Fundamentals of Financial Instruments. Sunil K. Parameswaran

instruments can be secured or unsecured. In the case of secured debt, the terms of the contract will specify the assets of the firm that have been pledged as security or collateral. In the event of the failure of the company, the security holders have a right over these assets. In the case of unsecured debt securities, the investors can only hope that the issuer will have the earnings and liquidity to redeem the promise made at the outset. In the United States, secured corporate debt securities are known as bonds, while unsecured debt securities issued by corporations are termed as debentures. In certain countries the terms bonds and debentures are used for both categories of debt securities. Also, the world over, government debt securities are known as bonds.

      Debt instruments can be either negotiable or nonnegotiable. Negotiable securities are instruments which can be endorsed from one party to another, and hence can be bought and sold easily in the financial markets. A nonnegotiable instrument is one which cannot be transferred. Equity shares are obviously negotiable securities. While many debt securities are negotiable, certain loan-related transactions, such as loans made by commercial banks to business firms and savings bank accounts of individuals, are examples of assets that are not negotiable.

Debt securities are referred to by a variety of names such as bills, notes, bonds, debentures, etc. US Treasury securities are fully backed by the federal government, and consequently have no credit risk associated with them. The term credit risk refers to the risk that the issuer may default or fail to honor their commitment. Thus, the interest rate on Treasury securities is used as a benchmark for setting the rates of return on other, more risky securities. The US Treasury issues three categories of marketable debt instruments – T-bills, T-notes, and T-bonds. T-bills are discount securities also known as zero-coupon securities. That is, they are sold at a discount from their face value, and do not pay any interest. They have a maturity at the time of issue that is less than or equal to one year. T-notes and T-bonds are sold at face value and pay interest periodically. A T-note is akin to a T-bond but has a time to maturity between 1 and 10 years at the time of issue, whereas T-bonds have a life of more than 10 years.

PREFERRED SHARES

      Preferred stocks are a hybrid of debt and equity. They are similar to debt in the sense that holders of such securities are usually promised a fixed rate of return. However, such dividends are payable from the post-tax profits of the firm, as in the case of equity shares. On the other hand, interest payments to bondholders are made from pre-tax profits, and therefore constitute a deductible expense for tax purposes.

      If a company were to refrain from paying the preferred dividends in a particular year, then the shareholders, unlike the bondholders, cannot take legal recourse as a matter of right. In practice, most preferred shares are cumulative in nature. This implies that any unpaid dividends in a financial year must be carried forward, and the accumulated dividends must first be paid before the company can contemplate the payment of dividends to equity shareholders.

      Preferred shareholders have restricted voting rights. That is, they usually do not enjoy the right to vote unless the payment of dividends due to them is in arrears. In the event of liquidation of the firm, the preferred shareholders will have to be paid off before the claims of the equity holders can be entertained. Thus, the order of priority of the stakeholders of the firm from the standpoint of payments is bondholders first, followed by preferred shareholders, and then equity shareholders. Within the category of bondholders, secured debt holders get priority over unsecured debt holders. The term preferred arises because such shareholders are given preference over equity shareholders, and not because the shareholders prefer such instruments.

FOREIGN EXCHANGE

      The term foreign exchange refers to transactions pertaining to the currency of a foreign nation. Thus, foreign exchange markets are markets where foreign currencies are bought and sold. The conversion of one currency into another is termed as exchange. A foreign currency is also a type of financial asset, and consequently it will have a price in terms of another currency. The price of one country's currency in terms of that of another is referred to as the exchange rate. Foreign currencies are traded among a network of buyers and sellers, composed mainly of commercial banks and large multinational corporations, and not on an organized exchange. Thus, the market for foreign exchange is referred to as an over-the-counter or OTC market. Physical currency is rarely paid out or received. What happens in practice is that currency is transferred electronically from one bank account to another.

DERIVATIVES

Derivative securities, more appropriately termed as derivative contracts, are assets which confer upon their owners certain rights or obligations, as the case may be. These contracts owe their availability to the existence of markets for an underlying asset or a portfolio of assets, on which such agreements are written. In other words, these assets are derived from the underlying asset. If we perceive the underlying asset as the primary asset, then such contracts may be termed as derivatives, as they are derived from such assets.

      The three major categories of derivative securities are:

       Forward and futures contracts

       Options contracts

       Swaps

FORWARD AND FUTURES CONTRACTS

      A typical transaction, where the exchange of cash for the asset being procured takes place immediately, is referred to as a cash or a spot transaction. As soon as the deal is struck, the buyer hands over the payment for the asset to the seller, who in turn transfers the rights to the asset to the buyer at the same time. In the case of a forward or a futures contract, however, the actual transaction does not take place at the moment an agreement is reached between the two parties. What happens in such cases is that at the time of negotiating the deal, the two parties merely agree on the terms on which they will transact at a future point in time. The actual transaction per se occurs only at a future date that is decided at the outset, and at a price that also is decided at the beginning. Thus, no money changes hands when two parties enter into such contracts; however, both the parties to the contract have an obligation to go ahead with the transaction on the predetermined date, as per the agreed terms. Failure to do so will be tantamount to default.

      EXAMPLE 1.1

      WIPRO Technologies, an Indian company, has imported products from Frankfurt, and has entered into a forward contract with HSBC to acquire EUR 500,000 after 60 days at an exchange rate of INR 72.50 per euro. This is clearly a forward contract, for while the terms and conditions, including the exchange rate, are fixed at the outset, the currency itself will be procured only 60 days after the date of the agreement. Sixty days hence, WIPRO will be required to pay INR 36,250,000 to the bank and accept the euros. The bank as per the contract is obliged to accept the Indian currency and deliver the euros.

Forward contracts and futures contracts are similar in the sense that both oblige the buyer to acquire the underlying asset on a future date, and the seller to deliver the asset on that date. And in the case of either kind of security, both the buyer and the seller have an obligation to perform at the time of expiration of the contract. There is one major difference between the two types of contracts, however. Futures contracts are standardized, whereas forward contracts are customized. The terms standardization and customization may be understood as follows. In any contract of this nature, certain terms and conditions need to be clearly defined. The major terms which should be made explicit are the following:

      1 The number of units of the underlying asset that have to be delivered per contract.

      2 The acceptable grade or grades that may be delivered by the seller.

      3 The place or places where the seller is permitted to deliver.

      4 The date or in certain cases the time interval, during which the seller has to deliver.

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