CHAPTER 3: FINANCIAL INSTRUMENTS

INTRODUCTION
This module will focus on these topics the money market instruments and the
capital market instruments. This module will also enlighten the students regarding the
flow of the letter of credit in being a tool for businesses who are engaged in conducting
international transactions and trading.

INTENDED LEARNING OUTCOME

At the end of the module, the learners are expected to:

1. Analyze the difference between money market instruments and capital market
instruments.
2. Analyze the different government – issued money market instruments and capital
market instruments.
3. Discuss how a letter of credit operates.
4. Analyze the difference among the different non – negotiable capital market
instruments.
5. Comprehend the differences among the different marketable capital market
instruments.

COURSE CONTENT

MONEY MARKET INSTRUMENTS

- Money market instruments are short-term securities. They are paper or electronic
evidences of debt dealt in the money markets. Only debt securities are short –
term. Equity securities are long – term and belong to the capital market. Money
market instruments are issued by the government and corporations needing
short – term funds. Government securities are generally issued by the Bureau of
the Treasury.

Cash Management Bills

- Cash management bills are government – issued securities with maturities of

less than 91 days, specifically 35 days or 42 days. They have shorter maturities
than T- Bills. Government securities are unconditional obligations of the
government issuing them, backed up by the full taxing power of the issuing
government. As such, they are theoretically default – free. Investing in these bills
affords security and liquidity to investors.
Treasury Bills (T – Bills)

- Treasury bills (T – bills) are issued by the Bureau of the Treasury with 91-day,
182-day, and 364-day maturities. The odd number of days is to generally is to
generally ensure that they mature on a business day. Like Treasury bonds (T-
bonds), they are sold only through government securities eligible dealers, dealers
authorized by the government to sell T-bills. Transactions are done through
bidding online.

Banker’s Acceptances

- Banker’s acceptance is a time draft issued by a bank payable to seller of goods.

It is drawn on and accepted by the bank. Before acceptance, the draft is not an
obligation of the bank; it is merely an order by the drawer to the bank to pay a
specified sum of money on a specified date to a named person or to the bearer
of the draft just like an ordinary check. Upon acceptance, which occurs when an
authorized bank employee stamps the draft “accepted” and signs it, the draft
becomes a primary and unconditional liability of the bank. If the bank is well
known and enjoys a good reputation, the accepted draft may be readily sold in an
active market. The bank substitutes its own creditworthiness for that of the
drawer that makes banker’s acceptances marketable instruments.
- Time draft issued by a bank is an order for the bank to pay a specified amount of
money to the bearer of the time draft on a given date. It is different from sight
draft, which is an order to pay immediately. A bank check is a sight draft.

Letters of Credit

- Banker’s acceptances are generally used with the purchase of goods or services
either domestically or internationally. In these cases, the buyer has its bank issue
a letter of credit on its behalf in favor of the seller. For imports, an international
letter of credit is opened; for local purchase, a domestic letter of credit is opened.
A commercial letter of credit is a contractual agreement between a bank, known
as the issuing bank, on behalf of the buyer, authorizing another bank, the
correspondent bank known as the advising or confirming bank, to make payment
to the beneficiary, the seller. The issuing bank, on the request of the buyer,
opens the letter of credit. The issuing bank makes a commitment to honor
drawings made under the credit. The beneficiary is the seller of goods and
services. Essentially, the issuing bank replaces the buyer as the payor.

Negotiable Certificates of Deposit

- Certificate of deposit is a receipt issued by a commercial bank for the deposit of

money. It is a time deposit with a definite maturity date and a definite rate of
interest. CD stipulates that the bearer is entitled to receive annual interest
 payments at the rate indicated in the certificate, together with the principal upon
maturity of the certificate.

