MONEY MARKET & RELATED FINANCIAL INSTRUMENTS Transactions in the money market are not confined to one singular

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 closes the transactions electronically. As a result, money market
Financial Instruments securities commonly have an active secondary market.
-According to Conceptual Framework for Financial Reporting (2018), an asset is a resource controlled by the entity as a result A mature secondary market for money market instruments allows the money market to be the preferred place for firms to
of past events and from which future economic benefits are expected to flow to the entity. Assets can be classified in terms of temporarily store excess funds up until such time they are needed again by the organization. Investors who place funds in
physicality, tangible and intangible assets. the money market do not intend earn high returns for their money
Tangible assets Participants in the money market include the following:
-are assets that has physical properties and can be easily seen, touched or perceived by the five senses Value of tangible assets  Bureau of Treasury.
are based on its physical properties. Examples of tangible assets include buildings, equipment, machinery, land and supplies
 Commercial banks. Private Individual.
Intangible assets  Commercial Non-Financial Institutions
 . Investment companies
- are identifiable assets that do not have physical substance and usually represents a legal claim to some future economic  . Finance/commercial leasing companies.
benefit. Financial instruments (also called as financial assets or securities) are basically intangible as future economic benefit  Insurance companies.
takes form of a claim to cash that will be received in the future.
 Pension funds.
There is a minimum of two parties involved in a financial instrument  Money market mutual funds

 the issuer, Bureau Of Treasury

 and the investor The Bureau Sells Government Securities To Raise Funds. Short- Term Issuances Of Government Secunties Allow The
ISSUER Government To Obtain Cash Until Tax Revenues Are Collected.

-the party that issues the financial instrument and agrees to make future cash payments to the investor. COMMERCIAL BANKS

Investor -Issues treasury securities; sell 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
-the party that receives and owns the financial instrument and bears the right to receive payments to be made by the issuer. repurchase agreements.

Financial instruments have two main economic purposes: PRIVATE INDIVIDUAL

 Allows transfer of fund from entities with excess funds (investors) to entities who needs funds (issuer) for business -These private individuals made their investment through money market mutual funds
purposes (e.g. to pay for tangible assets).
COMMERCIAL NON- FINANCIAL INSTITUTIONS
 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. -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
MONEY MARKET
FINANCE/ COMMERCIAL LEASING COMPANIES
 One primary misconception is that money or currency is the security being traded in a money market. This is not true.
Same with other markets, financial instruments are the primary subject of trading in a money market. However, the - These companies raise money market instruments i.e. commercial paper to lend funds to individual borrowers.
financial instruments traded in the money market are short-term and highly liquid, that it can be considered close to
being money INSURANCE COMPANIES

Money market characteristics: - These are companies that invest on money market to maintain liquidity level in case of unexpected demands most especially
for property and casualty insurance companies
 Usually sold in large denominations.
 Low default risk PENSION FUNDS
 Mature in one year or less from original issue date - Maintain funds in money market as preparation for long-term investing in stocks and bonds market.
MONEY MARKET MUTUAL FUNDS

- these funds permit small investors to invest in the money market by accumulating funds from numerous small investors yo
buy large denomination money market securities.

TYPES OF MONEY MARKET FINANCIAL INSTRUMENTS

REPURCHASE AGREEMENT
TREASURY BILLS
A repurchase agreement (repo) is a financial contract involving two securities transactions, a sale/purchase of a debt security
- also known as T-bills are the short-term money market instrument, issued by the central bank on behalf of the government to on a near date and a reversing purchase/sale of the same or equivalent debt security on a future date. Repurchase agreements
curb temporary liquidity shortfalls. enable short-term funds to be transferred between financial or non-financial institutions, usually ranging from one-day to 3 to
14 days
 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 NEGOTIABLE CERTIFICATES OF DEPOSIT
 Treasury bills can be sold via two methods: auctions or competitive bidding and noncompetitive bidding. In auctions,
the Bureau of Treasury announces quantity and type of securities that they will sell. Interested parties give bid  are securities issued by banks which records a deposit made. The certificate indicates the interest rate and the maturity
offering and the Treasury accepts the highest bids. The Treasury accepts the bids in ascending order of yield until the date of the deposit.
accepted bids reach the offering amount. Each accepted bid is awarded at the highest yield paid to any accepted bid.  Negotiable certificate of deposit is also classified as a bearer instrument
 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
COMMERCIAL PAPERS
accepted competitive bid.
 When analyzing investments, investors often try to compare performance of financial instruments with each other. To - an unsecured, short-term debt instrument issued by corporations. It's typically used to finance short-term liabilities such as
address this, most investors look at percentages to be able to compare returns better. At the point of view of investors, payroll, accounts payable, and inventories. Commercial paper is usually issued at a discount from face value
the discount rate indicates how much retum, in %, they can get from a particular security. The annualized discount
rate for a non-interest-bearing security (like Treasury bill) is described in Eq 3.1 IN THE PHILIPPINES, COMMERCIAL PAPERS ARE NOT REQUIRED TO REGISTER WITH SEC IF THEY MEET
THE FOLLOWING REQUIREMENTS:
EQ.4.1 ANNUALIZED DISCOUNT RATE
 Issued to not more than 10 non-institutional lenders
 Payable to a specific person
 Neither negotiable her assignable and held on to maturity
 Amount not exceeding P50million

