Overview of Financial System

 The financial system is an organized and regulated structure where an

exchange of funds takes place between the lender and the borrower. It
supplies the necessary financial inputs for the production of goods and
services, in turn, promote the well-being and standard of living of people in
the country.  

The financial system consists of a variety of institutions, markets, and

instruments that are related in a systematic manner and provide the principal
means by which savings are transformed into instruments, according to
Prasanna Chandra. 

Photo: Suomen Pankki

Figure 1.1

The financial system is significant to attain economic development since they

induce people to save by offering attractive interest rates. These savings are then
channelized by lending to various business concerns that are involved in
production and distribution. It helps in monitoring corporate performance It links
savers and investors. This process is known as capital formation It helps in
decreasing the transaction cost and increase returns which will motivate people to
save more It helps the government in deciding monetary policy

Components of Financial System

 1.  Financial institutions: It is a corporation affianced in the business of
dealing with financial and monetary matters such as deposits, loans,
investments, and currency exchange. They are providing various services to
the economic development with the help of issuing financial instruments. They
are further divided into banking institutions and non-banking institutions.

a)    Banking institutions: they are the key part of economic development. They
play a vital role in the field of savings and investment of money from the public
and lending to business concerns. 

b)    Non-banking institutions: they are the entities and the institutions that provide
certain bank-like and financial services but do not have a banking license.
Government nonbank financial institutions, on the other hand, consist of the
Government Service Insurance System (GSIS), Social Security System (SSS),
National Home Mortgage Finance Corporation, Philippine Veterans Investment
Development Corporation, and National Development Corporation The private
nonbank financial institutions are First Metro Investment Corporation. Philippine
Depository and Trust Corporation and many more (www.bsp.gov.ph)

2. Financial market: it is a market which deals with various financial instruments

such as shares, debentures, bonds, etc., and financial services such as merchant
banking, underwriting, etc. They are further divided into 

a)    Capital market: institutional arrangement for borrowing medium and long
term funds and which provides facility for marketing and trading of securities.
Examples are shares, debentures, bonds, etc. They are then divided into:

        Primary market: where securities are offered for the first time for receiving
the public subscription.

        Secondary market: where pre-issued securities dealt between the investors.

b)    Money market: it is for short-term funds, which deals in financial assets
whose period of maturity is up to 1 year. They are highly liquid and easily
marketable. Example are  treasury bill, commercial paper, etc

3.  Financial services:  these services are provided by the finance industry. They
are usually customer focused. They study the needs of the customer in detail before
deciding their financial strategy, giving due regard to cost, liquidity, and maturity.
Example are insurance company, credit rating facility, etc

4. Financial instruments: it is any contract that gives rise to a financial asset of
one entity and financial liabilities or equity instruments to another entity. The
various instruments are shares, debentures, bonds in the capital market and
Treasury bill, commercial paper, certificate of deposit, repurchase agreement in the
money market.

Topic Overview: Financial Markets

Financial Markets is a market in which financial assets (securities) such as
stocks and bonds be purchased or sold. Funds are transferred in financial
markets when one party purchases financial assets previously held by another
party. Financial markets facilitate the flow of funds and thereby allow
financing and investing by households, firms, and government agencies. 

Fundamentals of Financial Markets

Financial Markets is a market in which financial assets (securities) such as
stocks and bonds be purchased or sold. Funds are transferred in financial
markets when one party purchases financial assets previously held by another
party. Financial markets facilitate the flow of funds and thereby allow
financing and investing by households, firms, and government agencies. 
 photo: Fastnewsfeed  

Overview of the Philippine Financial Market

Money Market

            The money market is a financial market that deals with short-term
maturities of financial contracts. Most money market instruments are fixed-income
debts. The available money market instruments are Treasury Bills (T-bills), Small
Investors Program Bills, Cash Management Bills, Banko Sentral Ng Pilipinas
(BSP) Reverse Repurchase, BSP Special Peso Deposit, Bankers Acceptances, and
Short-term Commercial Papers (CPs). The domestic money market is dominated
by government debt issued regularly. Other major investors of money are the
Social Security System (SSS), the Government Service Insurance System (GSIS),
the Home Development Mutual Fund (HDMF), trust funds, mutual funds, and
retail investors.
Capital Market

            A financial market that deals with beyond one (1) year maturities is the
capital market. Is further subdivided into two types of market: primary market vs.
secondary, and debt vs. equity. Primary market refers to the issuance of new
securities representing an actual transfer of funds from the investors to the issuing
entity through an initial public offering (IPO), while secondary market refers to the
trading of securities thus providing for investors a liquidity mechanism in the
market. On the other hand, debt is a financial obligation that has to be repaid with
interest, while equity is a form of ownership in an enterprise and does not have to
be repaid. The available capital market debt instruments are Treasury Bonds, Fixed
Rate Note, Small Investor Program Bonds, Municipal Bonds, and Government
Bonds.

            The Philippine Stock Exchange (PSE) provides an active trading platform
in the Philippine equities market. The instruments traded in the PSE are common
stocks, preferred stocks (convertible and non-convertible), warrants, and bonds.
The issues in the Philippine equities market are classified as Commercial and
Industrial Issues, Property Issues, Mining Issues, Oil Issues, and Small
Denominated Treasury. The active participants of the Philippine stock market are
the trust departments, insurance firms, and other institutional investors both local
and foreign. PSE is the formal market for equities transactions.

