MODULE 4.

FINANCIAL INSTRUMENTS

OBJECTIVES
After successful completion of this module, you should be able to:
• Describe the different financial instrument
• Identify the limitations or risk in using each financial instrument
• Describe how financial instruments be valued and treated in financial reports

COURSE MATERIALS
Financial instruments are monetary contracts between parties ..... International Accounting
Standards IAS 32 and 39 define a financial instrument as "any contract that gives rise to a financial
asset of one entity and a financial liability or equity instrument of another entity".

Financial instruments or assets or securities are intangible as future economic benefits

takes a claim in the form of cash that will be received in the future.

Two parties involved: the issuer and the investor

Issuer is the party that issues the financial instruments and promises to make future cash
payments to the investor. Normally, issuer has requirements for the business when issuing
financial liabilities/obligations.

Investor is the party who owns the financial instruments issued by the borrower which
bears the promise to pay for the principal + interests. This is normally traded in the financial market
by investors to persons willing to pay for the proceeds and willing to take (inherent) risks.

MONEY MARKET
In the money market, financial instruments are traded and not cash/currency
- Short term and highly liquid
- Sold in large denominations
- Low default risk and matures within one year or less
- Classified in the financial statements as cash equivalents (redeemable within three
months or less from the date of purchase)

TYPES OF FINANCIAL INSTRUMENTS

Money market instruments took the form of short-term deposits, government securities,
commercial papers and certificates of deposit which form part of the Philippine interest rate
market.

Treasury Bills
- Government securities issued by the Bureau of Treasury which mature in less than a
year
- Three tenors: 91-day, 182-day and 364-day (# of days is a universal practice
ensuring that the bills mature in a business day)
 - Quoted either by their yield date (a discount) or by their price based on 100 points
per unit.
- T-bills which will mature in less that 91-day are called Cash management Bills (35
day or 42 day)
- Banks bid for the t-bills held by the Bureau of Treasury and resell these to investors.
- Have zero default risk (safest investment instrument) since the government can
always print more money that they can use to redeem these securities at maturity.
- Can be traded easily in the secondary market.
- Interest not stated but sold at a discount (lower purchase price than the maturity
value)

Repurchase Agreement
What Is a Repurchase Agreement?
A repurchase agreement (repo) is a form of short-term borrowing for dealers in
government securities. In the case of a repo, a dealer sells government securities to investors,
usually on an overnight basis, and buys them back the following day.

For the party selling the security and agreeing to repurchase it in the future, it is a repo;
for the party on the other end of the transaction, buying the security and agreeing to sell in the
future, it is a reverse repurchase agreement.

Repos are typically used to raise short-term capital.

Think of a repurchase agreement as a loan with securities as collateral. For example, a

bank sells bonds (collateral) to another bank and agrees to buy the bonds back later at a higher
price.

Negotiable Certificates of Deposits

These are securities issued by banks which records a deposit made indicating the
interest rate and the maturity date. This can’t be easily withdrawn since this is different from a
demand deposit. The CD restricts the holder from withdrawing the fund until maturity date for a
promise of high return than a regular demand deposit.

Commercial Paper
- Unsecured promissory notes that are only issued by large and credit worthy
enterprises
- Maturity can be short-term or long term
- Directly issued to the buyer, no secondary market
- Issuers maintain credit lines with banks to back-up the commercial papers when it
falls due and no funds are available to pay for the lenders (reduces the risk).
- May have stated interest rate or sold at discounted basis

Banker’s Acceptance
This refers to an order to pay a specified amount of money to the bearer on a specified
date. This is often used to finance the purchase of goods that have yet to be delivered to the
buyer. This type of instrument is used by importers and exporters of goods where buyer and
seller have no established credit with each other. This is directly payable to the buyer.

EVALUATING MONEY MARKET SECURITIES

In evaluating money market securities, interest and tenor of the securities before maturity
are the large factors to consider. As the interest increases, the value od the securities reduces.

As a finance person, one must have to understand which money market to invest on which
can be evaluated based on the interest rates and liquidity. Interest rates dictate the potential return
that can be received from an investment. Interest rates on money market is relatively low as a
result the low risks associated with them and the short maturity period.

Money market securities have a deep market so that these are competitively priced; they
carry the same risks profile and attributes making each instrument a close substitute for each
other.

VALUATION ON MONEY MARKET SECURITIES

Valuation of money market securities is important to determine at what amount an investor
is willing to pay in exchange of a security. This can be valued using the present value approach
where the interest rate used in the valuation shall reflect the required return from the instrument
based on the investors’ perceived risk.

The formula for present value is:

PV = CF/(1+r)n

Where:
CF = cashflow in future period
r = the periodic rate of return or interest (also called the discount rate or the
required rate of return)
n = number of periods

Let's have an example.

Assume that you would like to put money in an account today so that you have enough
money in 10 years. If you would like to invest P10,000 in 10 years, and you know you can get 5%
interest per year from a savings account during that time, how much should you put in the account
now?

To compute:

PV = P10,000/ (1 + .05)10 = P6,139.13

a. On ordinary calculator, you divide P10,000 by 1.05 then press equals (=) ten times.
b. Using the PV table, locate the period of 10 years, then rate of 5%. Using the equivalent
factor, multiply it to the P10,000 amount.
 Hence, P6,139.13 will be worth P10,000 in 10 years if you can earn 5% each year. In other
words, the present value of P10,000 in this scenario is P6,139.13. It is important to note that the
three most influential components of present value are time, expected rate of return, and the size
of the future cash flow.

Why Does Present Value (PV) Matter?

The concept of present value is one of the most fundamental and prevalent in the world of
finance. It is the basis bond pricing, stock pricing financial modeling, banking, insurance, and
pension fund valuation. It accounts that money we receive today can be invested to earn a return.
Present value accounts for the time value of money.

