MIDTERM MODULE Capital Markets

John Buco Colegio de Jimenez, Inc.

FGA

Financial Instruments
Target Outcomes
At the end of the lesson, you are expected to
1. differentiate money market instruments and capital market instruments
2. identify and explain the different government-issued money market instruments and
capital market instruments

MONEY MARKET INSTRUMENTS

Money market instruments are short-term securities. They are paper or electronic evidence of
debt dealt in the money markets. Only debt securities are short-term. Equity securities are
long-term and belong to the capital market. Money market instruments are issued by the
government and corporations needing short-term funds. Government securities are generally
issued by the Bureau of the Treasury.

CASH MANAGEMENT BILLS

Cash management bills are government-issued securities with maturities of less than 91 days,
specifically 35 days or 42 days. They have shorter maturities than T-bills. Government
securities are unconditional obligations of the government issuing them, backed up by the full
taxing power of the issuing government.

TREASURY BILLS (T-BILLS)

Treasury bills (T-bills) are issued by the Bureau of the Treasury with 91-day, 182-day and
364-day maturities. The odd number of days is to generally ensure that they are mature on a
business day. Like Treasury bonds (T-bonds), they are sold only through government
securities eligible dealers, dealers authorized by the government to sell T-bills. Transactions
are done through bidding online.
The Philippine government issues two types of government securities. Treasury bills, which
are short-term, and T-bonds, which are long-term.

BANKER’S ACCEPTANCE
A banker’s acceptance is a time draft issued by a bank payable to a seller of goods. It is
drawn on and accepted by the bank.

A time draft issued by a bank is an order for the bank to pay a specified amount of money to
the bearer of the time draft on a given date.

LETTERS OF CREDIT
Banker’s acceptance is generally used with the purchase of goods or services either
domestically or internationally. In the cases, the buyer has its bank issue a letter of credit on
its behalf in favor of the seller.

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The letter of credit states that the bank will accept the seller’s time draft if the seller presents
the bank with shipping documents that transfer the title on the goods to the bank. The bank
notifies the seller of the letter of credit through a correspondent bank in the case of exports in
the exporter’s country.

NEGOTIABLE CERTIFICATES OF DEPOSIT

A certificate of deposit (CD) is a receipt issued by a commercial bank for the deposit of
money. It is a time deposit with a definite maturity date (of up to one year) and a definite rate
of interest. CD stipulates that the bearer is entitled to receive annual interest payments at the
rate indicated in the certificate, together with the principal upon maturity of the certificate.

A negotiable certificate of deposit is a bank-issued time deposit that specifies an interest rate
and maturity date and is negotiable.

REPURCHASE AGREEMENTS
Repurchase agreements are legal contracts that involve the actual sale of securities by a
borrower to a lender with a commitment on the part of the borrower to repurchase the
securities at the contract price plus a stated interest charge at a later date.

MONEY MARKET DEPOSIT ACCOUNTS

Money market deposit accounts (MMDA’s) are PDIC insured deposit accounts that are
usually managed by banks or brokerages and can be a convenient place to store money that is
to be used for upcoming investments or has been received from the sale of recent
investments.

EXPLANATION: In the Philippines, Money Market Deposit Accounts (MMDAs) are

similar to savings accounts but typically offer higher interest rates and might require
higher minimum balance requirements. These accounts are offered by banks and are
PDIC (Philippine Deposit Insurance Corporation) insured up to PHP 500,000 per
depositor, per bank. MMDAs are suitable for individuals looking to park their funds
temporarily while earning interest, especially when planning to make future
investments or after liquidating assets.

Example: Suppose you have a sum of money that you're planning to use for a down
payment on a house in six months. You could deposit this money into an MMDA.
Not only would your funds earn a better interest rate than they would in a regular
savings account, but they would also be safe and accessible when you need them, all
while being insured against bank failure.

