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

2. 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

3. 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. 

4. Risk and return
Required
return
Perceived risk

5. The risk-averse investor
Required
return
Market line
Perceived risk

6. The speculative investor
Required
return
Market line
Speculative investor
Perceived risk

7. 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

8. 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

9. 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.

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

11. Caps, floors, and collars

12. 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