Foreign Exchange Market

            The foreign exchange market (forex) refers to the market that deals with
foreign currencies like the Philippine peso, US dollar, and other major currencies.
The trading in foreign currencies is merely done through Philippine Dealing
System. The foreign exchange instruments are the Spot Transactions. Foreign
Exchange Forward Contracts, and Swap Contracts. The Philippines maintains a
floating exchange rate whereby market forces primarily determine the rate of
exchange, Peso/US dollar spot transactions corner the bulk of forex transactions in
the country. The investors in the forex market are commercial banks, mutual funds,
trust departments, and institutional and retail investors. Trading in the forex market
is done through the Philippine Dealing System; it provides a platform for the
buyers and the sellers to meet with provisions of real-time-weighted average rate
and volumes of trade for the peso.

Derivatives Market
            The derivatives market includes all financial contracts deriving their value
from any other underlying assets. Derivatives provide a risk management tool in
the financial system. The derivatives instruments are the Forward Contracts, Swap
Contracts, and Option Contracts. The increase in derivatives trading is attributed to
the bank’s acquisition of derivative licenses and the existence of derivative
instruments as risk management tools. The BSP regularly issues circulars and
guidelines affecting the trading of derivatives. It sets standards and gives
accreditation to financial institutions for derivative transactions.

The function of Financial Markets

We might ask: What is the function of Financial Markets?
Financial markets perform the essential economic function of channeling funds
from households, firms, and governments that have saved surplus funds by
spending less than their income to those that have a shortage of funds because they
wish to spend more than their income. This function is shown schematically in
Module 1 Topic 1 Figure 1.1. Those who have saved and are lending funds, the
lender-savers, are at the left and those who must borrow funds to finance their
spending, the borrower-spenders, are at the right. The principal lender-savers are
households, but business enterprises and the government (particularly state and
local government), as well as foreigners and their governments, sometimes also
find themselves with excess funds and so lend them out. The most important
borrower-spenders are businesses and the government (particularly the federal
government), but households and foreigners also borrow to finance their purchases
of cars, furniture, and houses. The arrows show that funds flow from lender-savers
to borrower-spenders via two routes. In direct finance (the route at the bottom of
Module 1 Topic 1 Figure 1.1), borrowers borrow funds directly from lenders in
financial markets by selling them securities (also called financial instruments),
which are claims on the borrower’s future income or assets. Securities are assets
for the person who buys them, but they are liabilities (IOUs or debts) for the
individual or firm that sells (issues) them.

For example, if Genuine Motors needs to borrow funds to pay for a new factory to
manufacture electric cars, it might borrow the funds from savers by selling them a
bond, debt security that promises to make payments periodically for a specified
period of time, or a stock, security that entitles the owner to a share of the
company’s profits and assets.
Structure of Financial Markets
 Now, let’s look at the structure of Financial Markets. The following
descriptions of several categorizations of financial markets. This illustrates
the essential features of these markets.

Debt and Equity Markets

A firm or an individual can obtain funds in a financial market in two ways. The
most common method is to issue a debt instrument, such as a bond or a mortgage,
which is a contractual agreement by the borrower to pay the holder of the
instrument fixed amounts at regular intervals (interest and principal payments)
until a specified date (the maturity date), when the final payment is made. The
maturity of a debt instrument is the number of years (term) until that instrument’s
expiration date.

A debt instrument is short-term if its maturity is less than a year and long-term if
its maturity is 10 years or longer. Debt instruments with a maturity between one
and 10 years are said to be intermediate-term.

The second method of raising funds is by issuing equities, such as common stock,
which are claims to share in the net income (income after expenses and taxes) and
the assets of a business. If you own one share of common stock in a company that
has issued one million shares, you are entitled to 1 one-millionth of the firm’s net
income and 1 one-millionth of the firm’s assets. Equities often make periodic
payments (dividends) to their holders and are considered long-term securities
because they have no maturity date. In addition, owning stock means that you own
a portion of the firm and thus have the right to vote on issues important to the firm
and to elect its directors.

The main disadvantage of owning a corporation’s equities rather than its debt is
that an equity holder is a residual claimant; that is, the corporation must pay all its
debt holders before it pays its equity holders. The advantage of holding equities is
that equity holders benefit directly from any increases in the corporation’s
profitability or asset value because equities confer ownership rights on the equity
holders.

Topic Introduction
The next focus of our study is financial institutions. Financial institutions are what
make financial markets work. Without them, financial markets would not be able
to move funds from people who save to people who have productive investment
opportunities. Financial institutions thus play a crucial role in improving the
efficiency of the economy.

Fundamentals of Financial Institutions 

Financial institutions play such a major role in channeling funds to borrowers with
productive investment opportunities, this financial activity is important in ensuring
that the financial system and the economy run smoothly and efficiently. They
provide loans to businesses, help us finance our educations or the purchase of a
new car or home, and provide us with services such as cheque and savings
accounts.

  

photo:QSStudy

In this topic,  we examine how banking and other financial institutions are
conducted to earn the highest profits possible: how and why banks make loans,
how they acquire funds and manage their assets and liabilities (debts), and how
they earn income. Although we focus on commercial banking, because this is the
most important financial intermediary activity, many of the same principles are
applicable to other types of financial intermediation.
Types of Financial Intermediaries
In this topic, we will discover why financial intermediaries have such an important
function in the economy. Now we look at the principal financial intermediaries
themselves and how they perform the intermediation function. They fall into three
categories: depository institutions (banks), contractual savings institutions, and
investment intermediaries.

  photo:
Doing Business in the Philippines

Depository Institutions
Depository institutions (for simplicity, we refer to these as banks) are financial
intermediaries that accept deposits from individuals and institutions and make
loans. These institutions include commercial banks and the so-called thrift
institutions (thrifts): savings and loan associations, mutual savings banks, and
credit unions.

