Chapter 7: Review Questions information in between parties and enforceable mitigations

1. Describe what financial markets are. according to the contract. Since financial market is a vast network
Financial markets are places where lending and borrowing of of exchange, a balance between regulation and protection is
financial instruments takes place. Place where lender and observed to meet investor preference, but at the same time protect
borrowers such as business entities, investors, banks, etc. meet to interest. Lastly, with technological advancement, financial markets
exchange instruments such as bonds, stocks and other financial are now able to open platforms that charges low transaction cost
and non- financial assets. to those who engage in trading due to accessibility and portability.
2. Distinguish between public financial markets and corporate 8. What benefits could be achieved if the Code of Ethics
financial market. governing Financial Market Activities would be implemented
The primary distinction between a private and a public company is and followed by the participants?
that a public company's shares are traded on a stock exchange, In the observance of professionalism, integrity of capital markets,
unlike private company’s shares are exchanged privately or over- duties to clients, conflicts of interest and duties to market
the-counter. counterparts, as mentioned by the issued circular letter no. CL
3. Distinguish between primary market and secondary market. 2010-013, can achieve the following:
The primary market is where securities are created, but the -Transactions are carried in a right manner of transaction
secondary market is where they are traded between investors. A -Capital markets will gain more trust from their clients by serving
stock exchange is considered a secondary market because it only them with honesty
bridges sellers and buyers of stock in order for them to make a -Individuals will continue to patronize financial markets if markets
transaction. are able to prioritize client’s preference or just simply conducting
4. What are the basic functions of the financial markets? proper regulations.
Explain them. -Less dispute or complaint is likely to arise from investors or other
 Raising Capital. Through financial markets, firms or traders regarding an unsettled transaction.
individuals can raise funds by reinvesting profits, -All financial participants are recognized and queries are
borrowing money from banks or bonds; and by selling addressed as regards to financial transactions that takes place.
stock. 9. What are the forces that brought about the major changes
 Commercial Transactions. Financial markets serve as in the financial markets for the last two to three decades?
medium to make a transaction commercial, meaning Exchanging, trading, selling and borrowing had never been more
individuals and entities can exchange payments for flexible, complex and vast after two to three decades without
goods and services through financial markets. technology, deregulation, liberalization, consolidation and
 Price Setting. Financial market helps in the price globalization that took place.
determination of goods and services based on the 10. What is a stock exchange? What is its main purpose?
individuals selling and buying behavior. A stock exchange is also a financial market that bridges primary
 Asset Valuation. Because financial markets are able to sources of shares, debentures, government securities and bonds
identify prices, it is the place perfect to determine an with those who want to buy it. The stock exchange’s main purpose
asset’s market value for buyers and sellers of such. lies in the need for sellers and buyers to have a place to
 Arbitrage. This market strategy happens due to the communicate, transact and settle the sale of financial assets, with
changes in currency values which are taken advantage less ease while ensuring transparent exchange of financial assets.
by investors through simultaneous purchase and sale of 11. What is the implication of the SEC granting a “Self-
the same asset in different markets. Regulation Organization” status to the Philippine Stock
 Investing. This function makes financial markets very Exchange?
popular today due to portability and individuals’ ability to “Self-Regulatory Organization” status implies that the bourse, or
open accounts, and buy and sell stocks easily. Business stock market, which is the PSE in this instance, can implement its
and other organizations re able to acquire funds by the own rules and establish penalties on erring trading participants
issuance of stocks and bonds through the financial and listed companies.
market. 12. What does “listing of securities” mean?
 Risk Management. Financial markets are place for Under stock exchange, transparency of financial participants is
different financial instruments, with different risk attached, observed to carry out financial transactions that meets both buyers
that are being traded and invested by many. Investors and sellers needs and wants such as assuring that expected
and issuers are able to diversify their portfolio with high return of stock is achievable or such company issuing stocks are
and low risk instruments through the financial markets. solvent enough to liquidate stocks when the time comes. Listing of
5. What are the two principal sources of funds in the financial securities requires the disclosure of important information of stocks
market? Explain briefly. being bought and sold.
