OVERVIEW

Financial Markets is the marketplace where investors go to raise money to grow their
businesses. It is the avenue where the sale, purchase, creation and trading of financial
instruments occur such as shares, bonds, derivatives, debentures, currencies, and the like. The
trading of the securities occurs in the stock market, forex market, derivative market or bond
market. It plays a crucial role in a country’s economy.

Watch:
What is financial market?
https://youtu.be/bqd7WXbiOt0

MODULE 1. INTRODUCTION TO FINANCIAL SYSTEM AND FINANCIAL MARKET

OBJECTIVES
After successful completion of this module, you should be able to:
• Describe the elements of financial systems, particularly the financial market
• Describe the importance of financial market in maximizing firms profit and wealth
• Differentiate the different types of financial markets

COURSE MATERIALS
NATURE AND IMPORTANCE OF FINANCIAL SYSTEM
Finance
Basically, finance represents money management and the process of acquiring needed
funds. It is the lifeblood of the business for continuity of business operations.

Finance is the application of economic principles to decision making that involves the
allocation of money under conditions of uncertainty. It is how funds are obtained and then how
this will be invested to make money.

There are two functions in a financial management:

1. Accounting – this is the goal of employees to maximize profit for their benefits, driven my
rewards and promotions
2. Finance – the goal is to maximize wealth of the owners. The OWNERS ultimate goal Is to
maximize wealth that is why they enter into the financial markets.

Sources of wealth:
1. Capital assets which may be money to earn interest
2. Capital assets which can be land or building to earn rent
3. Labor/profession in order to earn wages/salaries/fees

Flow of funds:
Direct financing – where borrowers/spenders deals directly from lenders thru financial instruments
or securities.

Indirect financing – where borrowers and lenders transact thru intermediaries.

 INDIRECT FINANCING

Financial
Intermediaries
FUNDS FUNDS

FINANCIAL
Lenders/Savers FUNDS FUNDS Borrowers/Spenders
MARKETS

DIRECT FINANCING

ELEMENTS OF FINANCIAL SYSTEM

1. Lenders and borrowers – the players
2. Financial intermediaries – how it will occur
- Special type of financial entity that acts as the third party to facilitate the borrowing
activities between borrowers and lenders.
3. Financial instruments- what will be used
- Medium of exchange of contractual obligation which can be traded (tangible of
intangible)
- Can be:
➢ cash or
➢ derivative (A derivative is a financial security with a value that is reliant upon or
derived from, an underlying asset or group of assets—a benchmark. The
derivative itself is a contract between two or more parties, and the derivative
derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes. These assets are
commonly purchased through brokerages.
4. Financial markets – the place of trading
- Money market for cash financial instruments
- Capital market for derivative financial instruments
5. Regulatory control environment – controller of trading activities
- Involves different businesses and financial risks
- Regulated by the central bank
6. Money creation – the value created
7. Price discovery- how much is created
- It is the process of determining or valuing the financial instrument in the market. The
price is driven by risks, high risk high return, low risk low return.
Financial Market refers to channels or places where funds and financial instruments such as
stocks, bonds and other securities are exchanged between willing individuals or entities.

TYPES OF FINANCIAL MARKET

Based on instruments traded

a. Money Market – this is the sector of the financial market where financial instruments that
will mature or be redeemed in one year or less from issuance date are traded.

Why do companies deal with money market?

- Cash requirements of entities do not coincide with their cash receipts (borrowers)
- Fund providers generates opportunity cost in the form of foregone interests by
investing excess cash in financial instruments that can quickly be converted to cash
when needed with minimal risk (lenders)

b. Capital market – this is the sector in the financial market where financial instruments
issued by government and corporations that will mature beyond one year from issuance
date are traded.

There are two types: (1) equity (share certificate) or (2) debt (PN, bonds)

Based on Market Type

a. Primary Market – this is the financial market wherein fund demanders like corporation or
government agencies raise funds through new issuances of financial instruments (bonds
or stocks).
Why?
- normally to finance new projects or expansions.
How?
- Coursed thru investment banks as intermediary.
Who?
- Borrowers are fund demanders and lenders are fund providers.

Four types of issue methods

1. Public offering – the issuer offers for subscription or sale to general public
2. Private placement -the issuer looks for single investor to purchase the whole
securities issuance than to general public
3. Auction – this is another offering to general public on treasury bills, bonds and
other securities issued by the govt.
4. Tap issue – this happens when issuer is open to receive bids for their
securities at all times. Issuers maintain the right to accept or reject the bid
prices.

b. Secondary Market – this is where securities issued in the primary market are
subsequently traded (resold and repurchased – second hand).

Who are the players?

- Securities brokers are facilitators
- Sellers are demanders and buyers are funds providers
 PRIMARY MARKET
Money

LENDERS BORROWERS THE DIFFERENCE

Securities
SECONDARY MARKET
Money

THE DIFFERENCE BUYERS SELLERS

Securities

ACTIVITIES/ASSESSMENTS
Answer the following Exercises

Exercise No. Mod 1-1 (Case Study)

Property Corporation requires funds for its inventory, payment of salaries and wages, payment of
utilities and other monthly operating costs.

a). You are to suggest which financial market; the company may approach and why?
b). Discuss the financial instruments to raise in this requirement.

Exercise No. Mod 1-2 (Case Study)

Incorporated in 2000, Dairy Corporation is one of the leading manufacturers and marketers of
dairy-based branded foods in India. In the initial years, its operation was restricted only to
collection restricted only to collection and distribution of milk. But, over the years it has gained a
reasonable market share by offering a diverse range of dairy based products including fresh milk,
flavored yogurt, ice creams, butter milk, cheese, ghee, milk powders etc. In order to raise capital
to finance its expansion plans. Dairy Corporation has decided to approach capital market through
a mix of Offer for sale and a public issue of shares.

a). Name and explain the types of financial market being approached by the company.
b). Identify the possible financial instruments to be raised for this.