Commercial Banks These financial intermediaries raise funds primarily by issuing

checkable deposits (deposits on which checks can be written), savings deposits
(deposits that are payable on demand but do not allow their owner to write checks),
and time deposits (deposits with fixed terms to maturity). They then use these
funds to make commercial, consumer, and mortgage loans and to buy government
securities and municipal bonds. Around 43 commercial and universal banks are
found in the Philippines which is 9.2 percent of the total number of banks in the
whole world. As a group, they are the largest financial intermediary and have the
most diversified portfolios (collections) of assets.
Savings and Loan Associations (S&Ls) and Mutual Savings Banks These
depository institutions, of which obtain funds primarily through savings deposits
(often called shares) and time and checkable deposits.

In the past, these institutions were constrained in their activities and mostly made
mortgage loans for residential housing. Over time, these restrictions have been
loosened so the distinction between these depository institutions and commercial
banks has blurred. These intermediaries have become more alike and are now more
competitive with each other.

Credit Unions These financial institutions, numbering about 40 in the Philippines,

are typically very small cooperative lending institutions organized around a
particular group: union members, employees of a particular firm, and so forth.
They acquire funds from deposits called shares and primarily make consumer
loans.

Contractual Savings Institutions

Contractual savings institutions, such as insurance companies and pension funds,
are financial intermediaries that acquire funds at periodic intervals on a contractual
basis. Because they can predict with reasonable accuracy how much they will have
to pay out in benefits in the coming years, they do not have to worry as much as
depository institutions about losing funds quickly. As a result, the liquidity of
assets is not as important a consideration for them as it is for depository
institutions, and they tend to invest their funds primarily in long-term securities
such as corporate bonds, stocks, and mortgages.

Life Insurance Companies Life insurance companies insure people against

financial hazards following death and sell annuities (annual income payments upon
retirement). They acquire funds from the premiums that people pay to keep their
policies in force and use them mainly to buy corporate bonds and mortgages. They
also purchase stocks but are restricted in the amount that they can hold.

Fire and Casualty Insurance Companies These companies ensure their

policyholders against loss from theft, fire, and accidents. They are very much like
life insurance companies, receiving funds through premiums for their policies, but
they have a greater possibility of a loss of funds if major disasters occur. For this
reason, they use their funds to buy more liquid assets than life insurance companies
do. Their largest holding of assets consists of municipal bonds; they also hold
corporate bonds and stocks and government securities.
Pension Funds and Government Retirement Funds   A Private pension funds and
state and local retirement funds provide retirement income in the form of annuities
to employees who are covered by a pension plan. Funds are acquired by
contributions from employers and from employees, who either have a contribution
automatically deducted from their paychecks or contribute voluntarily. The largest
asset holdings of pension funds are corporate bonds and stocks. The establishment
of pension funds has been actively encouraged by the federal government, both
through legislation requiring pension plans and through tax incentives to encourage
contributions.

Investment Intermediaries
This category of financial intermediaries includes finance companies, mutual
funds, money market mutual funds, and investment banks.

Finance Companies Finance companies raise funds by selling commercial paper

(a short-term debt instrument) and by issuing stocks and bonds. They lend these
funds to consumers (who make purchases of such items as furniture, automobiles,
and home improvements) and to small businesses. Some finance companies are
organized by a parent corporation to help sell its product. For example, Ford Motor
Credit Company makes loans to consumers who purchase Ford automobiles.

Mutual Funds These financial intermediaries acquire funds by selling shares to

many individuals and using the proceeds to purchase diversified portfolios of
stocks and bonds. Mutual funds allow shareholders to pool their resources so that
they can take advantage of lower transaction costs when buying large blocks of
stocks or bonds. In addition, mutual funds allow shareholders to hold more
diversified portfolios than they otherwise would. Shareholders can sell (redeem)
shares at any time, but the value of these shares will be determined by the value of
the mutual fund’s holdings of securities. Because these fluctuate greatly, the value
of mutual fund shares does, too; therefore, investments in mutual funds can be
risky.

Money Market Mutual Funds These financial institutions have the characteristics
of a mutual fund but also function to some extent as a depository institution
because they offer deposit-type accounts. Like most mutual funds, they sell shares
to acquire funds that are then used to buy money market instruments that are both
safe and very liquid. The interest on these assets is paid out to the shareholders. A
key feature of these funds is that shareholders can write checks against the value of
their shareholdings. In effect, shares in a money market mutual fund function like
checking account deposits that pay interest. Money market mutual funds

Hedge Funds Hedge funds are a type of mutual fund with special characteristics.
Hedge funds are organized as limited partnerships with minimum investments
ranging from $100,000 to, more typically, $1 million or more. These limitations
mean that hedge funds are subject to much weaker regulation than other mutual
funds. Hedge funds invest in many types of assets, with some specializing in
stocks, others in bonds, others in foreign currencies, and still others in far more
exotic assets.

Investment Banks Despite its name, an investment bank is not a bank or a

financial intermediary in the ordinary sense; that is, it does not take in
deposits and then lend them out. Instead, an investment bank is a different
type of intermediary that helps a corporation issue securities. First, it advises
the corporation on which type of securities to issue (stocks or bonds); then it
helps sell (underwrite) the securities by purchasing them from the corporation
at a predetermined price and reselling them in the market. Investment banks
also act as deal makers and earn enormous fees by helping corporations
acquire other companies through mergers or acquisitions

Definition and Purpose of Money Markets

 Money Markets are used to facilitate the transfer of short-term funds from
individuals, corporations, or governments with excess funds to those with
deficient funds. 

