Contracts, securities, assets – they are all the same in finance! They refer to a piece of paper that promises to pay a certain cash flow
according to a formula.
The main purpose of a financial contract
is to solve a cash flow problem. By solving we mean re-engineering the given (but disliked) cash flow into something that is more suitable. Therefore, intuitively a financial contract must represent a cash flow itself, which when added to an existing cash flow transforms it into something suitable.
Every financial contract must have the following features:
- The parties to it (or to be more technical, the counterparties)
- The timing of the cash flows
- The formula for the cash flows (i.e. any contingencies that would determine the amount of payout)
- Who pays when, what and how much (including fees)
- Legal declarations
Every contract could be interpreted and described this way. And this is the way every contract is written in the financial markets
. Let us take a look at some of the standard contracts.
Some notational clarification: A company’s stock means its collection of shares as a single asset class. A share is a single financial contract. If a company has 1000 shares outstanding, you buy 10 shares or 1% of the stock. A share is a contract that gives the owner a share in the residual profits of the firm. By residual we mean what is left after all creditors have been paid off. Since we don’t know before hand how much is going to be left before hand, the cash flow of a share is a random variable. Also, we don’t if the firm will make residual profits every year. So the timing is also random. Another key defining characteristic is that a share does not have a finite life. It does not mature. It will remain valid as long as the company exists.
In a stock market at any point in time there are people willing to buy certain shares and there are people willing to sell certain shares. A trade
happens if the prices quoted by both parties agree and we say the market clears.
Pricing of stock: The following formula is a popular way to price stocks:
where E(Dt) is the dividend
you expect to receive at time t and r is the discounting rate
. This thus gives the PV
of the future expected cash flow.
A bond is a much simpler contract than a share. A bond has fixed life – anywhere from 1 month to 30 years and promises to pay a fixed amount(coupon is the finance jargon) according to a specified periodicity.
Example: XYZ Bond.
Issuer: XYZ Ltd.
Face Value: $1000
Issue Date: 31 July 2007
Coupon: 8% Semiannual
Maturity Date: 31 July 2009
The cash flow from the contract are 8% of $1000 per bond every six months from 31 July 07 until 31 July 09. On 31 July 09 XYZ would pay back the last leg of the coupon
payment and the face value of $1000 back. This is only if all goes well. If XYZ goes bankrupt
i.e. it does not have enough money to meet creditor obligations, then the bond holder may not be able to receive the stated payments. He may be able to recover only a part of what the company owes to him.
Pricing of a bond: Pricing is done in following way
where C is the coupon, F is the face value of the bond, Z is the bond yield
per period, and N is the number of coupons.
There are many kinds of bonds. One way to classify is based on who issues the contract. So there are:
- Government bonds
are issued by the treasury
of a government (also known as T-bill or a T-bond in most places or G-sec in India).
- Corporate bonds
are issued by companies.
We saw that every financial contract contains a formula for its cash flows. If the formula of a financial contract explicitly involves prices of other financial contracts or economic variables such as interest rates
or just about anything like temperature, rain fall, etc then the financial contract is called a derivative.
Some examples of derivatives are Forwards, Call Option, Put Option, Barrier Option, Swaps and Forwards etc.
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