Financial Financial InstrumentsInstruments

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PlanPlan

Evolution of the forms of business Evolution of the forms of business organizationorganization

Stocks and bondsStocks and bonds– Cash flow vs control rightsCash flow vs control rights– Hybrid instrumentsHybrid instruments

DerivativesDerivatives– Options, forwards, futures, and swapsOptions, forwards, futures, and swaps

Typical investment strategiesTypical investment strategies

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Forms of Business Forms of Business OrganizationOrganization Sole proprietorshipSole proprietorship PartnershipPartnership CorporationCorporation

Evaluate byEvaluate by The life of the entityThe life of the entity The ability to raise capitalThe ability to raise capital The owners' liabilityThe owners' liability

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Modern CorporationModern Corporation

AdvantagesAdvantages– Limited liabilityLimited liability

• 1811: 1811: general act of incorporation in NYgeneral act of incorporation in NY

– Easy transfer of ownershipEasy transfer of ownership

– Unlimited lifeUnlimited life

– Ability to raise large amounts of Ability to raise large amounts of moneymoney

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Equity vs DebtEquity vs Debt

ShareholdersShareholders– Control rights (e.g., elect directors)Control rights (e.g., elect directors)– Limited liabilityLimited liability– Residual claim on assets (after paying up Residual claim on assets (after paying up

liabilities)liabilities)– Dividends (fully taxable)Dividends (fully taxable)

DebtholdersDebtholders– Fixed contractual claim against the corporationFixed contractual claim against the corporation– No voting power unless the debt is not paidNo voting power unless the debt is not paid– Interest on debt is tax-deductibleInterest on debt is tax-deductible

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Modern CorporationModern Corporation

DisadvantagesDisadvantages– Start-up can be costlyStart-up can be costly

– Earnings subject to double Earnings subject to double taxationtaxation

– The agency problemThe agency problem•Separation of control and Separation of control and

ownershipownership

•The leverage effect of debtThe leverage effect of debt

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SecuritiesSecurities

CharacteristicsCharacteristics– Contingent contractual claimContingent contractual claim– MarketabilityMarketability– Necessary conditions: record-keeping, Necessary conditions: record-keeping,

legal infrastructure (contracting and legal infrastructure (contracting and enforcement)enforcement)

Derivatives: second levelDerivatives: second level– Payoff depends on the value of other Payoff depends on the value of other

(underlying) securities(underlying) securities

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Bond CharacteristicsBond Characteristics

Amount / date of issue, maturity, Amount / date of issue, maturity, currency, par valuecurrency, par value

Coupon paymentsCoupon payments– Frequency, floating vs fixed rateFrequency, floating vs fixed rate

Security (attachment to the property)Security (attachment to the property)– Debenture/note vs bondDebenture/note vs bond

Protective covenantsProtective covenants– Restrictions on further indebtedness, max Restrictions on further indebtedness, max

dividendsdividends SenioritySeniority

– Subordinated Subordinated debt paid after debt paid after senior senior debtdebt

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Fixed Income Fixed Income InstrumentsInstruments Money market: maturity below 1 Money market: maturity below 1

yearyear– Treasury / corporate billsTreasury / corporate bills

• Zero-coupon / pure discount bondsZero-coupon / pure discount bonds

– Repos (repurchase agreements)Repos (repurchase agreements)• Collateralized loanCollateralized loan

– Interbank ratesInterbank rates• E.g., E.g., LIBORLIBOR

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Fixed Income Fixed Income InstrumentsInstruments (2)(2) Capital marketCapital market

– Treasury notes and bondsTreasury notes and bonds• Considered risk-freeConsidered risk-free

– Federal agency and municipal Federal agency and municipal securitiessecurities

• No explicit guaranteeNo explicit guarantee

– Corporate bondsCorporate bonds• Subject to default risk, may be callable Subject to default risk, may be callable

and with collateraland with collateral

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OptionsOptions

Right to buy/sell at strike price in the Right to buy/sell at strike price in the futurefuture– Call / putCall / put– European / AmericanEuropean / American– Long / shortLong / short

Asymmetric payoffAsymmetric payoff Driven by volatility of the underlying Driven by volatility of the underlying

assetasset Intrinsic value vs time valueIntrinsic value vs time value

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Embedded OptionsEmbedded Options

Common equity Common equity – Call on the value of the firm with Call on the value of the firm with

strike equal to the face value of debtstrike equal to the face value of debt Convertible bondsConvertible bonds

– Hybrid instrumentHybrid instrument– Mitigate the problem of excessive risk Mitigate the problem of excessive risk

takingtaking Executive optionsExecutive options Real optionsReal options

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Exotic OptionsExotic Options

Exchange optionExchange option Binary Binary optionoption Asian Asian optionoption Barrier Barrier optionoption: :

– Knock-in / knock-out Knock-in / knock-out – Call / putCall / put

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Interest Rate OptionsInterest Rate Options

Cap (Cap (on on r r with strike with strike x): x): – Call on %Call on %

Floor:Floor:– Put on %Put on %

Collar Collar of the borrower: of the borrower: – Long cap and short floorLong cap and short floor– Forward on %Forward on %

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Preferred StockPreferred Stock

Preference over common stock in cash Preference over common stock in cash rights:rights:– in the payments of dividends in the payments of dividends – in the assets in case of bankruptcyin the assets in case of bankruptcy

No voting rights, unless no dividendsNo voting rights, unless no dividends Is it really debt in disguise?Is it really debt in disguise?