There  are three basic characteristics common in money market securities which
we will discuss here:

 They are usually sold in large denominations.

 They have low default risk.
 They mature in one year or less from their original issue date. Most money
market instruments mature in less than 120 days.

Money market transactions do not take place in any one particular location or
building. Instead, traders usually arrange purchases and sales between participants
over the phone and complete them electronically. Because of this characteristic,
money market securities usually have an active secondary market. This means that
after the security has been sold initially, it is relatively easy to find buyers who will
purchase it in the future. An active secondary market makes money market
securities very flexible instruments to use to fill short-term financial needs. For
example, Microsoft’s annual report states, “We consider all highly liquid interest-
earning investments with a maturity of 3 months or less at the date of purchase to
be cash equivalents.

The Purpose of the Money Markets

The well-developed secondary market for money market instruments makes the
money market an ideal place for a firm or financial institution to “warehouse”
surplus funds until they are needed. Similarly, the money markets provide a low-
cost source of funds to firms, the government, and intermediaries that need a short-
term infusion of funds.

The goal of most investors in the money market who are temporarily warehousing
funds is not to earn particularly high returns on their funds. Rather, they use the
money market as an interim investment that provides a higher return than holding
cash or money in banks. They may feel that market conditions are not right to
warrant the purchase of additional stock, or they may expect interest rates to rise
and hence not want to purchase bonds. It is important to keep in mind that holding
idle surplus cash is expensive for an investor because cash balances earn no
income for the owner. Idle cash represents an opportunity cost in terms of lost
interest income.

Who Participates in the Money Markets?

The players in the money market would be to list those who borrow and those who
lend. The problem with this approach is that most money market participants
operate on both sides of the market. For example, any large bank will borrow
aggressively in the money market by selling large commercial CDs.

At the same time, it will lend short-term funds to businesses through its
commercial lending departments. Nevertheless, we can identify the primary money
market players—the Treasury, the Federal Reserve System, commercial banks,
businesses, investments and securities firms, and individuals.
Treasury Department is unique because it is always a demander of money market
funds and never a supplier. The Treasury is the largest of all money market
borrowers worldwide. It issues Treasury bills (often called T-bills) and other
securities that are popular with other money market participants. Short-term issues
enable the government to raise funds until tax revenues are received. The Treasury
also issues T-bills to replace maturing issues.

Federal Reserve System: The Fed holds vast quantities of Treasury securities that
it sells if it believes interest rates should be raised. Similarly, the Fed will purchase
Treasury securities if it believes interest rates should be lowered. The Fed’s
responsibility for interest rates makes it the most influential participant in the
money market. The Federal Reserve’s role in controlling the economy through
open market operations.

Commercial banks hold a percentage of government securities second only to

pension funds. This is partly because of regulations that limit the investment
opportunities available to banks. Specifically, banks are prohibited from owning
risky securities, such as stocks or corporate bonds. There are no restrictions against
holding Treasury securities because of their low risk and high liquidity.

Banks are also the major issuer of negotiable certificates of deposit (CDs),
banker’s acceptances, federal funds, and repurchase agreements. Using money
market securities to help manage their own liquidity, many banks trade on behalf
of their customers.

Not all commercial banks deal in the secondary money market for their customers.
The ones that do are among the largest in the country and are often referred to as
money center banks. The biggest money-center banks include Citigroup, Bank of
America, J.P. Morgan, and Wells Fargo.

Businesses: Many businesses buy and sell securities in the money markets. Such
activity is usually limited to major corporations because of the large dollar
amounts involved. As discussed in the previous topic, the money markets are used
extensively by businesses both to warehouse surplus funds and to raise short-term
funds of Investment and Securities Firms

Investment Companies are large diversified brokerage firms that are active in the
money markets. The largest of these include Bank of America, Merrill Lynch,
Barclays Capital, Credit Suisse, and Goldman Sachs. The primary function of these
dealers is to “make a market” for money market securities by maintaining an
inventory from which to buy or sell. These firms are very important to the liquidity
of the money market because they ensure that sellers can readily market their
securities.

Finance Companies: Finance companies raise funds in the money markets

primarily by selling commercial paper. They then lend the funds to consumers for
the purchase of durable goods such as cars, boats, and home improvements.

Insurance Companies Property and casualty insurance companies must maintain

liquidity because of their unpredictable need for funds. For example, when
typhoons and flooding hit the country more than 1,000 homes were destroyed and
lives lost. Insurance companies paid out over a billion in benefits to policyholders.
To meet this demand for funds, the insurance companies sold some of their money
market securities to raise cash.

Pension Funds: Pension funds invest a portion of their cash in the money markets
so that they can take advantage of investment opportunities that they may identify
in the stock or bond markets. Like insurance companies, pension funds must have
sufficient liquidity to meet their obligations. However, because their obligations
are reasonably predictable, large money market security holdings are unnecessary.

Individuals: When the pandemic attack in early 2020, followed the right way with
inflation the interest rates that banks were offering on deposits became unattractive
to individual investors. At this same time, brokerage houses began promoting
money market mutual funds, which paid much higher rates. Individuals are looked
onto the money market to support their domestic needs.

