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Intended Learning Outcomes

 Describe what a money market is & explain how it works

MONEY MARKETS  Describe the users of money market and the different
types of money market instruments
AND CAPITAL MARKETS  Describe capital market

 Explain the role of the various capital market participants

 Explain capital market trading

 Explain the nature and trading process of corporate

bonds

MONEY MARKETS MONEY MARKETS

 It refers to the network of corporations, financial
institutions, investors and governments which deal
with the flow of short-term capital.
 It exists to provide the loans that financial
institutions and governments need to carry out
their day-to-day operations.
 For instance, banks may sometimes need to borrow in the
short term to fulfill their obligations to their customers and
they use the money market to do so.
 Banks may find that they have greater demand
for mortgages or loans than they do for savings
accounts at certain times.
 This creates a mismatch between the money they have
available and the money they have loaned out, so the
bank will need to borrow in order to be able to fulfill the
demand for loans.
 The money markets are the mechanisms that
bring the borrowers and investors together
without the comparatively costly intermediation
of banks.

MONEY MARKETS Who uses the money market?

Companies Banks Investors

 There is an identifiable money market for each a. When companies need to a. If demand for long-term a. Individuals seeking to
currency because interest rates vary from one raise money to cover their loans and mortgages is invest large sums of
payroll or running costs, not covered by deposits money at relatively low
currency to another. they may issue commercial from savings accounts, risk may invest in
paper-short-term, unsecured banks may then issue financial instruments.
 These markets are not independent and both loans for Php 100,000 or certificates of deposit, Sums of less than Php
investors and borrowers will shift from one currency to more that mature within 1-9 with a set interest rate 50,000 can be invested
months and fixed-term maturity in money market funds.
another depending upon relative interest rates. of up to five years
 Most money market transactions occur in the b. A company that has a cash
surplus may “park” money for
investor’s home currency. a time in short-term, debt-
based financial instruments
such as treasury bills and
commercial paper, certificates
of deposit or bank deposits.

