CHAPTER 3 FINANCIAL INSTRUMENTS i] The good li fli titre inspired if oto ts) nore \ A Berta Ruse echt gaol UI} At the end of this chapter, the students should be able to: differentiate money market instruments and capital market instruments; EU Cot Un icles RU AME a eeu) Ue cur iciau nent ice compare MMDAs and MMMFs; certificate of assignments and certificate of nel lH CSE Maumee ele ler UC eae ie ee cet ie CMC uta ae) understand the differences among the differant marketable capital market Se aT1. Markets” a INTRODUCTION aa In Chapter 1, we learned about the different types of financial markets. In this chapter, ‘we will study the financial instruments that they deal with. Prior to that, let us learn something * about the Capital Market Institute of the Philippines (CMIP). CMIP Is a bullish organization that stokes and develops'the investment character of Filipinos in the Philippine financial/capital market. It is committed to promoting, developing, ‘and advancing awareness and knowledge on capital market and its role in the development of the national economy through developing, organizing, and Conducting programs, projects, tesearches, and other activities to. upgrade. competencies .of members, practitioners, entrepreneurs, professionals, teachers, and students in dealing with the Phillppine capital market. ttfurther aims tor, j + inculcate-in the Filipino people a lasting investment consciousness and a strong desire to save and invest and to bécome active participants in the Philippine capital market; : * work jointly or in coordination with concerned organizations and agencies toward a lasting investment culture in the country; * coordinate. with educational, business, financial institutions, and other relevant agencies nationwide in formulating programs, strategies, and methodologies that will facilitate teaching and learning about financial markets and investment concepts, principles, and practices; and 5 * conduct national seminars, briefings, and workshops on current trends and Issues related to investments and the financial market. ([Link]) {n this chapter, you will learn about the different money market instruments and the different capital market instruments. You will be familiarized with the different government- issued securities dealt with in the money market. You will also be knowledgeable about the negotiated (non-marketable) capital market and the instruments dealt with in the said market. Similarly, the instruments dealt with in the negotiable/marketable securities market will be discussed. As preview to accounting, the students will be introduced to the different types of corporation-issued stacks and the different types of corporation-declared dividends to stockholders, in finance, financial instruments are classified as to their term or maturity date. They can either be short-term (with maturity of one year or less) or long-term (with maturity of more than one year). Short-term instruments belong to the money market, while long-term instruments belong to the capital market. * However, in accounting, Its not the term that determines the classification of securities as short-term or long-term. Current assets are assets that will be converted to cash within a period of one year. Non-current assets have lives longer than a year. Both finance and accounting classify short-term securities as short-term, But for long-term securities; what finance treats as longrterm can be treafed In accounting as short-term or current if the intention of the holder or owner of the securitfes'|s to sell them when the need for cash arises. They do not need to wait for the maturity date to convert it to cash. This means that 68 asand not wait for its maturity, the security Is classified as current or short-tert hand, if the intention of the company is to hold the securities until the maturity n to them for regular dividend income or interest income, then the securities are ted Under non-current assets as long-term Investment. For the purposes of this book, follow the classification in finance. The clarification in the foregoing is intended to help ing Students in studying finance, 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 tothe capital market, Money market instruments are issued by the government and corporations needing short-term funds. Government securities aregenerally issued by the Bureau of the Treasury. The detalls on the securities issued by the Philippine Bovernment discussed in this book are all from the [Link], the official website of the Philippine Treasury. ‘Cash Management Bills . Cosh 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 (GS) aré unconditional obligations of the government issuing them, backed up by tthe 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) i bans? a 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 ensure that they mature ona business day. Like Treasury bonds (T-bonds), they are sold ‘only through government securities eligible dealers (GSEDs), dealers authorized by the government to sell T-bills. Transactions are done through bidding online. . é The Philippine government issues two types of government securities: Treasury bills, which are short-term, and T-bonds) which are long-term. T-bills are zero coupon securities because they have no coupon payments (interest payment) and only have face values. They are sold at adiscount, which means that their purchase price is less than their face value. This difference between their purchase price and thelr face value is the sole source of their return generally referred to as discount yield (dy) or margin, They,do not earn interest, They are generally quoted either by their yield rate, which is the discount or by their price based on 100 points per unit, The yield is the Increment or interest on an investment. Relative to government securities, It is the discount earned on T-bills or the coupon paid to the holder of T-bonds. Both the discount and the coupon are expressed asa percentage of the value of the GS on a per annum basis. Conventionally, the yields in longer-dated or termed GS are higher than the yields in shorter-termed GS. The image on the next page is a sample of the Philippine government's latest offerings of T-bills dated April 6, 2016. 