➢ The money markets and the bond markets serve

WHAT IS MONEY MARKET? different purposes.

● refers to the network of corporations, financial ● Bond issuers typically raise money to finance
institutions, investors and governments which investments that will generate profits or, in the
deal with the flow of short-term capital. case of government issuers, public benefits for
● expanded significantly as a result of the general many years into the future. Issuers of money
outflow of money from the banking industry, a market instruments are usually more concerned
process referred to as disintermediation. with cash management or with financing their
portfolios of financial assets.
How Money Market Works
If the money markets are active, or "liquid",
● exists to provide the loans that financial
borrowers and investors always have the option of
institutions and governments need to carry out
engaging in a series of short-term transactions rather
their day-to-day operations.
than in longer-term transactions, and this usually holds
● For instance, banks may sometimes need to
down longer-term rates. In the absence of active
borrow in the short term to fulfill, their
money markets to set short-term rates, issuers and
obligations to their customers, and they use the
investors may have less confidence that longer-term
money market to do so.
rates are reasonable and greater concern about being
WHO USES THE MONEY MARKET? able to sell their securities with less active money
markets, on balance, also tend to have active bond
● The primary function of the money market is for markets.
banks and other investors with liquid assets to
gain a return on their cash or loans. TYPES OF MONEY-MARKET INSTRUMENTS
● They provide borrowers such as other banks,
Commercial Paper
brokerages, and hedge funds with quick
access to short-term funding. ● Is a short-term debt obligation of a
● The money market is dominated by private-sector firm or a government-sponsored
professional investors, although retail investors corporation.
with P50,000 can also invest. Smaller deposits ● Only companies with good credit ratings issue
can be invested via money market funds. Banks commercial paper because investors are
and companies use the financial instruments reluctant to bring the debt of financially
traded on the money market for different comprised companies. They tend to issued by
reasons, and they carry different risks. highly rated banks and are traded in similar
ways to securities.
Companies Banks Investors
Banker’s Acceptances
a. When a. If demand for a. Individuals ● is a promissory note issued by a non-financial
companies need long-term loans seeking to firm to a bank in return for a loan. The bank
to raise money and mortgages invest large resells the note in the money market at a
to cover their is not covered sums discount and guarantees payment.
payroll or by deposits from of money at Acceptances usually have a maturity of less
running costs, savings relatively low risk than six months.
they may issue accounts, banks may invest in
Commercial may then issue financial Treasury Bills
paper- short certificates of instruments.
term, unsecured deposit, with a Sums ● are securities with a maturity of one year or
loans for set of less P50,000 less, issued by national governments. Treasury
P100,000 or interest rate and can bills issued by a government its own currency
more that fixed-term be invested in are generally considered the safest of all
mature within maturity of up to money market possible investments in that currency. Such
1-9 months. five years. funds. securities account for a larger share of money
market trading than any other type of
instrument.

b. A Company Government Agency Notes

that has a cash
surplus may ● a type of short-term debt instrument, specifically
park money for a money market instrument issued by federal
a time in short government agencies or national government
term, debt-based agencies and government-sponsored
financial corporations.
instruments such ● Entities like the development banks, housing
as treasury bills finance corporations education lending
and Commercial agencies and agricultural finance agencies.
paper, They are heavy borrowers in the money
certificates of markets.
deposit, or bank
deposits Local Government Notes

● also known as municipal notes, are short-term

debt securities issued by state and local
government to raise funds for specific projects.
They are typically issued with maturities. These
WHAT MONEY MARKETS DO?
are notes issued by, provincial or local
➢ The money markets are thus related to the bond governments and by agencies of these
markets, in which corporations and governments governments such as schools authorities and
borrow and lend based on longer-term contracts. Similar transport commissions.
to bond investors, money-market investors are
extending credit, without asking any ownership in the
borrowing entity or any control over management.
Interbank Loans long-term bond before they reach maturity and
eventually to sell their holdings of stock as well.
● Loans extended from one bank to another with
which it has no affiliation. Many of these are Two types of exchanges in the secondary market for
across international boundaries and are used capital securities
by the borrowing institution to re-lend to its own
costumers. Banks lend far greater sums to 1. Organized exchanges
other institutions their own country. 2. Over-the-counter exchanges

