Chapter 12 Types of financial instrument

1. Corporate Financial Strategy4th edition Dr Ruth Bender Chapter 12Types of financial instrument

2. Types of financial instrument: contents • Learning objectives • Options terminology • Factors affecting the value of an option • Black–Scholes options valuation model • Payoffs on options • Public (market) debt and private (bank) debt • Continuum of financial instruments • Credit ratings (long-term debt) • Securitization cash flows • Mezzanine and convertibles give return in two ways • Mezzanine and convertibles, from lender’s point of view • Positioning the convertible • Why use a convertible? • Features of convertibles

3. Learning objectives • Distinguish different types of financial instrument, assess the broad categories into which they fall, and contrast their fundamental characteristics. • Discuss the continuum of financial instruments, and explain why the terms of a particular instrument will affect its position on the continuum. • Describe how credit rating agencies work. • Understand in broad terms the accounting treatment of financial instruments.

4. Options terminology • A call option is the right to buy • A put option is the right to sell • A European option can be exercised at a particular date • An American option can be exercised during a period • If price of underlying asset > exercise price the option is in-the-money • If price of underlying asset = exercise price the option is at-the-money • If price of underlying asset < exercise price the option is out of-the-money (underwater)

5. Factors affecting the value of an option CALL PUT Price of underlying asset Exercise price of option Time to exercise ?? Volatility of price of underlying asset Risk-free rate ?? Option value increases with time to expiry, but today’s value of the sum received decreases with time, so the net end result is uncertain. (In principle, same should apply to the direction of value for volatility, but it doesn’t.)

6. Black–Scholes options valuation model C = price of call option P = current price of the shares E = exercise price t = time remaining until expiry of option r = risk-free rate N(d1) = hedge ratio N(d2) = probability of exercise Measures of volatility

7. Payoffs on options Payoffs to buyers PUT AND BUY THE SHARE Value to option owner CALL PUT Value of share at expiry Value of share at expiry Value of share at expiry Payoffs to sellers CALL PUT Value of share at expiry Value of share at expiry

8. Public (market) debt and private (bank) debt Public debt • Issued using a prospectus • Probably underwritten • Can be cheaper, with fewer covenants • Not suitable for small amounts of finance • Face value is generally denominated in units of 100 or 1,000 of currency. But it may not be issued at 1,000 and probably won’t trade at that amount. Trading price is shown as a % of the face value. Interest will be based on this face value. • Difficult to resolve if the company faces problems Private debt • Advanced by a bank • May be syndicated to a group of banks • Flexible and quick • E.g. Term loans, overdrafts, revolvers (a revolving line of credit is a credit commitment of up to an agreed amount for a specified time, to be drawn and repaid as needed)

9. Continuum of financial instruments Ordinary shares Required return Preference shares Convertibles Mezzanine High yield debt Unsecured debt Secured debt Perceived risk

10. Credit ratings (long-term debt) AAA AA+ AA AA– A+ A A– BBB+ BBB BBB– BB+ BB BB– B+ … D Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 … C Based on opinion of overall financial capacity to pay. Uses qualitative and quantitative analysis. Information supplied by the company, or from other sources. May relate to a company, or to a particular debt obligation. Short-term debt is also rated, using a different system. There are other ratings agencies Investment grade junk

11. Securitization cash flows Credit enhancement Subscription proceeds Servicing fees Originating company Investors Issuer (Special Purpose Vehicle) Proceeds of asset sale Principal & interest Payment of principal & interest Asset pool (principal and interest from borrowers)

12. Mezzanine and convertibles give return in two ways Required return Return from capital gain Return from yield Perceived risk

13. Mezzanine and convertibles, from lender’s point of view MEZZANINE CONVERTIBLES Initial investment in Year 0 Interest received in years 1 to n In Year n, one of two things will happen Either The loan is repaid Or Loan is converted into shares • Initial investment in Year 0 • Interest received in years 1 to n • In Year n, two things happen • The loan is repaid And • Warrant is exercised to receive shares

14. Positioning the convertible

15. Why use a convertible Convertibles are used to delay equity or sweeten debt

16. Features of convertibles • If under-priced, dilutes eps more than necessary • If over-priced, have to repay at inopportune time • Gearing effect • Attracts investors • Tax advantages • Self-liquidating • Cheaper yield • Less eps dilution For issuer • Higher yield than equity • Upside of capital gain • Can decide if/when to convert • Possibility of non-repayment • If share price doesn’t rise – lost out by allowing cheap debt For holder Advantages Disadvantages