CA 51021 - FINANCIAL MARKETS convert to stocks and/or long-term debt
like bonds)
Topic 1: Financial Markets and Institutions
Providers and users of funds
● Providers of funds – savers; suppliers
of capital; individuals and institutions
with excess funds; they look for rate of
return on their funds to be provided or
invested
● Users of funds – can be borrowers or
corporations needing funds; demanders
or users of capital; individuals and
institutions who need funds to finance
their investment activities; they are
willing to pay a rate of return on the
amount they borrow/receive
How is capital transferred between savers
(providers of funds) and borrowers (users of
funds)?
● Direct transfers - providers of funds
(e.g savers) give money directly to
users of funds (e.g. corporations) for
the latters’ securities (e.g. shares of Why companies go to Financial
stocks and long-term debt like bonds) Intermediaries?
without going to or without the ● Financial intermediaries hire highly
intervention of an organization (e.g. qualified people to assess risky
financial institution like bank) investments.
● They know how to diversify (scatter)
● Investment banks – these facilitate the money/funds to different investments
issuance or selling of corporations’ instead of only to a single investment.
securities (e.g shares of stocks and Bonds, T-bill, stocks
bonds); these buy the securities from ● They have cost advantage or
the corporations and sell them to the economies of scale (especially in the
savers; securities and money just pass case of mutual funds).
through investment banks ● They help reconcile conflicting interests
of users and providers of funds.
● Financial intermediaries – these ● They give providers of funds
obtain money from savers in exchange (particularly savers) liquidity (as in the
for their securities (e.g. bank deposit case of commercial banks on deposits).
accounts for banks, insurance policies
for insurance companies, mutual fund What is a market?
shares for mutual fund companies); ● A market is a venue where goods and
then, these buy other corporations’ services are exchanged.
securities (stocks or long-term debt like ● A financial market is a place where
bonds) using the money obtained; individuals and organizations wanting to
these create new form of capital or borrow funds are brought together with
convert one form of capital to another those having a surplus of funds.
(e.g. bank deposit accounts, insurance
policies, and/or mutual fund shares The Importance of Financial Markets
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● Well-functioning financial markets corporations when the stocks are issued and
facilitate the flow of capital from sold.
providers of funds (e.g inventors) to the
users of capital. Secondary Market - This is the market where
● Well-functioning markets promote previously issued securities are traded (e.g.
economic growth. The users can make PSEi – Phils. Dow Jones- USA; S&P 500 – USA;
use of the funds for expansion and the DAX – Germany; CAC 40 – France; FTSE 100 -
providers of funds obtained additional Great Britain). In this market, the money goes to
income. the previous stockholder who sold the stocks.
● Economies with well-developed
markets perform better than economies Public Market - It is where standardized
with poorly-functioning markets. contracts are traded in an organized exchanges.
An example of this is a stock market.
Types of Financial Markets
● Physical assets market vs. Financial Private Market - It is where transactions are
assets market negotiated directly between two parties (e.g.
● Spot market vs. Futures market bank loans).
● Money market vs. Capital market
● Primary market vs. Secondary market What are derivatives? How can they be used
● Public market vs. Private market to reduce or increase risk?
● A derivative security’s value is “derived”
Physical assets market - This is the market for from the price of another security (e.g.,
tangible or real assets (e.g. wheat, real estate, options and futures).
computers and machines). ● Can be generally used to “hedge” or
reduce risk.
Financial assets market - It deals with stocks, ● Also, speculators can use derivatives to
bonds, notes, mortgages and derivatives. bet on the direction of future stock
prices, interest rates, exchange rates,
Spot market - This is the market where the and commodity prices. In many cases,
assets are bought or sold for “on the spot” these transactions produce high returns
delivery. Regular markets for products/services if you guess right, but large losses if
are examples of this market. you guess wrong. Here, derivatives
can increase risk.
Futures market - This is the market in which
participants agree today, to buy or sell an asset Examples of Derivatives
at some future date (e.g. A farmer is willing to ● Call Option - it gives the holder the
sell his crops after six months at price of P120 right to buy the underlying asset at a
per kilo. The agreement or the contract including certain price (exercise price or strike
the setting of price will occur today but the actual price) within a specific period of time.
sale transaction will transpire in the future). ● Put Option - it gives the holder the right
to sell the underlying asset at a certain
Money Market - This is the market for short-term date in the future at a certain price.
