Financial market – instruments to transfer capital and instruments to transfer risk
Introduction
Within the scope of this research, we will conduct comparative analysis of different financial instruments, concentrating on applications for non-financial company to acquire capital and availability of instruments on the Polish market (being the representative of the emerging market economy). Broadly speaking, financial instrument may be defined as “an instrument having monetary value or recording a monetary transaction.” (Perrault, 2002) In order to conduct comparative analysis of financial instruments, we will have to assess them within the conceptual framework of financial markets within which those instruments are utilized.
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Financial markets
It is through the activities of the financial markets, the buying and selling of corporate securities, that the value of a firm is determined. Securities are financial instruments, such as shares and debentures, which represent claims by their holders on the assets of the company. Financial transactions determine the price or value of the asset(s) being traded. () It is the active trading between buyers and sellers that determines the all-important price of a firm’s securities in the market, and consequently the financial markets establish the market value of the firm. Clearly if a firm’s securities, for example, in the case a private company, are not actively traded in a financial market then the task of valuation is much more difficult.
Thus, in addition to enabling mutually beneficial financial transactions to take place, financial markets also provide critical financial information about a firm, that is they place a value on a firm’s securities. Without this information it would be much more difficult to determine the effect on the firm’s value of its investment and financing decisions and to judge the effectiveness of its management.
The prices of securities in the financial markets tend to respond very promptly to new information, good or bad, about a firm’s future prospects. (Perrault, 2002) Supposing an engineering firm secures a substantial new contract, or a pharmaceutical company discovers a cure for a major form of cancer, then the stock market is likely to respond very rapidly (usually within minutes) to reflect this new information in the company’s share price. In this scenario traders in the market will immediately mark up the value of the company’s shares to reflect their new assessment of the value of its future returns.
Financial markets are future oriented and continually assess the future expectations of companies. Their very essence is investors and traders competing with each other for information which will enable them to profit by making a more accurate assessment of a company’s future than their rivals. Financial markets can also be categorized as primary or secondary markets. When a security is issued for the first time it is issued in the primary market and this is the only time the finance raised by the sale of the security goes directly to the issuer, whether that issuer is a firm or government.
Once the security is traded again it enters the secondary market and this time it does not raise any money for the issuer, the buying and selling of the security are directly between investors in the marketplace. Thus the primary market involves the issue of new securities and provides capital for the original issuer. In contrast the secondary market can be viewed as a ‘used’ or ‘second-hand’ securities market and is simply a market for the trading of existing securities—no new money is raised for the issuer. The lion’s share of stock market trading takes place in the secondary market, it is by far the dominant market.
Primary market issues can be subdivided into seasoned and unseasoned issues. In the case of a company, a seasoned issue involves the issue of more of an existing security which is already trading in the market. For example, if a company such as Airtours, BT, or Cadbury Schweppes was to issue more of its ordinary shares then this would be termed a seasoned issued. () The shares are already very well known to investors and traders in the marketplace, and they have an established track record. Unseasoned issues, on the other hand, have no track record. They are issues of completely new securities and are often referred to as initial public offerings (IPOs). As unseasoned issues have no established trading history in the markets they are more difficult to value than seasoned issues.
Partly because of this lack of information, and also a desire for a successful issue, unseasoned issues or IPOs in general seem to be consistently underpriced (by approximately 15 per cent on average) by the merchant or investment bank which is underwriting the issue. Other more cynical reasons for the underpricing of IPOs suggest favoritism on behalf of the underwriters to their special clients. The underwriters, it has been suggested, allocate their favored clients sizeable portions of the underpriced issue, thus allowing them to sell at a significant profit when the issue starts trading in the markets.
Financial instruments
Financial instruments consist of cash (coins, notes and demand bank deposits), shares/equities and debt (short-term debt such as bank loans and trade credit and long-term debt in the form of loans and debentures). Financial instruments, be they debt or equity, which are traded in the financial markets are collectively referred to as securities. Securities is a generic term covering all types of financial instruments traded in the financial markets. More precisely a security represents “a claim by the holder on the future income or assets of the party issuing the security.” (Chen & Khan, 2003) For example, an ordinary company share represents a claim by the shareholder on the earnings and assets of the company. Securities can be short-term, such as 3-month Treasury bills (Tbs), or long-term, such as corporate bonds and equities.
