, the bonds are held up for bidding commonly to institutional investors who would then
have the option to make it available to the general public.
Government or treasury bonds are considered to have the least risks, and that is because they are backed by taxpayers.
The risk of default is relatively low.

• Treasury bills are shorter in term, usually less than a year. Interest is not paid, instead the bills are priced at
a discount. Your income is derived from the difference between the discounted price you paid and the full
amount that the government pays back, which is called “spread”.

• Fixed Rate Treasury Notes (FXTN) pays semi-annual interest or as described during the offer.

• Retail treasury bonds (RTB) are longer than FXTNs. They usually carry quarterly interest payments.

• Republic of the Philippines (ROP) bonds are dollar-denominated debt instruments.

Ordinary (Common) Equity Shares

Ordinary equity share is a form of long-term equity that represents ownership interest of the firm. Ordinary equity
shareholders are called residual owners because they're clean the earnings and asset is what remains after
satisfying the prior claims various creditors and preferred shareholders. Ordinary equity shareholders are the true
owners of the Corporation and consequently bear the ultimate risks and rewards of ownership.
Business firms organized as a corporation may choose to:

• issue publicly traded stock (publicly owned corporation) or

• keep ownership only among the original organizers (closely held corporation).
As owners of the firm, ordinary shareholders are considered to be residual domains. this means that ordinary shareholders
have the right to claim any cashflows or value after all other claimants have received what they are owed. These profits
can be used to reinvest in the firm to foster growth, payout dividends to shareholders, or a combination of the two.

Shareholders assume a limited liability because their risk of potential loss is limited to their investment
in the corporation’s equity shares.

Features of Ordinary Equity Shares

1. Par value/No par value
Ordinary equity share may be sold with or without par value. Whether or not the equity share has any par
value is stated in the corporation’s charter. Par value of ordinary equity share is the stated value attached to a
single share at issuance.
 2. Authorized, issued and outstanding

• Authorized shares is the maximum number of shares that a corporation may issue without amending
its charter.

• Issued shares is the number of authorized shares that have been sold.

• Outstanding shares are those shares that are held by the public.

• Both the firm’s dividends per share and earning per share are based on the outstanding shares. The
number of issued shares may be greater than the number of outstanding shares because shares may
be repurchased by the issuing firm.
3. No maturity
Ordinary equity share has no maturity and is a permanent form of long-term financing. Although ordinary share
is neither callable nor convertible, the firm can repurchase its shares in the secondary markets either through a
brokerage firm or a tender offer.

• Callable – In finance, this means payable before maturity. Since shares have no maturity date, they
cannot be callable.

• Tender offer – is a formal offer to purchase shares of a corporation.

4. Voting rights
Each share of ordinary equity generally entitles the holder to vote on the selection of directors and in other
matters. Shareholders unable to attend the annual meeting to vote may vote by proxy.

• A proxy is a temporary transfer of right to vote to another party. Proxy voting is done under the rules and
regulations of the Securities and Exchange Commission, but proxy solicitations are the firm’s
responsibility.
5. Book value per share
The accounting value of an ordinary equity share is equal to the ordinary share equity (ordinary share plus paid-
in capital plus retained earnings) divided by the number of shares outstanding.
6. Numerous rights of stockholders
Collective and individual rights of ordinary equity shareholders include among others:

a. Right to vote on specific issues as prescribe by the corporate charter such as election of the board of directors,
selecting the firm’s independent auditors, amending the articles of incorporation and bylaws, increasing the
amount of authorized stock and so forth.
b. Right to receive dividends if declared by the firm’s board of directors.
c. Right to share in the residual assets in the event of liquidation.
d. Right to transfer their ownership in the firm to another party.
e. Right to examine the corporate banks.
 f. Right to share proportionally in the purchase of any new issuance of equity shares. This is known as the pre-
emptive right.

Preferred Share

Preferred share is a class of equity shares which has preference over ordinary (common) equity shares in the payment of
dividends and in the distribution of corporation’s assets in the event of liquidation.

Preference means only that the holders of the preferred share must receive a dividend (in the case of a growing concern
firm) before holder of ordinary equity shares are entitled to anything. Preferred shares generally has no voting privileges
but it is a form of equity from a legal and tax standpoint.

Preferred Share Features

The following are the major features of preferred shares:
1. Par value
Par value is the face value that appears on the stock certificate. In some cases, the liquidation value per share is
provided for in the certificate.
2. Dividends
Dividends are stated as percentage of the par value and are commonly fixed and paid quarterly but are
not guaranteed by the issuing firm.

