Financial Instruments

Define the following and identify specific characteristics of the following financial instruments:
• Negotiable Certificates of Deposit
o Securities issued by the banks which records a deposit made
o Indicates:
▪ Interest rate and,
▪ Maturity date of the deposit
• Since it is indicated, it is treated as a term security with a specific maturity
date
• Cannot be easily withdrawn by the depositor
o since it is different from a demand deposit account
▪ wherein money can be withdrawn upon demand of
depositor
o Certificate of deposit
▪ Essentially restricts holders from withdrawing funds on demand
▪ Concept:
• Investors are willing to accept a higher return in exchange of having no
access to liquidity
o Also classified as a bearer instrument
▪ Whoever person or entity which possesses the instrument upon maturity will
receive the principal and interest
▪ This feature:
• Allows the negotiable certificates of deposit to be purchased and sold
between investors
o Interest Rates
▪ Based on the outcome of the negotiation between the depositor and the bank
▪ Both parties should agree on the interest rate of the CD
▪ Usually at the same level with other money market securities – since it carries a
low level of risk
o Investors can buy or sell certificates of deposit up until the instrument’s maturity.
o Maturity
▪ Can be between one to four months up to six months
▪ Longer maturity on CDs, lesser demand
▪ Upon maturity
• Bank shall pay the principal plus the interest to the investor who holds the
CD
o In the Philippines
▪ Bangko Sentral ng Pilipinas
• Allows and regulates the issuance of Long-Term Negotiable Certificates
of Deposits (LTNCD)
o Refers to interest bearing negotiable certificate of deposit with a
minimum maturity of five years
o Offers a higher return compared to a regular time deposit account
▪ Due to a long period that depositors will be unable to
withdraw the money
• Short-Term and Long-Term Commercial Papers
o Commercial Papers
▪ Unsecured promissory notes
▪ May be short-term or long-term
▪ Commercial Papers are unsecured
• Only large and creditworthy corporations can issue this security
• Lenders will not accept commercial papers from small companies
• They assume high level of risk
▪ Issued directly to the buyers
▪ Usually, no secondary market
 ▪ Dealers
• May redeem commercial papers if the bearer needs cash. Seldom
happens.
▪ Non-Bank Corporations
• Usually issue commercial papers and use the proceeds to fund loans that
they extend to their clients
▪ Issuers
• Often maintain line of credits with banks to serve as a backup for a
commercial paper
• If they are not able to pay the maturing commercial paper, the bank will
lend funds to the issuer to enable the latter to pay for the commercial paper
▪ Availability of Line Credits
• Reduces the risk associated with commercial papers → reduces the
interest rate
▪ Bank usually extends the line of credit and agrees to provide the loan in advance
in case there is a need to pay off the commercial paper. In exchange, the issuer
pays of a service charge in exchange of a line credit
▪ Issuers agrees to pay the line of credit fee because this is lower versus paying
interest in the commercial paper for an extended period
▪ May either have stated interest rate on its face or sold at a discounted basis
▪ Not required to register with SEC if they met the following requirements
(Philippines):
• Issued to 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
o Short-Term Commercial Papers
▪ Means an evidence of indebtedness of any person with a maturity of 365 days or
less
o Long-Term Commercial Papers
▪ Means an evidence of indebtedness of any person with a maturity of more than
365 days
• Banker’s Acceptances
o Order to pay a specified amount of money to the bearer on a specified date
o Often used to finance purchase of goods that have not yet been transferred from the seller
to the buyer
o Usually offered to importers and exporters
o Acceptance
▪ Formed when a draft or a promise to pay is made by the bank’s client and the bank
then ultimately accepts, promising to pay on behalf of the client
▪ Bank acceptance of the draft – translates to a promise to pay to whomever party
presents it to the bank for payment
o After acceptance, the client then gives the draft to the vendor to finance the purchase
o Usually payable to the bearer
o Can be subsequently purchased and sold until it matures
o Usually sold at a discount
o Interest rates are usually low since default risk is very minimal
• Treasury Bills, Notes and Bonds
o Treasury Bills
▪ Government securities issued by the Bureau of Treasury which mature in less than
a year
▪ There are three tenors:
• 91 days
• 182 days
• 364 days bills
 o Number of days is based on the universal practice around the
world ensuring that the bills mature on a business day
▪ Quoted:
• Yield rate – the discount
• Price based in 100 points per unit
▪ Cash Management bills
• Treasury bills which mature in less than 91 days
▪ No longer certificated because it is a government security
▪ Bid for T-bills in auction held by the Bureau of Treasury (banks that compose
majority of Government Security Eligible Dealers (GSED)) → Resell (T-Bills) by
banks to investors
▪ Have virtually zero default risk since government can always print more money
that they can use redeem these securities at maturity
▪ Risk of inflationary changes – lower since the maturity term is shorter
▪ Market for Treasury Bills
• Deep – market has numerous different buyers and sellers
• Liquid – securities can be quickly traded at low transactions cost
▪ Interest Rate
• Not explicitly stated; hence, interest is not actually paid by the government
when they sell this security
▪ Issued at discount
• Lower price than the par value at maturity
▪ Can be sold via two methods:
• Auctions or Competitive bidding
o Bureau of Treasury announces quantity and type of securities that
they will sell.