Exercise No. Mod 1-3 (Case Study)

Gabriel won a cash prize of Php 20,000 in the National level Robotics Competition. On the advice
of his father, he visits a nearby bank to open a Fixed deposit account in his name with the prize
money. His sister Heart accompanied him to the bank. On reaching the bank, he notices big
banners which are placed within the premises containing information about the various
arrangements through which corporates may raise their capital through the bank. Being a finance
graduate, Heart explains to Gabriel that banks play the role of the financial intermediary by helping
in the process of channelizing the savings of the households into the most profitable business
ventures.
a). Aside from the bank, suggest other financial intermediaries that help in the process of
channelizing the savings of the households into the most productive to use.
b). Identify the functions of those financial intermediaries that you will be suggesting

Exercise No. Mod 1-4 (True or False)

1). Financial system is a set of arrangements or conventions embracing the lending and borrowing
of funds by non-financial economic units and the intermediation of this function by financial
intermediaries in order to facilitate the transfer of funds, to create additional money when required,
and to create markets in debt and equity instruments including their derivatives so that the price
and allocation of funds are determined efficiently.

2). Financial system is composed of network of inter-related systems of financial markets,

intermediaries and services.

3). Funds can flow from lender-savers to the borrower-spenders in two routes: via direct financing
or indirect financing

4). In direct financing, the borrowing activity between both parties still happens though indirectly
through the intervention of a financial intermediary.

5). In indirect financing, the borrower-spenders borrow and deal directly with lenders through
selling financial instruments (or securities).

6). Lenders and Borrowers are also known as fund demanders and fund providers, respectively

7). Financial intermediary are special type of financial entity that acts as a third party to facilitate
the borrowing activity between lenders and borrowers

8). Financial instruments are medium of exchange of contractual obligation of a party, where such
contract can be traded

9). Financial Markets is same with the other economic markets where suppliers and buyers of
financial instruments meet.

10). Regulatory environment is the governance body to ensure that the transactions that occur
within the financial systems complies with the laws and regulations imposed to the actors as well
as the elements that plays within the system.

11). Capital market is the sector of the financial system where financial instruments that will
mature or be redeemed in one year or less from issuance date are traded.

12). Money market is the sector of the financial markets where financial instruments issued by
governments and corporations that will mature beyond one year from issuance date (long-term)
are traded.
13). Capital market securities are classified into two: equity (which represent ownership interest)
and debt.

14). Primary market is a type of financial market wherein fund demanders such as corporation or
a government agency raise funds through new issuances of financial instruments e.g. bonds and
stocks.

15). Tap Issue is usually used for issuance of treasury bills, bonds and other securities issued by
the government and are commonly executed exclusively with market makers. Auction is a method
that

Exercise No. Mod 1-5 (Multiple Choice)

1). Which if the following is not a source of wealth
a. labor
b. capital
c. wages (This is technically form of wealth under labor not source of wealth)
d. entrepreneurship

2). Which of the following is not correct about Financial System?

a. Financial system is a set of arrangements embracing the lending and borrowing of funds
by non-financial economic units and the intermediation of this function by financial intermediaries
in order to facilitate the transfer of funds, to create additional money when required, and to create
markets in debt and equity instruments so that the price and valuation of funds are determined
effectively. (...the price and valuation of funds are determined efficiently not effectively).
b. Financial system allows households, companies and the government who have available
funds to invest these funds in more potentially productive vehicles that can result in faster growth
in the economy.
c. A properly functioning financial system also enhances welfare of individual consumers as
they have immediate access to funds allowing them to purchase things as they prefer.
d. The financial system encourages fund savings from its stakeholders and transform these
savings efficiently into investment vehicles that help the economy grow faster.

3). In this route of fund flows, the borrower-spenders borrow and deal directly with lenders through
selling financial instruments (or securities).
a. Indirect Financing b. Direct Financing c. Indirect Funding d. Direct Funding

4). In this route of fund flows, the borrowing activity between both parties still happens though
indirectly through the intervention of a financial intermediary.
a. Indirect Financing b. Direct Financing c. Indirect Funding d. Direct Funding

5). Which of the following is not an element of the Financial System

a. Financial Market
b. Financial Intermediaries
c. Financial Instruments
d. Regulatory Compliance (Regulatory Environment)

6). Which of the following is not correct about Financial Market?

 a. Financial markets help in creating more efficient allocation of capital which results in higher
production and efficient that ultimately leads to economic growth.
b. Financial market refers precisely to the physical venue where funds and financial
instruments such as stocks, bonds and other securities are exchanged between willing individuals
and/or entities e.g. Philippine Stocks Exchange and Philippine Dealings and Exchange. (Not
precisely a physical venue since it includes channels as well)
c. Participants in the financial markets include ultimate lenders and borrowers such as
household, government and businesses, financial intermediaries, broker and dealers, regulators,
fund managers and financial exchanges.
d. The main economic function of the financial markets is to serve as a channel to transfer
excess funds from fund providers to fund demanders.