ACTIVITIES/ASSESSMENTS
Answer the following exercises:

Exercise Mod 4-1 (Essay)

In simple language, what do you understand about financial instruments? What is its importance
and role to the business and to the economy?

Exercise Mod 4-2 (True or False)

1). According to Conceptual Framework for Financial Reporting (2018), a property 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.

2). 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.

3). The investor is the party that issues the financial instrument and agrees to make future cash
payments to the investor.

4). The issuer is the party that receives and owns the financial instrument and bears the right to
receive payments to be made by the issuer.

5). 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.

6). On an accounting perspective, investors recognize financial instruments as a liability.

7). At the point of issuance of the financial instrument, the issuer usually gives something of value
(usually cash) to the investor. The financial instrument then becomes the proof (hence, called as
security) of the future claim of the investor from the issuer.

8). One primary misconception is that money or currency is the security being traded in a money
market.

9). Financial instruments are the primary subject of trading in a money market
10). Financial instruments traded in the money market are short-term and highly liquid, that it can
be considered close to being money.

11). 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.

12). Most transactions in the money market are very large, hence, they are considered as retail
markets.

13). 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.

14). Investors look at the money market as a permanent investment that will provide a slightly
higher return than holding on the money or depositing it in banks.

15). If investors believe that the prevailing market conditions do not justify a stock purchase or
there might be a possible interest rate hikes impacting bonds, then they can choose to invest on
money market instruments in the meantime.

16). Money market Instruments took the form of short-term deposits, government securities,
commercial papers and certificates of deposit which form part of the Philippine interest rate
market.

17). Money market instruments are governed by Philippine regulations and are influenced by
market movements.

18). Treasury Bills are government securities issued by Bangko Sentral ng Pilipinas which mature
in less than a year.

19). There are three tenors of Treasury Bills: (1) 91 day (2) 182-day (3) 364-day Bills.

20). Treasury bills have virtually zero default risk since the government can always print more
money that they can use redeem these securities at maturity.

21). 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.

22). When a P1,000 Treasury bill with a 91-day tenor can be purchased at 995, this means that
its Annualized Investment rate is 1.98%

23). A repurchase agreement (repo) is a financial contract involving two securities transactions,
a sale/purchase of a debt security on a near date and a reversing purchase/sale of the same or
equivalent debt security on a future date.
24). 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.

25). Dealers of government securities commonly use repos to manage liquidity and take
advantage of expected changes in interest rates.

26). Negotiable certificates of deposit are securities issued by banks which records a deposit
made.

27). 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.

28). Long term commercial paper means an evidence of indebtedness of any person with a
maturity of three hundred and sixty-five (365) days or less.

29). 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 high level of risk since this security is not secured.

30). Banker’s acceptances refer to an order to pay a specified amount of money to the bearer on
a specified date.

31). Banker’s acceptance are usually offered to importers and exporters.

32). Banker’s acceptances are usually payable to the order. Hence, this can be subsequently
purchased and sold until it matures.

33). Money market securities may be evaluated based on the interest rates and liquidity.

34. Valuation of money market securities is important to determine at what amount an investor is
willing to pay in exchange of a security

35). As a general rule, as the interest rate rises, the value of the security becomes higher. This
means that the market risk is increases thus the impact on the value of the securities also reduces.

Exercise Mod 4-3 (Multiple Choice)

1). Using the present value approach, what is the market security value of one-year Treasury bill
is at P1,000 with an annual interest rate of 3%?
a. P 1,030.00 b. P 970.87 c. P 1,000.00 d. P942.60

2). Using the present value approach, what is the market security value of 90-day Treasury bill is
at P1,000 with an annual interest rate of 4%?
a. P 990.10 b. P 961.54 c. P 1,000.00 d. P 1,040.00

3). Using the present value approach, what is the return of one-year Treasury bill is at P1,000
with an annual interest rate of 3%?
 a. P 30.00 b. P 29.13 c. P 0.00 d. P57.40

4). Using the present value approach, what is the return of 90-day Treasury bill is at P1,000 with
an annual interest rate of 4%?
a. P 9.90 b. P38.46 c. P 0.00 d. P 40.00

5). What is the Annualized Discount rate of a P1,000 Treasury bill with a 91-day tenor that can be
purchased at 995?
a. 1.98% b. 2.02% c. 0.50% d. 1.00

6). What is the Annualized Investment rate of a P1,000 Treasury bill with a 91-day tenor that can
be purchased at 995?
a. 1.98% b. 2.02% c. 0.50% d. 1.00

7). are the main vehicle used for transactions in the financial market. For
the purposes of presentation in financial statements, these may be presented under cash
equivalents or investments.
a. Financial Intermediary b. Financial Instruments c. Currency d. Money

8). Which of the following is not correct about financial instruments?

a. The issuing party usually needs additional funds for investment to further grow their
business.
b. 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.
c. At the point of issuance of the financial instrument, the issuer usually receives something
of value (usually cash) from the investor.
d. The investor is the party that issues the financial instrument and agrees to make future
cash payments to the investor.

9). Which of the following is not an economic purpose of financial instruments?

a. 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).
b. 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.
c. 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. (Refers to “Mature Secondary
Market for money market instruments” not to financial instruments)
d. All are economic purposes of financial instruments.

