KYLA R.

DAYAWON BSA-2A
FINANCIAL MARKETS AND INSTITUTIONS

REVIEW QUESTIONS (CHAPTER 8)

Money Markets
1. Explain the phrase “money market”.
- The money market refers to the network of corporations, financial institutions, investors, and
governments which deal with the flow of short-term capital. When a business needs a cash for a
couple of months until big payment arrives, or when a government tries to meet its payroll in the
face of big seasonal fluctuations in tax receipts, the short-term liquidity transactions occur in money
market.

2. Describe how money market mechanism works to bring providers and users of short-term fund together.
- The money markets exists to provide the loans that financial institutions and governments need to
carry out their day-to-day operations. For instance bank may sometimes need to borrow in the short-
term to fulfil their obligations to their customers and they use the money market to do so. For
example, most deposits accounts have a relatively short notice period and allow customers access
money either immediately, or within a few days or weeks. Because of this short notice period,
banks cannot make long-term commitments with all the money they hold on deposit. They need to
ensure that a proportion of it is liquid (easily accessible) in market terms.

3. Explain how banks, companies and investors use financial instruments in the money market.
- Banks. If demand for long-term loans and mortgages is not covered by deposits from savings
accounts, bank may then issue certificates of deposit, with a set interest rate and fixed-term maturity
up to five years.
- Companies. When companies need to raise money to cover their payroll or running costs, they may
issue commercial paper- short-term, unsecured loans P 100,000 or more that mature within 1-9
months.
- Investors. Individuals seeking to invest large sums of money at relatively risk may invest in
financial instruments. Sums of less than P 50,000 can be invested in money market funds.

4. Give and describe the types of money-market instruments.

 Commercial Paper- Short-term debt obligation of private-sector firm or a government sponsored

corporation. Only Companies with good credit ratings issue commercial paper because investors
are reluctant to bring the debt of financially compromised companies. They tend to be issued by
highly rated banks and are traded in similar way to securities.
 Banker’s Acceptance- the main way for firms to raise short-term funds in the money markets. An
Acceptance is a promissory note issued by a non-financial firm to a bank in return for a loan. The
bank resells the note in the money market at a discount and guarantees payment. Acceptances
usually have a maturity of less than six months.
 Treasury Bills- often referred to as T-Bills, are securities with a maturity of one year or less, issued
by the national governments. Treasury bills issued by a government in its own currency are
generally considered the safest of all possible investment in that currency. Such securities account
for a larger share money market trading than any other type of instrument.
 Government Agency Notes- National Government and Government-Sponsored corporations are
heavy borrowers in the money markets in many countries. These include entities such as
Development banks, housing finance corporations, education lending agencies, and agricultural
finance.
 Local Government Notes- Local Government Notes are issued by, provincial or local governments
and by agencies of these governments such as schools authorities and transport commissions. The
ability of the government at this level to issue money-market securities varies directly from country
to country. In some cases, the approval of National Authorities is required; in other, local agencies
are allowed to borrow only from banks and cannot enter the money markets.
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  Interbank Loans- Loans extended from one bank to another with which it has no affiliation are
called interbank loans. Many of these loans are across international boundaries and are used by the
borrowing institution to re-lend to its own customers.
 Time Deposits- Another name for securities of deposits that cannot be withdrawn without penalty
before a specified date. Although time deposits may last for as long as five years, those with terms
less than one year compete with other money market instrument. Time deposits with terms as 30
days are common. Large time deposits are often used by corporations, government and money
market funds to invest cash for brief periods.
 Repos- Repurchase agreement known as repos play a critical role in money markets. They serve to
keep the markets high liquid, which in turn ensures, that there will be a constant supply of buyers
for new market instruments.

Capital Markets
5. Explain what capital market is.
- Capital Markets is a financial market in which longer term debt (original maturity of one year or
greater) and equity instruments are traded. Capital market securities include bonds, stocks and
mortgages. Capital market securities are often held by financial intermediaries such as insurance
companies and pension funds which have a little uncertainty about the amount of funds tehys will
have available in the future.

6. Who are primary issuers of capital market securities?

- Primary issuers are:
1. National and Local Government, and
2. Corporations.

7. What does Capital trading market occur?

- Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks and bonds are introduced. Investment funds, corporations and
individual investors can all purchase securities offered in primary market.
- Capital markets also have a well- developed secondary markets. A secondary market is where the
sale of previously issued securities takes place, and it is important because most investors plan to
sell long-term bonds before they reach maturity and eventually sell their holdings of stocks as well.

8. What are the bonds? How are they traded?

- A bond is a long-term promissory note issued by affirm. A bond certificate is the tangible evidence
of debt issued by a corporation or a governmental body and represents a loans made by the investors
to the issuer.
- The initial primary sale of corporate bond issues occurs either through a public offering, using an
investment bank serving as an underwriter or through a private placement to a small group of
investors (often financial institutions). The investment banks guarantees the firm a price for newly
issued bond by buying the whole issue at a fixed price. The investment bank then seeks to resell
these securities to investors into a higher price. As a result, the investment bank takes risk that it
may not be able to resell the securities to investors in a higher price. Then firm’s bond value
suddenly falls due to an unexpected change in rates or negative information being released about
the issuing firm. If this occurs, the investment banks may takes a loss on its securities underwriting.
However the bond issuer is protected by being able to sell the whole issue.
9. Enumerate the advantages and disadvantages of issuing bonds as a source of long-term funds.
Advantages:
1. Long term debt is generally less expensive than the other forms of financing because (a) investors
view debt as a relatively safe investment alternative and demand a lower rate of return and (b)
interest expenses are tax deductible.
2. Bondholders do not participate in extraordinary profits; the payment are limited to interest.
3. Bondholders do not have voting rights.
4. Flotation
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generally lower than those
on 03-06-2023 of ordinary
10:13:29 GMT -06:00(common) equity shares.

