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Financial Instruments

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Title: Financial Instruments


1
Financial Instruments
  • In this section we examine financial instruments
    in
  • detail. We will examine 3 issues
  • Characteristics of Financial instruments.
  • Uses of Financial Instruments
  • Types of Financial Instruments.

2
Financial Instruments
  • Def A financial instrument (FI) is a legal
    contract
  • representing the right to receive future benefits
    under a
  • stated set of conditions.
  • Issuer and Investor
  • Examples of FIs
  • A loan by Nedbank (investor) to Mr. Xa
    (issuer/borrower) to purchase a car.
  • A bond issued by the National Treasury.
  • A bond issued by the City of Jorburg.
  • A share issued by the Mvelaphanda Holdings.

3
  • Let us consider the definition further.
  • -A FI - is a written legal obligation that is
    subject to government enforcement.
  • Without enforcement of the specified terms the FI
    would not exist.
  • -A FI obligates one party to transfer something
    of value, usually money, to another party (party
    is person,
  • company, government).

4
  • -A FI specifies that payment will be made at
    some
  • future date. In some cases such as mortgage
    repayments or car loan dates may be very
    specific. In the case of an insurance contract
    you cannot specify payment dates.
  • -A FI specifies certain conditions under which
    payment will be made. E.g. dividends paid when
    company is profitable. Car insurance paid in the
    event of theft or accident.

5
  • Financial instruments can be classified into two
    main groups underlying instruments and
    derivative instruments.
  • Underlying instruments are used by savers/lenders
    to transfer resources directly to
    investors/borrowers. Examples of underlying FIs
    include stocks and bonds. Bonds and shares offer
    payments based solely on the issuers status.
    Bonds for example make payments depending on the
    solvency of the firm that issued them.
  • Derivative instruments are instruments whose
    values and payoffs are derived from the
    behaviour of the underlying asset. The main use
    of derivatives is to shift risk among investors.
    The most common derivative instruments are
    options and futures. E.g. oil.

6
  • An option provides the holder with the right (not
    obligation) to buy or sell a specified quantity
    of an underlying asset at a fixed price at or
    before the expiration of the option.
  • The holder of an option has the right and not
    obligation to exercise the option. If exercising
    the option is not beneficial the holder can
    choose not to exercise that right and allow the
    option to expire.
  • An option that can be exercised at any time prior
    to expiration is called an American option.
  • An option that can only be exercised at
    expiration is called a European option. Options
    that are a hybrid of the two are known as Bermuda
    style options.

7
  • Options
  • A call option gives the holder the right (not
    obligation) to buy a particular security at a
    particular time for a stated price.
  • A put option gives the holder the right (not
    obligation) to sell a particular security at a
    particular time for a stated price.
  • Futures
  • A future is the obligation to buy a particular
    security at a particular time for a stated price.
    A future is simply a delayed purchase of a
    security.
  • These are used a lot in commodity markets because
    of the volatility of these markets.

8
Important Terms
  • Maturity - the term to maturity of a debt
    obligation is the number of years over which the
    issuer has promised to meet the conditions of the
    obligation. The convention is to refer to the
    term to maturity as its maturity or term.
  • Par value - The par value of a bond is the amount
    that the issuer agrees to repay the holder of the
    debt instrument by maturity date. Also referred
    to as the principal, face value, redemption value
    or maturity value.
  • Coupon rate - It is the interest rate that the
    issuer/borrower agrees to pay each year.

9
Characteristics of Financial Instruments
  • Divisibility Refers to the size of the units in
    which the asset
  • can be purchased. Generally investors prefer
    assets that are
  • highly divisible.
  • Transactions costs Costs of purchasing and
    selling assets.
  • E.g. a bank loan. Negotiation costs, information
    costs, etc.
  • Liquidity The ability to convert an asset
    quickly into cash
  • without experiencing a significant reduction in
    its value.
  • Physical assets are much less liquid than
    financial assets. The
  • shorter the time that elapses before an assets
    full price is
  • realized, the more liquid the asset.

10
Characteristics of Financial Instruments
  • Standardization Financial agreements can be
    complex. To overcome
  • the potential costs of complexity financial
    instruments tend to be
  • standardized. E.g. most mortgages have a standard
    application
  • process and offer standardized terms. It would be
    difficult to sell shares
  • if the shares sold to one investor differed from
    those sold to another.
  • Communicate Information Continuous monitoring of
    the issuer of the FI
  • is very costly. The FI summarizes certain
    essential information about
  • the issuer.

11
Uses of Financial Instruments
  • Means of Payment E.g. company stock as payment
    for working. (No FI is as yet as good as money).
  • Store of Value Transfer purchasing power into
    the future.
  • Allow trading of risk Transfer risk from one
    person or company to another. E.g. an insurance
    contract.

