Unit 2

Financial Markets and Instruments

Financial Investments
 Index
Key Ideas 3
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2.1. Introduction and Objectives 3

2.2. Bank Deposits 5
2.3. Short-Term Fixed-Income Assets 7
2.4. Criteria for Financial Investment Selection 10

In Depth 14

Test 15
 Key Ideas

2.1. Introduction and Objectives

When analyzing investments, we must know whether we are dealing with purely
financial investments, based on choosing those financial products best suited to
maximize profitability of liquidity or treasury surplus, which are created and exist
within a company, under the framework of risks and terms established by the Board;
and other, more complex productive investments (such as those for launching a
product, setting up a company, purchasing equipment, etc.), that we will see in the
following unit.

As we could see when dealing with concepts regarding financial operations, they are
any operation that involves an exchange in cash flows at different times in which a
company or individual disburses money in exchange for future benefits. That is why
the purchase of any financial asset (financial investment) constitutes a financial
operation, in which capital is disbursed at the start. Depending on how returns are
achieved, both for the capital and the interests, we will use the corresponding
formulas in each case (simple or compound interests), as we have seen before.

The end goal of any financial investment is the acquisition of banking products or
existing assets in financial markets, without any intention to create productivity or
to provide services, which is the case for productive investments.

There are many situations in which a company may have liquidity, capital (which, lest
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we forget, must match the benefits) which may be based on the nature of the
business or company activity (as is the case with insurance companies), or by
generating cash flows that the company does not allocate to making new productive
investments (increasing the company’s output, purchasing equipment, cementing a
business abroad, etc.), nor does it allocate it to paying dividends to shareholders.

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 That is why, at times, companies play an essential role in financial markets, not from
a financing aspect, as an alternative to bank loans, but through liquidity surplus
management by acquiring other financial instruments issued by other economic
entities (private companies and the public sector), through the trading of negotiable
instruments (such as promissory notes, bonds and stocks), and offering banking
products (checking accounts, demand deposits, term deposits, etc.), which will allow
banking entities to provide loans to their client portfolio.

These assets therefore constitute investment instruments for the investing

company, while also representing the issuing company’s financing products. They can
sometimes be mistaken for one another, as they refer to the same instrument, but
they need to be set apart in terms of accounting and status as regards the
company’s balance. The difference is that, for the investing company, the financial
asset is located in the assets side of their balance, whereas for the issuing company
it is a financial asset located in the liabilities side of their balance.

These are financial investments that represent a number of financial instruments

and assets which are traded in financial markets, and that allow a company to
increase their wealth or overall returns, thanks to the profitability gained from them,
the restatement of the price of the traded product, as well as its inherent profitability.

In the interest that maintaining that liquidity does not imply a lower overall
profitability of the company’s asset, one must find financial assets that can be
expected not to decrease in returns during the stipulated term.

If the company’s fixed asset’s return was, for example, 10%, keeping a high liquidity
on the asset, invested in financial assets at a constant rate with returns of 2% would
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mean, a decrease in the company’s overall returns. This is why these investments
must be seen as merely temporary, and therefore, when selecting financial assets,
our options are limited to those products with short-term maturity dates, adapting
requirements to fixed dates according to cash-flow forecasts or to the company’s
treasury department, and with risk limits established by the Board.

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 Since there is a unit dedicated to Financial Markets and Instruments, where we will
see their functioning in full detail, as well as the features of every existing financial
asset, in this unit we will only be dealing briefly with those products typically linked
to liquidity management, short-term financial assets.

While the offer of products from Banking Entities can be quite large, since they
include deposits (checking accounts, demand deposits, or term deposits) as well as
structured products whose profitability will depend on the evolution of some index
(inflation, IBEX, Dow Jones, etc.) or another financial variable (EUR/USD, oil, etc.), we
will focus on explaining products related to financial markets, such as promissory
notes or repos, which is why we will give a brief description of them in the context in
which they are traded, i.e. Money Markets.

2.2. Bank Deposits

Bank deposits are products in which an investor hands over money to the banking
entity for safekeeping, with the intention that it be returned or refunded under the
conditions agreed to by both parties, plus interests.

 Checking accounts. These are bank accounts that let the investor or owner
conduct any necessary operation in the process of performing obligations and
exercising rights before a third party, such as settling payrolls, direct debits,
transfers, payment of credit or debit cards, liquidity availability though branches
and ATMs, loan account charges, check deposits, etc.
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That is to say, it is the financial vehicle for companies to conduct their day to day
transactions. They tend to manage low amounts but it is true that, over the past
few years, higher profitability has been registered as a result of the so-called
liabilities war among entities in need of liquidity after the financial crisis.

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  Demand deposits. Allow funds to be accessed immediately, just like checking
accounts, through branches, ATMs, or through checks or transfers, but they don’t
have the operability of checking accounts, which is why they handle larger
amounts. Interest rates are usually offered according to the average balance that
the client has over an established period. It is not a common asset for companies.