Overnight loans Capital Market Trading

● are short-term unsecured loans from one bank A. Bond

to another. They may be used to help the B. Ordinary (Common) Equity Shares
borrowing bank finance loans to customers, but C. Preferred Share
often the borrowing bank add money to its
A. Bond- is any long-term promissory note issued by the
reserves in order to meet regulatory
firm. A bond certificate is the tangible evidence of debt
requirements and balance assets and liabilities
issued by a corporation or a governmental body and
Time Deposits represents a loan made by investors to the issuer.

● Another name for certificate of deposit or CD’s, Trading Process for Corporate Bonds
● are interest bearing bank deposits issued by a
The initial or primary sale of corporate bonds issues
bank for a specified period of time at a specified
occurs either through a public offering, using an
rate of interest. They are essentially a form of
investment bank serving as a security underwriter or
negotiable time deposit. Time deposit cannot be
through a private placement to a small group of
withdrawn without a penalty without a specified
investors (often financial institutions. Generally, when a
date.
firm issues bonds to the public, many investment banks
Repos or Repurchase Agreements are interested in underwriting the bonds. The bonds can
generally be sold in a national market.
● They serve to keep the markets highly liquid,
which in turn ensures that there will be a
constant supply of buyers for new
money-market instruments.
● is a combination of two transactions. In the first,
a securities dealer, such as a bank, sells
securities it owns to an investor, agreeing to
repurchase the securities at a specified higher
price at a future date. In the second
transaction, days or months later, the repo is
unwound as the dealer buys back the
securities from the investor. The amount the Other arrangements can be as follows:
investor lends is less than the market value of 1. Competitive Sale- the investment bank can
the securities, a difference called the spread or purchase the bonds through competitive
haircut, to ensure that it still has sufficient bidding against other investment banks or by
collateral if the value of the securities should fall directly negotiating with the issuer.
before the dealer repurchases them. 2. Negotiated Sale – a single investment bank
Capital Markets obtains the exclusive right to originate,
underwrite and distribute the new bonds
● It is a financial market in which longer-term debt through a one-on-one negotiation process. With
(original maturity of one year or greater) and the negotiated sale, the investment bank
equity instruments are traded. Capital markets provides the origination and advising services to
securities include bonds, stocks, and the issuers.
mortgages. 3. Best Efforts Underwriting Basis- the
underwriter does not guarantee a firm price to
Capital Market Participants the issuer. The investment bank incurs no risk
of mispricing the security since it simply seeks
1. National and local government
to sell the securities at the best market price it
● The national government issues long-term
can get for the issuing firm.
notes and bonds to fund the national debt while
local governments issue notes and bonds to The advantages and disadvantages of using bonds
finance capital projects.
2. Corporations Advantages
● Corporations issue both bonds and stock to
finance capital investment expenditures and 1. Long-term is generally less expensive than other
fund other investment opportunities. forms of financing.

