Unit 1: Introduction to Financial Management

Lesson 1.4

Financial Instruments
Contents

Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 5

Cash Instruments 6
Securities 6
Deposits and Loans 9
Derivative Instruments 10
Forward Contracts 10
Futures Contracts 11
Options 12
Swap 14
Foreign Exchange Instruments 16
Spot Currency 16
Outright Forward 16
Currency Swap 17

Case Study 18

Keep in Mind 19

Try This 20

Practice Your Skills 21

Challenge Yourself 22

Bibliography 23
Unit 1: Introduction to Financial Management

Lesson 1.4

Financial Instruments

Introduction

Suppose you are lending a significant amount of money to someone, and you agreed that
the person would pay monthly until the principal amount is settled. Would you need proof
that this person owes you money and that you have agreed on a payment plan?

Most people who find themselves in a similar situation would want to have a written
agreement. When businesses borrow money from an individual or an institution, a real or
virtual document serves as proof of their transaction. Such a document represents the legal
agreement between parties concerning assets of value. This document is called a financial
instrument.

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In the world of business, the value of assets continuously changes. The image shown is a
stock chart that shows the fluctuations in a financial asset’s value. To protect the entities
engaged in the trade of assets, different financial instruments were created. In this lesson,
you will learn about these instruments and their uses.

Learning Objectives DepEd Competency

At the end of this lesson, you should be able to

● Compare and contrast the varied
do the following:
financial instruments
● Define financial instruments. (ABM_BF12-IIIa-4).

● Compare and contrast the varied

financial instruments.
● Determine the financial instrument used
in a business transaction.
● Explain the importance of financial
instruments in the financial system.

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Quick Look

The Debtor and the Creditor

Instruction:
1. Form a group of three or four members.
2. Discuss the problem situation given below.

Company A, the debtor with Address 1, made a business loan letter request to
Company B. Company A attached the documents that show their credibility as a
debtor.

Company B, the creditor with Address 2, after examining the documents and
conducting financial investigation about company A, approved the loan request.

Both parties agreed to a loan amounting to ₱600,000 carrying a simple interest of

12%, payable monthly for a year. They also agreed to include finance charges
amounting to 1% of the loan. They also agreed that either party can cancel the
agreement any time with a 30-day prior notice to the other party.

Today both parties executed a Finance Agreement. The first payment shall begin 60
days after the execution of the agreement. Bank deposits shall be the method of
payments through Bank Account No.: 0123-456-789.

3. Prepare a Finance Agreement for two parties. You may refer to the sample form
provided. You may also refer to the computation of finance charges, interest, and
total payments, and monthly payments.

Sample Finance Agreement Template

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Solution:
Given: Amount of loan is ₱ 600,000
Interest rate: 12%
Computation:
𝐹𝑖𝑛𝑎𝑛𝑐𝑒 𝐶ℎ𝑎𝑟𝑔𝑒𝑠 = ₱600, 000(0. 01) = ₱6, 000
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱600, 000(0. 12) = ₱72, 000
𝑇𝑜𝑡𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = ₱600, 000 + ₱6, 000 + ₱72, 000 = ₱678, 000
₱678,000
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = 12
= ₱56, 500

Questions to Ponder
1. How do creditors and debtors differ?
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2. What are your important realizations and insights from the activity?
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3. Looking at yourself, four or five years from now, in a corporate world, who do you
want to be, the creditor or the debtor? Why?
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Learn the Basics

In the previous lessons, you have learned that the financial system facilitates the flow of
funds and capital between debtors and creditors. They can do this by transacting directly or
through financial institutions. The figure shown below shows the flow of funds between
them:

Figure 1. The financial system facilitates the flow of funds and capital.

In the diagram, you can see the movement of funds within the system. These funds and
capital are exchanged using financial instruments.

The form you have just accomplished in the activity is a kind of financial instrument. There
are several types of financial instruments that will satisfy the needs of the investors,
creditors, and debtors or borrowers. Do you now have the idea of what the other financial
instruments could be?

