WNT rowpanions Chapter 1 Rationale in Studying Financial Markets and Institutions Introducing Money and Interest Rates The Payments System Financial InstrumentsChapter RATIONALE IN STUDYING FINANCIAL MARKETS AND INSTITUTIONS Expected Learning Outcomes After studying the chapter, you should be able to ... 1. Understand the importance of studying a. Financial Markets b. Financial Institutions 2. Explain briefly the role of the a. Financial Markets b. Financial Institutions 3. Know the effective ay proach in st institutions Studying fi nancial markets and we gyCHAPTER 1 ‘RATIONALE IN STUDYING FINANCIAL MARKETS AND INSTITUTIONS THE NEED TO STUDY FINANCIAL MARKETS {n.2 market system, businesses of all types face risks, and many businesses fai. Economists and policy makers are particularly concemed about the rich and Potential failure that financial institutions (bank and non-bank) face because they play a vital role in the financial system. Financial markets and institutions not only influence your everyday life but also involve huge flows of funds - trillions of dollars — throughout the world Sconomy which is turn affect business profits, the production of goods and Services and the economic well-being of the countries around the worlar « The study of financial markets and institutions will reward you with an understanding of many exciting issues such as how funds are transferred fron People who have an excess of available funds to people who have a shortage. Indeed, well-functioning financial markets are a key factor in producing high economic growth and poorly performing financial markets are one reason that! many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth, the behavior of business and consumers and the cyclical performance of the economy. On the evening television news, you have just heard that the bond market has been booming. In the business section of a local newspaper, you read that the Euro is slightly higher against the yen. A European airline loses millions of dollars with derivatives. The Dow Jones Industrial Average is off 18 Points in active trading. Another local newspaper reported that “with inflation slowing again in June, 2019, the Bangko Sentral ng Pilipinas (BSP) Governor has Sounded off on potential rate cuts in the near term. There was even a hint that the Overnight borrowing rate cut will likely come before the last installment ot i latest reserve requirement reduction scheduled at the end of July, 2019 wi was implemented by the BSP in early May, 2019, will occur.4 Chapter | 0 that it is easier for you to finance the mall retail business? Will the d time to build a new factory Does this mean that interest rates will fall purchase of a new computer system for your st Pronomy improve in the future so that it is a goo building or add to the one you are in? Should you try to raise funds by issuing stocks or bonds or instead go to the bank for a loan? If you import goods from ‘abroad, should you be worried that that they will become more expensive? re examples of Financial Markets at work, That markets fence over modern life comes is n alibly of “Wall Street”, the “stock market” and the gs they attach to these time-worn phrases are often All these events ai exercise enormous influ people around the word speak “currency marks”, the meanin| unclear and out-of-date. This book explains the purposes that different financial markets serve and It cannot tell you whether your investment pate a, (t9 date is 77° clarifies the way they work. is likely to rise or fall in value. But it may help you understand how (i determined and how the different securities or financial instruments in it are created and traded. s answers to the businessmen’s questions by examining how hh as those for stocks, bond and foreign currency exchange) (such as banks, insurance companies, mutual funds and This book provide: financial markets (suc! and financial institutions other institution) work. The word “market” usually conjures up an image of the bustling, paper-strewn floor of the New York Stock Exchange and of Philippine Stock Exchange and of traders motioning frantically in the “futures” cubicles of Chicago. These images are out-of-date as almost all the dealings are now handled computer to computer, often with minimal human intervention. >’ Financial Markets have been around ever since mankind settled down to growing crops and trading them with others. The independent decisions of all of those farmers constituted a basic financial market, and that market fulfilled may be the same purposes as financial markets do today. Financial Markets are comprehensively discussed in Unit IN.-\ f Rationale in i Studying Financial Markets and Institutio ms § we EED TO STUDY FINANCIAL INSTITUTIONS funds transfers are common among individuals i jes where financial markets and Oh aid sinesses I developed economies generally find it more eters But ient to enlist es of financial institution when the time comes to raise capital ital, ake financial market work. Without th le to move funds from people who abe te tment opportunities. Thus, they also ha f the economy as 4 whole. es Financial institutions are what mi financial ma ts would not be abl uctive invest performance © t acquire funds by issuing termediaries that by purchasing securities or re financial int 10 acquire assets stitutions 4! those funds t Financial im liabilities and in turn use making loan. tem because they reduce , allow sharing and solve problems created by adverse relation and moral hazard. As @ result, financial institutions allow ‘small savers and borrowers t benefit from the existence of financial markets thereby increasing the efficiency of the economy: le in the financial syst important rol They play on ost, an exciting one. Not only | directly but also gain .d institutions that we cial institutions are in one’s life, as an ns is indeed ets and institutiol rn materials that affect the life of the individual derstanding of events in financial markets am iedia. Understanding how finan there will be many times individual, an employee, OF the owner of a business, when you will interact with them. Cases provided in this textbook which provide specific analytic tools are useful if one makes his/her career at @ financial institution and also give him/her a feel of what a job as a manager of a financial institution is all about. The field of financial mark will one lea a clearer un hear about i managed is important financial institutions is that they are among the try and frequently pay very hi salaries. Hence for studying financial institutions: It cial sector. Even if your interests lie institutions are run because |, an employee, OF the owner Knowing how when you ‘Another reason for studying largest employers in the count some of you have a very practical reason may help you get a good job in the finan ce ee should still care about how financial ee Se eattye in your life, as an individual Feet inis en you will interact with these institutions. ‘ahetew fork yea: are managed may help you get a better deal em or if you decide to supply them with funds.INANCIAL MARKETS APPROACH IN STUDYING FI INSTITUTIONS derlying all discussions in this text has three levels, namely, The framework U! Inderstanding f i a Unde derstand economic analysis, that is, students develop Students learn to un : the econom! n they need to organize concepts and facts a) ic intuitiol 5) Evaluating Students learn Students learn to u: critically about how they interpret to evaluate current developments and the financial news, se financial data and economic analysis to think t current events. o) Predicting ; has Students learn to use economic analysis to predict likely changes in the economy and the financial system. . This book stresses @ unifying, analytic framework to study financial markets and institutions. This framework uses a few basic concepts to keep organize your thinking about the determination of asset prices, the structure of financial markets, bank management and the role of monetary policy in the economy. The asic concepts are equilibrium, basic supply and demand analysis to explain behavior in the financial markets, the search for profits, and an approach to financial structure based on transaction costs and asymmetric information. r vides the tools needed to understand trends in the financial market place and in variables such as interest rates and exchange rates. This text also emphasizes the interaction of theoretical analysis and empirical data in order to expose the reader to real-life events and data. The framework also. pro ‘And to function better in the real world outside it i el r the classroom, it is recommended ioe mist oe i fee habit of regularly following the financial news ing financial publicati i i Saari Ape publications or read the financial / business Last i ye A fale he ent has become an extremely valuable and convenient Spdeted frejuenty. sree thts sites contain additional information and af particular interest. ites to further explore topics that one finds ofThis chapt markets an regulation, snooze chapters Rationale in Studying Financial Markets Gnd Instituy cleat er offers a preliminary overview of the fascinating stud d institutions. We will return to a more detailed tr structure and evaluation of financial markets and in: 'Y Of financial Catment of the stitutions in the REVIEW QUESTIONS Questions 1. Why is there a need to understand how monetary policy is conducted by central banks worldwide? What crucial role do banks and other financial institutions play? Why is understanding how financial institutions are managed important to your life? Give three important reasons why is there a need to study Financial Markets, What is the most significant role that financial markets play? Explain briefly the three levels of the framework that underlie the study of financial markets and institutions.INTRODUCING MONEY AND INTEREST RATES Expected Learning Outcomes After studying the chapter, you should be able to ... 