LFC
CHAPTER 1
FINANCE- Application of economic principles to
decision-making that involves the allocation of
money under conditions of uncertainty.
- Life-blood of the company.
FINANCIAL MANAGEMENT- Ensure
maximization of profit and wealth
Sources of Wealth
1. Labor- salary/wage
2. Land- rent
3. Capital- interest
4. Entrepreneurial skills- profit
Study of Capital Markets (key areas)
1. The financial system
2. Structure of interest rates
3. Pricing of assets
 Transforms fund savings into investment
vehicles.
FINANCIAL SYSTEM- Set
arrangements/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 (and
their derivatives) so that the price and allocation
of funds are determined efficiently.
- Composed of network of inter-
related systems of financial markets,
intermediaries and services.
- Main reason for existence:
matching the difference between the spending
of fund providers and fund demanders.
- Regular, time-efficient and cost-
effective link between fund demanders and fund
providers.
HOUSEHOLDS- Primary fund provider
BUSINESS FIRMS & GOVERNMENT- Main
fund demander
Flow of funds (two routes)
1. DIRECT FINANCING- through selling
financial instruments.
o Financial instruments-
represent claims on the future
income or assets of the borrower
Borrower- liabilities
Lenders- asset
2. INDIRECT FINANCING- through a
financial intermediary.
 Financial markets help in creating more
efficient allocation of capital
(physical/financial)
 Enhances welfare of individual consumers
as they have immediate access to funds.
 Addresses the problem of information
asymmetry where one stakeholder to a
transaction holds superior information than
the other party which causes inefficient
allocation of financial resources.
Elements of the Financial System
1. LENDERS and BORROWERS
- Who are the players?
- Most essential stakeholders
- Lenders- have excess funds that
they lend for a return
- Borrowers- willing to pay the return
for additional funds
2. FINANCIAL INTERMEDIARIES
- How will the exchange occur?
- Acts as a third party to facilitate the
of borrowing activity between lenders
and borrowers.
- Gather funds from lenders and
redistribute it to borrowers through
an investment vehicle.
3. FINANCIAL INSTRUMENTS
- What will be used?
- A contract where a party recognize it
as an asset and another is a liability.
(IFRS 32)
- Medium of exchange of contractual
obligation of a party.
- Tangible/Intangible
4. FINANCIAL MARKETS
- Where will it be traded?
- Where suppliers and buyers of
financial instruments meet.
5. REGULATORY ENVIRONMENT
- How is it controlled?
- Governance body that ensure
compliance of transactions in the
financial systems to laws and
regulations imposed to the actors
and elements in the system.
- Financial systems are normally
regulated by Central banks.
6. MONEY CREATION
- What is the value it creates?
- Money is used to either be
reinvested or earned our from the
system flows.
7. PRICE DISCOVERY
- How much is created?
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- Process of determining or valuing the
financial instrument in the market.
FINANCIAL MARKET- Channels or places
where funds and financial instruments are
exchanged. (NYSE, PSE)
- Intend to establish a consistent,
efficient, and cost-effective bridge between
lenders and borrowers.
- Participants (e.g. household,
gov’t, businesses, financial intermediaries,
broker and dealers, regulators, fund managers
and financial exchanges)
- Main economic function: serve as
a channel to transfer funds from fund providers
to fund demanders.
- Trading- exchanging of financial
instruments.
Major Economic Functions
a. PRICE DISCOVERY- fund providers
determined the required return for a
financial instrument
a. Determines how the funds
are allocated based on the
borrowers’ willingness to accept the
return required by the lender.
b. LIQUIDITY- Investors can sell
financial instruments for cash.
Debt investment- maturity date
Equity instruments-
voluntary/involuntary liquidation
c. REDUCTION IN TRANSACTION
COSTS
b. Costs incurred to trade a
financial instrument.
Two types:
a. Search costs- incurred to
look for financial instruments.
 Explicit Search Cost-
Expenses needed to
advertise.
 Implicit Search Cost-
Value of time.
b. Information costs-
evaluating investment
characteristics to justify
worthiness.
Types of Financial Markets
BASED ON INSTRUMENTS TRADED
1. MONEY MARKET
- Short-term securities
- Cash financial instruments
- Financial instruments that will mature
or be redeemed in one year or less
from issuance date
- Short-term and long-term investors
- Short-term liquidity needs
- Conduit to efficiently transfer large
amounts of money from fund
providers to fund demanders for
short maturity term quickly and at a
cheap cost.
- Instruments are very liquid, easily
convertible to cash and have very
little default risk.
- e.g. T-bills, Commercial papers,
Certificates of Deposit, Repurchase
agreement, Bakers’ acceptances,
Redeemable preference shares
2. CAPITAL MARKET
- Long-term securities
- Derivative financial instrument
- Financial instruments that will mature
beyond one year from issuance date
and perpetual securities (no maturity)
- Foundation is made up by the
dealers and brokers market.
- Capital market securities:
a. Equity (ownership interest)
b. Debt
- e.g. Stocks (no maturity)
BASED ON MARKET TYPE
1. PRIMARY MARKET
- Lenders and borrowers
- Fund demanders raise funds through
new issuances of financial
instruments
- Sold to original fund providers
- Issuance of additional debt or equity
securities of an already publicly
traded company.
- Non-negotiable
instruments(mortgage loans,
savings deposits & life policies) are
issued only in primary market
- Transactions are usually coursed
through investment banks
a. Investment banks- provides
advice to issuers (price,
transaction costs, number to
be issued) based on their
fund needs.
- Responsible in all aspects
to ensure proper execution of
the issuance.
- Underwrite securities
- Underwriting- investment
banks guarantee the price
and sells it to the general
public.
Issue Methods in Primary Market
1. PUBLIC OFFERING
- Securities are offered for sale to the
general public through issuing a
prospectus or placing an offer
document
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- Private companies who will sell 4. TAP ISSUE- issuers are open to receive
shares to the general public for the bids for their securities at all times.
first time shall undergo an Initial - Issuers can accept or reject
Public Offering (IPO) through the
help of investment banks. 2. SECONDARY MARKET
- Can either be: - Where securities issued in the primary
a. Offer for subscription market are subsequently traded, resold
- IPO and repurchased.
- General public is invited to - Centralized market wherein buyers and