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 The money markets do not exist in a particular place or
operate according to a single set of rules nor do they
offer a single set of posted prices with one current
interest rate for money.
 Rather, they are webs of borrowers and lenders, all
linked by telephones and computers.
 At the center of each web is the central bank whose
policies determine the short-term interest rates for that
currency.
 The constant soundings among these diverse players for
the best available rate at a particular money are the
forces that keep the market competitive.
TYPES OF MONEY-MARKET INSTRUMENTS
 Money Market Securities
 These are short-term instruments with an original
maturity of less than one year.
 These are used to “warehouse” funds until needed.
The returns earned on these investments are low due
to their low risk and high liquidity.
 These are usually more widely traded than longer-
term securities and so tend to be more liquid.
BANKER’S ACCEPTANCE
 Before the 1980s, banker’s acceptances were
the main way for firms to raise short-term funds
in the money markets.
 An acceptance is a promissory note issued by a
non-financial firm to a bank in return for a loan.
 The bank resells the note in the money market at
a discount and guarantees payment.
 Acceptances usually have a maturity of less than
six months.
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What money markets do?
 The money markets are related to the bond markets in which
corporations and governments borrow and lend based on longer-
term contracts. Similar to bond investors, money-market investors
are extending credit without taking any ownership in the
borrowing entity or any control over management.
 A well-functioning money market facilitates the development of a
market for longer-term securities.
 Money markets attach a price to liquidity, the availability of
money for immediate investment.
 In the absence of active money markets to set short-term rates,
issuers and investors may have less confidence that longer-term
rates are reasonable and greater concern about being able to
sell their securities should they so choose.
COMMERCIAL PAPER
 It is a short-term debt obligation of a private-sector firm
or a government-sponsored corporation.
 Only companies with good credit ratings issue
commercial paper because investors are reluctant to
bring the debt of financially compromised companies.
 They tend to be issued by highly rated banks and are
traded in a similar way to securities.
 In most cases, the paper has lifetime or maturity, greater
than 90 day but less than nine months.
 It is usually unsecured although a particular commercial
paper issue may be secured by a specific asset of the
issuer or may be guaranteed by a bank.
BANKER’S ACCEPTANCE
 It is different from commercial paper in
significant ways:
 They are usually tied to the sale or storage of specific
goods such as an export order for which the proceeds will
be received in two or three months.
 They are not issued at all by financial-industry firms.
 They do not bear interest; instead, an investor purchases
the acceptance at a discount from face value and then
redeems it for face value at maturity. Investors rely on the
strength of the guarantor bank, rather than of the issuing
company for their security.
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TREASURY BILLS
 They are often referred to as T-bills.
 They are securities with a maturity of one year
or less issued by national governments.
 They are issued by the government in its own
currency are generally considered the safest of
all possible investments in that currency.
LOCAL GOVERNMENT NOTES
 These are issued by, provincial or local governments
and by agencies of these governments such as
schools authorities and transport commissions.
 The ability of governments at this level to issue
money-market securities varies greatly from country
to country.
 In some cases, the approval of national authorities is
required; in others, local agencies are allowed to
borrow only from banks and cannot enter the money
markets.
TIME DEPOSITS
 They are also known as Certificates of Deposit or CDs/
 They are interest bearing bank deposits that cannot be
withdrawn without penalty before a specified date.
 Although time deposits may last for as long as five years,
those with terms of less than one year compete with other
money-market instruments.
 Time deposits with terms as brief as 30 days are common.
 Interest rates depend on length of maturity with longer
terms getting better rate.
 The main risks are being locked into low interest rates if
rates rise and early withdrawal penalties.
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GOVERNMENT AGENCY NOTES
 National government agencies and government-
sponsored corporations are heavy borrowers in
the money markets in many countries.
 These include entities such as development banks,
housing finance corporations, education lending
agencies and agricultural finance agencies.
INTERBANK LOANS
 They are loans extended from one bank to another with
which it has no affiliation.
 Many of these loans are across international
boundaries and are used by the borrowing institution to
re-lend to its own customers.
 Bank lend far greater sums to other institutions in their
own currency: Overnight loans are short-term unsecured
loans from one bank another. They may be used to help
the borrowing bank finance loans to customers but often
the borrowing banks adds the money to its reserves in
order to meet regulatory requirements and to balance
assets and liabilities.
REPURCHASE AGREEMENTS (REPOS)
 They serve to keep the markets highly liquid, which in turn ensures
that there will be a constant supply of buyers for new money-market
instruments.
 A repo is a combination of two transactions.
 In the first, a securities dealer, such as a bank sells securities it
owns to an investor, agreeing to repurchase the securities at a
specified higher price at a future date.
 In a second transaction, days or months later, the repo is unwound
as the dealer buys back the securities from the investor.
