1. Chapter 12 Types of financial instrument
Corporate Financial Strategy 4th edition
Dr Ruth Bender
Chapter 12 Types 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 Payoffs to sellers
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
Financial Instruments and Raising Equity
Dr Ruth Bender
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
Originating company
Servicing fees
Subscription
proceeds
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
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
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

14. Positioning the convertible

15. Convertibles are used to delay equity or sweeten debt
Why use a convertible
Can’t use
debt
Cash restrictions
– can’t afford interest
– can’t afford repayments
Profit restrictions
Covenant restrictions from existing lenders
Can’t use equity
Dilutes eps
Loss of control by block-holder
Convertibles are used to delay equity or sweeten debt

16. Features of convertibles
Gearing effect
Attracts investors
Tax advantages
Self-liquidating
Cheaper yield
Less eps dilution
If under-priced, dilutes eps more than necessary
If over-priced, have to repay at inopportune time
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