subscribe to unissued sellers can transact
shares. - Transactions occur through help of
- Proceeds: company securities brokers (facilitator)
b. Offer for sale - The original issuer of the financial
- Secondary offering but first instrument is not involved
time to be issued to the - Economic functions:
public. a. Price discovery- Higher prices
- Existing shareholders invite suggest that issuing companies may
the public to but portion of raise higher amount of financial
their shares. capital when they sell new securities
- Proceeds: existing b. Liquidity and reduction in
shareholders. borrowing costs- active trading
- Underwriter provides an undertaking - A liquid market means buyers
to purchase the remaining securities and sellers are equally matched and
if the offer will not be fully subscribe also reduces interest rates, as
to the public (fee is paid in liquidity premium can be removed.
exchange). c. Support to the primary market-
2. PRIVATE PLACEMENT helpful information in setting prices
- “Limited Public Offer” for new issuances and assessing
- Issuer looks for a single investor, an receptiveness of the market for new
institutional buyer or group of buyers issuances.
to purchase the whole securities. d. Implementation of monetary
- Securities are illiquid and not easily policy- secondary market allows
converted to cash regulators to trade securities to
- Only firms/financial institution are influence liquidity and interest rates
able to buy. - Investors can sell securities at fair
- Underwriter subscribes to all market value if they need cash (liquidity)
securities and sells it at a higher - Provides information to investors on the
price (difference of prices is market value of the investments.
underwriting spread). - Minimized transaction costs because it is
3. AUCTION- usually used for T-bills, a centralized market
bonds and other gov’t securities. - Issuers can have an idea of how much is
- To market makers only the fair market value of their financial
- Three Methods: instruments
a. Dutch auction - Value of the company can be determined
- Seller begins sale at a high based on the prices of the financial
price, lowered down until buyer instruments
agrees to purchase - How well they are using the funds
b. English auction - Market structure- how buyers and
- Prospective buyers submit an sellers interact to arrive at the price and
initial bid price quantity of the securities to be traded
- Other buyers submit new bid to - Classification of Secondary Market
top the previous one based on market structure:
c. Descending price sealed a. ORDER-DRIVEN MARKET
auction (First-price sealed STRUCTURE- buyers and sellers
auction) propose their price through their
- Bidders submit sealed bids to brokers who conveys the bid in a
sellers. centralized location. (auction
- Sealed bids are ranked market)
- Highest bids receive full - Types of orders:
allocation while lower bids a. Market orders
receive allocation pro rata. - “At-best orders”
- Orders placed with broker
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- No price set
- Executed immediately at the
prevailing best market price
(most favourable)
b. Limit orders
- Price/price range is set
- Broker executes the
transaction when prices go
higher (sell) or lower (buy)
than the limit price or range.
c. Day orders
- Only valid until the end of the
business day.
d. Good-until-cancelled
orders
- Remains valid for a - Securities
sustained period (60 days)
up until the client voluntarily
cancel
a. QUOTE-DRIVEN MARKET
STRUCTURE
- Primary dealer markets,
professional markets, market-
made markets
- Seller dictates price
- Market makers set a bid quote (to
buy) and offer quote (to sell), the
difference of which is a spread.
- Spread represents transactional
costs of trading and reflects
liquidity.
- Narrow spread- liquid
- Wide spread- illiquid
- e.g. Trading of bonds and
currency
Classification of Primary and Secondary
markets based on where financial
instruments are traded
1. EXCHANGE (Formalized)
- Centralized trading locations
- All financial instruments are listed and
must be complied with regulations set
forth
- Most exchanges are Order-driven
- e.g. NYSE, PSE, Chicago Board of
Trade for commodities
2. OVER-THE-COUNTER MARKET
(Informal)
- Where unlisted financial instruments
are traded
- Can be done through computers
- Do not have formalized mechanisms
- Bonds, loans, spot money and foreign
exchange markets
- Negotiable certificates of deposit,
banker’s acceptances
BASED ON COUNTRY’S PERSPECTIVE
1. INTERNAL OR NATIONAL MARKET
- Financial market operating in a certain
country.
- Two parts:
a. Domestic market-
Residents/Citizens of the country
issue the securities
b. Foreign market- Issuers of the
securities are not residents of the
country
- Rules of the regulatory authority
where the security is issued will
prevail.
2. EXTERNAL MARKET
- Securities have two unique
characteristics:
are offered
simultaneously to investors in
different countries
- Securities are issued outside the
regulatory jurisdiction of any single
country.
- e.g. International market, offshore
market, Euromarkets
BASED ON MANNER OF FINANCIAL
INTERMEDIARIES
1. BROKER MARKET
- Buyer and seller are brought together
by a broker
- Usually composed of national and
regional securities exchanges.
- Philippine Stock Exchange (only broker
market in the PH)
2. DEALER MARKET
- Buyer and seller are not brought
together by a third party.
- Market makers execute the sell or buy
orders
- Two distinct trades:
- Seller sells his securities to
dealer
- Buyer buys his securities from a
dealer
- Ask price- lowest price
- Bid price- highest proposed price
- Investors pay the ask price when
purchasing securities and receives
the bid price when selling them
- Dealers earn profit through spread
between bid and ask prices
- Do not have centralized trading floors
- Consist of many market makers
- Market maker- dealers who create
market by offering to sell/buy
securities at ask/bid prices)
CHAPTER 2
FINANCIAL INTERMEDIATION- The process
of indirect financing using financial
intermediaries as the main route to transfer
funds from lenders to borrowers.
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 Financial intermediaries e.g. depository
institutions, insurance companies, asset
management firms, regulated investment
companies and investment banks
Services provided by financial
intermediaries:
- Enable trading of financial assets through
brokering arrangements
- Enable trading of financial assets through its
own capital
- Assist in forming financial assets and
distributing it
- Provide investment advice and consultation
services
- Manage financial assets
- Facilitate payment mechanism
Benefits from Financial Intermediaries
1. Accretion of flow of funds between
entities- fund providers use financial