 The amount the investor lends is less than the market value of the
securities, a difference called the spread or haircut, to ensure that
it still has sufficient collateral if the value of the securities should
fall before the dealer repurchases them.
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CAPITAL MARKET
 It is a financial market in which longer-term debt
(original maturity of one year or greater) and
equity instruments are traded.
 Capital market securities include bonds, stocks
and mortgages.
 These are often held by financial intermediaries such as
insurance companies and pension funds which have little
uncertainty about the amount of funds they will have
available in the future.
CAPITAL MARKET TRADING
 It occurs in either the primary market or the
secondary market.
 The primary market is where new issues of stocks and
bonds are introduced.
 A secondary market is where the sale of previously
issued securities takes place and it is important because
most investors plan to sell long-term bonds before they
reach maturity and eventually to sell their holdings of
stock as well.
 Organized Exchanges – has a building where securities
(including stocks, bonds, options and features) trade.
 Over-the-counter Exchanges
TRADING PROCESS FOR CORPORATE BONDS
 The initial or primary sale of corporate bond issues
occurs either through a public offering, using an
investment bank serving as a security underwriter or
through a private placement to a small group of
investors (often financial institutions).
 Most often , corporate bonds are offered publicly
through investment banking firms as underwriters.
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CAPITAL MARKET PARTICIPANTS
 National and Local Government
 It issues long-term notes and bonds to fund the
national debt while local governments issue notes and
bonds to finance capital projects.
 Corporations
 They issue both bonds and stock to finance capital
investment expenditures and fund other investment
opportunities.
BOND
 It is any long-term promissory note issued by the firm.
 A bond certificate is the tangible evidence of debt
issued by a corporation or a governmental body and
represents a loan made by investors to the issuer.
 Bonds are the most prevalent example of the interest
only loan with investors receiving exactly the same two
sets of cash flows:
 The periodic interest payments; and
 The principal (par value or face value) returned at
maturity
 The investment bank guarantees the firm a price for newly issued
bonds by buying the whole issue at a fixed price (the bid price)
from the bond-issuing firm at a discount from par.
 The investment bank then seeks to resell these securities to investors
as the higher price (the offer price).
 As a result, the investment bank takes a risk that it may not be
able to resell the securities to investors at a higher price. This may
occur if a firm’s bond value suddenly falls due to an unexpected
change in interest rates or negative information being released
about the issuing firm.
 If this occurs, the investment bank takes a loss on its security
underwriting.
 However, the bond issuer is protected by being able to sell the
whole issue.
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Other arrangements can be as follows:
 Competitive Sale
 The investment bank can purchase the bonds through
competitive bidding against other investment banks or by
directly negotiating with the issuer.
 Negotiated Sale
 A single investment bank obtains the exclusive right to
originate, underwrite and distribute the new bonds through a
one-on-one negotiation process.
 Best Efforts Underwriting Basis
 In their arrangement, the underwriter does not guarantee a
firm price to the issuer. The investment banks incurs no risk of
mispricing the security since it simply seeks to sell the securities
at the best market price it can get for the issuing firm.
Disadvantages of Bonds
 Debt (other than income bonds) results in interest
payments that, if not met, can force the firm into
bankruptcy.
 Debt (other than income bonds) produces fixed charges,
increasing the firm’s financial leverage. Although this
may not be a disadvantage to all firms, it certainly is
for some firms with unstable earnings streams.
 Debt must be repaid at maturity and thus at some point
involves a major cash outflow.
 The typically restrictive nature of indenture covenants
may limit the firm’s future financial flexibility.
Bonds Features and Prices
 Indenture – the agreement between the firm
issuing the bonds and the bond trustee who
represents the bondholders.
 It provides the specific terms of the loan agreement,
including the description of the bonds, the rights of the
bondholders, the rights of the issuing firm and the
responsibilities of the trustees.
 Current Yield – refers to the ratio of the annual
interest payment to the bond’s market price
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Advantages of Bonds
 Long-term Debt is generally less expensive than
other forms of financing because (1) investors
view debt as a relatively safe investment
alternative and demand a lower rate of return,
and (b) interest expenses are tax deductible.
 Bondholders do not participate in extraordinary
profits; the payments are limited to interest.
 Bondholders do not have voting rights.
 Flotation costs of bonds are generally lower
than those of ordinary equity shares.
Bonds Features and Prices
 Par Value – the face value of the bond that is
returned to the bondholder at maturity
 Coupon Interest Rate – the percentage of the
par value of the bond that will be paid out
annually in the form of interest (Stated interest
payment/par value
 Maturity – the length of time until the bond
issuer returns the par value to the bondholder
and terminates the bond
Yield to Maturity
 This refers to the bond’s internal rate of return.
 It is the discount rate that equates the present value of
the interest and principal payments with the current
market price of the bond.
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EXAMPLE: Credit Quality Risk

