Corporate Financial Strategy

Chapter 11

Financial instruments: the building blocks

Corporate Financial Strategy4th edition

Dr Ruth Bender

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

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Corporate Financial Strategy

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. 

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Corporate Financial Strategy

Risk and return

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Perceived risk

Requiredreturn

Corporate Financial Strategy

The risk-averse investor

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Perceived risk

Requiredreturn

Market line

Risk-averse investor

Corporate Financial Strategy

The speculative investor

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Perceived risk

Requiredreturn

Market line

Speculative investor

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The building blocks of financial instruments

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Risk v Return

YieldFixed / Floating / Other

Discretionary or by right?

UpsideSale / Redemption /

Exchange?

Depends on markets or on the company?

Guaranteed? Discretionary?

Perks

Downside protection

Repayment

Security

Guarantees

Covenants

Voting rights

Veto rights

Board representation

Corporate Financial Strategy

Characteristics of debt and equity

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  Debt EquityRisk 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

Corporate Financial Strategy

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.

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Risk profiles determine yield and gain to investors

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Perceived risk

0%

100%

100% yield

100% gain

Proportion of required

return supplied by

yield

Corporate Financial Strategy

Caps, floors, and collars

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cap

floor

collar

Corporate Financial Strategy

Net flows from swapping from floating rate into fixed

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Borrower

Lender

Counterparty

Loan & repayments

Floating rate interest payments

Fixed rate interest payments

Floating rate interest payments

Borrower borrows Floating

Borrower swaps into Fixed