POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Sta. Mesa, Manila

Financial Markets

Money Markets and Related Financial Instruments

Submitted by:
Bello, Gerald
Faz, Shiela
Quimson, Jean Kayla
Tadeo, Shaina Mae
BSMA 2 – 7

Submitted to:
Prof. Luzviminda S. Payongayong
FINANCIAL INSTRUMENT

According to Conceptual Framework for Financial Reporting (2018) an asset is a

resource controlled by the entity as a result of past events and from which future economic

benefits are expected to flow to the entity.

Assets can be classified in terms of physical tangible and intangible assets.

 Tangible assets are assets that have physical properties and can be easily seen

properties. Examples of tangible assets include buildings, equipment, machinery,

land and supplies.

 Intangible assets are identifiable assets that do not have physical substance and

usually represents a legal claim to some future economic benefit.

Financial Instruments (also called as financial assets or securities) are basically

intangible as future economic benefit takes form of a claim to cash that will be received in the

future. They are the main vehicle used for transactions in the financial market. These tools help

the finance manager handle his cash, his short-term operating requirements, and long-term

business requirements (Yumang, Chan Pao, & Pefianco-Benito, (2016).

Most types of financial instruments provide efficient flow and transfer of capital all

throughout the world's investors. These assets can be cash, a contractual right to deliver or

receive cash or another type of financial instrument, or evidence of one's ownership of an entity

(Yumang, Chan Pao, & Pefianco-Benito, (2016).

For the purposes of presentation in financial statements, financial instruments may be

presented under cash equivalents o investments. Securities that are maturing within 90 days or

less are classified under cash equivalents. Otherwise, they are classified under investments.
 There is a minimum of two parties involved in a financial instrument: the issuer; and the

investor.

 The issuer is the party that issues the financial instrument and agrees to make

future cash payments to the investor. The issuing party usually needs additional

funds for investment to further grow their business.

 The investor is the party that receives and owns the financial instrument and

bears the right to receive payments to be made by the issuer. The investors usually

have surplus funds that are not earning anything and are willing to bear some risk

to earn something from their surplus funds. On an accounting perspective,

investors recognize financial instruments as an asset.

At the point of issuance of the financial instrument, the issuer usually receives something

of value (usually cash) from the investor. The financial instrument then becomes the proof

(hence, called as security) of the future claim of the investor from the issuer.

Financial instruments have two main economic purposes:

 Allows transfer of fund from entities with excess funds (investors) to entities who

needs funds (issuer) for business purposes (e.g. to pay for tangible assets).

 Permit transfer of fund that allows sharing of inherent risk associated with the

cash flows coming from tangible asset investment between the issuer and

investor.
 Usually, the initial investor does not hold on to the instrument up until the time the issuer

can make the payment. In such cases, investors trade their financial securities to other individuals

or institutions that are willing to pay for their claim to future payment.

Financial intermediaries also operate in the financial system demand funds from

“investors” and convert these to various financial assets that the general public is willing to buy.

As a result of these interlinked activities, claims of the final wealth holders generally differ from

the liabilities recognized by the issuer (final demanders of funds).

MONEY MARKET

One primary misconception is that money or currency is the security being traded in a

money market. This is not true. Same with other markets, financial instruments are the primary

subject of trading in a money market. However, the financial instruments traded in the money

market are short-term and highly liquid, that it can be considered close to being money.

Money market securities have three fundamental characteristics:

 Usually sold in large denominations

 Low default risk

 Mature in one year or less from original issue date. Most money markets instruments

mature in less than 4 months.

Transactions in the money market are not confined on one location. Instead, the traders

organize the purchasing and selling of the securities among participants and closes the
transactions electronically. As a result, money market securities commonly have an active

secondary market.

An active secondary market enables individuals or organizations to trade money market

instruments to cater to short-term financial needs.

Money market instruments become a flexible tool as individuals or organizations may invest

in these for short-term gains and convert it back to cash quickly once liquidity need arises. They

are safe as these are quality investments for short periods but do not provide very high returns

compared to long-term investments.

On an accounting perspective, most money market instruments are considered as cash

equivalents due to the fact that they mature (i.e. cash can be redeemed) within three months or

less from the date of purchase.