Repurchase Agreements

- Repurchase agreements are legal contracts that involve the actual sale of
securities by a borrower to a lender with a commitment on the part of the
borrower to repurchase the securities at the contract price plus a stated interest
charge at a later date. A repurchase agreement is usually a short-term loan from
a corporation, state or local government, or other large entity that has idle funds
to a commercial bank, securities dealer, or other financial institutions. They were
created by brokerage houses and popularized by commercial banks. A reverse
repurchase agreement or reverse repo is an agreement involving the purchase of
securities by one party to another with the promise to sell them back at a given
date in the future. Therefore, from the point of view of the seller of the security,
the transaction is a repurchase agreement and from the point of view of the
buyer, the transaction is a reverse repo.

Money Market Deposit Accounts

- Money market deposit accounts are PDIC-insured deposit accounts that are
usually managed by banks or brokerages and can be a convenient place to store
money that is to be used for upcoming investments or has been received from
the sale of recent investments. They are very safe and highly liquid investments,
typically paying higher interest than regular savings accounts but lower than
money market mutual funds. They are also called money market accounts.
MMDAs usually offer check – writing privileges. MMDAs are insured by the
Philippine Deposit Insurance Corporation (PDIC) up to 500,000 per person, per
bank. As long as the balance in the account remains below insurance limit, every
bit of principal and interest earned on the account is 100% guaranteed.

Money Market Mutual Funds

- Money market mutual funds are investment funds that pool funds from numerous
investors and invest in money market instruments offered by investment
companies. A mutual fund is an investment company that pools the funds of
many individual and institutional investors to form a massive asset base. The
assets are then entrusted to a full-time professional fund manager who develops
and maintains a diversified portfolio of security investments.

More comprehensively, mutual funds can be classified as:

 1. Growth Funds – invest in assets that are expected to reap large capital gains
(generally equity securities)
2. Income Funds – invest in stocks that regularly pay dividends and in notes and
bonds that regularly pay interest
3. Balanced Funds – combine the features of both growth funds and income funds
4. Sector Funds – invest in specific industries as health care, financial services,
utilities extractive industries
5. Index Funds – invest in a basket of securities that make up some market index
as the S&P 500 index of stocks
6. Global Funds – Invest in securities issued in many countries providing
diversification

Certificate of Assignment

- Certificate of assignment is an agreement that transfers the right of the seller

over a security in favor of the buyer. The underlying security carries a promise to
pay a certain sum of money on a fixed date like a promissory note. The
arrangement allows the buyer to hold the security as a guaranteed source of
repayment.

Certificate of Participation

- Certificate of participation is an instrument that entitles the holder to a

proportionate equitable interest in the securities held by the issuing firm or an
entitlement to a pro rata share in a pledged revenue stream, usually lease
payments. The lessor assigns the lease and the payments to a trustee, which
then distributes the payments to the certificate holders. The transaction is
between the buyer and the original issuer of the security. A dealer issues the
certificate of participation. The dealer’s liability is to vouch for the integrity of the
original security rather than to repay the loan if the issuer defaults. The certificate
of participation is a useful instrument when the original security is in a large
denomination and when there are a few buyers.
CAPITAL MARKET INSTRUMENTS

- After gaining knowledge in examining the different money market instruments,

we are now ready to learn the different capital market instruments available to
investors.
- As stated, these long – term instruments are basically either equity securities or
debt securities. Capital market instruments include corporate stocks, mortgages,
corporate bonds, treasury securities, state and local government bonds, US
government agency securities, and non-negotiable bank, and consumer loans
and leases.
 Capital market instruments, just like capital markets, can be classified as:

1. Non – negotiable / non – marketable instruments

2. Negotiable / marketable instruments
Non – negotiable / Non – Marketable instruments

Non- negotiable or non – marketable instruments in the capital markets are the
following:

1. Loans
- Loans are direct borrowings of deficit units from surplus units like banks. They
can be short-term or long-term. Companies needing large amounts of funds to
finance special projects like purchase of land or building, plan expansion, or even
bond retirement usually resort to borrowing from capital markets. They do one-
on-one transaction with the lenders. Stockholders usually guarantee these loans.
The amount of loan granted depends on how well the lenders know the
borrowers and generally on their deposits with said banks or with the amount of
transactions they do with the said banks. Long – time, established companies
can really borrow large amounts of funds to finance their capital needs.

