Financial Instruments: Lesson 1.4

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Lesson 1.

Financial
Instruments

Business Finance
Accountancy, Business, and Management

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Suppose you are
lending money to
people. Would you
need proof of the
amount of money they
owe you?

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Most people would want a
real or virtual document to
serve as proof of their
transaction.

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Investors and creditors also
want the value of their assets
protected from fluctuations.
Hence, the creation of
financial instruments.

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Quick Look

The Debtor and the Creditor


Instructions:
1. Form a group of three or four members.
2. Discuss the problem situation provided in the next slides.
3. Prepare a Finance Agreement for two parties. You may refer
to the sample form provided. You may also refer to the
computation of finance charges, interest, total payments,
and monthly payments.

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Quick Look

The Debtor and the Creditor


Company A, the debtor with Address 1, made a business loan
letter request to Company B. Company A attached the documents
that show their credibility as a debtor.

Company B, the creditor with Address 2, after examining the


documents and conducting financial investigation about company
A, approved the loan request.

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Quick Look

The Debtor and the Creditor


Both parties agreed to a loan amounting to ₱600,000 carrying
an annual simple interest of 12%, payable monthly for a year.
They also agreed to include finance charges amounting to 1%
of the loan. They also agreed that either party can cancel the
agreement any time with a 30-day prior notice to the other party.

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Quick Look

The Debtor and the Creditor


Today both parties executed a Finance Agreement. The first
payment shall begin 60 days after the execution of the
agreement. Bank deposits shall be the method of payments
through Bank Account No.: 0123-456-789.

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Quick Look

Questions to Ponder

1. How do creditors and debtors differ?


2. What are your important realizations and insights from the
activity?
3. Looking at yourself, four or five years from now, in a
corporate world, who do you want to be, the creditor or the
debtor? Why?

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Learning Competency

Compare and contrast the varied financial instruments


(ABM_BF12-IIIa-4).

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Learning Objectives

At the end of this lesson, you should be able to do the following:


● Define financial instruments.
● Compare and contrast the varied financial instruments.
● Determine the financial instrument used in a business transaction.
● Explain the importance of financial instruments in the financial
system.

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What instrument is the most profitable
for investment?

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Financial Instruments

● an agreement between parties


○ an asset to one party and a liability to the other

● an asset, that holds capital and can be created, liquidated,


revised, and traded in the market
Types of Financial Instruments

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Cash Instruments

● instruments whose value is directly established and


perceived by the market
● kinds:
○ securities
○ deposits and loans
Cash Instruments

Securities Deposits and Loans

● considered as cash
instruments because they
fungible or interchangeable
constitute monetary value
with other assets of similar
● exchanged through an
value
agreement between the
parties

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Cash Instruments

Securities

● entitle the holder to have a


Stocks
part ownership of a publicly
or Equity Securities
listed company
● offered through an IPO

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Cash Instruments

Stocks or Equity Securities


● stock price may increase over time
● companies pay dividends to the stockholders
● stockholders can:
○ participate in annual company’s general meeting
○ access to company reports
○ indirectly influence decisions

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Cash Instruments

Stocks or Equity Securities

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Cash Instruments

Securities

● offered by companies and


governments who need Bonds or Debt
funds Securities
● entitles the holder to get
their money back with
interest

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Cash Instruments

Bond or Debt Securities


● affordable, tradable and liquid
● holders get steady income through
coupons at predetermined dates
● holders are priority when it comes to the
liquidation process

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Classification of Bonds

Kinds of Bonds

municipal agency corporate government


bonds bonds bonds bonds

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Cash Instruments

Municipal Bonds Agency Bonds

issued by the national and issued by various government


local government units to agencies like Mutual Funds and
finance local infrastructures Unit Investment Trust Funds

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Cash Instruments

Corporate Bonds Government Bonds

● offered by private ● issued by the Bureau of


corporations or companies Treasury
● represent debt obligations ● Peso and Dollar
rather than equity denominated securities

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Cash Instruments

Cash Deposits

● the money that people


put into their bank
account
● becomes a bank
assets, but the bank is
liable to return it

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Cash Instruments

Cash Loan

borrowing money with an


agreement to pay back the full
amount plus interest at a certain
due date

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BTr Website as Bond Hub

Closer
Look

The Green Land Company owns land and would like to build
townhouses in the city. The company issues bonds to the public
through the Bureau of Treasury (BTr) to fund their project rather
than make bank loans.

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BTr Website as Bond Hub

Closer
Look

The investors who visit the BTr websites can then accomplish
the BTr’s requirement to be included in the bond offerings and to
finalize the bond contract.

In this contract the investors finance such a project and expect


to be remunerated through interest.