10). Money market securities have fundamental characteristics, except:

a. Usually sold in large denominations
b. Low default risk
c. Mature in one year or less from original issue date.
d. Money market securities commonly have an active secondary market.
 MODULE 5. DEBT SECURITIES MARKET

OBJECTIVES
After successful completion of this module, you should be able to:
• Identify different types of bonds
• Select the bond or debt security investments that will yield higher value

COURSE MATERIALS
Debt market or debt securities market is the financial market where the debt instruments
or securities are transacted by suppliers and demanders of funds. This is the:
- Money market for short term debts
- Capital market for long term debts, like equity in the stock market

DEBT INSTRUMENTS
What are debt instruments?
➢ A paper or electronic obligation that enable the issuer to raise funds by promising to
repay lender in accordance to terms of the contract
➢ Provide a way to market participants to easily transfer the ownership of debt obligations
from one party to another.
➢ A legally enforceable evidence of a financial debt and the promise to timely repay the
principal and interest.

Importance of debt instruments

1. It makes the repayment of the debt instrument legally enforceable
2. It increases transferability of the obligation by way of increased liquidity and a means to
trade this in the financial market.

Types pf Debt Instruments

a. Short-term debt instruments – obligations both personal and corporate that are paid
within one year.
Examples are: credit card bills, payday loans, car title loans, consumer loans, revolving
credit lines, treasury bills
b. Long term debt instruments – obligations due for payment for over a year through
periodic installment payments.
Examples are: mortgage, car loans

DEBT SECURITY
What is a debt security?
➢ refers to a debt instrument that has defined basic terms and can be bought or sold
between two parties.
➢ Also known as fixed-income securities that are traded over the counter
➢ Interest rate is largely determined by the perceived repayment ability of the borrower.
➢ The total dollar value of traded debt securities that are conducted daily is much larger
than the traded stocks.
 Examples are: collateralized securities, collateralized debt obligations (CDO),
collateralized mortgage obligations (CMO), mortgage backed securities issued by the
Government National Mortgage Association, zero-coupon rate.

Basic terms of a debt security

- Notional (estimated/theoretical) amount or amount borrowed
- Interest rate
- Maturity and renewal date

Types of debt securities

1. Money market debt securities – debt securities with maturities of less than one year like
treasury bills and certificate of deposits
2. Capital debt securities – debt securities with maturities of more than one year like notes,
bonds and mortgage backed securities

Debt Security vs Debt Instrument

What is the difference between debt security and debt instrument?
Debt security
➢ refers to money borrowed that must be repaid and has a fixed amount, a maturity date
and interest rate.
➢ Can be bought or sold between two parties
➢ Some are discounted in the original market price.
➢ Examples are treasury bills, bonds, preferred stock and commercial paper

Debt instrument
➢ Can be paper or electronic form; a tool that an entity can utilize to raise capital
➢ Gives market participants the option to transfer the ownership of the debt obligation from
one party to another
➢ Primary focuses on debt capital raised by institutional entities.
➢ Examples are bonds, debentures (unsecured loans), leases, certificates, bills of
exchange and promissory notes, credit cards, loans, credit lines

A bond is a typical example of a debt instrument as it is an instrument of indebtedness of the

bond issuer to the holders. It is also a debt security, under which the issuer owes the holders a
debt and is obliged to pay them interest (the coupon) or to repay the principal at maturity date.

Debt securities have implicit level of safety because they ensure that the principal amount is
returned to the lender at maturity date or upon the sale of the security. They are classified by their
level of default risk, the type of issuer and income payment cycles. The riskier the bond, the higher
is its interest rate or return yield.

Types of bonds
1. Corporate bonds – these are bonds issued by corporations to finance operations or
expansions.
 2. Government bonds – these are bonds issued by government that provides the face value
on the agreed maturity date with periodic interest payments. This type of bond attracts
conservative investors.
3. Municipal bonds- these are bonds issued by the local government and their agencies
purposely to fund special projects.
4. Mortgage bonds – these are pooled mortgages on real estate properties which are locked
in by the pledge of particular assets. Payments may be monthly, quarterly or semi-
annually.
5. Asset-backed bonds (Asset-backed Securities ABS) – this is a financial security
collateralized by pool of assets such as loans, leases, credit card debt, royalties or
receivables.
6. Collateralized Debt Obligation (CDO) - this is a structured financial product that pools
together cash flow generating assets and repackages this asset pool into discrete
tranches (which vary substantially in their risk profile) that can be sold to investors. Like
the senior tranches are generally safer because they have first priority on payback from
the collateral in the event of default.

Characteristics of Bond
• Coupon rate – this is the fixed interest rate or return of the bond which is paid to the
bondholders semi-annually.
• Maturity date – this is the period when the bond issuer pays the investor at full-faced
value of the bond. This may be short-term or long-term.
• Current or market price – bonds can be purchased at par, below par or above par. The
market price depends on the level of interest rate in the market.

Bond Valuation
This is a technique in determining the theoretical fair value of a bond. Bond valuation
includes calculating the present value of the bond’s future interest payments, also known as its
cash flows, and the bond’s value upon maturity, also known as the face value or par value.

Approach in Bond Valuation

a. Traditional approach – where valuation is to discount every cash flow of a bond by the
same interest rate or discount rate for each period.
b. Arbitrage Free Valuation approach – this value the bond as a package of cash flows, with
each cash flow viewed as a zero-coupon bond and each cash flow discounted at its unique
discount rate.

Valuation of bonds with embedded options

There are two models:
a. The lattice model which is used to value callable bonds and putable bonds
b. The Monte Carlo simulation model which is used to value mortgage-backed securities and
certain types of asset-backed securities.
 ACTIVITIES/ASSESSMENTS
Answer the following Exercises
Exercise No. Mod 5-1 (Essay)
Give a brief summary of your understanding of what debt securities are and their importance to
the businesses and to the economy.

Exercise No. Mod 5-2 (True or False)

1). Financial market is a forum or market that enables suppliers and demanders of funds to make
transactions.

