School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Course Code & Title : BAFIMARX: Financial Markets
Module No. & Title : Module 2: Introducing Money and Interest Rates
Time Frame (Weeks/Hours) : 1 Week (4 hours)
Overview
This module explores the fundamental concepts of money and interest rates—key pillars in the study of
financial markets and economic decision-making. Students will be introduced to the nature and functions
of money, the forces that drive money supply and demand, and how interest rates serve as a critical tool
in pricing financial instruments and managing risk. The module also explains the concept of the time
value of money, the term structure of interest rates, and the implications of interest rate changes on
individuals, businesses, and the economy.
Desired Learning Outcomes
By the end of this module, students are expected to:
o Analyze the determinants of money supply and money demand
o Apply the concept of the time value of money in financial decision-making
o Describe how interest rates are determined
o Interpret the term structure of interest rates
o Assess the economic and financial impact of changing interest rates
Content/Discussion
Topic 1: Introducing Money
Money is any item or commodity that is generally accepted as a means of payment for goods and services
or for repayment of debt, and that serves as an asset to its holder. On the simplest level, money is
composed of the bills and coins which have been printed or minted by the National Government (these
are called currency). But money also includes the funds stored as electronic entries in one’s checking
account and savings account.
Before its invention, people bartered, swapping goods they produced themselves for things they needed
from others. Barter is sufficient for simple transactions but not when the things traded are of differing
values, or not available at the same time. Money, by contrast, has a recognized uniform value and is widely
accepted.
In the Philippines, the central bank that controls the country’s economy is the “Bangko Sentral ng
Pilipinas”. While government still print and guarantee money, in today’s world it no longer needs to exist
as physical coins or notes but can be found solely in digital form.
Characteristics and Key Functions of Money
Money is not money unless it has all the following defining characteristics:
o Store of value
o Item of worth
o Means of exchange
o Unit of account
Prepared by: Sophia Anne C. Baterina, CPA Page 1 of 7
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
o Standard of Deferred Payment
Underlying all these characteristics is trust – people must be confident that if they accept money, they
can use it to pay for goods and services.
Topic 2: The Supply and Demand for Money
The Money Supply
Although the general description of money is relatively straightforward, the precise definition of the
overall supply of money is complex because of the wide variety of forms of money in modern economies.
The Key Measures for the Money Supply are:
M1. The narrowest measure of the money supply. It includes currency in circulation held by the nonbank
public, demand deposits, other checkable deposits, and traveler’s checks. M1 refers primarily to money
used as a medium of exchange.
M2. In addition to M1, this measure includes money held in savings deposits, money market deposit
accounts, noninstitutional money market mutual funds and other short-term money market assets (e.g.,
“overnight” Eurodollars). M2 refers primarily to money used as a store of value.
M3. In addition to M2, this measure the financial institutions, (e.g., large-denomination time deposits
and term Eurodollars). M3 refers primarily to money used as a unit of account.
L. In addition to M3, this measure includes liquid and near-liquid assets (e.g., short-term Treasury notes,
high-grade commercial paper and bank acceptance notes).
Changes in the supply of money will affect the interest rate and therefore the cost of borrowing money.
This will have an impact on consumption and investment levels in the economy.
The Demand for Money
The Sources of the Demand for Money are:
o Transaction demand
o Precautionary demand
o Speculative demand
The rate of interest is the price paid in the money market for the use of the money (or loans). The rate is
a percentage of the amount borrowed.
Topic 3: The Time Value of Money
In general business terms, interest is defined as the cost of using money over time. This definition is in
close agreement with the definition used by economists, who prefer to say that interest represents the
time value of money.
Time value of money is the basic notion that a peso received today is worth more than a peso received
at some future date. This is because a peso received today can be invested and its value enhanced by an
interest rate or return such that the investor received more than a peso in the future.
Prepared by: Sophia Anne C. Baterina, CPA Page 2 of 7
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Two forms of time value of money calculations are commonly used in finance for security valuation
purposes:
1. The value of a lump sum payments
2. The value of annuity payments
Present Value of a Lump Sum
The present value function converts cash flows received over a future investment horizon into an
equivalent (present) value as if they were received at the beginning of the current investment horizon.