Most transactions in the money market are very large, hence, they are considered as

wholesale markets. The required size of the transaction usually averts individual investors in

directly participating in the money market. As a result, dealers and brokers execute transactions

in the trading rooms of brokerage houses and large banks to match customers (buyers to sellers)

with each other. Despite this limitation, individual investors nowadays can invest in the money

market by joining funds that trade mostly using money market instruments.
 A mature secondary market for money market instruments allows the money market to be

the preferred place for firms to temporarily store excess funds up until such time they are needed

again by the organization. Investors who place funds in the money market do not intend to earn

high returns for their money. Instead, investors look at the money market as a temporary

investment that will provide a slightly higher return than holding on the money or depositing it in

banks. If investors believe that the prevailing market conditions do not justify a stock purchase or

there might be a possible interest rate hikes impacting bonds, then they can choose to invest on

money market instruments in the meantime.

Holding on to cash is a very expensive option for investors as this does not generate any

return. Any idle cash becomes an opportunity cost to investors by means of interest income not

earned by holding on to the cash. To reduce opportunity costs, money markets become a viable

option to temporarily invest idle funds.

Investors also plan their strategy to incur the lowest opportunity costs. Investors want to

have an easy source of cash to be able to act quickly if there are available investment

opportunities that come but at the same time do not want to let go of potential objectives.

Financial intermediaries also use money market instruments to attain interest income. As a

result, they invest money market securities to achieve these investment requirements or deposit

outflows.

Money market securities are also an inexpensive way for government and financial

institutions to raise funds. Fund demanders need to have funds quickly because the timing of

cash inflows and outflows does not synchronize with each other. These funds are usually
available for short periods of time; therefore, their rates are generally lower than funds which are

available for use over longer periods of time (Yumang, Chan Pao, & Pefianco-Benito, (2016).

For businesses, timing of cash collections from revenue may not match when the

business needs to pay its operating expenses.

For government, collection of revenue only comes at certain points of the year (tax

payment deadlines) but expenses are incurred throughout the year. To resolve the need for funds

as a result of the mismatch, these entities turn to money markets to obtain funds.

Participants in the money market include the following:

 Bureau of Treasury – The bureau sells government securities to raise funds. Short-term

issuances of government securities allow the government to obtain cash until tax

revenues are collected.

 Commercial banks – Issues treasury securities; sell certificates of deposits and extends

loans; offers individual investor accounts that can be used to invest in money markets.

Banks are the primary issuer negotiable certificates of deposits, banker’s acceptances and

repurchase agreements.

 Private Individual – These private individuals made their investment through money

market mutual funds.

 Commercial Non-Financial Institutions – These entities buy and sells money market

securities to manage their cash i.e. to temporarily store excess funds in exchange of

somewhat higher return and obtain short-term funds.

  Investment companies – Trade securities in behalf of their clients. Makes a market for

money market securities through maintaining an inventory of financial instruments that

can be bought or sold. Investment companies help maintain liquidity of money market

since they make sure that sellers can easily sell their securities when the need arises.

 Finance or commercial leasing companies – These companies raise money market

instruments i.e. commercial paper to lend funds to individual borrowers

 Insurance companies – These are companies that invest on money market to maintain

liquidity level in case of unexpected demands most especially for property and casualty

insurance companies.

 Pension funds – Maintain funds in money market as preparation for long-term investing

in stocks and bonds market. Need to maintain liquidity to meet obligations but since

future obligations are likely expected, huge money market investments are not necessary.

 Money market mutual funds – These funds are pooled investment. It permits small

investors (e.g. individuals) to invest in the money market by accumulating funds from

numerous small investors to buy large-denomination money market securities. Aside

from that, these funds also have no specific maturity date and the degree of default risk is

low (Yumang, Chan Pao, & Pefianco-Benito, (2016).

TYPES OF MONEY MARKET FINANCIAL INSTRUMENTS

Treasury Bills

Issued by the Central Government, Treasury Bills are known to be one of the safest

money market instruments available. However, treasury bills carry zero risk. Therefore, the
returns one gets on them are not attractive. Treasury bills come with different maturity periods

like 3-month, 6-month and 1 year and are circulated by primary and secondary markets. Treasury

bills are issued by the Central government at a lesser price than their face value. The interest

earned by the buyer will be the difference of the maturity value of the instrument and the buying

price of the bill, which is decided with the help of bidding done via auctions. Treasury bills have

virtually zero default risk since the government can always print more money that they can use

redeem this securities at maturity. Risk of inflationary changes is also lower since the maturity

term is shorter. Market for Treasury bill is both deep and liquid. Deep market means that the

market has numerous different buyers and sellers while liquid market means that securities can

be quickly traded at low transactions costs. Investors prefer to go to a deep and liquid market

such as Treasury bills since there is only little risk that they will not be able to liquidate the

securities when they prefer to.