1. Explain the role of money in a nation’s economy 2. Enumerate and describe the characteristics and key functions of money 3. Explain how money evolved from the barter system to the present 4. Be familiar with the history of money in the Philippines 5. Know the relationship between supply and demand for money 6. Explain the impact of money on the growth of the economy 7. Describe the quantity theory of money as well as value of money over time 8. Explain the nature and determination of interest rates 9. Understand the relationship between interest rates and risk 10. Explain.the effect of change in interest rates on the economy LUBYvat control a country’s 10_Chapter? _ jk th i central oP ig the central bank in the it i ion’ ment and Today it is the nation’s govern rf ‘the centr 1 economy. The Federal Reserve (known co ow much of it is in circulation, and US. The Fed issues currency. seen sh prow it money: Jn interest it w! : untry’s economy is the Is the CO f wal bank that cove still print and guarantee e cen! . ment Pilipinas”. While govt nysical coins or notes, but {d it no longer needs t ital form. decides how muc! In the Philippines, th “Bangko Sentral ng money, in today’s wor! can be found solely in digi 10 exist a5 PI JONS OF MONEY fining characteristics: table, uniform, divisible, in limited e. Underlying all of these pt money, they CHARACTERISTICS AND KEY FUNCT! ss it has all of the following de be durable, po! means of exchang' fident that if they acce| Money is not money unles Money must have value, supply, and. be usable as a characteristics is trust — people must be cont can use it to pay for goods. Store of value Money acts as a means by which people can store their wealth for future use. It must not, therefore, be perishable, and it helps if it is of a practical size that can be stored and transported easily. Item of worth Most money originally has an intrinsic value, such as that of the precious metal that was used to make the coin. This in itself acted as some guarantee the coin would be accepted. Means of exchange It must be possible to exchan, I ge money freely and widel its vale should bea stable as posible It helps if that a aaa i ind if there are sufficient denominati eae eh ions so change can be Unit of account Money can be used to record wealth money. any nationally. It helps if only en sanesed,: traded, or, epee . Ifanybody could issue it, then trust in eee stony issues ould disappear.Introducing Money and Interest Rates 11 Standard of Deferred Payment Money is also useful because of its ability to serve as a standard. of deferred payment. : Money can facilitate exchange at a given point by providing a medium of exchange and unit of account. THE EVOLUTION OF MONEY People originally traded surplus commodities with each other in a process known as bartering. The value of each good traded could be debated, however, and’ money evolved as a practical solution to the complexities of bartering hundreds. of different things, Over the centuries, money has appeared in many forms, but, whatever shape it takes, whether as a coin, a note, or stored on a digital server, money always provides a fixed value against which any item can be compared. Barter (10,000 — 3000nce) . In early forms of trading, specific items were exchanged for others agreed by the negotiating parties to be of similar value. Barter — the direct exchange of goods — formed the basis of trade for thousands of years. Adam Smith, 18"-century author of The Wealth of Nations, was one of the first to identify it as a precursor to money. Barter in practice Essentially, barter involves the exchange of an item (such as a cow) for one or more of a perceived equal “value” (for example a load of wheat). For the most part of the two parties bring the goods with them and hand them over at the time of a transaction. Sometimes, one of the parties will accept an “I owe you,” or LOU, or even a token, that it is agréed can be exchanged for the same goods or something else at a later date.eae ee ges of Barter 12_Chapter?___ ‘Advantages and Disadvant® Advantages een partners. ok Jinks between P + Pring eee ‘a se att does not rely on trust that hanged - «Physical goods are excl I retain its value- money wi Disadvantages i what the other offers. «Market needed - Both parties must want wh dred et value on items ne day, but less @ week later. : divisible - For example, @ living animal © Hard to establish a s certain value to one party 0! © Goods may not be easily cannot be divided. « ‘Large-scale transactions can be difficult. - easy, moving 1,000 is not. Transporting one goat is Evidence of trade records (7000ace) s were used to record trade exchanges, becoming more complex Pictures of item: documented. as values were established and Coinage (600pce-1100cr) Defined weights of precious metals used by some merchants were later formalized as coins that were usually issued by states. Bank notes (1100-2000) States began to use bank notes, issuing paper IOUs that ; were and could be exchanged for coins at any time. eS ae! Digital money (2000 onward) Money can now exist “virtually.” on com ‘ fs ters, i place without any physical cash changing De Te eames een oeIntroducing Money and Interest Rotes, ¥3 ARTIFACTS OF MONEY Since the early attempts at setting values for bartered goods, “money” has come in many forms, from IOUs to tokens. Cows, shells and precious metals have ‘al} been used. Barter (5,000xcx) Early trade involved directly exchanged items — often perishable ones such‘as a cow. Sumerian cuneiform tablets (4,000pcr) Scribes recorded transactions on clay tablets, which could also act as receipts. Cowrie shells (1,000sce) Used as currency across India and the South Pacific, they appeared in many colors and sizes. Lydian gold coins (600pcr) In Lydia, a mixture of gold and silver was formed into disks, or coins, stamped with inscriptions. Athenian drachma (600pce) The Athenians used silver from Laurion to mint a currency used right across the Greek world. Han dynasty coin (200pct) Often made of bronze or copper, early Chinese coins had holes punched in their center. Roman coin (27act) Bearing the head of the emperor, these coins circulated throughout the Roman Empire. Byzantine coin (700cr) Early Byzantine coins were pure gold; later ones also contained metals such as copper.oS 34__Chapter2______— in (900 cr, Paya cs ‘Anglo-Saxon coin (900ct) sa sting tat nT is King (TE) ; inscripti This 10" century silver penny has an inserP of Mercia. Arabic dirham (900ce) a pire were carried to Scandinavia by Many silver coins from the Islamic em| Vikings. THE ECONOMICS OF MONEY From the 16” century, understanding of the aan. Seaplane sophisticated. Economics as a discipline emerged, Erne fd the nent inflation caused in Europe by the large-scale importation 0 K discovered, Americans. National banks were established in the late 17" century, with the duty of regulating the countries’ money supplies. By the early 20" century, money became separated from its direct relationship to precious metal. The Goid Standard collapsed altogether in the 1930s. By the mid- 20" century, new ways of trading with money appeared such as credit cards, digital transactions, and even forms of money such as cryptocurrencies and financial derivatives. As a result, the amount of money in existence and in circulation increased enormously. Potosi inflation (1540-1640) ‘The Spanish discovered silver in Potosi, Bolivia, and caused a cent The S disc , it f inflation by shipping 350 tons of the metal back to Europe annually, a The great debasement (1542-1551) England’s Henry VIII debased the silver penny, Inflation increased as trust dropped, making it three-quarters copper. Early joint-stock companies (1553) Merchants in England began to form companies in which, ; (Stock) and shared its rewards. "mpanies in which investors bought sharesIntroducing Money