 Term deposits or time deposits. The condition for using this product is that the
investor may not get their money back until the deposit’s maturity date. The ability
to do so may be contractually agreed to, but it usually carries some type of penalty
fee, although this guarantees access to the cash. It is the most frequent product
used for liquidity placement by companies in the banking context.

Entities have tried to increase the appeal of these products through the
introduction of different features, with interest rates matching certain indexes, or
by the combination of fixed rates plus a variable rate, based on the evolution of
some other financial variable.

 Market-linked deposits or structured products. These are financial deposits

whose value is determined by the evolution of a certain index established within
the contract (Ibex-35, a particular company’s share price, Euribor, etc.) as a whole,
or by the sum of a fixed amount (lower than one might get from a term deposit)
with another variable, depending on the reference index.

They can usually guarantee the investments nominal value, although that is not
always the case, depending on what amount is being sought in case the reference
index reaches certain established levels.
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Unit 2. Key Ideas
 2.3. Short-Term Fixed-Income Assets

As for the financial assets that exist in short-term financial markets, and that are
used to place treasury surplus, we will treat them as separate instruments to those
we have previously analyzed, given that their creation, offerors, sales channels and
functioning, are very different from those we have seen before and from those that
we will analyze in more depth in the unit called “Financial Markets”.

Among the most common assets used when making short-term financial
investments, we can find the following:

Treasury Bills

These are securities issued by the Spanish Public Treasury (Directorate-General for
the Treasury) in the short term, via book entry.

 The minimum amount per issuance is 1,000 euro and its multiples.

 They are issued at a discount. The purchase price is lower than the redemption
value that the investor will receive back, which matches the nominal value (1,000
euro).

 The difference between purchase price and redemption value will determine the
return or interest rate gained from the asset.

 Normal issuing terms: 3, 6, 12 and 18 months.

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 Issuing is done through public auction.

Treasury Bills are one of the most popular financial assets and are frequently used
for liquidity investments by companies for short-term maturities. However, there

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Unit 2. Key Ideas
 are times when the maturities required by the investor when investing these assets
does not match with existing or applicable maturities at that moment. This can be
solved through what is known as repos.

Repos (or repurchase agreements) are an investment of a public fixed-income asset

(Treasury Bonds) by which the financial middle-man (a bank or another entity) sell
their assets to the investor under a pact of repurchase. The key features of this asset
are:

 From an economic point of view, it functions as a guaranteed loan.

 From a legal point of view, it is different from a loan in that the regulatory
framework is different. The borrower (securities offeror) is called the seller, while
the creditor (who takes the security or asset) is called the buyer.

 For the seller, it is a temporary transfer of the asset, whereas for the buyer it is a
temporary acquisition of the asset.

 All conditions are established beforehand, when signing the repo agreement: the
starting asking price, repo rate (profitability of the investment until the agreed-
upon maturity date), date and repurchase price of the value or asset.

For example: Bank X sells Treasury Bills to its portfolio at 3.5% with a maturity term
of 45 days to an investor for 300,000 euro. What will be the price of repurchase?

 Starting price: 300,000 euro

Repurchase price on maturity (45 days): ?
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 Agreed return: 3.5%

 Answer. Price = 300,000 (1 + 0.035x45/360) = 301,312.50

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Unit 2. Key Ideas
 Company promissory notes

These are assets issued by large companies, most of them of proven solvency, that
use them as a short-term financing formula, and whose key features are:

 They are securities issued at a discount, whose profitability lies in the difference
between the purchase price and the promissory note’s nominal value which will
be payed on maturity or at the amortization date.

 They are securities issued at a discount, with an implicit return.

 They are short-term securities. Around 85% of all promissory notes are issued to
terms shorter than six months, and rarely go over 18 months. The most
commonly-used terms are 1, 3, 6, 12 and 18 months.

 There are several types of issuances:

• Planned issuances which include:

 Amount to issue.

 Length of the issuing program.

 Issuing frequency and timetables.

 Placement terms.
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 Manner of issuance: they can be numbered, in which case the features of

the issuance are set in advance, or tailor-made, which adapt to the investor’s
needs, within the range of options of the program.

• Unplanned: standalone issuances of tailor-made promissory notes.

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 After analyzing the aforementioned investment instruments, it is worth mentioning
that, despite being used frequently by companies for liquidity management, they are
not the only ones. There can also be situations where somewhat more complex
products are used, or which have longer terms, or perhaps higher risks than those
mentioned, depending on the investor’s characteristics or risk profile, portfolio
diversification objectives, or operational possibilities regarding terms that may
require a specific amount of liquidity.