• Cumulative dividends – These are dividends that are carried over whenever they are not paid in a
particular year.

• Noncumulative dividends – Dividends not declared in any particular year are lost forever and the
preferred shareholders cannot claim such anymore.
3. No definite maturity date
Preferred share is usually intended to be a permanent part of the firm’s equity and has no maturity date.

• However, preferred share sometimes carries special retirement provisions. Almost all preferred shares
have a call feature that gives the issuing firm the option of purchasing the share directly from its
owners, usually at a premium above its par value.

• Some preferred shares have a sinking fund provision that requires the issuer to repurchase and retire
the share on a scheduled basis.
4. Convertible preferred shares
Owners of convertible preferred shares have the option of exchanging their preferred share for ordinary
or common equity shares based on specified terms and conditions.
 5. Voting Rights
Preferred share does not carry voting rights. Special voting procedures may take effect if the issuing firm omit
its preferred dividends for a specific time period.
6. Participating Features
Participating preferred share entitles its holders to share in profits above and beyond the declared dividend,
along with ordinary equity shareholders. Most preferred share issues are nonparticipating.
7. Protective Features
Preferred share issues often contain covenants to assure the regular payment of preferred share dividends and to
improve the quality of preferred share. For example, covenants may restrict the amount of common share cash
dividends, specify minimum working capital levels, and limit the sale of securities senior to preferred share.

Preferred shareholders have priority over ordinary are common shareholders with regard to earnings and assets.
Thus, dividends must be paid on preferred share before they can be paid on the ordinary equity shares, and in the
event of bankruptcy, the claims of the preferred shareholders must be satisfied before the ordinary equity
shareholders receive anything.
8. Call Provision
A call provision gives the issuing corporation the right to call in the preferred share for redemption. As in the
case of bonds, call provisions generally state the company must pay an amount greater than the par value of the
preferred share, the additional sum being known as call premium.
9. Maturity
This means that preferred shares need to be paid off at a specified maturity date.

Application:
How much will bond investors receive in one year from the following coupon rates?
1. Par value – PhP 25,000 | Coupon rate 8%
2. Par value – PhP 100,000 | Coupon rate 4%
3. Par value – PhP 50,000 | Coupon rate 5%

4. Filinvest Land, Inc. (FLI) returns to the local debt market with the listing of its PHP 8.1 Billion 3-Year and 5-
Year Fixed Rate Bonds at the Philippine Dealing & Exchange Corp. (PDEx). The bonds carry an interest rate
of 3.3353% and 4.1838% per annum. Calculate the coupon payment for both rates assuming that an investor
has PhP50,000 worth of bonds for each of these.

5. Aboitiz Equity Ventures, Inc. (AEV), listed its PHP 7.55 Billion 3-year and 5-year Fixed Rate Bonds on the
Philippine Dealing & Exchange Corp. (PDEx). The bonds carry an interest rate of 2.8403% and 3.3059% per
annum. Calculate the coupon payment for both rates assuming that an investor has PhP50,000 worth of bonds
for each of these.
Summary of the Lesson:

• Money market deals with the trading of financial instruments with maturity dates of one year or less.

• Capital market is a financial market in which longer-term debt (original maturity of one year or greater)
and equity instruments are traded

References:

1. Marginal Revolution University. (2016, July 12). Intro to the Bond Market [Video]. YouTube.
https://www.youtube.com/watch?v=O7ww0gQwuhI&t=311s

2. Jiang, S. (2020, September 25). Bond Rating [Photograph]. Investopedia.

https://www.investopedia.com/ask/answers/09/bond-rating.asp
3. Fernando, J. (2020, November 18). Bond. Investopedia. https://www.investopedia.com/terms/b/bond.asp

4. Pesolab. (2020, September 1). Investing in Philippine bonds: A beginner’s guide.

https://pesolab.com/investing-in-philippine-bonds-a-beginners-guide/
5. What is the Yield to Maturity (YTM)? (n.d.). Https://Corporatefinanceinstitute.Com/.
https://corporatefinanceinstitute.com/resources/knowledge/finance/yield-to-maturity-ytm/
Lesson 3: Foreign Exchange Markets

Lesson Objectives:
At the end of this lesson, you should be able to:
1. Understand what factors significantly influence the currency exchange rates of a country

2. Describe how foreign exchange market provides the mechanism for the transfer of purchasing power from
one currency to another
3. Understand what exchange rate is
4. Distinguish between spot transactions and forward transactions
5. Distinguish between direct quotes and indirect quotes
6. Identify and explain the factors that influence exchange rates.