Two principal sources of funds in the financial markets are debt
financing and equity financing. Debt financing entails borrowing
money, whereas equity financing entails selling a portion of the
company's stock.
6. Distinguish between the organized stock exchange and
over-the-counter exchange. Chapter 8- Money Market and
When brokers and dealers conduct business directly over 1. Explain the phrase "money market",
computer networks and by phone, a decentralized dealer market Money market is a system of institutions that deals with sustaining
takes place or an Over-the Counter Exchange. In contrast, a stock the flow of short- term capital.
exchange is a controlled and organized market where buyers and 2. Describe how the money market mechanism works to bring
sellers trade equities in a safe, transparent, and systematic providers and users of short-term fund together.
manner. Money market provides businesses that needs immediate cash to
fund present operations an alternative or a solution by setting up a
7. What are the attributes of financial markets that investors transaction between those who are willing to lend their money for a
as well as creditors are looking for? Explain them briefly. short-period of time. Money market makes it possible through the
Investors prefer financial markets over other trading ways because use of financial instruments.
of liquidity, reliability, legal procedures, suitable investor protection 3. Explain how banks, companies and investors use financial
and regulation and low transaction cost. Financial markets make instruments in the money market.
financial instruments more liquid because it opens a place for The financial instruments use in money market are highly liquid. In
active traders, sellers and buyers, with the same preference or exchange for lending money, investors can expect a return in a
appetite, to meet. Financial markets also aid in assuring reliable short period of time. Same with borrowers who needs immediate
transaction, trusted exchange, by proper disclosure of relevant
funds. In exchange of a short-term obligation, borrowers can raise creditworthiness of the issuer, not by a lien on any
capital in the shortest amount of time possible. specific property.
4. Give and describe the types of money-market instruments.  ii. Secured long-term bonds are investment through debts
Types of money-market instruments: commercial paper, a short- that is secured by a specific asset owned by the issuer.
term debt obligation of a private sector firm or a government- The said asset serves as collateral or a security for the
sponsored corporation; bankers’ acceptances, a promissory note loan.
issued by a non-financial firm to a bank in return for a loan;  iii. Junk bonds are bonds that are rated below investment
treasury bills, securities with a maturity of one year or less, issued grade.
by national governments; government agency notes, resulting  iv. Floating rate of variable rate bonds are bonds in which
obligations of national government agencies and government- its interest payment changes depending on market
sponsored corporations as a borrower; local government notes, conditions.
issued by provincial or local governments, and by agencies of 14. Distinguish between ordinary or common stock and
these governments; interbank loans, loans that are extended from preferred stock.
one bank to another with which it has no affiliation; time deposits, Ordinary or common stock is a form of long-term equity that
interest bearing bank deposits that cannot be withdrawn without represents ownership interest of the firm. On the other hand,
penalty before a specified date; and, repos, a combination of two preferred stock is an equity share which has preference over
transactions. ordinary equity shares in the payment of dividends and in the
Capital Markets distribution of corporation assets in the event of liquidation.
5. Explain what capital market is. 15. Compare the features of bonds, ordinary equity shares
Capital market is a financial market in which longer-term debt and preferred share in terms of
(original maturity of one year or greater) and equity instruments a. Ownership & control of the firm
are traded. In bonds, the investors do not become a part owner of the
6. Who are the primary issuers of capital market securities? company. While for both ordinary equity shares and preferred
The primary issuers of capital market securities are the national share, shareholders became part-owner of the company. But the
and local government, and corporations. difference lies in the voting rights of those shareholders. Those
7. What does capital market trading occur? who hold ordinary equity share have a say in the way the company
Capital market trading occurs in either the primary market or the is managed while those who hold preferred shares don’t have the
secondary market. right to vote.
