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.