Mater Dei College, Tubigon, Bohol

College of Accountancy, Business, and Management

LESSON 3 – MONEY MARKET AND RELATED FINANCIAL INSTRUMENTS

Money Market

In the money market, it is not that the actual money or cash is being traded but instead
the financial instruments are the ones being used in the exchange. These instruments are highly
liquid and somewhat have the characteristics close to cash or money. In the money market, the
securities have three fundamental characteristics which are:
1. Usually sold in large denominations;
2. Low default risk; and
3. Mature in one year or less from original issue date.

Most money market instruments mature in less than 4 months. Transactions in the
money market are not confined to one singular location. Instead, the traders organize the
purchasing and selling of the securities among participants and close the transactions
electronically. As a result, money market securities commonly have an active secondary market.
An active secondary market enables the parties to trade money market instruments to cater to
short-term financial needs. Money market instruments become a flexible tool as the parties may
invest in these for short-term gains and convert it back to cash quickly once liquidity needs
arise. In an accounting perspective, most money market instruments are considered as cash
equivalents due to the fact that they mature (i.e. cash can be redeemed) within three months or
less from the date of purchase.

Most transactions in the money market are very large, hence, they are considered as
wholesale markets. The required size of the transaction usually averts individual investors in
directly participating in the money market. As a result, dealers and brokers execute transactions
in the trading rooms of brokerage houses and large banks to match customers (buyers to
sellers) with each other. Despite this limitation, individual investors nowadays can invest in the
money market by joining funds that trade mostly using money market instruments.

A mature secondary market for money market instruments allows the money market to
be the preferred place for firms to temporarily store excess funds up until such time they are
needed again by the organization. Investors who place funds in the money market do not intend
to earn high returns for their money. Instead, investors look at the money market as a temporary
investment that will provide a slightly higher return than holding on the money or depositing it in
banks. If investors believe that the prevailing market conditions do not justify a stock purchase
or there might be possible interest rate hikes impacting bonds, then they can choose to invest in
money market instruments in the meantime. Holding on to cash is a very expensive option for
investors as this does not generate any return. Any idle cash becomes an opportunity cost to
investors by means of the interest income not earned by holding on to the cash. To reduce
opportunity costs, money markets become a viable option to temporarily invest idle funds.

Investors also plan their strategy to incur the lowest opportunity costs. Investors want to
have an easy source of cash to be able to act quickly if there are available investment
opportunities that come but at the same time do not want to let go of potential interest income.
As a result, they invest in money market securities to achieve these objectives. Financial
intermediaries also use money market instruments to attain investment requirements or deposit
outflows.

On the other hand, money markets offer a least expensive alternative for fund
demanders such as the government and financial intermediaries when they have short-term

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College of Accountancy, Business, and Management
fund requirements. Fund demanders need to have funds quickly because the timing of cash
inflows and outflows does not synchronize with each other. For businesses, timing of cash
collections from revenue may not match when the business needs to pay its operating
expenses. For the government, collection of revenue only comes at certain points of the year
(tax payment deadlines) but expenses are incurred throughout the year. To resolve the need for
funds as a result of the mismatch, these entities turn to money markets to obtain funds.

Participants in the money market include the following

 Bureau of Treasury. The bureau sells government securities to raise funds. Short-term
issuances of government securities allow the government to obtain cash until tax
revenues are collected.
 Commercial banks. Issues treasury securities; sells certificates of deposits and extends
loans; offers individual investor accounts that can be used to invest in money markets.
Banks are the primary issuer negotiable certificates of deposits, banker's acceptances
and repurchase agreements.
 Private Individual. These private individuals made their investment through money
market mutual funds
 Commercial Non-Financial Institutions. These entities buy and sells money market
securities to manage their cash i.e. to temporarily store excess funds in exchange of
somewhat higher return and obtain short-term funds.
 Investment companies. Trade securities on behalf of their clients. Makes a market for
money market securities through maintaining an inventory of financial instruments that
can be bought or sold. Investment companies help maintain liquidity of the money
market since they make sure that sellers can easily sell their securities when the need
arises.
 Finance/commercial leasing companies. These companies raise money market
instruments i.e. commercial paper to lend funds to individual borrowers
 Insurance companies. These are companies that invest in the money market to
maintain liquidity level in case of unexpected demands most especially for property and
casualty insurance companies.
 Pension funds. Maintain funds in the money market as preparation for long-term
investing in stocks and bonds. Need to maintain liquidity to meet obligations but since
future obligations are likely expected, huge money market investments are not
necessary.
 Money market mutual funds. These funds permit small investors (e.g. individuals) to
invest in the money market by accumulating funds from numerous small investors to buy
large-denomination money market securities.