intermediaries to transfer funds to fund
demanders
2. Efficient allocation of funds
- Financial intermediaries manage
asymmetric information.
- Asymmetric information occurs when
potential borrowers have more information
about the transaction compared to the
bank.
- Asymmetric information may lead to two
further problems:
a. Adverse selection- high risk
borrowers that would tend to
default is more likely to be
more active in borrowing
funds than low risk borrowers
who pay on time.
- Occurs before a - Financial intermediaries incur these
transaction take place.
b. Moral hazard- borrowers
have the tendency to take
undesirable or immoral risks
with the money, lowering the
chance that the loan will be
paid back.
- Occurs after loan is
granted
- Financial intermediaries can
screen out bad borrowers and monitor
action of their borrowers
3. Creation of money- borrowers, banks,
depositors, and the gov’t are the ones
who receive money.
4. Support in price discovery- Financial
intermediaries play the role as experts
and facilitators to enable to assign
values to financial instruments based on
different factors.
5. Improved liquidity for lenders-
Financial intermediaries can manage
cash from different lenders through
immediately cashable products such as
current and savings accounts and at the
same time offer non-marketable financial
products such as mortgages, leases and
credit contracts.
6. Reduced price risk for lenders
- Low-risk financial products (deposits)
- High-risk financial products(shares,
bonds, property financing)
- Financial intermediaries bear the risk of
lenders (Risk sharing or Asset
transformation)
- Risky assets are converted into safer
assets for investors.
7. Diversification of lenders
- Diversification- process of investing
funds in a portfolio of assets that have
individual returns that do not move at
the same direction together.
- Allows lenders to share risk from their
investment
- Risk refers to the uncertainty that an
investor will earn on their invested
assets.
8. Economies of scale- Occurs when fixed
costs are optimized per unit as a result
of sheer volume transactions.
- Cost per transaction is reduced
as the number of transactions increases.
- Two main economies of scale:
a. Transaction costs-
trading/managing funds and
investment transactions.
b. Research costs- economic,
industry, and financial analysis
to monitor performance of
potential companies to be
invested in.
costs in behalf of all its depositors
- These costs are spread over all
depositors of the bank.
9. Payments system- The financial system
serves as the main structure for making
payments
10. Risk mitigation- uncertainty that
something damaging may occur to a
person or entity. Some financial
intermediaries offer protection or
insurance.
11. Implementation of monetary policy
and function- Government is able to
influence interest rates
Economic functions of the transformation of
financial instruments
1. Maturity intermediation-banks covert
long-term assets into short-term assets
by extending loans to borrowers based
on the time they need it and giving
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financial assets to depositors for their
desired investment prospect
- Allows financial intermediaries to
charge lower interest rate for borrowers.
2. Risk reduction through
diversification- Diversification e.g.
Mutual funds
- Investing in many companies
allows the mutual fund to diversify and
reduce the overall risk of the investment,
which is advantageous for individuals
with limited capital.
3. Cost reduction for contracting and
information processing
- Information processing cost-
cost of acquiring and processing
information needed to evaluate purchase
or subsequent sale.
- Contracting costs- cost of writing loan
agreements and enforcing terms of
agreements.
- Financial intermediaries employ
personnel that possess so that they can
act in behalf of investors
- Liquidity risk- risk that
depositors may require cash in exchange
of the financial claim they have.
- Financial intermediaries always
maintain high level of cash and
marketable securities.
Classification of Financial Intermediaries
1. DEPOSITORY INSTITUTIONS
- Accepts cash deposits
- Extend loans to entities
- Main source of revenue: interest earned
from loans
- Biggest portion of asset base are loans
- Categories of loans:
a. Business/Commercial/Industrial loan
b. Commercial/Residential real estate
loans
c. Individual loans for vehicle or credit
card purchases
d. Other loans
- Biggest portion of liabilities are deposits
(transaction accts, household savings,
large time deposits, passbook savings
acct)
- Invests on securities for liquidity
- In the PH, further subdivided into:
a. Commercial banks
- Domestic & foreign
- Raise funds through offering
checking deposit, savings deposit
account and time deposits.
- CB use these funds to extend
mortgage and commercial loans to
borrowers and purchase gov’t
securities and corporate bonds.
- Universal banks- CB that also
offer investment banking services.
b. Thrift banks
- Domestic only
- Cater to lower income groups
- Small savings and longer, easier
termed loans
- Saving banks- accumulates
savings deposits, and invests them
for specified purposes
- Banks’ variety of services:
a. Individual banking- financial
requirements of individuals
b. Institutional banking- financial and
non-financial corporations and gov’t
entities
c. Global banking- CB contend with
investment banks
- Deposits are insured by the Philippine
Deposit Insurance Corporation up to
500,000 max
- Types of deposit accounts:
a. Demand deposits
- Checking accounts
- Can be withdrawn upon demand,
minimal interest
b. Savings deposits
- Withdrawn upon demand
- Interest below market interest rates
- Do not have specific maturity
c. Money market demand account
- Deposits placed on money markets
- Slightly higher interest than
savings deposits
- Can be withdrawn after a short
period of time
d. Time deposits
- Certificates of deposits
- Fixed maturity
- Fixed/floating interest rate
- Banks can procure funds from non-
depository sources such as borrowing
through issuing financial instrument and
borrowing reserves from the BSP
- Rediscounting- standing credit facility
offered by the BSP to aid banks to meet
temporary liquidity needs through
refinancing loans
- Used by BSP to regulate liquidity
level
- Overdraft- deficit in a deposit account
- Overdraft credit line- offered by BSP to
cover for any shortfall deposit accounts
- Emergency loans- offered by BSP to
solvent banks experiencing liquidity
problems. (Section 84 of RA No. 7653)
- Shall not exceed 50% of its
deposits
- Contractual savings institutions-
obtain funds at periodic intervals based
on an existing contract.
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- Focuses on investing in long- - >NAV- premium

