Chapter 11 Financial instruments: the building blocks Corporate Financial Strategy 4th edition Dr Ruth Bender Chapter 11 Financial instruments: the building blocks

Financial instruments: contents Learning objectives Risk and return The risk-averse investor The speculative investor The building blocks of financial instruments Characteristics of debt and equity Rules for designing a financial instrument Risk profile determines yield and gain to investor Caps, floors, and collars Net flows from swapping floating rate into fixed

Learning objectives Explain the fundamental characteristics of debt and equity. Identify and contrast the different risk-reduction mechanisms used by investors and lenders. Analyse a financial instrument to determine the yield, upside, and risk reduction mechanisms it adopts. Understand the basics of interest rate management tools. 

Risk and return Required return Perceived risk

The risk-averse investor Required return Market line Perceived risk

The speculative investor Required return Market line Speculative investor Perceived risk

The building blocks of financial instruments Risk v Return Downside protection Repayment Security Guarantees Covenants Voting rights Veto rights Board representation Yield Fixed / Floating / Other Discretionary or by right? Upside Sale / Redemption / Exchange? Depends on markets or on the company? Guaranteed? Discretionary? Perks

Characteristics of debt and equity   Debt Equity Risk to the investor Low, protected by security and covenants High Yield Interest, normally contractually agreed Dividends, at the discretion of the directors Potential upside to the investor None Very high

Rules for designing a financial instrument The expected return on a financial instrument must be consistent with the investor’s perceived risk The return will come from yield and upside.

Risk profiles determine yield and gain to investors 100% Proportion of required return supplied by yield 100% yield 100% gain 0% Perceived risk

Caps, floors, and collars

Net flows from swapping from floating rate into fixed Lender Floating rate interest payments Loan & repayments Borrower Borrower borrows Floating Floating rate interest payments Fixed rate interest payments Counterparty Borrower swaps into Fixed