TOPIC 1: Introduction to Financial Markets • Forward FX - the exchange of currencies in the future

on a specific date and at a pre-specified exchange rate.

PRIMARY MARKET:
Derivative Security Market - a financial instrument whose
- where new securities are issued and sold for the first
value depends on, or is derived from, the value of another
time. (definition)
asset, known as the underlying asset.
- to enable issuers to raise funds for their operations,
expansions, or projects. (purpose) 1. Futures Contracts: standardized and traded on
- here are the issuers and investors who buy the new exchanges.
securities. (participants)
2. Options Contracts: provide the right, but not the
- occur directly between the issuer and the investors.
obligation, to buy or sell an asset at a specified price
(transactions)
within a specified period.
SECONDARY MARKET:
3. Swaps: agreements to exchange cash flows or other
- where previously issued securities are traded among financial instruments.
investors. It includes stock exchanges and over-the-
4. Forwards Contracts: customized contracts traded over-
counter markets. (definition)
the-counter (OTC) and not on exchanges.
- to provide liquidity and enable investors to buy and sell
existing securities. (purpose) Financial Market Regulation
- here are investors who buy and sell securities among
themselves. (participants) - The Philippine Stock Exchange, Inc. (PSE) is a self-
- occur between investors. The issuing company is not regulatory organization that provides and ensures a fair,
involved. (transactions) efficient, transparent and orderly market for the buying
and selling of securities. It also offers a convenient and
MONEY MARKET: efficient venue in raising capital to support the growth
of businesses.
- where short-term borrowing, lending, and trading of
financial instruments with maturities of one year or less Philippine Stock Exchange:
occur. (definition)
- to provide liquidity for the financial system and to - Enforce PSE Rules Governing Trading Rights and Trading
facilitate the management of short-term funding needs Participants on: (admission of PSE trading participants;
for financial institutions. (purpose) acquisition of trading right; commencement,
- treasury bills, commercial paper, certificates of deposit, suspension, and cessation of trading operations; and
repurchase agreements, and bankers' acceptances. appointment of nominee
(instruments) - Enforcement of Revised Trading Rules and other
- central bank, commercial banks, financial institutions, trading-related rules which do not require an audit of
corporations, and government entities. (participants) books and records or special information gathering.
- low-risk with low returns due to their short-term - Impose sanctions for violation of the above rules,
nature and high liquidity. (risk & return) including suspension.

CAPITAL MARKET: Capital Markets Integrity Corporation:

- where long-term securities, such as stocks and bonds, - Enforce and impose sanctions for violation of the
are issued and traded and have maturities of more than Revised Trading Rules and other trading-related rules
one year. (definition) which do not require an audit of books and records or
- to facilitate the raising of long-term capital for entities, special information gathering and also for violation of
and to provide investment opportunities for investors. SRC, SRC IRR, rules and directives of the SEC, PSE, and
(purpose) CMIC.
- stocks, corporate, and gov’t bonds, and long-term debt
Securities & Exchange Commission:
securities. (instruments)
- individual investors, institutional investors, investment - Review and affirm, modify, or set aside PSE’s and
banks, and corporations. (participants) CMIC’s decision.
- high-risk with high returns due to their long-term - Revoke licenses of trading participant, salesmen, and
nature. (risk & return) Associated Persons.
- Issue an order for the takeover of the operation of a
Foreign Exchange Market (FX Market) - a global
trading participant.
decentralized marketplace where currencies are traded.
Asset transformers have evolved to meet this need by
• Spot FX - the immediate exchange of currencies at
offering low risk claims to savers while granting higher risk,
current exchange rates.
more illiquid investments (loans) to the funds demanders.
Depository Institutions - offer liquid, government insured Factors of DRP: creditworthiness; debt structure; industry
claims to savers, such as demand deposits, savings deposits, risk; and economic condition.
time deposits, and share accounts.
Liquidity Premium - compensates investors for the risk
Non-depository Institutions – are life insurance companies, associated with holding an asset that may not be easily
casualty insurance companies, and pension funds. converted into cash without a significant loss in value.

