Financial Instruments

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Financial Instruments

Professor Lasse H. Pedersen

Prof. Lasse H. Pedersen

1

Overview
Real and financial assets Use of financial assets Important examples of financial assets

Prof. Lasse H. Pedersen

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Real Versus Financial Assets
Real Assets
– Assets used to produce goods and services – Examples: factories, land, human capital, etc.

Financial Assets
– Claims on real assets such as
stocks bonds

– Derivatives
Prof. Lasse H. Pedersen

Use of Financial Instruments
Allocation of Capital
– Financing of projects

Consumption Smoothing:
– saving and borrowing

Allocation of Risk
– Diversification – Hedging – Insurance

Meeting place for investors with different (not necessary opposite) investment needs Prof. Lasse H. Pedersen

Important Financial Assets
Fixed Income Securities
– ‘Borrowing instruments’ – Treasury bonds – Municipal bonds – Corporate bonds

Equity
– ‘Ownership in a firm’ – A stock is a ‘claim to funds after all debts have been paid’

Prof. Lasse H. Pedersen

Important Financial Assets
Derivatives
– Definition: ‘securities whose payoff depends on values of other assets’ – Examples Options Futures Swaps

Investment Companies
– Mutual Funds
Prof. Lasse H. Pedersen

Treasury Bonds
Types of Treasury bonds
– Treasury Bills (less than 1 year maturity) – Treasury Notes (1-10 year maturity) – Treasury Bonds (10-30 year maturity)

Semi-annual coupon payments

Prof. Lasse H. Pedersen

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Municipal Bonds
Issued by state and local governments
– Exempt from federal income tax – Exempt from (issuing) state local tax

Types of ‘munis’
– General obligation bonds: baked by the ‘full faith of credit’ of the issuer (taxing power) – Revenue bonds (riskier): issued to finance specific projects (airports, hospital, etc.) Prof. Lasse H. Pedersen 8

Corporate Bonds
Default Risk Commercial paper
– Short term

Corporate bond
– Longer term – Typically pays semi-annual coupons – Different “seniority” classes senior junior or subordinated
Prof. Lasse H. Pedersen 9

Equity
Equity
– Future cash-flows are uncertain. – Maturity is indefinite. – Involves risk, variable liquidity.

Two main classes of equities
– Common Stock – Preferred Stock
Prof. Lasse H. Pedersen 10

Equity, Continued
Common Stock
– Voting rights (“ownership”) – Right to dividends – Limited liability – In case of default, last in line

Preferred Stock
– Non-voting – Usually receive fixed stream of dividends – Receive dividends before common – More like debt than equity Prof. Lasse H. Pedersen 11

Derivatives
Examples: options and futures Motivation: Hedging
– Farmer (price risk associated with selling) – Gas company (price risk from buying) – Multinational firm (exchange rate risk)

Motivation: Speculation
– High leverage and high risk
Prof. Lasse H. Pedersen 12

Futures
A contract to purchase/ sell an asset (commodities or financial) – At a specified price – On a specified date

Prof. Lasse H. Pedersen

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Options
Call option
– The right to buy an asset at a specified price (the “strike price”) before a specified date

Put option
– The right to sell an asset at a specified price before a specified date

Prof. Lasse H. Pedersen

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Mutual Funds Markets
Financial intermediaries that pool funds from investors and buy assets Advantages: – Record keeping and administration – Diversification and divisibility – Professional management and analysis – Lower transactions costs Prof. Lasse H. Pedersen 15

Asset-Backed Securities AssetBundling of existing securities such as – mortgages – auto loans – corporate bonds – credit card receivables

An example of financial engineering

Prof. Lasse H. Pedersen

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