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Check Your Progress

1 Differentiate equity-based and debt-based securities

Answer area

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Derivative Instruments

● its monetary value is derived from another financial asset


called the underlying assets
○ bonds, stocks, currency
● if the value of the underlying asset changes, it affects the
value of the derivative instrument
Classification of Derivatives

Derivative
Instruments

forward futures
contracts contracts options swap

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Derivative Instruments

Forward Contracts Futures Contracts

custom-made derivatives that


custom-made derivatives that
compel the seller to sell and the
take place at the end of the
contract at a specified price buyer to buy at a lock-in price
set at the time of agreement

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Derivative Instruments

Options Swap

provides the parties with an parties exchange or swap


option (not an obligation) to financial instruments such as
buy or sell at an exercise price cash flows, interest rates,
within the time frame derivatives and securities

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Derivative Instruments

Forward Futures Options Swap


The parties The buyer is Both parties
agreed to buy obliged to buy are expected
No obligations
and sell the and the seller to fulfill each
on the parties
Obligation asset on the is obliged to others’
to buy or sell
agreed sell the asset obligation on
the asset.
predefined on the agreed the swap
date. future date. contracts.
Derivative Instruments

Forward Futures Options Swap


The buyer has
An initial Both parties
No initial to pay the
margin pay as written
Payment payment is premium
payment is in the swap
required (periodic
required contract.
payments).
Derivative Instruments

Forward Futures Options Swap


Can execute
On the date On the date
Date of the contract On the date of
agreed upon agreed upon
execution anytime before the swap.
by the parties. by the parties.
the expiry date.
Derivative Instruments

Forward Futures Options Swap


Market OTC and the Central- Some are OTC OTC and the
Regulations price is exchange traded and some are price is
custom-made. and the price is exchange -traded. custom-made.
regulated by the
trading
commission.
Derivative Instruments

Forward Futures Options Swap


High High
Low counterparty Reduces the
counterparty risk counterparty risk
risk-could bring potential loss and
Risk - parties may - parties may
unlimited profit or could give
default on the default on the
loss unlimited gains.
obligations. obligations.
A Promise to Buy in the Future

Closer
Look

Suppose ION Company produces electronic products like


cellphones, laptops, cameras, etc, and need gold in their
production. The company then can enter into a future contract
with the Mines Company that produces gold to buy the product
at the current price and makes initial payment to ensure that
their production will not be affected by the fluctuating prices of
gold.

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A Promise to Buy in the Future

Closer
Look

At the end of the contract, the buyer, ION Company, is obliged to


buy the specified quality and quantity of the gold product and the
seller, Mines Company, is obligated to sell the said gold.

This situation is an example of a futures contract derivative.

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Foreign Exchange Instruments

● also called FX or Forex


● investors buy and sell
currency and exchange
them for another currency
● regulated by the Securities
and Exchange Commission
(SEC)

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Categories of Forex Instruments

Foreign
Exchange
Instruments

Spot Currency Outright Forward Currency Swap

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Foreign Exchange Instruments

Spot Currency Outright Forward

● retail or sale of the foreign ● also known as currency


currency on “the same
forward
day” or 1-2 business days
● value is based on current ● parties lock in the currency
exchange rate rate and the delivery date

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Foreign Exchange Instruments

Currency Swap

two foreign parties exchange


currency including the amount
of equal value and currency
rate

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Buying Items From Other Countries Online

Closer
Look

I would like to purchase a sale item online in USD currency. The


sale is only offered until the next day. I need the money in USD
and should make a currency spot transaction now so it will be in
my account the next day and catch up with the sale.

This transaction is an example of spot currency.

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Locking in the Currency Rate for a Future Purchase

Closer
Look

A production company from the US buys imported products from


Japan and both parties agree to make two transactions. The two
merchants entered into a spot contract on their first transaction
and an outright forward contract for the second transaction
where the currency rate and date are locked in with the agreed
currency rate of USD and JPY and date. With this instrument the
two parties and even the investors are protected from the
fluctuating currency rates.

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Check Your Progress

2 What are the four derivatives? Why are they called derivatives?

Answer area

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Solutions in Building and Improving Homes

Case S
tudy

The study focused on Project Dungganon (a Hiligaynon word


meaning “honorable”) which is the flagship project of Negros Women
for Tomorrow Foundation, Inc. (NWTF) that offers group-based loans
utilizing the Grameen lending methodology. The said project
provides access to collateral-free credit and training and aims to
assist the deprived women from rural communities of Negros and
help them start their own business and become a self-dependent
individual to improve their living conditions.
ReferenBea Parungo, Jitendra Balani, and Naeem Razwani, “Improving access to Housing Microfinance Solutions Among Low-
income Households in the Philippines,” FinDev Gateway (Terwilliger Center for Innovation in Shelter, October 2020),
https://www.findevgateway.org/case-study/2020/10/improving-accsess-housing-microfinance-solutions-among-low-income-
households, last accessed on November 6, 2021. ce here and attach the link :) 49
Solutions in Building and Improving Homes

