CHAPTER 3

FINANCIAL
INSTRUMENTS
INTODUCTION
-In chapter 1, we learned about the different types of financial markets. In these chapter,
we will study the financial instruments that they deal with. Prior to that, let us learn
something about the Capital Market Institute of the Philippines(CMIP).

-In this chapter, you will learn about the different money market instruments and the
different capital market instruments. You will be familiarized the different government
issues securities dealt with in the money market. You will also be knowledgeable about
the negotiated(non-marketable) capital market and instruments dealt with in the said
market.
What is capital market institute of the
Philippines(CMIP)?
 CMIP is a bullish organization that strokes and develops the investment chapter of
Filipino in the Philippine financial/capital market. It is committed to promoting,
developing, and advancing awareness and knowledge on capital market and its
role in the development of the national economy through Developing, Project,
Organizing, and Conducting programs, Research, and other activities to upgrade
competencies of the members, practitioners, entrepreneurs, professionals,
teachers, and student in dealing with the Philippine Capital Market.
Aims to:

> inculcate in the Filipino people a lasting investment consciousness and a strong desire to
save and invest and to become active participants in the Philippines capital market

> work jointly or in coordinate with concerned organization and agencies toward a lasting
investment culture in the country

> coordinate with education, business, financial institutions, and other relevant agencies
nationwide in formulating programs, strategies, and methodologies that will facilitate teaching
and learning about financial markets and investment concepts, principles, and practices; and

> conduct national seminars, briefings, and workshops on current trend and issues related to
investments and the financial market.
In finance, financial market instruments are classified as their
term or maturity date. They can be :
 Short-term(with maturity of one year or less), it belongs
to the Money market.
 Long-term(with maturity of more than one year), it
belongs to the Capital market.
MONEY MARKET INSTRUMENTS

 Are short-term securities . They are paper or electronic

evidence of dept dealt in the money market. Money market
instrument are issued by the government and corporations
needing short-term funds. Government securities are
generally issued by the Bureau of the Treasury.
CASH MANAGEMENT BILLS
 Are government-issued securities with maturities of less
than 91 days, specifically 35days or 42days. They have
shorter maturities than T-bills. Government securities(GS)
are unconditional obligation of the government issuing
them, backed up by the full taxing power of the issuing
government. As such, they are theoretically default-free
Investing in these bills affords security and liquidity to
investors.
TREASURY BILLS(T-bills)
 T-bills are issued by the Bureau of the Treasury with 91-days, 182-days, and
364-day maturities. The odd numbers of days is to generally ensure that they
mature on a business day.

 Like Treasury bonds(T-bonds), they are sold only through government

securities eligible dealers(GSEDs), dealers authorized by the government to sell
T-bills. Transactions are done through bidding online.

 The Philippine government issues to types of government securities: Treasury

bills, which are short-term, and T-bonds, which are long-term. T-bills are zero
coupon securities be they have no coupon payments(interest payment) and only
have face values. They are sold at a discount, which means that their purchase
price is less than their face value. This difference between their purchase and
their face value is the source of their return generally referred to as discount
yield(dy) or margin. They do not earn interest.
BANKER’S ACCEPTANCE
 Banker acceptance is a time draft issued by a bank payable to a seller of goods. It is drawn on and
accepted by the bank. Before acceptance, the draft is not an obligation of the bank; it is merely an order
by the drawer to pay a specified sum of money on a specified date to a named person or to bearer of the
draft just like an ordinary check:
 Upon acceptance, which occurs when an authorized bank employee stamps the drafts” accepted” and
signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is well known
and enjoys a good reputation, the accepted draft may be readily sold I active market(LaRoche1998).
The bank substitutes its own creditworthiness for that of the drawer that makes bankers acceptance
marketable instruments.
 Time Draft issued by a bank is an order for the bank to pay a specified amount of money to the bearer
of the time draft on a given date. It is different from:
 Sight Draft, which is an order to pay immediately. A bank check is a sight draft.
LETTERS OF CREDIT
 Are generally used with the purchase of goods or services either
domestically or internationally in these cases, the buyer has issue a
letter of credit (L/C) on its behalf in favor of the seller. For imports:
 An International Letter of Credit is opened; for local purchase,
 A domestic Letter of Credit is opened, a Commercial Letter of
Credit is a contractual agreement between a bank, known as the
Issuing bank, on behalf of the buyer (drawer), authorizing another
bank, the Correspondent bank known as Advising or Confirming
bank, to make payment to the beneficiary, the seller.
 The letter of credit states that the bank will accept the seller’s time daft if
the seller presentation the bank with shipping documents that transfer title
on the goods to the bank. The bank notifies the seller of the letter of credit
through a correspondent bank in the case of export in the exporters country.

