Financial Markets Saunders
Financial Markets Saunders
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Foreign exchange risk - sensitivity of the full and fair disclosure of information on
value of cash flows on foreign securities issues to actual and potential
investments to changes in the foreign investors
currency’s price in terms of dollars firms planning to issue new stocks or
Spot FX - the immediate exchange of bonds - register their securities with the
currencies at current exchange rates. SEC and to fully describe the issue, and
Forward FX - the exchange of currencies any risks associated with the issue, in a
in the future on a specific date and at a legal document called a prospectus
pre-specified exchange rate. monitors trading on the major
exchanges
Derivative Security (Markets) not intended to protect investors
a financial security (such as a futures against poor investment choices, but
contract, option contract, swap rather to ensure that investors have full
contract, or mortgage-backed security) and accurate information
whose payoff is linked to another,
Financial institutions - perform the essential
previously issued security such as a
function of channeling funds from those with
security traded in the capital or foreign
surplus funds (suppliers of funds) to those with
exchange markets
shortages of funds (users of funds)
agreement between two parties to
exchange a standard quantity of an Financial Institutions are distinguished by:
asset or cash flow at a predetermined
Whether they accept insured deposits -
price and at a specified date in the
future Depository versus non-depository financial
value of the underlying security to be institutions.
exchanged changes, the value of the Whether they receive contractual
payments from customers
derivative security changes
the newest of the financial security
Depository institutions: - commercial
markets
potentially the riskiest of the financial banks, savings associations, savings banks,
securities credit unions.
main purpose of the derivatives markets Non-depository institutions
• Contractual: insurance companies,
is to transfer risk between market
participants pension funds,
• Non-contractual: securities firms
and investment banks, mutual
funds.
Financial Market Regulation
Direct transfer of funds - from suppliers of
The Securities Act of 1933 - Full and fair
funds to users of funds
disclosure and securities registration.
- financial claims would flow directly from
The Securities Exchange Act of 1934 -
users of funds to suppliers of funds
Securities and Exchange Commission (SEC)
is the main regulator of securities markets
Indirect transfer of funds to the ultimate user of
funds via FIs.
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Commercial banks —depository their retirement years and are exempt
institutions whose major assets are loans from current taxation.
and whose major liabilities are deposits.
Unique Economic Functions Performed by
Commercial banks’ liabilities include more
Financial Institutions
non deposit sources of funds, such as
subordinate notes and debentures, than Services Benefiting Suppliers of Funds:
do those of other depository institutions.
Thrifts —depository institutions in the Monitoring costs —Aggregation of
form of savings associations, savings funds in an FI provides greater incentive
banks, and credit unions. Thrifts generally to collect a firm’s information and
perform services similar to commercial monitor actions. The relatively large size
banks, but they tend to concentrate their of the FI allows this collection of
loans in one segment, such as real estate information to be accomplished at a
loans or consumer loans. lower average cost (economies of scale).
Insurance companies —financial o In an economic sense, fund
institutions that protect individuals and suppliers have appointed the
corporations (policyholders) from adverse financial institution as a
events. delegated monitor to act on
Securities firms and investment banks — their behalf.
financial institutions that help firms issue Liquidity and price risk —FIs provide
securities and engage in related activities financial claims to household savers
such as securities brokerage and securities with superior liquidity attributes and
trading. with lower price risk.
Finance companies —financial o FIs provide further claims to
intermediaries that make loans to both fund suppliers, thus acting as
individuals and businesses. Unlike asset transformers
depository institutions, finance companies Transaction cost services —Similar to
do not accept deposits but instead rely on economies of scale in information
short- and long-term debt for funding. production costs, an FI’s size can result
Mutual funds —financial institutions that in economies of scale in transaction
pool financial resources of individuals and costs.
companies and invest those resources in Maturity intermediation —FIs can
diversified portfolios of assets. better bear the risk of mismatching the
Hedge funds —financial institutions that maturities of their assets and liabilities.
pool funds from a limited number of Denomination intermediation —FIs
wealthy individuals and other investors such as mutual funds allow small
and invest these funds on their behalf, investors to overcome constraints to
usually keeping a large proportion buying assets imposed by large
(commonly 20 percent) of any upside minimum denomination size.
return and charging a fee (2%) on the Services Benefiting the Overall Economy:
amount invested.