Financial Instruments
According to the Conceptual Framework for Financial Reporting (2018), an asset is a
resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity. Assets can be classified in terms of physicality:
tangible and intangible assets.

Tangible assets are assets that have physical properties and can be easily seen,
touched or perceived by the five senses. Value of tangible assets are based on its physical

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College of Accountancy, Business, and Management
properties. Examples of tangible assets include buildings, equipment, machinery, land and
supplies.
Intangible assets are identifiable assets that do not have physical substance and
usually represents a legal claim to some future economic benefit. Financial instruments (also
called as financial assets or securities) are basically intangible as future economic benefit takes
the form of a claim to cash that will be received in the future. Financial instruments are the main
vehicle used for transactions in the financial market. For the purposes of presentation in
financial statements, financial instruments may be presented under cash equivalents or
investments. Securities that are maturing within 90 days or less are classified under cash
equivalents. Otherwise, they are classified under investments. Its category may depend on the
maturity of the instrument whether short term or long term but most instruments in the financial
markets are classified short term or part of the current assets. But the recognition of these
securities will depend on the intent of the investor for these instruments.
There is a minimum of two parties involved in a financial instrument:
 the issuer,
 the investor.

The issuer is the party that issues the financial instrument and agrees to make future
cash payments to the investor. The issuing party usually needs additional funds for investment
to further grow their business. On the other hand, the investor is the party that receives and
owns the financial instrument and bears the right to receive payments to be made by the issuer.
The investors usually have surplus funds that are not earning anything and are willing to bear
some risk to earn something from their surplus funds. From an accounting perspective,
investors recognize financial instruments as an asset.
At the point of issuance of the financial instrument, the issuer usually receives something
of value (usually cash) from the investor. The financial instrument then becomes the proof
(hence, called as security) of the future claim of the investor from the issuer.

Financial instruments have two main economic purposes:

 Allows transfer of fund from entities with excess funds (investors) to entities who needs
funds (issuer) for business purposes (e.g. to pay for tangible assets).
 Permit transfer of fund that allows sharing of inherent risk associated with the cash flows
coming from tangible asset investment between the issuer and investor.

Usually, the initial investor does not hold on to the instrument up until the time the issuer
can make the payment. In such cases, investors trade their financial securities to other
individuals or institutions who are willing to pay for their claim to future payment. Financial
intermediaries also operate in the financial system, demand funds from "investors" and convert
these to various financial assets that the general public is willing to buy. As a result of these
interlinked activities, claims of the final wealth holders generally differ from the liabilities
recognized by the issuers (final demanders of funds). Financial instruments that are used in the
money market are discussed in this chapter while those that are used in the capital markets are
presented in subsequent chapters.

Types of Money Market Financial Instruments

Money market instruments take the form of short-term deposits, government securities,
commercial papers and certificates of deposit which form part of the Philippine interest rate
market. Money market instruments are governed by Philippine regulations and are influenced by
market movements. Generally, these instruments are reported by the investors as part of their
short-term investments or cash equivalents depending when these instruments were acquired.
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 Mater Dei College, Tubigon, Bohol
College of Accountancy, Business, and Management
In cases that certain financial instruments were acquired more than 12 months before maturity it
will reported under noncurrent assets except that the investor intended to have it traded within
the immediate reporting cycle.