Financial instruments consist of cash (coins, notes and demand bank deposits), shares/equities and debt (short-term debt such as bank loans and trade credit and long-term debt in the form of loans and debentures). Financial instruments, be they debt or equity, which are traded in the financial markets are collectively referred to as securities. Securities is a generic term covering all types of financial instruments traded in the financial markets. More precisely a security represents “a claim by the holder on the future income or assets of the party issuing the security.” (Chen & Khan, 2003) For example, an ordinary company share represents a claim by the shareholder on the earnings and assets of the company. Securities can be short-term, such as 3-month Treasury bills (Tbs), or long-term, such as corporate bonds and equities.
Shares
Shares are units of ownership in a company and shareholders are the legal owners of the company. Shareholders have a right to participate in a company’s profits (they usually receive dividends which are distributions of after-tax profits) and in its decision-making. (BIS, 2002) However, day-to-day decision-making is usually delegated to the company’s directors and managers—the agency relationship. Shares can be either ordinary or preference.
Shares are units of ownership in a company and shareholders are the legal owners of the company. Shareholders have a right to participate in a company’s profits (they usually receive dividends which are distributions of after-tax profits) and in its decision-making. (BIS, 2002) However, day-to-day decision-making is usually delegated to the company’s directors and managers—the agency relationship. Shares can be either ordinary or preference.
Ordinary shares
Ordinary share capital provides a permanent source of funding for a company. Holders of ordinary shares normally receive a return on their investment by way of dividends, which are periodic and variable distributions of a company’s earnings. Ordinary shareholders will also receive a return by way of a capital gain, if the company is successful and the market value of the share increases. Ordinary shareholders will only receive their share of the profits (dividends) after the company has satisfied all its other financial obligations such as interest on debt, taxes, and preference dividends.
Ordinary share capital provides a permanent source of funding for a company. Holders of ordinary shares normally receive a return on their investment by way of dividends, which are periodic and variable distributions of a company’s earnings. Ordinary shareholders will also receive a return by way of a capital gain, if the company is successful and the market value of the share increases. Ordinary shareholders will only receive their share of the profits (dividends) after the company has satisfied all its other financial obligations such as interest on debt, taxes, and preference dividends.
In the event of a liquidation, all creditors, secured and unsecured, will rank prior to the ordinary shareholders in the distribution of a company’s assets. Thus ordinary shareholders come at the end of the financial obligations queue. They are the firm’s residual risk bearers and consequently they will expect a return commensurate with this level of risk. It is the equity of a company (equity equals total assets minus total liabilities) which belongs to the ordinary shareholders, thus ordinary shares are frequently called ‘equities’. (Jeanneau, 2002)
Preference shares
Preference shares are often described as hybrid securities, that is, they are considered neither equity or debt securities—they possess certain characteristics of both. (Perrault, 2002) Preference shares resemble ordinary equity shares in that the holder is entitled to a dividend but of a limited or fixed amount which is paid, as the name implies, in preference to any ordinary dividend out of a company’s after tax profits. Preference shareholders may also rank ahead of ordinary shareholders for a distribution of a company’s assets in the event of a liquidation.
Preference shares are often described as hybrid securities, that is, they are considered neither equity or debt securities—they possess certain characteristics of both. (Perrault, 2002) Preference shares resemble ordinary equity shares in that the holder is entitled to a dividend but of a limited or fixed amount which is paid, as the name implies, in preference to any ordinary dividend out of a company’s after tax profits. Preference shareholders may also rank ahead of ordinary shareholders for a distribution of a company’s assets in the event of a liquidation.
Because the payments to preference shareholders are ‘for a limited amount that is not calculated by reference to the company’s assets or profits or the dividends on any class of equity share’, preference shares are classed as non-equity shares. (Perrault, 2002) There are two main types of preference shares, cumulative and non-cumulative. Holders of cumulative preference shares will be entitled to receive any arrears of dividend which may occur in years when a company is unable to pay the full, or any, preference dividend. Non-cumulative preference shareholders will not be entitled to any arrears of dividend.
It is also possible for a company, if permitted by its Articles of Association, to issue convertible preference shares (Perrault, 2002). Holders then have the option, according to the terms of the issue, of converting their non-equity preference shares into equity shares at a specified conversion rate. Preference shares may also be redeemable or irredeemable, but most commonly they are irredeemable and represent a permanent source of financing just like equities.