2). Debt can be short term or long term that is why it can be within capital market definition if short
term, while in money market if long term.

3). Debt market or Debt Securities Market is the financial market where the debt instruments or
securities are transacted by suppliers and demanders of funds.

4). A debt instrument is a paper or electronic obligation that enables the issuing party to raise
funds by promising to repay a lender in accordance with terms of a contract.

5). Types of debt instruments include notes, bonds, debentures, certificates, mortgages, leases
or other agreements between a lender and a borrower.

6). The importance of a debt instrument is twofold. First, it makes the repayment of debt legally
enforceable. Second, it increases the transferability of the obligation, giving it increased liquidity
and giving creditors a means of trading these obligations on the market.

7). Without debt instruments acting as a means of facilitating trading, debt would only be an
obligation from one party to another.

8). Long-term debt instruments are obligations due in one year or more, normally repaid through
periodic installment payments.

9). Short-term debt instruments, both personal and corporate, come in the form of obligations
expected to be repaid within one calendar year.

10). In corporate finance, short-term debt usually comes in the form of revolving lines of credit,
loans that cover networking capital needs and Treasury bills.

11). Long-term debt instruments in personal finance are usually mortgage payments or car loans.

12. Debt security refers to a debt instrument, such as a government bond, corporate bond,
certificate of deposit (CD), municipal bond or preferred stock, that can be bought or sold between
two parties and has basic terms defined, such as notional amount (amount borrowed), interest
rate, and maturity and renewal date.
13). The interest rate on a debt security is largely determined by the perceived repayment ability
of the borrower; higher risks of payment default almost always lead to higher interest rates to
borrow capital.

14). Also known as fixed-income securities, most debt securities are traded over the counter.

15). Debt securities, sometimes referred to as fixed-income securities, include money market
securities and capital market debt securities such as notes, bonds, and mortgage backed
securities.

16). Money market securities are debt securities with maturities of less than one year. Money
market securities of most interest to individual investors are treasury bills (T-bills) and certificates
of deposit (CDs).

17). Capital market debt securities are debt securities with maturities of longer than one year.
Examples are notes, bonds, and mortgage-backed securities.

18). Usually Financial Instruments and Financial Securities are interchangeably used, and these
are indeed similar.

19). All financial instruments are financial securities.

20). A security is a fungible, negotiable financial instrument that holds some type of monetary
value.

21). A security represents an ownership position in a publicly-traded corporation (via bonds), a

creditor relationship with a governmental body or a corporation (represented by owning that
entity's stock), or rights to ownership as represented by an option.

22). Financial Instruments are called securities since securities carry some value on them. When
they are exchanged in the market, the realization will be informed of cash and a benefit for the
holder of the securities.

23). Alternately we can call financial instruments are called Securities, since they are backed by
Corporations or Government.

24). Debt securities are negotiable and tradable debt instruments which carry value on them.

25). A credit card bills, and payday loans are examples of debt securities.

26). Debt securities represent a claim on the earnings and assets of a corporation, while equity
securities are investments into debt instruments.

27). A stock is an equity security, while a bond is a debt security.

28). When an investor buys a stock, he is essentially loaning the corporation money, and he has
the right to be repaid the principal and interest on the bond. In contrast, when someone buys a
bond from a corporation, he essentially buys a piece of the company.

29). While most people are more familiar with the market for equity securities, the debt market is
nearly twice its size, globally.

30). Debt securities have an implicit level of risk simply because they ensure that the principal
amount that is returned to the lender at the maturity date or upon the sale of the security.

31). Debt market or Debt securities market is also known as bond market is a financial market in
which the participants are provided with the issuance and trading of debt securities.

32. The bond market primarily includes government-issued securities and corporate debt
securities, facilitating the transfer of capital from savers to the issuers or organizations requiring
capital for government projects, business expansions and ongoing operations.

33). In the bond market, participants can issue new debt in the market called the primary market
or trade debt securities in the market called the secondary market.

34). In bond markets, the participants are either buyers of funds (that is, debt issuers) or sellers
of funds (institutions).

35). The general bond market can be classified into corporate bonds, government and agency
bonds, municipal bonds, mortgage-backed bonds, asset-backed bonds, and collateralized debt
obligations.

36). National government provides corporate bonds to raise money for different reasons, such as
financing ongoing operations or expanding businesses.

37). Public Corporations issue government bonds and entice buyers by providing the face value
on the agreed maturity date with periodic interest payments. This characteristic makes
government bonds attractive for conservative investors.

38). Local governments and their agencies, states, cities, special-purpose districts, public utility
districts, school districts, publicly owned airports and seaports, and other government-owned
entities issue municipal bonds to fund their projects.

39). Pooled mortgages on real estate properties provide mortgage bonds. Mortgage bonds are
locked in by the pledge of particular assets.

40). Asset-backed security (ABS) is a financial security collateralized by a pool of assets such as
loans, leases, credit card debt, royalties or receivables.

41). Bond valuation is a technique for determining the true fair value of a particular bond.
42). Because a bond's par value and interest payments are not fixed, an investor uses bond
valuation to determine what rate of return is required for a bond investment to be worthwhile.

43). When the bond matures, the bond issuer repays the investor the full discounted value of the
bond.

44). If interest rates increase, the value of a bond will decrease since the coupon rate will be lower
than the interest rate in the economy. When this occurs, the bond will trade at a premium, that is,
above par.

45). Practitioners commonly use two models in cases of bonds with embedded options: The
traditional model and Monte Carlo simulation model.

