Ch4-Financial Instruments Flashcards
What are the main forms of financial instruments?
1) Debt/Loan capital
2) Equity capital
3) Convertibles
4) Contingent convertibles
5) Floating rate notes
6) Subordinated debt
7) Asset-backed up securities
8) Covered Bonds
9) Options issued by a company
Briefly describe Debt/Loan capital.
What are the three types of debt?
(a)DEBENTURE STOCKS- loans that are secured on some or all assets.
(I)MORTGAGE DEBENTURE- there are specific assets secured mentioned in the legal documentation. (II)FLOATING CHARGE RATE- the company can change then secured assets in the normal course of the business as long as they are replaced by equally satisfactory assets. Debenture stocks are used to raise large amounts of funds. Debenture holders are creditors to the business.
(b) UNSECURED LOAN STOCKS- there is no specific security for the loan. If the company is unable to settle the debt, the default for the unsecured loan stockholders is to sue the company. they rank after the debenture stockholders(lower than). Unsecured loan stockholders rank equally with the creditors of the business. The redemption yield of the unsecured loan stock is higher than the one for debenture stock to compensate for the risk.
(c) EUROBONDS- Companies raise finance by issuing euro bonds. Euro bonds are the borrowing of money in another country. The loan capital is not subject to any tax jurisdictions of any country. they can be traded in any currency. This depends on the parties involved. Eurobonds are unsecured. Trading in Eurobonds occurs through banks rather than through the stock exchange. Redeemed at par. coupons paid annually.
Explain Equity Capital
What are the 2 types of shares that we have?
(a) Ordinary Shares
The marketability of ordinary shares differs from the loan capital. Here are the reasons why.
(i) Ordinary shares of the company tend to be large hence they are issued in large numbers.
(ii)The company only has one type of ordinary shares compared to the loan capital which is fragmented into pieces
(iii) Ordinary shares(their residual nature) are sensitive to the decisions/views of the shareholders. Investors tend to buy and sell ordinary shares more frequently than loan capital.
TYPES OF BASIC ORDINARY SHARES:: deferred shares, redeemable ordinary shares, non-voting shares, shares with multiple voting rights, and golden shares.
(b)Preference Shares
Preference shareholders receive a stream of investment income. They have a preferential right over the returned capital. They do not have a default since they are like dividends. they receive a lower redemption yield than ordinary shares because they are secured.
Convertibles
They are unsecured loan stocks or preference shares that convert into ordinary shares of the issuing company.
~Convertible unsecured loan stocks are unsecured loan stocks that give the right to convert into ordinary shares of the company at a later date
~Convertible preference shares are preference shares that give the right to convert into ordinary shares of the company at a later date.
convertibles provide a higher income than ordinary shares and a lower income than a conventional loan stock or preference shares.
Conversion premium is the difference between the cost of obtaining one ordinary share through convertibles and the market price for the share.
From the investor’s POV, it is the opportunity to combine a lower risk debt security with the potentially large gains of equity(ordinary shares have a high potential return since they are highly risky)(HOW?- unsecured loan stocks and preference shares are not secured and each provides a lower return)
Contingent Convertibles
Floating rate notes
Subordinated debt
~They are loan stocks that convert into ordinary shares of the issuing company once a specified trigger is reached(the trigger can be the price of the share).
~They are medium-term debt securities issued in the euro markets whose interest payments float with short-term interest rates.
~in the event of default, the holder of the subordinated debt ranks below the firm’s general creditors(but ahead of preference shareholders and ordinary shareholders). the holder is a junior debt.
Asset-backed securities.
Covered Bonds
Options issued by companies
They are securities backed by ring-fenced pools of assets. Investors are repaid through interest and capital repayments made from the pools of assets.
alternatively, asset-backed up security may be backed up by car loans, unsecured personal loans, and credit cards. Credit risk is reduced by the loans being secured on pools of assets and by the diversification of the loans within the pools of assets.
~Are bonds issued by banks with ring-fenced pools of assets that will repay the investors if the issuing institution fail.
~Options issued by a company on its own shares and issued to senior managers as part of their remuneration package.
What is a future contract?
~a standardized, exchange tradable contract between 2 parties
~to trade a specific asset
~on a specific date in the future
~at a specified price
what are the main categories of futures?
what is a margin?
Bond futures, short interest rates futures, currency futures, and stock index futures
~a margin is a sum of money that is deposited with the clearing house that acts as a cushion against adverse movements in the market(changes in the prices), it can be potential losses. Additional payments of a variation margin are made to ensure that the clearing house’s exposure to credit risk is controlled.
What is a bond future?
The contract requires the physical delivery of the bond hence it is the delivery of the contract.
if the contract is specified in terms of a particular bond, then it would be possible to deliver the required amount of stock.
if the contract is specified in terms of the notional stock, then there needs to be a linkage between it and the cash market.
what do they mean about the short interest rate futures?
the contract is based on the interest paid on notional deposit for a specified period from the expiry of the future.
the contract is cash-settled.
the way that the quotation is structured means that interest rates fall the prices rise, and vice versa.
Stock index futures
Currency Futures
~the contract provides for a notional transfer of assets underlying a stock index at a specified price on a specified date
~the contract requires the delivery of a set amount of a given currency on a specified date(this is usually done when a person has some obligations in the currency of another party to avoid the interest rate risks)
what are the uses of financial futures?
~a company can use financial futures to lock in the value of assets and liabilities/ to guarantee the value of receipts and payments.
Currency futures can be used to fix the value of foreign receipts or payments
What is an option?
what are the types of options?
define each of the options.
What are the uses of options?
~An option gives an investor a right but not an obligation to sell or buy an asset on a future specified date.
~ we have a call option and a put option.
~ a CALL OPTION gives the right but not the obligation to BUY a specified asset on a SET DATE in the future for a SPECIFIED PRICE.
~a PUT OPTION gives the right but not the obligation to SELL a specified asset on a SET DATE in the future for a SPECIFIED PRICE.
~ Options allow a company to protect itself against adverse movements in the financial environment while retaining the ability to profit from favourable movements.
it makes sense because, at present, we decide on the price and the date to sell the asset using the present interest rate. So when there are changes in the interest rate, the price at which an asset will be sold or bought won’t be affected because it is fixed, it cannot be changed.
what is a strike price?
what is exercising an option?
what happens when a person decides to exercise an option? (consider both options)
what is an expiration date in derivatives? When does the person get to exercise an option?
~That is the specified price in the future while drafting the contract.
The strike price is the one that is used to purchase or sell the option.
~ When a person decides not to sell an option, it is called exercising an option.
~If a person decides to exercise a call option, they will be given a stock(asset) at the strike price. When a person exercises a put option, they have the right to sell the stock at a strike price.
~ An expiration in derivatives is the last day that an options or futures contract is valid. As an option approaches expiry, the contract holder must decide whether to sell, exercise, or let it expire.
*when you exercise the option, you usually pay a fee and a second commission to buy or sell the shares.
What is a Swap?
what are the types of Swaps?
define each type of swap?
~ A swap is a contract between 2 parties under which they agree to exchange a series of payments according to a prearranged formula.
~Interest rate swaps and the currency swaps
~(1) interest rate swap- one party pays the other fixed payments(this can be thought of as the fixed interest payments on a deposit) while the other pays variable payments(which can be thought of as the floating interest payments on the same deposit) based on the short-term interest rate. both payments are in the same currency
~(2) currency swap- an agreement to exchange a fixed series of interest payments and a capital sum in one currency for the same in another currency.