7). The sector of the financial system where financial instruments that will mature or be redeemed
in one year or less from issuance date are traded.
a. Current or Short-term Market b. Debt Market c. Money Market d. Long term Market

8). The sector of the financial markets where financial instruments issued by governments and
corporations that will mature beyond one year from issuance date (long-term) are traded.
a. Long term Market b. Stock Market c. Debt Market d. Capital Market

9). Market wherein fund demanders such as corporation or a government agency raise funds
through new issuances of financial instruments e.g. bonds and stocks.
a. New Market b. Internal Market c. Initial Public Offering Market d. Primary Market

10). Private companies who will sell shares to the general public for the very first time is said to
undergo an
a. Public Market Offering b. Initial Public Offering c. New Market Issuance
d. Primary Market Offering

11). This refers to the market wherein the securities issued in primary market are subsequently
traded
a. Primary market b. Secondary market c. Consequent Market d. Trading Market

12). Which of the following is not an economic function of Secondary Market

a. Price discovery
b. Liquidity and reduction in borrowing costs
c. Support to Primary market
d. Implementation of fiscal policy (Monetary policy)

13). The market structure where the buyers and sellers propose their price through their brokers
who conveys the bid in a centralized location.
a. Secondary market
b. Order Driven market (Type of secondary market)
c. Quote Driven market
d. Auction
14). This refers to the market where issuers who are considered residents in a country that issues
securities and where these securities are traded afterwards.
a. Internal/National Market
b. Domestic Market (Type of Internal/National Market)
c. Foreign Market
d. Resident Market

15). This refers to the market where issuers who are not residents of a country can sell or issue
securities and subsequently traded.
a. Internal/National Market
b. Domestic Market
c. Foreign Market (Type of Internal/National Market)
d. Non-Resident Market
 MODULE 2. PHILIPPINE FINANCIAL SYSTEM

OBJECTIVES
After successful completion of this module, you should be able to:
• Describe the role of Bangko Sentral ng Pilipinas in the Financial Market
• Describe the evolution of currency and instruments used in financial markets
• Set their personal target of inflation based on the information made available to them
• Correlate the roles of different agencies in the financial market environment

COURSE MATERIALS

Financial regulation is a type of regulation whereby rules and standards (controls over
the market factors) were set to oversight the ability of the companies to establish and maintain
appropriate level of capital to sustain its operations.

Market Drivers being regulated

1. Competitiveness
2. Market behavior (integrity on companies’ activities and representation)
3. Consistency (information disclosures and policies)
4. Stability (govt mitigate market risks to protect the interests of the clients)

Financial activity regulation is the setting up of standards, control and order on the financial
activities regardless of the source.

Regulatory Bodies
These regulatory bodies correlate each roles in the financial environment.

• Bangko Sentral ng Pilipinas

Its function is to:
1. Liquidity management
2. Currency issues
3. Lender of last resort
4. Financial supervision
5. Management of foreign currency reserves
6. Determination of exchange rate policy

The BSP Law establishes the Bangko Sentral ng Pilipinas (“BSP”), its
organizational set-up, responsibilities, corporate authorities, key operational procedures,
and special powers over banks. It then defines the key roles of the BSP, namely: (a) as a
central monetary authority with the sole power to issue currency and legal tender and to
regulate the supply of money and credit in the system; (b) as government banker with the
power to represent the national government in all dealings with international financial
institutions; and (c) as a central bank with regulatory and supervisory power over all banks
and financial institutions exercising quasi-banking functions.

To provide the BSP with the reports they need, you need to have detailed
information about your operations and your portfolio. The reports you must submit range
from your balance sheet to more specific reports like an ageing analysis of your non-
 performing loans (NPLs) by economic activity. For many of the required reports, you must
provide detailed classification.

• Insurance Commission
This is mandated by Exec Order 192 s. 2015 to ensure enforcement of Republic Act
10607 – Insurance Code Its function is to regulate and supervise the insurance, pre-need
and health maintenance organization industry.

• Securities and Exchange Commission (SEC)

This agency is tasked to administer oversight on the corporate sector, capital market
participants and securities and investment instruments and promote corporate
governance.

• Bureau of Investment (BOI)

This is the lead agency to promote investment in country and thereby generate local
and foreign investment in the country. This is an attached agency of the DTI. It provides
advisory, actualization and post services to the investors.

MONETARY POLICY
Monetary policy is the monitoring and control of money supply by a central bank – this is
undertaken by the Bangko Sentral ng Pilipinas in the Philippines. This is used by the government
to be able to control inflation and stabilize currency.

Monetary Policy is considered to be one of the two ways that the government can influence
the economy – the other one being Fiscal Policy (which makes use of government spending, and
taxes).

Monetary Policy is generally the process by which the central bank, or government
controls the supply and availability of money, the cost of money, and the rate of interest.

Money Supply and Payment System

The financial system is an interrelated financial process which fueled by money. Money
supply is the availability of financial resources for deployment in the financial system. The
monetary demand in the market is managed by BSP. Money will take the form of the following:
• Cash (coins and bills)
• Demand deposits
• Other financial instruments

Money is expected to be regulated to enable the sovereign to have control to its economy.
For a monetary policy to be appropriate or effective, the BSP must ensure the following are
present:
• Alignment to the target goals
• Access to information
• Responsiveness of the variable set

The BSP under RA 7653 has the sole power to issue currencies. The management of the
note and coins rests with the local banks. The local banks must observe the following:
 • Banks shall classify their cash deposits and sort by series and by denomination,
by being fir or clean notes or dirty or unclean notes.
• Banks should provide securely sealed bags or containers for fit and dirty notes
which should be properly labelled.
• Banks’ deposits shall be packed ins sealed bags or containers in standard quantity
of twenty (20) full bundles per denomination.
• Banks located in the provinces may make direct deposits of currencies to the
nearest BSP regional/branch or shipped to the BSP in Manila if none.
• Coins shall also be sorted as the notes and must be free from adhesive tapes.

Purchasing Power
The purchasing power is practically based on the consumer price index. The Consumer
Price Index (CPI) is the weighted average value of the basket of prices of all commodities
representing the market. The degree of movement of the CPI from a period to another is called
inflation rate.