 What is the bond’s approximate yield to  It is the chance that the bond issuer will not be able to
make timely payments.
maturity given the following info:  BOND RATINGS – involve a judgment about the future
Par value of Bond Php 1,000 risk potential of the bond provided by rating agencies
Interest Rate 10% such as Moody’s, Standard and Poor’s and Fitch IBCA,
Term 10 years Inc. Dominion Bond Rating Services.
Current Price Php 900  Bond Ratings are favorably affected by:
 A low utilization of financial leverage
100 +
1,000−900  Profitable operations
Approximate Yield to Maturity = 10
0.6 900 +0.4 (1,000)  A low variability of past earnings
 Large firm size
= 11.70%
 Little use of subordinated debt

CREDIT RATINGS

 The poorer the bond rating, the higher the rate of return Credit Risk Credit Rating Description
demanded in the capital markets. Investment Grade
Highest Quality AAA The obligor’s (issuer’s) capacity to meet its
 The bond credit ratings agencies assign similar rating financial commitment on the obligation is
based on detailed analyses of issuers’ financial extremely strong.
High Quality AA The obligor’s capacity to meet its financial
condition, general economic and credit market commitment on the obligation is very strong.
conditions and the economic value of any underlying Upper Medium A The obligor’s capacity to meet its financial
Grade commitment on the obligation is still strong, though
collateral. somewhat susceptible to the adverse effects of
 High quality corporate bonds are considered investment changes in circumstances and economic conditions.
Medium Grade BBB The obligator exhibits adequate protection.
grade while higher credit risk bonds are speculative, However, adverse economic conditions or
also called junk bonds and high-yield bonds. changing circumstances are more likely to lead a
weakened capacity to meet its financial
commitment.

CREDIT RATINGS CREDIT RATINGS

Credit Risk Credit Rating Description Credit Risk Credit Description

Below Investment Grade Rating
Somewhat BB Faces major ongoing uncertainties or exposure to
speculative adverse business, financial, or economic conditions
Below Investment Grade
which could lead to the obligor’s inadequate Most CC Current highly vulnerable to
capacity to meet its financial commitment.
Speculative nonpayment
Speculative B Adverse business, financial, or economic conditions
will likely impair the obligor’s capacity or Imminent C Used to cover a situation where a
willingness to meet its financial commitment. Default bankruptcy petition has been filed or
Highly Speculative CCC Currently vulnerable to nonpayment and is similar action taken, but payments on
dependent upon favorable business, financial
and economic conditions for the obligor to meet
this obligation are being continued.
its financial commitment Default D Obligations are in default or the filing
of a bankruptcy petition has occurred
and payments are jeopardized.

