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Intro to Financial Contracts

8/8/2010 7:24:00 AM

1. What are some examples of financial contracts? Security is a name of a financial contract (FC) that trades in a financial market. EX. Shares of Common Stock FC= Financial Asset b/c purchaser gives up money to buy it but in return gets an asset that has value Base Claims (primary claims): Stocks, Bonds, Loans, and Leases: claims where two parties are agreeing to exchange cash flows over time and those cash flows will depend directly on the financial successes of the party that sold the contract Derivatives or Contingent Claims: Option Contracts, Futures Contracts, and more: the price and payoffs of these contracts are tightly linked to the price of their underlying or base asses or contract. Stock option payout is contingent on the prices of stock shares at the future time when the option expires The options and shares of stocks are two different contracts: the stock is a base asset and the option is a derivative asset Repackage Claims some company purchases and holds a pool of financial assets and collects income from them. Then they sell new cash streams which are backed up by the existence of the back up pool and the stream of regular income the pool generates EX: Mutual Funds Investments or Investment Management is an area of finance that deals w/ the use of financial contracts to grow wealth as fast as possible while also being sure to manage the level of risk that is experienced by and investor Corporate Finance sub-field of finance that focuses on the role of a corps. Chief Financial Officer (CFO). Investment and Corporate professionals combine some of the tools and wisdom gained from the study of financial records w/ some of the economic ideas so that corps. can best grow and prosper 2. In Simples Terms, What Basically Is a FC? Most FCs involve the exchange of money or cash flow across time Cash exchange in present (Time-Zero) and then future

The person receiving money in the future typically has to buy the contract. So they give up money in the present to receive money in the future. Common Contracts (these are: S-T, Money Market Securities, Debt Securities): T-Bill you initially give up money and the gov promises to deliver a single cash flow at some set date w/in a years time. Flow of future cash is called the bills Face Value or Par Value Commercial Paper a security or contract that is like a T-Bill except instead of gov selling it and paying back its Face Value, it is typically a business corporation Certificate of Deposits or CDs Some involve just one flow of cash, at maturity, but the contract is sold by a commercial bank. Money Market Securities if contract lasts for less than one year. Debt Securities future flow is promised and legally binding Long Term Debt Contracts: Corporate Bonds: When a company issues some bond, it is usually promising to pay a Face or Par value in the future PLUS and annual or semi-annual stream of smaller payments. (coupon payments) Treasury and Government Bonds Same as corporate bonds but issued by the government instead. Bonds w/ initial maturities of b/t 1-5 yrs are called Notes Loans A way for a person or company to borrow money. Typically originated by commercial banks. o No face or par value just a set of even regular flows o Regular flows occur more frequently than w/ bonds usually monthly Leases A lot like loans and person borrowing has to repay in steady

stream but instead of getting cash at time-zero. The lessee (borrower) gains the use of some physical asset for a period of time. Ownership of Equity Contracts Common Stock grant a person a share in a business activity. Stockholders have right to vote on certain corporate matters if they hold a large portion of stocks. They are another FC w/ a possible future stream of cash flow granted to the holder

o Are NOT debt and no legally binding cash flow, firms may or may not make dividend payments. Amt is decided by firms management and approved by its board of directors. It is possible that a dividend may not be issued Firms that do not currently issue dividends are typically expected to in the future Stocks and bonds thus both create future cash flow for their holders, but cash flow streams for stocks will be much less defined Socks are viewed as having more risk than bonds A Confusing Contract Preferred Stock like common stocks- issues shares and pays out dividends. Like debt contracts- grants no ownership of firm or voting rightsalso like debt the dividends are exactly specified to be a given amt and are legally-binding. . Finance theory tends to think of preferred stock as a form of debt. Like a bond- pays a constant coupon forever but no large face payment. o Preferred applies to the situation: if a firm goes into the bankruptcy courts, then preferred shareholders have priority and stronger rights than do the common share holders.