term securities (stocks, mortgages, - <NAV- discount
corporate bonds) - Secondary market
- e.g. insurance companies and - Brokerage commission fee
pension funds - Costs in investing in RICs:
2. INSURANCE COMPANIES a. Shareholder fee or sales
- Underwriters of risk charge
- Collects premiums in exchange for b. Annual fund operating
selling protection against future risks expense known as expense
- Invests money collected in the financial ratio
market - RICs allow individual shareholders to
- Insurance products: combine their resources.
a. Life insurance ii. Exchange Traded Funds (ETF)
b. Health insurance - Like mutual funds, but the
c. Property and Casualty Insurance shares trade in an exchange
d. Liability insurance (Directors’ - Open-ended and closed-ended
Action insurance) - Open-end but has
e. Disability insurance premium/discount
f. Long-term care insurance - Secondary market
g. Structured settlements - Allowed to place limit orders,
h. Financial guarantee insurance stop orders
3. INVESTMENT INTERMEDIARIES iii. Hedge Funds
- Primary objective is to maximize return - Sophisticated investors
from investments - Organized as a private
 Asset Management firms investment partnership or
- Manage funds through buying offshore investment corporation
and selling of financial
instruments - Strategies:
- Types of accounts or funds: a. Leverage- use of borrowed money
a. Regulated Investment to invest
companies (RIC) b. Short selling- sale of security not
- Sells shares to the general owned expecting its price to
public in exchange for cash decline
- Asset management strategies: c. Derivatives
a. Passive funds (indexed d. Simultaneous selling and buying of
funds)- mimic movements in securities
the market index - Evaluated through absolute return
b. Active funds- outperform the (peso amount realized)
index fund via actively trading - Relative return- difference between
securities in the fund portfolio. realized return and the return shown
- Each share in the portfolio is valued at in a benchmark index.
Net Asset Value iv. Separately managed accounts
- New investments and withdrawals on - Distinct funds solely dedicated to an
the fund are valued at the end-of-day individual or institutional investor.
NAV.  Investment Banks
- Assist entities in raising money to
fund their initiatives.
- Assist potential investors by serving
as the dealer/broker
- Based on activities:
a. Full-service investment
- Two types of RICs: banks- wide-range of activities
a. Open-end funds (mutual b. Boutique investment banks-
funds) one or two
- Do not have fixed number - Activities:
of shares a. Public offering of services
b. Closed-end funds - Assist firms to offer securities
- Fixed number of shares - Give recommendation to
- Do not issue additional issuing companies
shares - Possess information on
- Market price may be higher current willingness of investors
or lower than NAV
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- Participate in IPO and problems with creditors and