Debt instruments
Companies use long-term debt instruments, such as bonds and debentures, to raise substantial sums of loan or debt capital. A bond is a long-term debt instrument which can be used by companies (or governments) to raise very substantial sums of money. (Perrault, 2002) A debenture is any document which sets out the terms and conditions under which a company has borrowed money—it is a written acknowledgement of a debt, usually given under the company’s seal. To avoid undue repetition we will use the term ‘bond’ in a generic sense to cover all forms of long-term, tradeable corporate debt (including debentures). When a company issues a new bond (or any new security) it will initially be sold in the primary market and the issue proceeds, net of issue costs, (e.g. underwriters’ fees and commissions) will go to the company. Subsequently the bond will be traded in the secondary market and its price will fluctuate over its lifetime.
Companies use long-term debt instruments, such as bonds and debentures, to raise substantial sums of loan or debt capital. A bond is a long-term debt instrument which can be used by companies (or governments) to raise very substantial sums of money. (Perrault, 2002) A debenture is any document which sets out the terms and conditions under which a company has borrowed money—it is a written acknowledgement of a debt, usually given under the company’s seal. To avoid undue repetition we will use the term ‘bond’ in a generic sense to cover all forms of long-term, tradeable corporate debt (including debentures). When a company issues a new bond (or any new security) it will initially be sold in the primary market and the issue proceeds, net of issue costs, (e.g. underwriters’ fees and commissions) will go to the company. Subsequently the bond will be traded in the secondary market and its price will fluctuate over its lifetime.
Types of bonds
There are two broad categories of bonds traded in the capital markets: those issued by governments (government bonds) and those issued by companies (corporate bonds). Bonds issued by governments to raise money are often referred to as ‘gilts’ or gilt-edged bonds. (Chen & Khan, 2003) So called because there is, in democratic and developed capitalist economies, virtually no risk of a government defaulting on its bonds. Defaulting means being unable at some stage to make the interest and principal payments on the bonds issued.
There are two broad categories of bonds traded in the capital markets: those issued by governments (government bonds) and those issued by companies (corporate bonds). Bonds issued by governments to raise money are often referred to as ‘gilts’ or gilt-edged bonds. (Chen & Khan, 2003) So called because there is, in democratic and developed capitalist economies, virtually no risk of a government defaulting on its bonds. Defaulting means being unable at some stage to make the interest and principal payments on the bonds issued.
The primary interest, however, is in corporate bonds, of which there are today many different types (e.g. Eurobonds, zero coupon bonds, and ‘junk’ bonds) each with its own particular characteristics. (BIS, 2002) The risk of companies defaulting on their bonds is greater than that of governments and consequently the returns required by investors from corporate bonds are generally higher. Unlike shareholders, corporate bond holders are not owners of the company, they are creditors, and as creditors their claim on the assets, or future earnings, of the company may be secured or unsecured.
Corporate bonds which are secured on assets of a company are technically known as debentures or debenture loan stock. (Jeanneau, 2002) Bonds which are not so secured are known as subordinated debentures or unsecured loan stock. Unsecured bonds will be more risky than secured bonds, therefore investors will typically expect a higher return in the form of a higher interest rate. Should a company go into liquidation, secured creditors will be paid from the sale proceeds of the secured asset(s) in preference to unsecured creditors.
The traditional form of debenture is where a company borrows a substantial sum of money directly from a single financial institution, such as an insurance company or pension fund, for a period of 20-30 years. The loan will be secured on specific assets of the company, typically fixed assets such as land and property. This type of debenture is known as a mortgage debenture. Debenture loan stock, in contrast, is where the lump sum will be borrowed by splitting it into smaller tradeable units and selling them in the stock market. In the UK loan stock is usually traded in units with a par or face value of £100.
Bonds can also be broadly classified as redeemable or irredeemable. A redeemable bond is one which over its lifetime makes regular interest payments to the holder and which will be bought back (redeemed), usually for a specified value, by the issuer at some stated time in the future. (Perrault, 2002) The time of redemption is normally quoted as occurring over a defined number of years at some time in the future such as 2012-2015. This means that the bond can be redeemed at any time during the period 2012-2015 rather than on a single specified date. For this reason redeemable bonds are often referred to as ‘dated’ bonds. (Perrault, 2002) In contrast an irredeemable or perpetual bond is ‘undated’, that is, it has no specified time for capital repayment (redemption) and instead is treated as paying only interest in perpetuity. A bond which pays interest in perpetuity and is never to be redeemed is called a consol.