3. What is some FC worth? What should you pay for some future stream of risky cash flow? Valuation the process of finding a price or value in todays (time-zero) dollars for some security, contract or informal investment opportunity that spins of a stream or timeline of risky future cash flow. Valuation is one of the most intricate and subtle areas of finance. Valuation is about assessing all the future possibilities for a given opportunity and then collapsing that opportunities future back into one single number.. a present value or price. If good data is available, then its always best to make your own estimates of future cash flow and conduct a DCF analysis A different approach is to just let speculators come together in markets and let them fight back and forth until a consensus price or value is reached through market trading

Comparables or Comps Approach relies on using the market price data of one contract to estimate the value of another contract that does not trade in any market. Has no economic theory, just takes one observable price and scales it to a smaller or larger amt. Economic theory of valuing a FV or opportunity involves assessing its future cash flows and risk and then processing this data in a disciplined way to collapse the future back into a current price or value. The main technique for doing this is called DCF (Discounted Cash Flow) Though it is theoretically sound, limitations on data and estimation techniques may render it unreliable and other second-choice valuation methods must then be used instead DCF is a fundamental building block for all work in finance and is the theoretical glue that helps you understand the field as a whole lattice of ideas.

4. How does the existence of a sophisticated system of financial contracts help society? Business helps society by being a quick and efficient way of turning raw materials, labor, energy and ideas into final products and services that basically improve peoples lives FCs and markets basically catalyze the workings of businessallows for more ideas to be persued, more risk to be taken, for things to work faster and more efficiently. Existance of FCs and markets has a major impact on a countrys economic activity and its gross domestic product, GDP Core aspects about FCs that allow a business to work more efficiently Allow for a lot of choice and help business people design strategy o Business involves sizing up the unknown and building strategies to move forward o FCs allow to plan and prepare for what the future might throw at the company Provide a legal outline and clarity. Allow people w/ opposite, but complimentary, needs to come together and combine resources.


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Financial Contract claims sometime referred to as a financial asset in that the purchaser of the contract surrenders cash to buy it, but in return, they acquire an asset that has value People and companies used FCs to improve their economic status o To be able to buy more tomorrow (or feel more secure or happy tomorrow) than they do today Financial Security FC that trades in a financial market such as stocks, bonds, loans and leases Considered to be primary or base claims, where two parties are agreeing to exchange cash flows over time and those cash flows will depend directly on the financial successes of the party that sold the contract. EX common stock Money Market Securities- S-T debt contracts (<1 year) all are aka debt securities which means the future flow is legally binding. Also sometimes called zero coupon debt bc no coupon flows just one large lump sum. It is the primary way people invest when they want to face lower risk levels that come with stocks, although they face lower returns T-Bill o Description: The US Government promises to deliver a single cash flow at some set date w/in a years time. o Considered to be risk free bc the buyer is guaranteed a future CF of the face value, no more, no less Commercial Paper o Description: security or contract very similar to T-Bill except the party selling the Paper and paying its face value is typically a business corporation Certificate of Deposit (CDs) o Description: some involve just one flow of cash at contracts maturity, but for CDs the contract is sold by a commercial bank Debt Contracts L-T contracts (>1 year) Bills Notes

o Description: Treasury and Gov Bonds that have initial maturities of b/t 1&5 years Bonds o Corporate Bonds Description: when a company issues some bonds, it is usually promising to pay a Face Value in the future plus an annual stream or semi-annual stream of smaller payments o Treasury and Government Bonds Description: same as corporate bonds but issued by a gov institution. Loans o Description: Another way for a person or company to borrow money- usually originating by commercial banks Only a set of even regular flows, NO Face Value Flow Flows usually occur more often than bonds, usually monthly Typically private transactions between one firm and a bank. Whereas, bonds are usually sold in markets to a o Why large # of investors at the same time. use Loans? Borrower maintains a lot of freedom on how to use the money Invest in a business idea or spend it on a house or vacation Capital Investment investing the borrowed money, borrower is using the loan as a source of capital Using loan to allowcate some of their future salary toward the enjoyment of something today Business Investment lender is looking for a lower-risk place to grow their current cash A business person may look to Bus Invstmts such as making products or providing services Peples will look to financial invstmts to grow their wealth