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Essential Questions

What instrument is the most profitable for investment?

A financial instrument is an agreement or a contract between parties, which is an asset to

one party and a liability to the other party. As an asset, financial instruments hold capital
and can be created, liquidated, revised, and traded in the market. The financial instruments
can be in the form of cheques, cash, forex (currency), shares, stocks, futures, options,
bonds, etc. Financial instruments can be categorized as shown in Figure 2.

Figure 2. Categories of Financial Instruments

Cash Instruments
Cash Instruments are instruments, whose value is directly established and perceived by
the market1. Cash instruments can be securities, deposits and loans.

Securities
Securities are cash instruments that are fungible or interchangeable with other assets of
similar value. The most common securities are stocks and bonds.

Stocks are also referred to as equity securities. It entitles the holder to have a part
ownership of a publicly listed company. Equity securities are offered when a company
declares an Initial Public Offering (IPO), which means that the company will start selling
stocks on the financial market.

1
Market- (noun) system or institution that facilitates trade and enables the distribution and allocation of resources

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Stocks are considered long-term investments. Investors buy stocks because:

● The stock’s price can increase in value over time.
● The company pays dividends to stockholders, although some companies may not
give dividends but offer good interest rates.
● Stockholders participate in annual company's general meetings and have access to
the company's reports and relevant information. However, they have no right when it
comes to decision making but can influence it directly.

What are some companies or groups in the Philippines that offer stocks today?

Company List on Philippine Stock Exchange

Philippine Stock Exchange. “Company list.” Accessed February
9, 2022. https://edge.pse.com.ph/companyDirectory/form.do.

After the IPO and once the company’s stocks are in the market, investors can now buy or
sell the stocks to other investors. In buying and selling stocks, stockbrokers handle the stock
trading. By selling the stocks, the company can expand and increase its capital and repay its
liabilities. Investors, on the other hand, earn money from the profits of the company
through dividends.

Figure 3. How Stocks Work

Bonds, also known as debt securities, are cash instruments offered to investors by the
company or the government to fund the company’s project or activity. When investors buy
bonds, they are financing the company to implement its project and pay off their liabilities.
The investors are then entitled to get their money back with interest at the bond’s maturity
date.

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Investors buy bonds because:

● Bonds are affordable, tradable and liquid (although less liquid than equities). They can
be bought and sold in the open market for higher rates.
● Bond holders get steady income through coupons at predetermined dates.
● Bond holders are priority when it comes to the liquidation process.

Bonds are classified into four and these are municipal bonds, agency bonds, corporate
bonds, and government bonds.

a. Municipal bonds are issued by the national or local government units, and other
government institutions to finance local infrastructures such as building schools,
hospitals, city libraries, highways and railroads, and sewerage systems. Some
municipal bonds render tax-free coupons (annual interest payments) for investors.

b. Agency bonds are bonds that are issued by various government agencies like
Mutual Funds and Unit Investment Trust Funds (UITF). UITFs are agency bonds
regulated by the Bangko Sentral ng Pilipinas (BSP) but are offered and managed by
banks.

c. Corporate Bonds are offered by private corporations or companies to the public

and investor institutions to raise their capital. Corporate bonds are actually debt
obligations or IOUs2 that give the bond holders higher-ranking positions when it
comes to liquidation of assets (in extreme cases of bankruptcy) but do not give the
holders the ownership interests of the company unlike in equity.

d. Government bonds are bonds issued by the country’s treasury. In the Philippines,
the Bureau of Treasury (BTr) issues two government securities: the Peso and US
Dollar denominated securities.
The money invested in government bonds are commonly used in infrastructures and
military projects. Infrastractures include telecommunication systems, transportation
systems, sewage systems, and housing.

2
IOU - (abbreviation) phonetic acronym of the words “I owe you”

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Closer Look

Btr Website as Bond Hubs

The Green Land Company owns land and would like to build townhouses
in the city. The company issues bonds to the public through the BTr to
fund their project rather than make bank loans.