Discussion:
The foreign exchange market is a market where currency is traded. If we exchange our local Philippine peso for US dollars,
what’s in it for us? What can ownership of US dollars or Euros do? The answer is: purchasing power for goods and services
in overseas markets. Hence, foreign exchange market is also known as the market to exchange purchasing power in
different countries.

Participants in the Foreign Exchange Market

1. Large commercial banks (foreign exchange dealers) – buy and sell any of the major currencies on a continuous
basis.

2. Foreign exchange (FX) brokers – unlike dealers, they do not keep inventory of currency to trade but match
suppliers with buyers of currency for commission.
3. Multinational corporations
4. Central banks

The forex market provides a service to individuals, businesses, and governments need to buy or sell currencies other
than that used in their country. This might be in order to travel abroad or make investments in another country or to pay
for import products or convert export earnings.
It is also a marketplace in which currencies are bought and sold purely to make profit via speculation. When trading very large
volumes of currency, even small fluctuations in price can provide profits or losses . The forex market is open 24 hours, five
days a week, which makes it unusual, as equity markets have set daily trading hours and are closed overnight

The foreign exchange market provides a mechanism for the transfer of purchasing power from one currency to another.
This is where Traders convert 1 foreign currency into another and it's one of the largest financial markets in the world.
Currency trading entails no specific physical location; instead, it is an over the counter market whose main participants
are commercial and investment banks, in foreign exchange dealers and brokers around the world. They communicate
using electronic networks. Any firm’s bank or experts within the firm, can access this market to exchange one currency
for another.
Exchange Rates
Definitions:

• The price of one country’s currency expressed in terms of another country’s currency.

• The value of one nation's currency versus the currency of another nation.
Exchange rates are important because they affect the relative price of domestic and foreign goods.

Example 1: A Filipino manufacturing business that imports raw materials from Vietnam will have to pay more whenever
the Philippine peso depreciates. This can affect the cost of producing goods which in turn raises the prices when
products are being sold to the consumers.

Example 2: For a frequent international traveler, the prices of flight tickets rely heavily on exchange rates. A
strong Philippine peso would mean it would be more affordable to book flights because less of local currency is
needed to purchase tickets prices in US dollars.

How Are International Exchange Rates Set?

Appreciation – An increase in a currency’s value in the forex market.
Depreciation - A decrease in the currency's value in the forex market.

A currency’s price is always expressed in terms of another country’s currency.

Currency prices can be determined in two main ways: a floating rate or a fixed rate. A floating rate is determined by the
open market through supply and demand on global currency markets. Therefore, if the demand for the currency is high,
the value will increase. If demand is low, this will drive that currency price lower.

Who demands currency on a forex market?

• Consumers who wish to buy imports. Example: For the market of US dollars, foreigners who wish to purchase
goods only available in the United States will need dollars.

• Investors who wish to invest in foreign assets.

• Governments and central banks

Who supplies currency on a forex market?

• Foreign consumers who buy domestic goods

• Foreign investors who invest in domestic assets

• Foreign government and central banks

A fixed or pegged rate is determined by the government through its central bank (with government intervention). The
rate is set against another major world currency (such as the U.S. dollar, euro, or yen). To maintain its exchange rate, the
government will buy and sell its own currency against the currency to which it is pegged. Some countries that choose to
peg their currencies to the U.S. dollar include China and Saudi Arabia.
Factors Influencing Exchange Rates

1. Inflation. 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 I said result there will be an increased demand for the
country's economy.

3. Balance of payments. Balance of payments is used to refer to a system of accounts that catalogs the flow of goods
between the residence of two countries. For instance, The Philippines is net exporter of goods in therefore has a
surplus balance of trade, countries purchasing the goods must use the country's currency. this increased demand
for the currency in the market value

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.

The Theory of Purchasing Power Parity

One of the most prominent theories of how exchange rates are determined is the theory of the purchasing power parity
(PPP). it states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the
two countries. The theory of PPP is an application of the law of 1 price to national price levels.

To illustrate, if the law of one price holds, a 10% rise in the yen price of Japanese steel results in a 10% appreciation of
the dollar. Applying the law of one price to the price levels in the two countries produces the theory of purchasing
power parity, which maintains that is the Japanese price level rises 10% relative to the US price level, the dollar will
appreciate by 10%. The theory of PPP suggests that if one country’s price level rises relative to another’s, its currency
should depreciate (the other country’s currency should appreciate).
The PPP conclusion that exchange rates are determined solely by changes in relative price levels rests on the assumption not
all goods are identical in both countries. When this assumption is true, the law of one price states that the relative prices of all
these goods (that is, relative price level between the two countries) Will determine the exchange rate.

