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

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Exchange rate ($/€)

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(00

0s)

(b) € Account Receivable

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0.85 0.90 0.95 1.00 1.05 1.10 1.15

Exchange rate ($/€)

Gai

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FIGURE 5A-1 (Continued)

FIGURE 5A-1 (Continued)

(c) Forward Market Hedge of Receivable

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0.85 0.90 0.95 1.00 1.05 1.10 1.15

Exchange rate ($/€)

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(00

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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

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0.85 0.90 0.95 1.00 1.05 1.10 1.15

Exchange rate ($/€)

Gai

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($0

00)

Premium

Strike price

FIGURE 5A-2 (Continued)

(b) Call Option on € 1 Million

-50

0

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0.85 0.90 0.95 1.00 1.05 1.10 1.15

Exchange rate ($/€)

Gai

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Premium

Strike price

FIGURE 5A-2 (Continued)

(c) Option Market Hedge of Receivable

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0.85 0.90 0.95 1.00 1.05 1.10 1.15

Exchange rate ($/€)

Gai

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(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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