Exercise No. Mod 5-3 (Multiple Choice)

1). Which of the following approaches is appropriate for bonds with embedded options?
a. Traditional valuation b. Arbitrage free valuation c. Risk free valuation d. Lattice model

2). The fixed return that an investor earns periodically until bond matures.
a. coupon rate b. cost of capital c. return of investment d. coupon bond

3). The date when bond issuer repays or pays the investor the full-face value of the bond.
a. payment date b. repayment date c. maturity date d. bond amortization date

4). This is the prevailing value of bond based on the level of interest in the environment. This
maybe at par, premium or at discount.
a. Current Price (or Market Price) b. Premium Price c. Discounted Price d. Par Value

5). This technique of determining the theoretical value of bond includes calculating the present
value of the bond's future interest payments, also known as its cash flow, and the bond's value
upon maturity, also known as its face value or par value.
a. Net Present Value b. Capital Budgeting c. Bond Valuation d. Theoretical valuation

6). Which of the following is not correct about the importance of a debt instrument?
a. It makes the repayment of debt legal. (legally enforceable)
b. It increases the transferability of the obligation, giving it increased liquidity and giving
creditors a means of trading these obligations on the market.
c. Without debt instruments acting as a means of facilitating trading, debt would only be an
obligation from one party to another.
d. When a debt instrument is used as a trading means, debt obligations can be moved from
one party to another quickly and efficiently.

7). A credit card bill is an example of

a. short term securities b. money market securities c. short term debt instruments d. short
term equity instruments

8). Which of the following is not a debt security?

a. pay day loans evidenced by loan agreement
 b. government bond
c. preferred stock
d. collateralized debt obligations

9). Which of the following are money market debt securities?

a. Treasury bills and Certificate of Deposits
b. Treasury bills, notes and bonds
c. Certificate of Deposits and Preferred stocks
d. Credit Card bills and Pay Day Loans

10). Which of the following are capital market debt securities?

a. Treasury bills and Certificate of Deposits
b. Treasury bills, notes and bonds
c. Certificate of Deposits and Preferred stocks
d. Treasury notes and bonds

11). What is the difference between debt instrument and debt security?
a. They can be interchangeably used hence similar.
b. Not all debt instruments are debt securities, however debt securities are all debt
instruments.
c. Not all debt securities are debt instruments, however debt instruments are all debt
securities.
d. Debt instruments are negotiable and tradable debt securities.

12). What is the difference between debt securities and equity securities?
a. Equity securities represent a claim on the earnings and asset of the corporation while debt
securities are investments into debt instruments.
b. Equity securities are in the form of stocks like preferred stock while debt securities are in
the form of bonds
c. Equity securities represents investment in debt instruments while debt securities are
investment in preferred stocks.
d. Both are negotiable and tradable securities, hence similar.

13). Which of the following is the safest (least risky) investment?

a. treasury bills b. investment of common stock with voting rights c. preferred stock non-
cumulative d. corporate bonds

14). Debt securities are typically classified by the following except:

a. level of default risk b. type of issuer c. income payment cycles d. interest rate

15). Which of the following is incorrect about bond market?

a. Also known as debt securities or credit market
b. The bond market primarily includes government-issued securities and corporate debt
securities, facilitating the transfer of capital from savers to the issuers or organizations requiring
capital for government projects, business expansions and ongoing operations.
 c. In the bond market, participants can issue new debt in the market called the initiate public
offering or trade debt securities in the market called the secondary market.
d. The goal of the bond market is to provide long-term financial aid and funding for public and
private projects and expenditures.

16). Corporations provide to raise money for different reasons, such as financing
ongoing operations or expanding businesses.
a. corporate bonds b. institutional bonds c. private bonds d. pubic bonds

17). National governments issue government bonds and entice buyers by providing the face value
on the agreed maturity date with periodic interest payments.
a. corporate bonds b. institutional bonds c. private bonds d. government bonds

18). Local governments and their agencies, states, cities, special-purpose districts, public utility
districts, school districts, publicly owned airports and seaports, and other government-owned
entities issue to fund their projects.
a. corporate bonds b. municipal bonds c. private bonds d. government bonds

19). are locked in by the pledge of particular assets.

a. corporate bonds b. municipal bonds c. mortgage bonds d. government bonds

20. is similar to a mortgage-backed security, except that the underlying securities

are not mortgage-based.
a. Asset backed bonds b. non-mortgage backed security c. mortgage bonds d.
collateralized debt obligation

21). is a structured financial product that pools together cash flow-generating assets and
repackages this asset pool into discrete tranches that can be sold to investors.
a. Asset backed bonds b. non-mortgage backed security c. mortgage bonds
d. collateralized debt obligation

22). manage and measure bond portfolio performance. Many are

members of broader indices that may be used to provide and measure the performances of global
bond portfolios.
a. bond indices b. debt security indices c. consumer price indices d. market indices

23). A corporate bond was issued by X Corporation to an Y Corporation. From this investment, Y
Corporation will earn 5% every year for 5 years. Y Corporation has paid for this Php1,000.00
value bond for only Php990.00. What do you call the 5% that will be earned by Y Corporation?
a. coupon rate b. cost of capital c. cost of debt d. cost of bond

24). Following above, the Php 990.00 referred is called

a. current price b. face value c. bond value d. coupon value

25). Following above, the Php 1,000.00 referred is called .

a. current price b. face value c. bond value d. coupon value
 MODULE 6. EQUITY SECURITIES MARKET

OBJECTIVES
After successful completion of this module, you should be able to:
• Describe the different types of market capitalization
• Determine value of stocks based on the financial information made available to them
• Describe the rules and regulations applicable for a listed corporation

COURSE MATERIALS
Equity Securities Market is the avenue where equity instruments are traded. Equity
instrument is a type of financial instrument that can be traded in the financial market.

If we say Equity, this is the shareholders’ equity portion in the statement of financial
position which is the residual value of the company after deducting the liabilities from the assets.