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

EVALUATING MONEY MARKET SECURITIES

For example, a P1,000 Treasury bill with a 91- day tenor can be purchased at 995. To compute for the discount rate, we just -As a finance person, you should be able to understand and evaluate which money market securities to invest on depending on
need to substitute above information in the formulA the purpose of the business. Money market securities may be evaluated based on the interest rates and liquidity

-Another variation of the annualized discount rate is what we call the investment rate. The investment rate address two- VALUATION OF MONEY MARKET SECURITIES
weaknesses of the discount rate. The first one is the use of face amount as the denominator. Since the investor will pay less -Valuation of money market securities is important to determine at what amount an investor is willing to pay in exchange of a
than the face amount and the security is sold as a discount instrument, the computed return is understated. The second security. In some cases, investors need to give an amount as a bid to be able to buy securities. Money market securities can be
valued using the present value approach.
weakness is the use of 360 days to annualize the return which also understates the return. To be more specific, investment rate
uses 365 days (368 days during leap year) to annualize the return. The investment rate portrays a more accurate representation
of how much 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. 4.2 presents the formula for the annualized investment rate
For example, face value of a one-year Treasury bill is at P1,000 with an annual Interest rate of 3%. To compute for the value
of the Treasury bill, use the formula above. The face value which will be received upon maturity is P1,000. The interest rate Determination of Interest Rates
will be 3% and the number of periods is 1 (since it has a one-year maturity term
-To determine the appropriate interest rate or rates of the following factors should be considered assuming the cash flows are
Assume that another P1,000 Treasury bill with maturity term of 90 days with an annual interest rate of 4% is being evaluated. already been established:
Assume 360 days. The value of said Treasury bill is computed as follows
 Interest rates in the industry
 Risk Exposure
 Compensation on the market expectation

-In finance, interest can be determined by the function of the risk and the compensation of the investor on the difference between
The annual interest rate should be converted to match the 90- day maturity term. Hence, annual interest term of 4% shall be the risk – free rate and the market fluctuations (Eq 5.1)
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

Managing the Credit Risk of the Financial Instrument i = interest

CHAPTER 5 Rf = risk free rate where ( Real risk free rate = Rf – inflation)
Dm = debt margin or debt spread or the risk premium
Credit Risk and Interest Rates
The risk – free rate should be the rate that assumes zero default in the market where this is more or less equivalent to the rates
 Credit Risk – This is the risk that the borrower was not able to repay its obligation. offered by the sovereign. Hence, normal basis of the risk free rate is the Treasury bills issued by the republic. In the Philippines ,
 Interest Rates - is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed. this can also be referred in the Philippine Dealing Systems or PDS group.

Theories related in setting Interest Rates The PDS group is an organized market that was formed out of the financial distress in 1997. Using the technology,
the group provides full financial serviced from trading to clearing and to settlement.
 According to Fabozzi and Drake, there are two economic theories that drives the interest rates.

Loanable Funds Theory – assumes that it is ideal to supply funds when the interest are high and vice versa. This theory was
introduced by Knut Wicksell in 1900s.

Liquidity Preference Theory – was introduced by John Maynard Keynes, that the interest rates are dependent on the preference
of the household whether they hold or use it for investment. There by that the longer the term the higher the rates because
investors preferred the short – term investment more.

Why do investors preferred short – term investments?

Expectation Theories – is that the interest rates are driven by the expectation of the lender or borrowers in the risks of the
market in the future.

Pure Expectation Theory – is based on the current data and statistical analysis to project the behavior of the market in the future.

Biased Expectation Theory – includes that there are other factors that affect the term structure of the loans as well as the interest
to be perceived moving forward.

-The forward rates will be affected or will be adjusted if the liquidity of the borrower will be weaker or stronger in the future. The
adjustment or increase on the interest rate is called the Liquidity Premium. Liquidity Premium increases as the maturity
lengthens.

Market Segmentation Theory – this theory assumes that the driver of the interest rates are the savings and investment flows.
The idea is that buyers of bonds with different maturities have different characteristics and investment goals. For example,
insurance companies tend to buy long-term bonds in order to maximize income.
In commerce, risk is a very important factor to consider that may drives the business up or down.
Risk relates to the volatility of return patterns in the business. Thus, the challenge on quantifying the risk is imperative for the
investors to be able to determine how much they can keep themselves whole. There are risk that are inherent in every financing
transaction
These are:
Default Risk- Arise on the inability to make payment consistently
Liquidity Risk - Is identified by ensuring the business to be capable of meeting all its currently maturing obligation.
Legal Risk- Is dependent on the covenants set and agreed in between the lenders and borrowers. The legal risk will arise only
upon the ability of any of the parties to comply with the covenants of the contract. Normally, the burden is to the borrower to
comply given that the party who is obliged to pay back is them.