(less than 1 year), highly liquid debt securities ● Futures contract – it is an agreement
(e.g. treasury bills, foreign exchange market, to buy or sell a certain commodity
negotiable certificate of deposits, commercial asset, at a specific price, at a specific
papers, and interbank money market) time in the future. (E.g. A farmer, to
harvest his crop in 6 months, believing
Capital Market - This is the market for stocks its price to drop in the future, can enter
and intermediate or long-term securities. into a contract today to sell its crop at a
specific price, in 6 months. However,
Primary Market - This is the market where someone has to enter a contract to the
private or public corporations raise new capital. farmer believing that price of the
In this market, the money goes to the farmer’s crop will increase in 6 months).
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Types of Financial Institutions
● Investment banks – companies that
helps companies to raise capital; also
known as “underwriters.
● Commercial banks – accept deposits
and lend money; these are the regular
type of banks that we know.
● Financial services corporation -
Large corporations that combine many
different financial institutions within a ● Private equity companies –
single corporation (e.g. Citigroup which organizations which buy and manage
owns Citibank- a commercial bank, an entire corporations instead of buying
investment bank, a securities brokerage some stocks of those corporations.
organization, insurance companies and
leasing companies). Stock Market Transactions
● Credit unions – cooperative ● Primary market transaction – sale of
associations primarily for the purpose of new shares of stock by the issuing
giving loans to their members. corporation; money goes to the
● Life insurance companies - it takes corporation; this occurs in the primary
savings in the form of premiums, invest market (e.g. Apple Computer decides to
these premiums to securities, and make issue additional stock with the
payments to the insurer’s beneficiaries. assistance of its investment banker. An
● Mutual funds - corporations that investor purchases some of the newly
accept money from savers and then issued shares.).
use the funds to buy stocks, long-term ● Secondary market transaction – sale
bonds or short-term securities issued by of previously issued shares of stock by
the businesses or government units; a stockholder; money goes to the
these organizations pool funds and stockholder; this occurs in the
reduce risks by diversification (putting secondary market (e.g. An investor
money to various investments) (e.g. BPI buys existing shares of Apple stock in
Money Market Fund, Land Bank Bond the open market).
Fund, Metro Equity Fund)
● Exchange traded funds – similar to What is an IPO?
mutual funds but money received are ● An initial public offering (IPO) occurs
invested in specific type of securities when a company issues stock in the
representing an industry or market (e.g. public market for the first time.
Infrastructure companies or Chinese
companies); these can be bought or
sold in a stock exchange (e.g. First
Metro Philippine Equity Exchange
Traded Fund- FMETF, in the Philippine
Stock Exchange) ● “Going public” enables a company’s
● Hedge funds – similar to mutual funds owners to raise capital from a wide
but are unregulated, require large variety of outside investors. Once
minimum investments and are issued, the stock trades in the
marketed to individuals and institutions secondary market.
with high net worth; traditionally use to ● IPO may include new shares (primary
hedge (protect) from risk market transactions) and previously
issued shares owned by the current
stockholders of the private company
(secondary market transactions)
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● Public companies are subject to Efficiency Continuum
additional regulations and reporting ● Others believe that the market is not
requirements. efficient;
● However, most observers believed that
Where can you find a stock quote, and what there is an efficiency continuum instead
does one look like? - meaning market for some companies’
stocks are highly efficient while the
market for other stocks are highly
inefficient:
What is meant by stock market efficiency?
● Stock market efficiency means that
securities are normally in equilibrium Possible Reasons Markets May Not Be
and are “fairly priced.” Efficient
● For rational traders (those who buys ● Behavioral finance is the study of the
and sells stocks), if the stock or market influence of psychology on the behavior
price is “too low”, these traders will of investors. It focuses on the fact that
quickly take advantage of this investors are not always rational, and
opportunity and buy the stock, pushing are influenced by their own biases.
prices up, back to its the proper level. ● Behavioral finance borrows insights
● Investors cannot “beat the market” from psychology to better understand
except through good luck or better how irrational behavior can be
information. sustained over time. Some examples
include:
Efficient Market Hypothesis (EMH) ○ Evaluating risks differently in
● Efficient Market Hypothesis (EMH) is up and down markets.
the general name of the studies related ○ Overconfidence leads to
to market efficiency self-attribution bias and
● It identifies 3 levels of efficiency: hindsight bias.