Definition of Terms
Equity instrument
It is a type of financial instrument wherein the issuer agrees to pay an amount to the
investor in the future based on the future earnings of the company. The earnings used as basis
of the amount to be paid to equity instrument is determined after setting all required payments of
business. The most common example of equity instruments is shares.

Authorized capital stock

This refers to the maximum amount stated in the articles of incorporation as authorized by
SEC that can be subscribed by investors of a corporation if the shares have a par value. Par value
is the nominal value of the share that is indicated in the face of the stock certificate. A corporation
cannot issue additional shares in excess of the authorized capital stock unless it files amendment
of the articles of incorporation and seeks approval from SEC.

Outstanding shares
This refers to the total shares of stocks issued to subscribers or shareholders, whether
partially paid or fully paid up. This does not include treasury shares.

Treasury shares
These are shares that are repurchased or bought back by the company from its
shareholders.

Issued shares
These refer to all shares that were issued by the company, whether outstanding or
treasury shares.

Why invest in equity instruments?

The earnings of the equity instruments are through the following:
• Capital appreciation
This refers to the rise in the value of an asset in relation to the increase in its market price.
Since shares can be sold in the secondary market, investors may sell shares they originally
bought from a corporation to prospective investors at an agreed price. Example: Mr. A bought
1,000 shares at P10. Six months later, the price of the shares appreciates to P12. This means
that if Mr. A sells its shares, he will earn a realized income of P2 per share.

• Dividends
- these are payments made by corporations to shareholders representing increase
earnings of the company.
- dividends are usually pad our quarterly, but some companies pay it semi-annually or
annually.
- these are recommended by management and approved by the board of directors.
- These can be in the form of cash, property or own shares of the company.

Dividends are not dependent on capital appreciation of the shares; it is based on the
current performance of the business. It may be declared even if the share price is going
down as long as long as approved by the board of directors. The company should also
maintain retained earnings of below 100% than its paid-up capital per Sec 42 of the
Corporate Code or else, the company will be penalized for improperly accumulated
earnings tax (IAET) of 10% on the excess of total retained earnings as against the paid-
up capital. This penalty is on the premise that if earnings are declared and paid to
shareholders, a 10% final tax will be collected.

Types of Shares
• Preference share
These are the features of the preference shares:
- Its holders have the distinct rights to be prioritized over ordinary shares in terms of
liquidation.
- It has fixed periodic dividend payments.
- It has no voting rights, but holders of these shares can also have voting rights at the
option of the corporation.
- These are treated as quasi-debt where dividends associated to the shares are like
interest payments on a debt.
- Preference shares can be:
a. Cumulative – dividends in arrears and the current dividend should be paid to
preference shares holders before paying the ordinary shares holders.
b. Callable – allows the issuing corporation to retire or repurchase outstanding shares
within a predetermined period of a time at a specified price. Usually the call price
is higher that the issuance price but gradually decreases over time.
c. Convertible – allows shareholders to convert the preference shares to a stated
number of ordinary shares after a certain date.

• Ordinary shares
These represent the true ownership of the corporation which is called the residual
value to be received by the common stock shareholders after all claims of creditors
and preference shareholders on the net assets are satisfied.

These are the salient features of ordinary shares:

- Dividends are not guaranteed unlike the preference shareholders.
- Ordinary shareholders have limited liability where their obligation is up to the amount
they have invested.
 - High returns in terms of dividends when the company is earning.
- It has voting rights to decide on certain corporate decisions. One share is equivalent
to one vote.
- It has pre-emptive rights where ordinary shareholders are permitted to retain their
proportionate share in the company in case of new share issuances, protecting them
from being diluted of ownership.
- It has stock right to exercise the pre-emptive right. A stock right is a financial instrument
which permits shareholders to buy additional shares from the company at a cheaper
price than the market price, in direct proportion of the shares they own.

Ordinary shares can be:

a. Privately owned – owned by private investors and shares are not publicly traded.
b. Closely owned – owned by an individual investor or a small group of private investors
like a family.
c. Publicly owned or publicly traded – owned by mixed of public and private investors
and the shares are actively traded in the stock market.
d. Widely owned – owned by many unrelated individuals or institutional parties.

Rights versus Warrants

What Are Stock Rights? (source: Investopedia)
Stock rights are instruments issued by companies to provide current shareholders with the
opportunity to preserve their fraction of corporate ownership. A single right is issued for each
share of stock, and each right can typically purchase a fraction of a share, so that multiple rights
are required to purchase a single share.

What Are Warrants? (source: Investopedia)

Warrants are long-term instruments that also allow shareholders to purchase additional
shares of stock at a discounted price, but they are typically issued with an exercise price above
the current market price. A waiting period of perhaps six months to a year is thus assigned to
warrants, which gives the stock price time to raise enough to exceed the exercise price and
provide intrinsic value. Warrants are usually offered in conjunction with fixed income securities
and act as a "sweetener," or financial enticement to purchase a bond or preferred stock.

In short, Rights are issued to get investors to buy more of a company's stock and often provides
voting rights in some business decisions. Warrants are mostly offered to attract investors when
a company issues new stock. They tend to have a longer period before they expire, usually a year
or 2.

STOCK MARKET
The stock market is composed of exchanges and over the counters where shares are
issued and traded publicly. This can be:
- Physical and virtual
- Primary and secondary

The physical site where shares are purchased and sold face to face on a trading floor is
called a stock exchange. The most well-known organized exchange is the New York Stock
Exchange where buyers and sellers who participate in organized exchanges meet in a specified
location and uses an open out-cry auction model to trade securities. Organized exchanges
employ floor trades that oversee and facilitate the trading of specific shares. The floor traders are
representatives of different brokerage firms.

