FINANCIAL ASSETS (INSTRUMENTS)

Chapter 2

FINANCIAL INSTRUMENTS

• A real or virtual document representing a legal agreement involving some sort of monetary value.

• In today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument

ASSETS

• Tangible asset

•A physically observable, or touchable item such as inventory, building…etc

• Financial asset

•An asset that represents a promise to distribute cash flows some time in the future such as common stocks, bonds….etc

MAJOR FINANCIAL INSTRUMENTS

• Treasury bills

• Repurchase agreements

• Federal funds

• Bankers’ acceptances

• Commercial paper

• Negotiable CDs

• Eurodollars

• Money market funds

• Treasury notes/bonds

• Municipal bonds

• Term loans

• Mortgages

• Corporate bonds

• Preferred stock

• Common stock

Lisa Inc.

Dividends 75.25

Retained Earnings 65

FINANCIAL INSTRUMENTS AND THE FIRM’S BALANCE SHEET

•Firm issues financial instruments so it can purchase the tangible assets necessary to produce income.

•The purpose of issuing financial instruments is to raise capital.

BALANCE SHEET - EQUITY

• Common equity

• stockholder’s total investment in the firm

• Par value

• nominal or face value of a stock or bond

• Retained earnings

• earnings the firm has not paid out as dividends throughout its history

• Additional paid-in capital

• difference between the value of newly issued stock and its par value

DEBT

• A loan to an individual, company, or government

• Debt features

• Principal value

• Face value

• Maturity value

• Par value• Interest payments or discounted securities• Maturity date• Priority to assets and earnings

SHORT-TERM DEBT

• Treasury Bills (T-bills): A short-term obligation of the U.S. Treasury having a maturity period of one year or less and sold at a discount from face value.

SHORT-TERM DEBT

• Repurchase Agreement (Repo): An agreement with a commitment by the seller ( dealer ) to buy a security back from the purchaser.

SHORT-TERM DEBT

• Federal Funds: overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve.

• Banker’s Acceptance: A short-term credit investment which is created by a non-financial firm and whose payment is guaranteed by a bank.

• Commercial Paper: written instrument or document such as a check or draft or promissory of short-term notes issued primarily by corporations.

SHORT-TERM DEBT

• Certificate of Deposit: is a promissory note issued by a bank.

SHORT-TERM DEBT

• Eurodollar Deposit: U.S. dollar on deposit with a bank abroad, especially in Europe.

• Money Market Mutual Funds: is a type of fixed income mutual fund that invests in debt securities that are characterized by their short maturities and minimal credit risk

LONG-TERM DEBT

• Loans: is a debt evidenced by a note which specifies, among other things, the principal amount, interest rate, and date of repayment

• Bonds: is a fixed interest financial asset issued by governments, companies, banks, public utilities and other large entities.• Government bonds

• Treasury bonds

• Municipal bonds

• Revenue bonds

• General obligation bonds

• Corporate bonds

• Mortgage bonds

BOND RATINGS

Represents the credit worthiness of corporate or government bonds.•Moody’s Investors Service (Moody’s)

•Standard & Poor’s Corporation (S&P)

•Investment grade bonds

• triple B or better

•Criteria for rating bonds

•Importance of bond ratings

•Changes in ratings

STOCK (EQUITY)

• Preferred stock : is an investment in a company from which fixed interest payments are paid .

• Common stock: a claim to a part of the corporation's assets and earnings.• Represents ownership

in a corporation• Common stockholders

vote for members of the board of directors

RISK AND RETURN

Risk

Return

Short-term U.S Treasury Bills

Bonds

Preferred stock

Common stocks

DERIVATIVES

• Is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the "underlying”

• Futures contracts, forward contracts, options and swaps are the most common types.

WHICH FINANCIAL INSTRUMENT IS BEST?

• It depends on the risk/return tradeoff

• It depends on the issuance rating

• It depends on the financial markets structure

• It depends on the availability of the financial reports

• In general: many people prefer to invest in portfolios rather than individual security.