and Interest Rates_15 Bank of England (1694) The Bank of England was created as a bod: interest rate and manage national debt. ly that could raise funds at a low The Royal Mint (1696) Isaac Newton became Warden and argued that debasing undermined confidence. All coins were recalled and new silver ones were minted. US dollar (1775) The Continental Congress authorized the issue o! but the first national currency was not minted by t f United States dollars in 1775, he US Treasury until 1794. Gold Standard (From 1844) The British pound was tied to a defined equivalent amot unt of gold. Other countries adopted a similar Gold Standard. ’ Credit Cards (1970s) The creation of credit cards enabl make smaller purchases. This resulted in the growth of led consumers to access short-term credit to personal debt. Digital Money (1990s) ‘The easy transfer of funds and convenience of electronic payments became increasingly popular as internet use increased. Euro (1999) ‘Twelve EU countries joined together and replaced their national cu the Euro. Bank notes and coins were issued three years later. rrencies with Bitcoin (2008) Bitcoin — a form of electronic money that exists solely as encrypted data on servers — is announced. The first transaction took place in January 2009. *16 Chapter? IN THE PHILIPPINES I MONEY HIGHLIGHTS IN THE HISTORY OF Pre-Spanish Regime already tradi Philippine wa 8 f the Spanish in 1521, ee and Macau. Through the ies such as China, re circulating in the Prior to the coming o ins wel hhange was barter, some coll with neighboring countri prevailing medium of excha Philippines as early as the 8" century. dust, silver wires. coffee, sugar rice, - hand 14 century the spices, carabao were used as money. Between Or ‘ (ypciaign merttade penniform gold barter rings were Ped » Piloncitos and other commodities were in circulation. : Commodity money such as gold, gold Spanish Regime The Spanish introduced coins in the Philippines w in 1521. Silver coins minted in Mexico were pred first mint was established in order to standardize coinage. hen they colonized the country lominantly used in 1861, the American Regime After gaining independence in 1898 when Spain ceded the Philippines to the United States. The country’s first local currency, the Philippine Peso, was introduced replacing the Spanish-Filipino Peso. The Philippine National Bank was authorized to issue Philippine Bank Notes, Later, the Bank of the Philippine Island was authorized to issue its own bank notes. These notes were redeemable by the issuer but not made legal tender. Japanese Regime When the Philippines was occupied by Japan durin, issued the Japanese War Notes. There bills hi government asset and were called “mickey m ig World War II, the Japanese lad no reserves nor backed up by any nouse” money. Post-War Period Japanese currencies circulating in the Phili were closed and all Philippine National circulation, Bankterest Rates_ 17 Fea hi aoe Money and Ini ae The new treasury certificate (called Victory Money) were printed in 500, P200, 100, P50, P20, P10, PS, P2 and PI denominations ‘with the establishment of the Central Bank. In 1949, a new currency called Central Bank Notes” was issued. In 2010 the Central Bank launched the “New Generation Currency”, which is tiniform in size where significant events in Philippine history, iconic buildings and heritage-sites were featured. In 2018, the New Generation Currency Coin series were put in circulation. ‘THE SUPPLY AND DEMAND FOR MONEY Money facilitates the flow of resources in the circular model of macroeconomy. Not enough money will slow down the economy, and 100 much money can cause inflation because of higher price levels. Either way, monitoring the supply and iumand for money is vital for the economy's central bank's monetary policy, evrch aims to stabilize price levels and to support economic growth. 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: MI. ‘The narrowest measure of the money supply. It includes currety in arreulation held by the nonbank public, demand deposits, other checkable Gleposits, and traveler's checks. MI refers primarily to money used as a medium of exchange. ‘M2. In addition to MI, this measure includes maney held in savings deposits, money market deposit accounts, noninstitutional money market ‘matval 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 includes the financial institutions, (e.g. large-denomination time deposits and term Eurodollars). M3 refers primarily to money used as a unit of account.18 Chapter 2 jes liquid and near-liquid asso, includ 4 measure N° Mie commercial paper and bank © L. Inaddition to M3, this # high-ra (eg,, short-term Treasury notes, acceptance notes). react ther depository institutions are The deposits of the: public at banks i oh the MI money. supply. If the considered money and are therefore inclu hold money as personal currency public withdraws money from bank deposits to money will affect the banks (“under the mattress"), this increase in atte Pr ael ability to extend loans and will influence the supp! rt of the suppl Some common forms of public payment may not eta att pide ah Re money. Check payments from one person to another withoutabeing ‘ane money supply because check merely transfers money or tchided th te addition to the supply of money. Consumer credit cards are Aeon money supply; they are considered instant loans to consumers an are Not a net addition to the money supply. The Bangko Sentral ng Pilipinas (BSP) is responsible for determining the supply of money. It uses daily open market operations to influence the creation of money by banks and to guide the availability of money in the economy. BSP also has an impact on the creation of money by banks through reserve requirements and the discount rate that is, the interest rate at which banks can borrow from the BSP as a lender of last resort. 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: demanded for day-to-da: ayments through balances held by households and firms (instead of sioke bonds or other assets). This kind of demand varies with GDP: it does not depend on the rate of interest. tee * Precautionary demand. Money 4 oe payments. This kind of demand variee t°%_ #8 @ result of unanticipated aries with GDP, * Speculative demand. Money demand i i . led because of i Sanya reo tie = % Halanees and old off on bond ect ete ee ey exIntroducing Money and Interest Rates_19 interest rates to rise. This kind of demand has a negative relationship with the interest rate, The rate of interest is the price paid in the money market for the use of money (or loans). The rate is a percentage of the amount borrowed. If a person holds P1,000 in currency, the opportunity cost of holding the money is the interest ‘that could he earned on the P1,000 in an interest-bearing account. The opportunity cost of holding money goes up if the interest rate increases, which may lead to decreased consumption and increased saving. Conversely, if the interest rate is low, it is relatively cheap to borrow money and the quantity of money demanded goes up. Therefore, the demand for currency has a negative relationship with the interest rate. Changes in other factors will lead to shifts in the demand curve for money. Increases in the economy's price level will increase the demand for money (note that the demand for money is tied to the interest rate, not the price level). If the real GDP increases, the demand for money increases because of the higher demand for products. Also, when banks develop new money products that allow for easier, low-cost withdrawal, the demand for money will decrease, such as, banks offering savings accounts with shorter (or, less stringent) time deposit requirements and lower penalties for withdrawal. THE IMPACT OF MONEY In the macroeconomic short-run, some prices (e.g., wage rates affected by labor contracts) will be inflexible. This causes economic fluctuations, with real GDP either below potential GDP (recessionary gap) or above potential GDP (inflationary gap). ‘The BSP's monetary policy has an immediate, short-run impact on the economy. In particular, higher interest rates will decrease investment because it becomes more expensive to borrow money, and will also decrease consumption because consumers will tend to, save more as interest rate returns increase. In addition, as higher Philippine interest rates increase the demand for pesos on the foreign exchange markets (because of the higher returns on Philippines deposits), the higher pesos will decrease exports by making them increasingly expensive. This means that real GDP growth and the inflation rate slow when the BSP raises the interest rate. The reverse occurs when the interest rate is lowered.en the economy faces an ! tied in the sh run _ SP may then pursue a Monetary policy can be SE 5 potential ity of money and raising the inflationary gap (real GDF jecreasin he quar siment, consumption and, net policy to avoid