Treasury Bills
Treasury Bills are government securities issued by the Bureau of Treasury which mature
in less than a year. There are three tenors of Treasury Bills: (1) 91 day (2) 182-day (3) 364-day
Bills. The number of days is based on the universal practice around the world of ensuring that
the bills mature on a business day. Treasury Bills are quoted either by their yield rate, which is
the discount, or by their price based on 100 points per unit. Treasury Bills which mature in less
than 91-days are called Cash Management Bills (e.g. 35-day, 42-day). Being government
securities, these are no longer certificated (i.e. scripless) same with the practice in other
countries such as China, Canada and USA. Banks that compose the majority of the
Government Security Eligible Dealers (GSED) bid for T- bills in the weekly auctions held by the
Bureau of Treasury. The banks then resell the T-bills to investors. In 2020, the Philippine
government issued a 35-day until 3rd quarter of the year.

Treasury bills have virtually zero default risk since the government can always print more
money that they can use to redeem these securities at maturity. Risk of inflationary changes is
also lower since the maturity term is shorter. Market for Treasury bills is both deep and liquid.
Deep market means that the market has numerous different buyers and sellers while liquid
market means that securities can be quickly traded at low transaction costs. Investors prefer to
go to a deep and liquid market such as Treasury bills since there is only little risk that they will
not be able to liquidate the securities when they prefer to.

Government securities, particularly treasury bills, are the safest investment instrument in
the market. Because they are backed by the full taxing power of the government, they are
practically default risk-free. While there may be market risks owing to changes in interest rates,
these are an attractive investment vehicle since the safety of the investor's principal is assured.
These are also marketable and highly liquid. They can be traded easily in the secondary market
anytime the market is open.

Interest rate is not explicitly stated in the Treasury bill; hence, interest is not actually paid
by the government when they sell this security. Instead, treasury bills are issued at a discount
(meaning lower price than the par value at maturity). The return realized by investors comes
from the increase in the value of the securities (purchase price to the price upon maturity). This
means that for a Php 1,000 Treasury bill sold at 990, the investor only needs to pay Php 990 as
their investment. Once they redeem the Treasury bill at maturity date, they will be able to collect
the Php 1,000. Simply put, they had a return of Php 10 from this investment.

Treasury bills can be sold via two methods: auctions or competitive bidding and
noncompetitive bidding. In auctions, the Bureau of Treasury announces the quantity and type
of securities that they will sell. Interested parties give a bid offering and the Treasury accepts
the highest bids. The Treasury accepts the bids in ascending order of yield until the accepted
bids reach the offering amount. Each accepted bid is awarded at the highest yield paid to any
accepted bid.

In noncompetitive bidding, bidders only give the amount of securities that they want to
buy. The Treasury accepts all noncompetitive bids. The price for all the securities under
noncompetitive bids is set at the highest yield paid to any accepted competitive bid. In essence,
non- competitive bidders still pay the same price that are paid out by competitive bidders. The
main difference between the two methods is that competitive bidders may or may not receive

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College of Accountancy, Business, and Management
allocation from the securities being sold while noncompetitive bidders are guaranteed to receive
the securities.

When analyzing investments, investors often try to compare performance of financial

instruments with each other. To address this, most investors look at percentages to be able to
compare returns better. From the point of view of investors, the discount rate indicates how
much return, in %, they can get from a particular security. The annualized discount rate for a
non-interest-bearing security (like Treasury bill) is described in equation below:

For example, a Php 1,000 Treasury bill with a 91-day tenor can be purchased at 995. To
compute the discount rate, we just need to substitute the above information in the formula:

Another variation of the annualized discount rate is what we call the investment rate. The
investment rate addresses two weaknesses of the discount rate. The first one is the use of face
amount as the denominator. Since the investor will pay less than the face amount and the
security is sold as a discount instrument, the computed return is understated. The second
weakness is the use of 360 days to annualize the return which also understates the return. To
be more specific, the investment rate uses 365 days (366 days during leap year) to annualize
the return. The investment rate portrays a more accurate representation of now much an
investor will earn from the security since it uses the actual number of days per year and the true
initial investment in the computation. Eq.3.2 presents the formula for the annualized investment
rate.