MONEY MARKET MUTUAL FUNDS

Money market mutual funds (MMMF’s) are investment funds that pool funds from numerous
investors and invest in money market instruments offered by investment companies.

Explanation: MMMFs are investment funds that pool money from many investors to
purchase short-term, high-quality securities like treasury bills, certificates of deposit,
commercial paper, and other money market instruments. These funds aim to provide

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investors with high liquidity and low risk, with returns typically higher than those of
savings accounts or MMDAs,

Example: An investor chooses to invest in a Philippine money market mutual fund

like the BDO Money Market Fund. This fund pools money from various investors to
invest in short-term debt instruments, allowing the investor to earn returns with
minimal risk and high liquidity.

CETIFICATE OF ASSIGNMENTS
A certificate of assignments is an agreement that transfers the right of the seller over security
in favor of the buyer.

Explanation: A certificate of assignment is essentially a legal document or

agreement that signifies the transfer of rights or interests from one party (the
assignor) to another (the assignee) over a particular security or financial asset. This
process is common in debt markets and for securities that are not standardly traded
on public markets.

Example: Imagine you own a private corporate bond that you wish to sell before its
maturity date. You could use a certificate of assignment to legally transfer your rights
and interest in this bond to another investor, making them the new owner of the
bond and entitled

CERTIFICATE OF PARTICIPATION
A certificate of participation is an instrument that entitles the holder to a proportional
equitable interest in the securities held by the issuing firm or an entitlement to a pro-rata
share in a pledge revenue stream, usually lease payments.

Certificates of Participation in the Philippines are a form of financing that allows

investors to participate in lease-financing agreements with public entities. COPs are
essentially a share in a lease agreement, providing returns to the investor based on
the lease payments received from the public entity.

Example: A local government unit (LGU) in the Philippines might need to build a
new public market but lacks the immediate funds to finance the construction. The
LGU could enter into a lease agreement with a financing company, which issues
Certificates of Participation to investors. These investors then receive returns based
on the lease payments made by the LGU for using the public market.

CAPITAL MARKET INSTRUMENTS

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 Capital market instruments, just like capital markets, can be classified as:

1. non-negotiable/non-marketable instruments
2. negotiable/marketable instruments

• NON-NEGOTIABLE/NON-MARKETABLE INSTRUMENTS
Non-negotiable/non-marketable instruments in the capital markets are the following:

1. Loans
2. Leases
3. Mortgages
4. Lines of Credit

Non-negotiable or non-marketable instruments refer to financial instruments that

cannot be easily bought or sold in the open market. These instruments have specific
characteristics that limit their transferability, making them non-negotiable. Let's
explore the reasons why each of the mentioned instruments (loans, leases,
mortgages, and lines of credit) is considered non-negotiable in capital markets:

1. Loans:
Non-Negotiability Reason: Loans are agreements between a lender and a
borrower, where the borrower receives a sum of money and agrees to repay it
with interest over a specified period. The terms and conditions of loans are
often tailored to the specific needs and creditworthiness of the borrower.
 Why Non-Negotiable: The terms of a loan, including interest rates,
repayment schedules, and other conditions, are usually set based on the
agreement between the borrower and the lender. These terms are not
standardized and may not be suitable for open market trading. As a result,
loans are typically non-negotiable.
2. Leases:
 Non-Negotiability Reason: Leases involve the renting or leasing of an asset
(e.g., equipment, property) for a specified period. The terms of the lease, such
as rental payments and duration, are agreed upon between the lessor (owner)
and lessee (user).
 Why Non-Negotiable: Similar to loans, the terms of a lease are specific to the
agreement between the lessor and lessee. The unique characteristics of the
leased asset and the specific needs of the parties involved make leases non-
negotiable in an open market context.
3. Mortgages:
 Non-Negotiability Reason: Mortgages are loans specifically used to finance
the purchase of real estate. The terms of a mortgage, including interest rates,
repayment schedules, and loan-to-value ratios, are determined between the
borrower and the lender.
 Why Non-Negotiable: The unique nature of real estate transactions, coupled
with the individualized terms of each mortgage agreement, makes mortgages