8. What are the bonds? How are they traded? b. Obligation to provide return
Bonds are any long-term promissory note issued by a firm. Bond investors receive the principal amount of the bonds upon its
Corporate bonds are sold upon its issuance through a public maturity.
offering or through an investment bank. Then investment banks c. Claims to assets in the event of bankruptcy
resell these securities to investors at a higher price. preferred stock shareholders will receive assets before common
9. Enumerate the advantages and disadvantages of issuing stock shareholders. bonds, ordinary equity shares and preferred
bonds as a source of long-term funds. share
Advantages of issuing bonds as a source of long-term funds: (1) d. Cost of distributor
long-term debt is generally less expensive than other forms of bonds, ordinary equity shares and preferred share
financing, (2) bondholders do not participate in extraordinary e. Risk-return trade off
profits; the payments are limited to interest, (3) bondholders do not bonds, ordinary equity shares and preferred share
have voting rights, and (4) flotation costs of bonds are generally f. Tax obligation of the corporation
lower than those of ordinary (common) equity shares. While the bonds, ordinary equity shares and preferred share
disadvantages include: (1) debt (other than income bonds) results g. Tax obligation of the recipient of income
in interest payments that, if not met, can force the firm into bonds, ordinary equity shares and preferred share
bankruptcy, (2) debt (other than income bonds) produces fixed
charges, increasing the firm's financial leverage, (3) debt must be
repaid at maturity and thus at some point involves a major cash
outflow, and (4) the typically restrictive nature of indenture CHAPTER 9- Foreign Exchange Market
covenants may limit the firm's future financial flexibility. 1. List the factors that affect the value of a currency in foreign
exchange markets.
The list of the factors that affect the value of a currency in foreign
exchange markets include: inflation, interest rates, balance of
10. How is the bond's internal rate of return or yield to payments and government intervention.
maturity determined? 2. Explain how exports and imports tend to influence the
The bond's internal rate of return or yield to maturity is determined value of a currency.
by finding the discount rate that equates the present value of the If a country exports more than it imports, then it means there is a
interest and principal payments with the current market price of the high demand for its goods, and thus, for its currency. The
bond, which is through the use of a formula. economics of supply and demand dictates that when demand is
11. How is credit quality risk of bonds may be issued by a high, prices rise and the currency appreciates in value. On the
corporation minimized? other hand, if a country imports more than it exports, then it means
Credit quality risk of bonds issued by a corporation can be there would be less demand for its currency, so prices will decline,
minimized by judging and assessing: low utilization of financial and so its currency. In short, increased demand for a country's
leverage; profitable operations; low variability of past earnings, exports causes its currency to appreciate while an increased
large firm size; and, little use of subordinated debt. demand for imports causes the domestic currency to depreciate.
12. What is the relationship between bond rating and 3. Differentiate between the spot exchange rate and the
expected rate of return? forward exchange rate.
The poorer the bond rating, the higher the expected rate of return The spot exchange rate is used in spot transactions. It is the
demanded in the capital markets. Bond rating provides an exchange rate at which the currency is traded for immediate
indicator of default risk that in turn affects the rate of return that delivery. On the other hand, the forward exchange rate is used in
must be paid on borrowed funds. forward transactions. It is the exchange rate at which the currency
Money Markets and Capital Markets for future delivery is quoted. In short, spot exchange rate is the
13. Describe the following types of bonds rate at present time while the forward exchange rate is the rate at
 i. Unsecured long-term bonds are investment through a much later date.
debts that are vouched only by the general 4. What is meant by translation exposure in terms of foreign
exchange risk?
Translation exposure is the risk where a company's equities, 6. Describe briefly the following mortgage loans
assets, liabilities, or income will change in value as a result of  Equity Participating Mortgage (EPM) is a loan where an
exchange rate changes. This occurs when a firm denominates a outside investor shares in the appreciation of the
portion of its equities, assets, liabilities, or income in a foreign property. This investor will either provide a portion of the
currency. purchase price of the property or supplement the monthly
5. What procedures(s) would you recommend for a payment. In return, the investor receives a portion of any
multinational company in studying exposure to political risk? appreciation of the property.