There are two types of inflation rate:

• Core inflation – used for most of the economic estimates where it excludes in the equation
the movement of the commodities or incidents with very volatile movements.
• Headline inflation – captures the changes of the cost of living based on the movement of
the basket or commodities as a whole.

Payment System
The payment system is a set of interrelated processes of settlement of goods or services
rendered in exchange for a set of instruments that will undergo either a banking or non-banking
procedures. This requires the following:
• Standard methods of transmitting payment messages within the system
• Agreed means of settlement
• Common operating procedures and rules, e.g. admission, fees and operating
hours

History of Philippine Currencies and Notes

Source: http://www.bsp.gov.ph/bspnotes/hist_curr.asp

Philippine money–multi-colored threads woven into the fabric of our social, political and
economic life. From its early bead-like form to the paper notes and coins that we know today,
our money has been a constant reminder of our journey through centuries as a people relating
with one another and with other peoples of the world.
 Pre-Hispanic Era

Long before the Spaniards

came to the Philippines in 1521, the
Filipinos had established trade
relations with neighboring lands like
China, Java, Borneo, Thailand and
other settlements. Barter was a
system of trading commonly
practiced throughout the world and
adopted by the Philippines. The
inconvenience of the barter system
led to the adoption of a specific
medium of exchange – the cowry
shells. Cowries produced in gold,
jade, quartz and wood became the
most common and acceptable form
of money through many centuries.

The Philippines is naturally rich

in gold. It was used in ancient times
for barter rings, personal adornment,
jewelry, and the first local form of
coinage called Piloncitos. These had
a flat base that bore an embossed
inscription of the letters “MA” or “M”
similar to the Javanese script of the
11th century. It is believed that this
inscription was the name by which
the Philippines was known to
Chinese traders during the pre-
Spanish time.

Barter rings made from pure

gold, were hand-fashioned by early
Filipinos during the 11th and the
14th centuries. These were used in
trading with the Chinese and other
neighboring countries together with
the metal gongs and other
ornaments made of gold, silver and
copper.
 Spanish Era
1521-1897

The cobs or macuquinas of

colonial mints were the earliest coins
brought in by the galleons from
Mexico and other Spanish
colonies. These silver coins usually
bore a cross on one side and the
Spanish royal coat-of-arms on the
other.

The Spanish dos mundos were

circulated extensively not only in the
Philippines but the world over from
1732-1772. Treasured for its beauty
of design, the coin features twin
crowned globes representing
Spanish rule over the Old and the
New World, hence the name “two
worlds.” It is also known as the
Mexican Pillar Dollar or the
Columnarias due to the two columns
flanking the globes.

Due to the shortage of fractional

coins, the barrillas, were struck in the
Philippines by order of the Spanish
government. These were the first
crude copper or bronze coins locally
produced in the Philippines. The
Filipino term “barya,” referring to
small change, had its origin in
barrilla.

In the early part of the 19th

century, most of the Spanish colonies
in Central and South America
revolted and declared independence
from Spain. They issued silver coins
bearing revolutionary slogans and
symbols which reached the
Philippines. The Spanish
government officials in the islands
were fearful that the seditious
markings would incite Filipinos to
rebellion. Thus they removed the
inscriptions by counter stamping the
coins with the word F7 or YII. Silver
coins with the profile of young
Alfonso XIII were the last coins
minted in Spain. The pesos fuertes,
issued by the country’s first bank, the
El Banco Español Filipino de Isabel
II, were the first paper money
circulated in the Philippines.

Revolutionary Period
1898-1899

General Emilio Aguinaldo, the

first Philippine president, was vested
with the authority to produce
currencies under the Malolos
Constitution of 1898. At the Malolos
arsenal, two types of two-centavo
coppercoins were
struck. Revolutionary
banknotes were printed in
denominations of 1,5 and 10 Pesos.
These were handsigned by Pedro
Paterno, Mariano Limjap and
Telesforo Chuidian. With the
surrender of General Aguinaldo to the
Americans, the currencies were
withdrawn from circulation and
declared illegal currency.
 American Period
1900-1941

With the coming of the

Americans 1898, modern banking,
currency and credit systems were
instituted making the Philippines one
of the most prosperous countries in
East Asia. The monetary system for
the Philippines was based on gold
and pegged the Philippine peso to
the American dollar at the ratio of
2:1. The US Congress approved the
Coinage Act for the Philippines in
1903.

The coins issued under the

system bore the designs of Filipino
engraver and artist, Melecio
Figueroa. Coins in denomination of
one-half centavo to one peso were
minted. The renaming of El Banco
Espanol Filipino to Bank of the
Philippine Islands in 1912 paved the
way for the use of English from
Spanish in all notes and coins issued
up to 1933. Beginning May 1918,
treasury certificates replaced
the silver certificates series, and a
one-peso note was added.
 The Japanese Occupation
1942-1945

The outbreak of World War II

caused serious disturbances in the
Philippine monetary system. Two
kinds of notes circulated in the
country during this period. The
Japanese Occupation Forces issued
war notes in big denominations.
Provinces and municipalities, on the
other hand, issued their own guerrilla
notes or resistance currencies, most
of which were sanctioned by the
Philippine government in-exile, and
partially redeemed after the war.

The Philippine Republic

A nation in command of its

destiny is the message reflected in
the evolution of Philippine money
under the Philippine Republic.
Having gained independence from
the United States following the end
of World War II, the country used as
currency old treasury certificates
overprinted with the word "Victory".

With the establishment of the

Central Bank of the Philippines in
1949, the first currencies issued
were the English series notes
printed by the Thomas de la Rue &
Co., Ltd. in England and the coins
minted at the US Bureau of Mint.
The Filipinization of the Republic
coins and paper money began in the
late 60's and is carried through to the
present. In the 70's, the Ang Bagong
Lipunan (ABL) series notes were
circulated, which were printed at the
Security Printing Plant starting 1978.
A new wave of change swept
through the Philippine coinage
 system with the flora and fauna
coins initially issued in 1983. These
series featured national heroes and
species of flora and fauna. The new
design series of banknotes issued in
1985 replaced the ABL series. Ten
years later, a new set of coins and
notes were issued carrying the logo
of the Bangko Sentral ng Pilipinas.