Characteristics of bonds
Bonds have a face or par value and carry a coupon which is the interest rate payable at regular intervals. Bondholders receive periodic interest payments, of a known amount, during the period of the loan and the principal is repaid when the stock reaches maturity—if the issuer does not default. The interest paid on bonds may be at a fixed or floating interest rate and, unlike dividend payments, interest is a tax-deductible expense. A company is allowed to charge the interest on debt against profits. This tax benefit tends to make debt a cheaper source of long-term financing than equity. (Chen & Khan, 2003)
Bonds have a face or par value and carry a coupon which is the interest rate payable at regular intervals. Bondholders receive periodic interest payments, of a known amount, during the period of the loan and the principal is repaid when the stock reaches maturity—if the issuer does not default. The interest paid on bonds may be at a fixed or floating interest rate and, unlike dividend payments, interest is a tax-deductible expense. A company is allowed to charge the interest on debt against profits. This tax benefit tends to make debt a cheaper source of long-term financing than equity. (Chen & Khan, 2003)
Bonds can be traded in the stock market in the same way as equity capital, or they may be held until maturity or redemption at which time the holder will be repaid the bond’s par value. If a bond is being sold in the market above its par value it is trading at a premium: conversely if it is being sold in the market below its par value it is trading at a discount. Like equity prices, bond prices can rise or fall on the bond market depending upon the movement in the general level of interest rates. Thus a bondholder may incur a capital gain or loss if the bond is sold in the open market before maturity. (Jeanneau, 2002) Bond prices are quoted daily in the companies and markets section of the Financial Times. The prices are given for UK gilts, and for other international government and corporate bonds.
Convertible debt
There are times when a company may decide to finance its long-term operations by issuing convertible debt. Convertible debt (e.g. convertible debentures or convertible loan stock) is a form of hybrid debt finance where the holder of the debt instrument has the option to convert the debt into equity at a pre-specified rate of conversion, usually a predetermined number of equity shares per £100 of debt held. (Perrault, 2002) Normally the terms of the convertible issue will specify a defined period of time, called the conversion period, over which holders may or may not exercise their rights to convert. When a convertible issue is made, the conversion period will not normally commence until some years into the future.
There are times when a company may decide to finance its long-term operations by issuing convertible debt. Convertible debt (e.g. convertible debentures or convertible loan stock) is a form of hybrid debt finance where the holder of the debt instrument has the option to convert the debt into equity at a pre-specified rate of conversion, usually a predetermined number of equity shares per £100 of debt held. (Perrault, 2002) Normally the terms of the convertible issue will specify a defined period of time, called the conversion period, over which holders may or may not exercise their rights to convert. When a convertible issue is made, the conversion period will not normally commence until some years into the future.
The rate of return on convertible debt is usually lower than on non-convertible debt as the convertible holder enjoys the right to acquire equity shares, usually at a favorable rate. Thus from the issuing company’s point of view, this right to equity participation or ‘equity incentive’ tends to make convertible debt a cheaper form of debt financing than a conventional loan. The risk for the investor with convertible debt is that it implies growth in the issuing company’s share price. For example, if a convertible bond is issued at £100 par when the company’s share price at the time of issue is £2.00 and the conversion price is set at £2.50, then the conversion rate or ratio is £100/£2.50=40. Thus on conversion a bondholder will receive 40 equity shares for each £100 of debt held. (Perrault, 2002)
With convertible debt or loan stock a conversion premium indicates that the underlying share price is not sufficient to justify conversion. In other words, it is more expensive to buy the convertibles than the equivalent number of ordinary shares. For example, if convertible debt or loan stock is quoted in the market at £110 and the debt is convertible into 100 ordinary shares which are trading at £1.00 each, the conversion premium would be 10 per cent. (Perrault, 2002) Conversely, a conversion discount indicates that the price of the convertible is lower than the equivalent number of ordinary shares.
Warrants
Warrants are similar to convertible debt. They are options which give the holder the right to purchase a specified number of equity shares in a company at a predetermined share price. As with convertible debt there is usually a defined period of time over which the option may be exercised. When an issue of warrants takes place it is usually tied to a debt issue. (BIS, 2002) While warrants have similar characteristics to convertible debt they differ in that when debt-holders exercise their rights to convert to equity the original debt is eliminated, it is swapped for equity. Also, with a warrant, the holder subscribes additional cash to the company if the option is exercised. This not the case in converting debt to equity, where one type of security is exchanged for another.