subsequent public offerings
(secondary offering)
- Due process documented via
prospectus, which contains
all information regarding the
firm that is relevant to the
decision of investors
- Red herring- preliminary
prospectus shared to potential
investors
- Quiet time- restricts what
company officials can say
about the company
- Investment bank underwrites
the shares
- Underwriting arrangement:
a. Firm commitment-
investment bank buys
securities based on a fixed
price then sells it at a
higher price
- Small issues- underwrite
- Large issues- underwriting
syndicate
b. Best effort
- Do not buy securities
- Offer to the general public
and earn based on the
gross spread of the
securities it can sell
b. Private placement of securities-
offered only to a select number of
firms
c. Trading of securities- Trade
securities on behalf of their clients.
- Earn through commissions
- Propriety/Prop trading- uses
capital to trade securities based
on how they forecast potential
movements in prices, interest
rates and foreign currency.
- Two risks:
a. Interest rate risk
b. Credit risk- borrower
might not pay
d. Advisory services for mergers,
acquisitions and financial
restructuring
- Investment banks can provide
advice for both buyers and
sellers.
- Help in looking for potential M&A
candidates
- Financial restructuring occurs
when a corporation undergoes a
significant modification of its
capital structure, operating
structure, corporate strategy and
corporate tactical plans.
- Restructuring to prevent
bankruptcy, avoid potential
undergo reorganization.
- Costs: salaries of personnel
working on the engagement.
e. Merchant banking
- Investment banks use its own
money to lend money as a
creditor or buy shares as an
investor.
f. Securities finance and prime
brokerage service
- Investors borrow money to buy a
security or borrow securities to
sell a security short or cover a
short sale.
- Repurchase agreement
- Prime brokerage- offered by
investment banks to hedge fund
and large institutional investors.
e.g. securities finance, global
custody, risk management
system, prioritized operational
support.
g. Asset management-
endowments, insurance
companies, pension funds, etc.
- Mutual/Hedge fund
f. Research- to identify potential
candidates as acquirer or acquire.
 Finance Companies- raise funds through
issuing stocks and bonds or selling
commercial papers
Other Market Participants
1. Household Sector- individuals and
families, unincorporated businesses
(retailers, farmers and professional
partnerships)
2. Government- regulates all participants and
the market. Includes National
Government Agencies (NGAs), Local
Gov’t Units (LGUs) and Government-
owned and Controlled Corporations
(GOCCs).
3. Corporate Sector/Non-financial
Corporations-
a. Financial corporations- depository
institutions, investment banks, asset
management companies, and
insurance companies.
b. Non-financial corporations- issue
financial instruments to raise funds
and trade financial instruments in the
money market
- Captive finance companies- non-
financial corporations with
subsidiaries that engage in the same
activities as financial corporations.
4. Foreign Sector- all entities situated outside
the jurisdiction of a certain country.
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- Foreign central banks and foreign c. Control of new players