inflation eet rate decrea es i =ase, real GDP and lower the interest rate. The higher 1" nd will dec ee assumed to be fully i it te export. This decrease in aggregate © Tong-Fun, pric price level. In the macroeconomic leo potent ‘al GDP. flexible, and this will move real G 20 Chapter 2 sP increases the mone; run equilibrium and tee ne Teva goes Ny sea inflationary g4P exists, with the natural rate. The tightness in the labor : rate. Because of higher labor costs, ra ning real GDP to the level of If the economy is at its long supply, it will increase aggregate as well as the real GDP. This means actual unemployment rate being below th market will.lead to a rise in the money wage the short-run aggregate supply will increase potential GDP. THE QUANTITY THEORY OF MONEY’ The quantity theory of money holds that changes in the money supply MS directly influences the economy's price level, but nothing else. This theory follows from the equation of exchange: MxV=PxY where M/= quantity of money V = velocity of money (i.e., the average number of times a unit of money is used during a year t " eee ig a year to purchase GDP's goods P= price level Y=real GDP The equation of exchange essentiall: u ly states thi tee expenditures (P x Y) equal the money ‘actually ee nomy's nominal GDP or According tothe quantity theory of money, veloc Me seonomy (04 x 1) soa ee money M and i ‘Considered constant: Y= Ds is not affected by the coe ee oogm een is not affected by Mant Also, potential real ExT cue tet flows dicey fom the equation af excharme Ween " This view ofthe equation of ecto oaeal 1 the ch ee Ae el ee | equation of exchange express anges in P, in the long-run. mney, that is, money affects only nominal. the (neo) classi a af minal values by ssical neutrality of words, the money supply leaves re; ut not real value: other S al output unaffe I values. InIntroducing Money and Interest Rates 21 rate and the inflation rate are Historical evidence suggests that the money growth ‘ear-to-year relationship is positively related in the long-run. However, the y: weaker. n the short-run, as the economy does The equation of exchange does not hold it flexibility. Although, the relationship not immediately adjust because of price in between M and P may not be casual, as suggested by quantity money theorists, it appears that there is a correlation between Mand P in the long-term. Therefore, growth in M can be used as a statistical estimate for the rate of inflation, that is, the Central bank can he effective in stabilizing prices. It is less clear what the Central bank's impact on short-term real GDP and real interest rates is. 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. Present Value ent value (or present discounted value) is based on the commonsense notion that a peso of cash flow paid to you one year from now is Tess valuable to you than a peso paid to you today: This notion is true because you can deposit a peso in a savings account that earns interest and have more than a peso in one year. Economists use a more formal definition, as explained in this section. The concept of pres pt instrument, which we will call a simple Joan. In this loan, the. lender provides the borrower with an amount of funds (called the principal) that must be repaid to the lender at the maturity date, along with an additional payment for the interest. For example, if you made your friend Jane 2 simple loan of P100 for one year, you would require her to repay the principal of P100 in one year's time along with an additional payment for interest; say, P10. In the case of a simple loan like this one, the interest payment divided by the amount of the loan is a natural and sensible way to measure the interest rate. This measure of the so-called simple interest rate, iis: Let's look at the simplest kind of del ep 2 a ife — F100 0.10 = 10%22 “Chapter 2 the year You would have P110, which \d of i Ifyou make this P100 loan, at the © can be rewritten as: proox(1 +0-10)= PH! Id have: .d year you wou Ifyou then lent out the PI 10, at the end of the second Y* prio x (1+ 0410) = P21 or, equivalently, (1+0.10) = P121 = 0 fe ee tthe end of the third year: .10) x (1 + 0.10) P100 x (1 + 0.10) x( a baeat Continuing with the loan again, you wou! P121 x (1 +0.10) =P100x(1 +0.10) =P133 Generalizing, we can see that at the end of m years, your P100 would turn into: P100x(1+i)" The amounts you would have at the end of each year by making the P100 loan today can be seen in the following timeline: Today Year Year Year Year ° . 2 3 n HK—--—- ++ — +| . 100 Pio Pit p13 Pioo x (1+ 0.10)" This concept is extensively discussed in another Management, 2019 Comprehensive Edition.” P°0K Of these authors. FinancialIntroducing Money and Interest Rates 23 INTEREST RATES 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. From the viewpoint of a potential borrower, the interest rate is the premium that must be paid in order to acquire goods sooner and pay for them later. From the lender's viewpoint, it is a reward for waiting — a payment for supplying others with current purchasing power. The interest rates allows the lender to calculate ‘ future benefit (future payments eamed) of extending a loan or saving funds lay. Ina modern economy, people often borrow funds to finance current investments and consuniption. Because of this, the interest rate is often defined as the price of loanable funds. This definition is correct. But we should remember that, it is the earlier availability of goods and services purchased, not the money itself that is desired by the borrower. HOW INTEREST RATES ARE DETERMINED Interest rates are determined by the demand for and supply of loanable funds. Investors demand funds in order 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. able funds stems from the productivity of capital. Investors are willing to borrow in order to finance the use of capital in production because they expect that expanding future output will provide them with more than enough resources to repay the amount borrowed (the principal) and the interest on the loan. The demand of investors for loan: As Figure 2-1 illustrates, the interest rate brings the choices of investors and consumers wanting to borrow funds into harmony with the choices of lenders willing to supply funds. Higher interest rates make it more costly for investors to undertake capital spending projects and for consumers to buy now rather than later. Both investors and ‘consumers will therefore, curtail their borrowing as the tors will borrow less because some investment projects interest rate rises. Invest that would be profitable at 4 low interest rate will be unprofitable at higher rates. Some consumers will reduce their current consumption rather than pay the higheth anon ofa in fore, the amoun' s SN 868. There ate, interest rate. u increa! rest rate ito th vhen the inte late: : i emiuim when the inter re interest a borrowers i8 inversely illing t© reduce their current pacarnd ple (lenders) WT hers. If some people are is Pe funds t fe also rewards The interest rat vide loan tment project (or consume more consumption in order to pro’ vest i js t consumption by an i undertake an 1" heir current F b going © boro other must curtail ss lenders with the incentive to an eet interest rate prov! can-either invest or consume equal ammount. In essence Oo that, borrowers CA eople willing to save 7 it consumption so tha trates give P to reduce their curren t income. Higher interest to purchase more goods in the oe On Os { the ability t0 | though people have ill Ie funds) Even e fe sacar irene a arate current consumption to 2 pst ra of ie ree hh i Be price is right. Higher interes Sippy fa funds market if the F . st rate rises, the a etd eae more. Therefore, as the ea wil . pe of funds supplied to the loanable funds market Figure 2-1: Determining the Interest: Rate Supply Interest rate Demand Q Loanable Funds As Figure 2-1 illustrates, the interest rate will h.: . demanded into balance with th ity san, bring the quantity of funds rate, the quantity of funds borrowers dey a now (rather than later) will just equal the Sk Je investment and consumption interest rate brings the choices of borrowers and 12, funds lenders save. So, the The rate of interest functio value, and its use is bou; payment of interest. The NS as the price in th 2 le ight and sold in th Money market, Money has a time financial institutions that deg market it rebiriy- forthe eal in govern oa ment securities___Introducing Money and Interest Rates 25 and loans, f eet bs ee exchange make up the money market. The money tlectronically ot e ey ic physical location but consists of transactions made y phone. Equilibrium in the money market occurs when the MD and MS curves i Sint Tai bee intersect at the equilibrium interest rate, as shown in Figure atats ate the quantity of money from MS to MS, the CREME weioe aie Ok anit ie i right, resulting in a decrease in the casa aad tat