Capital Market Trading 2. Bondholders do not participate in extraordinary

profits; the payments are limited to interest.
● Primary Market – is where new issues of
stocks and bonds are introduced. Investment 3. Bondholders do not have voting rights.
funds, corporations and individual investors can 4. Flotation costs of bonds are generally lower than
all purchase securities offered in the primary those of ordinary (common) equity shares
market.
○ When firm sell securities for the very Disadvantages
first time, the issue is an initial public
offering. Subsequent sales of a firm’s 1. Debt (other than income bonds) results in interest
new stocks or bonds are simply primary payments that, if not met, can force the firm into
market transactions. bankruptcy.
● Secondary Market – where the sale of
2. Debt (other than income bonds) produces fixed
previously issued securities take place, and it ia
charges, increasing the firm’s financial leverage.
important because most investors plan to sell
3. Debt must be repaid at maturity and thus at some Subordinated Debentures
point involves a major cash outflow. 4. The typically
restrictive nature of indenture covenants may limit the
firm’s future financial flexibility. ● Claims of bondholders of subordinated
debentures are honored only after the claims of
BOND FEATURES AND PRICES secured debt and unsubordinated debentures
have been satisfied.
The various features of corporate bonds and some of
the terminology associated with bonds follow:
Income Bonds
• Par Value- The face value of the bond that is returned
to the bondholder at maturity. • Coupon Interest Rate-
The percentage of the par value of the bond that will be ● An income bond requires interest payments only if
paid out annually in the form of interest. Formula is: earned and non payment of interest does not lead
Stated interest payment divided the Par value • to bankruptcy. Usually issued during the
Maturity- The length of time until the bond issuer returns reorganization of a firm facing financial difficulties,
the par value to the bondholder and terminates the these bonds have longer maturity and unpaid
bond. interest is generally allowed to accumulate for
some period of time and must be paid prior to the
• Indenture- The agreement between the firm issuing payment of any dividends to stockholders
the bonds and the bond trustee who represents the
bondholders. It provides the specific terms of the loan
agreement, including the description of the bonds, the B. Secured Long-Term Bonds
rights of the bondholders, the rights of the issuing firm
and the responsibilities of the trustees.
Mortgage Bonds
• Current Yield- This refers to the ratio of the annual
interest payment to the bond's market price.
● A mortgage bond is a bond secured by a lien on
• Yield to Maturity- This refers to the bond's internal real property. Typically, the market value of the
rate of return. It is the discount rate that equates the real property is greater than that of the mortgage
present value of the interest and principal payments bonds issued. This provides the mortgage
with the current market price of the bond. bondholders with a margin of safety in the event
that the market value of the secured property
FORMULA: declines.

Mortgage bonds can further be subclassified as follows:

(a) First Mortgage Bonds - The first mortgage bonds

have the senior claim on the secured assets if the
Credit Quality Risk same property has been pledged on more than
one mortgage bond.
● Credit quality risk is the chance that the bond (b) Second Mortgage Bonds- These bonds have the
issuer will not be able to make timely payments. second claim on assets and are paid only after
the claims of the first mortgage bonds have been
Bond ratings satisfied.
● Involve a judgment about the future risk (c) Blanket or General Mortgage Bonds - All the
potential of the bond provided by rating assets of the firm are used as security for this
type of bonds.
agencies such as Moody's, Standard and
(d) Closed-end Mortgage Bonds - forbid the further
Poor's and Fitch IBCA, Inc. Dominion Bond
use of the pledged assets security for other
Rating Services.
bonds. This protects the bondholders from dilution
a) Bond ratings are favorably affected by:
of their claims on the assets by any future
b) A low utilization of financial leverage, mortgage bonds.
c) Profitable operations; (e) Open-end Mortgage Bonds - These bonds allow
d) A low variability of past earnings: the issuance of additional mortgage bonds using
e) Large firm size: the same secured assets as security. However, a
f) Little use of subordinated debt. restriction may be placed upon the borrower,
● The poorer the bond rating, the higher the rate requiring that additional assets should be added to
of return demanded in the capital markets. the secured property if new debt is issued.
(f) Limited Open-end Mortgage Bonds - These
TYPES OF BONDS bonds allow the issuance of additional bonds up
A. Unsecured Long-Term Bonds to a limited amount at the same priority level using
the already mortgaged assets as security.
Debentures

● These are unsecured long-term debt and OTHER TYPES OF BONDS

backed only by the reputation and financial
stability of the corporation. Because these
bonds are unsecured, the earning ability of the 1. Floating Rate or Variable Rate Bonds
issuing corporation is of great concern to the
bondholder.
A floating rate bond is one in which the interest payment
changes with market conditions. In periods of unstable
interest rates this type of debt offering becomes appealing
to issuers and investors. To the issuers like banks and
finance companies, whose revenues go up when interest
rates rise and decline as interest rates fall, this type of
debt eliminates some of the risk and variability in earnings
that accompany interest rate swings. To the investor, it
eliminates major swings in the market value of the debt
that would otherwise have occurred if interest rates had satisfying the prior claims of various creditors and
changed. preferred