12
Types of Financial Instruments
  • FIs can be categorized as money market
    instruments and capital market instruments.
  • Money Market Instruments
  • Money market instruments are short-term debt
    instruments that have maturity of one year or
    less. They generally have a relatively high
    degree of liquidity. They tend to have a low
    expected return but also a low degree of risk as
    compared to the capital market instruments.
    Examples include treasury bills, commercial
    paper, repurchase agreements etc.

13
Examples of Money Market Instruments
  • I. Treasury Bills
  • These are short term IOUs of governments that
    issues them. They are the least risky and most
    marketable of all money market instruments. They
    are issued at a discount from the face value and
    pay no explicit interest payments. The difference
    between the purchase price and the face value
    constitute the return the investor receives.
  • Because TBs are considered to have no risk of
    default (they are issued by government), have
    very short maturities, have a known return, and
    are traded in active markets, they are the
    closest approximation that exists to a riskless
    investment.

14
Repurchase Agreements (RA) - (a.k.a Sale and
Repurchase Agreement)
  • A repurchase agreement is an agreement between a
    borrower and a lender to sell and repurchase a
    security.
  • A borrower will institute an RA by contracting to
    sell securities to a lender at a particular price
    and simultaneously contracting to buy back the
    government security at a future date at a
    specified price.
  • A more accurate descriptive term is Sale and
    Repurchase Agreement, since what occurs is that
    the cash receiver (borrower/seller) sells
    securities to the cash provider (lender/buyer)
    now in return for cash, and agrees to repurchase
    those securities from the buyer for a greater sum
    of cash at some later date, that greater sum
    being the cash lent and some extra cash
    (constituting interest, known as the repo rate).
  • There are three types of repo maturities
  • Overnight repo this refers to a one-day
    maturity transaction.
  • Term repo a repo with a specified end date.
  • Open repo - no stated end date.

15
  • III. CDs (Negotiable Certificates of Deposits)
  • CDs are time deposits with a bank.
  • IV. Bankers Acceptances
  • These are contracts by a bank to pay a specific
    sum of money on a particular date.
  • V. Commercial Paper
  • Commercial paper is a short-term instrument
    issued by large well-known corporations. Their
    interest rates are determined in part by the
    creditworthiness of the corporations.

16
Capital Market Instruments
  • These are securities with maturity greater than 1
    year and those with no designated maturity at
    all. Examples include government bonds,
    municipal bonds, corporate bonds etc.

17
Examples of Capital Market Instruments
  • Treasury Notes - These are government-issued debt
    instruments whose duration ranges from 1 year to
    10 years.
  • Treasury Bonds - These are debt instruments with
    a maturity beyond 10 years. Treasury bonds are
    usually callable before maturity while treasury
    notes are usually not callable.
  • Treasury instruments are usually considered to be
    safe from default and thus differences in
    expected returns are due to differences in
    maturity, differences in liquidity and the
    presence or absence of a call provision.
  • Corporate Bonds - Corporate Bonds are debt
    instruments issued by private firms. They promise
    to pay interest at periodic intervals and return
    the principal at a fixed date. They are similar
    to government bonds in payment pattern but they
    differ in the sense that they have a risk of
    default.
  • Corporate bonds differ in risk not only because
    of differences in probability of default of the
    issuing firms, but also because of difference in
    the nature of their claims on the assets and
    earnings of the issuing firm. For example,
    secured bonds have specific collateral backing
    them in the event of bankruptcy whereas unsecured
    bonds do not.
  • Corporate bonds are most often callable. This
    means firms can force the holders to surrender
    them at a fixed price during a set period of time.

18
  • Preferred Stock - This promises to pay to the
    holder periodic dividend payments. There is no
    return of principal in this case because
    preferred stock is almost always infinite in
    life.
  • Failure to pay a promised divided does not result
    in bankruptcy. Usually when a firm fails to pay
    dividends these dividends are cumulated and all
    unpaid stock dividends must be paid off before
    any common stock dividends can be paid.
  • If a firm is liquidated bondholders are paid
    first followed by preferred stockholders and then
    finally ordinary shareholders.
  • Most preferred stocks are callable and are
    convertible into ordinary shares.
  • Equity (Ordinary Shares/Common Stocks) - Common
    stocks represent an ownership claim on the
    earnings and assets of a firm. After debt holders
    have been paid, the management of the firm can
    either payout the remaining earnings to the
    shareholders as dividends or reinvest the
    earnings in the business.

19
  • Financial instruments can also be categorized
    into those that are used to store value and those
    used for trading risk.
  • Financial instruments used mainly as a store of
    value
  • Bank loans the borrower needs funds to use
    while the lender is looking for a way to store
    value into the future.
  • Bonds in exchange for obtaining funds today a
    corporation (in the case of a corporate bond)
    promises to make payments in the future. Again
    bonds are used by the borrower to finance current
    operations and by the lender to store value.
  • Home mortgages In exchange for the funds the
    borrower promises to make a series of payments.
    The house is the collateral for the loan.
  • Stocks the firm that sells the shares uses that
    to raise funds while the holder of the shares (or
    buyer of the shares) use them primarily as stores
    of wealth.
  • Loans, bonds, mortgages store value for the
    lender. Stocks store value for investors.

