CHAPTER 7 7.

RISK MANAGEMENT – futures, options and other derivatives contracts

FINANCIAL MARKETS: AN OVERVIEW can provide protection against may types of risks.

Financial markets are the meeting place for people, corporations, and DEBT AND EQUITY MARKETS
institutions that either need money or have money to lend or invest.
Debt instruments – such as a bond or a mortgage, which is a contractual
- Exists as a vast global network of individuals and financial agreement by the borrower to pay the holder of the instrument fixed peso
institutions that may be lenders, borrowers or owners of public amounts at regular intervals until a specified date, when a final payment is
companies worldwide. made.
- Bond and stock markets.
- Maturity is the number of years until that instrument’s expiration
Stock markets are places where individual investors and corporations can trade date.
currencies, invest in companies, and arrange loans. - Short term debt instruments if its maturity is less than a year.
Long-term debt instruments if its maturity is ten years or longer.
Public financial markets – where participants are national, state and local - Intermediate-term is a debt instruments with a maturity between
governments that are primarily borrowers of funds for highways, education one and ten years.
welfare and other public activities.
Equity instruments – raising funds by issuing ordinary stocks, which are
Corporate financial markets – includes large corporations. claims to share in the net income and the assets of a business.

Primary market – where corporations use financial markets to raise new The main disadvantage of owing a corporation’s equities rather than its debt
funds, the sale of securities. is that an equity holder is a residual claimant: that is, the corporation must pay
all its debt holders before it pays its equity holders.
- Refers to original sale of securities by governments and
corporations. The main advantage of holding equities is that equity holders benefit directly
- Public offering involves selling securities to the general public from any increases in the corporation’s profitability or asset value because
whereas, private placements is a negotiated sale involving a equities confer ownership rights on the equity holders.
specific buyer.
- Investment bank is an important financial institution that assists STOCK EXCHANGE – is an organized secondary market where securities
in the initial sale of securities in the primary market. like shares, debentures of public companies, governments securities and bonds
issued by municipalities are purchased and sold. They are known as barometer
Secondary market – the place where the sold securities are traded between of the company’s economy.
investors.
Purpose of stock exchange is to facilitate the exchange of securities between
- Popularly known as Stock Market or Exchange. buyers and sellers, thus providing a market place, virtual (virtual market) or
- Brokers are agents of investors who match buyers with sellers of real.
securities, they are also members of a stock exchange; dealers link
buyers and sellers by buying and selling securities and stated Listing agreement – regulates the company’s behavior through requirements
prices. Both are crucial to a well-functioning secondary market. agreed upon by the company in order to be listed. It ensures that the
companies provide all the information pertaining to its working from time to
TWO BROAD SEGMENTS OF STOCK MARKETS time, including events that affect its valuation.

1. Organized Stock Exchange – stock exchanges have a physical location Listing – admission of securities to dealings on a recognized stock exchange
where stocks buying and selling transactions take place in the stock exchange of any incorporated company, central and stage governments.
floor.
The principal objective of listing is to provide liquidity and marketability to
2. Over-the-Counter (OTC) Exchange – shares, bonds and money listed securities and ensure effective monitoring of trading for the benefits of
instruments are traded using a system of computer screens and telephones. all participants in the market.

TWO IMPORTANT FUNCTIONS OF SECONDARY MARKETS Official quotation is the price at which the securities are brought and sold on
an organized stock exchange.
1. They make it easier to sell financial instruments to raise cash.
DAY TRADING is a buying and selling of shares, currency, or other financial
2. They determine the price of the security that the issuing firm sells in the instruments in a single day.
primary market.
Day traders should be knowledgeable of the ff:
Financial intermediaries – banks, insurance companies among others.
1. Market data – the current trading information for each day-trading market.
WHAT FINANCIAL MARKETS DO
2. Scalping – A strategy in which traders hold their share or financial assets
1. RAISING CAPITAL – important source of capital. for just few minutes or even seconds.
2. COMMERCIAL TRANSACTIONS – provide arrangement for paying 3. Margin trading – A method of buying shares that involves the day trader
bills more easily. borrowing a part of the sum needed form the broker who is executing the
transactions.
3. PRICE SETTING – provide price discovery of different items, based upon
the prices at which individuals are willing to buy and sell. 4. Bid-offer spread – difference between a price at which a share is sold, and
that at which it is bought.
4. ASSET VALUATION – offer the best way to determine the value of a firm
or of the firm’s assets, or property. - Day trading is a high-risk occupation.
- Day trading is stressful.
5. ARBITRAGE – commodities and currencies may be traded at very
- Day trading is expensive.
different prices in different locations.
IMPORTANT ATTRIBUTES OF FORMAL MARKETS:
6. INVESTING – provide an opportunity to earn a return on funds that are
not needed immediately. 1. Liquidity
2. Transparency bear interest: instead, an investor purchases the acceptance at a discount form
3. Reliability face value and then redeems it for face value at maturity.
4. Legal Procedures
5. Suitable investor protection and regulation 3. Treasury bills – often referred to as T-bills, are securities with a maturity of
6. Low transaction costs one year or less, issued by national governments.

FORCES OF CHANGE 4. Government agency notes – these include entities such as development
banks, housing finance corporations, education lending agencies and
1. Technology agricultural finance agencies.
2. Deregulation
3. Liberalization 5. Local government notes – are issued by, provincial or local governments,
4. Consolidation and by agencies of these governments such as schools authorities and
5. Globalization transport commissions. The approval of national authorities is required.

CHAPTER 8 6. Interbank loans – loans extended from one bank to another with which it
MONEY MARKETS AND CAPITAL MARKETS has no affiliation.

“Money Market” refers to the network of corporations, financial institutions, 7. Time deposits – another name for certificates of deposits or CDs, are
investors, and governments which deal with the flow of short-term capital. interest-bearing bank deposits that cannot be withdrawn without penalty
before a specified date.
 A place where short-term liquidity transactions occur.
8. Repos – also known as repurchase agreements which play a critical role in
Disintermediation – a process where money markets have expanded
the money markets. They serve to keep the markets highly liquid, which in
significantly because of the general outflow of money from the banking
turn ensures that there will be a constant supply of buyers for new money-
industry.
market instruments.
HOW DOES MONEY MARKET WORKS?
A repo is a combination of two transactions. In the first, a securities dealer,
 Money market exists to provide the loans that financial institutions such as a bank, sells securities it owns to an investor, agreeing to repurchase
and governments need to carry out their day-to-day operations. the securities it owns to an investor, agreeing to repurchase the securities at a
 Money markets are the mechanisms that bring these borrowers and specified higher price at a future date. In the second transaction, days or
investors together without the comparatively costly intermediation months later, the repo is unwound as the dealer buys back the securities from
of banks. They make it possible for borrowers to meet short-run the investor. The amount the investor lends is less than the market value of the
liquidity needs and deal with irregular cash flows without resorting securities, a difference called the spread or haircut, to ensure that it still has
to more costly means of raising money. sufficient collateral if the value of the securities should fall before the dealer
repurchases them.
The primary function of the money market is for banks and other investors
with liquid assets to gain a return on their cash or loans. “Capital Markets” is a financial market in which longer-term debt (original
maturity of one year or greater) and equity instruments are traded.
WHO USES THE MONEY MARKET?
 It includes bonds, stocks, and mortgages.
a. Companies
b. Banks The primary issuers of capital market securities are the National and Local
c. Investors government, and Corporations.

WHAT MONEY MARKETS DO? National Government issues long-term notes and bonds to fund the national
debt while local governments issue notes and bonds to finance capital
Similar to bond investors, money-market investors, money market investors projects.
are extending credit, without taking any ownership in the borrowing entity or
any control over management. Corporations issue both bonds and stock to finance capital investment
expenditures and fund other investment opportunities.
Yet, money market and bond markets have different purposes. Bond issuers
typically raise money to finance investments that will generate profits. Issuers CAPITAL MARKET TRADING – occurs in either the primary market or
of money-market instruments are usually more concerned with cash the secondary market. The primary market is where new issues of stocks and
management or with financing their portfolios of financial assets. bonds are introduced.

TYPES OF MONEY MARKET INSTRUMENTS Initial public offering (IPO) – When firms sell securities for the securities
for the very first time.
1. Commercial paper – is a short-term debt obligations of a private sector
firm or a government-sponsored corporation. A secondary market is where the sale of previously issued securities takes
place, and it is important because most investors plan to sell long-term bonds
The use of commercial paper also creates a risk that if interest rates should before they reach maturity and eventually to sell their holdings of stock as
rise, the total cost of successive short-term borrowings may be greater than well.
had the firm undertaken longer-term borrowing when rates were low.
The two types of exchanges in the secondary market for capital expenditures:
2. Bankers’ acceptances
1. Over-the-counter exchanges where most money market transactions
An acceptance is a promissory note issued by a non-financial firm to a bank originate over the phone, most capital market transactions, measured by
in return for a loan. The bank resells the note in the money market at a volume, occur in organized exchanges.
discount and guarantees payment. Acceptances usually have a maturity of less
than six months. 2. An organized exchange has a building where securities trade. Exchange
rules govern trading to ensure the efficient and legal operation of the
Differences of bankers’ acceptances from commercial paper: exchange, and the exchange’s board constantly reviews these rules to ensure
that they result in competitive trading.
Bankers’ acceptances are usually tied to the sale or storage of specific goods,
such as export order for which proceeds will be received in two or three TYPES OF CAPITAL MARKETS
months. They are not issued at all by financial-industry firms. They do not
A. BONDS – is any long-term promissory note issued by the firm. A bond return demanded in the capital markets. A higher credit risk bonds are
certificate is the tangible evidence of debt issued by a corporation or a speculative, also called junk bonds and high-yield bonds.
governmental body and represents a loan made by investors to the issuer.
CREDIT RATINGS
The two sets of cash flows that a bond provides are the periodic interest
payments and the principal returned at maturity. Investment Grade

1. Highest quality (AAA) – the issuer’s capacity to meet its financial

commitment in the obligation is extremely strong.

2. High quality (AA) - the issuer’s capacity to meet its financial commitment
in the obligation is very strong.

3. Upper medium grade (A) - the issuer’s capacity to meet its financial
commitment in the obligation is still strong, through somewhat susceptible to
the adverse effects of changes in circumstances and economic conditions.

4. Medium grade (BBB) – the obligator exhibits adequate protection.

Other arrangements of bond transactions can be as follows: However, adverse economic conditions are more likely to lead a weakened
capacity to meet its financial commitment.
1. Competitive sale – the investment bank can purchase the bonds through
competitive bidding against other investments banks or by directly negotiating Below investment grade
with the issuer.
5. Somewhat speculative (BB) – faces major ongoing uncertainties or
2. Negotiated sale – a single investment bank obtains the exclusive right to exposure to adverse business, financial, or economic conditions which could
originate, underwrite and distribute the new bonds through a one-on-one lead to the obligor’s inadequate capacity to meet its financial commitment.
negotiation process.
6. Speculative (B) – adverse business, financial, or economic conditions will
3. Best efforts underwriting basis – the underwriter does not guarantee a likely impair the obligor’s capacity or willingness to meet its financial
firm price to the issuer. commitment.

ADVANTAGES OF USING BONDS 7. Highly speculative (CCC) – currently vulnerable to nonpayment, and is
dependent upon favorable business, financial, and economic conditions for the
 Long-term debt is generally less expensive than other forms of obligor to meet its financial commitment.
financing.
 Bondholders do not participate in extraordinary profits: the 8. Most speculative (CC) – current highly vulnerable to nonpayment.
payments are limited to interest.
 Bondholders do not have voting rights. 9. Imminent default (C) – used to cover a situation where a bankruptcy
 Floatation costs of bonds are generally lower than those of petition has been filed or similar action taken, but payments on this obligation
ordinary shares. are being continued.

DISADVANTAGES OF USING BONDS 10. Default (D) – obligations are in default or the filing of a bankruptcy
petition has occurred and payments are jeopardized.
 Debts results in interest payments that, if not met, can force the
firm into bankruptcy.
 Debt produces fixed charges, increasing the forms financial TYPES OF BONDS
leverage.
 Debt must be repaid at maturity and thus involves major cash flow. A. Unsecured Long-term Bonds
 The restrictive nature of indenture covenants may limit the firm’s
future financial flexibility.  Debentures are unsecured long-term debt and backed only by the
reputation and financial stability of the corporation.
BOND FEATURES AND PRICES  Subordinated Debentures are claims of bondholders that are
honored only after the claims of secured debt and unsubordinated
 Par Value is the face value of the bond that is returned to the debentures have been satisfied.
bondholder at maturity.  Income Bonds requires interest payments only is earned and non-
 Coupon interest rate is the percentage of the par value of the payment of interest does not lead to bankruptcy.
bond that will be paid out annually in the form of interest.
 Maturity the length of time until the bond issuer returns the par B. Secured Long-term Bonds
value to the bondholder and terminates the bond.
 Indenture is the agreement between the firm issuing the bonds and  Mortgage bonds is a bond secured by a lien on real property. The
the bond trustee who represents the bondholders. It provides the market value of the real property is greater than that of the
specific terms of the loan agreement, including the description of mortgage bonds issued.
the bonds, the rights of the bondholders, the rights of the issuing (a) First Mortgage Bonds – have senior claim on the secured
firm and the responsibilities of the trustees. assets if the same property has been pledge on more than one
 Current yield refers to the ratio of the annual interest payment to mortgage bond.
the bond market price. (b) Second Mortgage Bonds – these bonds have the second claim
 Yield to maturity refers to the bond’s internal rate of return. It is on assets and are paid only after the claims of first mortgage bonds
a discount rate that equates the present value of the interest and have been satisfied.
principal payments with the current market price of the bond. (c) Blanket or General Mortgage Bonds – all assets of the firm
are used as security for this type of bonds.
Credit Quality Risk is the chance that the bond issuer will not be able to (d) Closed-end Mortgage Bonds – bonds forbid the further use of
make timely payments. the pledge assets security for other bonds. This protects the
bondholders from dilution of their claims on the assets by any
Bond ratings involve a judgement about the future risk potential of the bond future mortgage.
provided by rating agencies. The poorer the bond rating, the higher the rate of
 (e) Open-end Mortgage Bonds – these bonds allow the issuance The accounting value of an ordinary equity share is equal to the ordinary share
of additional bonds up to a limited amount at the same priority equity divided by the number of shares outstanding.
level using the already mortgaged assets as security.
6. Numerous rights of stockholders
OTHER TYPES OF BONDS
VALUATION – it is a complicated by the uncertainty of future returns and/or
1. Floating Rate or Variable Rate Bonds changes in the share’s price.

A floating rate bond is one in which the interest payment changes with market C. PREFERRED SHARE
conditions.
Preferred share is a class of equity shares which has preference over ordinary
2. Junk or Low-Rated Bonds equity shares in the payment of dividends and in the distribution of
corporation assets in the event of liquidation.
A junk or low rated bonds are bonds rated BB or below. The major
participants of this market are new firms that do not have an established Preference means only that the holders of the preferred share must receive a
record of performance, although in recent years junk bonds have been dividend before holder of ordinary equity shares are entitled to anything.
increasingly issued to finance corporate buyouts. Preferred shares generally have no voting right privileges but it is a form of
equity from a legal and tax stand point.
3. Eurobonds
Preferred share features:
These are bonds payable or denominated in the borrower’s currency, but sold
outside the country of the borrower, usually by an international syndicate of 1. Par value – is the face value that appears on the stock certificate.
investment bankers.
2. Dividends – are stated as percentage of the par value and are commonly
4. Treasury Bonds fixed and paid quarterly but are not guaranteed by the issuing firm.

Treasury bonds carry the “full-faith-and-credit” backing of the government 3. Cumulative and Noncumulative Dividends – if preferred dividends are
and investors consider them among the safest fixed-income investments in the cumulative are not paid in a particular year, they will be carried forward as an
world. arrearage. If preferred dividends are noncumulative, dividends not declared in
any particular year are lost forever and the preferred shareholders cannot
B. ORDINARY (COMMON) EQUITY SHARES claim such anymore.

Ordinary equity shares are a form of long-term equity that represents 4. No definite maturity date – preferred share is usually intended to be a
ownership interest of the firm. Ordinary equity shareholders are called permanent part of the firm’s equity and has no definite maturity date.
residual owners because their claim to earnings and assets is what remains However, some preferred shares have a sinking fund provision that requires
after satisfying the prior claims of various creditors and preferred the issuer to repurchase and retire the share on a scheduled basis.
shareholders.
5. Convertible preferred share – these are shares that have the option of
exchanging their preferred share for ordinary equity share based on specified
terms and conditions.

6. Voting rights – does not ordinarily carry voting rights.

7. Participating features – participating preferred share entitles its holders to

FEATURES OF ORDINARY EQUITY SHARES share in profits above and beyond the declared dividend, along with ordinary
equity shareholders. Without no participated preferred, the return is limited to
1. Par value/No par value
the stipulated dividend.
Par value of ordinary shares is the stated value attached to a single share at
8. Protective features – preferred shares issues often contain covenants to
issuance.
assure the regular payment if preferred share dividends and to improve the
2. Authorized, issued, and outstanding quality of preferred share. PS have priority over ordinary shareholders with
regard to earnings and assets.
Authorized shares are the maximum number of shares that a corporation may
issue without amending its charter. Issued shares is the number of authorized 9. Call provisions – gives the issuing corporation the right to call in the
shares that have been sold. Outstanding shares are those shares held by the preferred share for redemption. As in the case of bonds, call provisions
public. Treasury shares are previously issued shares that are reacquired and generally state that the company must pay an amount greater than the par
held by the firm. value of the preferred share, the additional sum being termed a call premium.

3. No maturity 10. Maturity – it had no maturity and never needed to be paid off.

Ordinary equity share has no maturity and is a permanent form of long -term PREFERRED SHARE VALUATION
financing. A tender offer is a formal offer to purchase shares of a corporation.
Preferred share valuation is relatively simple if the firm pays fixed
4. Voting rights dividends at the end of each year. If this condition holds, then the stream of
dividend payments can be treated in perpetuity and be discounted by the
Each share of ordinary equity generally entitles the holder to vote on the investor’s required rate of return on a preferred share issue. A perpetuity is an
selection of directors and in other matters. Shareholders unable to attend the annuity with an infinite life span.
annual meeting to vote may vote by proxy. A proxy is a temporary transfer of
the right to vote to another party.

 Majority Voting – is a voting system that entitles each shareholder

to cast one vote for each share owned.
 Cumulative voting – is a voting system that permits the
shareholder to cast multiple votes for a single director.

5. Book value per share

  Appreciation of a currency can make it harder for domestic
manufacturers to sell their goods abroad and can increase
competition at home from foreign goods because they cost less.

FACTORS INFLUENCING EXCHANGE RATES

1. Inflation – tends to deflate the value of a currency because holding the

currency results in reduced purchasing power.

2. Interest rates – when interest rates are higher relative to other countries,
individuals and companies will be enticed to invest in that country. As a result,
there will be an increased demand for the country’s currency.

3. Balance of payments – used to refer to a system of accounts that catalogs

the flow of goods between the residents of two countries.

4. Government intervention – through intervention of the central bank like

buying or selling the currency in the forex market, may support or depress the
value of the currency.

5. Other factors – includes political and economic stability, extended stock

market rallies, and significant declines in the demand for major exports.

MANAGED FLOAT is the current method of exchange rate determination. It

is when there is an intervention by governments or central banks may occur to
maintain fairly stable exchange rates.

THEORY OF PURCHASING POWER PARITY is one of the most

prominent theories of how exchange rates are determined. It states that
exchange rates between any two currencies will adjust to reflect changes in
the price levels of the two countries. The theory of PPP is simply an
application of the law of one price to national price levels.

The two kins of Foreign Exchange Rate Transactions are:

A. SPOT TRANSACTIONS

Spot transactions are those which involve immediate (two-day) exchange of

bank deposits. The spot exchange rate is the exchange rate for the spot
CHAPTER 9 transactions.
FOREIGN EXCHANGE MARKET
 Direct quotes are quoted exchange rate in the spot exchange
Exchange rates are the relationships among the values of currencies. market. A direct quote indicates the number if units of the home
currency required to buy one unit of the foreign currency.
 It is simply the price of one country’s currency expressed in terms  Indirect quote indicates the number of units of foreign currency
of another country’s currency. that can be bought for one unit of the home currency.
 In summary, a direct quote is the peso/foreign currency rate, and
Devaluation is an adjustment in the exchange rate where the currency was
an indirect quote is the foreign currency/peso rate.
made cheaper with respect to the dollar.

Upvaluation or revaluation resulted when currency became more expensive

with respect to the dollar.

The determination of exchange rates are influenced by such important factors

as: (a) the country’s economic strengths, (b) its level of exports and imports,
(c) the level of monetary activity, and (d) the deficits or surpluses in its
balance of payments. In short, day-to-day fluctuations in exchange rates are
caused by supply and demand conditions in the foreign exchange market.

The forex market provides a service to individuals, businesses, and

governments who need to buy or sell currencies other than that used in their
country. It provides a mechanism for the transfer of purchasing power from
one currency to another.

WHY ARE EXCHANGE RATES IMPORTANT?

 They affect the relative price of domestic and foreign goods.

 When a country’s currency appreciates, the country’s goods abroad
become more expensive and foreign goods in that country become
cheaper. Conversely, when a country’s currency depreciates, its
goods abroad become cheaper and foreign goods in that country
become more expensive.
 conversely, increased demand for imports causes the domestic currency to
depreciate.

4. Productivity – as a country becomes more productive relative to other

countries, its currency appreciates.

Foreign exchange risk refers to the possibility of a drop in revenue or an

increase in cost in an international transaction due to a change in foreign
exchange rates. Importers, exporters, investors and multinational forms are all
exposed to this foreign exchange risk.

AVOIDANCE OF EXCHNAGE RATE RISK IN FOREIGN CURRENCY

MARKETS

1. The firm may hedge its risk by purchasing or selling forward exchange
contracts.

2. The firm may choose to minimize receivables and liabilities denominated in

foreign currencies.

3. Maintaining a monetary balance between receivables and payables

denominated in a particular foreign currency avoids a net receivable or net
liability position in that currency.

4. The use of trigger pricing where foreign funds are supplied at an indexed
price but with an option to convert to a future-based fixed price when a
specified basis differential exists between the two prices.

5. A firm may seek to minimize its exchange-rate risk by diversification.

6. A speculative forward contract does not hedge any exposure to foreign

currency fluctuations, its creates the exposure.

 Cross rates is the indirect computation of the exchange rate of one CHAPTER 10
currency from the exchange rates f two other currencies. The MORTGAGE MARKETS AND DERIVATIVES
arbitrage conditions for the cross rates is called triangular
arbitragage. Mortgages are long-term loan secured by real estate. The loan is amortized
and the borrower pays it off over time in some combination of principal and
interest payments that result in full payment of the debt by maturity.

CHARACTERISTICS OF THE RESIDENTIAL MORTGAGE

A. Mortgage Interest Rates – is the most important factors in the decision of

the borrower of how much and from whom to borrow.

The three important factors that affect the interest rate on the loan:

 Current long-term market rates can be determined by the supply of

and demand for long-term funds, which are in turn affected by
several global, national, and regional factors.
 Term or life of the mortgage is usually 15 to 30 years.
 Number of discount points paid: Discount points are interest
 Arbitrage is a buy-and-sell strategy that would involve an
payments made at the beginning of a loan.
investment of funds for short time and no risk bearing, yet the
trader could make a sure profit. It is the process of buying and B. Loan Terms – mortgage loan contracts contain many legal and financial
selling in more than one market to make a riskless profit. The terms, most of which protect the lender from financial loss.
person involved in this transaction is called the arbitrageur.
C. Collateral – mortgage loans requires collateral, usually the real estate
being financed, be pledge as security.
B. FORWARD TRANSACTIONS
D. Down Payment – to obtain mortgage loan, the lender requires the
Forward transactions involve the exchange of bank deposits at some specified borrower to make a down payment on the property, that is, to pay a portion of
future date. The forward exchange rate is the exchange rate for the forward the purchase price. The down payment reduces morel hazard for the borrower.
transaction.
E. Private Mortgage Insurance (PMI) – is an insurance policy that
FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN guarantees to make up any discrepancy between the value of the property and
the loan amount, should a default occur.
1. Relative Price Level – a rise in a country’s price level (relative to the
foreign price level)causes its currency to depreciate, and a fall in the country’s F. Borrower Qualification – before granting a mortgage loan, the lender will
relative price level causes its currency to appreciate. determine whether the borrower qualifies for it.
2. Trade Barriers – increasing trade barriers causes a country’s currency to TYPES OF MORTGAGE LOANS
appreciate in the long run.
1. CONVENTIONAL MORTGAGES – these are originated by banks or
3. Preferences for Domestic Versus Foreign Goods – increased demand for other mortgage lenders but are not guaranteed by government or government-
a country’s exports causes its currency to appreciate in the long run: controlled entities.
2. INSURED MORTGAGES – these mortgages are originated by banks or The above problems inspired the creation of mortgage-backed security.
other mortgage lenders but are guaranteed by either the government or
government-controlled entities. Mortgage-backed security is a security that is collateralized by a pool of
mortgage loans. This is also known as securitized mortgage.
3. FIXED-RATE MORTGAGE – the interest rate and the monthly payment
do not vary over the life of the mortgage. Securitization is the process of transforming illiquid financial assets into
marketable capital market instruments. Securitized mortgages are low-risk
4. ADJUSTABLE-RATE MORTGAGE (ARMs) – is tied to some market securities that have higher yield than comparable government bond and attract
interest rate, and therefore changes over time. ARMs usually have limits, funds from around the world.
called caps, on how high (or low) the interest rate can move in one year and
during the term of the loan. BENEFITS IF SECURITIZED MORTGAGE

5. GRADUATED-PAYMENT MORTGAGES (GPMs) – these mortgages A. SM has reduced the problems and risks caused by regional lending
are useful for home buyers who expect their incomes to rise. institutions’ sensitivity to local economic fluctuations.

6. GROWING EQUITY MORTGAGE (GEMs) – the payments will B. Borrowers now have access to a national capital market.
initially be the same as on a conventional mortgage. Over time, however, the
payment will increase. This increase will reduce the principal more quickly C. Investors can enjoy the low-risk and long-term nature of investing in
than the conventional payment stream would. mortgages without having to service loan.

7. SHARED APPRECIATION MORTGAGES (SAMs) – the lender lowers D. Mortgage rates are now more open to national and international influences.
the interest rate in the mortgage in exchange for a share of any appreciation in
The most common type of mortgage-backed security is the mortgage pass
the real estate.
through, a security that has the borrower’s mortgages pass through the trustee
8. EQUITY PARTICIPATING MORTGAGE (EPM) – an outside investor before being disbursed to the investors in the mortgage-pass through.
shares in the appreciation of the property. This investor will either provide a
PART II: DERIVATIVES
portion of the purchase price of the property or supplement the monthly
payment. Derivatives includes such as financial options, futures and forwards, interest
rate swaps and currency swaps. These are financial instruments that “derive”
9. SECOND MORTGAGE – these are loans that are secured by the same
their value on contractually required cash flows from some other security or
real estate that is used to secure the first mortgage. The second mortgage is
index.
junior to the original loan which means that should a default occur, the second
mortgage holder will be paid only after the original loan has been paid off, if
sufficient funds remain.

10. REVERSE ANNUITY MORTGAGES (RAMs) – the bank advances

funds to the owner on a monthly schedule to enable him to meet living CHARACTERISTICS OF DERIVATIVES
expenses he thereby increasing the balance of the loan which in secured by the
real estate. a. whose value changes in response to the change in a specified interest rate,
security price, commodity price, and among others.

b. requires no initial net investment or little net investment relative to other

types of contracts that have a similar response to changes in market
conditions.

c. that is settled at a future date.

HOW DERIVATIVE WORKS

1. Derivatives for hedging

Settling cost by fixing price for a future deal in advance against unexpected
rises or falls in.

2. Derivatives for speculations

Investors may buy or sell an asset in the hope of generating a profit form the
asset’s price fluctuations. If the share prices do rise, the investor can profit by
buying at a fixed option price and selling at the current higher price. If share
prices fall, the investor can sell the option or let it lapse, losing a fraction of
the value of the asset itself.

TYPICAL EXAMPLES OF DERIVATIVES

1. FUTURE CONTRACTS is an agreement between a seller and a buyer that

requires that seller to deliver a particular commodity at a designated future
SECURITIZATION OF MORTGAGES date, at a predetermined price.

The ff. items are several problems when trying to sell mortgages to the 2. FORWARD CONTRACTS is similar to a future contract but differs in
secondary market: three ways:

 Mortgages are usually too small to be wholesale instruments.  A forward contract calls for delivery on a specific date, whereas a
 Mortgages are not standardized. futures contract permits the seller to decide later which specific
 Mortgage loans are relatively costly to service. day within the specified month will be the delivery date.
 Mortgages have unknown default risk.  Unlike a futures contract, a forward usually is not traded on a
market exchange.
 Unlike a futures contract, a forward contract does not call for a
daily cash settlement for price changes in the underlying contract.
Gains and losses in forward contracts are paid only when they are
closed out.

a.) OPTIONS – give its holder the right either to buy or sell an
instrument, at a specified price and within a given time period. The
option holder has no obligation to exercise the option. On the other hand,
the holder of a future contract must buy or sell within a specified period
unless the contract is closed out before delivery comes due.

b.) FOREIGN CURRENCY FUTURES – these are similar to financial

futures except specific foreign currencies are specified in the futures
except specific foreign currencies are specified in the future contracts
rather than specific debt instruments.

c.) INTEREST RATE SWAPS – these are contracts to exchange cash

flows as of a specified date or a series of specified dates based on a
notional amount and fixed and floating rates.