Post on 01-Jan-2016
Financial Operations Financial Operations andand Market
Financial instrument
A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Design Guide
investors’ claims on future cash flow the investors’ right to participate in company
decisions and the investors’ claims on company assets in
liquidation.
ASSET CLASSINSTRUMENT TYPE
Securities Other cash Exchange traded derivatives OTC derivatives
Debt (Long Term)>1 year
Bonds LoansBond futures
Options on bond futures
Interest rate swapsInterest rate caps and floors
Interest rate optionsExotic instruments
Debt (Short Term)<=1 year
Bills, e.g. T-BillsCommercial paper
DepositsCertificates of deposit
Short term interest rate futures Forward rate agreements
Equity Stock N/AStock options
Equity futuresStock options
Exotic instruments
Foreign Exchange N/A Spot foreign exchange Currency futures
Foreign exchange optionsOutright forwardsForeign exchange swapsCurrency swaps
Types of instruments
Instruments of Study
Bonds Common Stock Preferred Stock
Bonds
A bond is defined as a debt security wherein the issuer owes the holders a debt and is obligated to repay the principal and interest. Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer.
Types of Bonds
Fixed-interest-rate bond ( fixed coupon) Convertible bond ( convertible into other kinds of
securities at maturity) Zero coupon bond ( non-interest)
Characteristics of a Bond
Call provisions- the right to retire call prior to its maturity.
Protective covenants (control) Rights in Liquidation
Bond Ratings
Bond Rating Grade Risk
Moody's S&P/ Fitch
Aaa AAA Investment Highest Quality
Aa AA Investment High Quality
A A Investment Strong
Baa BBB Investment Medium Grade
Ba, B BB, B Junk Speculative
Caa/Ca/C CCC/CC/C Junk Highly Speculative
C D Junk In Default
Common Stock
A security that represents ownership in a
corporation.
Characteristics of Common stock
Holders of common stock exercise control by Electing Board of Directors Voting on corporate policy Least of all claimants during liquidation
Common Stock as an Investment
Dividends Possible share price appreciation
Annual income = d0 + P1 – P0
And annual return = Dividend yield + Percentage change in
share price = d0 / P0 + ( P1 – P0 )/ P0
do = dividend par share
P0 and P1 = beginning of year and end of year stock price resp.
Preferred Stock
A security with a class of ownership in a corporation with a stated dividend that must be paid before
dividends to common stock holders. They do not usually have voting rights.
Financial Markets
Financial markets are the channels through which investors provide money to companies.
Private equity
Venture capitalists
Financial investors who make high risk, equity investments in firms deemed capable of rapid growth and high returns.
- Wealthy individuals
- Professional venture capital companies
Funds Generating Markets
Three types of markets. Domestic Foreign and International financial markets - where currency employed
is outside the control of the issuing monetary authority.
Issue Costs
Ex. Investment banker fee; legal, accounting and printing fees.
Intended shares to be sold €10 millions @ €20
-underwriter wishes to sell @ issue price €19 and a spread €1.50
-net to ABC is €17.50.
Efficient MarketThe degree to which stock prices reflect all available, relevant information.
Informational efficiency
Weak form efficient- current prices fully reflects information about the past.
Semi-strong form efficient- current prices fully reflects all publicly available information.
Strong form efficient- current prices fully reflects all information private or public.
Forward Contracts
Class of securities call derivatives.
Speculations in Forward Markets Buy low, sell high Sell high, buy low ( F – S ) €1 million
FIGURE 5A-1 Forward Market Hedge
(a) Forward Sale of € 1 Million
-200
-150
-100
-50
0
50
100
150
200
0.85 0.90 0.95 1.00 1.05 1.10 1.15
Exchange rate ($/€)
Gai
n o
r lo
ss in
do
llars
(00
0s)
(b) € Account Receivable
-200
-150
-100
-50
0
50
100
150
200
0.85 0.90 0.95 1.00 1.05 1.10 1.15
Exchange rate ($/€)
Gai
n o
r lo
ss in
do
llars
(00
0s)
FIGURE 5A-1 (Continued)
FIGURE 5A-1 (Continued)
(c) Forward Market Hedge of Receivable
-200
-150
-100
-50
0
50
100
150
200
0.85 0.90 0.95 1.00 1.05 1.10 1.15
Exchange rate ($/€)
Gai
n o
r lo
ss in
do
llars
(00
0s)
a
b
c
Forw ard sale
Receivable
Hedgedreceivable
Gain or loss
Gain or loss on Forward Sale + Value of receivable ( F – S) € 1million + (S) € 1 million =(F) € 1 million =( 0.9769)€ 1 million =$ 976 900
Hedging with Options
An option is a security entitling the holder the right to exercise an underlying asset at a specific price and time.
Two types of options:
Put : right to sell
Call: right to buy
FIGURE 5A-2 Option Market Hedge
(a) Put Option on € 1 Million
-40
-20
0
20
40
60
80
100
120
140
160
0.85 0.90 0.95 1.00 1.05 1.10 1.15
Exchange rate ($/€)
Gai
n o
r lo
ss in
do
llars
($0
00)
Premium
Strike price
FIGURE 5A-2 (Continued)
(b) Call Option on € 1 Million
-50
0
50
100
150
200
0.85 0.90 0.95 1.00 1.05 1.10 1.15
Exchange rate ($/€)
Gai
n o
r lo
ss in
do
llars
(00
0s)
Premium
Strike price
FIGURE 5A-2 (Continued)
(c) Option Market Hedge of Receivable
-150
-100
-50
0
50
100
150
200
0.85 0.90 0.95 1.00 1.05 1.10 1.15
Exchange rate ($/€)
Gai
n o
r lo
ss in
do
llars
(00
0s) Put Receivable
Hedgedreceivable
Limitation of Financial Marketing Hedging
For commercial risks to be hedged, two basic conditions must hold:
Asset creating the risk must trade in the financial markets.
The amount and timing of the foreign cash flow must be known with reasonable certainty.
Valuing Options
The value is of an option is evaluated base the on the following ;
- the current price of the underlying asset
- the option’s time to maturity
- the option’s strike price
- the interest rate
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