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 non-negotiable. The terms are often influenced by factors such as the
borrower's creditworthiness, property value, and prevailing market conditions.
4. Lines of Credit:
 Non-Negotiability Reason: A line of credit is a flexible borrowing
arrangement that allows a borrower to access funds up to a predetermined
limit. The terms, including interest rates and repayment terms, are established
between the borrower and the lender.
 Why Non-Negotiable: Lines of credit are designed to provide flexibility for
the borrower within the agreed-upon limit. The terms are often based on the
borrower's creditworthiness and financial situation, making them specific to
the agreement between the parties. The individualized nature of these terms
makes lines of credit non-negotiable in the open market.

• NEGOTIABLE/MARKETABLE INSTRUMENTS
The following are specific marketable or negotiable instruments dealt with in the capital
markets:

1. Corporate stocks
Share of stocks may be classified as:
A. 1. Par value shares
2. No par value shares
a. With stated value
b. Without stated value

B. 1. Common shares
2. Preferred shares
a. As to assets
b. As to dividends
i. Cumulative ii.
Non-cumulative
iii. Participating
iv. Non-
participating
2. Bonds
Bonds can be classified as follows:
1. As to security
a. Secured bonds
b. Unsecured bonds
2. As to interest rate
a. Variable rate bonds
b. Fixed rate bonds
3. As to retirement
a. Putable bonds
b. Callable/redeemable bonds
c. Convertible bonds
4. Other classification
a. Income bonds

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 b. Indexed or purchasing power bond
c. Junk bond

Marketable or negotiable instruments, like corporate stocks and bonds, are easily
tradable in the open market because they have standardized features. For stocks,
these include categories like common and preferred shares, and for bonds,
characteristics like interest rates, security, and retirement options. The
standardization makes them straightforward to buy and sell, promoting liquidity and
efficiency in the financial markets.

Midterm Quiz 1

1. Discuss at least three money market instruments 2.

Differentiate T-bills and T-bonds.
3. Differentiate Non-negotiable market and negotiable market.
4. In your own opinion, how important is loan to people nowadays? What are the pros
and cons of loans?

Financial Intermediation
Target Outcomes
At the end of the lesson, you are expected to
1. define financial intermediation
2. explain the roles of different depository financial institutions and non-depository
financial institutions

FINANCIAL INTERMEDIARIES: DEFINITION

Financial intermediaries are the financial institutions that act as a bridge between investors
and borrowers. They may simply as a bridge between deficit units and surplus units
without owning the securities issued by the deficit units.

The securities issued by original issuers/borrowers are called primary securities. The
securities issued by financial intermediaries are called secondary securities.

A depositor-bank relationship and a borrower-lender relationship are the typical direct

finance relationship or transactions. Direct security or primary security flows directly
from the lending or investing unit to the borrowing or deficit unit.

The relationship between the depositors, from whom funds came, and the borrowers who
borrowed from the bank is indirect, thus indirect finance.

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The asset transformation role of financial intermediaries is evidenced by their issuance of
secondary securities. The primary securities they buy are transformed into secondary
securities that they issue.

The old financial environment was a highly specialized financial system where banks were
set up to take in deposits and grant only short-term loans.

The new financial environment was characterized by market-determined or deregulated rates

on assets and liabilities of financial intermediaries and by greater homogeneity among
financial institutions.

Financial intermediaries are basically classified into depository institutions and nondepository
institutions.