Warrants are similar to convertible debt. They are options which give the holder the right to purchase a specified number of equity shares in a company at a predetermined share price. As with convertible debt there is usually a defined period of time over which the option may be exercised. When an issue of warrants takes place it is usually tied to a debt issue. (BIS, 2002) While warrants have similar characteristics to convertible debt they differ in that when debt-holders exercise their rights to convert to equity the original debt is eliminated, it is swapped for equity. Also, with a warrant, the holder subscribes additional cash to the company if the option is exercised. This not the case in converting debt to equity, where one type of security is exchanged for another.
Warrants entitle the holder to subscribe for equity shares at a predetermined (normally favorable) share price, known as the exercise price. If a company performs well then its share price in the market is likely to exceed the exercise price. In which case warrant holders will either exercise or sell their options. If the option to purchase is exercised, the company receives additional equity finance, but in this case the original debt is not retired, it remains outstanding until maturity when it will be redeemed by the company.
Mezzanine finance
Mezzanine finance is an intermediate type of finance, it falls between conventional debt and equity finance. It is generally high-risk, high-interest bearing debt with a convertible equity property, for example it may be issued with warrants. (Chen & Khan, 2003) Mezzanine finance is high risk because it ranks low in the order of priority for repayment in the event of a liquidation and for this reason it is often referred to as subordinated debt. To compensate for the risk the debt is usually ‘priced’ at several percentage points, about 4-5 per cent, above normal interest rates. Mezzanine finance is typically used to finance mergers, acquisitions, and management buy-outs (MBOs).
Mezzanine finance is an intermediate type of finance, it falls between conventional debt and equity finance. It is generally high-risk, high-interest bearing debt with a convertible equity property, for example it may be issued with warrants. (Chen & Khan, 2003) Mezzanine finance is high risk because it ranks low in the order of priority for repayment in the event of a liquidation and for this reason it is often referred to as subordinated debt. To compensate for the risk the debt is usually ‘priced’ at several percentage points, about 4-5 per cent, above normal interest rates. Mezzanine finance is typically used to finance mergers, acquisitions, and management buy-outs (MBOs).
Money market securities
Most transactions in the money markets involve marketable securities. These are short-term, easily liquidated securities such as Treasury bills (Tbs), Certificates of Deposit (CDs), and commercial paper (CP). (Jeanneau, 2002) These securities can be issued and traded by businesses, government and financial institutions depending upon the type of instrument involved.
Most transactions in the money markets involve marketable securities. These are short-term, easily liquidated securities such as Treasury bills (Tbs), Certificates of Deposit (CDs), and commercial paper (CP). (Jeanneau, 2002) These securities can be issued and traded by businesses, government and financial institutions depending upon the type of instrument involved.
Treasury bills (Tbs)
For reasons which we will shortly explain Treasury bills (Tbs) are a key money market instrument. Only governments can issue Treasury bills. They will sell Treasury bills in the financial markets to raise funds to finance public expenditure. Treasury bills are sold at a discount to their nominal value. Rather than pay interest, Treasury bills are issued at a discount to their face or nominal value, although a rate of interest is implied by the level of discount offered. The government will then buy back the bills on maturity from the holder at their £100 nominal value. In this case the investor earns a return of £2 on an investment of £98 over a three-month period. (Perrault, 2002)
For reasons which we will shortly explain Treasury bills (Tbs) are a key money market instrument. Only governments can issue Treasury bills. They will sell Treasury bills in the financial markets to raise funds to finance public expenditure. Treasury bills are sold at a discount to their nominal value. Rather than pay interest, Treasury bills are issued at a discount to their face or nominal value, although a rate of interest is implied by the level of discount offered. The government will then buy back the bills on maturity from the holder at their £100 nominal value. In this case the investor earns a return of £2 on an investment of £98 over a three-month period. (Perrault, 2002)
To a corporate treasurer
Treasury bills have the attractions as short-term investments of being highly liquid, there is a highly developed secondary market, and because they are government securities, their risk, in developed countries, is non-existent. The corporate treasurer can invest surplus funds in Treasury bills through the firm’s bank. The market price of Treasury bills will be directly related to short-term interest rates. If short-term interest rates rise, the price of a bill will fall. Conversely, if short-term interest rates fall, the price of a bill will rise. It is their close connection with short-term interest rates that makes Treasury bills one of the most important short-term money market securities.