As the repository and custodian

of country's numismatic heritage, the
Museo ng Bangko Sentral ng
Pilipinas collects, studies and
preserves coins, paper notes,
medals, artifacts and monetary
items found in the Philippines during
the different historical periods. It
features a visual narration of the
development of the Philippine
economy parallel to the evolution of
its currency.

ACTIVITIES/ASSESSMENTS
Answer the following exercises

Exercise No. Mod 2-1 (Essay)

Give a brief summary of your learnings on the Philippine financial system.

Exercise No. Mod 2-2 (True or False)

1). Every country must implement its regulatory system to ensure controls and governance.

2). Regulation was designed to set rules and guidelines to be followed that is designed to ensure
balance among the individuals, firms and/or citizens as the case maybe.

3). Financial regulation is a type of regulation whereby rules and standards were set to oversight
the ability of the companies to establish and maintain appropriate level of capital to sustain its
operation. It also includes setting controls over the market factors that will affect the financial
sustainability of the firms and players in the industry.

4). Financial sector has an important role in shaping the overall economy of a country hence it is
a must that this must not be regulated.

5). Government role is to set standards to regulate and ensure that information provided in the
market are fair, consistent, and conservative.

6). Market stability is an external and fatal factor to be considered by the firms in the financial
market.
7). Financial Activities has been referred to activities that deals on funding certain transaction or
expenditures. In the financial market, the financial activities are focused on the trading of
securities and financial instruments.

8). Setting rules to set standards, control and order on the financial activities, regardless of the
source, is called as financial activity regulation.

9). The Bangko Sentral ng Pilipino is created under the New Central Bank Act or Republic Act
7653 and an attached agency of the Department of Finance. Under the Philippine law, this will
act as the central monetary authority which will act as a corporate body that is responsible
concerning money, banking and credit.

10). Assurance Commission mandated by virtue of Executive Order No. 192 s. 2015 to ensure
enforcement of the provisions of the Insurance Code or Republic Act 10607, i.e. to regulate and
supervise the insurance, pre-need, and health maintenance organization industry. It is governed
by Department of Finance that supervises and regulates the operations of life and non-life
companies, mutual benefit associations, and trusts for charitable uses.

11). The Securities and Exchange Commission is the national government regulatory agency to
administer oversight on the corporate sector, capital market participants and securities and
investment instrument and promote corporate governance over these. It was created on October
26, 1936 under the Commonwealth Act No. 83.

12). Philippine Economic Zone Authority is the lead agency to promote investment in country and
thereby generate local and foreign investment in the country. It is an attached an agency of the
Department of Trade and Industry. The agency provides advisory, actualization and post services
to the investors.

13). Money supply is the availability of financial resources for deployment in the financial system.
It is making the money available for use or for trade or investment.

14. Money is expected to be regulated somehow to enable the sovereign to have control to its
economy.

15. The central bank, BSP for the case of the Philippines, is authorized by the republic under R.A.
7653 that they have the sole power to issue currency, within the territory of the Philippines. Given
it is a sole authority, no one is allowed to issue or reproduce any document or object for general
monetary circulation.

16). The purchasing power is practically based on the consumer price index. In economics, the
consumer price index or CPI is the weighted average value of the basket of prices of all
commodities representing the market.

17). There are two types of inflation: the core inflation and headline inflation.

18). Per the BSP, headline inflation is used for most of the economic estimates where it excludes
in the equation the movement of the commodities or incidents with very volatile movement or
outliers.

19). Core inflation on the other hand captures the changes of the cost of living based on the
movement of the basket of commodities as a whole.
20). The payment system is a set of interrelated processes of settlement of goods or services
rendered in exchange for a set of instruments that will undergo either a banking or non-banking
procedures.
 MODULE 3. MANAGING THE CREDIT RISK IN MONEY MARKET

OBJECTIVES
After successful completion of this module, you should be able to:
• Identify the different levels and methods of rating entities
• Make recommendation on the results of liquidity and solvency
• Understand how to improve value of collaterals

COURSE MATERIALS
Credit risk is a business risk that a lender bears when a borrower fails to pay his
obligations.

Credit Information Systems is dedicated to providing the best credit reporting, appraisal
management and lending risk mitigation products with unequaled service. Credit Information
Systems brings Information, Technology, and Compliance together to serve the customers in this
rapidly changing regulatory environment.

In the Philippines, RA No. 9510 was enacted in Oct. 31, 2008 establishing the credit
information system.

CREDIT RATING
This is a driver of the interest rate or risk consideration that affects the confidence level of
the investors.

These are determined by companies that are recognized globally that objectively assigns
or evaluates countries and companies based on the riskiness of doing business with them.

The riskiness is primarily driven by the ability of the country or company to manage their
liquidity and solvency in the long run. The higher the grade is, the lower is the default risk.

The following are the three major rating companies:

a). Standard and Poor’s Corporation (S&P) – founded in 1941 by Henry Varnum Poor
to assess credit worthiness of an industry

b). Moody’s Investors Service (Moody) – founded in 1909 is aimed to provide credit
rating on debt securities.

c). Fitch Ratings – founded in 1914 and owned by Hearst, provides credit opinions
based on the credit expectations on certain quantitative and qualitative factors that drive
a company.