Banks grow their own wealth indirectly by providing these loans For loans the bank lending the money faces both default and price risk

Leases o Description: a lot like loans b/c borrower has to repay steady stream of payments, but instead of getting money at timezero the borrower gains use of an asset for a period of time. o Annuity Due o Why buy? Might use a lease instead of buying because it may be cheaper and more convenient Most lenders can make money by providing services w/ the lease that are helpful to the firm Preferred Stock o Description: looks like stock or equity but is more like debt Like a bond that pays a constant coupon payment forever but never makes a large face pmt. Do not have a ending or maturity date. o Like CStock b/c it is issued in shares and pays dividend o Like Debt: Grants NO ownership of firm Grants NO voting rights Dividends paid are exactly specified to be a given amt and they are legally-binding o preferred only applies if a firm goes into the bankruptcy courts, then the preferred shareholders have priority and stronger rights than do the common shareholders

Equity Contracts Common Stock o Description Stock grants a person a share of ownership in the company Grants the right to vote on certain corporate matters. FC with possible future stream of cash flow is granted to the holder- this cash flow is never voted on by investors

its level is decided by management and approved by board of directors Cash Flows are not legally binding or promised. Stream is implied and firms are pressured to pay dividends in order to hold investors Stream can vary from dividend to dividend Stocks are viewed as having more risk than bonds Most investors only hold for a finite period of time but growth is seen to be perpetual. Every single investor expects a stocks price will on-

average rise in the future and that they will on-average earn capital gains as opposed to capital losses The stock market as a whole is always on-average, expected to rise for passibeve investors buying or holding any shares. Day-to-Day traders S-T who dont collect dividends expect to earn ALL of their return in the form of capital gains. o Why buy? Passive Investors Trying to grow money for future at a higher rate than they could achieve w/ bank CDs or corp bonds Dont know much abt mkts and firms, but know they can hold a diverse set of stocks LT, is a smart way form them to grow their wealth Active Investors They could be speculators who make a living off

buying and selling mispriced stocks. Trade frequently and try to outperform the passive investors by using skill, info and timing to beat the market Contingent Claims or Derivatives Price of payoffs of these contracts are tightly lined to the price of their underlying base asset or contract

The seller of the claim will pay the buyer of the claim X dollars if some specific, verifiable and measureable event happens in the future the buyers payout is contingent on a specific event o EX car insurance Like betting: can help economy: o Existence of these markets allows people and productive firms to use the contracts to reduce certain risks that they face and thus opens up more business opportunities to them o Time-series of prices that these mkts creats can be used buy buss and govs to lear abt the size and nature of certain economic risk that would otherwise be vague Options o Deal in which one party can buy some asset at a specified date in the future at a price that is established today Buyer will only exercise the option if deal is favorable o in a stock option the options and the shares of stock are two separate contracts: the stock is a base asset the option is a derivative asset

Futures o Deal in which one party must buy/sell some asset at a specified date in the future at a price that is established today Insurance Face Value or Par Value the flow of future cash Term Length of time until the FC reaches maturity Loan Amount Loans arent thought of as being sold but rather issued for some amt of cash given to the borrower Coupon Payments An annual or semi-annual stream of smaller payments in addition to a lump face value payment Called coupon payments for Bonds C=c*Face o C=CouponPayment o c=coupon rate that is listed in the bond contract