2coe HBKCTIO Banker's Acceptances Banker's acceptance is a time draft issued by a bank payable to a 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 ona 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 signsit, the draft becomes a primary and unconditional liability of the bank. If the bankis well known and enjoys a good reputation, the accepted draft may be readily sold in an active market (LaRoche 1998). 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 Isa 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 (L/C) 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 8 contractual agreement between a bank, known as the issuing bank, on behalf of the buyer (drawer), authorizing another bank, the correspondent bank known as the advising or 70Financia. IysTRUM 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 or services. Essentially, the issuing bank replaces the buyer as the payor. The letter of credit states that the bank will accept the seller’s time draft if the seller presents the bank with shipping documents that transfer title on the goods to the bank. The bank notifies the seller of the letter of credit through a correspondent bank in the case of exports in the exporter’s country. When the goods have been shipped, thesseller presents its time draft and the specified documents to the accepting bank's correspondent, which forwards them to the accepting bank. If the documents are in order, the accepting bank takes them, accepts the draft, and discounts it for the exporter. At this point, the transaction is complete from the exporter’s point of view; it has shipped the goods, turned over title to them, and received payment. The responsibility of the buyer is to the issuing bank, which the buyer has to pay for the entire amount of the transaction including any necessary charges and fees. Through a letter of credit, the bank substitutes its own promise to pay for the promise of one of its customers, By substituting its promise, the bank reduces the seller’s risk, facilitating the flow of goods and services through international markets. If the seller becomes concerned about the soundness of the bank issuing the letter of credit, the seller may ask his own bank to issue a confirmation letter in which that bank guarantees against foreign bank default. A confirmation letter transfers the payment obligation to the guaranteeing/confirming bank from the originating/issuing bank. Negotiable Certificates of Deposit Certificate of deposit {CD) is a receipt issued by a commercial, bank for the deposit of money. Itis a time deposit with a definite maturity date (of up to one year) 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. They are not ordinarily redeerhed prior to maturity, but in the early 1960s, a secondary market was established in which CDs [Link] of $100,000 or more can be traded:prior to maturity. That was when the so-called negotiable certificates of deposit were born (Thomas 1997). They are not the regular certificates of deposits or time deposits held by depositors in banks, which are not marketable, Negotiable certificate of deposit is a bankissued time deposit that specifies an interest rate and maturity daté and is negotiable, It is a short-term, 2 to 52 weeks, and of a large denomination, 100,000, 500,000, and P1M, The normal round lot trading unit among dealers is P1 million, itis a bearer instrument, that is, payable to whoever holds the CD-when it matures. Therefore, itis important that the owners must take good care of them because when lost, the one who found it can claim payment, Negotiable CDs are more risky than T-bills. When'CDs mature, the owner receives the full amount deposited plus the earned interest.Capita MARKETS Lee tah sali ae Secondary markets for CDs exist. In Asia, CDs market has grown rapidly in the pas, decade, despite that It is relatively small and illiquid compared to its counterparts in Europ, and the United States. In the Philippines, banks like Union Bank, BDO, and HSBC offer CDs. |, the US, the heart is found in New York City. CDs are more heterogeneous than T-bills. T-bilj; have similar rates, maturity periods, and denominations; more variety is found in CDs. Thi, takes it harder to liquidate large blocks of CDs because.a more specialized investor is Much Needed, Securities dealer who “makes” the secondary market in CDs mainly trades in million units, Smaller denominations can be traded, but will bring a relatively lower price. Income received from CDs is subject to taxation at all government levels. In recent years, CD yields have been above those available on bankers’ acceptances. (Keown et al. 1998) Banks Issue negotiable CDs to attract additional funds to make additional loans or to counteract the restrictive effect of deposit withdrawals. Banks began Issuing negotiable CDs, which were:not subject to statutory interest rate ceilings, in an effort to halt the withdrawa| of deposits. When central banks adopt restrictive policies, commercial banks issue negotiable CDs increasing the outstanding supply of these marketable securities. Negotiable CDs are held by lenders with a need for temporary investment outlets for large amounts of fund typically at PIM or more. The primary buyers of negotiable CDs are corporations, money market mutual funds, government institutions, charitable organizations like PCSO, and foreign buyers. 