Financial Markets – AE4

LESSON 1: Introduction to Financial Markets – Money market

Financial System

an economic arrangement wherein financial institutions facilitate the transfer of funds and assets between
borrowers, lenders, and investors. Its goal is to efficiently distribute economic resources to promote economic
growth and generate a return on investment (ROI) for market participants.

Financial System is divided into: Financial Instruments, Financial Markets and Financial Institutions

Financial Instruments Financial Markets Financial Institutions

It is “What” the investors buy and It is “Where” the financial “Who” channels funds from those
sell / trade in the financial markets. instruments are traded. with surplus funds (suppliers of
funds) to those with shortages of
funds (users of funds).

Financial Intermediaries in PH

Financial Markets

- any place or system that provides buyers and sellers the means to trade financial instruments

Dimensions of Financial Market

Primary Market Secondary Market

-is a market that issues new securities. is a place where the investor trades the securities such
Example: Initial public offering, bonus and right as stock exchanges
issues.
Markets that trade financial instruments once they are
Markets in which corporations raise funds through new issued.
issues of securities.
 PRIMARY Market

SECONDARY MARKET

Money Market and Capital Market

Money Market Capital Market

-is used for short term lending or borrowing -is used for long term securities or borrowing
- markets that trade debt securities or instruments with -are markets that trade equity securities(stocks) and
maturities of one year or less. debt (bonds) instruments with maturities of more than
- market used for trading of short-term financial one year
instruments

Why people trade in Money Market?

SUPPLIERS OF FUNDS (Investor) USERS OF FUNDS (Investee)

1.Excess Funds 1. Short Term Funds

2. Opportunity Cost 2. Immediate Provision

Characteristics of Money Market Instruments

1.Sold in large denominations

2.Low Default risk

3.Maturity of ≤1 year

Types of Money Market Instruments

Treasury bills —short-term obligations issued by the government. Risk free investment because government will
never run out of money to pay.

Federal funds —short-term funds transferred between financial institutions usually for no more than one day.
Repurchase agreements —agreements involving the sale of securities by one party to another with a promise to
repurchase the securities at a specified date and price.

Commercial paper —short-term unsecured promissory notes issued by a company to raise short-term cash.

Negotiable certificates of deposit — bank-issued time deposit that specifies an interest rate and maturity date and is
negotiable (saleable on a secondary market).

Banker’s acceptances —time drafts payable to a seller of goods, with payment guaranteed by a bank.

Measuring/Computing the Yield

1.Holding period yield (HPY)

2.Bond Equivalent Yield (BEY)

3.Effective Annual Return/Yield (EAR)

4.Bond Discount Yield (BDY)

5.Equivalent annual return for MMI

Important Note in Computation

1. The difference between compounding interest and simple interest

Simple interest – the interest is only computed based on the principal amount

Compounding interest – the interest from previous period also earns interest (1+ interest rate)^n -1

2. You are computing for the yield or interest rate for money market (Short term market), that is why you will either
use 365 days or 360 days in the formula.

1. Holding period yield

- The simplest computation of yield rate.

- It ignores the time period of the investment.

- FORMULA: no time value

Total income / Purchase price

2. Bond Equivalent Yield

- Quoted nominal, or stated interest on a security.

- FORMULA: with time value, simple interest

= HPY x 365/n

3. Equivalent Annual Return

-The return on an investment product that has more than one compounding period.

4. Bond Discount Yield

-Annualized percentage of discount over face value.

5. Equivalent Annual Return for Money market instruments w/Interest

-Some money market securities pay interest only once during their lives: at maturity. Thus, the single-payment
security holder receives a terminal payment consisting of interest plus the face value of the security,

EXAMPLES:

The entity invested and bought P1,000,000 10% 2-year bonds. The interest and principal are to be paid at the
maturity date. Compute for the interest and maturity of the bonds using (1)Simple interest (2) Compounding interest

1. Simple Interest 2. Compounding interest

1,000,000 x 10% = 100,000 interest per year 1,000,000 x 10% = 100,000 interest on the first year
x 2 years +1,000,000 principal

200,000 interest 1,100,000

+1,000,000 principal x 10%

1,200,000 maturity value 110,000 interest on the 2nd year

+1,100,000 total receivable on the end of 1st year

1,210,000 Maturity value

OR

1,000,000 x 1.10^2 = 1,210,000

Suppose you can purchase a $1 million Treasury bill that is currently selling on a discount basis (i.e., with no
explicit interest payments) at 97½ percent of its face value. The T-bill is 140 days from maturity (when the $1 million
will be paid).

1. Holding Period Yield (HPY) HPY = ( P fP−P0 0 ) HPY = ( Face vaP

Where:
Pf = Face value
P0 = Purchase price of the security

1,000,000 – 975,000 = 25,000 income

25,000 / 975,000 = 2.56% HPY

2. Bond Equivalent Yield (BEY)

i bey= ( P fP−P0 0 )( 365n ) BEY = ( Face value−Purchase
Purchase price
price
)( maturity )
365

Where:
¿( )( 140 )
1,000,000−975,000 365
Pf = Face value 975,000
P0 = Purchase price of the security ¿ 6.68%
n = Number of days until maturity
Suppose you can purchase a $1 million Treasury bill that is currently selling on a discount basis (i.e., with no
explicit interest payments) at 97½ percent of its face value. The T-bill is 140 days from maturity (when the $1 million
will be paid)

3. Equivalent Annual Return (EAR)

( )
365/ n
i bey
EAR= 1+ −1
365 /n

( )
365/ 140
6.68 %
EAR= 1+ −1
365 /140
EAR=6.82 %

 Easier Way- with tine vslue, compounding interest

365/ 140
EAR=( 1+ HPY )
365/n
−1 EAR=( 1+2.56 % ) −1
EAR=6.82 %

4. Bond Discount Yield (BDY)

- Annualized percentage of discount over face value.

BDY¿ ( Face value− purchase price

Face value )( Maturity )
360
i dy=( )( 140 )
1,000,000−975,000 360
1,000,000
i dy=¿ 6.43%

Suppose you can purchase a $1 million jumbo CD that is currently 105 days from maturity. The CD has a quoted
annual interest rate of 5.16 percent for a 360-day year. EAR is calculated as:

5. Equivalent Annual Return for Money market instruments w/Interest

( )
365/ 105

( )
365
365/ n
365
i spy ( ) 5.16 % ( )
360 360
EAR= 1+ −1 EAR= 1+ −1
365/n 365 /105

Where: EAR=5.33 %
n = Number of days until maturity

ispy = single-payment interest rate