1. AP/ECON 3430 3.0 A MONETARY ECONOMICS I: FINANCIAL MARKETS AND INSTITUTIONS Fall 2016
Topic 5: Financial Instruments
Session 5A
Course Director:
Prof. Brenda Spotton Visano
© Brenda Spotton Visano 2016

2. Designing a Financial Contract
Return to our hypothetical monetary economy. Consider building a boat. As a physical “capital good,” it is expected to generate increased output for higher consumption (more fish, e.g.), but requires 3 months to build.
The boat builder needs food and shelter for these 3 months.
Sketch out the terms of the contract you would be willing to agree on.

3. Characteristics of Boat Building Contracts
What’s the relationship between the boat builder and those providing food so that the boat builder can build the boat?
Who gets paid how much and why?
How long is the contract in force?
Can you extract your commitment easily?
Is the ownership of the contract transferable?
What are the risks to your investment?

4. General Characteristics of Financial Contracts
Reviewing the possible contracts, what are the general terms and conditions (the characteristics) of these contracts?
Primary Purpose
Type of Financial Contract
Type/Nature of Income
Issuer of the contract
Term to Maturity
Liquidity
Marketability
Risks

5. Financial Instruments
In reverse: define the following financial instruments using the terms and conditions of the underlying legal obligation:
Currency
Chequing Account Balances
Bank Loans: Line of Credit with a chartered bank
Bonds: Government of Canada Treasury Bond
Home Mortgage with a credit union
Stocks: Common Shares in Apple Inc.

6. Financial Instruments
Financial instruments are contracts governing the transfer of funds (purchasing power)
Defined by terms and conditions of the transfer of the funds
Not net wealth per se (though advanced financial systems may enable greater wealth production)
What determines the price of a financial instrument/contract?

7. Value of a Financial Instrument
What gives the boat “value”?
What gives value to the contractual claim on the boat? What gives financial contracts value? When considering a financial asset (= contract = instrument), what characteristics would you find valuable?
How might we determine a monetary price for that value?

8. Vocabulary of Financial Returns
$100 today is worth how much in 1 year if the interest rate = 6%?
$106 to be paid in 1 year is worth how much today if the discount rate is 6%?
A contract with a market price of $100 today delivers $106 in 1 year. What is the internal rate of return?
You buy a contract that pays you $6 every year, in perpetuity. The price of that contract on the market = $100. What is the yield on this asset?
Apple Inc.’s Price-Earnings ratio is ~16. What is the expected earnings yield on Apple shares?
If the expected inflation rate is 2% per year, what is the real rate of return in all of the above?

9. Negotiating the Current Price
As a saver/lender – How do you decide how much you would be willing to pay today for a contract that promises to pay you $106 in 1 year’s time?
As a capital owner/investor - How do you decide how much you would be willing to sell a contract for today that commits you to a payment of $106 in 1 year’s time?

10. Considerations
Present Value formulas for simple Discount Bonds (Treasury Bills), Coupon Bonds, and Fixed Payment Loans
Liquidity
Opportunity Costs
Inflation
Capital Gains/Losses
Degree of Certainty/Uncertainty

11. Structuring Debt Contracts
How might one structure the terms of a debt contract?
Set a Face Value and a Term to Maturity - negotiate the Current Price of the contract (i.e., the amount to be loaned)
Set a Face Value, a Term to Maturity, and a Periodic Payment – negotiate the Current Price of the contract
Specify a fixed Periodic Payment in perpetuity – negotiate the Current Price of the contract
Set a Current Price and a Periodic Payment – negotiate the Annual Interest Rate and Future Value of the contract