Financial Instruments

NES FF 2005/06 2 Plan Evolution of the forms of business organization Evolution of the forms of business organization Stocks and bonds Stocks and bonds –Cash flow vs control rights –Hybrid instruments Derivatives Derivatives –Options, forwards, futures, and swaps Typical investment strategies Typical investment strategies

NES FF 2005/06 3 Forms of Business Organization Sole proprietorship Sole proprietorship Partnership Partnership Corporation Corporation Evaluate by The life of the entity The life of the entity The ability to raise capital The ability to raise capital The owners' liability The owners' liability

NES FF 2005/06 4 Modern Corporation Advantages Advantages – Limited liability 1811: general act of incorporation in NY 1811: general act of incorporation in NY – Easy transfer of ownership – Unlimited life – Ability to raise large amounts of money

NES FF 2005/06 5 Equity vs Debt Shareholders Shareholders –Control rights (e.g., elect directors) –Limited liability –Residual claim on assets (after paying up liabilities) –Dividends (fully taxable) Debtholders Debtholders –Fixed contractual claim against the corporation –No voting power unless the debt is not paid –Interest on debt is tax-deductible

NES FF 2005/06 6 Modern Corporation Disadvantages Disadvantages – Start-up can be costly – Earnings subject to double taxation – The agency problem Separation of control and ownership Separation of control and ownership The leverage effect of debt The leverage effect of debt

NES FF 2005/06 7 Securities Characteristics Characteristics –Contingent contractual claim –Marketability –Necessary conditions: record-keeping, legal infrastructure (contracting and enforcement) Derivatives: second level Derivatives: second level –Payoff depends on the value of other (underlying) securities

NES FF 2005/06 8 Bond Characteristics Amount / date of issue, maturity, currency, par value Amount / date of issue, maturity, currency, par value Coupon payments Coupon payments –Frequency, floating vs fixed rate Security (attachment to the property) Security (attachment to the property) –Debenture/note vs bond Protective covenants Protective covenants –Restrictions on further indebtedness, max dividends Seniority Seniority –Subordinated debt paid after senior debt

NES FF 2005/06 9 Fixed Income Instruments Money market: maturity below 1 year Money market: maturity below 1 year –Treasury / corporate bills Zero-coupon / pure discount bonds Zero-coupon / pure discount bonds –Repos (repurchase agreements) Collateralized loan Collateralized loan –Interbank rates E.g., LIBOR E.g., LIBOR

NES FF 2005/06 10 Fixed Income Instruments (2) Capital market Capital market –Treasury notes and bonds Considered risk-free Considered risk-free –Federal agency and municipal securities No explicit guarantee No explicit guarantee –Corporate bonds Subject to default risk, may be callable and with collateral Subject to default risk, may be callable and with collateral

NES FF 2005/06 11 Options Right to buy/sell at strike price in the future Right to buy/sell at strike price in the future –Call / put –European / American –Long / short Asymmetric payoff Asymmetric payoff Driven by volatility of the underlying asset Driven by volatility of the underlying asset Intrinsic value vs time value Intrinsic value vs time value

NES FF 2005/06 12 Embedded Options Common equity Common equity –Call on the value of the firm with strike equal to the face value of debt Convertible bonds Convertible bonds –Hybrid instrument –Mitigate the problem of excessive risk taking Executive options Executive options Real options Real options

NES FF 2005/06 13 Exotic Options Exchange option Exchange option Binary option Binary option Asian option Asian option Barrier option: Barrier option: –Knock-in / knock-out –Call / put

NES FF 2005/06 14 Interest Rate Options Cap (on r with strike x): Cap (on r with strike x): –Call on % Floor: Floor: –Put on % Collar of the borrower: Collar of the borrower: –Long cap and short floor –Forward on %

NES FF 2005/06 15 Preferred Stock Preference over common stock in cash rights: Preference over common stock in cash rights: –in the payments of dividends –in the assets in case of bankruptcy No voting rights, unless no dividends No voting rights, unless no dividends Is it really debt in disguise? Is it really debt in disguise? –Fixed dividend: usually, cumulative –Stated liquidating value Call provision: Call provision: –Can be converted to common shares

NES FF 2005/06 16 Forward Obligation to buy/sell at pre-specified (delivery) price at certain time in the future Obligation to buy/sell at pre-specified (delivery) price at certain time in the future –Long/short position –The forward price = delivery price that would make the contract worth exactly zero Symmetric payoff Symmetric payoff Low liquidity Low liquidity –Must be offset by the counter deal Credit risk Credit risk

NES FF 2005/06 17 Futures Standardized exchange-traded contract Standardized exchange-traded contract –Amount, quality, delivery date, place, and conditions of the settlement Credit risk taken by the exchange Credit risk taken by the exchange –The exchange clearing-house is a counter-party –Collateral: the initial / maintenance margin –Daily marking to market Open interest vs volume Open interest vs volume

NES FF 2005/06 18 Swap Interest rate swap Interest rate swap –Exchange of fixed-rate and floating-rate interest payments for a fixed par value Currency swap Currency swap –Exchange of interest payments in different currencies Motivation: comparative advantages Motivation: comparative advantages

NES FF 2005/06 19 Different Types of Swaps Currency swap Currency swap Step-up / amortizing Step-up / amortizing –Changing par Extendable / puttable Extendable / puttable –Changing maturity Equity swap Equity swap –To avoid taxes Swaption, credit swap, … Swaption, credit swap, …

NES FF 2005/06 20 Major Derivative Instruments Stocks: options Stocks: options Stock index: futures Stock index: futures Commodities: futures, forwards, options Commodities: futures, forwards, options Currency (FX): forwards, swaps, options Currency (FX): forwards, swaps, options Interest rates: swaps, forwards, options Interest rates: swaps, forwards, options

NES FF 2005/06 21 Indices Aggregate picture of a particular market segment Aggregate picture of a particular market segment –Should be replicable by investors –Benchmark to evaluate portfolio performance Weighting Weighting –Equal vs market cap –Free-float adjustment: exclude strategic stakes

NES FF 2005/06 22 Indices (2) Equity indices: Equity indices: –Small-cap vs large-cap –Value vs growth Fixed income indices Fixed income indices –Short-term vs long-term –High vs low credit rating

NES FF 2005/06 23 Credit Derivatives Separate CR mgt from the underlying asset Separate CR mgt from the underlying asset Types of insured credit risk: Types of insured credit risk: –Credit event, value of the underlying asset, recovery rate, maturity Total return swap Total return swap –Fixed or floating payments in exchange for the current income from the underlying asset Credit default swap Credit default swap –Regular premium payments in exchange for a one-time premium in case of the credit event

NES FF 2005/06 24 Role of Derivatives To hedge risks To hedge risks –Make risk-offsetting bets To speculate To speculate –Take a view on the future direction of the market To lock in arbitrage profit To lock in arbitrage profit –Long-short (self-financed) portfolio To change the nature of liability/investment To change the nature of liability/investment –Without a need to remove it …at low cost ! …at low cost !

NES FF 2005/06 25 Investment Strategies Naked forward Naked forward Forward spread Forward spread –Calendar / cross Naked option Naked option Covered option Covered option Spread: options of one type Spread: options of one type –Bear / bull / butterfly / calendar Combination: options of different type Combination: options of different type –Straddle / strip / strap / strangle