Future Value of a Lump Sum
The future value of a lump sum equation translates a cash flow received at the beginning of an investment
period to a terminal (future) value at the end of an investment horizon.
Present Value of an Annuity
The present value of an annuity equation converts a finite series of constant (or equal) cash flows received
on the last day of equal intervals throughout the investment horizon into an equivalent (present) value as
if they were received at the beginning of the investment horizon.
Future Value of an Annuity
The future value of an annuity equation converts a series of equal cash flows received at the equal intervals
throughout the investment horizon into an equivalent future amount at the end of the investment
horizon.
Prepared by: Sophia Anne C. Baterina, CPA Page 3 of 7
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Topic 4: Interest Rates
Nominal interest rates are the interest rates actually observed in financial markets. These nominal
interest rates (or just interest rates) directly affect the value of most securities traded in the money and
capital markets, both home and abroad. Changes in interest rates influence the performance and decision
making for individual investors, businesses, and governmental units alike.
The interest rates link the future to the present. It allows individuals to evaluate the present value (the
value today) of future income and costs. In essence, it is the market price of earlier availability. The
interest rates allow the lender to calculate the future benefit (future payments earned) of extending a loan
or saving funds today.
How are Interest Rates Determined?
Interest rates are determined by the demand for and supply of loanable funds. Investors demand funds
to finance capital assets that they believe will increase output and generate profit. Simultaneously,
consumers demand loanable funds because they have a positive rate of time preference. They prefer
earlier availability.
Determining Interest Rate
As illustrated, the interest rate will bring the quantity of funds demanded into balance with the quantity
supplied. At the equilibrium interest rate, the quantity of funds borrowers demand for investment and
consumption now (rather than later) will just equal the quantity of funds lenders save. So, the interest
rate brings the choices of borrowers and lenders into harmony.
Prepared by: Sophia Anne C. Baterina, CPA Page 4 of 7
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Factors That Cause the Supply and Demand to Shift
A shift in the supply or demand curve occurs when the quantity of a financial security supplied or
demanded changes at every given interest rate in response to a change in another factor besides the
interest rate. In either case, a change in the supply or demand curve for loanable funds causes interest
rate to move.
Supply of Funds Demand for Funds
Utility Derived from Assets
Wealth
Purchased with Borrowed Funds
Restrictiveness of Nonprice
Risk
Conditions on Borrowed Funds
Near-Term Spending Needs Economic Conditions
Monetary Expansion
Economic Conditions
According to Keynesian theory, the rate of interest is determined as a price in two markets:
1. Investment funds. The rate of interest balances the demand for funds (required for investment)
and the supply of funds (from savings). Households delay consumption by saving (and are
rewarded by earning interest) depending on their time preference and the rate of interest.
2. Liquid assets. Borrowers require cash in the long-term (that doesn’t need to be repaid to the
lender immediately), they are willing to compensate lenders for giving up liquidity. Keynes
introduced the influence of the liquidity preference on the interest rate.
Topic 5: Term Structure of Interest Rates
A yield curve is a line that plots the yields or interest rates of bonds that have equal credit quality but
different maturity dates. The slope of the yield curve predicts the direction of interest rates and the
economic expansion or contraction that could result.
Types of Yield Curves
Normal: Shows low yields for shorter-maturity bonds increasing for bonds with a longer maturity. The
curve slopes upward. This indicates that yields on longer-term bonds continue to rise, responding to
periods of economic expansion.
Inverted: Slopes downward with short-term interest rates exceeding long-term rates. This type of curve
corresponds to a period of economic recession when investors expect yields on longer-maturity bonds to
trend lower in the future.
Flat: Shows similar yields across all maturities, implying an uncertain economic situation. A few
intermediate maturities may have slightly higher yields that cause a slight hump to appear along the flat
curve.
Investors can use the yield curve to make predictions about the economy that will affect their investment
decisions.