companies invest in other countries d. Setting minimum capital
in order to requirement
a. Stabilize their local currency e. Minimum governance rules
compared to foreign 3. CONSISTENCY
currencies - The problem: asymmetric
b. Gain return from investing information
excess funds in attractive - Principle of prudential regulation-
countries/markets with huge the gov’t impose rules/standards that
growth potential will govern the behaviour of financial
- Supranational institutions- institutions
international entity formed by two or 4. STABILITY
more central governments via - Systematic instability- threat where
international treaties a firm was not able to meet its
5. Non-profit organizations- businesses that commitment because of their failure
exist to respond to specific causes to address the risks of the market/

CHAPTER 3 FINANCIAL ACTIVITY REGULATION- setting

rules/standards, control and order on the
REGULATION- A process whereby the financial activities
designated government authority provides
oversight and establishes rules for firms in an Regulators of Financial Activities
industry.
1. BANGKO SENTRAL NG PILIPINAS
WORLD BANK- sets regulatory measures to - Created under the New Central Bank Act
address certain risks and social factors. or Republic Act 7653
- Attached agency of the Department of
a. Systemic risk- probability of a firm to fail Finance
its objective - Central monetary authority
b. Consumer protection- policies enforced - Responsible for money, banking and
assumes the effect to the consumers’ credit
welfare - Functions:
c. Efficiency enhancement- ensure the a. Liquidity management-
dynamism and agility of the policy to issues monetary policy to
adopt in a fast-changing environment maintain price stability
d. Social objectives- alignment in the b. Currency issue- sole
objectives of the society responsibility to issue notes
and coins
FINANCIAL REGULATION- rules and c. Lender of last resort-
standards were set to oversight the ability of the provider of discounts,
companies to establish and maintain advances and financial
appropriate level of capital to sustain its support to financial
operation. institutions
- Setting controls over the market factors that d. Financial supervision-
will affect financial sustainability empowered to exercise
regulatory powers over non-
Market Drivers Regulated bank institutions
1. COMPETITIVENESS e. Management of foreign
- Regulated: access to capital, credit currency reserves- to
and loan term offerings, support to preserve the international
providers of financing, management stability and position of the
of business risks, transaction costs Philippine peso.
and tariffs. f. Determination of exchange
- Main determinant: buyers and rate policy- market-oriented
sellers foreign rate policy (behaviour)
2. MARKET BEHAVIOR g. Banker, financial advisor, and
- Can be demonstrated on their: official depository of the
a. Integrity on their activities government
b. Integrity on their presentation - Governed by the Monetary Board
- The government normally sets: - The Monetary Board is composed of 7
a. Full disclosure of information members. Chaired by the governor of
b. Prohibition on insider trading BSP and 6 other members from: (1)
member of the cabinet designated by the
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President; (5) from the private sector (3
members shall serve for 6 years, 2
members for 3 years. All members can
be re-appointed once.
- Governor- Chief Executive Officer of
BSP
- BSP is supported by four
sectors/functions:
a. Financial Supervision Sector-
supervision and regulation of
financial institutions
b. Monetary and Economics
Sector- formulation of monetary
policy
c. Currency Management Sector
d. Corporate Services Group-
human capital management,
corporate source management
2. INSURANCE COMMISSION
- Mandated by Executive Order no. 192 s.
2015 to ensure enforcement of
Insurance Code or Republic Act 10607
- Governed by Department of Finance
- Regulates life and non-life companies,
mutual benefit associations
- Issues licenses and can suspend/revoke
such licenses
- Functions:
a. Promulgation of policies, rules
b. Licensing
c. Conducting insurance agent’s
examinations
d. Examination of financial condition
e. Evaluation of statistical reports
f. Review of premium rates
g. Adjudication of claims
complaints
h. Review and approval of life and
non-life policies
3. PHILIPPINE SECURITIES AND
EXCHANGE COMMISSION
- National gov’t regulatory agency on the
corporate sector.
- Created October 26, 1936 under the
Commonwealth Act No. 83
- Republic Act 8799 or the Securities
Regulation Code widens
responsibility and scope of SEC to (page
81)
4. BOARD OF INVESTMENTS
- Generate local and foreign investment in
the country
- Attached agency of Department of Trade
and Industry
- Provides advisory, actualization and post
services to investors.
- Incentivizes investors through provision
of tax holidays etc.
MONEY SUPPLY
- The availability of financial resources for
deployment in the financial system. Making
the money available for use or for trade or
investment.
- Balanced with monetary demand of the
market
- This balance is managed by the Central
Bank.
- Forms of money:
a. Cash (coins and bills)
b. Demand deposits
c. Other financial instruments
- Qualities of an effective monetary policy:
a. Alignment to the target goals
b. Access to information
c. Responsiveness of the variable set
REGULATION OF CIRCULATION OF NOTES
- BSP have the sole power to issue currency
in the Philippines (R.A. 7653)
- Illegal production of money- imprisonment
of 5-10 years
- Chapter 4 of BSP Circular No. 829 series
2014, deposit of banks’ notes:
a. Classify cash deposits and sorted by
series and by denomination (clean/fit
or dirty/unfit notes)
b. Sealed bags for clean notes. For dirty
notes, sealed bag with deposit slip
and labelled “UNFIT”
c. Twenty (20) full bundles per
denomination. Each bundle
containing 1000 notes in 10 equal
straps.
d. Bank ins provinces- direct deposits
with nearest BSP branch.
and If w/o office available- Ship to BSP
Quezon City
e. Coins shall be free from adhesive
tapes
f. Coins are also sorted
- Currency note/coin is considered “unfit”
when it:
a. Can no longer be identified
b. Has indications of filing, clipping or
perforation
c. Has lost more than 2/5 of their surface
the d. Split edgewise resulting to loss of
either the face or back portion
e. The Embedded Security Thread or
Windowed Security Thread is
completely lost except when it is
caused by wear and tear
PURCHASING POWER
- Based on Consumer Price Index
- CPI- weighted average value of the basket
of prices of all commodities representing
the market.
- Commodity group: food and non-alcoholic
beverages, alcoholic beverages and
tobacco, clothing and footwear, housing,
LFC
utilities and other fuels, health, transport,
education, communication etc.
- Inflation rate- degree of movement of the
CPI from a period to another
- BSP is one of the credible agencies that
targets inflation
- Philippine Statistic Authority- the body that
determines the current inflation rate
- Two types of inflation:
a. Core inflation- excludes the
movement of the commodities or
incidents with outliers.
b. Headline inflation- captures the
changes of the cost of living based
on the movement of the basket of
commodities as a whole.
PAYMENT SYSTEM
- Set of interrelated processes of settlement
of goods or services rendered in exchange
for a set of instruments that will undergo
either banking or non-banking procedures.
- Dependent on the best amenable,
convenient and acceptable solution for both
parties.
Characteristics of an Effective Payment
System (Accdg. To BSP)
- Standard methods of transmitting payment
messages within the system
- Agreed means of settlement
- Common operating procedures and rules
Standard methods of Transmitting Payment
- Conventional way: literal arm’s length
- E-banking system- online payment, fund
transfer
Agreed Means of Settlement
- Both parties must agree on how the
payment is to be rendered.
- Cash or cheque payment
- Online payment
- Automated Teller Machine
- Fund Transfer
- Credit cards
- Debit cards and Stored Value Cards
- Electronic money
- Manual Money Transfer
- Paybox System
- Cash deposit
- Assignment
Common Operating Procedures and Rules
- Mutually accepted
- Provides guidelines and protection for both
parties in case of breach
- Policies set by banks are regulated by BSP
Importance of Payment System
1. Safe and Real Time Transactions
- Safeguards the identity and
transaction
- 3 banking days but the reference date
is the date of the transaction, not the
posting date.
Facilitates Financial Market Transactions
- The database can be used to make future
analysis or projections of the investors
- The system can also be used to validate the
credit rating of certain instruments
- Platforms integrated with online brokerage
companies:
a. Facilitate opening an account
b. Facilitate purchase/sale of the
transactions
c. Reduce human intervention to provide
objective approach
EFFECTIVE RISK MANAGEMENT
Risks of Payment Systems
1. Credit Risk
2. Liquidity Risk
3. Default risk- risk that payment will be made
on time
4. Technological risk- system downtime and
bugs
5. Legal risk- changes in rules and regulations
CHAPTER 4
FINANCIAL INSTRUMENTS
- Basically intangible as future economic
benefit takes form of a claim to cash that
will be received in the future.
- Main vehicle used for transactions in the
financial market.
- May be presented under cash equivalents
(90 days or less) or investments.
- Two parties involved:
a. Issuer- issues the instrument and
agrees to make future cash payments
to the investor.
b. Investor- receives and owns the
financial instrument and bears the
right to receive payments.
- Proof (security) of the future claim of the
investor from the issuer.
LFC
- Two main economic purposes:
a. Allows transfer of funds from investors
to issuers for business purposes
b. Permit transfer of fund that allows
sharing of inherent risk
MONEY MARKET
- Financial instruments are the primary
subject of trading, not money.
- FI are short term and highly liquid, that it
can be considered close to being money.
- Money market securities have three
fundamental characteristics:
a. Sold in large denominations
b. Low default risk
c. Mature in one year or less from
original issue date
d. Most mature in less than 4 months.
- Electronically transacted
- Money market securities have an active
secondary market
- Most Money Market instruments are
considered as cash equivalents
- Investors who place funds in the money
market do not intend to earn high returns for
their money. Instead, investors look at the
money market as a temporary investment
that will provide a slightly higher return than
holding on the money or depositing it in
banks.
- Participants in the money market:
a. Bureau of Treasury- sells gov’t
securities to raise funds
b. Commercial Banks- issues treasury
securities; sell certificates if deposit
and extends loans
c. Private individual- makes investment
through money market mutual funds
d. Commercial Non-financial
Institutions- buy and sells money
market securities to manage their
cash (temporarily store excess funds)
e. Investment Companies- trade
securities in behalf of their clients.
f. Finance/Commercial Leasing
Companies- raise money market
instruments
g. Insurance Companies- invests on
money market to maintain liquidity
level
h. Pension funds- maintain funds in
money market as preparation for long
term investing in stocks and bonds
market and to maintain liquidity.
i. Money Market Mutual Funds- permit
small investors to invest in the money
market by accumulating fund from
numerous small investors.
Types of Money Market Financial
Instruments
- Short-term deposits, gov’t securities,
commercial papers and certificates of
deposit
- Influence by market movements.
1. TREASURY BILLS
- Issued by Bureau of Treasury
- Three tenors (to assure maturity on a
business day):
a. 91-day- Cash Management Bills
b. 182-day
c. 364-day
- Quoted by yield rate (discount) or by
their price based on 100 points per unit
- Weekly auctions to banks composing
the Gov’t Security Eligible Dealers
(GSED). The banks then resell these to
investors.
- Zero default risk
- Market is both deep (numerous
different buyers) and liquid (securities
can be quickly traded at low
transactions).
- Government securities are the safest
investment instrument in the market
because they are backed by the full
taxing power of the gov’t.
- Interest rate is not stated in the T-bill,
interest is not paid by the gov’t
- T-bills are issued at a discount (lower
price than the par value at maturity)
- The return realized by investors comes
from the increase in the value of the
securities.
- T-bills can be sold via two methods:
a. Auctions/Competitive bidding-
Accepts the highest bids. Bidders
may or may not receive allocation
b. Non-competitive bidding-
accepts all bids. Bidders are
guaranteed to receive the
securities.
- ANNUAL DISCOUNT RATE- indicates
how much return, in %, can investors
get from a particular security.
- ANNUALIZED INVESTMENT RATE-
addresses two weaknesses of discount
rate:
a. Use of face amount as
denominator (return is
understated)
LFC