 In this topic, we will study the financial instrument in money markets.  We can
gain a greater understanding of money market security characteristics and how money
market participants use them to manage their cash.
 o

Money Market Instruments

A variety of money market instruments are available to meet the diverse needs of
market participants. One security will be perfect for one investor; different security
may be best for another. In this section, we gain a greater understanding of money
market security characteristics and how money market participants use them to
manage their cash. Money Market instruments are Treasury Bills, Eurodollars,
Federal Funds,  Repurchase Agreement, Negotiable Certificates of Deposit,
Commercial paper, and Banker’s Acceptances

Treasury Bills

To finance the national debt, the Treasury Department issues a variety of debt
securities. The most widely held and most liquid security is the Treasury bill.
Treasury Bills or popularly known as T-Bills are peso-denominated short-term
fixed-income securities issued by the Republic of the Philippines through its
Bureau of Treasury.

Why invest in Treasury Bills?

 You get the interest in advance.

 With a minimum of Php 500,000, you can already enjoy high yields.
 Investing in T-bills is practically risk-free since there is a low probability
that the Philippine government will default on its own local currency debt

The Federal Reserve is the Treasury’s agent for the distribution of all government
securities. It has set up a direct purchase option that individuals may use to
purchase Treasury bills over the Internet. The government does not actually pay
interest on Treasury bills. Instead, they are issued at a discount from par (their
value at maturity). The investor’s yield comes from the increase in the value of the
security between the time it was purchased and the time it matures.

Eurodollars

Many contracts around the world call for payment in U.S. dollars due to the
dollar’s stability. For this reason, many foreign companies and governments
choose to hold dollars. Eurodollars are bank deposit liabilities denominated in U.S.
dollars but not subject to U.S. banking regulations. For the most part, banks
offering Eurodollar deposits are located outside the United States.

Federal Funds
Federal funds are short-term funds transferred (loaned or borrowed) between
financial institutions, usually for a period of one day. The term federal funds (or
fed funds) is misleading. Fed funds really have nothing to do with the federal
government. The term comes from the fact that these funds are held at the Federal
Reserve bank. The interest rate for borrowing these funds was close to the rate that
the Federal Reserve charged on discount loans.

Purpose of Fed Funds: The Federal Reserve has set minimum reserve
requirements that all banks must maintain. To meet these reserve requirements,
banks must keep a certain percentage of their total deposits with the Federal
Reserve. The main purpose of fed funds is to provide banks with an immediate
infusion of reserves. Banks can borrow directly from the Federal Reserve, but the
Fed actively discourages banks from regularly borrowing from it. One indication
of the popularity of fed funds is that on a typical day a quarter of a trillion dollars
in fed funds will change hands.  Terms for Fed Funds Fed funds are usually
overnight investments. Banks analyze their reserve position on a daily basis and
either borrow or invest in fed funds, depending on whether they have a deficit or
excess reserves.

For Example:  Suppose that a bank finds that it has Php50 million in excess
reserves. It will call its correspondent banks (banks that have reciprocal accounts)
to see if they need reserves that day. The bank will sell its excess funds to the bank
that offers the highest rate. Once an agreement has been reached, the bank with
excess funds will communicate to the Federal Reserve bank instructions to take
funds out of its account at the Fed and deposit the funds in the borrower’s account.
The next day, the funds are transferred back, and the process begins again.

Most fed funds borrowings are unsecured. Typically, the entire agreement is
established by direct communication between buyer and seller.

Repurchase Agreements
Repurchase agreements (repos) work much the same as fed funds except that non-
banks can participate. A firm can sell Treasury securities in a repurchase
agreement whereby the firm agrees to buy back the securities at a specified future
date. Most repos have a very short term, the most common being for 3 to 14 days.
There is a market, however, for one- to three-month repos.

The Use of Repurchase Agreements Government securities dealers frequently

engages in the repos. The dealer may sell the securities to a bank with the promise
to buy the securities back the next day. This makes the repo essentially a short-
term collateralized loan. Securities dealers use the repo to manage their liquidity
and to take advantage of anticipated changes in interest rates.

The Federal Reserve also uses repo in conducting monetary policy. If you
remember that the conduct of monetary policy typically requires that the Fed adjust
bank reserves on a temporary basis. To accomplish this adjustment, the Fed will
buy or sell Treasury securities in the repo market. The maturities of the Federal
Reserve repurchase agreement (repos) never exceed 15 days.

Interest Rate on Repos: Because repurchase agreements (repos) are collateralized

with Treasury securities, they are usually low-risk investments and therefore have
low-interest rates. Though rare, losses have occurred in these markets. 
Negotiable Certificates of Deposit
A negotiable certificate of deposit is bank-issued security that documents a deposit
and specifies the interest rate and the maturity date. Because a maturity date is
specified, a CD is term security as opposed to a demand deposit: Term securities
have a specified maturity date; demand deposits can be withdrawn at any time.

A negotiable CD is also called a bearer instrument. This means that whoever holds
the instrument at maturity receives the principal and interest. The CD can be
bought and sold until maturity. A round lot is the minimum quantity that can be
traded without incurring higher than normal brokerage fees. Negotiable CDs
typically have a maturity of one to four months. Some have six-month maturities,
but there is little demand for ones with longer maturities.

Commercial Paper
Commercial paper securities are unsecured promissory notes, issued by
corporations, that mature in no more than 270 days. Because these securities are
unsecured, only the largest and most creditworthy corporations issue commercial
paper. The interest rate the corporation is charged reflects the firm’s level of risk.
Terms and Issuance Commercial paper always has an original maturity of less than
270 days. This is to avoid the need to register the security issue with the Securities
and Exchange Commission. (To be exempt from SEC registration, the issue must
have an original maturity of less than 270 days and be intended for current
transactions.) The most commercial paper actually matures in 20 to 45 days. Like
T-bills, most commercial paper is issued on a discounted basis. About 60% of
commercial paper is sold directly by the issuer to the buyer. The balance is sold by
dealers in the commercial paper market. A strong secondary market for
commercial paper does not exist. A dealer will redeem commercial paper if a
purchaser has a dire need for cash, though this is generally not necessary.