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TYPES OF BONDS
 Unsecured Long-term Bonds
 Debentures
 These are unsecured long-term debt and backed only by the
reputation and financial stability of the corporation.
 Because these bonds are unsecured, the earning ability of
the issuing corporation is of great concern to the
bondholder.
 Subordinated Debentures
 Claims of bondholders of subordinated debentures are
honored only after the claims of secured debt and
unsubordinated debentures have been satisfied.
Secured Long-term Bonds
 Mortgage Bond
 It is a bond secured by a lien on real property.
 Typically, the market value of the real property is
greater than that of the mortgage bonds issued.
 This provides the mortgage bondholders with a
margin of safety in the event that the market value of
the secured property declines.
 Should the issuing firm fail to pay the bonds at
maturity; the trustees can foreclose or sell the
mortgaged property and use the proceeds to pay
the bondholders.
Classifications of Mortgage Bonds
 Closed-end Mortgage Bonds
 They forbid the further use of the pledged assets security
for other bonds. This protects the bondholders from dilution
of their claims on the assets by any future mortgage bonds.
 Open-end Mortgage Bonds
 These bonds allow the issuance of additional mortgage
bonds using the same secured assets as security.
 However, a restriction may be placed upon the borrower,
requiring that additional assets should be added to the
secured property if new debt is issued.
 Limited Open-end Mortgage Bonds
 These bonds allow the issuance of additional bonds up to a
limited amount at the same priority level using the already
mortgaged assets as security.
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TYPES OF BONDS
 Unsecured Long-term Bonds
 Income Bond
 It requires interest payments only if earned and non-
payment of interest does not lead to bankruptcy.
 Usually issued during the reorganization of a firm facing
financial difficulties, these bonds have longer maturity and
unpaid interest is generally allowed to accumulate for
some period of time and must be paid prior to the
payment of any dividends to stockholders.
Classifications of Mortgage Bonds
 First Mortgage Bonds
 They have the senior claim on the secured assets if the
same property has been pledged on more than one
mortgage bond.
 Second Mortgage Bonds
 These bonds have the second claim on assets and are
paid only after the claims of the first mortgage bonds
have been satisfied.
 Blanket or General Mortgage Bonds
 All the assets of the firm are used as security for this
type of bonds.
OTHER TYPES OF BONDS
 Floating Rate or Variable Rate Bond
 It is one in which the interest payment changes with market
conditions.
 A common feature of all the floating rate bonds is that an
attempt is being made to counter uncertainty by allowing the
interest rate to float. In this way, a change in cash inflows to
the firm may be offset by an adjustment in interest payments.
 Junk or Low-rated Bonds
 These are bonds rated BB or below.
 The major participants of this market are new firms that do not
have an established record of performance, although in recent
years junk bonds have been increasingly issued to finance
corporate buyouts.
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OTHER TYPES OF BONDS
 Eurobonds
 These are bonds payable or denominated in the
borrower’s currency but sold outside the country of the
borrower, usually by an international syndicate of
investment bankers.
 Treasury Bonds
 They carry the “full-faith-and-credit” backing of the
government and investors consider them among the safest
fixed income investments in the world.
 The BSP sells Treasury securities through public auctions
usually to finance the government’s budget deficit.
ORDINARY (COMMON) EQUITY SHARES
 Business firms organized as a corporation may choose
to issue publicly trade stock (publicly owned
corporation) or keep ownership only among the
original organizers (closely held corporation.
 As owners of the firm, ordinary shareholders are
considered to be residual domains. This means hat
ordinary shareholders have the right to claim any
cash flows or value after all other claimants have
received what they are owed.
 Shareholders assume a limited liability because their
risk of potential loss is limited to their investment in
the corporation’s equity shares.
Features of Ordinary Equity Shares
 Voting Rights
 Each share of ordinary equity generally entitles the
holder to vote on the selection of directors and in other
matters.
 Proxy is a temporary transfer of the right to vote to
another party.
 Common Systems of Voting
 Majority Voting is a voting system that entitles each
shareholder to cast one vote for each share owned.
 Cumulative Voting is a voting system that permits the
shareholder to cast multiple votes for a single director.
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ORDINARY (COMMON) EQUITY SHARES
 It is a firm of long-term equity that represents
ownership interest of the firm.
 Ordinary equity shareholders are called residual
owners because their claim to earnings and assets is
what remains after satisfying the prior claims of
various creditors and preferred shareholders.
 Ordinary (common) equity shareholders are the
true owners of the corporation and consequently bear
the ultimate risks and rewards of ownership.
Features of Ordinary Equity Shares
 Par Value/No Par Value
 Ordinary equity share may be sold with or without par value.
 Par Value of Ordinary Equity Share is the stated value attached to a
single share at issuance.
 Authorized, Issued and Outstanding
 Authorized Shares is the maximum number of shares that a corporation
may issue without amending its charter.
 Issued Shares is the number of authorized shares that have been sold.
 Outstanding Shares are those shares held by the public.
 Treasury Shares are previously issued shares that are reacquired and
held by the firm.
 No Maturity
 Ordinary equity share has no maturity and is a permanent form of long-
term financing.
 A tender offer is a formal offer to purchase shares of a corporation.
Features of Ordinary Equity Shares
 Book value per share
 The accounting value of an ordinary equity share is equal to the ordinary
share equity (ordinary share plus paid-in-capital plus retained earnings)
divided by the number of share outstanding.
 Numerous rights of stockholders
 Right to vote on specific issues as prescribed by the corporate charter
such as election of the BOD, selecting the firm’s independent auditors,
amending the articles of incorporation and by-laws, increasing the
amount of authorized stock and so forth
 Right to receive dividends if declared by the firm’s BOD
 Right to share in the residual assets in the event of liquidation
 Right to transfer their ownership in the firm to another party
 Right to examine the corporate banks
 Right to share proportionately in the purchase of any new issuance of
equity shares. This is known as the pre-emptive right.
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PREFERRED SHARE
 Preferred Share is a class of equity shares which has
preference over ordinary (common) equity shares in the
payment of dividends and in the distribution of
corporation assets in the event of liquidation.
 Preference means only that the holders of the
preferred share must receive a dividend (in the case of
a going concern firm) before holder of ordinary
(common) equity shares are entitled to anything.
 Preferred shares generally has no voting privileges but
it is a form of equity from a legal and tax sand point.
PREFERRED SHARE FEATURES
 Par Value is the face value that appears on the stock
certificate. In some cases, the liquidation value per
share is provided for in the certificate.
 Dividends are stated as a percentage of the par value
and are commonly fixed and paid quarterly but are
not guaranteed by the issuing firm.
 Cumulative and Noncumulative Dividends
 If preferred dividends are cumulative are not paid in a
particular year, they will be carried forward as an
arrearage.
 If the preferred dividends are noncumulative, dividends not
declared in any particular year are lost forever and the
preferred shareholders cannot claim such anymore.
PREFERRED SHARE FEATURES
 Participating Features
 Participating preferred share entitles its holders to share in
profits above and beyond the declared dividend, along with
ordinary (common) equity shareholders.
 Protective Features
 Preferred share issues often contain covenants to assure the
regular payment of preferred share dividends and to improve
the quality of preferred share.
 Call Provision
 It gives the issuing corporation the right to call in the preferred
share for redemption.
 Maturity
 Today, most new preferred share has a sinking fund and thus,
an effective maturity date.
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 The issuance of preferred shares is favored when the following
conditions prevail:
1. Control problems exist with the issuance of ordinary share
2. Profit margins are adequate to make of additional leverage
attractive
3. Additional debt poses substantial risk
4. Interest rates are low lowering the cost of preferred share
5. The firm has a high debt ratio, suggesting infusion of equity
financing is needed.
PREFERRED SHARE FEATURES
 No definite maturity date
 Preferred share is usually intended to be permanent part of a
firm’s equity and has no definite maturity date. However,
preferred share sometimes carries special retirement
provisions.
 Convertible Preferred Share
 Owners of convertible preferred share have the option of
exchanging their preferred share for ordinary (common)
equity share based on specified terms and conditions.
 Voting Rights
 Preferred share does not ordinarily carry voting rights.
 Special voting procedures may take effect if the issuing firm
omits its preferred dividends for a specific time period.
PREFERRED SHARE VALUATION
 Preferred share is share that has a claim against income and
assets before ordinary share but after debt.
 Preferred share valuation is relatively simple if the firm pays
fixed dividends at the end of each year.
 The intrinsic value of a share of preferred share (Po) is the sum
of the present values of future dividends discounted at the
investor’s required rate of return.
𝐷𝑝
Po = 𝐾𝑝
where: Dp = per share cash dividend
Kp = Investor’s required rate of return on preferred share
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Comparative Features of Ordinary Equity Shares, Preferred Shares & Bonds