The investors who visit the BTr websites can then accomplish the BTr’s
requirement to be included in the bond offerings and to finalize the bond
contract.

In this contract the investors finance such a project and expect to be

remunerated through interest.

Deposits and Loans

Deposits and loans are considered as cash instruments because they constitute monetary
value and are done with some type of agreement or contract between the parties.

Cash deposit is the money that people put into their bank account, savings, current or
checking account, usually for security. The money deposited becomes the asset of the bank,
although the bank is liable for returning the money back based on the agreed terms and
conditions. Cash deposits can be done in person at the bank, by the automated teller
machine (ATM), or via online banking.

Cash loan is borrowing money from an individual, institution or company with an

agreement of paying back the full amount with interest at a certain period of time. Aside
from banks, the credit union and savings and loan associations also offer cash loans.

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Check Your Progress

Differentiate equity-based and debt-based securities.

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Derivative Instruments
Derivative instruments are financial instruments whose monetary value is derived or
determined from another financial asset, called the underlying assets. Examples of
underlying assets are bonds, stocks, and currency.

The price of stocks and other basic goods fluctuate and are affected by different factors.
These factors are sometimes caused by natural disasters which could not be controlled.
Bonds and currencies are also prone to interest rate risk and political risk. Such situations
affect the prices of these underlying assets, and in turn affects the derivative market.

There are four common derivatives namely forwards, futures, options, and swaps.

Forward Contracts
A forward contract is an agreement between two parties involving custom-made derivatives
that take place at the end of the contract at a specified price. It is done over-the-counter
(OTC), a decentralized market in which trading is done directly between the two parties
without a broker or central exchange.

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Closer Look

Locking in the Price of Future Purchase

A forward contract was made between two parties, wheat crop farmers
and a company producing bread. On the day of the contract, April 2021 the
wheat price was ₱11,627.72/metric ton which both parties agreed on. This
contract protects both parties against price variability which may be due to
weather conditions or disaster. The forward contract locks in the price of
the wheat as agreed by the two parties. With this, the manufacturer of
bread controls their production cost and the farmers are assured that they
have a buyer of their crop on the harvest time as long as they meet the
forward contract’s specifications and deliver the wheat on the agreed date.
The agreed-upon price is called the forward price or the delivery price.

Futures Contracts
Futures contracts or simply futures are financial derivatives that compel the seller to sell
and the buyer to buy an asset at a predefined future date and price. Futures are
standardized for quality and quantity to facilitate trading exchange, unlike the forward
contracts. The forward and future contracts are similar when it comes to lock-in price. The
forwards are transacted OTC and the prices are custom-made, on the other hand the futures
are facilitated under a central exchange market or broker and the prices are regulated by a
trading commission.

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Closer Look

A Promise to Buy in the Future

Suppose ION Company produces electronic products like cellphones,
laptops, cameras, etc, and need gold in their production. The company
then can enter into a future contract with the Mines Company that
produces gold to buy the product at the current price and makes initial
payment to ensure that their production will not be affected by the
fluctuating prices of gold. At the end of the contract, the buyer, ION
Company, is obliged to buy the specified quality and quantity of the gold
product and the seller, Mines Company, is obligated to sell the said gold.

Options
Options are derivative financial instruments where the parties make an agreement to
negotiate an asset at a specified price within the given time interval or before the future
date. Option owners are given the right either to buy or sell, but not an obligation, the asset
at the exercise price3 within the timeframe. When the option holder buys the asset, then the
option is said to be a call option and when the holder sells the asset it is called the put
option.

An option will have no value and is ineffective if it reaches the expiry date without exercising
the option. Options can be OTC or an exchange-traded, not going through a broker,
derivative applied to provide the investors with the way to venture into the up and down
movements of the market and help them manage the possibility of unfavorable market
conditions and eventually make profits.

