Financial instruments Notes

Financial instruments

The following are some of the most common instruments in use today

Money market instruments
They are short-term dated securities. Because of their short terms to maturity, they undergo the least price fluctuations and are therefore the least risky instruments. These include treasury bills, negotiable bank certificate of deposit, commercial paper, repurchase agreements e.t.c.
(a) Treasury bills
i. These are short-term debt instruments issued by the government.
ii. They are issued in 3, 6 and 12 month maturities to finance government activities.
iii. They pay a set amount at maturity and have no interest payments.
iv. Interest is covered by the fact that they are initially sold at a discount, that is, an amount lower than the amount they are redeemed at on maturity.
v. They are the most liquid of all money market securities because they are the most actively traded.
vi. Interest rates on treasury bills are usually the anchor/benchmark for all money market interest rates.
vii. They are also the safest among the money market instruments because the chance of default are minimal (the government can always increase taxes or issue currency to pay off its debts)
viii. Thus, T-bills are popular due to their zero default risk, ready marketability and high liquidity.
Types of treasury bills
There are several types of bills that are issued by governments:

(a) Regular-series bills
i. These are issued routinely every week or month in competitive auctions
ii. They have original maturities of three months, six months and one year.
iii. New three and six month bills are auctioned weekly; one year bills are normally sold once each month.
(b) Irregular-series bills
i. These are issued only when the treasury has a special cash need.
ii. They can be strip bills or cash management bills.
Strip bills comprise of a package offering of bills requiring investors to bid for an entire series of different bill maturities. Investors who did successively must accept bills at their bid price each week for several weeks running.
Cash management bills consist simply of reopened issues of bills that were sold in prior weeks. The reopening of a bill issue normally occurs when there is an unusual or unexpected treasury need for cash.
Calculating the yield on bills
i. Treasury bills do not carry a promised interest rate but instead are sold at a discount from par.
ii. Their yield is therefore based on their appreciation in price between time of issue and the time they mature or are sold by the investor.
iii. Bills yields are determined by the bank discount method which ignores compounding of interest rates and uses a 360-day year for simplicity.

(c) Commercial paper
i. A commercial paper is a short-term debt instrument issued by large banks and well known corporations.
ii. It promises to pay back higher specified amount at a designated/specified time in the immediate future, say, 30 days.
iii. Issuers of commercial paper sell the instrument directly to other institutions as a way of raising funds for their immediate needs instead of borrowing from banks.
iv. Issuance of commercial paper is a cheaper way of raising funds for a firm than borrowing from a bank.
v. A firm must be large and creditworthy enough for lenders to accept its commercial paper.
vi. Funds raised from paper issue are mainly used for current transactions e.g. to purchase inventories, pay taxes, meet pay rolls e.t.c. rather than capital transactions (long term investments)
vii. Commercial papers are traded in primary market.

viii. Opportunities for resale in the secondary market are limited, although some dealers redeem the notes they sell in advance of maturity and others trade paper issued by large finance companies and holding companies.
ix. Because of the limited resale possibilities, investors are usually careful to purchase those paper issues whose maturity matches their planned holding periods.

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