Banker’s Acceptances
A banker’s acceptance is an order to pay a specified amount of money to the bearer
on a given date. Banker’s acceptances have been in use since the twelfth century.
However, they were not major money market securities until the volume of
international trade ballooned in the 1960s. They are used to finance goods that
have not yet been transferred from the seller to the buyer.
For example, suppose that Builtwell Construction Company wants to buy a
bulldozer from Komatsu in Japan. Komatsu does not want to ship the bulldozer
without being paid because Komatsu has never heard of Builtwell and realizes that
it would be difficult to collect if payment were not forthcoming. Similarly,
Builtwell is reluctant to send money to Japan before receiving the equipment. A
bank can intervene in this standoff by issuing a banker’s acceptance.

opic Introduction
 Comparing Money Market Securities

In this topic we will compare the money market securities and share many
characteristics, such as liquidity, safety, and short maturities, they all differ in
some aspects like interest rates. The discussion of money market valuation will
follow.

Learning Outcomes:

 Illustrate the money market securities and their importance.

 Be familiar with the money market valuation.
 Comparing Money Market Securities
 In the money market securities share many characteristics, such as
liquidity, safety, and short maturities, they all differ in some aspects. In
terms of Interest rates,  the money market instruments appear to move very
closely together over time. This is because all have very low risk and a short
term. They all have deep markets and so are priced competitively. In
addition, because these instruments have so many of the same risk and term
characteristics, they are close substitutes. 
 The liquidity of security refers to how quickly, easily, and cheaply it can be
converted into cash. Typically, the depth of the secondary market where the
security can be resold determines its liquidity. For example, the secondary
market for Treasury bills is extensive and well developed. As a
result, Treasury bills can be converted into cash quickly and with little cost.
By contrast, there is no well-developed secondary market for commercial
paper. Most holders of commercial paper hold the securities until maturity.
In the event that a commercial paper investor needed to sell the securities to
raise cash, it is likely that brokers would charge relatively high fees.
 In some ways, the depth of the secondary market is not as critical for
money market securities as it is for long-term securities such as stocks and
bonds. This is because money market securities are short-term to start with.
 Nevertheless, many investors desire liquidity intervention: They seek an
intermediary to provide liquidity where it did not previously exist
  
 How Money Market Securities Are Valued
 Suppose that you work for Mill Corporation and that it is your job to submit
the bid for Treasury bills this week. How would you know what price to
submit?
 Your first step would be to determine the yield that you require. Let us
assume that, based on your understanding of interest rates. you decide you
need a 2% return. To simplify our calculations, let us also assume we are
bidding on securities with a one-year maturity. We know that our Treasury
bill will pay Php1,000 when it matures, so to compute how much we will
pay today we find the present value of Php1,000.  Here we will use the
process of computing a present value:
 Example 1 The formula is PV = FV(1 + i)n
 In this example FV = Php1000, the interest rate = 0.02, and the period until
maturity is 1, so
 Price = Php1,000(1 + 0.02) =Php$980.39
 Note what happens to the price of the security as interest rates rise. Since we
are dividing by a larger number, the current price will decrease.
 For example, if interest rates rise to 3%, the value of the security would fall
to Php970.87 [Php1,000/(1.03) = Php970.87].
 This method of discounting the future maturity value back to the present is
the method used to price most money market securities.
 Money Market Securities and their Markets

MONEY
USUAL SECONDARY
MARKET ISSUER BUYER
MATURITY MARKET
SECURITIES
4, 13, and 26
Commercial and
Treasury Bills Government weeks or 1, 3, and Excellent
companies
6 months
Federal Funds Banks Banks 1 to 7 days None
Repurchase Businesses and Businesses and
1 to 15 days Good
Agreements Banks Banks
Negotiable
Large money
Certificates of Businesses 14 to 120 days Good
center banks
Deposits
Commercial Finance Businesses 1 to 270 days Poor 
Paper companies and
 businesses
Banker's
Banks Businesses 30 to 180 days Good
Acceptance
Businesses,
Eurodollar
Foreign Banks Government and 1 day to 1 year Poor
deposits
Banks

  

Summary
Money market securities are short-term instruments with an original maturity of
less than one year. These securities include Treasury bills, commercial paper,
federal funds, repurchase agreements, negotiable certificates of deposit, banker’s
acceptances, and Eurodollars.

Money market securities are used to “warehouse” funds until needed. The returns
earned on these investments are low due to their low risk and high liquidity.

Many participants in the money markets both buy and sell money market
securities. The Treasury, commercial banks, businesses, and individuals all benefit
by having access to low-risk short-term investments.

 Interest rates on all money market securities tend to follow one another closely
over time. Treasury bill returns are the lowest because they are virtually devoid of
default risk. Banker’s acceptances and negotiable certificates of deposit are next
lowest because they are backed by the creditworthiness of large money center
banks.

Definition and Overview

 Bonds are securities that represent a debt owed by the issuer to the investor.
Bonds obligate the issuer to pay a specified amount at a given date, generally
with periodic interest payments. The par, face, or maturity value of the bond
(they all mean the same thing) is the amount that the issuer must pay at
maturity. The coupon rate is the rate of interest that the issuer must pay, and
this periodic interest payment is often called the coupon payment. This rate is
usually fixed for the duration of the bond and does not fluctuate with market
interest rates. If the repayment terms of a bond are not met, the holder of a
bond has a claim on the assets of the issuer.