PPP theory furthermore does not take into account that many goods and services (whose prices are included in the
measure of a country’s price level) are not traded across borders. Housing, land, and services such as restaurant
meals, haircuts and golf lessons are not traded goods. So even though the prices of these items might rise and lead to a
higher price level relative to another country’s, there would be a little direct effect on the exchange rate.
To better understand the theory of purchasing power parity, please refer to the following link:
https://www.youtube.com/watch?v=S5xqBK6s4bI
What are the foreign currency exchange rate transactions?

Spot transactions - are those which involved immediate(two-day) exchange of bank deposits. The spot exchange rate is
the exchange rate for the spot transactions.

• A spot exchange rate is the current price level in the market to directly exchange one currency for another, for
delivery on the earliest possible value date. Cash delivery for spot currency transactions is usually the
standard settlement date of two business days after the transaction date (T+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.

• These transactions happen in a currency forward.

• Currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for
the purchase or sale of a currency on a future date. They are generally used for hedging against risks.

• Hedging against investment risk means strategically using financial instruments or market strategies to offset
the risk of any adverse or volatile price movements.

• Currency forward contracts are only used in a situation where currency exchange rates can affect the price
of goods sold.

o For example, assume that Company A in the United States wants to contract for a future purchase of
semiconductor parts from Company B, which is located in the Philippines. Therefore, changes in the
exchange rate between the US dollar and the Philippine peso may affect the actual price of the purchase –
either up or down.
o The exporter from the Philippines and the importer in the US agree upon an exchange rate of PhP 47 per 1 USD that
will govern the transaction that is to take place six months from the date the currency forward contract is made
between them. At the time of the agreement, the current exchange rate is PhP 48 per 1 USD.

o If, in the interim and by the time of the actual transaction date, the market exchange rate is PhP 49 to 1 USD,
then the exporter/seller will have benefited by locking in the rate of PhP47. On the other hand, if the
prevailing currency exchange rate at that time is PhP 46 per 1 USD, then the importer/buyer will benefit from
the currency forward contract. However, both parties have benefited from locking down the purchase price so
that the seller knows his cost in his own currency, and the buyer knows exactly how much they will receive
in their currency.
Direct and Indirect Quotes
In the spot exchange market, the quoted exchange rate is typically called a direct quote.

• A direct quote indicates the number of units of the home currency required to buy one
unit of the foreign currency.

• One unit of foreign currency is expressed in terms of domestic currency.

• Example: We will use the US dollar as the foreign currency and Philippine peso as the
home currency. As of November 30, 2020, the direct quote for this pair is:
USD / PHP = 48.12
o This means that to purchase 1 US dollar, you need 48.12 Philippine pesos

An indirect quote indicates the number of units of foreign currency that can be bought for one
unit of the domestic currency.

• One unit of domestic currency is expressed in terms of foreign currency

• Using the example above: As of November 30, 2020, the indirect quote would be PHP / USD =
0.021 US dollar o This means that to purchase 1 Philippine peso, you need 0.021 US
dollars

• The formula for indirect quote is:

Indirect Quote = 1
_______________
Direct Quote

Summary of the Lesson:

• The foreign exchange market is a marketplace that allows the buying and selling of currencies.

• The forex market provides potential profit and purchasing power to its participants.

• Major participants in the forex market are large commercial banks, foreign exchange
dealers, multinational corporations and central banks.

• A currency’s price/value is always expressed in terms of another currency (should always be in

pairs).
References:

1. Banton, C. (2020, September 12). How Are International Exchange Rates Set? Investopedia.
https://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp#floating-
vs-fixed-exchange-rat
Marginal Revolution University. (2017, September 5). Purchasing Power Parity: When in
India, Get a Haircut [Video]. YouTube. https://www.youtube.com/watch?v=13y49v0Zp1c
2. Jagerson, J. (2020, February 21). What Is Hedging as It Relates to Forex Trading? Investopedia.
https://www.investopedia.com/ask/answers/forex/forex-hedge-and-currency-hedging-
strategy.asp#:~:text=Hedging%20with%20forex%20is%20a,pair%20from%20an%20adverse
%20move.&text=On e%20is%20to%20place%20a,is%20to%20buy%20forex%20options

3. Hargrave, M. (2020, September 12). Currency Forward Definition. Investopedia.

https://www.investopedia.com/terms/c/currencyforward.asp#the-basics-of-
currency-forwards

Exchange Rate. (n.d.). Https://Www.Toppr.Com/. https://www.toppr.com/guides/economics/open-

economy-