Treasury bills have the attractions as short-term investments of being highly liquid, there is a highly developed secondary market, and because they are government securities, their risk, in developed countries, is non-existent. The corporate treasurer can invest surplus funds in Treasury bills through the firm’s bank. The market price of Treasury bills will be directly related to short-term interest rates. If short-term interest rates rise, the price of a bill will fall. Conversely, if short-term interest rates fall, the price of a bill will rise. It is their close connection with short-term interest rates that makes Treasury bills one of the most important short-term money market securities.
Certificates of Deposit (CDs)
For a corporate treasurer with surplus funds to invest on a short-term basis Certificates of Deposit (CDs) are also a suitable form of financial instrument. A Certificate of Deposit (CD) is a written acknowledgement (certificate) issued by a financial institution, normally a bank, stating that a specified sum of money has been placed on deposit for a defined period of time. (BIS, 2002) The certificate will stipulate the rate of interest to be paid and the maturity date. CDs are typically issued with maturity periods of three or six months.
For a corporate treasurer with surplus funds to invest on a short-term basis Certificates of Deposit (CDs) are also a suitable form of financial instrument. A Certificate of Deposit (CD) is a written acknowledgement (certificate) issued by a financial institution, normally a bank, stating that a specified sum of money has been placed on deposit for a defined period of time. (BIS, 2002) The certificate will stipulate the rate of interest to be paid and the maturity date. CDs are typically issued with maturity periods of three or six months.
Negotiable CDs can be sold in the money markets before maturity. Thus a corporate treasurer investing in negotiable CDs has the option to sell the securities in the markets should the funds be needed by the firm. CDs issued by the major financial institutions have the attractions of being marketable, offering a guaranteed rate of return, and are low risk.
Commercial paper (CP)
Commercial paper (CP) is an unsecured promissory note issued by a corporation to raise short-term finance in the money markets, as an alternative to raising money (overdraft or short-term loan) direct from a financial institution. A promissory note is simply a written promise to pay. The paper is usually issued by large companies with sound credit ratings and with access to bank credit facilities to cover the issue. The paper can have a maturity period of from about 7 days up to one year, but 30-60 day paper is more common. (Chen & Khan, 2003) When the paper matures it can be refinanced by the company issuing new paper to replace it.
Commercial paper (CP) is an unsecured promissory note issued by a corporation to raise short-term finance in the money markets, as an alternative to raising money (overdraft or short-term loan) direct from a financial institution. A promissory note is simply a written promise to pay. The paper is usually issued by large companies with sound credit ratings and with access to bank credit facilities to cover the issue. The paper can have a maturity period of from about 7 days up to one year, but 30-60 day paper is more common. (Chen & Khan, 2003) When the paper matures it can be refinanced by the company issuing new paper to replace it.
Similar to Treasury bills, commercial paper is sold at a discount in the markets and the rate of interest is implied in the discount offered. Corporations with short-term funds to invest can buy commercial paper and perhaps obtain a slightly better return than that available from a short-term bank deposit. Commercial paper is a form of securitisation as the funds are raised on the back of a short-term security issued direct by a company, rather than by a financial institution. See also eurocommercial paper (ECP) which we referred to earlier. (Jeanneau, 2002)
Financial innovation
In recent years financial innovation and financial engineering have produced a rapid proliferation in the range of new financial instruments available in the financial markets. One reason for this has been an attempt to refine the nature of existing financial instruments so that they more closely meet the mutual needs of borrowers, lenders and intermediaries in the rapidly changing environment of the international marketplace. Another has been the creation of new financial instruments (e.g. derivatives) in an effort to circumvent some countries’ market regulations.
In recent years financial innovation and financial engineering have produced a rapid proliferation in the range of new financial instruments available in the financial markets. One reason for this has been an attempt to refine the nature of existing financial instruments so that they more closely meet the mutual needs of borrowers, lenders and intermediaries in the rapidly changing environment of the international marketplace. Another has been the creation of new financial instruments (e.g. derivatives) in an effort to circumvent some countries’ market regulations.
Derivatives
Derivatives are financial instruments whose value is derived from underlying or primary assets such as shares, bonds, commodities (e.g. coca and copper) and property. (BIS, 2002) When the value of the underlying or primary asset changes, so too does the value of the derivative. Thus the performance of a derivative is tied to the performance of the primary asset. Derivatives can be used as either hedging (risk protection) or speculative investment instruments.
