Unit 3: Money Market Instruments - Subjective Questions

Treasury Bills (T-Bills) are short-term money market instruments issued by the central government to meet temporary funding requirements.

Principal features:

• They are issued at a discount to face value and redeemed at par.
• The difference between the issue price and face value represents the investor's return.
• Common maturities include 91 days, 182 days, and 364 days.
• They do not carry an explicit coupon rate.
• They possess high liquidity and can be traded in the secondary market.
• They involve negligible default risk because they are backed by the sovereign government.
• Banks, financial institutions, corporations, mutual funds, and individuals may invest in them.

A Treasury Bill is purchased below its face value and redeemed at face value on maturity. Its return is the difference between these two amounts.

If is the face value, is the purchase price, and is the number of days to maturity, the annualized yield is:

For example, if a 91-day T-Bill with a face value of $100,000 is purchased for $98,000:

Thus, the annualized investment yield is approximately 8.19%. Actual market conventions may use 360 or 365 days and may calculate yield with reference to face value rather than purchase price.

Commercial Paper (CP) is an unsecured, short-term promissory note issued by financially sound companies to raise working capital or meet other short-term funding needs.

Features:

• It is generally issued at a discount and redeemed at face value.
• It is not backed by specific collateral.
• Its credit quality depends mainly on the issuer's financial strength and credit rating.
• It normally has a short maturity within the period permitted by applicable regulations.
• It is usually issued in large denominations to institutional investors.
• It may be traded in the secondary market, although liquidity can vary.

Purpose:

• Financing inventories and receivables
• Meeting seasonal working-capital requirements
• Paying short-term obligations
• Diversifying borrowing sources
• Reducing financing costs compared with some bank loans

Treasury Bills and Commercial Paper differ as follows:

Therefore, T-Bills primarily provide safety and liquidity, whereas CP generally offers a higher return with higher credit risk.

A Certificate of Deposit (CD) is a negotiable money market instrument issued by a bank or other eligible financial institution against a deposit placed for a specified period.

Major characteristics:

• It has a fixed maturity and specified redemption value.
• It may be issued at a discount or carry a stated interest rate.
• It is negotiable and may generally be transferred in the secondary market.
• It is commonly issued in standardized and relatively large denominations.
• Its maturity and issuance are governed by applicable central-bank regulations.
• Its return is generally higher than that on an ordinary savings deposit because funds are committed for a fixed period.
• Its risk depends on the financial strength of the issuing institution and any applicable deposit-protection framework.

CDs enable banks to mobilize short-term funds while giving investors a marketable investment option.

Commercial Paper (CP) and Certificates of Deposit (CDs) are both short-term money market instruments, but they differ in important respects:

Both instruments offer liquidity and short maturity, but they serve different issuers and financing objectives.

Corporate treasury management is the systematic management of an organization's cash, liquidity, funding, financial risks, and banking relationships.

Objectives:

• Ensure adequate liquidity for timely payment of obligations.
• minimize the cost of borrowing.
• Maximize returns on temporary surplus funds within acceptable risk limits.
• Control foreign-exchange, interest-rate, credit, and operational risks.
• Maintain financial flexibility and support corporate strategy.

Scope:

• Cash forecasting and cash positioning
• Working-capital and liquidity management
• Short-term investment and borrowing
• Bank-account and relationship management
• Foreign-exchange and interest-rate risk management
• Debt and capital-structure administration
• Treasury accounting, reporting, controls, and compliance

An efficient treasury function balances the three priorities of liquidity, safety, and profitability.

Cash forecasting estimates future cash inflows, outflows, and closing balances over a specified period. It may be prepared on a daily, weekly, monthly, or long-term basis.

Role in treasury management:

• Identifies future cash surpluses and deficits.
• Supports timely borrowing or investment decisions.
• Reduces unnecessary idle cash and avoidable interest cost.
• Helps ensure that payroll, supplier payments, taxes, and debt obligations are met on time.
• Assists in planning working-capital requirements.
• Provides early warning of potential liquidity problems.
• Improves negotiations with banks and lenders.

A sound forecast combines historical trends, budgets, receivable and payable schedules, planned capital expenditure, debt-service dates, and scenario analysis. Forecasts should be updated regularly by comparing projected figures with actual cash flows.

Corporate treasury operations convert treasury policies into day-to-day financial activities.