Interest Rates
Economic Theories That Affect the Term Structure of Interest Rates
1). Expectation theories > interest rates are driven by the expectation of the lenders or
borrowers in the risks of the market in the future.
- Pure expectation theory based in statistical and current data analysis
- Biased expectation theory – considers other factors that affect the term structure
of the loans as well as the interest rates to be perceived. (biased estimate over the
market behavior in the future).
 2). Market segmentation theory > assumes that the driver of the interest rates are the
saving and investment flows.

BSP defines interest rates to be a type of price which will compensate the risk of allowing
the finances to flow into the financial system. For lender – investment return for borrower – cost
of debt.

What is Cost of Debt?

Cost of debt refers to the effective rate a company pays on its current debt. It refers to
after-tax cost of debt, but it also means the company's cost of debt before taking taxes into
account. The difference in cost of debt before and after taxes lies in the fact that interest expenses
are deductible.

Cost of debt formula is: Cost of Debt = Interest Expense (1 – Tax Rate)

Example:
A company named Viz Pvt. Ltd took loan of $200,000 from a Bank at the rate of interest
of 8% to issue company bond of $200,000. Based on the loan amount and rate of interest, interest
expense will be $16,000 and the tax rate is 30%.

Cost of Debt = $16,000(1-30%)

Cost of Debt = $16000(0.7)
Cost of Debt = $11,200
Cost of debt of the company is $11,200.

What is a risk-free rate of return?

The risk-free rate of return is the theoretical rate of return of an investment with zero risk.
The risk-free rate represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time.

Formula:
Rfr = Rf less inflation rate
Example:

Mr. A wants to borrow funds from B. The risk free rate is 6% and current inflation is 2%. It
is expected that the inflation is expected to grow at 3%. B finds a relevant margin of 4% on the
loan.

Risk free rate is 6% - 2% = 4%

New nominal risk free rate is 4% + 3% = 7%
Interest rate for the loan will be 7% + 4% = 11%

It’s up for Mr. A to evaluate whether to borrow or source another financing institution that
offers lower interest rate.

Risks
In commerce, risk is a very important factor to consider that may drives the business up
or down. Risks relates to the volatility patterns in the business.
There are risks that are inherent in every financing transaction:
Default risk
This arises on the inability to make consistent payments. This type of risk may be
quantified by determining the probability of the borrower to default in their payments in the duration
of the loan.

Liquidity risk
This risk focuses on the entire liquidity of the company or its ability to service its current
portion of their debt as it becomes due.

Legal risk
This risk will arise only upon the ability of any of the parties (lender or borrower) to comply
with the covenants in the contract.

Market risk
Market risk is the impact of the market drivers to the ability of the borrowers to settle the
obligation. This is classified as a systematic risk because it arises from external forces or based
on the movement of the industry.

Mitigating the Interest Rate Risks

Since the interest rate is dependent on the inflation, tenor and other market risks,
companies should consider and make reasonable estimat4s to mitigate these risks.

Some measures to mitigate risks maybe considered:

Spot rates
This is an interest rate that is available or applicable for a particular time. Spot rate maybe
used to mitigate the risk by referring to historical yield vis-à-vis the forces that occur in those times.

Forward rates
These are normally contracted rates that fixed the rates and allow the party to assume
such risk on the difference between the contracted rate and the spot rate.

Swap rate
This is another contract rate where a fixed rate exchanges for a certain market rate at a
certain maturity.

What are Basis Points (BPS)?

In finance, Basis Points (BPS) are a unit of measurement equal to 1/100th of 1 percent.
BPS are used for measuring interest rates, the yield of a fixed-income security, and other
percentages or rates used in finance.

This metric is commonly used for loans and bonds to signify percentage changes or yield
spreads in financial instruments, especially when the difference in material interest rates is less
than one percent per year.
 One basis point is equal to .01 percent or 1/100th of 1 percent. The succeeding points
move up gradually to 100%, which equals 10000 basis points, as illustrated in the diagram below.

Percentage Basis Points

0.01% 1
0.1% 10
0.5% 50
1% 100
10% 1000
100% 10000

Examples:
> The difference between bond interest rates of 9.85 percent and 9.35 percent is 0.5 percent,
equivalent to 50 basis points.

> The Federal Reserve boosts the interest rates at 100 BPS, signaling an increase from 10
percent to 11 percent.

> Due to the growth of iPhone sales, Apple Inc. reported high earnings, more than what was
estimated; the stock increased 330 BPS, or 3.3 percent, in one day

Why do investors and analysts use BPS?

The main reasons investor use BPS points are:
1. To describe incremental interest rate changes for securities and interest rate reporting.
2. To avoid ambiguity and confusion when discussing relative and absolute interest rates,
especially when the rate difference is less than 1 percent, but the amount has material
importance to discuss.

For example, when discussing an interest rate that has increased from 11% to 12%, some
may use the absolute method stating there is a 1% increase in the interest rate, while some may
use the relative method stating a 9.09% increase in in the interest rate. Using basis points
eliminates this confusion by stating that there is an increase in the interest rate by 100 basis
points.

What instruments do BPS apply to?

The usage of basis points is primarily applied to yields and interest rates, but they may
also apply to the change in the value of an asset, such as, the percentage changes of stock
values. Other examples are:

> Treasury bonds

> Corporate bonds
> Interest rate derivatives
> Credit derivatives
> Equity securities such as common stock
> Debt securities such as mortgage loans
> Options, futures

Managing Solvency and Liquidity

Liquidity is often a more involved strategy than solvency due to it being a short-term
measurement of business. Managing risk associated with liquidity is a necessary component of a
broader business-wide risk management system that should be in place to help maintain
operations.

