Financial Operations and Financial Operations and 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 CLASS INSTRUMENT TYPE SecuritiesOther cashExchange traded derivativesOTC derivatives Debt (Long Term) >1 year BondsLoans Bond futures Options on bond futuresfutures Optionsfutures Interest rate swaps Interest rate caps and floors Interest rate options Exotic instruments Debt (Short Term) <=1 year Bills, e.g. T-Bills Commercial paperT-Bills Commercial paper Deposits Certificates of deposit Short term interest rate futuresinterest rate futuresForward rate agreements EquityStockN/A Stock options Equity futuresoptionsfutures Stock options Exotic instrumentsoptions Exotic instruments Foreign ExchangeN/ASpotSpot foreign exchangeCurrency futures Foreign exchange options Outright forwards Foreign exchange swaps Currency swapsoptions Outright forwards Foreign exchange swaps Currency 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 GradeRisk Moody'sS&P/ Fitch AaaAAAInvestmentHighest Quality AaAAInvestmentHigh Quality AAInvestmentStrong BaaBBBInvestmentMedium Grade Ba, BBB, BJunkSpeculative Caa/Ca/CCCC/CC/CJunkHighly Speculative CDJunkIn 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 = d 0 + P 1 – P 0  And annual return = Dividend yield + Percentage change in share price = d 0 / P 0 + ( P 1 – P 0 )/ P 0 d o = dividend par share P 0 and P 1 = 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 €20 -underwriter wishes to issue price €19 and a spread €1.50 -net to ABC is €17.50.

Efficient Market The 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

FIGURE 5A-1 (Continued)

Gain or loss  Gain or loss on Forward Sale + Value of receivable  ( F – S) € 1million + (S) € 1 million  =(F) € 1 million  =( )€ 1 million  =$

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

FIGURE 5A-2 (Continued)

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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