– Fixed dividend: usually, Fixed dividend: usually, cumulativecumulative– Stated liquidating valueStated liquidating value

Call provision: Call provision: – Can be converted to common sharesCan be converted to common shares

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ForwardForward

Obligation to buy/sell at pre-specified Obligation to buy/sell at pre-specified (delivery) price at certain time in the (delivery) price at certain time in the futurefuture– Long/short positionLong/short position– The forward price = delivery price that The forward price = delivery price that

would make the contract worth exactly zerowould make the contract worth exactly zero Symmetric payoffSymmetric payoff Low liquidityLow liquidity

– Must be offset by the counter dealMust be offset by the counter deal Credit riskCredit risk

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FuturesFutures

Standardized exchange-traded contractStandardized exchange-traded contract– Amount, quality, delivery date, place, and Amount, quality, delivery date, place, and

conditions of the settlementconditions of the settlement Credit risk taken by the exchangeCredit risk taken by the exchange

– The exchange clearing-house is a counter-The exchange clearing-house is a counter-partyparty

– CollateralCollateral: : the initialthe initial / / maintenance marginmaintenance margin– Daily marking to market Daily marking to market

Open interest vs volumeOpen interest vs volume

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SwapSwap

Interest rate swapInterest rate swap– Exchange of fixed-rate and floating-rate Exchange of fixed-rate and floating-rate

interest payments for a fixed par valueinterest payments for a fixed par value Currency swapCurrency swap

– Exchange of interest payments in Exchange of interest payments in different currenciesdifferent currencies

MotivationMotivation: : comparative advantagescomparative advantages

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Different Types of Different Types of SwapsSwaps Currency swapCurrency swap StepStep--upup / / amortizingamortizing

– Changing parChanging par EExtendable / puttablextendable / puttable

– Changing maturityChanging maturity Equity swapEquity swap

– To avoid taxesTo avoid taxes SwaptionSwaption, , credit swapcredit swap, …, …

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Major Derivative Major Derivative InstrumentsInstruments Stocks: optionsStocks: options Stock index: futuresStock index: futures Commodities: futures, forwards, Commodities: futures, forwards,

optionsoptions Currency (FX): forwards, swaps, Currency (FX): forwards, swaps,

optionsoptions Interest rates: swaps, forwards, Interest rates: swaps, forwards,

optionsoptions

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IndicesIndices

Aggregate picture of a particular Aggregate picture of a particular market segmentmarket segment– Should be replicable by investorsShould be replicable by investors– Benchmark to evaluate portfolio Benchmark to evaluate portfolio

performanceperformance WeightingWeighting

– Equal vs market capEqual vs market cap– Free-float adjustment: exclude strategic Free-float adjustment: exclude strategic

stakesstakes

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IndicesIndices (2)(2)

Equity indices:Equity indices:– Small-cap vs large-capSmall-cap vs large-cap– Value vs growthValue vs growth

Fixed income indicesFixed income indices– Short-term vs long-termShort-term vs long-term– High vs low credit ratingHigh vs low credit rating

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Credit DerivativesCredit Derivatives

Separate CR mgt from the underlying Separate CR mgt from the underlying assetasset

Types of insured credit riskTypes of insured credit risk::– Credit eventCredit event, , value of the underlying assetvalue of the underlying asset, ,

recovery rate, maturity recovery rate, maturity Total return swapTotal return swap

– Fixed or floating payments in exchange for Fixed or floating payments in exchange for the current income from the underlying assetthe current income from the underlying asset

Credit default swapCredit default swap– Regular premium payments in exchange for a Regular premium payments in exchange for a

oneone--time premium in case of the credit eventtime premium in case of the credit event

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Role of DerivativesRole of Derivatives

To hedge risksTo hedge risks– Make risk-offsetting betsMake risk-offsetting bets

To speculate To speculate – Take a view on the future direction of the Take a view on the future direction of the

marketmarket To lock in arbitrage profitTo lock in arbitrage profit

– Long-short (self-financed) portfolioLong-short (self-financed) portfolio To change the nature of To change the nature of

liability/investment liability/investment – Without a need to remove itWithout a need to remove it

……at low cost !at low cost !

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Investment StrategiesInvestment Strategies

Naked forwardNaked forward Forward spreadForward spread

– Calendar / crossCalendar / cross Naked optionNaked option Covered optionCovered option SpreadSpread: : options of one typeoptions of one type

– Bear / bull / butterfly / calendar Bear / bull / butterfly / calendar Combination: options of different typeCombination: options of different type

– Straddle / strip / strap / strangleStraddle / strip / strap / strangle