b. Use of 360 days (return is - Issued directly to buyer

understated) - No secondary market
- Uses 365 days (366 leap yr.) - The availability of line of credit reduces
- Uses true initial investment the risk of CP, reducing the interest rate.
- May either have a stated interest rate on
its face or sold at a discounted basis.
- Not required to register with SEC if:
a. Issued to not more than 19 non-
institutional lenders
b. Payable to a specific person
c. Neither negotiable none assignable
and held on to maturity
- T-bills are mostly meant as an investment d. Amount no exceeding ₱50 million
vehicle to temporarily store excess cash 5. BANKER’S ACCEPTANCES
2. REPURCHASE AGREEMENT - Order to pay a specified amount of money
- Financial contract involving two securities to the bearer on a specified date.
transactions, a sale/purchase of a debt - Often used to finance purchase of goods
security on a near date and a reversing that have not yet been transferred from
purchase/sale of the same or equivalent the seller to the buyer.
debt security on a future date. - Usually offered to importers and exporters
- Transfers short-term funds from one-day - Formed when a promise to pay is made
to 3 to 14 days, others 1-3 months. by the bank’s client and the bank accepts,
- Key component of the debt securities promising to pay in behalf of the client.
market - The bank will lend its name and
- Collateralized loans creditworthiness to the paying party.
- BSP uses repo to enforce monetary - Payable to the bearer
policy- Expands level of money supply as - Can be purchased and sold until it
it increases BSP’s level of reserves. matures
- Reverse repo- BSP acts as seller of gov’t - Sold at a discount
securities, thus, reducing it reserve - Interest rates are usually low
account and level of money supply. - Default risk is very minimal.
- BSP enters into repo agreements for a - Max: 365 days
minimum of one day (overnight) for both
repos and a maximum of 91 days and
364 days for repo and reverse repo.
3. NEGOTIABLE CERTIFICATES OF
DEPOSIT
- Securities issued by banks which records
a deposit made.
- Indicates interest rate and the maturity
date of the deposit.
- Term security with a specific maturity
date
- Cannot be easily withdrawn
- Restricts holders from withdrawing funds
on demand.
- Investors are willing to accept a higher
return in exchange of having no access to
liquidity.
- Classified as a bearer instrument,
whoever person or entity w/c possesses
the instrument upon maturity will receive
the principal and interest.
- Maturity period: one to 4 up to 6 months.
- Lesser demand for CDs with longer
maturity
4. COMMERCIAL PAPER
- Unsecured promissory notes
- Short-term (365 days or less) or long-term
(more than 365 days)
- Only large and creditworthy corporations
can issue this security.
LFC

Issuer Tenor Purpose Security Ret Risk

urn
T-Bills Gov’t 91, 182, 364 To raise funds for Unsecured Low Sovereign
tax risk
REPO BSP 1 to 3 to 14 days Manage liquidity Secured Low
Commercial
banks
NCD Bank 1 to 4 up to 6 Manage liquidity Secured High
months
CP Large Less than or more To fund operations Unsecured High
companies than 365 days
BA Bank 365 days Secured Low