20
Financial Instruments used primarily to transfer
risk
  • Insurance contracts the purpose of insurance
    policies is to assure that payments will be made
    under particular and often rare circumstances.
    These instruments are there to transfer risk from
    one party to another. Eg from you the student to
    Ingwe, Prosperity or Discovery medical insurance
    or from you the student to Outsurance car
    insurance etc.
  • Futures contracts - A futures contract is an
    agreement between two parties to exchange a fixed
    quantity of a commodity (such as wheat or corn)
    or an asset such as bond at a fixed price on a
    set future date. It is used to transfer the risk
    of price fluctuations from one party to another.
  • Options these are derivative instruments whose
    value depends on the value of an underlying
    asset. They also transfer risk from party of the
    contract to his or her counterparty.

21
What affects the value of a financial instrument?
  • Size - the bigger the promised payment the more
    valuable the financial instrument.
  • Timing - the sooner the payment the more valuable
    it is. A R100 paid next year is more valuable
    than R100 paid in 5 years (opportunity cost).
  • Payment likelihood - there is always uncertainty.
    The more likely it is that payment will be made,
    the more valuable the FI.
  • The circumstances under which payment is made
    Payments that are made when we need them most are
    more valuable than other payments.

22
Factors affecting a financial instruments risk
  • The maturity of the instrument generally the
    longer the maturity the more risky it is.
  • The creditworthiness of the issuer.
  • The nature and priority of the claims the
    instrument has on income and assets.
  • The liquidity of the instrument and the type of
    market in which it is traded.

23
Capital markets
Equity
Debt
Ordinary shares
Preferred shares
Commercial Paper
Bank loans
Bonds
Leases
24
Priority Structure
Priority
Preferred stock
Ordinary debt
Secured debt
Subordinated debt
Common stock
25
Valuation of Financial Instruments
  • Valuation is the process of determining the fair
    value of a financial instrument. Also referred to
    as pricing the financial instrument.
  • Once a fair price has been established by the
    valuation process the fair price is then compared
    to the price at which it is trading for in the
    market (i.e. the market price).
  • Based on this comparison, an investor will be
    able to assess the investment merit of a
    financial instrument. The following table shows
    the three main possibilities.

26
Valuation of Financial Instruments
27
Short-selling
  • It is worth noting that it is possible for an
    investor to sell a FI that he or she does not
    own. Selling an asset that you do not own is
    called short-selling.
  • Illustration
  • Definition short-selling is the selling of an
    asset that the seller doesn't own
  • Why to profit from a decline in the price of the
    asset
  • Mechanics Say the asset is a stock
  • 1) Borrow stocks through a dealer
  • 2) Sell them and deposit proceeds and margin in
    an account
  • 3) Close out/cover the position buy stocks and
    return them to the dealer.

28
Example 1
  • Suppose you calculate the fair price of ABSA at
    R40 but the market price is currently R65. In
    future you expect the market to self-correct and
    bring the price back to it correct value of R40.
    You currently do not own any ABSA shares. What
    would you do to profit from this?
  • You borrow some shares currently being traded at
    R65 and then sell them at the correct price when
    the market self-corrects. This is how you do it
  • Step1 - Borrow stocks through a dealer. That is,
    you borrow 100 shares at R65 each. Sell them at a
    price of R65 each to realize a payoff equal to
    R6500.
  • Step 2 - Wait for the market price to decline to
    its fair value of R40. When this happens, buy 100
    shares at R40 each. That is, you incur a cash
    outflow equal to R4000.
  • Step 3 - Close out/cover the position by
    returning the 100 shares to the dealer.
  • At the end of these three stages you would have
    realized a profit equal to R6500 R4000
    R2500.

29
Example 2
  • Before we get excited let us also note that if
    your fair price is incorrect you can actually
    make losses from short-selling.
  • Suppose, the fair price that you calculated
    (R40) was actually incorrect. Let us say the
    correct fair price is R90 rather than R40.
  • Step1 - Borrow stocks through a dealer. That is,
    you borrow 100 shares at R65 each. Sell them at a
    price of R65 each to realize a payoff equal to
    R6500.
  • Step 2 - Wait for the market price to decline to
    your calculated fair value of R40. But
    unfortunately for you the price of the ABSA share
    actually increases to R90. You must buy 100
    shares and give them back to the lender. Because
    the price has increased to R90 you now incur a
    cash outflow 90x100 9000.
  • Step 3 - Close out/cover the position by
    returning the 100 shares to the dealer.
  • At the end of the three stages you would have
    realized a loss equal to
  • R6500 R9000 -R2500.
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