st of borrowing could spur higher petra inte rate goes down from r’ to r’” as the money supply curve Say m MS to MS! (e.g., when the BSP increases the quantity of Figure 2-2: Money market equilibrium Note: MS = money suppiy, MD = money demand MS st i Interest rate 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). If, investors can earn a 10 percent return on a capital investment project (e.g., building a factory), they will be willing to pay a rate of interest of up to 10 percent. Households delay consumption by saving (and are rewarded by earning interest) depending on their time preference and the rate of interest. Savings percentages can differ significantly from one nation to another.26 Chapter ? nesses may have Teasons to holg b Because borroy Ids a ‘Jable money). Wers 2. Liquid assets. Hes readily available to be repaid to the lender assets in liquid for m (that does te lenders for giving ire cash in the long-ter compensate lenders isoediately), they are willing seacise of the liquidity preference on ; immedi es nvoduced the ee sidered investment i ical economists, 4 ee fad et Set for the interest rate, disregarde topic of funds as the cri liquidity preference. i ¢ rates of interest in two Although, intermediaries can achieve equality between th i it and money marke markets, the potential lack of balance between the resins eke y oa Pa was essential to Keynesians, who claimed that it cal short-run- THE NOMINAL OR MONEY RATE VERSUS THE REAL RATE OF INTEREST We have emphasized that the interest rate is a premium paid by borrowers for earlier availability and a reward received by lenders for delaying consumption. However, during a period of inflation (a general increase in prices), the nominal interest rate or money rate of interest is misleading indicator of how much borrowers are paying and lenders are receiving. Inflation reduces the purchasing Power of a loan's principal. Rising prices means that, when the borrower Tepays the principal in the future, it will not purchase as much as it would have when the funds were initially loaned. When inflation is common, lenders will recogni: Dr , gnize they i id wit pesos of less purchasing power. Unless they are coment ee inflation by an upward adjustment in the ; funds to the loanable funds market. At the same gaye, {HeY. Will supply’ fewer inflation, they will want co patcnge aed 1 time, when borrowers anticipate . efore they become Premium, an additional amount of interes i ae : st that refl ree of ena i cxamPle if borrowers and lender ti eXPeCted rate of future rate of inflation, they will be Sts fully anticipate a 5 percent Just as willi they were earlier to agree on a 4 ie iling to a ©n a9 percent i stability. ent interest rate ent interest rate as when both anticipated price Unlike when the general price level ; i ice level is staby ae “al hi to the te} 2 HHP Of loanable funds will Ti8ht) once decision om will increase (the makers antici ipate futureIntroducing Money and Interest Rates 27 inflation. The money interest rate thus, rises overstating the "true" cost of borrowing and the yield from lending. This true cost is the real rate interest, which is equal to the money rate of interest minus the inflationary premium. It reflects the real burden to borrowers and payoff to lenders in terms of their being able to buy goods and services. Our analysis indicates that, high rates of inflation will lead to a high money rate of interest. The real world is consistent with this view. INTEREST RATES AND RISK So far, we have assumed there is only a single interest rate present in the loanable funds market. In the real world, of course, there are many interest rates. There is the mortgage rate, the prime interest rate (the rate charged to business firms with strong credit ratings), the consumer loan rate and the credit card rate , to name but a few. 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. Similarly, credit card loans are riskier than loans secured by an asset, An example of a secured loan would be a mortgage loan on a house. If the borrower defaults, the lender can repossess the house. 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 an highly unfavorable manner. the money rate of interest on a loan has three components. 1 is the real price one must pay for earlier availability. The inflationary premium component reflects the expectation that the Ioan will be repaid with pesos of less purchasing power as the result of inflation, he probability of default (the risk imposed The risk-premium component reflects tl on the lender by the possibility that the borrower may be unable to repay the loan). As Figure 2-3 shows, The pure-interest componenl Figure 2-3: The Three Components of Money Interest Inflationary premium Pure interestLice tee te ERT oS, RATES ¢ main tools of the BSP to hing out the business cycl, one 28 Chapter? T he <1NG INTERES: THE IMPACT OF CHANGING IN ne js one 0 Control over short-term interest rales lation, smootl achieve its main goals of controlling and ensuring financial stability. ith a relatively short length for her hand, are relevant for loans d rate mortgages, r loans Wi on the ot! Short-term interest rates are relevant for 1d 10-20-30 year fixe repayment while /ong-ferm interest ee such as long-term corporate borrowing a i e effects of its actions If the BSP pushes shiort-term interest rates uP OF ioe iis economy. When it is are felt most directly by interest-rate sensitive ee o that require borrowing more expensive to borrow, people make fewer Purl” t encourages borrowing But when the BSP cuts the short-term interest rate, that e ‘ea 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 in existing loan, such as a mortgage. By contrast, a drop in interest rates is inten since borrowers are able to take out | mortgages tracking the base rate, interest ded to cause an increase in spending, pe More cheaply. For those with e t ments wil i saves ba tend to a or invest deposits that are mate pata vue isco Ing VIN; ging saving through v Tates might stimulate tis cannon), s n , ery low interest this can ultimately negatively impact long-term savings plang h > Such as pensions. WHEN INTEREST RATES ARE RAISED Higher interest rates make loans fe SS i accounts encourages saving rather than nraabl, While high interest on savings in economy, with demand for ood : » AS g it business and employment loves and services decreasing THe aa sal oor q r ventuallyIntroducing Money and Interest Rates__29 WHEN INTEREST RATES ARE LOWERED Lower interest rates make it cheaper to take out loans, and hence to spend more money. Saving becomes less attractive as interest rates are low. With more money in circulation, demand for products and services rise, stimulating businesses and increasing employment. REVIEW QUESTIONS Questions 1 2. 3: 4. Describe what money is. Explain briefly the significant of money in the economy of a country. Briefly describe each of the four main functions of money. Describe the history of money in the Philippines. Explain briefly how money facilitates the flow of resources in macroeconomy. Enumerate and describe the sources of demand for money. When is an asset suitable to use as a medium of exchange. Why are economists and policy makers interested in measuring money? A student makes the following assertion: “It is not possible for the total value of production to increase unless the money supply also increases. After all, how can the value of the goods and services being bought and sold increase unless there is more money available.” Explain whether you agree with this assertion.30 Chapter 2 ity at the end of the next 5 years 10. . Which alternative do you prefer P . Some investment analysts argue that ‘Why do interest rates and . Is a peso today worth more than a peso next 50 annul What is the future value oft 10%? if the annual compounding ra ‘ash or P1,200 each year for a 10 ci s ds f 10% annuity. H te O} period of 4 years. Assume a discount r ats very low interest rates on some long-term bonds make them risky investments. prices of financial securities move in opposite directions? year if the annual rate of inflation is zero? . Does preference of liquidity increase or decrease the cash value of a future income? Explain in your own words. . Which offer would you rather accept: An investment paying 10% compounded annually, or an investment paying 10% compounded quarterly? . Why don’t banks like inflation?THE PAYMENTS SYSTEM: AN OVERVIEW Expected Learning Outcomes After studying the chapter, you should be able to ... 