o Interested parties give bid offering and the Treasury accepts the
highest bids
o Treasury accepts the bids in ascending order of yield until the
accepted bids reach the offering amount
o Each accepted bid is awarded at the highest yield paid to any
accepted bid
o May or may not receive allocation from securities being sold
• Non-Competitive bidding
o Bidders only give amount of securities that they want to buy
o Price for all securities under non-competitive bids is set at he
highest yield paid to any accepted competitive bid.
o Guaranteed to receive the securities
o Notes
▪ a debt security that obligates issuers to repay the creditor the principal amount of
the loan and any interest payments within a defined time frame
▪ legal document that obligates an issuer to repay the creditor the principal amount
of a loan plus any interest payments at a predetermined date.
▪ includes all the terms of debt, including the principal amount, interest rate, terms
of repayment, and maturity date
▪ main types of notes include:
• Treasury Note
o fixed-income investments that are issued by the government
o issued when the government intends to raise funds to undertake
infrastructural projects, pay maturing debts, or undertake new
projects in the economy.
o Usually comes with a fixed interest rate and maturities of 2, 3, 5,
7, and 10 years
o pay interest every six months for the full term of the instrument
 • Unsecured Note
o Debt instrument that comes with a maturity of three to ten years
o Not secured by the issuer’s assets, as is the case with other types
of notes. Instead, it is backed by the issuer’s promise to pay, which
makes it riskier than other security investments
o Due to the increased level of risk associated with unsecured
notes, it offers a higher rate of return than secured notes to
compensate for the risk of loss.
o Companies issue unsecured notes through private offerings to
raise capital for corporate activities, such as share repurchases
• Promissory Note
o Promise by one party (note issuer) to pay another party (note
payee) a specified sum of money at a predetermined date or on-
demand
o Includes all the terms of debt such as principal amount, maturity
date, and terms of repayment. Sometimes, a promissory note may
include a provision that details the payee’s rights in the event of
an issuer’s default.
o Uses the term “pay to the order of” to specify the party who will
receive the loan repayment when it is due.
• Convertible Note
o Short-term instrument that converts into equity
o Used by angel investors who want to avoid placing a definite value
on a company, which provides them the option of converting their
creditor position into an equity position at an agreed price.
o Structured like a debt such that the capital invested into the
company can be converted to an equity position later in the future
o The number of shares an investor gets for each note held is
determined by a conversion rate, which may be fixed or changed
over time, depending on the initial terms of the agreement.
o Bond
▪ Debt instrument that provides a steady income stream to the investor in the form
of a coupon payments
▪ At maturity date, full face value of the bond is repaid to the bondholder
▪ Characteristics of a regular bond:
• Coupon Rate
o Interest rate possessed by some bonds
o Paid to bondholders semi-annually
o Fixed return that an investor earns periodically until it matures
• Maturity date
o Can be short-term or long-term
o When the bond matures, bond issuer repays the investor the full-
face value of the bond
o Face value
▪ Not necessarily the invested principal or purchase price
of the bond
▪ Corporate bonds – Php 1,000
▪ Government Bonds – Php 10,000
• Repurchase Agreement
o form of short-term borrowing for dealers in government securities
o dealer sells government securities to investors, usually on an overnight basis, and buys
them back the following day at a slightly higher price
o small difference in price is the implicit overnight interest rate
o typically used to raise short-term capital
o allow the sale of a security to another party with the promise that it’ll be purchased again
later at a higher price
 o seller acts as the borrower and the buyer as the lender
o provide quick liquidity
o They are safe because they’re backed by government securities but there is a risk that the
securities will drop in value, hurting the buyer’s investment
• Debt Securities Market
o Financial market where the debt instruments or securities are transacted by suppliers and
demanders of funds
A. Types of Long-Term Securities
a. Stocks
i. share in the ownership of a company
ii. represents a claim on the company’s assets and earnings
iii. have an unusually high amount of risk involved.
