Financial Instruments

Topics: Bond, Investment, Asset Pages: 5 (511 words) Published: May 27, 2013
Financial Instruments

Professor Lasse H. Pedersen

Prof. Lasse H. Pedersen


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

Prof. Lasse H. Pedersen


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

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

Prof. Lasse H. Pedersen

Important Financial Assets
– 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


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

– 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

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

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

Prof. Lasse H. Pedersen


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


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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