○ Weak form – past stock price
movements cannot be used to Topic 2: Determinants of Interest Rates
predict future stock prices and
beat the market; however, Nominal Interest Rate
published and inside info can ● It is the actual interest rate observed in
be used to beat the market the market.
and make profits; ● It affects directly the value of most
○ Semi-strong form – all securities traded in the money and
publicly available information capital markets.
is immediately reflected in the ● It influences the performance and
stock prices and cannot be decision making of investors,
used to beat the market; but businesses, and government units.
inside info can be used to beat
the market; Loanable Funds Theory
○ Strong form – this states ● The theory that explains interest rates
even inside information known and interest rate movements.
by company insiders such as ● It views the level of interest rates as
the managers cannot be used resulting from factors that affect the
to beat the market and make supply of and demand for loan funds.
high profits; ● It categorizes financial market
participants – consumers, businesses,
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governments, and foreign participants – demanders of funds will absorb the
as net suppliers or demanders of funds. loanable funds surplus.
Supply of Loanable Funds Factors That Cause Supply and Demand
● It is used to describe funds provided to Curves for Loanable Funds to Shift
the financial markets by net suppliers of
funds.
● Aggregate quantity of funds supplied is
directly related to interest rate.
- More funds are supplied as interest
rates increase (the reward for supply - A shift to the right of the supply curve
funds is higher). lowers the interest rate to I2
- A shift to the left of the supply curve
Demand of Loanable Funds increases the interest rate to I3
● It is used to describe the total net
demand for funds by fund users. Factors that cause the supply and demand
● Aggregate quantity of funds demanded curves for loanable funds to shift
is inversely related to interest rate
- The quantity of loanable funds Factors That Cause Supply and Demand
demanded is higher as interest rates Curves for Loanable Funds to Shift
fall.
Equilibrium Interest Rates
Factors that cause the supply and demand
curves for loanable funds shift
- Some of the providers of loanable funds
are willing to lower the interest rate
because of a surplus. Thus, the
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Premiums Added to r* for Different Types of
Debt
“Nominal” vs. “Real” Rates
Constructing the Yield Curve: Inflation
r = represents any nominal rate Step 1: Find the average expected inflation rate
over Years 1 to N:
r* = represents the “real” risk-free rate of interest.
It is a rate that would exist on riskless security
where no inflation is expected.
It is not static and it depends primarily on (1) the
rate of return that corporation and other borrower
expect to earn on productive assets; and (2) Assume inflation is expected to be 5% next year,
people’s time preferences for current versus 6% the following year, and 8% thereafter.
future compensation.
𝑟𝑅𝐹 = nominal risk-free rate. It represents the rate
of interest on Treasury securities. (r* + IP)
IP = Inflation premium. (average expected rate of
inflation/life of the security)
Must earn these IPs to break even vs. inflation;
DRP = Default risk premium. It reflects the these IPs would permit you to earn r* (before
possibility that the issuer will not pay the taxes).
promised interest or principal at the stated time.
Constructing the Yield Curve: Maturity Risk
LP = Liquidity or marketability premium. It is Step 2: Find the appropriate maturity risk
charged by lenders for some securities that premium (MRP). For this example, the following
cannot be converted to cash on short notice. equation will be used to find a security’s
appropriate maturity risk premium.
MRP = Maturity risk premium. Charged by
lenders due to significant risk of price declines
due to increase in inflation and interest rates.
Using the given equation:
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP + SP
r = required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium Notice that since the equation is linear, the
SP = Special provision maturity risk premium is increasing as the time to
maturity increases, as it should be.
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Add the IPs and MRPs to r* to Find the
Appropriate Nominal Rates It is the relationship among the real risk-free rate
(r*), the expected rate of inflation [E(IP)], and the
nominal interest rate (r).
r = r* + [E(IP)] Brigham
i = RFR + E(IP) Saunders
Fisher effect theorizes that nominal risk-free rate
must compensate investors for:
1. Any reduced purchasing power on
funds lent due to inflationary price
changes
Relationship Between Treasury Yield Curve
2. An additional premium above the
and Yield Curves for Corporate Issues
expected rate of inflation
● Corporate yield curves are higher than
that of Treasury securities.
Term Structure of Interest Rate
● The spread between corporate and
The term structure of interest rate is the
Treasury yield curves widens as the
relationship between interest rates or bond yields
corporate bond rating decreases.
between long and short-term interest rates in
● Since corporate yields include a default
varying maturity dates.
risk premium (DRP) and a liquidity
premium (LP), the corporate bond yield
Unbiased Expectations Theory
spread can be calculated as:
It is considered that the long-term security is
indifferent to short-term security in respect to
maturity.