Important operations include:

• Cash positioning: Determining available balances across all bank accounts.
• Payments and collections: Processing payments and accelerating customer collections.
• Liquidity management: Arranging short-term finance and investing surplus cash.
• Foreign-exchange operations: Executing spot, forward, swap, and hedging transactions.
• Debt administration: Tracking borrowings, interest payments, covenants, and maturities.
• Bank-account management: Opening, closing, reconciling, and controlling accounts.
• Trade-finance support: Managing letters of credit, guarantees, and documentary collections.
• Risk monitoring: Measuring exposures against approved limits.
• Accounting and reporting: Recording transactions and preparing management reports.
• Settlement and confirmation: Ensuring accurate and timely completion of financial transactions.

These activities require proper authorization, segregation of duties, documentation, and internal controls.

A corporate treasury must invest temporary surpluses safely and finance temporary deficits economically.

Management of cash surpluses:

• Invest in Treasury Bills, bank deposits, CDs, money market funds, or high-quality Commercial Paper.
• Match investment maturity with the expected date of cash requirement.
• Diversify investments across issuers and instruments.
• Observe approved credit, liquidity, and counterparty limits.
• Compare returns after considering transaction costs and taxes.

Management of cash deficits:

• Use bank overdrafts or cash-credit facilities.
• Issue Commercial Paper where eligible.
• Obtain short-term bank loans or use revolving credit facilities.
• Accelerate receivable collections and negotiate longer supplier credit.
• Liquidate marketable investments.

The treasury should choose an option by balancing cost, maturity, liquidity, credit risk, flexibility, and refinancing risk.

Treasury handles liquid assets and large financial transactions, making strong internal controls essential.

Key controls include:

• Segregation of duties: Dealing, confirmation, settlement, accounting, and reconciliation should be performed independently.
• Delegation of authority: Transaction and counterparty limits must be formally approved.
• Dual authorization: Significant payments and transactions should require at least two approvals.
• Independent confirmation: Deals should be confirmed directly with counterparties.
• Daily reconciliation: Bank balances, investments, borrowings, and treasury-system records should be reconciled.
• Access controls: Systems and bank portals should use role-based access and strong authentication.
• Policy compliance: Transactions should conform to approved instruments, maturities, and risk limits.
• Audit trail: All transactions and amendments should be fully documented.
• Business continuity: Backup systems and emergency procedures should be tested.

Regular internal and external audits help identify control failures and strengthen governance.

Treasury investment decisions are guided by three competing considerations: liquidity, risk, and return.

• Liquidity is the ability to convert an investment into cash quickly without substantial loss.
• Risk includes default, market, interest-rate, counterparty, and reinvestment risk.
• Return is the income or capital gain earned from the investment.

Highly liquid and low-risk instruments, such as Treasury Bills, usually provide relatively low returns. Instruments carrying greater credit or maturity risk, such as certain Commercial Papers, generally offer higher yields. Longer maturities may also offer higher returns but expose the company to price fluctuations and liquidity constraints.

A corporate treasury normally follows this priority:

1. Safety of principal
2. Availability of funds when required
3. Optimization of return

Accordingly, the highest-yielding instrument is not necessarily the most suitable treasury investment.

External Commercial Borrowing (ECB) refers to commercial borrowing raised by an eligible domestic entity from recognized non-resident lenders in accordance with the country's foreign-exchange and borrowing regulations.

Common forms may include:

• Foreign-currency bank loans
• Buyers' credit and suppliers' credit
• Floating-rate notes
• Fixed-rate bonds
• Foreign-currency convertible bonds, where permitted
• Loans from foreign equity holders or other recognized lenders
• Rupee-denominated bonds issued overseas, where permitted

ECBs may help borrowers access larger pools of funds, longer maturities, and potentially lower interest rates. However, they expose the borrower to exchange-rate movements, international interest rates, refinancing risk, and regulatory conditions relating to eligibility, maturity, cost ceilings, permitted uses, reporting, and repayment.

Advantages of ECBs:

• Access to international sources of capital
• Potentially lower interest rates than domestic borrowing
• Availability of longer maturities and larger loan amounts
• Diversification of funding sources
• Possible natural hedge for companies earning foreign-currency revenue
• Support for capital expenditure, expansion, and other permitted uses

Risks of ECBs:

• Currency risk: Domestic-currency depreciation increases the repayment burden.
• Interest-rate risk: Floating-rate borrowing becomes costlier when benchmark rates rise.
• Refinancing risk: Replacement funding may be unavailable at maturity.
• Country and regulatory risk: Rules governing ECBs may change.
• Liquidity risk: Foreign currency may not be readily available when payments fall due.
• Covenant risk: Breach of loan conditions may trigger penalties or acceleration.

A company should evaluate the fully hedged cost, maturity profile, cash-flow currency, and stress scenarios before using ECBs.