3
Exercise price - (noun) also known as the strike price of the underlying security that can be either purchased or
sold.

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Closer Look

An Option to Buy
An option holder presumes that the asset will be higher than the exercise
price or the strike price before the expiry date of the contract. On Date 1
the option holder bought the option contract of 100 shares at ₱500/share
with a strike price of ₱700. He then pays
500 × 100 = 50, 000Pesos

He expected that the price would go up to ₱1500/share, and on Date 2

before the expiry date, he executed the call option and bought 100 shares
at ₱700/share (strike price). He pays ₱70,000
700 × 100 = 70, 000

The option holder can sell the option since the price is ₱1500/share. He
then gets:
1500shares× ₱100 =₱ 150, 000

Subtract the amount at strike price, ₱70,000 and the original amount,
₱50,000:
₱150, 000 − 70, 000 − 50, 000 = 30, 000
He then gets a profit of ₱30,000.

If he executes a put option and sells the 100 shares at the strike price of
₱700/share. He then gets only ₱20,000:
70, 000 − 50, 000 = 20, 000

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Swap
Swap is a derivative financial instrument in which the two parties agree to exchange or swap
financial instruments such as cash flows, interest rate, derivatives or securities. Swaps are
OTC contracts between two parties or financial institutions that are custom-made to suit the
needs of both parties.

Closer Look

Exchanging Interest Rates

The NEO Company is a small and beginner enterprise company with
uncertain finances and a low credit rating. On the other hand, the PRO
Company is a more established company than NEO Company and has a
higher credit rating. Both companies received a loan for ₱10,000,000,
however NEO Company received a variable interest rate of 8% and the PRO
Company received a fixed interest rate of 7% only, because of its
company’s stability. The companies can exchange interest rates through a
swap contract for a predetermined period of time. After swapping, the NEO
Company now has the lower fixed interest rate of 7% and the PRO
Company has now the 8% variable interest rate. But because of the stability
and financial credibility of the PRO Company the variable interest rate of
the loan can go down to 6%. Now the two companies can benefit from the
new lower interest rates because of the swap contract.

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Table 1 Comparison Between the Derivatives

Forward Futures Option Swap

Obligation The parties The buyer is No Both parties are

agreed to buy obliged to buy and obligations expected to
and sell the the seller is obliged on the fulfill each
asset on the to sell the asset on parties to others’
agreed the agreed future buy or sell obligation on the
predefined date. date. the asset. swap contracts.

Payment No initial An initial margin The buyer Both parties pay

payment is payment is has to pay as written in the
required. required. the swap contract.
premium.

Date of On the date On the date agreed Can execute On the date of
Execution agreed upon by upon by the the contract the swap.
the parties. parties. anytime
before the
expiry date.

Market OTC and the Central- exchange Some are OTC and the
Regulations price is traded and the OTC and price is
custom-made. price is regulated some are custom-made.
by the trading exchange
commission. -traded.

Risk High Low counterparty Reduces the High

counterparty risk-could bring potential counterparty
risk - parties unpredictable loss and risk - parties
may default on profit or loss. could give may default on
the obligations. unpredictab the obligations.
le gains.

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Foreign Exchange Instruments

Foreign Exchange or simply called FX or Forex is an OTC market where investors buy and
sell currency and exchange them for another currency. As the values of the currency always
change, investors must always be on the lookout for variations of the prices to have better
trading. In the Philippines forex trading is regulated by the Securities and Exchange
Commission (SEC). There are three currency agreements, namely, spot, outright forward, and
currency swap.

Spot Currency
The spot currency agreement or transaction refers to the retail or sale of the foreign
currency on “the same day” delivery or the day after the specified spot date or for some 1 to
2 business days. The exchange rate of the currency is based on the current exchange rate
and is done on the OTC. Spot trading is not only done in currency but also in other financial
instruments.