Pension funds —fund participants Money supply transmission —
accumulate savings during their working Depository institutions are the conduit
years before withdrawing them during through which monetary policy actions
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impact the rest of the financial system financial institutions in 70 years,
and the economy in general. allowed for the creation of
Credit allocation —FIs are often viewed “financial services holding
as the major, and sometimes only, companies” that could engage
source of financing for a particular in banking activities, insurance
sector of the economy, such as farming activities, and securities
and residential real estate. activities.
Intergenerational wealth transfers — o
FIs, especially life insurance companies
GLOBALIZATION OF FINANCIAL MARKETS AND
and pension funds, provide savers with
INSTITUTIONS
the ability to transfer wealth from one
generation to the next. The pool of savings from foreign investors is
Payment services —The efficiency with increasing and investors look to diversify
which depository institutions provide globally now more than ever before.
payment services directly benefits the Information on foreign markets and
economy. investments is becoming readily accessible
and deregulation across the globe is
Risks Incurred by Financial Institutions
allowing even greater access to foreign
Credit risk markets.
Foreign exchange International mutual funds allow diversified
country or sovereign risk foreign investment with low transactions
Interest rate risk costs.
Market risk or asset price risk Global capital flows are larger than ever.
Off-balance-sheet risk
Liability withdrawal or liquidity risk
Technology PHILIPPINE FINANCIAL SYSTEM
operational risk
Insolvency risk Finance – allocation of scarce resources
Volcker Rule: Insured institutions may not - Obtain funds at the lowest cost
engage in proprietary trading - Use the funds efficiently to obtain
desired benefits
Regulation of Financial Institutions
Resources:
Enterprise risk management. - Recognizes
the importance of managing the combined Financial – money, shares/stocks, bonds
impact of the full spectrum of risks as an Real – property, mineral, goods
interrelated risk portfolio
2 types of Finance Decisions:
The Rise of Financial Services Holding
Companies. Household/individual – personal
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- Investors and borrowers - up to 100% equity investments in
- Other parties: financial intermediaries other than
o Financial service organizations commercial banks
o Regulatory bodies
b. Commercial banks – constitute the
Four levels of financial decision making: bulk of the banking system. - these are
institutions that accept deposits, which are
- Personal
subject to withdrawal by checks
- Sole Proprietorship
- Partnership c. Specialized government banks –
- Corporation unique government banks which are subject
to the supervision and regulation of the BSP
Financial markets
d. Thrift banks (Thrift Bank Act of 1995)
Capitalism brought:
d1. savings and mortgage
- The existence of private wealth
banks (SMBs)/savings and loan
- Freedom of choice associations - accumulate the
- Incentives (motivators)
savings of depositors and invest
- Efficient markets (one where the price
them in various ways
of any good (asset) fully reflects all
information associated with it) d2. Rural banks and
- The role of the government cooperatives - promote
comprehensive development
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> GSIS and SSS generate forced savings redeemable securities of which it is the
to fund the retirement benefits of its issuer
members.
(b) close company – an investment
3. Workmen’s Compensation Programs company whose shares issued are not
– to insure workers against accidents. redeemable
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regular equal installments with the 5. Savings and Loan Association Act – governs
purpose of accumulating to the organization and operation of non-stock
stockholders’ savings and repaying savings and loans associations
them with their accumulated savings
6. RA 7721 – liberalizes the entry and scope of
and profits upon surrender of their
operations of foreign banks in the Philippines
shares
7. Bangko Sentral ng Pilipinas - provides policy
- to encourage industry, savings and
directions in the areas of money, banking and
home building among its stockholders.
credit
10. Stock Savings and Loan
- has supervision over the operations of
Associations (SSLAs) – operating
banks and exercise regulatory powers
under the Savings and Loan
over the operations of non-bank
Association Act and are licensed and
financial institutions performing quasi-
supervised by the BSP
banking functions
- not allowed to do business with the
Main functions and responsibilities are:
general public but accept deposits
from and grant loans to their member Promotes price stability
depositors only Supervises all banks
Issues bank notes and coins
Manages international reserves
Non-bank financial institutions with quasi- Determines the exchange rates policy
banking functions: The bank of banks (provides loans and
financial assistance to banks)
a. Investment houses
Acts as the main depository bank of
b. Financing companies
the government
c. Investment companies
Tasks in promoting low inflation and a
d. Securities dealers
healthy financial system
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conducts business in safe and sound money tends to lose value and
manner invest in non-productive assets
Efficient payments and settlements such as jewelries and idle lands.
system – enables people to make safe, b. Pervasive unchecked circulation of fake
timely and accurate settlements of money
financial transactions Effects:
money loses its value
8. Philippine Deposits Insurance Corporation
an exception rather than the
(PDIC) – an official insurance corporation of the
rule that is a medium of
banking system.
exchange
- requires insured banks to pay an dollar currency may be used
assessment rate so that their deposits directly as another medium
are insured up to P500,000 per of exchange
depositor.