Treasury Notes and Bonds

The Government Treasury issues notes and bonds to finance the national debt. The
difference between a note and a bond is that notes have an original maturity of 1 to
10 years while bonds have an original maturity of 10 to 30 years. Treasury bills
mature in less than one year. The Treasury currently issues notes with 2-, 3-, 5-, 7-,
and 10-year maturities.

Federal government notes and bonds are free of default risk because the
government can always print money to pay off the debt if necessary. This does
not mean that these securities are risk-free.
 

TREASURY SECURITIES

TYPE MATURITY

Treasury Bills Less than one year

Treasury Notes 1 to 10 years

Treasury Bonds 10 to 30 years

Treasury Inflation-Protected Securities (TIPS)

The Treasury Department began (since 1997) offering an innovative bond designed
to remove inflation risk from holding treasury securities. The inflation-indexed
bonds have an interest rate that does not change throughout the term of the
security.

However, the principal amount used to compute the interest payment does change
based on the consumer price index. At maturity, the securities are redeemed at the
greater of their inflation-adjusted principal or par amount at the original issue.

The advantage of inflation-indexed securities also referred to as inflation-protected

securities, is that they give both individual and institutional investors a chance to
buy security whose value won’t be eroded by inflation. These securities can be
used by retirees who want to hold a very low-risk portfolio. They are offered by
the Treasury with maturities of 5, 10, and 30 years.

Treasury STRIPS
Separate Trading of Registered Interest and Principal Securities is commonly
called STRIPS. A STRIPS separates the periodic interest payments from the final
principal repayment. When a Treasury fixed-principal or inflation-indexed note or
bond is “stripped,” each interest payment and the principal payment becomes
separate zero-coupon security. Each component has its own identifying number
and maturity and can be held or traded separately. For example, a Treasury note
with five years remaining to maturity consists of a single principal payment at
maturity and 10 interest payments, one every six months for five years.

STRIPS are also called zero-coupon securities because the only time an investor
receives a payment during the life of each STRIPS component is when it matures.

Agency Bonds
Congress has authorized a number of agencies, also known as government-
sponsored enterprises (GSEs), to issue bonds. The government does not explicitly
guarantee agency bonds, though most investors feel that the government would not
allow the agencies to default. Issuers of agency bonds include the Student Loan
Association, the Farmers' Home Administration, the Federal Housing
Administration, the Veterans Administrations, and the Federal Land Bank.

These agencies issue bonds to raise funds that are used for purposes that Congress
has deemed to be in the national interest. For example, Student Loan Association
helps provide student loans to increase access to college. The risk-on agency bonds
are actually very low. They are usually secured by the loans that are made with the
funds raised by the bond sales. In addition, the federal agencies may use their lines
of credit with the Treasury Department should they have trouble meeting their
obligations. Finally, it is unlikely that the federal government would permit its
agencies to default on their obligations.

TOPIC OVERVIEW
 

This topic will continue the discussion of bonds:  Municipal bonds, Corporate
Bonds, and Financial Guarantees for Bonds
 mage ID : 163749039 Media Type : Stock Photo Copyright : Hilaludin Bin Abdullah Hilal

Topic Outline:
 Municipal bonds
 Corporate bonds
 Financial Guarantees for Bonds

Municipal Bonds
Municipal bonds are securities issued by local, county, and state governments. The
proceeds from these bonds are used to finance public interest projects, such as
schools, utilities, and transportation systems. Interest earned on municipal bonds
that are issued to pay for essential public projects is exempt from federal taxation.

Because investors will be satisfied with lower interest rates on tax-exempt bonds.
You can use the following equation to determine what tax-free rate of interest is
equivalent to a taxable rate:
 Equivalent tax-free rate = taxable interest rate * (1 - marginal
tax rate)
Suppose that the interest rate on a taxable corporate bond is
5% and that the marginal tax is 28%. Suppose a tax-free
municipal bond with a rate of 3.75% was available. Which
security would you choose?

Solution:

The tax-free equivalent municipal interest rate is 3.6%.

Equivalent tax@free rate = taxable interest rate * (1 - marginal

tax rate)

where:

Taxable interest rate = 0.05

Marginal tax rate = 0.28

Thus,

Equivalent tax@free rate = 0.05 * (1 - .28) = 0.036 = 3.6%

Since the tax-free municipal bond rate (3.75%) is higher than

the equivalent tax-free rate (3.6%), choose the municipal bond.

There are two types of municipal bonds: general obligation bonds and revenue
bonds. General obligation bonds do not have specific assets pledged as security or
a specific source of revenue allocated for their repayment. Instead, they are backed
by the “full faith and credit” of the issuer. This phrase means that the issuer
promises to use every resource available to repay the bond as promised. Most
general obligation bond issues must be approved by the taxpayers because the
taxing authority of the government is pledged for their repayment.

Revenue bonds, by contrast, are backed by the cash flow of a particular revenue-
generating project. For example, revenue bonds may be issued to build a toll road,
with the tolls being pledged as repayment. If the revenues are not sufficient to
repay the bonds, they may go into default, and investors may suffer losses.
 Risk in the Municipal Bond Market

Municipal bonds are not default-free. For example, a study by a Rating Company
reported a 0.63% default rate on municipal bonds. Default rates are higher during
periods when the economy is weak. Clearly, governments are not exempt from
financial distress. Unlike the federal government, local governments cannot print
money, and there are real limits on how high they can raise taxes without driving
the population away.