 Through a letter of credit, the bank substitute its own promise to pay for
the promise of one of its customers. By substituting its promise, the bank
reduces the sellers risk, facilitating the flow of goods and services through
international markets. If the seller becomes concerned about the soundness
of the bank issuing the letter of credit, the seller may ask his own bank to
issue a confirmation letter in which that bank guarantees against foreign
bank default. A confirmation letter transfer the payment obligation to the
guaranteeing /confirming bank from the originating/issuing bank.
NEGOTIABLE CERTIFICATION
OF DEPOSIT
 Certification of deposit(CD)
 Is a receipt issued by a commercial bank for the deposit of money. It is a time
deposit with a definite maturity date(of up to one year) and a definite rate of
interest.
 CD stipulates that the bearer is entitled to receive annual interest payments at the
rate indicated in the certificates, together with the principal upon maturity of the
certificate.
 They are not ordinarily redeemed prior to maturity, nut in the early 1960s, a
secondary market was established in which CDs in denominations $100,000 or
more can traded prior to maturity.
 Negotiable Certification of deposit

 A bank-issued time deposit that species an interest rate and maturity date and is
negotiable. It is a short-term, 2 to52 weeks, and of a large denomination,
(₱100,000)(₱500,000) and (1M).
 Therefore, it is important that the owners must take good care of them because
when lost, the one who found it can claim payment. Negotiable CDs are more
risky than T-bills.
 When CDs mature, the owner receives the full amount deposited plus the earned
interest.
 Banks issues negotiable CDs to attract additional funds to make loans or to
counteract the restrictive affect of deposit withdrawals.
 The primary buyers of negotiable CDs are corporations, money market mutual
funds, government institutions, charitable like PCSO, and foreign buyers.
REPURCHASE AGREEMENTS
 Are legal contracts that involve the actual sale of securities by a borrower to a lender with a
commitment on the part of the borrower to purchase the securities at the contract price plus a stated
interest charge at a later date.

 A repurchase agreement is usually a short-term loan(often overnight) from a corporation, state or local
government, or other large entity that has idle funds to a commercial bank, securities dealer, or other
financial institution.

 They were created by brokerage houses and popularized by commercial banks.

 A REVERSE REPURCHASE AGREEMENT or reverse repo is an agreement involving the purchase of

securities by one party to another with the promise to sell them back at a given date in the future.
Therefore, from the point of view of the buyer, the transaction is a reverse repo.
MONEY  Are PDIC-insured deposit account that are usually managed
by banks or brokerages and can be a convenient from place
MARKET to store money that is to be used for upcoming investments
or has been received from the sale of recent investment.

DEPOSIT  MMDAs usually offer check-writing privilege's.

 MMDAs are insured by the market Philippine Deposit
ACCOUNT Insurance Corporation(PDIC)up to ₱500,000 per person, per
bank.
S  The growth of MMDA market related the growth of MMMF
market. MMDA was actually designed by the government as
a step to save depository institution that were threatened by
the fast development of MMMF market. There is always a
very close competition, between these two markets.
MONEY MARKET MUTUAL
FUNDS MONEY MARKET MUTUAL FUNDS(MMMFs) are investment funds that

pool funds from numerous investors and invest in money market instruments
offered by investment companies.

 MUTUAL FUND is an investment company that pool the funds of many

individual and institutional investors to form a massive asset base. The assets
are then entrusted to a full-time professional fund manager who develops and
maintains a diversified portfolio of security investment.
Four basic types of
Mutual Funds (in the Philippines)