Common major characteristics of central
9. Securities and Exchange Commission (SEC) – banks:
established on October 26, 1936 by virtue of the
a. Publicly-owned – the BSP is fully owned and
Commonwealth Act # 83 or the Securities Act.
controlled by the government.
- issues certificate of incorporation to financial
- operate for a public purpose not to earn a
corporation, votes on and approves
profit
amendments thereto, discharges other
functions in connection with the licensing of b. Bank of currency issues and ultimate source
financing companies and investment houses, of money - note issue function for the country
and supervises and regulates their specific areas
- provide all the money the government
of operations.
requires
Major functions:
c. Banker’s Bank –maintaining accounts for
o Registration of securities other commercial banks
o Analysis of every registered security
d. Custodian of the country’s reserves of
o Evaluation of the financial condition and
foreign currencies –converting paper notes into
operations of applicants for security
metallic equivalent on demand
issue
o Screening of applications for broker’s or - Philippines - reserves are traditionally held in
dealer’s exchanges. US dollars
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- Plays a vital role in the growth and 4. Special Assistants Governor – 17 in all
development of the country. holding essentially top policy advisory positions
- Regulate monetary and credit
conditions of the country through
Five (5) Functional Sectors of the BSP:
effective use of its monetary tools.
- The only authorized government entity 1. Research Sector – entrusted with the
to print money preparation of data for the guidance of the
- Responsible for the proper Monetary Board
administration of the monetary banking
2. International Operations Sector –
credit system
- Provides policy directions in the areas of responsible for functions utilizing instruments
money, banking and credit. primarily at maintaining external monetary
- Has supervision over the operations of stability and liquidity and preserving the
banks and exercise regulatory powers convertibility of the peso.
over the operations of non-bank 3. Domestic Operations Sector – consists of the
financial institutions performing quasi- cash, loans and credits, and government
banking functions. securities departments
- Was created by RA 7653, otherwise
known as The New Central Bank Act; 4. Administrative Management Sector –
signed into law on June 14, 1993 composed of the accounting, administrative,
building maintenance, and building services
The Monetary Board: departments
- (7) members - term of six (6) years 5. Supervision and Examination Sector –
- The Governor – the CEO of the BSP and charged with the supervision and periodic
the Chair of the Monetary Board examination of all banking and non-bank
- Five (5) members from the private financial institutions performing quasi-banking
sector, serving full-time functions
- One member coming from the Cabinet
Units Directly Under the Supervision of the
Governor:
Guiding Principles of Monetary Administration:
A. Domestic-Monetary Stabilization – 1. General Counsel and Legal
attainment or maintenance of price stability 2. Security Plant Complex
3. Public Relations Office
B. International Monetary Stabilization - 4.
preserve the international value of the peso and
maintain its convertibility Organization of the Bangko Sentral ng Pilipinas:
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4. Credit availability: the greater the amount of
Chapter 2: Determinants of Interest Rates easily obtainable consumer credit the lower the
need to save.
Nominal interest rates - interest rates actually 5. Job security and belief in soundness of
observed in financial markets entitlements.
- Used to determine fair present value
and prices of securities. Determinants of Foreign Funds Invested in the
- Two components: U.S.
o Opportunity cost. 1. Relative interest rates and returns on global
o Adjustments for individual investments.
security characteristics. 2. Expected exchange rate changes.
Real Riskless Interest Rates 3. Safe haven status of U.S. investments.