A common feature of all the floating rate bonds is that an shareholders. Ordinary (common) equity shareholders are
attempt is being made to counter uncertainty by allowing the true owners of the corporation and consequently bear
the interest rate to float [e.g., interest rates may be the ultimate risks and rewards of ownership.
adjusted quarterly at 3% above the three-month London
Interbank Offered Rate (LIBOR)]. In this way a change in
cash inflows to the firm may be offset by an adjustment in Business firms organized as a corporation may choose to
interest payments. issue publicly traded stock (publicly owned corporation) or
keep ownership only among the original organizers
(closely held corporation). As owners of the firm, ordinary
2. Junk or Low-Rated Bonds shareholders are considered to be residual domains. This
means that ordinary shareholders have the right to claim
any cash flows or value after all other claimants have
Junk or low rated bonds are bonds rated BB or below. The received what they are owed. These profits can be used to
major participants of this market are new firms that do not reinvest in the firm to foster growth, pay out as dividends
have an established record of performance, although in to shareholders or a combination of the two.
recent years junk bonds have been increasingly issued to
finance corporate buyouts. Since junk bonds are of
speculative grade, they carry a coupon rate of between 3 FEATURES OF ORDINARY EQUITY SHARES
to 5 pc. and more than AAA grade long term debt. As a
result, there is now an active market for these new debt
instruments. Because of the acceptance of junk or 1. Par value/No par value
low-rated bonds, many new firms without established
performance records now have a viable financing
alternative to secure financing through a public offering, • Ordinary equity share may be sold with or without par
rather than being forced to rely on more-costly commercial value.
bank loans.
• Par value of ordinary equity share is the stated value
3. Eurobonds attached to a single share at issuance.

These are bonds payable or denominated in the • A firm issuing no par share may either assign a stated
borrower's currency, but sold outside the country of the value or place it on the books at the price at which the
borrower, usually by an international syndicate of equity share is sold.
investment bankers. This market is denominated by
bonds stated in U.S. dollars.
2. Authorized, issued, and outstanding

The Eurobond is usually sold by an international syndicate

of investment bankers and includes bonds sold by • Authorized shares is the maximum number of shares
companies in Switzerland, Japan, Netherlands, Germany, that a corporation may issue without amending its charter.
the United States and Britain, to name the most popular
countries
• Issued shares is the number of authorized shares that
have been sold. • Outstanding shares are those shares
An example might be a bond of a U.S. company payable held by the public.
in dollars and sold in London, Paris, Tokyo or Frankfurt.
• Treasury shares previously issued shares that are
Eurobonds are also referred to as bonds issued in Europe reacquired and held by the firm. Thus, outstanding share
by an American company and pay interest and principal is issued share less treasury share.
to the lender in U.S. dollars.
3. No maturity
The use of Eurobonds by U.S. firms to raise funds has
fluctuated dramatically with the relative interest rates an
abundance or lack of funds in the European markets • Ordinary equity share has no maturity and is a
dictating the degree to which they are used. permanent form of long-term financing.

4. Treasury Bonds • The firm can repurchase its shares in the secondary
markets either through a brokerage firm a tender offer.
(formal offer to purchase shares of a corporation)
Treasury bonds carry the "full-faith-and-credit" backing of
the government and investors consider them among the
safest fixed- income investments in the world. The BSP 4. Voting rights
sells Treasury securities through public auctions usually
to finance the government's budget deficit. When the
• Each share of ordinary equity generally entitles the
deficit is large, more bonds come to auction. In addition,
holder to vote on the selection of directors and in other
the BSP uses Treasury securities to implement monetary
matters.
policy.

