A financial instrument is a financial asset for the person who buys or holds one, and it is a

financial liability for the company or institution that issues it.

TYPES OF MONEY MARKET INSTRUMENTS

All of the money market instruments are, by definition, short-term debt instruments, with maturities
less than one year.

Treasury Bills:

 Short-term debt issued by government to finance its deficits. Maturity life is from 12 weeks to
12months.
 The federal government raises cash by issuing Treasury bills. Their duration is for one year or
less. Used by the government to raise short-term funds to bridge seasonal or temporary gaps
between its receipt (revenue and capital) and expenditure.
 In other words, T-Bills are short term (up to one year) borrowing instruments of the
Government. T-Bills are short term money market instruments issued by Govt.
 Treasury bills were first authorized by Congress (U.S.A) in 1929.
 Pay no interest but a fixed amount at maturity.
 They pay a set amount at maturity and have no interest payments, but they effectively pay
interest by initially selling at a discount, that is, at a price lower than the set amount paid at
maturity. For instance, in May 2013 you might buy a six-m onth Treasury bill for $9,000 that can
be redeemed in November 2013 for $10,000.
 T-Bills Exempt from Tax
 Most liquid and safest instrument
 Liquidity: Treasury bills are the most liquid of all money market instruments because they are
the most actively traded.
 No default: They are also the safest money market instrument because there is almost no
possibility of default, a situation in which the party issuing the debt instrument (the federal
government in this case) is unable to make interest payments or pay off the amount owed when
the instrument matures. The federal government is always able to meet its debt obligations
because it can raise taxes or issue currency (paper money or coins) to pay off its debts.
 Treasury bills are held mainly by banks, although small amounts are held by households,
corporations, and other financial intermediaries.

Negotiable Bank Certificates of Deposit

 A certificate of deposit (CD) is a debt instrument that is issued by a commercial bank against
money deposited with it for a specific period of time, usually at a specific rate of interest, with a
penalty for early withdrawal. At maturity, return the original purchase price (the principal).
 Debt instrument sold by a bank to depositors: Negotiable certificate of deposit (NCD) is a debt
instrument sold by a bank to depositors that pays annual interest of a given amount and at
maturity pays back the original purchase price.
 A negotiable certificate of deposit (NCD) refers to a certificate of deposit with a minimum par
value of $100,000, although typically, NCDs will carry a much higher face value. They are also
known as jumbo CDs.
 NCDs are similar to regular CDs, but the main differences are:
o Large face value
o Negotiable aspect
 Negotiable CDs are those sold in secondary markets.
 NCDs are guaranteed by a bank and can be traded in a highly-liquid secondary market. However,
they cannot be redeemed before maturity.
 Because NCDs are so large, they are usually purchased by institutions and wealthy individual
investors.
 Negotiable CDs are an extremely important source of funds for commercial banks, from
corporations, money market mutual funds, charitable institutions, and government agencies.
 Negotiable certificates of deposit usually come with short-term maturities, ranging from a few
weeks to one year. Interest is paid either twice a year or at maturity. The interest rates are
negotiable.
 ADVANTAGES
1. Low risk: NCDs are a favored investment product due to their low risk. In addition, NCDs are
insured by the Deposit Insurance Corporation (DIC).
2. More liquid: NCDs are much more liquid than regular CDs. A regular CD cannot be traded on a
secondary market, and therefore, the funds are locked in unless an investor is willing to pay a
penalty. However, NCDs have a highly liquid secondary market where an NCD holder can sell
their NCD if they require liquidity.
 NCDs generally offer a return for investors at a higher rate than Treasury bonds. Typically, the
yield is higher as well.
 Disadvantages of NCDs
1. Riskier than Treasury bills: NCDs are generally riskier than Treasury bills. It is due to the fact
that the probability of a specific bank or financial institution defaulting is larger than the
probability of default for the government.
2. Can be callable in some cases: Most NCDs do not feature a call option, meaning that the
financial institution that offers them cannot recall the certificate and pay back the funds early.
However, some financial institutions do offer callable NCDs, which is a large risk for investors in
a period of low interest rates. The financial institution can “call” the NCD and pay a much lower
prevailing market interest rate to future lenders/investors.