Closer Look

Buying Items From Other Countries Online

I would like to purchase a sale item online in USD currency. The sale is
only offered until the next day. I need the money in USD and should make
a currency spot transaction now so it will be in my account the next day
and catch up with the sale.

Outright Forward
The outright forward agreement, sometimes called currency forward, is a contract
between two parties that defines and locks in the currency rate and delivery date far off the
spot date. Such an instrument is a way to protect the investors and the traders in fluctuating
exchange currency rates.

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Closer Look

Locking in the Currency Rate for a Future Purchase

A production company from the US buys imported products from Japan
and both parties agree to make two transactions. The two merchants
entered into a spot contract on their first transaction and an outright
forward contract for the second transaction where the currency rate and
date are locked in with the agreed currency rate of USD and JPY and date.
With this instrument the two parties and even the investors are protected
from the fluctuating currency rates.

Currency Swap
Currency swap also known as FX or FOREX swap is an agreement in which the two foreign
parties exchange currency including the amount of equal value and currency rate.

Closer Look

Swapping Currencies
A Canadian Company X needs 10,000,000 CHF (Swiss franc) to buy goods
from Switzerland for their garment factory. A Swiss Company Y needs
11,000,000 CAD (Canadian dollars) to fund their project in Canada. Since
Company X can produce 11,000,000 CAD, and they need 10,000.000 CHF
and the currency rate is 1 CHF = 1.1 CAD, the two companies can enter
into a foreign currency swap contract through an OTC market.

Today, at the start of the contract, Company X receives 10,000,000 CHF

from Company Y which receives 11,000,000 CAD from Company X.

In a year at the end of the contract, since both agreed that the rate will be
1 CHF = 1.11 CAD, as stated in their contract, Company X will return the
10,000,000 CHF to Company Y which will return 1.11 x 10,000,000=

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11,100,000 CAD from Company X.

Rather than making loans through the banks which require several fees,
in this instrument the two companies can save several amounts of
money. The currency rates may be higher or lower, but the companies
are not much affected by the change since they already used the money
and may have incurred profits before the end of the contract.

Check Your Progress

What are the four derivatives? Why are they called derivatives?
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Case Study

Solutions in Building and Improving Homes

The study focused on Project Dungganon (a Hiligaynon word meaning
“honorable”) which is the flagship project of Negros Women for Tomorrow
Foundation, Inc. (NWTF) that offers group-based loans utilizing the Grameen
lending methodology. The said project provides access to collateral-free
credit and training and aims to assist the deprived women from rural
communities of Negros and help them start their own business and become
a self-dependent individual to improve their living conditions. The project
Dungganon tapped several institutions like the Microfinance Council of the
Philippines, Inc (MCPI) which provides microfinance institutions that can help
the project progress. The Terwilliger Center, through a Credit Suisse APAC
Foundation grant, worked closely with NWTF to develop a housing product.
The partnership’s objective was to introduce a client-centric housing finance
solution that addresses the unaffordability for low-income families.

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In summary, this study tackles on how the simple household individual can
benefit from the private and government institutions by applying the
financial instruments available in the Philippines.

Improving access to Housing Microfinance Solutions Among

Low-income Households in the Philippines
Bea Parungo, Jitendra Balani, and Naeem Razwani,
“Improving access to Housing Microfinance Solutions Among
Low-income Households in the Philippines,” FinDev Gateway
(Terwilliger Center for Innovation in Shelter, October 2020),
https://www.findevgateway.org/case-study/2020/10/improvin
g-accsess-housing-microfinance-solutions-among-low-income
-households, last accessed on November 6, 2021.

Keep in Mind

● A financial instrument is an agreement or a contract between parties or individuals

which is an asset to one party and a liability to the other party. As an asset it holds
capital and can be created, liquidated, revised, and traded to market. The financial
instruments can be in the form of cheques, cash, forex (currency), shares, stocks,
futures, options, bonds, etc.
● There are three types of financial instruments: cash instruments, derivative
instruments, and foreign exchange instruments.

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