1. value of your stocks sees a direct impact from the state of the
economy, a country’s political situation and the performance of the
entity itself
b. Bonds
i. Buying bonds essentially means you’re lending your money to a company,
corporation, municipality or government entity.
ii. Risk involved are relatively low compared to stocks
iii. their value rarely sees a fluctuation, making them one of the safest long-
investments
c. Cash Equivalents
i. entails financial products such as certificates of deposit, money market
funds and high-interest saving accounts.
ii. relatively safe long-term investment option since they generally have a
stable rate of return
iii. rate of return is often low and is usually not an appropriate format for
investments like retirement planning.
d. Property
i. most popular (and wisest) options for investing in property are finding
something in an up-and-coming area, tourism hotspot, popular area or an
area near a university
B. Strategies and Challenges in Bond Market
C. Assessing Bond Value
a. Bond Valuation
i. Technique for determining the theoretical fair value of a particular bond
ii. Includes calculating the present value of the bond’s future interest
payments
iii. Formula to value a bond:
1.
• Equity Securities Market
A. Types of Stocks
▪ Common Stock
• majority of stock issued is in this form
• represent ownership in a company and a claim (dividends) on a portion of
profits
• yields higher returns than almost every other investment
▪ Preferred Stock
• represents some degree of ownership in a company but usually doesn't
come with the same voting rights
• usually guaranteed a fixed dividend forever
B. Rights vs Warrants
▪ Rights
• Privilege granted shareholders of a corporation to subscribe to shares of
a new issue of common stock before it is offered to the public
• Such a right, which normally has a life of two to four weeks, is freely
transferable and entitles the holder to buy the new common stock below
the public offering price
▪ Warrants
• derivative that give the right, but not the obligation, to buy or sell a
security—most commonly an equity—at a certain price before expiration
• exercise price or strike price
o The price at which the underlying security can be bought or sold
• American warrant
o can be exercised at any time on or before the expiration date
• European warrants
o an only be exercised on the expiration date
• call warrants
o Warrants that give the right to buy a security
• put warrants
o give the right to sell a security
C. Types of Market Capitalization
▪ Market Capitalization
• Also called as Market Cap
• Means the market value of the company’s outstanding shares
• Measurement is by multiplication of stock price with outstanding shares
▪ Types:
• Small Cap Companies
o Companies market cap is between $500 million to $2 billion
• Mid-Cap Companies
o Have market cap more than $2 billion and less than @10 billion
• Large Cap Companies
o Have a market cap over $10 billion
o Also called as blue-chip stocks
D. Stock Valuation (use of Market Value Ratios)
▪ Market Value Ratios
• these ratios are used to decide whether the valuation of the shares are
overvalued, undervalued or at par with the market
• the financial metrics which are used to evaluate the stocks’ worth of
publicly traded companies
• mainly used by investors to check whether the prevailing market share
prices are in sync with the company’s performance
 • The overvaluation or undervaluation of share helps investors decide
whether they should go long or short on the shares they are going to invest
in.
• If a share is overpriced, the price will fall for sure in the future and thus an
investor should short the shares for a while.
• stock is underpriced then one should go long on it
▪ Price to Earnings or PE Ratio
• most used and important ratio under this category of ratios
• used to check whether the shares are over or underpriced as compared
to its earnings potential
• measured as the price of the share in the current time against the earnings
the company has reported for the financial period on per share basis.
▪ Earnings per Share
• earnings of the company earned in the period under analysis period with
respect to the outstanding number of the company’s shares during that
period
• used to understand whether investing in it is worth the money or not
▪ Cash Earnings per Share (CEPS)
• is of recent evolution and gives a glimpse of the actual cash earned by the
company per share
• a further variation to the EPS
• Net Earnings of the Company+ All non-cash expense items (depreciation,
amortization, etc) – Tax Provision)/ outstanding number of equity shares
• alternate formula is :CEPS = Operating Cash Flow / Outstanding Number
of Shares
▪ Book Value per Share
• analyze and decide whether the market price per share of the company is
how near or far with respect to its book value per share
• shows the relation between the book value of the company (total equity
excluding the preference shares of the shareholders) and the outstanding
shares in the market
• Book Value Per Share= (Equity Share Capital of the Company + All
reserves and Surplus (part of shareholders kitty))/ the number of
outstanding equity shares of the company.