Example:
Assume that a 1-year treasury bond yields 5%,
Representative Interest Rates on 5-Year while a 2-year bond yields 6.5%. Investors who
Bonds in May 2011 want to invest in 2-year bonds has the following
options.
1. Buy two-year bond then hold it for two
years
2. Buy one-year bond; hold it for one year;
and then at the end of year one,
reinvest the proceeds in another one
year security.
Fisher Effect
If they select strategy 1, for every peso that they
It is the relationship among the real risk-free rate will invest today, they will have an accumulated
(r*), the expected rate of inflation [E(IP)], and the 0.134225 by the end of year 2.
nominal interest rate (r).
2
𝑟 = (1. 065) − 1
r = r* + [E(IP)]
= 0. 134225 𝑜𝑟 13. 4225%
Fisher effect theorizes that nominal risk-free rate
If they select strategy 2, the yield should be
must compensate investors for:
obtained as follows:
1. Any reduced purchasing power on 1/2
funds lent due to inflationary price 𝑅 = [(1 + 1𝑅1)(1 + 𝐸(2𝑟1))]
1 2
−1
changes 1/2
0. 065 = [(1. 05)(1 + 𝐸(2𝑟1))] −1
2. An additional premium above the
2
expected rate of inflation (1. 065) = [(1. 05)(1 + 𝐸(2𝑟1))
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1.134225
= 1 + 𝐸(2𝑟1) demand and supply of loanable funds
1.05
for each segment.
1. 0802 − 1 = 𝐸(2𝑟1)
● The advocates of market segmentation
𝐸(2𝑟1) = 0. 0802 𝑜𝑟 8. 02% theory raise their arguments that the
different economic sectors have their
Liquidity Premium Theory own preferences in terms of maturity.
The long-term security will always have a higher And in the case that their preference
interest rate than the short-term security has not been met, a corresponding
because of the presence of the liquidity premium must be offered.
premium. This theory considers that the longer ● The theory is also saying that different
the maturity of the financial security, the higher economic sectors have their own
liquidity premium should be given. preferred maturities depending on their
respective needs.
Example:
ABC Capital forecasted that a one-year Treasury Implied Forward Rates
bill rates and liquidity premiums for the next four A forward rate (f) is an expected rate on a
years are expected as follows: short-term security that is to be originated at
some point in the future.
The one-year forward rate for any year, N years
into the future is:
Compute for the current one-year (one year spot
On March 1, 2020, the existing or current (spot)
rate) and expected one-year T-bond rates over
one-year, two-year, three-year, and four-year
the following three years.
zero-coupon Treasury security rates were as
follows:
Answer:
𝑅 = 0. 553%, 1𝑅2 = 0. 774%
𝑅 = 5. 60%
1 1
1 1
1/2
𝑅 = 0. 905%,
1 3
𝑅 = 1. 278%
1 4
𝑅 = [(1. 0560)(1. 0670 + 0. 0006)]
1 2
− 1
= 6. 1784 Using the unbiased expectations theory,
𝑅
1 3
= [(1. 0560)(1. 0670 + 0. 0006) one-year forward rates on zero-coupon Treasury
1/3 bonds for 2, 3, and 4 as of March 1, 2020 were:
(1. 0680 + 0. 0008)] − 1
= 6. 4112% 2
𝑅 = [(1. 0560)(1. 0670 + 0. 0006)(1. 0680 𝑓 = [(1. 00774) /(1. 00553)] − 1 = 0. 995%
2 1
1 4
1/4 3 2
+ 0. 0008)(1. 0720 + 0. 0010)] − 1 𝑓 = [(1. 00905) /(1. 00774) ] − 1 = 1. 012%
3 1
= 6. 6331% 4 3
𝑓 = [(1. 00278) /(1. 00905) ] − 1 = 2. 405%
4 1
Period 1 for 1 year
Period 1 for 2 years The expected one-year rate, one year in the
Period 1 for 3 years future, was 0.995, the expected one-year-rate,
Period 1 for 4 years two years in the future, was 1.012; and the
1st subscript is the period and the 2nd subscript expected one-year rate, three years into the
is the maturity. future, was 2.405.
Market Segmentation Theory
● According to the market segmentation
theory, interest rates are determined by
the interaction between the aggregate