References:

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed., Pearson).
New York, NY, US: Pearson.

Madura, J. (2018). Financial Markets and Institutions (12th ed., Global). Stamford, CT:
Cengage Learning.

Corporate Bonds
When large corporations need to borrow funds for long periods of time, they may
issue bonds. Most corporate bonds have a face value of $1,000 and pay interest
semiannually (twice per year). Most are also callable, meaning that the issuer may
redeem the bonds prior to maturity after a specified date.

A bond indenture is a contract that states the lender’s rights and privileges and the
borrower’s obligations. Any collateral offered as security to the bondholders is also
described in the indenture.

The degree of risk varies widely among different bond issues because the risk of
default depends on the company’s health, which can be affected by a number of
variables. The interest rate on corporate bonds varies with the level of risk, Bonds
with lower risk and a higher rating (AAA being the highest) have lower interest
rates than more risky bonds (BBB). The spread between the differently rated bonds
varies over time. The spread between AAA and BBB-rated bonds has historically
averaged a little over 1%. As the financial crisis unfolded, investors seeking safety
caused the spread to hit a record 3.38% in December 2008. A bond’s interest rate
also depends on its features and characteristics

Types of Corporate Bonds

A variety of corporate bonds are available. They are usually distinguished by the
type of collateral that secures the bond and by the order in which the bond is paid
off if the firm defaults.

Secured Bonds Secured bonds are ones with collateral attached. Mortgage bonds
are used to finance a specific project. For example, a building may be the collateral
for bonds issued for its construction. In the event that the firm fails to make
payments as promised, mortgage bondholders have the right to liquidate the
property in order to be paid. Because these bonds have specific property pledged as
collateral, they are less risky than comparable unsecured bonds. As a result, they
will have a lower interest rate.

Unsecured Bonds Debentures are long-term unsecured bonds that are backed only
by the general creditworthiness of the issuer. No specific collateral is pledged to
repay the debt. In the event of default, the bondholders must go to court to seize
assets. The collateral that has been pledged to other debtors is not available to the
holders of debentures. Debentures usually have an attached contract that spells out
the terms of the bond and the responsibilities of management. The contract
attached to the debenture is called an indenture

References:

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed., Pearson).
New York, NY, US: Pearson.

Madura, J. (2018). Financial Markets and Institutions (12th ed., Global). Stamford, CT:
Cengage Learning.

Financial Guarantees for Bonds

Financially weaker security issuers frequently purchase financial guarantees to
lower the risk of their bonds. A financial guarantee ensures that the lender (bond
purchaser) will be paid both principal and interest in the event the issuer defaults. 
Large, well-known insurance companies write what are actually insurance policies
to back bond issues. With such a financial guarantee, bond buyers no longer have
to be concerned with the financial health of the bond issuer. Instead, they are
interested only in the strength of the insurer. Essentially, the credit rating of the
insurer is substituted for the credit rating of the issuer. The resulting reduction in
risk lowers the interest rate demanded by bond buyers. The issuers must pay a fee
to the insurance company for the guarantee. Financial guarantees make sense only
when the cost of the insurance is less than the interest savings that result.
 

References:

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed., Pearson).
New York, NY, US: Pearson.

Madura, J. (2018). Financial Markets and Institutions (12th ed., Global). Stamford, CT:
Cengage Learning.

Topic Overview
Stocks typically sell in public markets where bid and ask prices are readily
available and transparent. By contrast, bonds typically trade over the counter,
where transaction details can be hidden from the public. To open this market to
scrutiny, in 2002 the Securities and Trade Commission created a trade reporting
and compliance engine (TRACE). TRACE has two significant missions:

1. Rules that say which bond transactions must be publicly reported.

2. The establishment of a trading platform that makes transaction data readily
available to the public.

TRACE is under the Financial Industry Regulatory Authority (FINRA). All

companies that trade securities are required to be members of FINRA. FINRA was
formerly the National Association of Securities Dealers (NASD). In 2007 it was
created to consolidate the regulatory and oversight functions of NASD with those
of the New York Stock Exchange.

The most common violations of rules result in fines or charges related to anti-
money laundering, the distribution of securities, quality of markets, reporting and
recordkeeping, sales practices, and supervision.

TOPIC OUTLINE

 Bond Markets
 Current Yield
 Bonds Investing

Duration: 3 hours
 

References:

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed., Pearson).
New York, NY, US: Pearson.

Madura, J. (2018). Financial Markets and Institutions (12th ed., Global). Stamford, CT:
Cengage Learning.

Current Yield Calculation

 

If you buy a bond and hold it until it matures, you will earn the yield to maturity.
This represents the most accurate measure of the yield from holding a bond.

The current yield is an approximation of the yield to maturity on coupon bonds that
is often reported because it is easily calculated. It is defined as the yearly coupon
payment divided by the price of the security,

                                                                   
 

  
For Example:
What is the current yield for a bond that has a par value of
$1,000 and a coupon interest rate of 10.95%? The current
market price for the bond is $921.01.
Solution:
where:
iC = Current Yield
C = Annual payment = 0.1095 * $1,000 = $109.50
P = price of the bond = $921.01
Thus,
ic = $109.50/$921.01 = 0.1189 = 11.89%
 

References:

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed., Pearson).
New York, NY, US: Pearson.

Madura, J. (2018). Financial Markets and Institutions (12th ed., Global). Stamford, CT:
Cengage Learning.