- Additional purchasing power required 4. Foreign central bank investments in the U.S.
to forego current consumption
Demand for loanable funds - total net demand
LOANABLE FUNDS THEORY for funds by fund users (households, businesses,
- equilibrium interest rates in financial government and foreign participants)
markets as a result of the supply and - interest rate falls = higher demand of
demand for loanable funds loanable funds
- Categorizes financial market - cost of borrowing funds is lower
participants – e.g., consumers, - for businesses: greater profitable
businesses, governments, and foreign projects/better economic conditions =
participants – as net suppliers or greater demand for loanable funds
demanders of funds o high interest rates = businesses
prefer to finance investments
Supply of loanable funds - funds provided to through internally generated
the financial markets by net suppliers of funds funds
- interest rate increase = increase in
supply of loanable funds Equilibrium Interest Rate - interest rate that
- Supply from Households (consumer equates the aggregate quantity of loanable
sector): funds supplied with the aggregate quantity of
o Determined based on total loanable funds demanded for a financial
wealth and risk of securities security
investment; Immediate
spending needs Factors That Cause the Supply and Demand
Greater perceived risk = Curves for Loanable Funds to Shift
less investment
Supply of Funds
Determinants of Household Savings o Wealth
1. Interest rates and tax policy. o Risk
2. Income and wealth: the greater the wealth or o Near-Term Spending Needs
income, the greater the amount saved. o Monetary Expansion
3. Attitudes about saving versus borrowing. o Economic Conditions
Demand for Funds
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o Utility Derived from Assets o Higher default risk = higher
Purchased with Borrowed Funds interest rate demanded by
o Restrictiveness of Nonprice buyer
Conditions on Borrowed Funds. o Not all securities exhibit default
o Economic Conditions risk
o Default/Credit Risk premium
MOVEMENT OF INTEREST RATES OVER TIME DRPj = ijt - iTt
- equilibrium interest rate is only a ijt = interest rate on security
temporary equilibrium issued by a non-Treasury issuer
(issuer j) of maturity m at time
DETERMINANTS OF INTEREST RATES FOR t
INDIVIDUAL SECURITIES
Liquidity Risk —risk that a security can be
Factors Affecting Nominal Interest Rates sold at a predictable price with low
Inflation —the continual increase in the transaction costs at short notice.
price level of a basket of goods and o if a security is illiquid, investors
services. add a liquidity risk premium
o High inflation = high interest (LRP) to the interest rate on the
rates security
Inflation (IP) ; CPI (Consumer Price Index);
t = year Special Provisions —provisions (e.g.,
o IP = [(CPIt+1 - CPIt)/ CPIt] x 100 taxability, convertibility, and callability)
that impact the security holder
Real Risk-Free Interest Rate —nominal beneficially or adversely and as such are
interest rate that would exist on a security reflected in the interest rates on securities
if no inflation were expected. that contain such provisions.
o Higher time value of money or
rate of time preference to Term to Maturity —length of time a
consume today = higher real security has until maturity.
interest rate
Term structure of interest rates - A comparison
Fisher Effect (Irving Fisher) of market yields on securities, assuming all
characteristics except maturity are the same
i= RFR + Expected (IP)
Maturity premium (MP) - change in required
i= nominal interest rate interest rates as the maturity of a security
RFR = real risk-free interest rate changes
Expected (IP) = expected inflation rate
Unbiased Expectations Theory
- at a given point in time the yield curve
Default Risk —risk that a security issuer reflects the market’s current
will default on the security by missing an expectations of future short-term rates
interest or principal payment. - Current long-term interest rates (1RN )
are geometric averages of current and
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expected future, E(Nr1 ), short-term
interest rate
N = term to maturity
1R1 = actual current one-year rate today
Example:
Market Segmentation Theory
Individual investors and FIs have specific
maturity preferences.
Interest rates are determined by distinct
supply and demand conditions within many
maturity segments.
Investors and borrowers deviate from their
preferred maturity segment only when
adequately compensated to do so.
Example:
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- A single cash flow occurs at the
beginning and end of the investment
horizon with no other cash flows
exchanged. lump sum payment A single
cash flow occurs at the beginning and
Time Value of Money and Interest Rates end of the investment horizon with no
other cash flows exchanged.
Time value of money - basic notion that a dollar Annuity
received today is worth more than a dollar - A series of equal cash flows received at
received at some future date fixed intervals over the investment
horizon.
- Simple interest: interest earned on an
investment is not reinvested Present Value of a Lump Sum
- Compound interest: interest earned on - Discount future payments using current
an investment is reinvested, most interest rates to find the present value
common (PV)
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Future Value of a Lump Sum
- The future value (FV) of a lump sum
received at the beginning of the
investment horizon
- FVt = PV(1+r)t
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- Rate earned over a 12-month period
taking the compounding of interest into
account
EAR = (1+r)c – 1
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