Kenneth R. Szulczyk
contracts are standardized, investors can buy and sell these contracts on secondary markets. We
study the derivatives market in Chapter 18.
Financial Instruments
Every financial instrument, except stock, has a principal, interest, and maturity. Principal is
the loan amount the borrower received from the lender. Then the borrower pays interest as
periodic payments to the lender because the lender allows the borrower to use the funds. Interest
is a cost to the borrower, but income to the lender. Finally, maturity is the date the security
expires, or the final date when the borrower pays the last payment for the principal plus interest.
Analysts and economists categorize financial instruments into two broadly defined classes:
money market and capital market. Money market comprises of short-term securities with a
maturity less than one year. Money market securities are popular and are simply a loan of funds
from one party to another. Money market securities are highly liquid and almost as good as
money – hence the name money market. Second category, the capital market, includes long-
term securities with a maturity greater than a year. Capital market includes common stock
because stock has no expiration date because the corporation, in theory, could live forever.
Thus, we define stock as a long-term security.
You should memorize the following securities because we continually refer to these
financial instruments throughout this book. For students to understand these securities,
remember who issues the security, and whether it is a money market or capital market security.
All these securities have one purpose. One party owes another party money plus interest except
stocks. Stocks represent ownership in a corporation and are not loans.
Money market securities have maturities less than one year, and we list the common ones:
U.S. Treasury bills or T-bills) are loans to the U.S. government. Maturities range from 15
days to one year. T-bills do not have an interest rate stamped on them, and they start at
$10,000. If an investor buys a T-bill for $19,000, and the T-bill has a face value of $20,000
with a maturity of six months. Then six months later, the government will pay $20,000.
The $1,000 reflects the interest. Commercial paper is a loan to a well-known bank or corporation for a short-time period.
Corporations use commercial paper to raise funds without issuing new stocks or bonds.
Commercial paper is a form of direct finance, and the loan has no collateral. Banker’s Acceptances are used in international trade. For example, a firm wants to buy
from a foreign exporter. Firm deposits money at a bank, and the bank guarantees payment
by issuing a banker’s acceptance. That way, the export accepts the banker’s acceptance and
ships the goods to the firm. If the firm does not deposit money at the bank and the bank
guarantees payment, then the bank must pay the foreign exporter, even if the firm
bankrupts. These securities are liquid because holders can sell them on a secondary market.