When analysing investments, investors often try to compare performance of financial

instruments with each other. To address this, most investors look at percentages to be able to

compare returns better. At the point of view of investors, the discount rate indicates how much

return in %, they can get from a particular security. The annualized discount rate for a non-

interest-bearing security is described as:

Annualized discount rate = ((Bv - Bp) / Bv) (360 / D)

Where: Bv = Face value or Market Value

Bp = Purchase Price

D = Tenor or period in days

Example: A P1,000 Treasury bill with a 91-day tenor can be purchased at 995.

Annualized discount rate = ((1,000 - 995) / 1,000) (360 / 91)

Annualized discount rate = ((5 / 1,000) (360 / 91)

Annualized discount rate =1.98%

The investment rate portrays a more accurate representation of how much investor will

earn from security since it uses the actual number of days per year and the true initial investment

in the computation.

Annualized investment rate = ((Bv - Bp) / Bp) (365 / M)

Where: Bv = Face value or Market Value

Bp = Purchase Price

M = Number of days to maturity

Using the previous example, the annualized investment rate is

Annualized investment rate = ((1,000 - 995) / 995) (365 / 91)

Annualized investment rate = ((5) / 995) (365 / 91)

Annualized investment rate = 2.02%

Treasury bills are also known to be very near to the definition of a risk free asset. As a

result, interest earned on treasury bills is among the lowest in the market. Investors may find that

earnings from Treasury Bills may not be sufficient to cover changes in purchasing power bought

by higher inflation. Treasury Bills are most meant as an investment vehicle to temporarily store

excess cash since it may hardly catch up with inflation.

Repurchase Agreements (Repo)

Repurchase Agreements, also known as Reverse Repo or simply as Repo, loans of a short

duration which are agreed upon by buyers and sellers for the purpose of selling and repurchasing.

These transactions can only be carried out between RBI approved parties Repo / Reverse Repo

transactions can be done only between the parties approved by RBI. Transactions are only

permitted between securities approved by the RBI like treasury bills, central or state government

securities, corporate bonds and PSU bonds. Dealers of government securities commonly use

repos to manage liquidity and take advantage of expected changes in interest rates. Dealers sell

their securities to a bank with an accompanying repo agreement promising to buy the securities

back at a specified future date. Essentially, repos are collateralized loans.

Negotiable Certificate Of Deposit

They are guaranteed by the bank and can usually be sold in a highly liquid secondary

market, but they cannot be cashed in before maturity. Because of their large denominations,

NCDs are bought most often by large institutional investors, which often use them as a way to

invest in a low-risk, low-interest security. Negotiable Certificate Of Deposit is also classified as a

bearer instrument. As a bearer instrument, whoever person or entity which possesses the

instrument upon maturity will receive the principal and interest. This feature allows negotiable

CDs to be purchased and sold between investors up until the maturity.

The certificate indicates the interest rate and the maturity date of the deposit. Interest

rates of CDs are based on the outcome of the negotiation between the depositor and the bank,
where the both parties agree. Negotiable Certificate Of Deposit may have maturity period

between one to four months up to six months. Upon the maturity, the bank shall pay the principal

plus the interest to the investor who holds the CD

NCDs are insured by the Federal Deposit Insurance Corp. (FDIC) for up to $250,000 per

depositor per bank. The Federal Deposit Insurance Corporation (FDIC) is an independent federal

agency insuring deposits in U.S. banks and thrifts in the event of bank failures. The FDIC was

created in 1933 to maintain public confidence and encourage stability in the financial system

through the promotion of sound banking practices. As of 2018, the FDIC insures deposits up to

$250,000 per depositor as long as the institution is a member firm.

In the Philippines, the BSP allows and regulates the issuance of long-term negotiable

certificate of deposit (LTNCD). Long-Term Negotiable Certificate of Deposit, is a bank product

offered to investors looking for a relatively safe investment, but with higher interest rates than a

regular savings account or short-term time deposit but unable to withdraw the money. LTNCD

refers to interest bearing negotiable certificate of deposit with a minimum maturity of five years.

LTNCDs are covered by the Philippine Deposit Insurance Corporation on a maximum insurance

coverage of up to P500,000 per depositor.

Commercial Paper

Commercial Paper are unsecured promissory notes, therefore, only large and

creditworthy corporations can issue this security. Commercial Paper may be short-term or long-

term. Short-term commercial paper means an evidence of indebtedness of any person with a
maturity of 365 days or less. Long-term commercial paper means an evidence of indebtedness of

any person with a maturity of more than 365 days.