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 (often ‘overnight) from a corporation, state or local government, or other large entity that has idle funds to a commercial bank, securities dealer, or other financial institution, 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 isa reverse repo, Repurchase agreements are closely associated with the functioning of the interbank call Joan market in the Philippines and the federal funds market in the US. In an interbank loan market or Fed funds transaction, the bank with excess reserves sells fed/reserve funds for ‘one day to the purchasing bank. The next day, the purchasing bank returns the fed/reserve funds plus one day’s interest reflecting the fed/reserve funds rate. Since there is a credit risk exposure to the selling bank in that the purchasing bank may not be able to repay the fed/ reserve funds the next day, the selling bank may seek collateral backing for the one-day loan of fed/reserve funds. Ina repo transaction, the funds-selling bank receives government securities as collateral from the funds-purchasing bank, That is, the funds-purchasing bank temporarily exchanges securities for cash, The next day, this transaction is reversed; the funds-purchasing bank sends back the fed/reserve funds borrowed plus interest at the repo rate; in return, it receives or repurchases Its securities used as collateral in the transaction. 79RPsare free from interest rate ceilings and are not subject to reserve requirements as long as the collateral are GS. The contract price of the securities that makes up the arrangement is fixed for the duration of the transaction, Anyone who buys an RP is protected from market price fluctuations throughout the contract period. This makes it a sound alternative investment for funds that are freed up for only very short periods of time. The collateral used most frequently in these transactions is a government-Issued security like a T-bill. The borrower provides the lender collateral in the form of GS making the loan free of default. However, it has poor marketability because it is a two-party agreement, but it is self-liquidating within a few days. RPs can be overnight RPs ot term RPs. Overnight RPs mature in a day. Term RPS have a maturity greater than 1 day. The difference between overnight RPs and term RPs is the same difference between demand deposits and time deposits. Term RPs are one way of avoiding the interest rate ceilings on time deposits, Assume that an investor invests overnight or over the weekend. The investor is concerned that T-bill prices will fall before they are sold. The investor can always find a bank or dealer willing to sell the desired number of T-bills and commit to buying them back later at a specified price. The purchase and sale prices are set to guarantee the investor a profit, ifthe interest rates fall or remain unchanged during the day(s) the investor holds the Thills, the rate of profit on the repo will be slightly less than the rate that the investor could have earned by buying and selling T-bills in the open market. This difference and the fee charged for the transaction constitute the bank’s or dealer’s profit. However, if interest rates rise, the investor still gets the guaranteed profit and the bank or dealer absorbs the loss. This change in the interest rates constitutes the risk in repos. (Shetty et al. 1995), > In another case, a large corporation with a'mhillion or more in funds that is not needed for a few days “buys” a large block of GS from a major bank. The bank agrees to repurchase the securities on the date the [Link] the funds at a price sufficiently above the price the company paid for the securities to provide a rate of return about one-quarter of one percent below the current federal funds rate. Thus, rather than holding large checking account balances, which earn no interest, the corporation makes a safe, convenient investment ata competitive yield. Banks, dealers, and others who borrow in this market find it a useful source of funds. Because aggressive management of cash positions by corporations, state; and local governments, and other large organization has become widespread, RP market has grown dramatically in the past 25 years. i Money Market Deposit Accounts Money market deposit accounts (MMDAs) are PDIC-insured deposit accounts that are usually managed by banks or brokerages and can be a convenient place to store money that is tobe used for upcoming investments or has been recelved from the sale of recent investments. They are very safe and highly liquid Investments, typlcally 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 pér person, per bank. As long as the balance in the account remains below the insurance limit, every bit of principal and interest earned on the account Is 100% guaranteed. PER 3: FINANOIAL INSTRUMENTS