• Shareholders unable to attend the annual meeting to

B. ORDINARY (COMMON) EQUITY SHARES
vote may vote by proxy. • A proxy is a temporary transfer
of the right to vote to another party.
Ordinary equity shares is a form of long-term equity that
represents ownership interest of the firm. Ordinary equity
• There are two common systems of voting:
shareholders are called residual owners because their
claim to earnings and assets is what remains after
Majority voting - a voting system that entitles each a. Dividends are stated as a percentage of
shareholder to cast one vote for each share owned. the par value and are commonly fixed and
paid quarterly but are not guaranteed by
the issuing firm. Some recent preferred
Cumulative voting - a voting system that permits the share issues called adjustable rate,
shareholder to cast multiple votes for a single director. variable rate, or floating rate preferred, do
not have a fixed dividend rate but peg
dividends to an underlying index such as
5. Book value per share one of the treasury bill rate or other
money market rates
3. Cumulative and Noncumulative dividends
• The accounting value of an ordinary equity share is a. Dividends payable to preferred shares are
equal to the ordinary share equity (ordinary share plus either cumulative or noncumulative: most
paid-in capital plus retained earnings)divided by the are cumulative. If preferred dividends are
number of shares outstanding. cumulative are not paid in a particular
year, they will be carried forward as an
arrearage. Usually, both accumulated
6. Numerous rights of stockholders (past) preferred dividends and the current
preferred dividends must be paid before
the ordinary equity shareholders receive
Collective and individual rights of ordinary equity
anything. If the preferred dividends are
shareholders include among others:
noncumulative, dividends not declared in
any particular year are lost forever and
(a) Right to vote on specific issues as prescribed by the preferred shareholders cannot claim
the corporate charter such as election of the such anymore
board of directors, selecting the firm's 4. No definite maturity date
independent auditors, amending the articles of a. Preferred share is usually intended to be
incorporation and bylaws, increasing the amount a permanent part of a firm’s equity and
of authorized stock, and so forth. has no definite maturity date. preferred
(b) Right to receive dividends if declared by the firm's share sometimes carries special
board of directors. retirement provisions. Almost all
(c) Right to share in the residual assets in the event preferred shares have a call feature that
of liquidation. gives the issuing firm the option of
(d) Right to transfer their ownership in the firm to purchasing the share directly from its
another party. owners, usually at a premium above its
(e) Right to examine the corporate banks. par value. Some preferred shares have a
(f) Right to share proportionally in the purchase of sinking fund provision that requires the
any new issuance of equity shares. This is known issuer to repurchase and retire the share
as the pre-emptive right. on a scheduled basis. Owners of
convertible preferred share have the
option of exchanging their preferred
C. PREFERRED SHARE share for ordinary (common) equity share
based on specified terms and conditions.
5. Convertible preferred share
Preferred share is a class of equity shares which has a. Owners of convertible preferred share
preference over ordinary (common) equity shares in the have the option of exchanging their
payment of dividends and in the distribution of corporation preferred share for ordinary (common)
assets in the event of liquidation. Preference means only equity share based on specified terms
that the holders of the preferred share must receive a and conditions.
dividend (in the case of a going concern firm) before 6. Voting rights
holder of ordinary (common) equity shares are entitled to a. Preferred share does not ordinarily carry
anything. Preferred shares generally has no voting voting rights. Special voting procedures
privileges but it is a form of equity from a legal and tax may take effect if the issuing firms omits
standpoint. its preferred dividends for a specific time
period. Preferred shareholders are then
permitted to elect a certain number of
The issuance of preferred shares is favored when the members to the board of directors in order
following conditions prevail: to represent the preferred shareholder’
interests.
7. Participating features
1. Control problems exist with the issuance of a. Participating preferred share entitles its
ordinary share. holders to share in profits above and