An over-the-counter market refers to the market wherein shares can be traded by dealers
that are connected electronically by computers. Dealers (also called as market makers) operating
in an OTC market try to make a market by matching the buy and sell orders they received from
investors.

New models to trade stocks have surfaced due to advancement of technology and
changing appetites of the investors. These are Electronic Communications Network (ECN).
This form of network directly links major brokerage firms and traders and removes the need for a
middleman.
The ECN provides the following:
- Transparency – can easily be viewed
- Cost reduction – no commissions for middleman
- Faster execution – because it is fully automated
- After-hours trading – trading can continue anytime of the day

Exchange Traded Funds (ETF) happens when a portfolio containing various securities is
purchased and a share is created based on this specific portfolio which can be traded in the
exchange.

The overall performance of a stock market is measured through stock market indexes
which represents the average of stock prices currently being traded. Investors use stock market
indexes to gain some insights on how a group of stocks could have performed in the market.

PHILIPPINE STOCK EXCHANGE (PSE)

- The national and sole stock exchange of the Philippines.
- One of the oldest stock exchanges in Asia starting in 1927 when it was still called
Manila Stock Exchange.
- Composed of 15-man board of directors
- It was created in 1992due to the merger of the country’s two former stock exchanges
namely: Manila Stock Exchange (MSE) which was established in Aug 8, 1927 and
Makati Stock Exchange (MkSE) which was established in May 27, 1963.

The PSE has been granted a “Self-Regulatory Organization (SRO) status by the SED in
June 1988 where it can implement its own rules and set penalties on erring trade participants and
listed companies.

The PSE through the Philippine Central Depository (PCD0 uses the computerized book
entry system to transfer ownership of securities from one investor to another thus eliminating the
need for physical exchange of scrip between the seller and the buyer.

The PSE regulates trading activities through the Capital Markets Integrity Corporation
(CMIC), a spin-off of the Market Regulation Division of PSE, to monitor and penalize trading
participants that violate the Securities Regulation Code and its implementing rules and
regulations, the Anti-Money Laundering Law and the Code of Conduct and Professional Ethics
for traders and salesmen, CMIC Rules and other relevant laws and regulations.
Other initiative to safeguard interests of the investors include:
a. Enforcement of static and dynamic thresholds to protect against unusual share price
fluctuations.
b. Disclosure requirement for publicly listed companies – material information is disclosed
within 10 minutes after its occurrence.
c. Securities Investors Protection Fund, Inc (SIPF) protects the investing public from extra
ordinary losses arising from fraud.

Corporate Compliance
Companies who plan to list publicly in the PSE:
a. Comply with the laws, regulations and full disclosure rules and policies of the Philippine
government
b. Have standard of quality, operations and size under efficient and effective management.
c. Conduct issuance, offering and marketing of securities in s fair and orderly manner and
ensure that securities are widely and equitably distributed to the public.
d. Give adequate fair and accurate information about the company and its securities to the
general public to enable them to make informed investment decisions.
e. Ensure that directors and officers act in the interest of all security holders as a whole,
particularly where the public represents only a minority of the security holders or where
director or security holder owning a substantial amount of shares has a material interest
in a transaction entered into by the company.

ACTIVITIES/ASSESSMENTS
Answer the following exercises
Exercise No. Mod 6-1 (Essay)
What is your understanding, in general, about the equity securities market?

Exercise No. Mod 6-2 (True or False)

1). Fundamentally, equity represents ownership of a firm. Same with debt, investors can put out
cash to purchase equity and trade these in financial markets through equity instruments.

2). Equity instrument is a type of financial instrument wherein the issuer (company) agrees to pay
an amount to the investor in the future based on the future earnings of the company, if any.

3). The most common example of equity instruments is shares.

4). Authorized capital stock refers to the total maximum amount stated in the Articles of
Incorporation that can be subscribed to or paid by investors of a corporation if the shares have a
par value.

5). A company can issue additional shares in excess of its authorized capital stock.

6). If the shares do not have a par value, the corporation does not have an authorized capital
stock but it has an authorized number of shares it may issue.

7). Outstanding shares refer to the total shares of stock issued under binding subscription
agreements to subscribers or stockholders, which are fully paid.
8). Outstanding shares include treasury shares. Treasury shares are shares that are repurchased
or bought back by the company from its stockholders. Issued shares refer to all shares that were
issued by the company, whether outstanding or treasury shares.

9). Among the three forms of business organization, only corporations can issue shares. Investors
prefer to put their money on shares because of the concept of unlimited liability.

10). Limited liability, i.e. legal provision that protects shareholders from losing more than they
invested in the company, exists. Responsibility of shareholders to creditors is only up to the extent
of their capital contribution.

11). Investors may earn from equity instruments through dividends only.

12). Capital appreciation refers to the rise in the value of an asset in relation to the increase in its
market price.

13). Dividends are payments made by corporations to shareholders representing excess earnings
of the company.

14). The IAET is a penalty tax imposed on corporations who intend to accumulate excess earnings
to enable its shareholders to avoid paying the 10% final tax on dividends that they might have
received if these were declared.

15). According to Section 43 of the Corporation Code, stock corporations are not allowed to
maintain retained earnings more than 200% of its paid-up capitalization at par (any additional
paid-up capital or excess over par is excluded).

1). The 10% IAET is patterned to the 10% final tax on dividends which the government should
have received if the dividends were declared properly.

17). There are two types of shares that corporations can issue: preference (or preferred) shares
and ordinary (or common) shares. Both shares represent ownership of the corporation but differ
in several aspects.

18). Normally, preference shareholders do not have voting rights, but corporations can opt to give
them voting rights explicitly in the Articles of Incorporation.