Dividend Payments What the payments are called for both common and preferred stock Loan and Lease Payments Periodic payments for loans and leases Dividend Growth Rate (g) Dividends for CS can vary and usually companies are pressured to increase dividends and make money for stockholders. g>0 we assume D2=D1*(1+g) Repackage Claims a company purchases and holds a pool of financial assets and collects income from them. They then sell new cash streams which are backed up by the existence of the asset pool and the stream of regular income the pool generates Mortgage-Backed Securities Mutual Funds o Purchases stock shares in dozens of companies and creates a fund or pool of assets that brings in a regular stream of cash flow. Shares of the fund are then sold to investors and the proceeds are used to purchase more shares to grow the fund even larger. Hedge Funds Market Price Vs. Intrinsic Value Market Price (P0~) o Price that the contract actuallay sells for. It is typically in constant flux Intrinsic Value (P0) o Someones personal estimate as to the true value of a contract If P0=$23 and P0~=$22.70: P0~<P0 then you must believe the shares are currently underpriced in the markets Implied Return (EndPrice-BegPrice)/BegPrice It is the borrowers cost of capital Yield to Maturity Same as implied return General Rule: investors will request more return when they see more risk in an investment

Risk the potential/probability that you wont get what you expect to onaverage occur in the future Default Risk o Risk that the issuing company runs into financial trouble and cant make good on its payments. Investory may get smaller payments than expected. They thought that on average they would have earned a positive return but actually do not. Price Risk o Risk that if the investor sells the bond before it reaches its maturity, the selling price (and earned return) will be unvertain. Valuation Process of finding a price or value in todays (time-zero) dollars for some security, contract, or informal investment opportunity that spins off a stream or timeline of risky future CF Comparables Approach vs. DCF Approach o Comparables Approach Relies on using the market price data of one contract to estimate the value of another contract that doesnt trade in any market Has no real economic theory- just copycat Approach Used when good data is available Based on economic theory Valuing a FC or opportunity involves assessing its future CF and risk and then processing this data in a disciplined way to collapses the future back into a current price or value Private Market Consists of an informal community of brokers who communicate and do business w/ each other Public Market Like NYSE IPO Initial Public Offering


Many small companies start out w/ private contracts and then go public at some point and make a first offering of public shares called IPOs Liquidity (cash) crisis Excess Volatility More swings in prices than there should be. o Want prices into a stock market to be almost-accurate o But not perfectly accurate, so that there are no incorrect prices and no profits to speculators o But also dont want errors in prices to be too big or the market would be to risky for passive investors Corporate Finance Focuses on the role of a corporations chief financial officer Combine some of the tools and wisdom gained from the study of FCs to come up w/ ideas of how the corp can best grow and prosper Use the resulting skill from the investment markets to manage the collective financial dealings of their firm Financial activities must be coordinated in a way that will best compliment the firms business, marketing, and operations strategies. Investment Management Deals w/ the use of FCs to grow wealth as fast as possible while also being sure to manage the level of risk that is experienced by and investor This needs to be a person who understands the fine details of the various FCs that exist, the markets they trade in, and the ways in which contracts can be combined to from superior wealth growing strategies They need to know what factors drive the price of a given contract Free Rate When no risk is present and investors are simply waiting one year for and exact amt of money to arrive Say rate is currently 3%, the risk free rate provides:



o It grows the investors money enough to remove the impact of inflation o It gives them additional return, beyond inflation coverage, as a reward for postponing the enjoyment of products and services they could be enjoying now For a 3% risk free rate, 1% could be covering for inflation while the other 2% acting as compensation Premium Additional reward in the form of additional return. The higher the risk the higher the risk premium will b

Cash Flow Uncertainty Suppose each set of cash flow is uncertain and you think it will end up being some where between FV(+/-)X% o X is some percentage of FV o The larger X is, the more uncertainty and investors will demand a higher risk premium and thus higher total return r. Time Value of Money TMV Money has a time-driven aspect to its value People wil not invest todays cash unless they expect to on-average receive more cash back at a future point o A dollar today is worth more today than a claim on a dollar in the future Investors assign TMV bc people wish to receive positive growth in their cash invstmts over time as form of compensation or reward for burdens they are choosing to bear o When investing they are postponing enjoyment of products or services they could use with the cash now TMV skills are used:

o In Accounting as part of statement prparation work o In finance to analyze contracts and plan out different strategies Present Value [PV] Represents a sum of cash at the sum of cash at the present moment (time-zero) Also, used to represent the todays-cash flow of some future flow Future Value [FV]