Lenders will not accept commercial papers from small companies since they are

going to assume high level of risk since it is note secured. Commercial papers are issued directly

to the buyer and usually, there is no secondary market. Dealers may redeem commercial paper if

the bearer needs cash, but this seldom happens. Commercial papers may either have a stated

interest rate on its face or sold at a discounted basis.

In the Philippines, commercial papers are not required to register with SEC if they

meet the following requirements:

• Issued not more than 19 non-institutional lenders

• Payable to a specific person

• Neither negotiable nor assignable and held on to maturity

• Amount not exceeding 50 million pesos

Banker's Acceptance

A banker's acceptance (BA) is a short-term debt instrument issued by a company that is

guaranteed by a commercial bank. Banker's acceptances are issued as part of a commercial

transaction. These instruments are similar to T-bills, are frequently used in money market

funds and are traded at a discount from face value on the secondary market, which can be an

advantage because the banker's acceptance does not need to be held until it matures.
 Example: Company A wants to buy a large equipment from Company B for the first

time. Since Company B doesn’t have any experience that will establish the creditworthiness of

Company A, it may be reluctant to ship the equipment immediately because they might

experience difficulty in collection afterwards. Company A may also be reluctant to send money

to Company B for the same reason that they may not receive the equipment as promised. To help

consummate the transaction, banks may intervene through the issuance of banker’s acceptance

wherein it will lend its name and creditworthiness to the paying party, i.e. Company A

EVALUATING MONEY MARKET SECURITIES

Money market securities may be evaluated based on the interest rates and liquidity.

Interest rates are very relevant in deciding which money market securities to invest since

this dictate the potential return that can be received from the investment. Interest rates on money

market tend to be relatively low as a result of the low risks associated with them and the short

maturity period. Money market securities have a very deep market; thus, they are competitively

priced. If you would notice, most money market securities carry the same risk profile and

attributes, thus, making each instrument a close substitute for each other. Hence, if a particular

security may have an interest rate that deviates from the average rate, supply and demand forces

in the market would ultimately correct it and force it back to the average rate.

Liquidity refers to how quick, efficient and cheap to convert a security into cash.

Treasury bills, that have a ready secondary market, are considered to be more liquid than

commercial papers which do not have a developed secondary market. Holders of commercial

papers tend to hold the security until it matures. For this reason, brokers may charge higher fee

for investors that would want to liquidate its commercial paper since more effort shall be made to
look for potential buyers compared to treasury bills that have buyers willing to purchase at short

notice. Since most money market securities are typically short-term, money market is often

preferred by investors who desire liquidity intervention – providing liquidity where it did not

previously exist.

VALUATION OF MONEY MARKET SECURITIES

Valuation of money market securities is important to determine at what amount an

investor is willing to pay in exchange of a security. In some cases, investors need to give an

amount as a bid to be able to buy securities. Money market securities can be valued using the

present value approach. The interest rate used in the valuation shall reflect the required return

from the instrument based on the investor’s perceived risk. Investors may also use the prevailing

interest rate in the market for the type of security being purchased.

Valuation formula which is practically present value formula

Market Security Value = Sb/(1+I)^n

Where: Sb = Face Value of the security

I = Interest Rate

n = Number of Periods

Example: Face value of a one-year Treasury bill is at P1,000 with an annual interest rate of 3%.

Market security value = P1,000/(1+3%)^1

Market Security value = P970.87

 This means that an investor is willing to pay P970.87 for a P1,000 Treasury bill based on

the risks surrounding the instrument. In absolute terms, the investor will get return of P29.13

from this investment.

Assume that another P1,000 Treasury bill with maturity term 90 days with an annual

interest rate of 4% is being evaluated. Assume 360 days.The value of said Treasury bill is

computed as follows:

Market Security Value = P1,000/(1+1%)^1

Market Security Value = P990.10

The annual interest rate should be converted to match the 90-day maturity term. Hence,

annual interest term of 4% shall be multiplied with 90/360 to get how much is the interest rate

for the tenor of the security. In this case, the interest rate to be used is 1% which represents the

interest cost associated with the 90 days that the money is held by the government.

As a general rule, as the interest rate rises, the value of the security becomes lower. This

means that the risk is increases thus the impact on the value of the securities also reduces. Actors

that drive the interest rate will be further discussed in the succeeding chapter for this book.
 Quiz

I. Modified True or False: Write “TRUE” if the statement is correct but if it is false,

change the word or phrases that make it incorrect to make the whole statement true.