Prepared by: Sophia Anne C. Baterina, CPA Page 5 of 7
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Shape of the Term Structure of Interest Rates
Unbiased Expectations Theory
At any given point in time, the yield curve reflects the market's current expectations of future short-term
rates. According to the unbiased expectations theory, the return for holding a four-year bond to maturity
should equal the expected return for investing in four successive one-year bonds (as long as the market
is in equilibrium).
Liquidity Premium Theory
Long-term rates are equal to geometric averages of current and expected short-term rates, plus liquidity
risk premiums that increase with the security's maturity. Longer maturities on securities mean greater
market and liquidity risk. So, investors will hold long-term maturities only when they are offered at a
premium to compensate for future uncertainty in the security's value. The liquidity premium increases
as maturity increases.
Market Segmentation Theory
Assumes that investors do not consider securities with different maturities as perfect substitutes. Rather,
individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the
liabilities they hold. Thus, interest rates are determined by distinct supply and demand conditions within
a particular maturity segment (e.g., the short end and long end of the bond market).
Topic 6: Interest Rates and Risks
Interest rates in the loanable funds market will differ mainly because of differences in the risks associated
with the loans. It is riskier, for example, to loan money to an unemployed worker than to a well-
established business with substantial assets. The risk also increases with the duration of the loan. The
longer the time period of the loan, the more likely it is that the borrower’s ability to repay the loan will
deteriorate or market conditions changes in a highly unfavorable manner.
Three Components of Money Interest
1. Pure interest. The real price one must pay for earlier availability.
2. Inflationary premium. Reflects the expectation that the loan will be repaid with pesos of less
purchasing power as the result of inflation.
3. Risk-premium. Reflects the probability of default (the risk imposed on the lender by the
possibility that the borrower may be unable to repay the loan).
Factors Affecting Nominal Interest Rates
o Inflation. The continual increase in the price level of a basket of goods and services.
o Real risk-free rate. Nominal risk-free rate that would exist on a security if no inflation were
expected.
o Default risk. Risk that a security issuer will default on the security by missing an interest or
principal payment.
o Liquidity risk. Risk that a security cannot be sold at a predictable price with low transaction cost
at short notice.
o Special provisions. Provisions that impact the security holder beneficially or adversely and as
such are reflected in the interest rates on securities that contain such provisions.
o Term to maturity. Length of time a security has until maturity.
Prepared by: Sophia Anne C. Baterina, CPA Page 6 of 7
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Topic 7: The Impact of Changing Interest Rate
If the BSP pushes short-term interest rates up or down, the effects of its actions are felt most directly by
interest-rate sensitive sectors of the economy. When it is more expensive to borrow, people make fewer
purchases that require borrowing. But when the BSP cuts the short-term interest rate, that encourages
borrowing and spending in the economy and puts upward pressure on prices.
If interest rates fluctuated all the time, the economy would become volatile. This is why the government
and central bank work together to keep inflation and interest at stable rates. Every time the interest rate
is changed, it sends a signal to society to either spend or save - and many also increase or decrease
confidence in the state of the economy. A rise interest rates encourages saving, since higher interest will
be paid on money in savings accounts, and investments can grow. Meanwhile, borrowing becomes less
attractive as interest repayments are steeper, and banks more selective about whom they lend to. This
impacts the affordability of obtaining or repaying an existing loan, such as a mortgage.
By contrast, a drop in interest rates is intended to cause an increase in spending, since borrowers can take
out loans more cheaply. For those with mortgages tracking the base rate, interest repayments will drop.
At the same time, savers will tend to spend or invest deposits that are attracting little interest. While
discouraging saving through very low interest rates might stimulate the economy, this can ultimately
negatively impact long-term savings plans, such as pensions.
- end of discussion -
Assessment of Learning
For the self-regulated assessment of your learning from this module, please accomplish and submit the
activity and/or quiz that will be conducted during our face-to-face classes.
References
Cabrera, E. (2022). Financial Markets and Institutions (pp. 8–29) [Review of Financial Markets and
Institutions]. GIC Enterprises & Co., Inc.
Hayes, A. (2023, September 27). Yield Curve. Investopedia.
[Link]
Saunders, A., & Marcia Millon Cornett. (2019). Financial markets and institutions. Mcgraw-Hill
Education.
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