Commercial Paper

 A short term, unsecured promissory notes which are issued at discount to face value by well-
known companies, banks and corporations that are financially strong
 Commercial paper refers to unsecured short-term promissory notes issued by financial and
nonfinancial corporations.
 It is typically issued by large, credit-worthy corporations with unused lines of bank credit and
therefore carries low default risk.
 Fixed maturity period.
 Maturity period - maximum of 9 months Commercial paper has maturities of up to 270 days.
 A popular debt instrument of the corporate world - Very safe instruments cause the financial
situation of the corporation can be anticipated over a few months
 Features of Commercial Paper:
 o Negotiable by endorsement and delivery - Flexible as well as liquid instruments
o Can be issued with varying maturities as required by the issuing company
o Unsecured instruments as they are not backed by any assets of the company which is
issuing the commercial paper
o Banks doesn’t act as intermediaries may act as agents: Unlike some other types of
money-market instruments, in which banks act as intermediaries between buyers and
sellers, commercial paper is issued directly by well-established companies, as well as by
financial institutions. Banks may act as agents in the transaction, but they assume no
principal position and are in no way obligated with respect to repayment of the
commercial paper. Companies may also sell commercial paper through dealers who
charge a fee and arrange for the transfer of the funds from the lender to the borrower.
 Advantages of Commercial Paper
1. High credit ratings fetch a lower cost of capital
2. Wide range of maturity provide more flexibility
3. It does not create any Claim on asset of the company
4. Tradability of Commercial Paper provides investors with exit options

Bankers’ Acceptance.
 It is a bank draft (like a check) issued by a firm, payable at some future date.
 It is guaranteed that it will be paid by a bank that stamps it “accepted”.
 The firm must deposit the required funds into its account to cover the draft.
 They are created to carry out international trade.
 The advantage to the firm is that the draft is more likely to be accepted by foreign exporter
since the bank guarantee the payment of the draft even if the local firm goes bankrupt.
 These “accepted” drafts are often resold in the secondary market at a discount.

Repurchase Agreements

 Repurchase agreements (repos) are effectively short-term loans. They are usually very short-
term (overnight or one day) but can range up to a month or more
 They use Treasury bills as collateral in case of default, between a non-bank corporation as the
lender and a bank as the borrower. Treasury bills serve as collateral, that is the lender receives if
the borrower does not pay back the loan.
 In the case of the repurchase agreement, the non-bank corporation buys the Treasury bill from
the bank.
 Simultaneously, the bank agrees to repurchase the Treasury bill later at a slightly higher price.
The difference between the original price and the repurchase price is the interest.
 Repos are made as follows: A large corporation, such as Microsoft, may have some idle funds in
its bank account, say $1 million, which it would like to lend for a week. Microsoft uses this
excess $1 million to buy Treasury bills from a bank, which agrees to repurchase them the next
week at a price slightly above Microsoft’s purchase price. The effect of this agreement is that
Microsoft makes a loan of $1 million to the bank and holds $1 million of the bank’s Treasury bills
until the bank repurchases the bills to pay off the loan.
 Repurchase agreements are now an important source of bank funds.
 The most important lenders in this market are large corporations.
 The Central Bank’s Funds
 These instruments are typically overnight loans between banks.
 The Central Bank funds designation is somewhat confusing because these loans are not made by
the federal government or by the Federal Reserve but rather by banks to other banks.
 Designed to enable banks temporarily short of their reserve requirement to borrow reserves
from banks having excess reserves.
 One reason why a bank might borrow in the federal funds market is that it might find it does not
have enough deposits at the Central Bank to meet the amount required by regulators.
 It can then borrow these deposits from another bank, which transfers them to the borrowing
bank.
 Federal funds rate, is a barometer of credit market conditions: This market is very sensitive to
the credit needs of the banks, so the interest rate on these loans, called the federal funds rate, is
a closely watched barometer of the tightness of credit market conditions in the banking system.
 When high, it indicates that banks are strapped for funds; when the rate is low, banks’ credit
needs are low.