Evaluating Money Market Securities CHAPTER 5

- Money market securities (MMS) may be
evaluated based on the interest rates and
liquidity.
- Interest rates on money market tend to be
relatively low as a result of the low risks and
the short maturity period.
- MMS have a very deep market
- Each MMS is a close substitute for each
other.
- T-bills are more liquid than Commercial
Papers
- Money market is often preferred by
investors who desire liquidity intervention
Valuation of Money Market Securities
- MMS can be valued using the present value
approach
- Interest rate used shall reflect the required
return from the instrument based on the
investor’s perceived risk.
- Investors may also use the prevailing
interest rate in the marker for the type of
security being purchased.
- As the interest rate rises, the value of
the security becomes lower.
CREDIT RISK- Risk that the borrower was not
able to repay its obligation. Such risk is valuated
as a factor to determine the cost of lending or
financing using debt.
Theories related in Setting Interest Rates
- Economic theories that drives the interest
rates:
a. Loanable Funds Theory- ideal to
supply funds when interests are high;
introduced by Knut Wicksell in 1900s
b. Liquidity Preference Theory- Interest
rates are dependent on the preference
of the household whether they hold or
use it for investment; introduced by
John Maynard Keynes
- The longer the term, the higher
the rates because investors prefer
short-term investments
- BSP defined interest rates to be a type of
price
- Interests are set to compensate the risk of
allowing the finances to flow into the financial
system.
- Lender- lending rate of return
- Borrowers- cost of debt
- The longer the life of the debt, the riskier the
repayment, interest rate is higher
- Economic theories that affect the term
structure of the interest rate:
a. Expectation Theories- interest rates
are driven by the expectation of the
lender/borrowers in the risks of the
market in the future.
i. Pure Expectations Theory
- Based on current data and
statistical analysis
- Rely on forward rates o future
interest rates
- Based on the strong estimates
based on the uncertainty of the
future
- Only relies on the term and not
other factors
LFC

ii. Biased Expectation Theory

- Considers other factors as well
as the interest to be perceived
moving forward
- Liquidity premium- increase on
the interest rate
 Liquidity Theory- liquidity
premium increase as the
maturity lengthens
 Preferred Habitat Theory- - Another way on how to calculate the
considers liquidity and risk interest rate is by the function of the market
premium but disregards value, par value and the interest expense
consensus of the market on paid by the debt securities or bonds.
the future interest rates.
“Habitat”- biased estimate
over the market behaviour
in the future.
b. Market Segmentation Theory- the
driver of the interest rates are the
savings and investment flows. It is the
same as preferred habitat theory
however it does not assume that any of
the players are willing to shift sector.
DEFAULT RISK- Inability to make payment
Determination of Interest Rate
consistently. This type of risk may be quantified
- Factors to be considered: by determining the probability of the borrower to
a. Interest rates in the industry default in their payments in the duration of the
b. Risk exposure loan.
c. Compensation on the market expectation
LIQUIDITY RISK- identified by ensuring the
- Interest can be determined by the function of
business to be capable of meeting all its
the risk and the compensation of the investor
currently maturing obligations.
on the difference between the risk-free and
the market fluctuations LEGAL RISK- common defaults:

a. Maintaining the financial ratios

b. Significant acquisition or disposal of
assets
c. Repayment of other obligation
d. Declaration of dividends of any form
- Risk-free rate- the rate that assumes zero without the consent of the lenders
default
- Treasury bills- normal basis of the risk-free MARKET RISK- Impact of the market drivers to
rate the ability of the borrowers to settle the
- In the PH, this can also be referred in the obligation. Classified as systematic risk because
Philippine Dealing Systems or PDS Group it arises from external forces and it is the most
- An organized market that was formed difficult to quantify among other risks.
out of financial distress in 1997
Mitigating the Interest Rate Risks
- Composed of four corporations:
a. Philippine Dealing and Exchange Possible Yield Curve
Corp.- trading services arm
b. Philippine Depository and Trust
Corp.- securities services
c. Philippine Securities Settlement
Corp.- payments and transfer
services
d. PDS Academy for Market
Development Corp.- training center
- Risk free rate can be determined by
deducting the prevailing inflation.
LFC

Spot Rates issues and 4,000+ financial

institutions
- Interest rate or yield available for a particular - Aaa to C
time. 3. Fitch Ratings
- Accrual rates, not hedge. - Founded in 1914 in New York, USA
- The applicable interest rate is based on the - Owned by Hearst, a global
prevailing the particular time. information services company
- They assess based on the credit
Forward Rates (Hedge Rates) analysis and intensive research
- Normally contracted rates that fixed the rates - Conduct assessment on 8000+
and allow a party to assume such risk on the entities around the globe with 25
difference between contracted rate and the different currencies.
spot rate. - AAA to D

Swap Rate Other rating agencies

- Contract rate where a fixed rate exchange for
a certain market rate at a certain maturity.
- Normally the fixed portion of a currency swap
- London Interbank Offered Rate
- used to benchmark interest rate which is
used are reference for international
banks to borrow
- Calculated using the Intercontinental
Exchange (ICE)
- Short-term rates from 1 day up to 1 year
and releasing more than 30 rates based
on about five currencies.
- Swap rate yield curve- correlation of the
swap rate and the maturity rate
- DBRS- established in 1976 in Toronto
Canada.
- Fourth largest ratings agency.
- 50,000 securities worldwide
- AAA to C
- CARE Ratings- 1993, India.
- Based in Mumbai
- 10 other regional offices
- AAA to D

Credit Ratings

- Affects the confidence level of the investors

to countries or companies.
- Determined by globally recognized
companies that objectively 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
risks.
- Three major rating companies
1. Standard & Poor’s Corporation
- American financial services
corporation founded in 1941 by
Henry Varnum Poor in New York,
USA
- Uses data gathered from 128
countries using more than 1500
credit analysts
- Credit ratings are categorized to
Investment Grade and Non-
Investment Grade an scaled from
AAA to D
2. Moody’s Investors Service
- Debt securities
- Established in 1909 in New York,
USA
- Gathers info from 130+ countries,
4,000+ non-financial corporate