The common defaults in the covenants are as follows

1. Maintaining the financial ratios

2. Significant acquisition or disposal of assets
3. Repayment of other obligation
4. Declaration of dividends of any form without the consent of the lenders

Market Risk
- Is the impact of the market drivers to the ability of the borrowers to settle the obligation. Market risk is classified as a systematic
risk because it arises from external forces or based on the movement of the industry.

Mitigating The Interest Rate Risks

- Since there interest rate is dependent on the inflation, tenor and other market risk. Companies should consider and make
reasonable estimates to mitigate these risks. Commercially, these are measures that the company may consider mitigating the
impact of the interest rates. The movement of the yield maybe normal or increasing, inverted or declining or flat or constant over
time

Spot Rates
The yield curves presented in Figure 5.1 was a set of points of rates on a particular maturity date. In a normal yield curve, most
theories expect that interest rates increasing as the maturity lengthens. Although on the other hand, yield curve may change or
move differently as expected especially when the inflation is decreasing, or the purchasing power is improving. Spot rate is the
interest rate or yield available/ applicable for a particular time.
Spot rates are already actual rates and are not hedge. When the agreement is a spot rate the applicable interest rate is based on the
prevailing market rate at the particular time. It is important to know the spot rates to be used for establishing market expectation
in the future. Spot rates will be used to mitigate the risk by referring to historical yield vis-à -vis the forces that occur in those times.
For example, a typhoon occurred in the Metro Manila that causes the prices of the resources to rise because of the scarcity of
resources resulting to increase in interest rates. Upon noting the effect on the spot rates of the external forces, we will expect in the
future that when such incident will recur the spot rates will increase. Thus, it is incumbent to the supplier of funds to consider
quantifying its effect so that the variability of rates will be managed.

Forward Rates
Forward rates are normally contracted rates that fixed the rates and allow a party to assume such risk on the difference between
the contracted rate and the spot rate. It is a challenge for the financial consultants and economic experts to determine that most
probable rates in the future. The clash will be that the lenders would like a more conservative rate while borrowers are aggressive
or lower as much as possible versus the expected spot rate in the future.

Swap Rate
Another way on how to mitigate the interest rate risk is enter into a swap rate. Swap rate is another contract rate where a fixed
rate exchange for a certain market rate at a certain maturity. Usually the one used as reference is the LIBOR. For the swap rate, it is
normally the fixed portion of a currency swap.

LIBOR or London Interbank Offered Rate is used to benchmark interest rates which is used as reference for international banks to
borrow. It is calculated using the Intercontinental Exchange or ICE. The rates issued short term from 1 day up to 1 year and
releasing more than 30 rates based on about five currencies. This is the reason why this rate is used as the reference for consumer Other rating agencies
loans across the world. There are other credit rating agencies other than the three major like DBRS and CARE Ratings. Unlike S&P, Moody's and Fitch,
these credit rating agencies were not located in the United States.
Credit Ratings DBRS was established in 1976 in Toronto, Canada. The company was considered as the fourth largest ratings agency. The company
Aside from the purchasing power and factors initially identified, another driver of the interest rate or risk consideration are the observe almost 50,000 securities worldwide. DBRS also has offices in New York, Chicago, London, Frankfurt and Madrid in Spain.
credit ratings. Credit rating affects the confidence level of the investors to countries or companies. The credit ratings are The rating follows from AAA to C as the least.
determined by companies that are recognized globally that objectively assigns or evaluates countries and companies based on the CARE Ratings started its operation in 1993 based in India. The company is based in Mumbai with partners in Brazil, Portugal,
riskiness of doing business with them. The riskiness is primarily driven by their ability to manage their liquidity and solvency in Malaysia and South Africa. Other than Mumbai they also have about 10 regional officers that aims to provide information to
the long run. The higher the grade the lower the default risk associated to the country or company. investors to serve as guide as they enter into new investment. They also use AAA as the best instrument to D as the least.

These three major rating companies are:

 Standard & Poor's Corporation (S&P)
 Moody's Investors Service
 Fitch Ratings
Although, the credit ratings provided by these companies are just recommendatory opinion and will serve as reference only and is
not an absolutely provide default probability to the companies.

Standard & Poor’s Corporation

Standard and Poor's Corporation or S&P is an American financial services corporation was founded in 1941 by Henry Varnum
Poor in New York, USA. The company uses data gathered from 128 countries using more than 1,500 credit analysts to assess the
creditworthiness to the industry. The credit ratings provided by S&P were categorized to Investment Grade and Non-Investment
Grade and scaled from AAA to D as presented in Table 5.1.