2. Leases
- Leases are rent agreements. The owner of the property is called the lessor and
the one who is renting and using the property is the lessee. The lease can be an
 operating lease, where the lessor shoulders all expenses including insurance and
taxes related to the property leased out and the lessee pays a fixed regular
amount usually on a monthly basis. It can also be a financing or capital lease,
where the lessee shoulders all expenses of the property as insurance and taxes.
Generally, capital leases are lease – to – own contracts where the lessee pays a
big initial down payment, pays a fixed regular amount, and later pays a minimal
amount to finally own the asset or property being leased.

3. Mortgages
- Mortgages are agreements where a property owner borrows money from a
financial institution using the property as a security or collateral for the loan. The
assets covered by mortgages are non – current assets or permanent assets as
land, building and other real estate properties. Land, building, and machineries
are usually mortgaged upon purchase. The companies borrow money from
banks and other lending institutions to buy the land, building or machinery and
such land, building, or machinery are used as collateral for the loan thus
obtained. Lending institutions are more secure knowing that something of value
guarantees the loan. In essence, mortgages are secured loans.

4. Lines of Credit
- Line of credit is a bank’s commitment to make loans to regular depositors up to a
specific amount. The line of credit includes letters of credit, standby letters of
credit, and revolving credit arrangements, under which borrowings can be made
up to a maximum amount as of any point in time conditional on satisfaction of
specified terms; before, as of, and after the date of drawdowns on the line. Lines
of credit provide the convenience of a readily available source of money that can
be used anytime and for whatever purpose. Personal lines of credit are for
households and can be used for home renovation, buying a car, vacation, or any
major purchase. Commercial lines of credit are for businesses and can be used
for current or short-term proposes like purchase of merchandise and pay
operating expenses or for capita; expenditures. But since the credit is ongoing
and has no termination, it is considered long-term. It is flexible providing ongoing
access to funds. Generally, it is secured against home equity. Borrowers only
pay interest on the funds used with flexible repayment options, sometimes
including the ability to pay as a little as interest only. It can also have the option
to combine with a mortgage to benefit from automatic rebalancing; therefore,
available credit increases automatically as payment is made. It is a great option if
you are looking for flexibility.

Negotiable / Marketable Instruments

- The following are specific marketable or negotiable instruments dealt with in the
capital markets:
Corporate Stocks

- Corporate stocks are the largest capital market instruments. Stocks are
evidences of ownership in a corporation. The holders are called shareholders or
stockholders. Shares of stocks are actually intangible while the stock certificates
are the tangible evidence of ownership. While there are stocks held for short-
term use, classified as current assets under marketable securities or temporary
investments, stocks are by nature long – term. They do not have maturity dates,
although redeemable preferred shares, like callable bonds, can be called for
redemption at the option of the issuing company.

Bonds

- Bonds are debt instruments issued by private companies and government

entities to borrow large sums of money that no single financial institution may be
willing or able to lend. A government bond is issued by a national government
and is denominated in the country’s own currency.

Corporate Bonds

- Corporate bonds are certificates of indebtedness issued by corporations who

need large amount of cash. Bond agreements are called bond indentures. At
times, it is impossible to borrow a large amount from single institution. This is the
time corporations decide to issue bonds instead.

Bonds can be classified as follows:

1. As to Security
a. Secured bonds
- Secured bonds are collateralized either by mortgages or other assets.
Securitized mortgages are mortgages packaged together by financial institutions
and sold as bonds backed by mortgage cash flows such as interest and principal
repayments on these mortgages.

b. Unsecured bonds
- Unsecured bonds, also called debenture bonds, do not have any sort of
guarantee. They do not provide any lien against any specific property or security
for the obligation, that is, there is no collateral. This is the reason why debenture
bonds are generally issued by companies with a steady high credit rating.
Companies such as large mail – order houses and commercial banks are some
of these companies.