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 Mater Dei College, Tubigon, Bohol
College of Accountancy, Business, and Management
Treasury bills are also known to be very near to the definition of a risk-free asset. As a
result, interest earned on Treasury bills are among the lowest in the market. Investors may find
that earnings from Treasury bills may not be sufficient to cover for changes in purchasing power
brought by higher inflation. Treasury bills are mostly meant as an investment vehicle to
temporarily store excess cash since it may hardly catch up with inflation.

Repurchase Agreement
A repurchase agreement (repo) is a contract where a party which is a seller/borrower
of an instrument will agree to the buyer/lender that the instrument will be repurchased or bought
back on a later date at a higher price. Repurchase agreements enable short-term funds to be
transferred between financial or non-financial institutions, usually ranging from one- day to 3 to
14 days. Some repos can also range from one to three months. There are repos which are
called open repos which do not have an indicative date of repurchase.
Repos are a key component of the debt securities market that produces short-term cash
or securities liquidity critical to price-making activity of fixed income dealers. Dealers of
government securities commonly use repos to manage liquidity and take advantage of expected
changes in interest rates. Dealers sell their securities to a bank with an accompanying repo
agreement promising to buy the securities back at a specified future date. Essentially, repos are
collateralized loans.
In the Philippines, the government (through BSP) also uses repo to enforce monetary
policy. The BSP purchases government securities from a bank with a commitment to sell it back
at a specified future date at a predetermined rate. In effect, a repo transaction expands the level
of money supply as it increases the bank's level of reserves. Under a reverse repo, the BSP
acts as the seller of government securities, thus, the bank's payment reduces its reserve
account resulting in a contraction in the system's money supply. For both repos, the BSP can
only affect the level of money supply temporarily, given that the parties involved commit to
reverse the transaction at an agreed future date. At present, the BSP enters into repo
agreements for a minimum of one (1) day (overnight) for both repos and a maximum of 91 days
and 364 days for repo and reverse repo agreements, respectively.
Since repos are collateralized by the accompanying securities, these usually are treated
as low-risk investments with low interest rates. While it is considered a secured instrument, a
risk may still be inherent in the sense that there is a possibility that the seller/borrower may not
buy back the instrument.

Negotiable Certificates of Deposit

Negotiable certificates of deposit are securities issued by banks which record a deposit
made. The certificate indicates the interest rate and the maturity date of the deposit. Since
maturity date is stated in the certificate, negotiable certificates of deposit are treated as a term
security with a specific maturity date. It cannot be easily withdrawn by the depositor since it is
different from a demand deposit account wherein money can be withdrawn upon demand of
depositor. A certificate of deposit essentially restricts holders from withdrawing funds on
demand. The concept behind CDs is that investors are willing to accept a higher return in
exchange for having no access to liquidity.
Negotiable certificate of deposit is also classified as a bearer instrument. As a bearer
instrument, whoever person or entity which possesses the instrument upon maturity will receive
the principal and interest. This feature allows negotiable CDs to be purchased and sold between
investors. Interest rates of CDs are based on the outcome of the negotiation between the
depositor and the bank. Both parties should agree on the interest rate of the CD. The interest

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College of Accountancy, Business, and Management
rates of CDs are usually at the same level with other money market securities since it carries a
low level of risk.
Investors can buy or sell certificates of deposit up until the instrument's maturity.
Negotiable CDs may have a maturity period between one to four months up to six months.
However, there is less demand for CDs with longer maturity. Upon maturity, the bank shall pay
the principal plus the interest to the investor who holds the CD.
In the Philippines, the BSP allows and regulates the issuance of long-term negotiable
certificates of deposits (LTNCD). LTNCD refers to interest bearing negotiable certificates of
deposit with a minimum maturity of five years. LTNCD offers a higher return compared to
regular time deposit accounts because of the long period that depositors will be unable to
withdraw the money. In this case, LTNCD will be reported as noncurrent assets of the investor
since the maturity is longer than 12 months.

