Chapter 1
Overview of Financial Instruments
Frank J. Fabozzi, Ph.D., CFA
Adjunct Professor of Finance School of Management Yale University
Broadly speaking, an asset is any possession that has value in an exchange. Assets can be classified as tangible or intangible. A tangible asset is one whose value depends on particular physical propertiesâexamples are buildings, land, or machinery. Intangible assets, by contrast, represent legal claims to some future benefit. Their value bears no relation to the form, physical or otherwise, in which these claims are recorded. Financial assets are intangible assets. For financial assets, the typical benefit or value is a claim to future cash. This book deals with the various types of financial assets or financial instruments.
The entity that has agreed to make future cash payments is called the issuer of the financial instrument; the owner of the financial instrument is referred to as the investor. Here are seven examples of financial instruments:
- A loan by Fleet Bank (investor/commercial bank) to an individual (issuer/borrower) to purchase a car
- A bond issued by the U.S. Department of the Treasury
- A bond issued by Ford Motor Company
- A bond issued by the city of Philadelphia
- A bond issued by the government of France
- A share of common stock issued by Microsoft Corporation, an American company
- A share of common stock issued by Toyota Motor Corporation, a Japanese company
In the case of the car loan by Fleet Bank, the terms of the loan establish that the borrower must make specified payments to the commercial bank over time. The payments include repayment of the amount borrowed plus interest. The cash flow for this asset is made up of the specified payments that the borrower must make.
In the case of a U.S. Treasury bond, the U.S. government (the issuer) agrees to pay the holder or the investor the interest payments every six months until the bond matures, then at the maturity date repay the amount borrowed. The same is true for the bonds issued by Ford Motor Company, the city of Philadelphia, and the government of France. In the case of Ford Motor Company, the issuer is a corporation, not a government entity. In the case of the city of Philadelphia, the issuer is a municipal government. The issuer of the French government bond is a central government entity.
The common stock of Microsoft entitles the investor to receive dividends distributed by the company. The investor in this case also has a claim to a pro rata share of the net asset value of the company in case of liquidation of the company. The same is true of the common stock of Toyota Motor Corporation.
DEBT VERSUS EQUITY INSTRUMENTS
Financial instruments can be classified by the type of claim that the holder has on the issuer. When the claim is for a fixed dollar amount, the financial instrument is said to be a debt instrument. The car loan, the U.S. Treasury bond, the Ford Motor Company bond, the city of Philadelphia bond, and the French government bond are examples of debt instruments requiring fixed payments.
In contrast to a debt obligation, an equity instrument obligates the issuer of the financial instrument to pay the holder an amount based on earnings, if any, after the holders of debt instruments have been paid. Common stock is an example of an equity claim. A partnership share in a business is another example.
Some securities fall into both categories in terms of their attributes. Preferred stock, for example, is an equity instrument that entitles the investor to receive a fixed amount. This payment is contingent, however, and due only after payments to debt instrument holders are made. Another âcombinationâ instrument is a convertible bond, which allows the investor to convert debt into equity under certain circumstances. Both debt instruments and preferred stock that pay fixed dollar amounts are called fixed-income instruments.
CHARACTERISTICS OF DEBT INSTRUMENTS
As will become apparent, there are a good number of debt instruments available to investors. Debt instruments include loans, money market instruments, bonds, mortgage-backed securities, and asset-backed securities. In the chapters that follow, each will be described. There are features of debt instruments that are common to all debt instruments and they are described below. In later chapters, there will be a further discussion of these features as they pertain to debt instruments of particular issuers.
Maturity
The term to maturity of a debt obligation is the number of years over which the issuer has promised to meet the conditions of the obligation. At the maturity date, the issuer will pay off any amount of the debt obligation outstanding. The convention is to refer to the âterm to maturityâ as simply its âmaturityâ or âterm.â As we explain later, there may be provisions that allow either the issuer or holder of the debt instrument to alter the term to maturity.
The market for debt instruments is classified in terms of the time remaining to its maturity. A money market instrument is a debt instrument which has one year or less remaining to maturity. Debt instruments with a maturity greater than one year are referred to as a capital market debt instrument.
Par Value
The par value of a bond is the amount that the issuer agrees to repay the holder of the debt instrument by the maturity date. This amount is also referred to as the principal, face value, redemption value, or maturity value. Bonds can have any par value.
Because debt instruments can have a different par value, the practice is to quote the price of a debt instrument as a percentage of its par value. A value of 100 means 100% of par value. So, for example, if a debt instrument has a par value of $1,000 and is selling for $900, it would be said to be selling at 90. If a debt instrument with a par value of $5,000 is selling for $5,500, it is said to be selling for 110. The reason why a debt instrument sells above or below its par value is explained in Chapter 2.
Coupon Rate
The coupon rate, also called the nominal rate or the contract rate, is the interest rate that the issuer/borrower agrees to pay each year. The dollar amount of the payment, referred to as the coupon interest payment or simply interest payment, is determined by multiplying the coupon rate by the par value of the debt ins...