2. Profit margins are adequate to make of additional beyond the declared dividend, along with
leverage attractive. ordinary (common) equity shareholders.
3. Additional debt poses substantial risk. Most preferred share issues are
4. Interest rates are low lowering the cost of nonparticipating. Without nonparticipated
preferred share. preferred, the return is limited to the
5. The firm has a high debt ratio, suggesting infusion stipulated dividend
of equity financing is needed. 8. Protective features
a. Preferred share issues often contain
covenants to assure the regular payment
PREFERRED SHARE FEATURES of preferred share dividends and to
improve the quality of preferred share. For
example, covenants may restrict the
The following are the major features of preferred share amount of common share cash dividends,
specify minimum working-capital levels
and limit the sale of securities senior to
1. Par value preferred share.
a. Par value is the face value that appears b. Preferred shareholders have priority over
on the stock certificate. In some cases, ordinary (common) equity shareholders
the liquidation value per share is provided with regard to earnings and assets. Thus,
for in the certificate. dividends must be paid on preferred share
2. Dividends
 before they can be paid on the ordinary COMPARATIVE FEATURES OF ORDINARY EQUITY
(common) equity share, and in the event SHARES,PREFERRED SHARES AND BONDS
of bankruptcy, the claims of the preferred
shareholders must be satisfied before the
ordinary (common) equity shareholders
receive anything. To reinforce these Ordinary Preferred Bonds
features, most preferred shares have Equity Shares Shares
coverage requirements similar to those
on bonds. These restrictions limit the (a) Ownership Belongs to Limited rights Limited rights
and control ordinary equity when under default
amount of preferred share a company can
of the firm shareholders dividends are in interest
use, and they also require a minimum through voting missed payments
level of retained earnings before common right and
dividends can be paid. residual claim
to income
9. Call provision
a. A call provision gives the issuing (b) Obligation None Must receive Contractual
corporation the right to call in the to provide payment obligation
preferred share for redemption. As in the retum before
case of bonds, call provisions generally ordinary
sharehoIder
state that the company must pay an
amount greater than the par value of the (c) Claim to Lowest claim Bondholders Contractual
preferred share, the additional sum being assets in of any and creditors obligation
termed a call premium. For example, bankruptcy security must be
Himaya Corporation’s 12 percent, P100 holder satisfied first
par value preferred share, issued in
(d)Cost of Highest Moderate Lowest
2005, is noncallable for 10 year, but it may distribution
be called at a price of P112 after 2015.
10. Maturity (e) Risk-return Highest Moderate Lowest
a. Three decades ago, most preferred share trade off risk,highest risk,moderate risk,moderate
was perpetual – it had no maturity and return (at retum return
least in
never needed to be paid off. However, theory)
today most new preferred share has a
sinking fund and thus an effective (f) Tax status Not deductible Not deductible Tax deductible
maturity date. of payment by Cost=Interest
corporation paymentx(1-Ta
x
rate)
PREFERRED SHARE VALUATION
(g) Tax status A portion of A portion of Government
of payment to Dividend paid Dividend paid bond interest
● Preferred share valuation is relatively simple if the recipient to another to another is tax
firm pays fixed dividends at the end of each year. corporation is corporation is exempt
tax exempt tax exempt
If this condition holds, then the stream of dividend
payments can be treated in perpetuity and be
discounted by the investor's required rate of return
on a preferred share issue. A perpetuity is an
annuity with an infinite life span. If. the preferred
share has high risk, investors normally require a
higher rate of return. This is because creditors
have priority over preferred share holders in their
claims to both income and assets.
● Thus, the intrinsic value of a share of preferred
share (Po) is the sum of the present values of
future dividends discounted at the investor's
required rate of return. This also can be
determined using the following valuation model.

where: Dp = Per share cash dividend Kp =Investor's

required rate of return on preferred share

For example, Federal Electric and Power Company has an

issue of preferred share outstanding that pays a yearly
dividend of P10.80. Investors require a 12% return on this
preferred share.

Determine the intrinsic value of the preferred share

Solution:

Po = P10.30 = P90 12%