Commercial Paper
Fundamentally, commercial papers are unsecured promissory notes. Commercial paper
may be short-term or long-term. Short term commercial paper means an evidence of
indebtedness of any person with a maturity of three hundred and sixty-five (365) days or less.
Long term commercial paper is an evidence of indebtedness of any person with a maturity of
more than three hundred sixty-five (365) days.
Since commercial papers are unsecured, only large and creditworthy corporations can
issue this security. Lenders will not accept commercial papers from small companies since they
are going to assume a high level of risk since this security is not secured. Commercial papers
are issued directly to the buyer and usually, there is no secondary market for commercial
papers. Dealers may redeem commercial papers if the bearer needs cash, but this seldom
happens.
Nonbank corporations like financing companies usually issue commercial papers and
use the proceeds to fund loans that they extend to their clients. Issuers often maintain a line of
credits with banks to serve as backup for a commercial paper. The line of credit is primarily for
the benefit of the issuer of the commercial paper. If the issuer is not able to pay the maturing
commercial paper, the bank will lend funds to the issuer to enable the latter to pay for the
commercial paper. The availability of line of credit reduces the risk associated with commercial
papers, hence, this reduces the interest rate. Banks usually extend the line of credit and agree
to provide the loan in advance in case there is a need to pay off the commercial paper. In
exchange, the issuer pays a service charge in exchange for the line of credit. Issuers of
commercial paper agree to pay the line of credit fee because this is lower versus paying interest
on the commercial paper for an extended period of time.
Commercial papers may either have a stated interest rate on its face or be sold at a
discounted basis.
In the Philippines, commercial papers are not required to register with SEC if they meet
the following requirements:
 Issued to not more than 19 non-institutional lenders
 Payable to a specific person
 Neither negotiable nor assignable and held on to maturity Amount not exceeding Php 50
million.
Otherwise, companies need to register with the SEC first prior to issuing any commercial
paper.

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 Mater Dei College, Tubigon, Bohol
College of Accountancy, Business, and Management
Banker's Acceptances
Banker's acceptances refer to an order to pay a specified amount of money to the bearer
on a specified date. Banker's acceptances are often used to finance purchase of goods that
have not yet been transferred from the seller to the buyer. Banker's acceptance is usually
offered to importers and exporters. An acceptance is formed when a draft or a promise to pay is
made by the bank's client and the bank then ultimately accepts, promising to pay on behalf of
the client. The bank's acceptance of the draft translates to a promise to pay to whomever party
presents it to the bank for payment. The client then gives the draft (i.e. banker's acceptance) to
the vendor to finance the purchase.

For example, Company A wants to buy a large piece of equipment from Company B for
the first time. Since Company B does not have any experience that will establish the
creditworthiness of Company A, it may be reluctant to ship the equipment immediately because
they might experience difficulty in collection afterwards. Company A may also be reluctant to
send money to Company B for the same reason that they may not receive the equipment as
promised. To help consummate the transaction, banks may intervene through the issuance of
banker's acceptance wherein it will lend its name and creditworthiness to the paying party, i.e.
Company A.
Banker's acceptances are usually payable to the bearer. Hence, this can be
subsequently purchased and sold until it matures. Banker's acceptances are usually sold at a
discount, similar to Treasury bills. Market dealers also facilitate the trading of banker's
acceptances by matching prospective sellers and buyers. Interest rates on banker's
acceptances are usually low since default risk is very minimal.