19). Preference shares are treated as debt; the required dividend associated with preference
shares is like the interest on debt.

20). Ordinary shareholders generally possess the voting rights to decide on certain corporate
decisions like electing the board of directors, issuance of new shares or change in fundamental
corporate direction.

21). A preemptive right is a financial instrument which permits shareholders to buy additional
shares from the company at a price cheaper than the market price, in direct proportion of the
number of shares they own.
22). The PSE regulates trading activities through the Financial Markets Integrity Corporation
(FMIC).

23). In conventional brokerage, investors buy or sell shares by opening an account with a
stockbroker. The broker will buy and sell shares in behalf of the investor in exchange for payment
called commission.

24). Online brokers typically charge lower commission compared to conventional brokers and
they offer investment advice and other services that a traditional broker also gives.

25). Market capitalization refers to the total market value of all outstanding shares of a company.
This is calculated by multiplying the total outstanding shares by the prevailing par value per share.

Exercise No. Mod 6-3 (Multiple Choice)

1). Which of the following is not a form of business organization in the Philippines?
a. corporation b. private limited company c. partnership d. sole proprietorship

2). Capital Appreciation happens when there is .

a. increase in par value of stocks b. increase in market value of stocks
c. Increase in market capitalization d. Decrease in market capitalization

3). Capital Depreciation happens when there is .

a. decrease in par value of stocks b. decrease in market value of stocks
c. Increase in market capitalization d. Decrease in market capitalization

3). Dividends maybe in the form of the following except:

a. Cash b. Stock c. Property d. Bonds

4). Improperly Accumulated Earnings Tax (IAET) is imposed for excess in Retained Earning
beyond .
a. 100% of Capital Stock
b. 100% of Authorized Capital Stock
c. 100% of Paid up Capital Stock at par value
d. 100% of Outstanding Stocks less Treasury shares

5). The following are distinctions of equity and debt except:

a. voice in management b. claims on asset and income c. maturity d. all of the above

6). Which of the following are 2 major types of shares?

a. Ordinary and Preferred shares
b. Callable and Convertible shares
c. Participating and Non-Participating shares
d. Cumulative and Non-Cumulative shares
7). is a financial instrument which permits shareholders to buy additional shares from
the company at a price cheaper than the market price, in direct proportion of the number of shares
they own.
a. Preemptive rights b. Stock rights c. Voting rights d. Preferential rights

8). allow existing shareholders to maintain their current voting influence and
protect them from dilution of earnings i.e. reduction of claim on earnings as a result of lowering of
its fractional ownership.
a. Preemptive rights b. Stock rights c. Voting rights d. Preferential rights

9). Which of the following is not correct about stock market?

a. The stock market is composed of exchanges and over the counters where shares are
issued and traded publicly.
b. The actual stock market is both physical and virtual as electronic trading of stocks has been
increasingly relevant due to the easy access to technology.
c. The stock market can be considered both a primary and secondary market.
d. However, since most of the transactions are buying and selling existing stocks of investors
(compared with new share issuances), the primary market is considerably bigger than the
secondary market. (Secondary market is bigger than primary market)

10). Electronic communications network (ECN) is a network which directly links major brokerage
firms and traders and removes the need for a middleman. ECN has been gaining ground lately
because of the following reasons, except:
a. transparency b. cost reduction c. faster execution d. elegance

11). Which of the following is correct about Philippine Stock Exchange?

a. One of the largest stock markets in the world
b. One of the oldest stock exchanges in Asia
c. It is a merger of two stock exchanges: Manila Stock Exchange and Malabon Stock
Exchange.
d. It is unlisted company since it is the one implementing rules and set penalties on erring
trade participants and listed companies.

12). Companies who plan to be listed in PSE should, except:

a. Comply with the laws, regulations and full disclosure rules and policies of the Philippine
government
b. Ensure that directors and officers act in the interest of all security holders as a whole,
particularly where the public represents only a minority of the security holders or where a director
or security holder owning a substantial amount of shares has a material interest in a transaction
entered into by the company.
c. Give adequate, fair and accurate information about the company and its securities to the
general public to enable them to make informed investment decisions
d. Have to be ISO certified so to ensure company has standards of quality, operations, and
size under efficient and effective management.

13). To be admitted for admission to listing in PSE, the following are general criteria except:
a. Track Record of Profitable Operations
 b. The company has been operating for at least ten (10) years prior to the filing of
the application and has a cumulative EBITDA of at least ₱50 Million for at least two
(2) of the three
(3) fiscal years immediately preceding the filing of the listing application.
c. The company is a newly formed holding company which uses the operational
track record of its subsidiary.
d. At listing, the capitalization of the company must be at least ₱500 Million.
(Market Capitalization not only capitalization)

1). Which of the following is not correct about Disclosure rules?

a. All companies listed in the PSE is required to comply with its disclosure rules.
The basic principle of the Exchange is to ensure full, fair, timely and accurate disclosure
of material information from all listed companies.
b. Corporate disclosures are classified into two: the structured and the unstructured
corporate disclosures.
c. Structured continuing disclosures are reportorial requirements submitted within
specific time frames such as annual, quarterly and monthly reports. Unstructured
continuing disclosures are communications of corporate developments as they happen
and are intended to update the investing public on the activities, operations and
business of the company.
d. Unstructured continuing disclosures include the Annual report (SEC Form 17-A)
– To be submitted within 105 days after end of fiscal year and Three Quarterly Reports
(SEC Form 17-Q)
– To be submitted within forty-five (45) days from end of the first three (3) quarters of
the fiscal year. (Structured Continuing disclosures)

15). Which of the following is not a platform for Capital Market?

a. Conventional Brokerage b. Online Trading c. Mutual Funds