2. As to interest rate:
 a. Variable rate bonds
- Variable rate bonds are bonds whose interest rate fluctuates and changes when
the market rates change
b. Fixed rate bonds
- Fixed rate bonds have rates that are fixed as stated in the bond indenture.

3. As to retirement
a. Putable bonds
- Putable bonds are bonds that can be turned in and exchanged for cash at the
holder’s option. The put option can only be exercised if the issuer takes some
specified action as being acquired by a weaker company or increasing its
outstanding debt by a large amount.

b. Callable / redeemable bonds

- Callable / redeemable bond is bond in which the issuer has the right to call the
bond for retirement for a price determined at the time the bond is issued. This
amount will typically be greater than the principal amount of the bond.

c. Convertible bonds
- Convertible bonds can be exchanged for common stocks. This feature attracts
investors, but these convertible bonds usually carry lower interest rates. Usually,
these bonds come with warrants, which are options to buy common stock at a
stated price.

4. Other classification
a. Income bonds
- Income bonds are bonds that pay interest only when the interest is earned by the
issuing company. If the issuing company incurs a loss, it is not required to pay
interest on the income bonds. These bonds cannot put issuing companies into
bankruptcy, but from the point of view of the investor, these bonds are riskier
than the ordinary bonds.

b. Indexed or purchasing power bond

- Popular in Brazil, Israel, Mexico, and a few other countries plagued by high rates
of inflation is the indexed or purchasing power bond. The interest rate paid on
these bonds is based on an inflation index such as the consumer price index.
Therefore, the interest paid rises automatically when the inflation rate rises
protecting the bondholders against inflation.

c. Junk bonds
 - Junk bonds are speculative, below – investment grade, high-yielding bonds.
They are big default risk investment; hence, these bonds are high-yielding. High-
yield bond mutual funds and other institutional investors, like energy-related
firms, cable TV companies, airlines, and other industrial companies, buy these
bonds. These bonds are usually used to finance corporate restructuring or
company buy – outs. Investors are generally large companies involved in
multibillion dollar takeovers. These bonds are not attractive to individual
investors.

Municipal Bonds

- State and local governments and other political subdivisions must finance their
own capital investment projects like roads, schools, bridges, sewage plants, and
airports. These projects need financing and these local governments usually
issue municipal bonds or local government unit bonds. New issues of municipal
bonds are generally bought by investment bankers and resold to commercial
banks, insurance firms, and high – income individuals. They are not, however, as
saleable as corporate bonds. Municipal / LGU bonds come in the following two
varieties:
1. General obligations bonds
2. Revenue bonds

- General obligation bonds are issued to raise immediate capital to cover

expenses and are supported by the taxing power of the issuer. Revenue bonds,
on the other hand, are issued to fund infrastructure projects and are supported by
the income generated by those projects. Both types of bonds are tax exempt and
particularly attractive to risk – averse investors because they are default – risk –
free.

Long – Term Negotiable Certificates of Deposit

- Long-term negotiable certificates of deposit are negotiable certificates of deposit

with a designated maturity or tenor beyond 1 year, representing a bank’s
obligation to pay the face value upon maturity, as well as periodic coupon or
interest payments during the life of the deposit. It is exactly the same as the short
– term negotiable CDs, but is long-term.

Mortgage – Backed Securities

- Individual mortgages are non – negotiable and as such are neither liquid nor
suited to trading in secondary markets. As a result, an instrument that came as a
result of mortgage companies and banks grouping mortgages into a standard
million block group and issuing securities backed up by these mortgages, called
 mortgage-backed securities, came to evolve. These are mortgage-backed
securities, which are usually in the form of bonds. These are usually sold to
pension funds or life insurance companies. The mortgage houses or banks
continue to collect the payments on the mortgages and pass them on to the
owner of the security in the form of interest on the bonds held. This has resulted
in a more efficient mortgage market contributing to lower mortgage rates for
homeowners.

References

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- CAPITAL MARKETS author Norma Dy Lopez – Mariano, PHD. (2017)