Derivatives are financial instruments whose value is derived from underlying or primary assets such as shares, bonds, commodities (e.g. coca and copper) and property. (BIS, 2002) When the value of the underlying or primary asset changes, so too does the value of the derivative. Thus the performance of a derivative is tied to the performance of the primary asset. Derivatives can be used as either hedging (risk protection) or speculative investment instruments.
Broadly speaking, there are two main forms of derivatives, futures and options, although a multiplicity of instruments has developed around these. There are, for example, various combinations of forward and options contracts, various types of debt instruments with flexible characteristics in terms of interest rates, currency denominations and maturities and other types of interest rate and currency swaps—to mention but a few! The main derivatives can be defined as follows:
Futures
Essentially a future is a contract between two parties (a buyer and a seller) to exchange a specified asset (e.g. a commodity, a financial instrument or currency) on an agreed date in the future for a price which is agreed now. They are actually formal contracts between two trading parties. These contracts can then be traded in recognized futures exchanges such as LIFFE and IFOX (which form a futures market. (Chen & Khan, 2003)
Essentially a future is a contract between two parties (a buyer and a seller) to exchange a specified asset (e.g. a commodity, a financial instrument or currency) on an agreed date in the future for a price which is agreed now. They are actually formal contracts between two trading parties. These contracts can then be traded in recognized futures exchanges such as LIFFE and IFOX (which form a futures market. (Chen & Khan, 2003)
Options
An options contract gives the holder the right, but not the obligation, to buy or sell a specified asset at an agreed price on or before a specified expiration date. With an options contract the buyer or holder has a choice, he/she can exercise or not exercise the options as desired. An option to buy is termed a call option and an option to sell is termed a put option. Futures and options are traded through organized exchanges such as LIFFE (The London International Financial Futures and Options Exchange) in the UK, IFOX (The Irish Futures and Options Exchange) in Ireland and the Chicago Board Options Exchange (CBOE) in the US. (BIS, 2002)
An options contract gives the holder the right, but not the obligation, to buy or sell a specified asset at an agreed price on or before a specified expiration date. With an options contract the buyer or holder has a choice, he/she can exercise or not exercise the options as desired. An option to buy is termed a call option and an option to sell is termed a put option. Futures and options are traded through organized exchanges such as LIFFE (The London International Financial Futures and Options Exchange) in the UK, IFOX (The Irish Futures and Options Exchange) in Ireland and the Chicago Board Options Exchange (CBOE) in the US. (BIS, 2002)
Derivative markets move very rapidly and trading in derivatives can be very costly or in some cases even fatal for a company or institution; they carry very heavy risks. Many of the implications of using the more complex derivatives are not yet fully understood and they are also very difficult to monitor. In the past some corporate treasury departments have experienced heavy losses through the use of derivatives. In 1993/94 Germany’s Metallgesellschaft (a large manufacturing MNC) had to be rescued by its banks when one of its subsidiaries ran up losses of around $1 billion in using oil derivatives. (Jeanneau, 2002)
But the most famous case associated with the trading in derivatives was the collapse of Barings Bank—the City of London’s oldest merchant bank—and the speed with which it happened, over a period of a few days in February 1995. One of the greatest difficulties in the Barings Bank case proved to be in trying to quantify the actual amount of the losses—estimated at more than $900m (£566m)—from derivative trades. At one point, just days before it collapsed, Barings had an estimated $27bn (£17.7bn) of futures positions on the Nikkei 225 index (in Tokyo), and was exposed to further losses of $280m for each 4 per cent drop in the index. (Perrault, 2002)
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Derivatives can therefore be very complex and high-risk instruments. As derivative markets tend to move very rapidly large losses/gains can accumulate in a very short space of time as was dramatically demonstrated in the Barings Bank case. In the early to mid-1990s derivatives undoubtedly had a ‘bad press’ but despite the more dramatic instances of losses and failures associated with them, they are nonetheless very useful instruments for risk protection—if used prudently. (Chen & Khan, 2003) One of the key problems of derivatives concerns actually assessing their affect on a company’s financial status—they are analogous to a financial ‘black hole’ in a balance sheet. Finance Reporting Standard (FRS) 13 ‘Derivatives and Other Financial Disclosures’, issued by the Accounting Standards Board (ASB), prescribes the reporting and disclosure requirements in relation to derivatives. (BIS, 2002)
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