Assessing prospective funding needs and ensuring enough money is available at the right
times to handle debt helps keep risk low. Because liquidity is associated with the short term,
regular tasks that can be done to manage risk include:

1. Monitoring and assessing current and future debt obligations

2. Planning for unexpected funding needs
3. Addressing daily liquidity obligations
4. Preparing to withstand any periods of liquidity stress

Ratios that are used to measure Solvency and Liquidity:

Current Ratio
The current ratio expresses the capability of current assets to cover its current liabilities
without resorting to selling long-term assets to cover its current obligations.

Formula Current Assets/Current Liabilities

Quick Ratio
Higher liquidity ratio using quick assets should reveal a very liquid company in terms of
financial health. It should show that a business have more funds to be used for other purposes.

Formula Current Assets less Inventories & Prepayments

Current Liabilities

Debt Ratio
This ratio measures the business total liabilities as a percentage of its total assets. It is the
business ability to pay its liabilities with its existing assets; which means that when a business sells
all its assets, this ratio will determine whether all liabilities can be paid off or not. The higher the
ratio, the riskier the business is for the lenders.

Formula Total Liabilities /Total Assets

A lower ratio implies for a very favorable climate for the business as it means a longer
period of existence. Most businesses have benchmarks for this ratio but a ratio of 0.5 is
reasonable as it is considered less risky. It means that the business has twice amount of assets
than its liabilities.

Debt to Equity Ratio

This ratio compares a business total debt total equity. A higher debt to equity ratio means
that the financing aspect of the business comes from creditors than from its owners.

A lower debt to equity ratio means the other way around. In a debt to equity ratio of 0.5,
this means that the business assets are funded by 2 to 1 by owners to creditors. In simple terms,
the owners owned the assets of the business by 2/3 while creditors owned the assets by 1/3.

Formula Total Liabilities/Total Equity

Collateral Valuation Methods
Collaterals are normally required by financial institutions when acquiring large loans – the
higher their value are, the bigger a loan can be with minimal interest rate.

The following are the most common valuation methods used:

Cost approach
The value of an asset can be determined by the cost to replace or reproduce it. Under this
approach is the appraisers factor in functional and operational obsolescence.

When valuing investments in private company stock using this approach, an appraiser
would subtract liabilities from the combined fair market values of the company’s assets.

Market approach
An asset is worth as much as other assets with similar utility in the marketplace under this
approach.

With investments in private company stock, for example, an appraiser might look at recent
transactions involving other companies in the same industry and compute pricing multiples from
those comparables.

Income approach
Investors pay for the expected cash they’ll receive every year from an asset and when the
asset is eventually sold (or salvaged) in the future. Often appraisers “discount” future earnings
based on the asset’s risk, using a discounted cash flow analysis.

Appraisers always consider all three approaches, but one or two may be more relevant
than the rest. For example, the cost and market approaches might be more relevant when valuing
vacant land. Conversely, the market and income approaches might be more relevant when
valuing a rental property with an established rent roll.

ACTIVITIES/ASSESSMENTS
Answer the following exercises:

Exercise No. Mod 3-1 (Essay)

What is your understanding on how risks are managed in the financial market?

Exercise No. Mod 3-2 (True or False)

1). Credit risk is one type of business risk that the borrower was not able to repay its obligation.

2). Credit risk also affects the valuation of accounts receivable.

3). BSP defined interest rates to be a type of price. Interest are set to compensate the risk of
allowing the finances to flow into the financial system.

4). The interest as a price is different on the perspective of the lender or borrower. For lenders,
interest rate is called as lending rate or return.

5). The interest as a price is different on the perspective of the lender or borrower. For the
borrowers, these will serve as cost of debt.
6). The tenor of the investment also defines the riskiness of the repayment of debt.

7). There are two economic theories that affect the term structure of interest rate. These are
expectations theory and market segmentation theory.

8). Expectation theories is that the interest rates are driven by the expectation of the lender or
borrowers in the risks of the market in the future. These maybe a pure expectation theory and
biased expectation theory.

9). Pure expectations theory is based on the current data and statistical analysis to project the
behavior of the market in the future.

10). Biased Expectation Theory includes that there are other factors that affect the term structure
of the loans as well as the interest to be perceived moving forward.

11). The adjustment or increase on the interest rate is called the liquidity premium

12). Liquidity premium increases as the maturity lengthens. This theory is called the liquidity
theory.

13). The risk-free rate should be the rate that assumes zero default in the market where this is
more or less equivalent to the rates offered by the sovereign.

14). Market Segmentation Theory assumes that the driver of the interest rates are the savings
and investment flows.

15). In commerce, risk is a very important factor to consider that may drives the business up or
down. Risk relates to the volatility of return patterns in the business.

16). There are risks that are inherent in every financing transaction. These are default risk, liquidity
risk, legal risks, and market risks, among others.

17). Default risk arise on the inability to make payment consistently.

18). Liquidity Risk is identified by ensuring the business to be capable of meeting all its currently
maturing obligation.

19). Legal risk is dependent on the covenants set and agreed in between the lenders and the
borrowers.

20). Market risk is the impact of the market drivers to the ability of the borrowers to settle the
obligation.

21). Since the interest rate is dependent on the inflation, tenor and other market risks. Companies
should consider and make reasonable estimates to mitigate these risks.

22). When the agreement is a spot rate the applicable interest rate is based on the prevailing
market rate at the particular time.

23). Forward rates are normally contracted rates that fixed the rates and allow a party to assume
such risk on the difference between the contracted rate and the spot rate.
24). Swap rate is another contract rate where a fixed rate exchange for a certain market rate at a
certain maturity.

25). The credit ratings are determined by companies that are recognized globally that objectively
assigns or evaluates countries and companies based on the riskiness of doing business with
them.

