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Understanding Financial Instruments

This chapter discusses financial instruments and their basic building blocks. [1] It explains that financial instruments provide different risk-return tradeoffs, with debt having lower risk but also lower potential upside than equity. [2] The chapter then outlines the key characteristics of debt versus equity and provides rules for designing new financial instruments based on balancing expected return with perceived risk. [3] It also introduces some common mechanisms used to manage risk, such as caps, floors, and collars for interest rates.

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200 views12 pages

Understanding Financial Instruments

This chapter discusses financial instruments and their basic building blocks. [1] It explains that financial instruments provide different risk-return tradeoffs, with debt having lower risk but also lower potential upside than equity. [2] The chapter then outlines the key characteristics of debt versus equity and provides rules for designing new financial instruments based on balancing expected return with perceived risk. [3] It also introduces some common mechanisms used to manage risk, such as caps, floors, and collars for interest rates.

Uploaded by

Ain rose
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Corporate Financial Strategy

4th edition
Dr Ruth Bender
Chapter 11

Financial instruments: the building


blocks

Corporate Financial Strategy


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

Corporate Financial Strategy 2


Learning objectives

1. Explain the fundamental characteristics of debt and equity.


2. Identify and contrast the different risk-reduction mechanisms used by
investors and lenders.
3. Analyse a financial instrument to determine the yield, upside, and risk
reduction mechanisms it adopts.
4. Understand the basics of interest rate management tools. 

Corporate Financial Strategy 3


Risk and return

Required
return

Perceived risk

Corporate Financial Strategy 4


The risk-averse investor

Risk-averse
investor

Required
return
Market line

Perceived risk

Corporate Financial Strategy 5


The speculative investor

Required
return
Market line
Speculative
investor

Perceived risk

Corporate Financial Strategy 6


The building blocks of financial instruments

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

Corporate Financial Strategy 7


Characteristics of debt and equity

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

Corporate Financial Strategy 8


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.

Corporate Financial Strategy 9


Risk profiles determine yield and gain to investors

100%

Proportion of
required
return 100% 100%
supplied by yield gain
yield

0%
Perceived risk

Corporate Financial Strategy 10


Caps, floors, and collars

cap

collar

floor

Corporate Financial Strategy 11


Net flows from swapping from floating rate into fixed

Lender
Floating rate interest
payments

Loan &
repayments

Borrower borrows Floating Borrower


Floating rate interest
payments

Fixed rate interest


payments

Borrower swaps into Fixed


Counterparty

Corporate Financial Strategy 12

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