Represents a single flow of cash occurring at some point n in the future Also represents value that some current time-zero cash could grow to Future Cash Flow [CF] Represents several general future flows of cash that does not have to be the same level Nominal Value of a Cash Flow The number shown on the number line, the assumed value of the flow if you were standing right at that particular point EX if asked what a nominal plow of $150 at timept 2 is worth if we are standing at time point zero we would be wondering what that time-two flows present value would be as if you were standing on timepoint zero Rate of Return (r) Reward they expect to earn o if PV=1000 and r=10 and FV=PV(1+r) o then on-average you will expect to get 1000(1.10)=1100 back in cash next year determined by all the trading that goes on in competitive markets. r= rf + rp o rf = risk free return o r = risk premium/ extra return Rate of Return vs. Discount Rate vs. Implied Return [I] Three names depending on your time perspective Represents the (usually annual)% rate at which a cash flows time is either growing or shrinking through time Term [N] The specific timepoint in the distance or Represents the amt of periods that some flow is from present moment Payment [PMT] Represents the level of cash flow that occurs at regular periods over some time span Lump Sum

Situation when you have a single cash flow that must be evaluatedor moved to a different time period FV=PV(1+r)n o Implied Return Perspective Looking at some PV that they will have to pay out and a FV that they will later receive in at time n You are interested in what implied return (r) you expect on-average to earn [PV] [FV] [N].[I] o Push-it-Forward Perspective You are considering the growth of some current investment and are wondering how much cash youll have in the future if your money grows at some rate of return (r) Interested in the amount of money (on average) you will have at n [PV] [I] [N].[FV] o Bring-it-Back Perspective Valuation- moving back to PV r=discount rate looking at some future cash flow FV, projected to exist in the future and r the discount rate is used to shrink it down to a smaller PV, so that the lender/investor may earn the FV. Want to know what to invest now to earn the FV [FV] [I] [N][PV]

Uneven Stream Set of multiple cash flows with no particular pattern to them

Must use [CF] and find [NPV] To find implied annual return using [CF] you need to use [IRR] Annuity aka Ordinary Annuities Regular series of the same cash flow Loansetc any regular even stream of cash flows [PMT] is used for flows PV=(PMT/r)*(1-(1/(1+r)n)) [I] [PMT] [N][PV]

Annuity Due Similar to Ordinary Annuity but the cash flows start at timepoint zero Leases Use beg/end key Annuity + Lump Sum (Corporate Bond) Mkt value= 976.43; 5 years remaining; coupon pmt $40; FV 1000 o 1000 [FV] 40 [PMT] 5 [N] -976.43 [PV] [I]=4.54% We have to assume time has already passed and the original bonds price has gone down from 1000 to 976.43 Deferred Annuity Annuity whose starting date is delayed or deferred so istead of cash flows starting at timepoint 1 they start at a later point Step 1: think of yourself being at the delayed startpt and that is timepoint zero and collapse that into PV Step 2: take your self back to the original time zero and think of the PV you found as your new FV with PMTs of 0 Perpetuity An ordinary annuity that is assumed to make regular pmts forever Preferred Stock PV=PMT/r Use 1000 for [N] Growing Perpetuity Also goes on forever but instead of level flows, the nominal flow level grows at a constant rate g into the future EX. Common Stock PMT3 = PMT2 (1+g)2 PV=PMT1/(r-g). And. PV3=PMT4/(r-g) Use 1000 for [N]

Utility The satisfaction that you derive from some transaction EX: buying a car or taking out a lone.

