Lesson Corporate Finance: Financial Contracts

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About Shruti_Mishra: I am a maths graduate from India and am currently persuing masters in Operations Research.

Contracts, securities, assets � they are all the same in finance! They refer to a piece of paper that promises to pay a certain <A HREF="cash_flow.wikipedia">cash flow</A> according to a formula.

The main purpose of a <A HREF="financial_contracts.wikipedia">financial contract</A> 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 <A HREF="financial_markets.wikipedia">financial markets</A>. Let us take a look at some of the standard contracts.

<A HREF="stocks.wikipedia">Stocks</A>
 
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 <A HREF="trade.wikipedia">trade</A> 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:
<center>
{{{P = sum(E(D[t])/(1+r)^t,t=0,T)}}}
</center>

where E(Dt) is the <A HREF="dividends.wikipedia">dividend</A> you expect to receive at time t and r is the <A HREF="discount_rate.wikipedia">discounting rate</A>. This thus gives the <A HREF="lesson_PV.lesson">PV</A> of the future expected cash flow.

<A HREF="bond_(finance).wikipedia">Bonds</A>

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 <A HREF="coupon.wikipedia">coupon</A> payment and the face value of $1000 back. This is only if all goes well. If XYZ goes <A HREF="bankrupt.wikipedia">bankrupt</A> 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
<center>
{{{P = sum(C/(1+z)^n,n=1,N)}}} + {{{F/(1+z)^N}}}
</center>
where C is the coupon, F is the face value of the bond, Z is the <A HREF="bond_yield.wikipedia">bond yield</A> 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:
- <A HREF="government_bonds.wikipedia">Government bonds</A> are issued by the <A HREF="treasury.wikipedia">treasury</A> of a government (also known as T-bill or a T-bond in most places or G-sec in India).
- <A HREF="corporate_bonds.wikipedia">Corporate bonds</A> are issued by companies.

<A HREF="derivatives_(finance).wikipedia">Derivatives</A>
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 <A HREF="interest_rates.lesson">interest rates</A>, <A HREF="inflation.wikipedia">inflation</A> 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.