Interest Rates and Fixed Return Securities Valuation

Submitted by:
Laganzon, Marjorie B.
Financial system links businesses that invest in physical capital to the financial sector
of the economy, from which financial capital is supplied via financial institutions and
financial instruments.

FINANCIAL MARKETS INSTITUTIONS

Financial transactions involve financial assets and financial liabilities. The creation and
transfer of such assets and liabilities constitute financial markets.

When a financial claims and obligations bought and sold have maturities of less than 1
year, the transaction constitute money markets. If maturities are more than 1 year, it is
referred to as capital markets.

Financial markets are classified into the money market and the capital market. The
money market is where short-term funds are raised through the buying and selling of
short-term debt securities such as commercial papers. The capital market is where
long-term funds are raised through the bond market, which deals with long-term debt
securities such as bonds, the stock market which deals with equity securities or stocks.

Basically, it is in the capital market, called the stock market, where an investor can buy
and sell stocks. This market consists of the primary market or secondary market,
depending on whether the securities were sold by the company itself or by an existing
shareholder(s).

In the primary market, new shares are issued and sold to the investing public for the
first time. It is where capital is actually raised by the company selling stock directly to
investors typically through an initial public offering. For instance, if San Miguel
Corporation decides to sell a new stock to raise equity funds, it will be a primary market
transaction. Since it is the first time the company has sold stock to the public, it is called
an initial public offering (IPO). The proceeds of the sale go to San Miguel Corporation,
the issuing company. Investors who have subscribed to the IPO have provided the
company with the necessary funds to continue its operation and expansion, and
become part owners of the company.

An underwriter or investment banker assists the issuer of a new security in setting the
offering price and in marketing the securities to the public. The investment bankers
serves as a middleman in the transfer of funds between the company in need of capital
and the public, and facilitates the issuance of shares.

There is occasionally a secondary offering in the primary market. This means that the
shares of stock being offered were previously issued but is being offered to the public
for the first time by a large or controlling shareholder. As such, the selling stockholder
gets the proceeds of the sale.
The secondary market is where securities can be bought and sold after they have
been issued to the public in the primary market. Thus, if you decide to buy existing
shares of San Miguel Corporation, you cannot buy them directly from the issuing
company anymore since they have all been sold to the investing public during the initial
public offering.

So, how can you avail of San Miguel shares when the IPO has been completed?
Investors can only buy these shares from existing shareholders who are willing to sell
their shares. When they do so, it is a secondary market transaction. The proceeds from
this transaction don not go to the issuing corporation; instead they go to the investor
who sold his shares.

The secondary market is where the original shareholders sell their shares to other
investors. An investor can only make a profit when he can sell his shares at a price
higher that the purchase price. This market gives a continuous reflection of the value of
securities (prices) at some point in time according to the best available information.

Secondary markets include the stock exchange and the over-the-counter (OTC) market.

Stock Market and Stock Exchange

There are differences in their definition but real concept of a stock exchange and stock
market remains constant. Simply defined, a stock market is an organized activity
involving the buying and/or selling of securities done within a stock exchange.

In a fundamental sense, a stock exchange brings buyers and sellers together. It is an

organization whose function is to facilitate the purchase and sale of stocks and other
securities. It is a market where investors can buy and sell securities after they have
been offered in the primary market.

Remember that the stock exchange is not a capital raising mechanism. As part of the
secondary market, it is only adjunct to the capital raising market or primary market. It is
merely a place or means where existing shareholders can sell their shares to those who
are ready to buy.

The stock exchange and the stock market facilitate the flow of savings into investments
by providing a ready market for the resale of securities. The inflow of funds in the stock
market is one efficient way of directing a needed resource (in this case, money) into a
growing economy. As such, the stock exchange plays a key role in economic
development by providing a centralized environment that brings together the demanders
and suppliers of funds to make secure and fast transactions.
Over-the-counter market

Stocks of corporations not listed and therefore not traded in the stock exchange but
registered and licensed by the Securities and Exchange Commission for sale to the
public are only available in the so-called over-the-counter (OTC) market. This market is
not a specific organization but another way of trading securities. OTC transactions are
carried out by direct inquiries and negotiations among the buyers and sellers through
the use of mail, telephone, telegraph, Teletype, or other forms of communications.

FINANCIAL INTERMEDIARIES

They are specialized business firms whose activities include the creation of financial
assets and liabilities.

Financial instruments are legal agreements that require one party to pay money or
something else of value or to promise to pay under stipulated conditions to a
counterparty in exchange for the payment of interest, for the acquisition of rights, for
premiums, or for indemnification against risk. In exchange for the payment of the
money, the counterparty hopes to profit by receiving interest, capital gains, premiums,
or indemnification for a loss event.

HOW THE MARKET DETERMINES MARKET INTEREST RATES

Philippines Interest Rate

Philippines Holds Key Interest Rate Steady at 4.5%. The central bank of the Philippines
left its key overnight reverse repurchase facility rate unchanged at 4.5% on its June
20th 2019 meeting, while markets had expected it at 4.25%. Policymakers said the
decision remains consistent with the manageable inflation outlook and firm domestic
growth prospects, unveiling that a prudent pause allows it to observe and assess the
impact of prior monetary adjustments.

VALUATION OF DEBT INSTRUMENTS

Valuation is the process of determining the fair value of a financial asset. The process
is also referred to as “valuing” or “pricing” a financial asset. In this chapter, we will
explain the general principles of fixed income security valuation. In this chapter, we will
limit our discussion to the valuation of option-free bond.
GENERAL PRINCIPLES OF VALUATION

The fundamental principle of financial asset valuation is that its value is equal to the
present value of its expected cash flows. This principle applies regardless of the
financial asset. Thus, the valuation of a financial asset involves the following three
steps:

Step 1: Estimate the expected cash flows.

Step 2: Determine the appropriate interest rate or interest rates that should be used to
discount the cash flows.

Step 3: Calculate the present value of the expected cash flows found in step 1 using the
interest rate or interest rates determined in step 2.

BOND YIELD

Bond yield is the return an investor realizes on a bond. The bond yield can be defined
in different ways. Setting the bond yield equal to its coupon rate is the simplest
definition.

CURRENT YIELD

Current yield is simply the coupon interest payments divided by the current price of the
debt instrument,

INTEREST RATE RISKS

Interest rate risk is the probability of a decline in the value of an asset resulting from
unexpected fluctuations in interest rates. Interest rate risk is mostly associated with
fixed-income assets rather than with equity investments. The interest rate is one of the
primary drivers of a bond’s price.

If interest rates increases bonds price will decrease.

BOND RATINGS

Bond ratings measures the default risks of bonds.

KEY TAKEAWAYS

 The three leading independent bond rating services include Fitch Ratings Inc.,
Standard & Poor's, and Moody’s Investors Service.
  Investment grade bonds assigned “AAA” to “BBB-“ ratings from Standard &
Poor's, and Aaa to Baa3 ratings from Moody’s, signify bonds issues with rosy
outlooks.
 Although junk bonds offer the highest returns, they run the notoriously high risk of
defaulting.

DEBT COST

It refers to the effective rate a company pays on its current debt. In most cases, this
phrase refers to after-tax cost of debt, but it also means the company's cost of debt
before taking taxes into account.

IMPORTANCE OF BOND RATINGS

Bond ratings are important not only for their role in informing investors, but also
because they affect the interest rate that companies and government agencies pay on
their issued bonds.