What actual strategies can be used to guard against such  Shared Appreciation Mortgages (SAMS) is a loan where
risk? the lender lowers the interest rate in the mortgage in
Just like how the saying “knowledge is power” goes, gathering exchange for a share of any appreciation in the real
information is the best procedure. Understanding and being aware estate (if the property sells for more than a stated
of a country’s political situation, as well as its rules and amount, the lender is entitled to a portion of the gain).
regulations, would be beneficial. And if a company enters an at-  Growing Equity Mortgage (GEMs) is a loan where the
risk country, a solution would be to purchase political risk payments will initially be the same as on a conventional
insurance. Although, buying political risk insurance does not mortgage. And over time the payment will increase. This
guarantee receiving compensation immediately after a detrimental increase will reduce the principal more quickly than the
event, it’s better than nothing. And another one is to negotiate conventional payment stream would.
terms of compensation with the host country.  Graduated-Payment Mortgages (GPMS) are useful for
6. What is LIBOR? How does it compare to the U.S. prime home buyers who expect their incomes to rise. The GPM
rate? has lower payments in the first few years, then the
Libor is a short-term variable interest rate at which banks lend to payments rise. The early payment may not even be
each other in certain London money markets. The U.S. prime sufficient to cover the interest due, in which case the
interest rate is default in the loan and will remained fixed until the principal balance increases. As time passes, the borrower
Federal Open Market Committee decides to change the Federal expects income to increase so higher payment will not be
Funds Rate. But for the LIBOR, businesses have the ability to set much burden
the LIBOR interest rate for a specific time period. The biggest  Fixed-rate Mortgages are loans where the interest rate
benefit of LIBOR is that, this rate option has historically and will and the monthly payment do not vary over the life of the
usually be lower than the Prime rate option. mortgage.
CHAPTER 10- Mortgage Markets and Derivatives
1. What distinguishes the mortgage from other capital
market?
Other capital markets are for buying and selling of long-term debt- 7. Give the largest providers of funds for mortgage loans.
or equity-backed securities while mortgage market is the market The largest providers of funds for mortgage loans are mortgage
for the sale of securities or bonds collateralized by the value of tools and trusts with 49%, commercial banks with 24%,
mortgage loans. The mortgage lender, commercial banks, or government agencies and others with 15%. There are also life
specialized firm will group together many loans and sell grouped insurance companies which covers about 9% and savings and
loans as securities called collateralized mortgage obligations loans associates that also covers 9%.
(CMOs). 8. What is meant by "securitization of mortgages"?
2. Most mortgage loans once had balloon payments: Now, Securitization of mortgages mean that various types of debt
most current mortgage loans are fully amortized. What is the instruments (assets) such as mortgages and other consumer loans
difference between a balloon loan and a fully amortizing loan? are pooled together to be sold as bonds to investors. A bond
A balloon loan, just like how a real balloon is constantly supplied compiled in this way is generally referred to as an asset-backed
with air to inflate it at the end, is a loan that comprises a stream of security (ABS) or collateralized debt obligation (CDO).
constant payments followed by a large payment at the end, which 9. Describe the impact of securitized mortgage on the
is called the balloon payment. In contrast, a fully amortized loan is mortgage market.
composed of equal payments, which are paid through the life of With institutional investors looking for appreciative investment
the loan. Which means that at the end of the payments, the opportunities that compete for funds with government notes bonds,
balance is zero. corporate bonds and stock, securitized mortgages’ popularity had
3. Give and explain briefly the three important factors that grown. Securitized mortgage on the mortgage market have attract
affect the interest rate on the loan. lots of investors and funds from all over the world. The main
The three important factors that affect the interest rate on the loan reason is because securitized mortgage are low-risk securities that
are: (1) current long-term market rates, which are the rates have higher yield than comparable government bond.
determined by the supply of and demand for long-term funds: (2) CHAPTER 11- Internalization of Financial Markets
term or life of the mortgage, which is usually 15 or 30 years. 1. In what way do global financial markets help government
Interest rate risk falls as the term to maturity decreases, which individuals, businesses and investors?
means that longer-term mortgages have higher interest rates than Global financial markets make it possible for money to extensively
short-term mortgages: and, (3) number of discount points paid, flow easily. Moreover, it provides a greater amount of finance.
wherein as exchange for the points, the lender reduces the interest Government individuals, businesses and investors can depend on
rate on the loan. international markets to raise needed funds. They can also seek
4. What features contribute to keeping long-term mortgage for greater investment opportunities.
interest rates low? 2. What is the largest financial market in the world?