Depository institutions refer to financial institutions that accept deposits from surplus units.
Depository institutions include:
1. Commercial banks
a. Ordinary commercial banks
b. Expanded commercial or universal banks

2. Thrift banks
a. Savings and mortgage banks
b. Savings and loan associations
c. Private development banks
d. Microfinance thrift banks
e. Credit unions
3. Rural banks

Non-depository institutions issue contracts that are not deposits. They can be classified into:
1. Insurance companies
a. Life insurance companies
b. Property/casualty insurance companies
2. Fund managers
3. Investment banks/houses/companies
4. Finance companies
5. Securities dealers and brokers
6. Pawnshops
7. Trust companies
8. Lending investors

Ordinary commercial banks perform the simpler functions of accepting deposits and granting
loans. Universal banks or expanded commercial banks are a combination of
commercial banks and investment houses.
The thrift banking system is composed of savings and mortgage banks, stocks savings and
loan associations, private development banks, microfinance thrift banks, and credit
unions.

Rural and cooperative banks promote and expand the rural economy in an orderly and
effective manner by providing the people in the rural communities with basic
financial services.

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Bank supervision deals with ensuring the soundness and safety of banks.

CAMELS rating aims to determine a bank’s overall condition and identity its strengths and
weaknesses financially, operationally, and managerially.

Life insurance companies are financial intermediaries that sell life insurance policies.

Property/casualty insurance companies offer protection against pure risk. Homeowners

insurance is insurance for houses and their contents.

Auto insurance covers one’s, spouses, and relatives’ homes and other licensed drivers to
whom the insurer gives permission to drive his car.

Flood insurance is taken if one considers a flood to be a risk for his business or property.

Windstorm insurance is a separate type of coverage that protects one’s home or business
against wind damage.

Umbrella liability policy provides coverage over and above one’s automobile or
homeowner’s policy.

Health insurance is a type of insurance that pays for medical expenses in exchange for
premiums.

Long-term care (LTC) is defined as a need for assistance with some of the activities of daily
living.

Professional liability coverage protects professionals, such as doctors, financial advisors,

nursing home administrators, lawyers, etc., against financial losses from lawsuits filed
against them by their clients or patients.

Fund managers are pension fund companies and mutual fund companies. Pension fund
companies sell contracts to provide income to policyholders during their retirement
years. Mutual fund companies are companies that allow investors, including
individuals, to buy into mutual funds that buy different securities in the securities
market.

Investment companies are financial intermediaries that pool relatively small amounts of
investors’ money to finance large portfolios of investments that justify the cost of
professional management.

Finance companies are profit-oriented financial institutions that borrow and lend funds to
households and businesses. Finance companies are sales finance companies, consumer
finance companies, and commercial finance companies.

Securities brokers are financial intermediaries that look for investors or savings units for the
benefit of the borrowers or deficit units and are compensated by means of
commission.

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Pawnshops are agencies that lend money on the security of pledged goods left in pawns.

Trust companies are corporations organized for the purpose of accepting and executing trusts
and acting as trustees under wills, as executors, or as guardians.

Lending investors are individuals or companies who loan funds to borrowers, generally
consumers or households.

Risk is the possibility that the actual return will deviate or differ from what is expected.
Financial intermediaries and investors as well have so many risks to face. This
includes market value risk, reinvestment risk, default risk, inflation risk, political risk,
off-balance-sheet risk, technology and operation risks, liquidity risks, currency risk,
and country risk.

Financial intermediaries play an important role in the socio-economic development of a

country in general, and of urban and rural areas, in particular.

The economic bases for financial intermediaries deal with the spread of risk made possible by
the pooling funds through diversification through economies of scale by bearing a
large part of the cost that individuals and small borrowers should have shouldered if
they themselves had done what the financial intermediaries are doing, absorbing
transaction costs, and gathering information.

Midterm Quiz 2

1. What is financial intermediation? What are the financial intermediaries?

2. What are the two basics classifications of financial intermediaries? Differentiate each.
3. Differentiate bank supervision and bank regulation.
4. Differentiate between mutual funds and money market funds.
5. Differentiate between finance companies and the other financial institutions.