Case S
tudy

The project Dungganon tapped several institutions like the


Microfinance Council of the Philippines, Inc. (MCPI) which provides
microfinance institutions that can help the project progress. The
NWTF worked with finance institutions to offer financing solutions for
housing units that low-income families can afford. In summary, this
study tackles on how the simple household individual can benefit
from the private and government institutions by applying the financial
instruments available in the Philippines.
ReferenBea Parungo, Jitendra Balani, and Naeem Razwani, “Improving access to Housing Microfinance Solutions Among Low-
income Households in the Philippines,” FinDev Gateway (Terwilliger Center for Innovation in Shelter, October 2020),
https://www.findevgateway.org/case-study/2020/10/improving-accsess-housing-microfinance-solutions-among-low-income-
households, last accessed on November 6, 2021. ce here and attach the link :) 50
Solutions in Building and Improving Homes

Case S
tudy

In summary, this study tackles on how the simple household


individual can benefit from the private and government institutions by
applying the financial instruments available in the Philippines.

ReferenBea Parungo, Jitendra Balani, and Naeem Razwani, “Improving access to Housing Microfinance Solutions Among Low-
income Households in the Philippines,” FinDev Gateway (Terwilliger Center for Innovation in Shelter, October 2020),
https://www.findevgateway.org/case-study/2020/10/improving-accsess-housing-microfinance-solutions-among-low-income-
households, last accessed on November 6, 2021. ce here and attach the link :) 51
Keep in Mind

● A financial instrument is an agreement or a contract between parties or


individuals which is an asset to one party and a liability to the other party.
As an asset it holds capital and can be created, liquidated, revised, and
traded to market. The financial instruments can be in the form of cheques,
cash, forex (currency), shares, stocks, futures, options, bonds, etc.

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Keep in Mind
Keep in Mind

● Cash instruments are instruments, whose value is directly established


and perceived by the market. These can be securities such stocks (equity
securities) and bonds (debt securities), or cash deposits and loans.

● Derivative instruments are financial instruments whose monetary value is


derived or determined from another financial asset, called the underlying
assets such as bonds, stocks, and currency.

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Keep in Mind

● Foreign exchange instruments or simply called FX or Forex is an OTC


market where investors buy and sell currency and exchange them to
another currency.

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Try This
Fill in the missing words to make the statement correct.

1. There are three types of financial instruments: cash


instruments, _____________________ instruments, and
foreign exchange instruments.

Answer area

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Try This
Fill in the missing words to make the statement correct.

2. _____________________ securities entitles the holder to


receive dividends from a company, while bonds or debt
securities entitles the holder to receive earnings from interest.

Answer area

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Try This
Fill in the missing words to make the statement correct.

3. Derivative instruments are financial instruments that derive


their value from _____________________.

Answer area

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Try This
Fill in the missing words to make the statement correct.

4. The money invested on _____________________ are used


to finance public infrastructure projects such as roads,
transportation systems, and housing.

Answer area

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Try This
Fill in the missing words to make the statement correct.

5. F i n a n c i a l i n s t r u m e n t s a r e t r a d e d i n t h e
_____________________ either directly or through financial
intermediaries.

Answer area

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Practice Your Skills
Identify the financial instrument used in each scenario.

1. A big supermarket chain is expanding its operations. It


announced that it would go public to raise the necessary
capital for its growth. What kind of financial instrument would
they issue?

Answer area

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Practice Your Skills
Identify the financial instrument used in each scenario.

2. Jen uses her credit card in almost all purchases she makes;
she finds this more convenient than withdrawing money and
paying in cash. She also uses her monthly credit card bill to
track her expenses. What financial instrument is Jen using?

Answer area

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Challenge Yourself
Write your answer inside the box.

1. How will you differentiate financial instruments from financial


markets and financial intermediaries?

Answer area

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Challenge Yourself
Write your answer inside the box.

2. Explain why businesses have to go to different financial


agreements.

Answer area

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Photo Credit

Slides 3 and 27: Marketing Dollar Business, by Genius Maker is free to use under Pixabay license via Pixabay.

Slide 22: Stocks and Bonds, by Alan Levine is free for commercial use via pxhere.

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Bibliography

Development Bank of the Philippines. “Government Securities”, DBP, (BSP). Accessed November 1, 2021.
https://www.dbp.ph/corporate-and-institutional-banking/treasury-products/government-securities/.

Dungo, Fehl. “Best Stock Brokers in the Philippines”. Accessed on October 27, 2021. https://philpad.com/best-stock-
brokers-in-the-philippines/.

Fernando, Jason. “Bonds”, Investopedia. Accessed on October 31, 2021. https://www.investopedia.com/terms/b/bond.asp.

O’shea, Arielle. “What are Stocks and How Do They Work?”. NerdWallet. Accessed October 29, 2021.
https://www.nerdwallet.com/article/investing/what-are-stocks-how-they-work.

Parameswaran, Sunil. Fundamentals of Financial Instruments (1st ed.) New York: Wiley, 2011.

PESOLAB. “Beginner’s Guide Philippine Retail Treasury Bonds”. Accessed on October 29,
2021.https://pesolab.com/guide-to-philippine-retail-treasury-bond/.

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