One feature is that mortgage loans require a collateral, usually the New York Stock Exchange is the largest financial market in the
real estate being financed, to be pledged as security. Moreover, world with outstanding shares of $14.4 trillion.
since borrowers generally agree to pay a monthly amount of 3. It is easy to estimate the worldwide size of its financial
principal and interest that will be fully amortized by its maturity, the markets?
lenders will receive a fair amount of payment throughout the term Estimating the worldwide size of financial markets is not easy.
of the mortgage. First, because it is hard to decide what exact transactions are
5. Distinguish between conventional mortgage loan and included under financial markets category. And second, collecting
insured mortgage loan. all data about millions of transactions accomplished every year is
Conventional mortgages are originated by banks or other not possible.
mortgage lenders but are not guaranteed by government or 4. What is meant by Cross-Border financing?
government-controlled entities. While insured mortgages are Cross-border financing is the process of providing funds for
originated by banks or other mortgage lenders but are guaranteed business activities that occur outside a country's borders. These
by either the government or government-controlled entities.
includes financing deals that happen beyond the country's of banks. The bonds are sold to investors in countries
borders. other than the one in whose money unit the bond is
5. Explain the development of financial instrument in the denominated.
international markets.  Foreign bond market- This credit market offers
In early years, financing is provided for people in the same region international bonds that are issued in the country in
or location since international transactions are not yet easily whose currency the bond is denominated.
manageable. Financial instruments are usually issued in the same
country where the transaction is perfected. But since financial
markets have been globalize already: transaction happening
across borders and much easier due to technology and
development, foreign bonds have emerged. These foreign bonds
have accumulated funds from international markets providing a
greater source of funds for businesses around the globe.

6. Explain briefly how the following factors influenced the

long-run trends of increased financial market activity
 Lower inflation- If there is a low inflation rate, financial-
market investors will require a lesser inflation premium
since they are not expecting an increase in prices to
devalue their assets which will make firms engage more
in raising long-term capital.
 Pensions- Pensions involve accounts in which money
should be saved, and therefore invested, until retirement.
It makes pre-funded individual pensions stimulate interest
in which has led to a huge increase in financial assets in
countries where private pension schemes were
previously uncommon.
 Stock and bond market performance - A rapid increase in
financial wealth has been possible due to the stock and
markets good performance. Due to this, investors whose
portfolios have appreciated are willing to reinvest in
financial markets. And the appreciation in the value of
their financial assets gives investors the collateral to
borrow additional money, which can then be invested.
 Risk management- Firms and investors can choose
which risks they do not want, or to take additional risks in
exchange for higher returns. And this resulted to an
enormous expansion of financial-market activities. Risk
management redistribute risk and give way for investors
to come up with alternative decisions and continuously
engage in investing transactions.
 Investors- Investors are the main force that makes
financial markets stronger. Investors lend their money as
they will also benefit from it. But since preferences vary,
so does the decisions and transactions that investors will
engage into.
7. Give the explains briefly the types of institutional investors.
The types of institutional investors are: mutual funds, which are
investment companies that accepts unlimited number of individual
investments; hedge funds, which accepts investment from only a
small number of wealthy individuals or big institutions: insurance
companies, one that guarantees a sum of money in the future in
case of fortuitous event; pension funds, which oversee retirement
savings of a large number of workers; and, algorithm traders,
which involves a programmed computers that automatically buy
and sell to exploit tiny price differences in securities and currency
markets.
8. Distinguish between the major types of international credit
markets
 Eurocredits- This market is affiliated with London
Interbank Offer Rate (LIBOR). It is usually offered for a
fixed term with no early payment credits. As of the
moment, it is existing for major trading currencies.
 Eurobond market- This is a credit market that offers
international bonds underwritten by international indicate