2.4. Criteria for Financial Investment Selection

When a company is setting criteria for the selection of financial investments, it is

crucial to create a document-based framework which establishes, very concisely and
specifically, the steps to follow whenever the company has liquidity or treasury
surplus, so as to avoid making any wrong decisions, or taking greater risks than is
acceptable, within the company’s context and under the guidelines set forth by the
Board or senior management.

This means that the company will use estimates to try to determine the current
financial environment, existing risk-rating standards and available prospects, steps
to follow regarding placing investments of certain volumes that depend on
alternative profiles of greater or smaller risk aversion and that adopt different
strategies, both for portfolio building and portfolio management.

Once the overall strategy has been laid out, we will create a guide aimed at improving
the investment process at different levels and/or stages, meeting the chosen
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risk/profitability criteria.

In regards to selecting investment alternatives, the steps to follow must be based on

the following concepts:

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Unit 2. Key Ideas
  Macroeconomic environment: a constant analysis of the current situation of each
region’s main macroeconomic situation as well as the main prospects offered by
the market, official international bodies, and well-known private analysts.

 Financial markets: evolution, current situation and prospects of the main fixed-
income financial markets, equity markets, money markets and factor markets. In
this section, we will dedicate to financial instruments prone to be part of
portfolios, including both a general and technical analysis.

 Defining risk profiles: defining critical variables that will determine the three basic
risk profiles: conservative, moderate and aggressive. The goal is to define them
and identify oneself with one of them.

 Defining investment instruments: once the profiles have been established one
must classify financial products, thus determining which can be incorporated to
each investment portfolio.

 Making generic portfolios: assets and investment instruments will be allocated

according to the chosen strategies, depending on the risk profile and time horizon
of the selected investment, with the aim of maximizing profitability:

• Conservative profile portfolio.

• Moderate profile portfolio.
• Aggressive profile portfolio.

Each portfolio’s makeup will be analyzed based on the nature of the instruments that
comprise it. We can show the process of establishing the basis for selecting
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investment alternatives graphically like this:

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Unit 2. Key Ideas
 When defining the portfolio’s composition, it is crucial to define which variables will
be considered to establish investment criteria.

These variables can be exogenous, such as the time horizon, region or area, or
endogenous, such as sensitivity measures. A combination of these will define the
steps to follow.

Because we are designing the makeup of an investment portfolio, which is a product

composed of other products, there is an enormous range of offer of available
instruments. Instruments will be classified according to a series of features that will
allow us to identify them and determining which strategy they correspond to. By way
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of example, and besides the classification linked to the kind of market where it is
traded (be it money markets or capital markets), we can express the inherent risks
to each product as shown in the graph below:

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Unit 2. Key Ideas
 Then watch the following video of investment Decisions:
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Unit 2. Key Ideas
 In Depth
SEC

https://www.investopedia.com/terms/s/sec.asp

Investopia website featuring a video article about the SEC and its importance in the US
financial system. What Is the Securities and Exchange Commission (SEC)?

Investment Products

https://www.investor.gov/introduction-investing/investing-basics/investment-
products

Manual of the US financial regulator, National Securities Market Commission, on a brief

introduction to the financial system, and financial investment alternatives for the
placement of liquidity in companies.
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Financial Markets and Instruments

Unit 2. In Depth 14
 Test
1. Which of the following assets poses a higher risk?
A. Financial promissory note from BBVA.
B. Term deposit from BBVA.
C. Treasury Bond issued by the Spanish government.
D. Asset issued by a company without a credit rating.

2. 2. Which banking product will yield higher returns?

A. Checking account.
B. Demand deposit.
C. Term deposit.
D. All of the above.

3. The minimum asking price for a Treasury Bill is:

A. 1,000 euro.
B. 5,000 euro.
C. 10,000 euro.
D. There is no minimum.

4. The main features of financial assets are:

A. Maturity, liquidity, profitability.
B. Maturity, profitability, risk.
C. Profitability and risk.
D. Liquidity, risk and profitability.
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5. Repos are:
A. Instruments to cover against insurance rate risks.
B. Purchasing stocks without owner.
C. A purchase agreement of a public debt asset at preestablished dates.
D. Bonds and obligations of the treasury.

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Unit 2. Test
 6. Which of these instruments do not have a fixed interest rate at the time they are
purchased?
A. Checking account.
B. Treasury Bills.
C. Financial promissory notes.
D. Structured products.

7. Derivatives have:
A. High risk.
B. High to moderate risk.
C. Moderate risk.
D. Low risk.

8. Which of these elements is most relevant when acquiring an asset?

A. Its maturity term.
B. Its profitability.
C. Its risk.
D. All of the above.

9. The approximate maximum maturity term for a promissory note is:

A. Two months.
B. Five years.
C. Twelve months.
D. Eighteen months.

10. Which of the following instruments is not usually used by companies?

A. Checking account.
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B. Treasury Bills.
C. Financial promissory notes.
D. Demand deposits.

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Unit 2. Test