▪ Market Value per Share
• obtained by dividing the total market value of the shares of the company
by the number of the shares which are outstanding
• total market capitalization of the company in the secondary market / total
number of outstanding shares of the company.
▪ Dividend Yield
• helps in measuring the amount of dividend distributed in a year against the
number of shares outstanding
• gives an insight into the company’s earning and investors can decide
whether they want to invest in the shares which pay a certain level of
dividend against the current price of the share in the market.
▪ Market to Book Ratio
• ratio which shows the relation between the market value of a share to its
book value and thus one can easily figure out the difference between the
two to evaluate whether the prices are under or overvalued as per the
equity standing in the books.
• Optimizing Transaction Costs
• Hedging of funds/ Hedge funds
A. Hedge Funds
▪ alternative investments using pooled funds that employ different strategies to earn
active returns, or alpha, for their investors
 ▪ may be aggressively managed or make use of derivatives and leverage in both
domestic and international markets with the goal of generating high returns
▪ generally only accessible to accredited investors as they require less SEC
regulations than other funds
• Exchange traded funds
A. type of security that involves a collection of securities—such as stocks—that often tracks
an underlying index, although they can invest in any number of industry sectors or use
various strategies
B. in many ways similar to mutual funds; however, they are listed on exchanges
C. shares trade throughout the day just like ordinary stock.
D. called an exchange traded fund since it's traded on an exchange just like stocks
• Purchasing Power
A. the value of a currency expressed in terms of the amount of goods or services that one unit
of money can buy
B. dollar amount of credit available to a customer to buy additional securities against the
existing marginable securities in the brokerage account
C. may also be known as a currency's buying power.
• Inflation rate
A. percentage increase or decrease in prices during a specified period, usually a month or a
year
B. percentage tells you how quickly prices rose during the period
C. hyperinflation
▪ inflation rate is more than 50% in a month
D. stagflation
▪ If inflation occurs at the same time as a recession
E. asset inflation
▪ Rising prices in assets like housing, gold, or stocks
• How to compute inflation rate?
A. typically calculated using the inflation rate formula
▪ requires:
• the starting point (a specific year or month in the past) in the consumer
price index for a specific good or service
• current recording for the same good or service in the consumer price index
• Subtract to find the difference between the two numbers.
▪ The formula is: B-A/A x 100 where A is the starting number and B is the ending
number.
• Annualized Discount rate
• How to compute annualized discount rate
• Annualized investment rate
• How to compute annualized investment rate
• Payment system
• Commercial banks vs savings banks
• Thrift banks vs rural banks
Sources:

• Fundamental of Financial Markets by Baron, Cachero and Lascano

• https://corporatefinanceinstitute.com/resources/knowledge/trading-
investing/note/#:~:text=A%20note%20is%20a%20debt,allows%20them%20to%20obtain%20finan
cing
• https://www.investopedia.com/terms/r/repurchaseagreement.asp#:~:text=A%20repurchase%20a
greement%20(repo)%20is,at%20a%20slightly%20higher%20price.
• https://www.bankrate.com/glossary/r/repurchase-agreement-repo-loan/
• https://www.seanest.com/en/blog/types-of-long-term-investments-what-are-the-best-long-term-
investment-options
• https://www.disnat.com/en/learning/trading-basics/stock-basics/different-types-of-stocks
• https://www.investopedia.com/terms/w/warrant.asp
• https://financial-dictionary.thefreedictionary.com/rights
• https://efinancemanagement.com/investment-decisions/market-capitalization
• https://efinancemanagement.com/financial-analysis/market-value-ratios
• https://www.investopedia.com/terms/h/hedgefund.asp
• https://www.investopedia.com/terms/e/etf.asp
• https://www.investopedia.com/terms/p/purchasingpower.asp
• https://www.thebalance.com/what-is-inflation-how-it-s-measured-and-managed-
3306170#:~:text=The%20inflation%20rate%20is%20the,be%202%25%20higher%20next%20yea
r.
• https://www.indeed.com/career-advice/career-development/how-to-calculate-inflation-
rate#:~:text=Utilize%20inflation%20rate%20formula,inflation%20rate%20as%20a%20percentage.