1. Distinguish between commodity and fiat money 2. Explain the importance of checks 3. Enumerate and explain the desirable outcomes of a payments system 4, Explain how a bank client can use automated teller machines (ATMs) 5. Explain how e-money, bitcoin and blockchain are used in the payments system 6. Describe the new peso real-time gross settlement (RTGS) platform of the next generation Philippine Payment and Settlement System (PhilPaSSplus) RUBSCHAPTER 3 TS SYSTEM: P. AYMEN INTRODUCING 1 THY BRVIEW TION 4 INTRODUC ‘The mechanism for conducting the economy nts system has evolve such wansactions is ealled a payments sysiem™ THE Paver ata wae over time from relying on payment made in 80 its in banks, to payments made with paper currency and checks written on depos! made by electronic funds transfers. Money facilitates transactions in The Transition from Commodity Money to Fiat Money Commodity money refers to a good used as money that has value independent of its use as money. Fiat money refers to money, such as paper Currency that has no value apart from its use as money. People accept paper currency in exchange for goods and services partly because the government has designed it to be legal tender, which means the government accepts paper currency in payment of taxes and requires that individuals.and firms accept it in payment of debts. Money is also useful because of its ability to serve as a standard of deferred Payment. Money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account. Historians disagree about i . ‘i : vided bagi se a rele oe began using ‘metallic coins. -t ‘ using metallic coins i 8.c, and people in Greece were using them in 700 KC. Far a ni be the year be sellers used coins minted from precious metal, such as gold ve oe as money, Gold and silver coins suffer from some deawba ne ae CoPPe economy's reliance on gold and silver coins alone : acks, however. An Io oetle becaeon se had difficulty transporting lanee efron * cumbersome Senile transactions and also ran the tisk of bei "ge number of gold coins probly beginning around the Year A, 1500 in sing Tobbed. To get around this a early banks — began to store gold a “rope, governments and private certificates. Anyone receiving ois in safe place: issue paper amount of gold. As lon; Paper cettificate sera issue . 8 8S -people had confidence ‘orn Claim the equivalent at the gold was available ifThe Payments System: An Overview _33 they demanded it, the paper certificates would circulate as a medium of exchange. In effect, paper currency had been invented. In modern economies, the central bank (Bangko Sentral ng Pilipinas), issues paper currency. The modern BSP payments system is a fiat money system because the BSP does not exchange paper currency for gold or any other commodity money. The BSP issues paper currency and holds deposits from banks and the national government. Banks can use these deposits to settle transactions with one another. Today, the BSP has a legal monopoly on the right to issue currency. Although in the nineteenth century private banks issued their own currency, they can no longer do so. In fact, it is mot the government's designation of currency as legal tender that explains why Paper currency circulates as a medium of exchange. Rather, paper currency circulates because of the confidence of consumers and firms that if they accept paper currency, they will be able to pass it along to someone else when they need to buy goods and services. Basically, it is a case of self-fulfilling expectations: You value something as money only if you believe that others will accept it from you as payment. Our society’s willingness to use pieces of paper issued by the BSP as money makes them an acceptable medium of exchange. The Importance of Checks Paper money has drawbacks, Another major innovation in the payments system came in the early twentieth century, with the increasing use of checks. Checks are promises to pay on demand money deposited with a bank or other financial institution. They can be written for any amount, and using them is a convenient way to settle transactions. Settling transactions with checks does, however, require more steps than settling, transactions with currency. Processing the enormous flow of checks worldwide costs the economy several billion dollars each year. There are also information costs to using checks — the time and effort required for the seller to verify whether the check writer (the buyer) has sufficient amount of money in her checking account to cover the amount of the check. Accepting checks requires more trust on the part of the seller than does accepting peso bills.34 Chapter 3 the Payments System New Technology and payments system but doesn’ Pilipinas supervises th essed by banks and othe, s . ae Waa re believes to be the five most desirable listed what The Bangko Sentral ng directly control it becau! private firms. The BSP has " ‘outcomes for a payments system: 1. Security, Episodes in whic systems and other parts of U about security. Better secur! confidence that funds will not 2. Efficiency. Resources devoted to aspects of processing payments are and services. Increasing the efficiency to function using fewer workers and computers, benefits the economy. 3. Speed. Fast settlement of payments facilitates transactions by both households and businesses. have hacked into retail credit carg nis system have raised concems ae reas consumers’ and businesses’ be stolen electronically. processing paper checks or other diverted from producing other goods of the payments system allows it or other capital, which h criminal 4. Smooth international transactions. The increasing amount of business that takes place across borders can be facilitated if payments can be made quickly and conveniently. 5. Effective collaboration among participants in the system. The payments system needs to efficiently involve governments, financial firms such as banks, and other businesses around the wé i : orld. Such involv: smooth transfers of funds in transactions, rvetnent igure fe far fied ae ee Cash registers in supermarkets and retail groceries or other products, ye bank instanty es eit card to buy aa. Sacha com slimes te consumers have begun sing hares the mea hie. ee With cheeks are linked to credit or debit candy pore, ™&EPhones or ac nie thal allow consumers to buy good &xample, Appl 3 checkout counter by Raving thi phe vith compas eee TH ac il F are examples of proximity. mopnen® " Watch, Apaie Ole register at the 7 A Pple Pa ji transactions using such . 7 7 'y and Android Pay ake POMENS is eatvely onl the total volume of > tt has been increasingThe Payments System: An Overview _ 35 Automated Clearing House (ACH) transactions include direct deposits of payroll checks into the checking accounts of workers and electronic payments on car loans and mortgages, where the Payments are sent electronically from the borrower's account and deposited in the lender’s account. ACH transactions reduce the transactions costs associated with processing checks, reduce the likelihood of missed payments, and reduce the costs lenders incur in notifying borrowers of missed payments, Forty years ago, Automated Teller Machines (ATMs) did not exist. To deposit or withdraw money from your checking account, you needed to fill out a deposit or withdrawal slip and wait in line a bank teller’s window. Adding to the inconvenience was the fact that many banks were open only between the hours of 10 am, and 4 py, (which were called bankers’ hours). Today, ATMs allow you to carry Out the same transactions at your bank whenever it is most convenient for you. Moreover, ATMs are connected to networks (such as BANCNET, Megalink, so you can withdraw cash from the ATMs of banks other than your own. E-Money, Bitcoin, and Blockchain The boundaries of electronic funds transfers have expanded to include e-money or electronic money, which is digital cash people use to buy goods and services. One of the best-known forms of e-money is the PayPal service. An individual or a firm can set up a PayPal account by linking to a checking account or credit card. As long as sellers are willing to accept funds transferred from a buyer's PayPal (or other e-money) account e-money functions as if it were conventional, government-issued money. The central bank does not control e-money, though, so it is essentially a private payments system. Recently, journalists, economists, and policymakers have been debating the merits of bitcoin, a new form of e-money. Unlike PayPal, bitcoin is not owned by a firm is instead the product of a decentralized system of linked eomputers. Bitcoins are produced by people performing the complicated calciilations necessary to ensure that online purchases made with bitcoins are legitimate—that is, that someone doesn't try to spend the same bitcoin multiple times. People who successfully complete these calculations are awarded a fixed number of biteoins—typically 25. This process of biteoin "mining" will continue until a maximum of 21 million bitcoins has been produced—a total expected to be reached in 2030.36_Chaprer 3 —_—_——— 36_Chapter3—— - nge for dollars ang ol le can buy and sell bitcoins A a reryphocuresyse You = eeeartl anal “some people refer t0 ! currencies on . ‘ rtphone. You can th + igi let" on a smal cece if i ina "digital wal ing a bar code