Evaluating Money Market Securities

As a finance person, you should be able to understand and evaluate which money
market securities to invest in depending on the purpose of the business. Money market
securities may be evaluated based on the interest rates and liquidity.
Interest rates are very relevant in deciding which money market securities to invest since
this dictates the potential return that can be received from the investment. Interest rates on the
money market tend to be relatively low as a result of the low risks associated with them and the
short maturity period. Money market securities have a very deep market; thus, they are
competitively priced. If you would notice, most money market securities carry the same risk
profile and attributes, thus making each instrument a close substitute for each other. Hence, if a
security may have an interest rate that deviates from the average rate, particular supply and
demand forces in the market would ultimately correct it and force it back to the average rate.

Liquidity refers to how quick, efficient and cheap it is to convert a security into cash. Treasury
bills, that have a ready secondary market, are more liquid than commercial papers which do not
have a developed secondary market. Holders of commercial papers tend to hold the security
until it matures. For this reason, brokers may charge a higher fee for investors that would want
to liquidate its commercial paper since more effort shall be made to look for potential buyers
compared to treasury bills that have buyers willing to purchase at short notice. Since most
money market securities are typically short-term, money market securities are often preferred by
investors who desire liquidity intervention - providing liquidity where it did not previously exist.

Valuation of Money Market Securities

Valuation of money market securities is important to determine at what amount an
investor is willing to pay in exchange for a security. In some cases, investors need to give an

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College of Accountancy, Business, and Management
amount as a bid to be able to buy securities. Money market securities can be valued using the
present value approach. The interest rate used in the valuation shall reflect the required return
from the instrument based on the investor's perceived risk. Investors may also use the
prevailing interest rate in the market for the type of security being purchased. Equation below
presents the valuation formula which is practically the present value formula.

For example, the face value of a one-year Treasury bill is at Php 1,000 with an annual
interest rate of 3%. To compute the value of the Treasury bill, use the formula above. The face
value which will be received upon maturity is Php 1,000. The interest rate will be 3% and the
number of periods is 1 (since it has a one-year maturity term)

This means that an investor is willing to pay Php 970.87 for a Php 1,000 Treasury bill
based on the risks surrounding the instrument. In absolute terms, the investor will get return of
Php 29.13 from this investment.

Assume that another Php 1,000 Treasury bill with maturity term of 90 days with an
annual interest rate of 4% is being evaluated. Assume 360 days. The value of said Treasury bill
is computed as follows:

The annual interest rate should be converted to match the 90-day maturity term. Hence,
the annual interest term of 4% shall be multiplied with 90/360 to get how much is the interest
rate for the tenor of the security. In this case, the interest rate to be used is 1% which represents
the interest cost associated with the 90 days that the money is held by the government.

As a general rule, as the interest rate rises, the value of the security becomes lower.
This means that the market risk increases thus the impact on the value of the securities also
reduces.
(Source: Financial Markets: Fundamentals and Trends (2021) by: Lascano, Marvin & Cachero, Andrew)

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College of Accountancy, Business, and Management

Self – Assessment Questions:

1. What role does the money market play in the financial economy?
2. What are the most important financial instruments, and why are they so important?
3. What are the primary advantages of money market instruments compared long-term
bonds?
4. Why are money markets the most secure form of investment?
5. What are the risks of a money market account, in your opinion?
6. The current market value of a one-year Php1,000 Treasury bill carrying an annual
interest rate of 4% is?
a. P1,040,00 b. P1,000,00 c. P970.87 d. 961.54
7. The prevailing market value of a 90-day P1,000 Treasury bill carrying an annual interest
rate of 5% is?
a. P1,050.00 b. P1,000.00 c. P990.10 d. P987.65
8. A 90-day P1,000 Treasury bill with an annual interest rate of 10% is being considered by
Investor A. The amount should Investor A be willing to pay to acquire this treasury bill is:
a. P990 10 b. P975.61 c. P909.10 d. P1,000.00
9. The amount Investor B realize as return in two P1,000 90- day Treasury bills with 5%
annual interest rate is:
a. P 0 b. P12.35 c. P24.69 d. P95.24
10. The annualized investment rate of a P1,000 Treasury bill with a 91-day tenor that can be
purchased at 990 is:
a. 5.00% b. 4.05% c. 2.02% d. 1.01%

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