Exchange-rate risk arises when an ECB is denominated in a foreign currency while the borrower's main revenues are in domestic currency. If the domestic currency depreciates, more domestic currency is required to pay foreign-currency interest and principal.

If a borrower must repay foreign currency amount and the future exchange rate is domestic-currency units per unit of foreign currency, the domestic repayment is:

An increase in raises the domestic-currency liability.

Hedging methods:

• Forward contract: Locks in an exchange rate for a future payment.
• Currency option: Provides protection while retaining favorable upside.
• Currency swap: Exchanges principal and interest obligations between currencies.
• Natural hedge: Matches foreign-currency debt payments with export receipts.
• Foreign-currency deposits: Accumulates funds in the repayment currency.

The company should compare hedge cost with risk tolerance and comply with applicable regulations.

Before raising an ECB, a company should examine the following factors:

• Regulatory eligibility: Whether the borrower, lender, currency, amount, and instrument are permitted.
• End-use restrictions: Whether the proposed utilization of funds is allowed.
• Maturity requirements: Compliance with the prescribed minimum average maturity.
• All-in cost: Interest, fees, withholding tax, hedging cost, and transaction expenses.
• Currency exposure: Extent of mismatch between debt payments and operating cash flows.
• Interest-rate structure: Choice between fixed and floating rates.
• Repayment capacity: Adequacy of future cash flows under adverse scenarios.
• Covenants and security: Restrictions imposed by lenders and assets offered as security.
• Refinancing risk: Ability to refinance or repay at maturity.
• Reporting compliance: Registration, documentation, and periodic regulatory reporting.

A decision should be based on the effective hedged cost, not merely the quoted foreign interest rate.

Micro, Small, and Medium Enterprises (MSMEs) contribute to employment, entrepreneurship, regional development, exports, innovation, and supply-chain growth.

Their classification is determined by the criteria prescribed under applicable law, which may include investment, turnover, employment, or a combination of measures.

Major financing needs:

• Working capital: Purchase of inventory, payment of wages, and financing of receivables.
• Term finance: Acquisition of machinery, land, buildings, and technology.
• Trade finance: Letters of credit, bank guarantees, export credit, and bill discounting.
• Growth capital: Capacity expansion, product development, and market entry.
• Emergency liquidity: Management of seasonal or unexpected cash-flow disruptions.

MSMEs often require flexible, timely, and reasonably priced finance because their internal resources and access to capital markets are limited.

MSMEs can obtain finance from both formal and alternative sources.

Major sources include:

• Bank finance: Term loans, cash credit, overdrafts, and working-capital demand loans
• Government-supported schemes: Subsidized loans, interest support, and development programs
• Credit-guarantee schemes: Partial protection to lenders for eligible collateral-free loans
• Microfinance and non-bank lenders: Small-value and specialized credit facilities
• Trade credit: Deferred payment terms offered by suppliers
• Receivable financing: Factoring, invoice discounting, and digital bill-discounting platforms
• Leasing and hire purchase: Use of equipment without immediate full payment
• Equity and venture capital: Investment from promoters, angel investors, or funds
• Supply-chain finance: Credit based on transactions with larger buyers
• Export finance: Pre-shipment and post-shipment credit

The appropriate source depends on cost, collateral, maturity, control implications, cash-flow pattern, and intended use.

Financing difficulties faced by MSMEs:

• Limited collateral and low promoter capital
• Incomplete accounting records and weak financial disclosures
• Short or nonexistent credit histories
• Irregular cash flows and seasonal demand
• High perceived probability of default
• Small loan sizes that increase lenders' administrative cost
• Delayed payments from customers
• Limited awareness of financial schemes and products
• High interest rates or extensive documentation requirements

Measures to reduce these difficulties:

• Expand credit-guarantee and collateral-free lending programs.
• Promote cash-flow-based lending and alternative credit scoring.
• Encourage formal registration, digital payments, and reliable accounting.
• Develop factoring and invoice-discounting platforms.
• Ensure timely settlement of MSME invoices by large buyers.
• Provide financial-literacy and advisory support.
• Strengthen credit-information systems and digital loan processing.

These measures reduce information asymmetry and improve lenders' confidence.

Factoring is an arrangement under which a business sells or assigns its trade receivables to a factor. The factor may provide immediate finance and may also manage collection, sales-ledger administration, and credit protection.

Invoice discounting allows a business to borrow against unpaid invoices while it usually continues to administer its sales ledger and collect payments from customers.

Both methods convert receivables into immediate cash, shorten the operating cycle, and reduce dependence on conventional collateral-based loans.