__________________ 1. Financial instruments are basically tangible as future economic

benefit takes form of a claim to cash that will be received in the future.

__________________ 2. The investor is the party that receives and owns the financial

instrument and bears the right to receive payments to be made by the payer.

__________________ 3. Transactions in the money market are not confined on one

location.

__________________ 4. Treasury bills have virtually zero default risk since the

government can always print more money that they can use redeem this securities at

maturity. Risk of inflationary changes is also lower since the maturity term is shorter.

__________________ 5. Repurchase Agreements, also known as Reverse Repo or

simply as Repo, loans of a short duration which are agreed upon by buyers and sellers for

the purpose of selling and repurchasing.

__________________ 6. Treasury bills are also known to be very near to the definition

of a risk free asset.

__________________ 7. Money market securities may be evaluated based on the interest

rates and liquidity.

__________________ 8. As the interest rate rises, the value of the security becomes

higher

__________________ 9. Interest rates are very relevant in deciding which money

market securities to invest

 __________________ 10. Valuation of money market securities is important to

determine at what amount an investor is willing to pay in exchange of a security

II. Multiple Choice: Encircle the letter of the best answer to the following

statements/questions below.

11. Which is not the fundamental characteristic of money market?

a. Usually sold in large denominations

b. Expensive way to raise funds

c. Low default risk

d. Mature in one year or less from original issue date. Most money markets

instruments mature in less than 4 months.

12. Most transactions in the money market are very large, hence, they are considered

as ____________.

a. Wholesale markets

b. Financial markets

c. Consumer markets

d. Global markets

13. ____________ are the main vehicle used for transactions in the financial market.

For the purposes of presentation in financial statements, these may be presented

under cash equivalents or investments.

a. Financial Intermediary

b. Financial Instruments
 c. Currency

d. Money Market

14. Which are the government securities issued by the Bureau of Treasury which

mature in less than a year?

a. Treasury bills

b. Banker’s Acceptance

c. Money market securities

d. Certificate of Deposits

15. What do you call the other variation of the annualized discount rate?

a. Market value

b. Purchase price

c. Investment rate

d. Interest rate

16. It is a security that is also classified as a bearer instrument?

a. Commercial Paper

b. Negotiable Certificate Of Deposit

c. Trasury Bill

d. Banker’s Acceptance

17. It is an independent federal agency insuring deposits in U.S. banks and thrifts in

the event of bank failures.

a. Federal Deposit Insurance Company

b. Federal Deposit Insurance Corporation

c. Federal Deposit Institution Company

 d. Federal Deposit Enterprise Corporation

18. Financial institutions that regulates the issuance of long-term negotiable

certificate of deposit (LTNCD).

a. Securities and Exchange Commission

b. Department of Trade and Industry

c. Bangko Sentral ng Pilipinas

d. Philippines Stock Exchange

19. It is an unsecured, short-term debt instrument issued by a corporation.

a. Commercial Paper

b. Negotiable Certificate Of Deposit

c. Trasury Bill

d. Banker’s Acceptance

20. Commercial papers are not required to register with SEC if they meet the

following requirements, except one:

a. Issued not more than 18 non-institutional lenders

b. Payable to a specific person

c. Neither negotiable nor assignable and held on to maturity

d. Amount not exceeding 50 million pesos

 Answers

1. Intangible

2. Issuer

3. True

4. True

5. True

6. True

7. True

8. Lower

9. True

10. True

11. B

12. A

13. B

14. A

15. C

16. B

17. B

18. C

19. A

20. A
 References

Chen, J. (2019, April 12). Definition Banker’s Acceptance (BA). Retrieved from

https://www.investopedia.com/terms/b/bankersacceptance.asp

Federal Deposit Insurance Corporation – FDIC – Definition (2019). Retrieved from

https://www.investopedia.com/terms/f/fdic.asp

Investing 101: What You Need to Know About LTNCD (Long-Term Negotiable Certificate of

Deposit) (2017). Retriever from https://www.securitybank.com/blog/investing-101-what-

you-need-to-know-about-long-term-negotiable-certificate-of-deposit/

Lascano, M., Baron, H., & Cachero, A. (2019). Fundamentals of financial markets.

Money Market Instruments (2017). Retrieved from https://www.bankbazaar.com/mutual-

fund/money-market-instruments.html

Negotiable Certificate Of Deposit (2018). Retrieved from https://www.investopedia.com/

terms/n/ncd.asp

Yumang, K., Chan Pao, T., & Pefianco-Benito, P. (2016). Exploring small businesses and

personal finance. Quezon City: Phoenix Publishing House.