EXAMPLE:
Ordinary Equity Shares Preferred Shares Bonds
Ownership and Belongs to ordinary equity Limited rights when Limited rights under
 Federal Electric and Power Company has an control of the firm shareholders through voting dividends are missed
right and residual claim to
default in interest
payments
issue of preferred share outstanding that pays a Obligation to
income
None Must receive payment Contractual obligation
yealy dividend of Php 10.80 Investors require a provide return before ordinary
shareholder
12% return on this preferred share. Determine Claim to assets in Lowest claim of any Bondholders and Highest claim
bankruptcy security holder creditors must be
the intrinsic value of the preferred share. satisfied first
Cost of distribution Highest Moderate Lowest
𝐷𝑝
Po = 𝐾𝑝 Risk-return trade off Highest risk, highest return Moderate risk, Lowest risk, moderate
(at least in theory) moderate return return

= 10.80/0.12 Tax status of

payment by
Not deductible Not deductible Tax deductible
Cost = Interest Payment
corporation x (1-Tax Rate)
= Php 90 Tax status of A portion of dividend paid Same as ordinary Government bond
payment to recipient to another corporation is shares interest is tax exempt
tax exempt

QUIZ (15 points) REFERENCES:

1. Explain how banks, companies and  Cabrera and Cabrera Financial Markets and
Institutions 2020
investors use financial instruments in the
money market.
2. Distinguish between ordinary or common
stock and preferred stock.
3. How is credit quality risk of bonds issued
by a corporation minimized?

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