LP = Yield on Less Liquid B - Yield on More Liquid B

TOPIC 2: Determinants of Interest Rates Factors of LP: trading volume; market conditions; bid-ask
spread; and issuer’s reputation.
Interest Rate - the cost of borrowing money or the return
on invested capital. r n =√ ( 1+ r 1 )( 1+ r 2 ) …(1+r n )
n

 Nominal Interest Rate: stated rate on a loan or

Maturity Risk Premium - compensates investors for the
investment, not adjusted for inflation.
increased risk associated with holding longer-term
 Real Interest Rate: rate adjusted for inflation, reflecting securities.
the true cost of borrowing or real return.
MRP = Yield on 10-year bond − Yield on 1-year bond
 Fixed Interest Rate: An interest rate that remains
Factors of MRP: interest risk rate; reinvestment risk;
constant over the life of the loan or investment.
inflation risk; and economic & political uncertainty.
 Variable Interest Rate: rate that can change over time
MRPt = maturity risk rate (t - 1)
based on market conditions or an index.
Special Provision - unique features or clauses in a bond or
Functions of Interest Rate:
other debt instrument that can affect the interest rate.
o Cost of Borrowing
Unbiased Expectation Theory - a theory in finance that
o Return on Investment attempts to explain the term structure of interest rates.

o Economic Indicator (1 + in)n = (1 + i1)(1 + E[i1,n])

Uses of Interest Rate: Implied Forward Rate:

o Loans and Mortgages f N =¿

o Savings and Investments

o Monetary Policy TOPIC 3: Interest Rates & Security Valuation

 Coupon rate - periodic cash flow a bond issuer

contractually promises to pay a bond holder (interest).
DETERMINANTS OF INTEREST RATE:
 Required rate of return (r) - rates used by individual
r = r* + IP + DRP + LP + MRP + SP market participants to calculate fair present values
(PV).
Real-Risk Free Rate - benchmark rate set by central banks,
serving as a foundation for other interest rates. ~
C F1
PV =
RFR = i – Expected (IP) ¿¿
Inflation Premium - part of the prevailing interest rates that  Expected rate of return or E(r) - rates participants
results from lenders compensating for expected inflation by would earn by buying securities at current market
pushing nominal interest rates to higher levels. prices (P).
~
Fisher Equation: (1+i) = (1+r*)(1+π) C F1
P=
N
¿¿
∑ INFLt  Realized rate of return (r ) - rate actually earned on
t −1
IP= investments. It equates the actual purchase price ( P )
N to the PV of the realized cash flows (RCFt).
Default Risk Premium - compensates investors for the risk
RC F1
that a borrower might default on their debt obligations. P=
¿¿
DRP = Yield on Corp bond − Yield on Treas Bond  Present Value of Bond
V b=
INT
2
¿ ΔP
P
=−Dur
Δr
[ ]
1
+ CX ¿
1+r 2
Premium bond - has a coupon rate (INT) greater than the
required rate of return (r); and the fair present value of the
bond (Vb) is greater than the face or par value (Par).

Premium bond: If INT > r; then Vb > Par TOPIC 5: Money Market

Discount bond: if INT < r, then Vb < Par Money market - is a place where short-term debt securities
are issued. It involves debt instruments with original
Par bond: if INT = r, then Vb = Par maturities of one year or less.
 Present Value of Stock (zero growth):

P t = D / rs

 Present Value of Stock (constant growth):

∞
Pt =∑ D 0 ¿ ¿ ¿
t=1

 Return on Stock (zero dividend growth):

r s=D/ P0
 Return on Stock (constant dividend growth):

D 0 (1+ g) D
r s= + g= 1 + g
P0 P0
Duration - is the weighted-average time to maturity
(measured in years) on a financial security. It measures the
sensitivity (or elasticity) of a fixed-income security’s price to
small interest rate changes.
T
C F t ×t
Dur=∑ ¿¿
t =1
¿¿

Closed-Form Duration:

Dur=N −
{INT
(P 0 × r)
× [ N−((1+ r)× PVIF Ar , N ) ]
}
 PVIFA r,N =1−¿ ¿
Percentage Change:

ΔP
P
=−Dur
Δr
1+r [ ]
Modified Duration:

Du r Annual
Du r Mod=
(1+ r period )
Price Change using Modified Duration:

ΔP
=−Du r Mod × Δ r annual
P
Convexity (CX) - measures the change in slope of the price-
yield curve around interest rate level R