TYPES OF CAPITAL MARKET INSTRUMENTS

 Capital market instruments are debt and equity instruments with maturities of greater than a
year.
 They have more price fluctuations than money market instruments and they are considered to
be fairly risky investments.
 Types of capital market instruments include

EQUITY INSTRUMENTS

 The word equity is used when referring to an ownership interest in a business. Examples include
stockholders' equity or owner's equity
 In the capital market equity is used as a source of finance (capital)
 Stocks are equity claims -represented by shares- on the net income and assets of a corporation.
 When the company wants to raise funds it can issue common stock or preference shares.
 The main types of equity are:
 Common stock: A security that represents ownership in a corporation.
o When the company issue common stock they gives shareholder to own some part of
company ownership. Holders of common stock exercise control by electing a board of
director and voting on corporate policy.
o In the event of liquidation, common stockholder have rights to a company's assets only
after bondholder, preferred shareholders and other debtholders have been paid in full.
o If the company goes bankrupt, the common stockholders will not receive their money
until the creditors and preferred shareholders have received their respective share of
the leftover assets.
o This makes common stock riskier than debt or preferred shares. The upside to common
shares is that they usually outperform bonds and preferred shares in the long run.
 Preference shares: The holder of preference share also own some percentage of the company
but cannot participate in anything to the company.
 Holder of preference share has the claim of the company asset and earning of the company.
 Normally has the first priority if there is any dividend payment than common stock holder.
 The main benefits to owning preference shares are that the investor has a greater claim on the
company’s asset than common stockholders.

Mortgages and Mortgage-Backed Securities

 Mortgages are loans to households or firms to purchase land, housing, or other real
structures, in which the structure or land itself serves as collateral for the loans.
 Mortgages are provided by financial institutions such as savings and loan associations, mutual
savings banks, commercial banks, and insurance companies.

Corporate Bond

 Intermediate and long-term debt issued by corporations with strong credit ratings to raise
capital.
 The typical corporate bond sends the holder an interest payment twice a year and pays off the
face value when the bond matures.
 Some corporate bonds, called convertible bonds, have the additional feature of allowing the
holder to convert them into a specified number of shares of stock at any time up to the
maturity date.
 This feature makes these convertible bonds more desirable to prospective purchasers than
bonds without it and allows the corporation to reduce its interest payments
 Because the outstanding amount of both convertible and nonconvertible bonds for any given
corporation is small, they are not nearly as liquid as other securities such as government bonds.
 The principal buyers of corporate bonds are life insurance companies; pension funds and
households are other large holders.

Government Securities

 These long-term debt instruments are issued by the Treasury to finance the deficits of the
federal government.
 Maturities of 2 – 30 years
 Because they are the most widely traded bonds, they are the most liquid security traded in the
capital market.
 They are held by the Federal Reserve, banks, households, and foreigners.

Government Agency Securities

 These long-term bonds are issued by various government agencies to finance such items as
mortgages, farm loans, or power generating equipment.
 Many of these securities are guaranteed by the federal government.
 They function much like government bonds and are held by similar parties.

State and Local Government Bonds

  State and local bonds, also called municipal bonds, are long-term debt instruments issued by
state and local governments to finance expenditures on schools, roads, and other large
programs.
 An important feature of these bonds is that their interest payments are exempt from federal
income tax and generally from state taxes in the issuing state.
 Commercial banks, with their high income tax rate, are the biggest buyers of these securities,
owning over half the total amount outstanding.
 The next biggest group of holders consists of wealthy individuals in high income tax brackets,
followed by insurance companies.

Consumer and Bank Commercial Loans

 Loans, originally made by banks, to businesses and households. They are also made by
finance companies. Secondary markets for these loans are only now just developing.
 These loans to consumers and businesses are made principally by banks but, in the case of
consumer loans, also by finance companies

FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT

FINANCE
 We have now considered a wide variety of financial instruments that arise through the process
of direct finance, in which the lender sells securities directly to the borrower.
 funds can move from lenders to borrowers by a second route, called indirect finance because
it involves a financial intermediary that stands between the lender-savers and the borrower-
spenders and helps transfer funds from one to the other
 Financial intermediation or indirect finance is the process of obtaining or investing funds
through third-party institutions like banks and mutual funds.
 Financial intermediation or indirect finance is the process of obtaining or investing funds
through third-party institutions like banks and mutual funds.
 As a source of funds for businesses and individuals, indirect finance is far more common than
direct finance. In virtually every country, credit extended by financial intermediaries is larger as
a percentage of GDP than stocks and bonds combined.
 Commercial banks are the financial intermediary we meet most often, but mutual funds,
pension funds, credit unions, savings and loan associations, and insurance companies are
important financial intermediaries.
 They lower transaction costs
 Why does some borrowing and lending take place, instead, through indirect finance– that is,
with the help of a financial intermediary?
 Why are financial intermediaries and indirect finance so important in financial markets?
 To answer this question, we need to understand the role of transaction costs, risk sharing, and
information costs in financial markets.