Chapter 6: Other Debt Instruments
Introduction to Debt Instruments
Debt instruments are financial assets or securities that represent a loan made by an investor to a borrower. They are a crucial part of the financial markets, providing ways for governments, corporations, and institutions to raise capital by promising to pay back the principal amount on a specified maturity date, along with interest.
Types of Debt Securities
In this section, we focus on primary money market instruments—Certificates of Deposit (CDs), Bankers’ Acceptances, and Commercial Paper—often used in short-term financing.
Certificate of Deposit (CD)
A Certificate of Deposit is a time deposit offered by banks with a fixed interest rate and maturity date. They are known for their stability and are often viewed as low-risk investments.
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Characteristics: CDs typically offer higher interest rates than savings accounts but require the funds to remain deposited for a predetermined period.
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Investment Use: They are used by consumers and large institutions alike, providing capital stock that banks can reinvest.
Bankers’ Acceptances
Bankers’ Acceptances are short-term debt instruments issued by companies that allow a company to receive payment on goods or services at a future date.
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Function: These are used in international trade to provide assurance that payment will be received once the goods are delivered. Essentially, they are a draft or bill of exchange guaranteed by a bank.
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Example Scenario: A U.S. company needing to purchase goods from a European supplier can provide a bankers’ acceptance to assure the supplier of payment on delivery.
Commercial Paper
Commercial Paper is an unsecured, short-term debt instrument issued by corporations for meeting immediate financial needs.
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Characteristics: These are typically issued at a discount from face value and reflect prevailing market interest rates.
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Example Usage: A corporation might use commercial paper to raise funds to cover short-term liabilities such as payroll or inventory.
Visualizing Market Relationships
To better understand the relationships between these instruments, consider the following representation of how institutions utilize them for short-term funding:
graph TD;
A[Institutions] --> B[Issue Debt Instruments];
B --> C(Certificates of Deposit);
B --> D(Bankers' Acceptances);
B --> E(Commercial Paper);
E --> F[Short-Term Financing Needs];
Summary Points
- CDs provide a safe, predictable return with higher interest rates compared to savings accounts.
- Bankers’ Acceptances facilitate international trade by ensuring payment, thereby reducing the risk to exporters.
- Commercial Paper serves the purpose of covering short-term liquidity needs without the need for collateral.
Glossary
- Debt Instrument: Any document that is a legally binding agreement of debt between parties concerned.
- Maturity Date: The due date on which the principal amount of a note, draft, acceptance bond, or other debt instrument becomes due and is repaid to the investor.
- Discount Rate: Derived from the face value and selling price; it’s the interest those initial buyers earn over the holding period.
Additional Resources
To deepen your understanding of these instruments and their roles in the economy, consider the following resources:
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Books
- “Fixed Income Securities” by Bruce Tuckman
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
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Online Resources
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Websites
- Federal Reserve Bank for insights on credit and interest rates
- Securities and Exchange Commission for regulations and guidelines
FINRA Securities Industry Essentials® (SIE®) Exam Preparation Quizzes
### Which of the following is true about Certificates of Deposit (CDs)?
- [x] They offer a fixed interest rate and require funds to remain until maturity.
- [ ] They have variable interest rates and can be withdrawn at any time.
- [ ] They are issued only by government institutions.
- [ ] They do not have a maturity date.
> **Explanation:** CDs typically have fixed interest rates and require deposits to remain until maturity to avoid penalties.
### Which debt instrument is specifically used in international trade to provide payment assurance?
- [ ] Commercial Paper
- [x] Bankers' Acceptances
- [ ] Certificates of Deposit
- [ ] Corporate Bonds
> **Explanation:** Bankers' Acceptances are used to assure international trade partners that payment will be received once goods are delivered.
### A company issues an unsecured, short-term debt used primarily to cover immediate financial needs. What is this instrument called?
- [x] Commercial Paper
- [ ] Corporate Bonds
- [ ] Certificates of Deposit
- [ ] Bankers' Acceptances
> **Explanation:** Commercial paper is typically unsecured and used for short-term financial needs without requiring collateral.
### What is the primary benefit of using CDs compared to savings accounts?
- [x] Higher interest rates
- [ ] No maturity date
- [ ] No penalty for early withdrawal
- [ ] Variable interest rates
> **Explanation:** CDs generally offer higher interest rates than savings accounts, albeit with less liquidity.
### Which of the following are characteristics of Commercial Paper?
- [x] It is unsecured.
- [ ] It is long-term.
- [ ] It requires collateral.
- [x] It is issued at a discount.
> **Explanation:** Commercial paper is short-term, unsecured, and typically issued at a discount, reflecting market interest rates.
### Why might a corporation choose to issue Commercial Paper instead of securing a bank loan?
- [x] Lower borrowing costs
- [ ] Requires collateral
- [ ] Longer repayment periods
- [ ] Strict regulations
> **Explanation:** Corporations might choose commercial paper due to the typically lower borrowing costs and lack of collateral requirement.
### In examining the relationships of debt instruments, which would be most actively involved in international transactions?
- [ ] Certificates of Deposit
- [ ] Corporate Bonds
- [x] Bankers' Acceptances
- [x] Letters of Credit
> **Explanation:** Bankers' Acceptances and Letters of Credit are key to facilitating secure international transactions.
### Which of the following specifically represents a guaranteed form of payment upon delivery of goods in international trade?
- [x] Bankers' Acceptances
- [ ] Corporate Bonds
- [ ] Certificates of Deposit
- [ ] Commercial Paper
> **Explanation:** Bankers' Acceptances provide a guarantee that payment will be made upon delivery, aiding risk management in trade.
### Which money market instrument is backed by large banks against their assets?
- [x] Certificates of Deposit
- [ ] Commercial Paper
- [ ] Retail Money Market Funds
- [ ] Convertible Bonds
> **Explanation:** CDs are typically offered by banks and backed by their assets up to the insured limit.
### Bankers' Acceptances are a promise of future payment, with payment guaranteed by a bank. True or False?
- [x] True
- [ ] False
> **Explanation:** This is true as Bankers' Acceptances are accepted by banks as a form of a post-dated payment guaranteeing future payment to the bearer.