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 Disadvantages:
1. Debt (other than income bonds) results in interest payment that, if not met, can force the firm
into bankruptcy.
2. Debt (other than income bonds) produces fixed charges, increasing the firm’s financial leverage.
Although this may not be a disadvantage to all firms, it certainly is for some firms with unstable
earnings streams.
3. Debt must be repaid at maturity and thus at some point involve a major cash outflow.
4. The typically restrictive nature of indenture covenants may limit the firm’s future financial
flexibility.

10. How is bond’s internal rate of return or yield to maturity determined?

- It is the discount rate that equates the present value of the interest and principal payments with the
current market price of the bond.
To determine yield to maturity date, the formula is:

Approximate Annual interest Principal Payment – Price of the Bond

Yield = Payment + Number of years to maturity
.6 (Price of bond) + .4 (principal payments)

11. How is the credit quality risk of bonds may be issued by a corporation minimized?
- Credit quality risk is the chance that the bond issuer will not able to make timely payments. Bond
ratings Involve a judgment about the future risk potential of the bond provided by ratings agencies
such as Moody’s, Standard and Poor‘s Fitch IBCA, Inc. Dominion bond ratings services. Bond
rations are favourably affected by:

(a) A low utilization of financial leverage;

(b) Profitable operations;
(c) A low variability of past earnings;
(d) Large firm size;
(e) Little use of subordinate debt.

12. What is the relationship between the bond ratings and the expected rate of return?
The poorer the bond rating, the higher the rate of return demanded in the capital markets.
The bond credit ratings agencies assign agencies similar ratings based on detailed analyses of
issuer’s financial condition, general economic and credit market conditions, and the economic
value of the underlying collateral. The agencies conduct general economic analysis of companies’
business and analyse firm’s specific financial situations. A single company may instance may carry
several outstanding bond issues and if these issues feature fundamental differences, then they may
have different credit level risks.

13. Describe the following types of bonds

i. Unsecured long-term bonds
Debentures. They are unsecured long term-debt and backed only by the reputation and financial
stability of the corporation. Because these bonds are unsecure, the earning ability of the issuing
corporation is a great concern to the bondholder.
Subordinate Debentures. Honored only after the claims of secured debt and unsubordinated
debentures have been satisfied.
Income Bonds. Requires interest payments only if earned and non-payment of interest does not
lead to bankruptcy. Usually issued during the reorganization of the firm facing financial difficulties,
these bonds have longer maturity and unpaid interest generally allowed to accumulate for some
period of time and must be paid prior to the payment of any dividends to stockholders.

ii.Secured Long-Term Bonds

Mortgage bonds. A mortgage bond is a bond secure by a lien on real property. Typically the market
value of the real property is greater than that of the mortgage bond issue. This provides the mortgage
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 bondholders with a margin of safety in the event that the market value of the secured property
declines.
It can be sub-classified as follows:
(a) First Mortgage Bonds
(b) Second Mortgage Bonds
(c) Blanket or General Mortgage Bonds.
(d) Closed-end Mortgage
(e) Open-end Mortgage Bonds
(f) Limited Open-end Mortgage Bonds

iii. Junk or Low-Rated Bonds

Junk or low rated bonds are bonds rated BB or Below. The major participants of this market are
new firms that do not have an established record of performance, although in recent years junk
bonds have been increasingly issued to finance buyouts.

iv. Floating rate or Variable Rate Bonds

A floating rate bond is one in which the interest payment changes with market condition. In periods
of unstable interest rates this type of debt offering becomes appealing to issuers and investors. To
issuers like banks and finance companies, whose revenues goes up when the interest rates rise and
decline as interest rates fall, this type of debt eliminates some of the risk and variability in earnings
in that accompany interest rate swings.

14. Distinguish between ordinary or common stock and preferred stock.

- Ordinary equity shares is a form of long-term equity that represents ownership interest of the firm.
Ordinary Equity shareholders are called residual owners because their claim to earnings and assets
is what remains after satisfying the prior claims of various creditors and preferred shareholders.
- Preferred share on the other hand is a class of equity shares which has preference over ordinary
(common) equity shares in the payment of dividends and in the distribution of corporation assets
in the event of liquidation.

15. Compare the features of bonds, ordinary equity shares and preferred share in terms of

Ordinary Equity Preferred Shares Bonds

Shares
(a) Ownership and Belongs to ordinary Limited rights and Limited rights under
control of the firm. equity shareholders when dividends are default in interest
through voting right missed. payments.
and residual claim to
income.
(b) Obligation to None Must receive Contractual
provide return payment before Obligation
ordinary shareholder
(c) Claim to assets in Lowest claim of any Bondholder and Highest Claim
bankruptcy security holder creditors must be
satisfied first.
(d) Cost of Highest Moderate Lowest
distribution
(e) Risk return Trade Highest risk, highest Moderate Risk, Lowest Risk,
Off return (at least in Moderate return Moderate Return
theory)
(f) Tax obligation of Not Deductible Not Deductible Tax Deductible cost
the corporation = Interest Payment x
(1- Tax rate)
(g) Tax obligation of A portion dividend is Same as ordinary Government bond
the recipient of paid to another shares interest is tax exempt.
income corporation is tax
exempt.

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