Corporate Financial Strategy
4th edition
Dr Ruth Bender
Chapter 11
Financial instruments: the building
blocks
Corporate Financial Strategy
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
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Learning objectives
1. Explain the fundamental characteristics of debt and equity.
2. Identify and contrast the different risk-reduction mechanisms used by
investors and lenders.
3. Analyse a financial instrument to determine the yield, upside, and risk
reduction mechanisms it adopts.
4. Understand the basics of interest rate management tools.
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Risk and return
Required
return
Perceived risk
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The risk-averse investor
Risk-averse
investor
Required
return
Market line
Perceived risk
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The speculative investor
Required
return
Market line
Speculative
investor
Perceived risk
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The building blocks of financial instruments
Risk
v
Return
Downside protection
Yield
Fixed / Floating / Other
Repayment
Discretionary or by right?
Security
Upside
Sale / Redemption /
Exchange?
Guarantees
Covenants
Voting rights
Depends on markets or on
the company?
Veto rights
Guaranteed?
Discretionary?
Board representation
Perks
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Characteristics of debt and equity
Debt
Equity
Risk to the investor
Low, protected by
security and
covenants
High
Yield
Interest, normally
contractually agreed
Dividends, at the
discretion of the
directors
Potential upside to
the investor
None
Very high
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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.
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Risk profiles determine yield and gain to investors
100%
Proportion of
required
return
supplied by
yield
100%
yield
100%
gain
0%
Perceived risk
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Caps, floors, and collars
cap
collar
floor
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Net flows from swapping from floating rate into fixed
Lender
Floating rate interest
payments
Loan &
repayments
Borrower borrows Floating
Borrower
Floating rate interest
payments
Fixed rate interest
payments
Borrower swaps into Fixed
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Counterparty