Exercise No. Mod 3-3 (Multiple Choice)

1. Which of the following is incorrect about credit risk?
a. Credit risk is one type of business risk.
b. This is the risk that the lender was not able to repay its obligation. (borrower not lender)
c. Credit risk also affects the valuation of accounts receivable.
d. Such risk is valuated as a factor to determine the cost of lending or financing using debt.

2. This economic theory accordingly drives the interest rate assumes that it is ideal to supply
funds when the interests are high and vice versa.
a. Loanable funds b. Liquidity preference c. Expectation d. Market Segmentation

3. This economic theory accordingly drives the interest rate assumes that the interest rates are
dependent on the preference of the household whether they hold or use it for investment.
a. Loanable funds b. Liquidity preference c. Expectation d. Market Segmentation

4. Which of the following is correct about interest rates?

a. BSP defined interest rates to be a type of price.
b. The interest as a price is similar on the perspective of the lender or borrower. (different)
c. For borrowers, interest rate is called as lending rate or return. (For lenders)
d. For lenders, these will serve as cost of debt. (For borrowers)

5. This economic theory accordingly affects the term structure of interest rate. Interest rates are
driven by the expectation of the lender or borrowers in the risks of the market in the future.
a. Loanable funds b. Liquidity preference c. Expectation d. Market Segmentation

6. This economic theory accordingly affects the terms structure of interest rate. This theory
assumes that the driver of the interest rates are the savings and investment flows.
a. Loanable funds b. Liquidity preference c. Expectation d. Market Segmentation

7. This theory is based on the current data and statistical analysis to project the behavior of the
market in the future
a. Pure Expectation b. Biased Expectation c. Liquidity d. Preferred Habitat

8. This theory includes that there are other factors that affect the term structure of the loans as
well as the interest to be perceived moving forward. The forward rates will be affected or will be
adjusted if the liquidity of the borrower will be weaker or stronger in the future.
a. Pure Expectation b. Biased Expectation c. Liquidity preference d. Market Expectation
9. To determine the appropriate interest rate or rates the following factors should be considered
assuming the cash flows are already been established:
a. Interest rates in the industry
b. Risk exposure
c. Compensation on the market expectation.
d. All of the above

10. Related to the determination of interest rates, the following are true except:
a. In finance, interest can be determined by the function of the risk and the compensation of
the investor on the difference between the risk-free rate and the market fluctuations
b. Another way on how to calculate the interest rate is by the function of the market value, par
value and the interest expense paid by debt securities or bonds.
c. The risk-free rate should the rate that assumes zero default in the market where this is more
or less equivalent to the rates offered by the sovereign.
d. The low risk rate can be real or excludes the effect of inflation or the exclusion of the effect
of the purchasing power of Philippine Peso. (Risk free rate)

11. Identify the risks described in each statement:

1st: Arise on the inability to make payment consistently. Most of the businesses was able to
raise financing on their demands, however their cash flows projected were not that guaranteed.
2nd: Identified by ensuring the business to be capable of meeting all its currently maturing
obligation.
a. Liquidity; Default b. Default; Liquidity c. Solvency; Default d. Default; Solvency

12. Identify the risks described in each statement:

1st: Dependent on the covenants set and agreed in between the lenders and the borrowers.
2nd: Classified as a systematic risk because it arises from external forces or based on the
movement of the industry.
a. Legal; Market b. Market; Legal c. Contractual; Industry d. Industry; Contractual

13. is the interest rate or yield available / applicable for a particular time.
a. Prevailing rate b. Spot rate c. Forward rate d. Day rate

14. Normally contracted rates that fixed the rates and allow a party to assume such risk on the
difference between the contracted rate and the spot rate.
a. Prevailing rate b. Spot rate c. Forward rate d. Future rate

15. Contract rate where a fixed rate exchange for a certain market rate at a certain maturity.
Usually the one used as reference is the LIBOR.
a. Swap rate b. Exchange rate c. Forward rate d. Future rate

16. The are determined by companies that are recognized globally that
objectively assigns or evaluates countries and companies based on the riskiness of doing
business with them. The riskiness is primarily driven by their ability to manage their liquidity and
solvency in the long run. The higher the grade the lower the default risk associated to the country
or company.
a. Credit Ratings b. Credit Score c. Investment Rating d. Investment Score
17. The following statements are correct, except:
a. Standard and Poor’s Corporation or S&P is an American financial services
corporation was founded in 1941 by Henry Varnum Poor in New York, USA.
b. Moody’s Investors Services or Moody’s is credit rating company particularly on
equity securities established in 1909 in New York, USA. (debt securities not equity)
c. Fitch Ratings was founded in 1914 in New York, USA. The company was owned by
Hearst.
d. DBRS was established in 1976 in Toronto, Canada. The company was
considered as the fourth largest ratings agency.

18. The following are major credit ratings company, except:

a. S&P b. Moody's c. Fitch d. MTRCB

19. Which of the following is not correct?

a. One of the challenges in financing is to ensure the ability of the borrowers to settle
the obligation. The risk involve in financing are: default risk, liquidity risk, and market
risk among others.
b. It is theoretically assumed that the cost of financing is affected by the availability of
loanable funds which is the Loanable Funds Theory and the maturity of the loans, where
the longer the life of the loans the higher the rate is Liquidity Premium Theory. (Liquidity
Preference Theory)
c. The three factors that affect the interest rates: (1) industry; (2) risk exposure; and
(3) compensation for the market expectation. Hence, the interest formula will require the
function of default or risk-free rate, inflation and debt premium for the compensation.
d. In order to mitigate the risk, most businesses hedge forward rates or enter into a
swap rate agreement. It is important for the borrowers and lenders to know what the
spot rate in the prevailing market is and employ certain expectations in the future.

20. The common unit of measure for interest rates and other percentage in finance is
called BPS. What does BPS stand for?
a. Basis points b. Basic percentages c. Basic point system d. Basic percentage system