with me 7 a feuee tal accepts bitcoins by coh based in Atlanta, ae fice abe of web sites, such as BitPay, ee way similar to how the” merchants process purchases made with bitcoins i ey Process credit card payments. i ce ae go et been wi Despite these possible benefits to using bitcoin, i ae ore ide consent adopted. The introduction of Apple Pay and Androi 4 a toimake payments with a way to use their smartphones linked to a credit cai donehens ts, which undercut one of bitcoins advantages. Some firms also a ior he the software underlying bitcoin is capable of dealing with a large number of fansactions. The most popular gnline bitcoin exchange, Japan-based Mt. Gox, closed in 2015, further reducing confidence in the crytocurrency, Despite the problems with bitcoin, the underlying technology behind it, known as blockchain, has attracted interest from both firms and governments as they attempt to increase the speed, efficiency, and security of the payments system, Blockchain is technically a distributed ledger, or an online network that registers Ownership of funds, securities, or any other good, including movies and songs, Blockchain allows indiyiduals and businesses around the world to settle transactions instantly and securely on encrypted sités. The ability to direct transactions through blockchain could eli Potentially greatly reducing costs. The adopting blockchain is the complexity if the techno logy and its resulting high cost. If the cost declines over time, blockchain may Bayuinits shee may become a key part of the CASHLESS SOCIETY connate rete rales ate exciting and lead some 01 a » ety. Roncash payments continue to inerease as. 9S *\€serve study found that electronic Payments now make UP more than two-thirds a al Payments, and Not surprisingly, the number of chec S written h; ® Of all noncash payments. billion per year. In reality, though, topping by more than 2 be difficult to attain in the an entirely casht near future for two, key ae checkless) society may Payment te ‘Ashless sociThe Payments System: An Overview _37 @) As we noted with respect to blockchain, the infrastructure for an ¢- Payments system is expensive to build. Q) Mees and firms worry about protecting their privacy in an mip acm that is subject to computer hackers, although ie ea oO lockchain believe its encryption technology can overcome s problem. While the flow of paper in the payments system is likely to Continue to shrink, it is unlikely to disappear. WHAT'S AHEAD? On May 17, 2021, Mr. Daxin Lucas of the Philippine Inquirer filed this report: BSP, Banks Testing New Payments Framework The Philippine economy can expect to see faster, more efficient and safer transactions and money transfers once an improved payments framework is adopted fully by the central bank and its private sector partners, according ti the country’s chief financial regulator. ‘According to Bangko Sentral ng Pilipinas (BSP) Governor Benjamin Diokno, an industry-wide- “rehearsal’ is now in full swing for the live run of the new peso real-time gross settlement (RTGS) platform of the next-generation Philippine Payment and Settlement System, dubbed “PhilPaSSPlus”. “Since the kickoff of the PhilPaSSPlus project in December 2019, all major preparatory activities have been going well through the BSP’s close collaboration with the industry”, he said in an online press briefing. “The outcome of this rehearsal will be a key consideration in determining the readiness of the peso real-time gross settlement ecosystem to go live by June 2021. The completion of the project’s user acceptance test by the BSP in the first quarter of 2021 kicked of the market rehearsal where key functionalities of PhilPaSSPlus were being tested by banks and other participating institutions prior to implementation. Safer, Faster and More Efficient The new RTGS facility is equipped with state-of-the-art technology, enabling it to deliver comprehensive functionalities and settle larger volume of financial transactions of varying types and complexities.37A__Chapter 3 xe the efficiency of funds floy, aa enhance t jent risk am, “PhilPaSsPlus is seen 10 sigan to mitigate ee Diokno said, ithin the economy, It is. als i C : Francie nant aside from enhancing pay™ oe ny sages which conform to nication messages | A SFhns will accept only it wll ee ey ce scril S ir tion tems aces the hippies and the inert other jurisdictions in the payment space. ic initiatives of the Bsp The switchover of the PhilPaSSPlus is one ct st eae sad inclusive payment in fulfilling its mandate of maintaining a safe, he BSP’s Digital Payments system. It is also an integral component of the Transformation Roadmap 2020-2023. Digital Transformation ii ‘ices ind “With this new-generation Peso RTGS system, the salaigiit oaichgna will be able to Keep pace with the rapidly Lahesirish in dicectd around the country and anywhere in the world,” the central ban! . One of the BSP’s tools for monetary and financial stability, PhilPass is a fully automated RTGS facility that enables settlement of large-value payment transactions between customers of financial institutions, as well as interbank and financial market transactions between financial institutions, all of which require immediate settlement, include remittances of Sovernment collections by authorized agent banks i Bureau of the Treasury; and settlement of securities and foreign exchange trades, and clearing results of retail payments done through checks, ATMs, InstaPay and PESONet. These to theThe Payments System: An Overview _37B REVIEW QUESTIONS Questions 1, ah ‘What are the sources in inefficiency of a barter system? What is Fiat Money? Explain the expression “Legal Tender”. Explain briefly the importance of using checks in paying for goods or services purchased, Describe: * c-money © bitcoin * — blockchain Describe a cashless society. Is it easily attainable? Describe briefly the mechanics and advantages of the new peso real-time gross settlement (RTGS) platform cited on page 37.FINANCIAL INSTRUMENTS Expected Learning Outcomes After studying the chapter, you should be able to ... ' 4. Describe what a financial instrument is Describe and give examples of primary and derivative financial instruments 2. 3. Explain what financial asset is; what a financial liability is 4. Give and describe examples of financial assets and financial liabilities 5. Describe equity financial instruments 6. Give and describe examples of derivative financial instrument ke gyCHAPTER 4 FINANCIAL INSTRUMENTS NATURE OF FINANCIAL INSTRUMENTS A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. The contract in the definition refers to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing. Financial instruments include primary instruments and derivative financial instruments. Based on the definition, financial instruments include financial assets, financial liabili equity instrument and derivatives. Derivatives include financial options, futures and forwards, interest rate swaps and currency swaps. A Financial Asset is any asset that is © Cash ¢ Equity instrument of another entity (e.g., investment in ordinary share of a corporation) * Receivable (accounts, notes and loans receivable) Some of the most commonly encountered Financial Instruments representing Financial Assets are the following: (a) Cash on Hand and in Banks ‘ 1. Petty cash. Refers to cash balances kept on hand at various locations to pay for minor expenditures such as postage and other small out-of- pocket expenditures. 2. Demand, savings and time deposits. Represent amounts on deposit in checking, savings and time deposit accounts respectively. Time deposits are placements covering a relatively long period of time.40 Chapter 4 3. Undeposited checks. but not yet presented to t 4. Foreign currencies io ‘ ank di 5. Money orders are financial instruments mie 7 a Me ue ; drawn generally from authorized post 0: cial institutions. i banking institutions to advance 6. Bank drafts are commitments by I foe by the party to whom the draft was directed. Are checks payable to the enterprise or dearey he bank for payment. (b) Accounts, notes and loans receivable and investment in bonds and other debt instrument issued by other entities: as 1. Trade-receivables (signed delivery receipts and sales invoice) 2. Promissory notes 3. Bond certificates (©) Interest in shares or other equity instruments issued by other entities 1. Stock certificates 2.. Publicly listed securities (@) Derivative Financial Assets 1. Futures Contracts 2. Forward Contracts 3. Call Options 4. Foreign Currency Futures 5. Interest Rate Swaps Financial Liabilities A financial liability i any liability that i (a) A contractual obligation (i) To deliver cash or another financi, Hs ancii (ii) To exchange financial assets aie entity under conditions entity; or that are * to another entity; or nancial liabilities with another Potentially unfavorable to theFinancial Instruments 41 (b) A contract that wi : il : oe : instruments and is | or may be settled in the entity's own equity (i) 4 jon detivative for which the entity is or may be obligated to 2 ‘er a variable number of the entity's own equity instruments; or (ii) A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments, Examples of Financial Liabilities are the following: * Accounts and notes payable, loans from other entities and bonds and other debt instruments issued by the entity. * Derivative financial liabilities, Obligations to deliver own shares worth a fixed amount of cash. * Some derivatives on own equity instruments. Equity Instruments assets of an entity after deducting all of its liabilities. An equity instrument is any contract that evidence a residual interest in the Examples of Equity Instruments aré: *© Ordinary Shares © Preference Shares ¢ Warrants or written call option that allow the holder to subscribe or purchase ordinary shares in exchange for a fixed amount of each or another financial asset.42 Chapter 4 Des Derivative Financial Instruments that "derive" their value m some other security or index, For ny to purchase a particular asset (say .d future date, at a predetermined Price ue from expected and actual Derivatives are financial instruments Contractually required cash flows fro instance, a contract allowing a compa gold, flour, or coffee bean) a designated | is a financial instrument that derives its val changes in the price of the underlying asset. Examples of Derivatives 41. Futures Contracts A futures contract is an agreement between a seller and a buyer that requires that seller to deliver a particular commodity (say corn, gold, or Soya beans) at a designated future date, at a predetermined price. These contracts are actively treated on regulated future exchanges and are generally referred to as “commodity futures contract." When the "commodity" is a financial instrument such as a Treasury bill or commercial paper, the agreement is referred to as a financial futures contract. Futures contracts are purchased either as an investment or asa hedge against the risks of future price changes, 2. Forward Contracts A forward contract is simil lar to a futures contract but differs in three ways:Financial Instruments 43 3. Call Options Options give its holder the right either to buy or sell an instrument, say 2 Treasury bill, at a specified price and within a given time period. Options frequently are purchased to hedge exposure to the effects of changing interest rates. Options serve the same purpose as futures in that respect but are fundamentally different. Importantly, though, the option holder has no obligation to exercise the option. On the other hand, the holder of a futures contract must buy or sell within a specified period unless the contract is closed out before delivery comes due. 4, Foreign Currency Futures Foreign loans frequently are denominated in the currency of the lender (Japanese yen, Swiss franc, German mark, and so on). When loans must be repaid in foreign currencies, a new element of risk is introduced. This is because if exchange rates change, the peso equivalent of the foreign currency that must be repaid differs from the peso equivalent of the foreign currency borrowed. 5. Interest Rate Swaps There are contracts to exchange cash flows as of specified date or a series of specified dates based on a notional amount and fixed and floating rates. Samples / Specimens of Financial Instruments can be found from page 44 to page 56.44 Chapter 4 TJ an AL INSTRUMENTS F FIN i SAMPLES AND SPECIMENS 0) 2019 042762 AS VALI NGFinancial Instruments — 45 Foreign Currency: US Dollars | 1@) KB46279860146 Chapter 4 Foreign Currency: Eures \ EKB BCE EBC 2 : +Financial Instruments — 47 Foreign Currency: Japanese Yen seria \\\\\\\ Stmtn 5006 % WN ae48 Chapter 4 Foreign Currency: Qatar Riyalski Financial Instruments Foreign Currency: Thai Baht -vombak> w$0 Chapter 4 Time DepositFinancial Instruments _51 Corporate Check weHo07e-46 (GA COMBATANT AND TRAM CANT MERION coworsrase sme Dawe March 34, 2¢ £ Pay he {35% Diamond Advertising Company jr» One hundred thousand only i BANK OF THE ® PHILIPPINE Isuanos52 Chapter SNe ero ala amend 52_Chapter4_ ¢ depo! with a Commercial _—— a Savings account passbook evide! Bank [Account Number 002839-0272-08 Name: Clarissa Santos ‘and Co., Inc. Branch: 0928 / Suca Parafiaque DATE DESCRIPTION _ Wi SS eae eae ascents aoe) Bank Statement evidencing existence of demand / current deposit with a Commercial Bank fr mascamam nvings and candy scone: “Rigas crete ues pa snes Sebel aren ‘pence an oars Four pet Da en SSE suseEQUITY INSTRUM Stock Certificate evi Equity Share idencing investment in Common Stock or Ordinary54 Chapier4 jMENTS DEBT INSTRUME rreasur jn Tre?! ent iD vestm ing Invest ificate evidencing Certificate e F § em ORE FOUR THOUSANoTH te MANDS OF THE TRUSTEES, mC Si OFTHE PReccEDS oF suey tS my Cura a ar rere 4 Comes we ae et CRON oa Fame OSM OR or TAS an eae TOU oF ET 2m Fee a ref Le ore et ‘ial Instruments 55 Promissory note evia lencing Receiva from Jane Monroe (Borrower) ble of City Finance Company (Lender) Promissory Note 1, Jane Monroe, do promise to pay City Finance Co. the sum of $50,000. Repayment is to be made in the form of 300 equal Payments at 69 interest, or $322.15 payable on the Ist of each month, beginning 8/1/2005 until the total debt is satisfied. Signed, 2/1/2005 Insurance Certificate representing investment in an insurance policy ‘D KINGDOM INSURANCE COMPANY INDEX SA Old trond Street ia Liverpool Street Station United Kingdom Wore conce Insurance Certificate Eicon ceshonisatl rs oF ascan SoUce, ons0IN, an NATURE OF “Te anove nal nodticy anes WNT ra Te uee sum or inet UnrTe SOOM MAS CERTIRIRD, AUTHENTICATED, SANCTIONED, a> AONE ie dome cKone "AN OSDUCTION'ON OF She eoericiany rome PRanSre TO OP scxscrsa Sonar 9D TO BE REMETTANEE SOUGHT AS APRIZE MONEVAWARib TO THE ABovE WENTEONED woven: wp er ee Ss rr cho ri ina | CoRTiPIED TO BE Di AGREEMENT WETH TH LAW or The UTED Khusbont Wath Resree ae ¥ Sie “i SAID RIND HAS SEON DOVESTEORTED AND AUTHORIZATION CODE: 2498020. Sap Sipe ce56 Chapter Forward Contract Forward Contract 48 September 2020 of, and Mr. Juan Santos Mr. Ricardo Dalisay hereby undertakes to take ee pavenbet 2020 at a price of hereby undertakes to deliver, one ton of corn or pam-12:000™) Php 35,000.00 at Balintawak Farmers Market (8: 2 Signed Juan antes Raarte Dalicay : Mr, Juan Santos Mr, Ricardo Dalisay Index Derivative Contract Specifications Nifty CPSE Index cee FUTIDX [opTiDx DNIFFYCPSE ES [cere : TM /ATM/OTM. 6-1-6 [> 3 seriol monthly futures and Serie) : ‘options |+ 7 serial weekly options contracts (excluding monthly expiry) > Monthly - Last Thursday ofthe ‘Thursday isa rads ‘expiry month. Ifthe last amg eee ee ee eaoey tay & oper J Weekly — Thursday of the nt Narr cmi e Rs 5 lakhs 2s Rs0.05 Rs.0.05 Operating of Corating rmes of 10% of the | * contract specific price range easton value Fuses Spread caer area aes sahew ln comrtat Fuses Spd rr contacts wl be avalable for MI-M2_ MNO Last half hour VWAP M2, Ma half an hour, of futures. ce the theoretical price ane, NenCS of trading inthe ast ‘ode ale published by ISL orecpey cee 15000Financial Instruments _57 REVIEW QUESTIONS Questions i Define financial instrument. 2. Give examples of primary financial instruments. 3. Explain the nature of a derivative. 4, Indicate whether the following instruments are examples of money market or capital market securities. BSP treasury bills Long-term corporate bonds © Ordinary shares (common stocks) «Preferred shares © Dealer commercial paper 5. Distinguish between financial assets and non-financial assets. 6. Give examples of financial instruments represented by financial assets and explain each briefly. 7. Distinguish between financial liabilities and non-financial liabilities. 8, Give examples of financial equity instruments and explain each briefly. 9. Give examples of derivatives and explain each briefly. Matching Quiz Match the following terms with the correct definitions: i f. primary market a. restructuring b. capital market g. secondary market c.| money market h. disinflation 4. real capital i. financial capital e. inflation58 Chapter 4 in the statement of financiay i ital is found t 1. This form of capital is foun? | ue position under long-term liabilities and equity. ower of the peso shrinks over time. 2. The purchasing P' ecurities being ‘A market where the s traded are new public > offerings. we ha maturity of less than | year. asset and liability structure down of price increases. mon stock, preferred stock, bonds and other long-term Securities wit of the firm. Redeploying the A leveling off or slowing aio lee Market composed of com commercial and government securities 8. This market trades previously issued securities. } 9, The high inflation rates of the 1980s caused this form of capital to hold its value better than other forms of capital during this time period.