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Chapter 11 Financial instruments: the building blocks

Corporate Financial Strategy 4th edition Dr Ruth Bender. Chapter 11 Financial instruments: the building blocks. Financial instruments: contents. Learning objectives Risk and return The risk-averse investor The speculative investor The building blocks of financial instruments

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Chapter 11 Financial instruments: the building blocks

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  1. Corporate Financial Strategy4th edition Dr Ruth Bender Chapter 11Financial instruments: the building blocks

  2. Financial instruments: contents • Learning objectives • Risk and return • The risk-averse investor • The speculative investor • The building blocks of financial instruments • Characteristics of debt and equity • Rules for designing a financial instrument • Risk profile determines yield and gain to investor • Caps, floors, and collars • Net flows from swapping floating rate into fixed

  3. Learning objectives • Explain the fundamental characteristics of debt and equity. • Identify and contrast the different risk-reduction mechanisms used by investors and lenders. • Analyse a financial instrument to determine the yield, upside, and risk reduction mechanisms it adopts. • Understand the basics of interest rate management tools.

  4. Risk and return Required return Perceived risk

  5. The risk-averse investor Risk-averse investor Required return Market line Perceived risk

  6. The speculative investor Required return Market line Speculative investor Perceived risk

  7. The building blocks of financial instruments Risk vReturn • Downside protection • Repayment • Security • Guarantees • Covenants • Voting rights • Veto rights • Board representation • Yield • Fixed / Floating / Other • Discretionary or by right? • Upside • Sale / Redemption / Exchange? • Depends on markets or on the company? • Guaranteed? Discretionary? • Perks

  8. Characteristics of debt and equity

  9. Rules for designing a financial instrument • The expected return on a financial instrument must be consistent with the investor’s perceived risk • The return will come from yield and upside.

  10. Risk profiles determine yield and gain to investors 100% Proportion of required return supplied by yield 100% yield 100% gain 0% Perceived risk

  11. Caps, floors, and collars cap collar floor

  12. Net flows from swapping from floating rate into fixed Lender Floating rate interest payments Loan & repayments Borrower Borrower borrows Floating Floating rate interest payments Fixed rate interest payments Counterparty Borrower swaps into Fixed

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