Value is the PV of any cash flows gained above and beyond what is the norm for a competitive deal. NPV (Net Present Value or Net Value Created) NPV variable, measures the amount of value created or destroyed by a deal or an opportunity If the deal/opportunity created value for a person, the NPV will be (+), it created $---- of your wealth If the deal/opportunity destroyed value for a person, the NPV will be (-), it destroyed $---- of your wealth If the deal/opportunity had a NPV of $0, it is still reasonable deal/opportunity and is still a reasonable way for you to grow your wealth o Just means that you have found a competitive deal that will grand you a competitive return for the risk you take, but not any extra bonus value. Wealth Transfer A consumer paying more or less than what an asset is actually worth EX Consumer B pays 14,000 for a used car from Consumer A that is worth 12,000 o Consumer A got 2,000 of the wealth of Consumer B by making a market deal o They each gain utility, but they could have done much better Creating Value Gaining wealth from participating in a market deal (Consumer A) Destroying Value Losing wealth from participating in a market deal (Consumer B) Implied Return (outsiders look at the loan) the return that one can earn by giving up some amt of cash today in return for a set of future cash flows. It is looking at a contract after it is already created Interest Rate (i) used when the lender is first building the loan contract, they strategically chooses the loans interest rate and then use that number to figure out what the payments should be for the loan. Competitive Rate (r) The rate that is available to borrowers (or a risk level) if they are careful and search the markets for a competitive deal.

b/c financial contracts create streams of future cash flows, there is almost always some level of risk. On any given day, the financial markets will (in an informal way) assign different competitive returns to different levels of risk. A lender does not always have to set a loans interest rate to a competitive level. EX: lender used and interest rate of 7.2%, to form a 60 month loan when competitive rates at the time were actually 5.5% o By using the 7.2% rate, the lender is making the loans payments higher than would be the case in a fair loan

contract By using an excessively high interest rate (i>r), the lender is capturing some value or wealth from the borrower. Mixed Transaction occurs when someone buys a product from a seller and transacts a loan w/ that same seller to fund or finance the purchase EX: people will purchase and finance a car at the same time w/ some care dealer EX: buy a TV and use the stores financing plan to fund it o The dealer is actually providing you with a good (asset) and also a service o The service is the financing they are providing you they are lending you money so that you dont have to pay today. Loan Balance (Balx) is the amt that the borrower must pay at time x to end the loan early It is prewired into the loan agreement and depends on the chosen interest rate (i) for the loan. Amortized Debt means that the borrower pays periodic interest plus some extra cash that goes to reduce the loans outstanding balance The Interest portion (Intx) keeps going down over time The Balance-reduction portion (BalRedx) goes up over time The final payment brings the balance to $0 and ends the loan If the borrower wanted to end the loan early right after making payment 2, then they would owe the lender a lump sum of the Balx in the payment 2 row, the borrower does not owe any future interest portions b/c they wont be borrowing the money anymore.

Down Payment paying cash for a percentage of the total cost and then financing the remaining percentage Refinance a Loan Obtaining a new loan, of which you use its proceeds to buy out of an old loan Used when you are destroying you own value through an old loan, it stops loses and value destruction. Under Water or Upside-Down on a mortgage loan means that you find yourself in a situation in which you owe more on the laosn than your house is worth (Balx>CPx) Loan balance is higher than competitive price of your home at osme time x in the future. Teaser/Sub-Prime Loans at first were called Sub-prime loans bc they were marketed to people with below prime credit scores. They were riskier borrowers Hindsight are now called teaser loans bc they make it easy to get started in a home for many first-time home buyers. Had very low or even no down-payments when a 20% down payment used to be they industry standard Had a standard interest rate and had a introductory period of two or three years where a much lower introductory rate seemed to be leading to lower interest and thus lower monthly payments Combination of no down-payment and say introductory payments that were say 1/3 lower than a standard loan, made homeownership a real possibility for a segment of society that previously would not be able to own a home. Balances were growing and not falling for these loans in the first two years , housing prices had to grow or else the loans would be in the danger zone.

System-Related Default defaults that could occur even if homeowners still maintained their same quality of employment. Negative Amortization The balance on your loan goes up instead of down as time pass

8/8/2010 7:24:00 AM

8/8/2010 7:24:00 AM