1. Stock Funds / Equity Funds

 invest primarily in share stocks.
2. Balance funds
 invest both in shares of stock and debt instruments combining the features of both the growth
funds and the income funds.
3. Bond funds
 Invest in long-term debt instruments of government or corporation.
4. Money market funds
 Invest purely in short-term debt instruments.
Mutual Funds can be classified as:
1. Growth funds – invest in assets that are expected to reap large capital
gains(generally equity securities)
2. Income funds – invest in stocks that regularly pay dividends and in notes and
bonds that regularly pay interest.
3. Balanced funds – combine the features of both growth funds and income
funds
4. Sector funds – invest in specific industries as health care, financial services,
utilities, extractive industries
5. Index funds – invest in a basket of securities that make up some market index
as the S&P 500 index of stocks
6. Global fund – invest in securities issued in many countries providing
diversification.
CERTIFICATION OF ASSIGNMENT
 Is an agreement that transfers the right of the seller over a security in favor of the buyer. The
underlying security carries a promise to pay a certain sum of money on a fixed date like a
promissory note. The arrangement allows the buyer to hold the security as a guaranteed sources of
repayment. The buyer has the option to force the liquidation of the underlying security to ensure
repayment.

Example:
ABC corporation own certain securities, say T-bills worth ₱100,000. ABC Corporation goes to a bank
and borrows money corresponding to the amount of the T-bills, that is, ₱100,000. ABC Corporation
executes a certificate of assigning the right over T-bills to the bank. The maturity and amount of the
loan need to match the maturity and amount of T-bills. When the maturity date comes, ABC
Corporation will pay the bank ₱100,000 that it borrowed and get back the cancelled certificate of
assignment.
CERTIFICATE OF
PARTICIPATION
Is an instrument that entitles the holder to a proportionate equitable interest in the
securities held by the issuing firm or an entitlement to a pro rata share in a pledge
revenue stream, usually lease payments.
 The certificate of participation is a useful instrument when the original security is
in a large denomination and when there are a few buyers.

Example:
DEF Corporation issued a promissory note for ₱300 million to a bank. The bank later
sold ₱5 million of this instrument to RST Company, Inc. The bank will issue a
certificate of participation in DEF’s promissory note to RST company, inc. The banks
certificate of participation does not make the bank liable in case DEF Corporation
defaults on its note.
EURODOLLAR CDs AND
EUROCOMMERCIAL PAPERS
 The US dollar has been an international medium of exchange. Foreign government and financial
institutions, like banks, hold a store of funds denominated in US dollars outside of the United States.
 Dollar domination deposits held offshore in US bank branches overseas and in other foreign banks are
called EURODOLLAR DEPOSITS and the market in which they trade is called Eurodollar Market.
 Eurodollar certificate of deposits or Eurodollar CDs are dollar-denominated, negotiable, large-time
deposits in banks outside the United states.
 Similarly Euro commercial papers (EuroCPs) are issued in Europe by dealers of commercial papers
without involving a bank. The Euro commercial rate is generally about one-half to one percent above
the LIBOR rate.
CAPITAL MARKET INSTRUMENTS
 After gaining knowledge in examining the different money
market instruments, we are now ready to learn the different
capital market instruments available to investors.
 As stated , these long-term instrument are basically either equity
securities or dept securities. Capital market instruments include
corporate stocks, mortgages, corporation bonds, non negotiable
bank, and consumer loans leases.
Capital market instruments:
 Non- negotiable / non-marketable instrument
1. Loans – are direct borrowing of deficit units surplus units like bank. They do one-on-one transaction
with the lenders.
2. Leases – are rent agreements. The owner property called the lessor and the one who is renting and
using property is the lessee.
3. Mortgages - are agreements where a property owner borrows money from a financial institution using
property as a security or collateral for the loan. In essence, mortgages are secured loans.
4. Lines of Credit – is a bank’s committed to make loans to regular depositors up to a specific amount.
The line of credit includes letters of credit, standby letters of credit, and revolving credit
arrangements, under which borrowing can be made up to a maximum amount as of any point in time
conditional on satisfaction of specified terms, before, as of, and after the date of drawdown on the
line.
PERSONAL LINES OF CREDIT
- for household and can be used for home renovation,
buying car, vacation, or any major purchase.
COMMERCIAL LINES OF CREDIT
- Are for businesses and can be used for current or short-term
purposes like purchase of merchandise and pay operating
expenses or for capital expenditures.
 Negotiable/marketable instrument
Corporate stocks – are the largest capital market instruments. Stocks are evidences of ownership in
a corporation. The holders are called share holders or stockholders.
shares of stock may be classified as:
A.
1. par value shares
2. No par value shares
a. with stated value
b. without stated value
B.
3. Common shares
4. Preferred shares
a. as to assets
b. as to dividends (cumulative, Non-cumulative, Participating ,
Non- Participating)
 Par value shares are shares where the specific money value is shown on the face
of the stock certificate and fixed in the Article of Incorporation. The par shares may
be issued at a premium(above par value), but may not be sold at a discount (below
par value).
 No par value are shares without any money appearing on the face of the stock
certificate.
 Preferred shares as to assets upon liquidation mean that the shares shall be given
preference over common shares in the distribution of the assets of the corporation
in case of liquidation.
 Cumulative preferred shares are entitled to receive all passed dividends in arrears.
 Non-cumulative preferred shares are not entitled to passed dividend or which are
called dividends in arrears for cumulative shares.
 Dividends out of earning can be in the form of:

1. Cash dividend – are dividend distributed in the form of cash, say ₱10/ share cash dividend, which means
the company will pay those who own shares in the company at the rate of ₱10/share.
2. Stock dividend - are dividends given out to stockholders in the form of the company's own shares
3. Unissued common stock – refers to that part of the authorized capital stock that has not been fully paid,
meaning, stock certificates have not been issued, hence unissued
4. Retained earning – refers to the profit of the company that have not been declared as dividends and
retained by the business to help in its operation.
5. Property dividend – the form of non-cash assets of the company distribution as dividends to stockholders.
6. Scrip dividend – deferred cash dividends. Scrips are promissory notes that will be paid by the company in
cash at a certain future date.
BONDS
are dept instruments issued by private companies and government entities to borrow large
sum of money that no single financial institution may be willing or able to lend.

A government bond is issued by a national government and is denominated in the

country's own currency.
Corporate Bonds- are certificates of indebtedness issued by
corporations who need large amount of cash.

Bonds can be classified as follows:

1. As security:
a. secure bonds – are collateralized either by mortgages or other assets.
b. unsecured bonds – also called debenture bonds, do not have any sort of guarantee.
2. As to interest rate:
a. variable rate bonds – are bonds whose interest rate fluctuates and changes when the market rates
changes.
b. fixed rate bonds – have rate that are fixed as stated in the bond indenture.
3. As to retirement:
a. Putable bonds – are bonds that can be turned in and exchanged for cash at holders option.
b. callable/ redeemable bonds – is bond in which the issuer has the right to call the bond for
retirement for a price determined at the time the bond is issued.
c. convertible bonds – can be exchanged for common stocks.

4. Other classification:
a. income bonds – bonds that pay interest only when the interest is earned by the issuing
company.
b. indexed or purchasing power bond – popular in Brazil, Israel , Mexico , and a few other
countries.
c. junk bonds – are speculative, below-investment grade, high-yielding bonds.
Treasury bonds - Similar to T-bills, treasury notes and bonds are
issued by the treasury of the country concerned.

Retail treasury bonds(RTBs) – are like T-notes, but

are usually longer in maturity(10 years and above)
Floating rate notes(FRNs) – in which interest
payment rise and fall are based on discount rates for
13-week T-bills. FRNs are issued for a term of 2-
years and pay interest quarterly.
Municipal bonds – state and local government and other political
subdivision's must finance their own capital investments projects like roads, schools,
bridges, sewage plants, and airport.

 Two varieties:
1. general obligation bonds – are issued to raise immediate capital to cover
expenses and are support by the taxing power of the issuer.

2. Revenue Bonds
LONG-TERM NEGOTIABLE
CERTIFICATES OF DEPOSIT
 Are negotiable certificates of deposit with a
designated maturity or tenor beyond 1 year,
representing a banks obligation to pay the face
value upon maturity, as well as periodic coupon or
interest payments during the life of the deposit.
MORTGAGE-BACKED SECURITIES
 INDIVIDUAL MORTGAGES ARE NON-NEGOTIABLE AND SUCH ARE
NEITHER LIQUID NOR SUITED TO TRADING ON SECONDARY MARKETS.

 THE MORTGAGE BACKED SECURITIES, WHICH ARE USUALLY IN THE

FORM OF BONDS.
 THESE ARE USUALLY SOLD TO PENSION FUNDS OR LIFE INSURANCE
CAMPANIES.
 THE MORTGAGE HOUSES OR BANKS SECURITY UN THE FORM OF
INTEREST ON THE BONDS HELS.