FINANCIAL MARKETS – PRELIM REVIEWER
I. Introduction to Financial Market
What is a Financial Market?
- Markets and institutions are primary channels to allocate capital in our society
- Financial institutions will be the mediators
- Proper capital allocation leads to growth in societal health, income, economic opportunity
- Can be distinguished along two dimensions: primary markets vs. secondary markets and money
markets vs. capital markets
Primary Market Secondary Market
- Initial Public Offering (IPO) - Stock Market
- PAR Value - Anyone with the capacity
- First offer of company in public
Money Market Capital Market
- Most conservative form of market - Stocks and Bonds
- Consistent gains - Trade debts with maturities of more
- Debt securities with maturities of 1 than 1 year
year or less - Substantial risk of capital loss but high
- Little or no risk but law in return in return
Foreign Exchange Markets
- Trading of one currency to another
- Globally
- Most conservative among all markets
- Considered to be the most risky
Spot Foreign Exchange
- Price is the current market price
- Immediate exchange of currencies at current exchange rates
Forward Foreign Exchange
- Exchange of currencies in the future of a specific date and at a pre-specified exchange rate
Financial Market Regulator
- Securities Exchange Act of 1934
- Securities and Exchange Commissions is the main regulator of security markets
- To prevent fraud and risk
Financial Institutions (FIs)
- Institutions through which supplies channel money to the users of funds
- Distinguished by the following:
o Whether they accept insure deposits
o Deposits vs Non-depository financial institutions
o Whether they receive contractual payment from customers
Deposit FIs Non-Deposit FIs
- Commercial Banks Contractual
- Savings Associations - Insurance and Pension Funds
- Savings Bank Non – Contractual
- Credit Unions - Securities and Investment banks
- Mutual Funds
Globalization of Financial Market and Institutions
- The pool of savings from foreign investors is increasing and investors look to diversify globally now
than ever before
- Information on foreign markets and investments is becoming readily accessible and deregulation
across the globe is allowing even greater access to foreign markets
- Global capital flows are larger than ever
II. Structure of Interest Rates
Interest Rate
- Interest paid by the debtors (borrowers) for the use of money the borrowed from creditors (lenders)
- Interest rate risk is that an investment value will change due to changes in the interest rates
Five Components of Interest Rate
1. Real Risk Free Rate
2. Expected Inflation
3. Default Risk Premium
4. Liquidity Premium
5. Maturity Premium
Determinants of Interest Rate
Nominal Interest Rate or Money Interest Rate
- Observed in the Market Place
- Includes all 5 components in the computation
- Percentage increase in money
Real Interest Rate
- Measures percentage increase in purchasing power the lender receives when borrowing repays
the loan with interest
- Rate on the real risk free rate when no inflation is expected
BASIC EQUATION:
r = Real Rate (RR) + Inflation Premium (IP) + Default Risk Premium (DRP)
Average inflation rate expected over Compensation for the possibility or
life of the security failure to pay
BASIC EQUATION EXPANDED:
r = Real Rate (RR) + Inflation Premium (IP) + Default Risk Premium (DRP) + Maturity Risk Premium
(MRP) + Liquidity Premium (LP)
Expected by investors due to interest
Compensation for securities that
rate risk.
cannot be easily converted.
Longer maturity, higher interest rate
Serves as the strategy of the
company.
Types of Treasury Debt Obligation (Regulated by the Bureau of Treasury)
Treasury Bills Treasury Notes Treasury Bonds
- Short term - Long term - Obligations of any
- Obligations that bear the - Obligations issued for maturity but usually over
shortest original maturities of 1-10 years five years
maturities
Types of Inflation
Cost – Push Inflation Demand – Pull Inflation Speculative Inflation
- Occurs when prices are - Occurs during economic - Caused by the
raised to cover rising expansions when expectation that prices
production costs demand for goods and will continue to rise,
(Wages) services is greater than resulting in increased
- Increase in cost of sales, supply buying to avoid even
Increase in price - Prices will depend on higher future prices
occasion - No basis as per price
Interest Rate and its role in Finance
- Deals with funds which denote money
- Money lent or money borrowed has a cost, that is the interest rate
- Changes in interest rate affects the level of Investment spending, level of consumer expenditures,
redistribution of wealth, and prices of financial securities
- The interest rate on government securities like Treasury bills are used as a benchmark yield for all
securities because these are considered to be default – free.
III. Bond Valuation
Bond Valuation and its Importance
- Technique for determining the theoretical fair value of particular bond
Elements of a Bond
- Maturity Date
- Term
- PAR Value / Maturity Value / Face Value
- Interest Rate
FORMULAS:
