Financial Market: Ms. Sheila May A. Fiel
Financial Market: Ms. Sheila May A. Fiel
MODULE
Prepared by:
This course explores the function, pricing, and institutional structures of financial
markets. Our intent is to understand the differences between these instruments and
the institutions that operate in today's financial markets. Rapid changes in the
composition of financial instruments and institutions mean that the content of this
course must be evolving as well. Understanding the economic foundations of these
intermediaries, in addition to the institutional instruments, and developing your
analytical and research skills, will prepare you not only for today's job market, but will
also help to increase your educational flexibility in adapting to future changes.
STUDY SCHEDULE
MODULE 1:
• Overview of Financial Environment
At the end of the module you will be able to:
1. Define what is financial market;
2. Describe the types of financial markets;
3. Describe the types of securities traded within financial markets;
4. Describe the role of financial institutions within financial markets;
5. Explain how financial institutions were exposed to the credit crisis;
6. Apply the loanable fund theory to explain why interest rates change;
7. Identify the most relevant factors that affect interest rate movements;
8. Explain how to forecast interest rates;
9. Describe how characteristics of debt securities cause their yields to vary;
10. Explain the theories behind the term structure of interest rates.
The following guides and house rules will help you to be on track and complete the
module with a smile on your face.
1. Read and understand every part of the module. If there are some contents or tasks
which you find difficult to understand, try to re-read and focus. You may also ask help
from your family at home, if it doesn’t work, you may send a private message on my
Facebook account (Sheila May Albaracin Fiel) or you may text me on this cellphone
number 09387329442.
2. Each module begins with an overview and a list of the topics you are expected to learn.
3. Before reading the module and working on the activities, answer the pretest first. Find
out how well you did by checking your answers against the correct answers in the
answer key.
4. At the end of each lesson try to reflect and assess if you were able to achieve the
learning objectives. Remember that you can always read again if necessary.
5. Learn to manage your time properly. Study how you can manage to work on this module
in consideration of your other modules.
6. Each module has worksheets where you can do all your activities. At the end of the
month, remove the worksheets and submit them to your teacher.
7. Have patience and do not procrastinate.
8. Practice the virtue of honesty in doing all your tasks.
9. Lastly, the activities in the module must be done by you and not by others. Your family
and friends may support and guide you but you must not let them do the work. DO
YOUR BEST AND GOD WILL DO THE REST.
Reflect on the quote above. Is it not amazing what education can do? How it transforms
an individual and changes one’s life? Did you ever wonder how teachers teach and affect
students? How they carefully plan everything? You’d be surprised to know that teachers and
experts spend a great deal of thought, time, effort and expertise to help a learner develop his
potential to the fullest.
It's the teacher’s responsibility to guide the learners towards becoming the best that they
can be. They are tasked to help provide students with the knowledge, skills, attitudes, and
values they need to succeed in their studies, work and life.
As a future accountants, you too have the responsibility to prepare yourself to become
an important agent who possesses knowledge and understanding of how you can help our
economy. This module will help you take the first step in achieving the goals stated above.
So are you now ready to embark on this journey? I wish you an enriching and productive
learning experience.
Module 1
Lesson 1 What is Financial Market?
Introduction
Learning Outcomes:
Figure 1. ETL and DI in Data Science: usage in financial market data warehouses.
Retrieved from: https://towardsdatascience.com/etl-and-di-in-data-science-usage-in-financial-markets-data-warehouses-21df4e1ebb42
Take Off
Have you heard the word Financial Market before? What do you think is Financial
Market? What is its role to the business sectors? Kindly take a few minutes to ponder about
these questions before proceeding.
Content Focus
A financial market is a market in which financial assets (securities) such as stocks and bonds
can be purchased or sold. Funds are transferred in financial markets when one party purchases
financial assets previously held by another party. Financial markets facilitate the flow of funds
and thereby allow financing and investing by households and firms, and government agencies.
Financial markets play a vital role in the allocation of resources and operation of
modern economies. Financial markets create products that provide a return for those who have
excess funds (Investors/lenders), making these funds available to those who need additional
money (borrowers). They provide a market that bridges the gap between borrowers and
lenders.
Financial markets transfer funds from those who have excess funds to those who
need funds. For example, they enable college students to obtain student loans, families to
obtain mortgages, business to finance their growth, and governments to finance many of their
expenditures. Many households and businesses with excess funds are willing to supply funds to
financial markets because they earn a return on their investment. If funds were not supplied, the
financial markets would not be able to transfer funds to those who need them.
Those participants that have greater income than their expenditures are referred
to as surplus units (investors). However, those participants that have greater expenditures
than their income are referred to as deficit units (borrowers).
The surplus units provide their net earnings to the financial market to earn return
on investment while the deficit units access funds to the financial markets so they can spend
more money than they receive.
Example_____________________________________________________________________
College students are typically deficit units, as they often borrow from financial
markets to support their education. After they obtain their degree, they earn more income than
they spend and thus become surplus units by investing their excess funds. A few years later,
they may become deficit units again by purchasing a home. At this stage, they may provide
funds to and access funds from financial markets simultaneously. That is, they may periodically
deposit savings in a financial institution while also borrowing a large amount of money from a
financial institution to buy a home.
Example_____________________________________________________________________
Last year, Riverto Co . had excess funds invested in newly issued Treasury debt
secuirties with a 10-year maturity. This year, it will P15 million to expand its operations. The
company decided to sell its holdings of Treasury bonds in the secondary market and received
P5 million from the sale. In also issued in its own debt securities, which have a 10-year maturity,
in the primary market. The investors who purchased Riverto’s debt securities can redeem them
at maturity or sell them before that time to other investors in the secondary market.
Securities can be classified as money market securities, capital market securities, or derivative
securities.
• Stocks- (or equity securities) represent partial ownership in the corporations that
issued them. They are classified as capital market securities because they have
no maturity and therefore serve as a long-term source of funds. Some
corporations provide income to their stockholders by distributing a portion of their
quarterly earnings in the form of dividends. Other corporations retain and reinvest
all their earnings which increases their growth potential.
3. Derivative Securities
Derivative securities are financial contracts whose values are derived from the values
underlying assets such as debt securities or equity securities. Many derivative securities
enable investors to engage in speculation and risk management.
Risk Management Derivative securities can be used in a manner that will generate
gain if the value of underlying assets declines. Consequently, financial institutions and
other firms can use derivative securities to adjust the risk of their existing investments in
securities. If a firm maintains investments in bonds, it can take specific positions in
derivative securities that will generate gains if bond values will decline. In this way
derivative values can be used to reduce a firm’s risk. The loss of the bonds is offset by
the gains on these derivative securities.
• They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
• They repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
• They accept the risk on loans provided.
• They have more expertise than individual surplus units in evaluating the
creditworthiness of deficit units.
• They diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.
Examples of Depository Institutions
o Commercial Banks- they serve surplus units by offering a wide variety of
deposit accounts, and they transfer deposited funds to deficit units by
providing direct loans or purchasing debt securities. Commercial bank
operations are exposed to risk because their loans and many of their
investments in debt securities are subject to the risk of default by the
borrowers. Commercial banks both serve the private and public sectors;
their deposit and lending services are utilized by the households,
business, and government agencies.
o Credit Unions- credit unions differ from commercial banks and savings
institutions in that they are (1) are non-profit and (2) restrict their business
to the credit union members, who share a common bond. Because of the
“common bond” characteristic, credit unions tend to be much smaller than
other depository institutions. They use most of their funds to provide loans
to their members.
o Mutual Funds- mutual funds shares to surplus units and use the funds
received to purchase a portfolio of securities. They are the dominant non-
depository financial institution when measured in total assets. Some
mutual funds concentrate their investment in capital market securities,
such as stocks or bonds. Typically, mutual funds purchase securities in
minimum denominations that are larger than the savings of an individual
surplus unit.
Now that you are done with Lesson 1, would you like to find out how much you have learned
from this lesson?
Good job! Keep on reading the rest of the module to learn more. God Bless you!
Self-check
Directions: Perform the task indicated in the Google Classroom entitled Activity 1.1
Module 1
Lesson 2 INTEREST RATE DETERMINATION
Introduction
Interest rate movements have a direct influence on the market values of debt
securities, such as money market securities, bonds and mortgage, and have an indirect
influence in security values. Thus, participants in financial markets attempt to anticipate interest
rate movements when restructuring their positions. Interest rate movements also affect the
value of most financial institutions. The cost of funds to depository institutions and the interest
received o some loans by financial institutions are affected by interest rate movements. Since
many financial institutions invest in securities (such as bonds), the market value of their
investment is affected by interest rate movements. Thus, managers of financial institutions
attempt to anticipate interest rates movements so that they can capitalize on favourable
movements or reduce their institution’s exposure to unfavourable movements. Individuals
attempt to anticipate interest rate movements so that they can monitor the potential cost of
borrowing or the potential return from investing in various debt securities.
Learning Outcomes:
✓ Apply the loanable funds theory to explain why interest rates change;
✓ Identify most relevant factors that affect interest rate movements.
Content Focus
The loanable funds theory, commonly used to explain interest rate movements, suggests that
the market interest rate is determined by factors controlling the supply of and demand for
loanable funds. The theory is especially useful for explaining movements in the general level of
interest rates. Furthermore, it can be used (along with other concepts) to explain why interest
rates among some debt securities of a given country vary.
Businesses demand for loanable funds to invest in long-term (fixed) and short-
term assets. The quantity of funds demanded by business depends on the number of
business projects to be implemented. Businesses evaluate a project by comparing the
present value of its cash flows to its initial investment, as follows:
where
Projects with a positive net present value (NPV) are accepted because the present value
of their benefits outweigh the costs. The required return to implement a given project will
be lower if interest rates are lower because the cost of borrowing funds to support the
project will be lower. Hence more projects will have positive NPV’s and businesses will
need a greater amount of financing. This implies that, all else being equal, businesses
will demand a greater quantity of loanable funds when interest rates are lower.
In addition to long term assets, businesses also need funds to invest in
their short-term assets (such as accounts receivable and inventory) in order to support
on going operations. Any demands for funds resulting from this typ eof investment is
positively related to the number of projects implemented and thus is inversely yrealted to
the interest rate. The opportunity cost of in vesting in short term assets is higher when
interest rates are higher. Therefore, firms generally attempt to support on going
opeations with fewer funds during period of high interest rates. This is another reason
that a firm’s toatal demand for loanble funds is inversely related to prevailing rates than
others interest rates. Although the demand for loanable funds by some businesses may
be more sensititive to interest rates than others, all businesses are likely to demand
more funds when interest rates are lower.
The demand for loanable funds in a given market also includes foreign demand by
foreign governments or corporations. For expample, British government may obtain
financing by issuing British Treasury securities to U.S investors; this represents British
deamdn for U.S funds. Because foreign financial transactions are becoming so common,
they have a significant impact on the demand for loanable funds in any given country. A
foreign country’s demand for U.S funds is influenced by, among other factors, the
difference between its own interest rates and US rates. Other things being equal, a
larger quantity of U.S funds will be demanded by forign governments and corporations if
their domestic interest rates are high realtive to U.S rates. As a result, for a given set of
foreign interest rates, the quantity of U.S loanable funds demanded by foreign
governments or firms will be inversely related to U.S rates.
Changes in economic conditions cause a shift in demand curve for loanabe funds,
which affects the equilibrium interest rate.
• Impact of Inflation on Interest Rate
More than 70 years ago ,Irving Fisher proposed a theory of interest rate
determination that is still widely used today.Its does not contradict the loanable funds
theory but simply offers an additional explanation for interest rate movements.Fisher
proposed that nominal interest payments compensate savers in two ways.First ,they
compensate for a saver’s reduced purchasing power.Second,they provide an additonal
premium to savers for forgoing present consumption .Savers are willing to forgo
consumption only if they received a premium on their savings above anticipated rate of
inflation, as shown in the following equation:
This relationship between interest rates and expected inflation is often referred to as the
Fisher effect. The difference between the nominal interest rate and the expected
inflation rate is the real return to saver after adjusting for the reduced purchasing power
over the time period of concern.It is referred to as the real interest rate because,unlike
the nominal rate of interest,its adjusts for the expected rate of inflation.The preceding
equation can be rearranged to express the real interest as
= i – E (INF)
When the inflation rate is higher than anticipated,the real interest rate is relatively
low. Borrowers benefit bacause they were able to borrow at a lower nominal interest rate
than would have been offered if inflation had been accurately forecasted. When the
inflation rate is lower than anticipated,the real interest rate is relatively high and
borrowers are adversely affected.
Thoughout the text,the term “interest rate” will be used tp represent the nominal, or
quoted,rate of interest.Keep in mind,however, that inflation may prevent purchasing
power from increasing during periods of rising interest rates.
The Federal Reverse can affect the supply of loanable funds by increasing or reducing
the total amount of deposits held at commercial banks or other depository
institutions.The process by which the Fed adjusts the money supply is described in
Chapter 4.When the Fed increases the money supply,it increases the supply of loanable
funds and this places downward pressure on interest rates.
Now that you are done with Lesson 2, would you like to find out how much you have learned
from this lesson?
Good job! Keep on reading the rest of the module to learn more. God Bless you!
Self-check
REFERENCES