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E18FINST

FINANCIAL INSTRUMENTS
1.0 TREASURY BILLS

Treasury Bills have a maturity period of less than one year. The interest on
Treasury Bills is paid in a different manner that the bills are sold at a discount
and redeemed at par value at maturity. The amount of discount and the term of
maturity determine the yield.

To clarify this with an example, by paying Rs. 84745.76 up front, one can
obtain an one year treasury bill going at 18% with a face value of Rs. 100,000
(84745.76 x 1.18 = 100,000).

There are several advantages associated with treasury bills. The most significant
feature is that it is a "risk free" investment, which is accepted as a collateral by
any financial institution. Further, it can be endorsed and transferred in favour of
someone else, prior to maturity. In addition, it can be discounted and encashed
at any time, prior to the date of maturity.

2.0 COMMERCIAL PAPERS

A company uses its strength and reputation to borrow directly from the public
and other firms by issuing commercial papers on short term, at an interest rate
less than the lending rate of the commercial banks, but higher than the savings
rate. Firms use this instrument to fund trade, commercial and production
activities. The firms often use ratings obtained from a reputed Rating Agency, in
raising funds this way.

3.0 DEBENTURES

This is a fixed interest rate medium term debt security issued by the firms. The
debentures are usually secured by the assets of the company. The debenture
holder is a creditor to the company. Unlike the other debt instruments,
debentures can be traded on a stock exchange. There are two types of
debentures, which are either convertible or redeemable. Convertible debentures
yield a fixed interest rate during its life span and they are converted into equity
at maturity, on a method of conversion agreed prior to the issuance. The
redeemable debenture is converted to money and paid back to the lender, at
maturity.

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4.0 BONDS

A bond is a long-term debt security (instrument). The significant aspects of a


bond are the duration of the bond, the coupon rate of interest (usually paid once
in every six months in U.S.A.) and the face value. In order to attract investors,
the bonds usually offer a marginally higher rate of interest than the market rate
of interest, which is prevalent at the time of issuance. Then, the bonds can be
bought and sold in the open (bond) market. If the market interest rate starts
rising the bond will start trading at a discount and if the market interest rate
starts falling, the bond will trade at a premium price. In general, the bond
market moves against fluctuations of the interest rates.

The most unique feature of a bond is that it usually carries a "call feature" which
allows the bond issuer to "call in" the bond and repay them at a predetermined
price, before maturity is reached. This option is often executed when the market
interest rate is significantly lower than the coupon interest rate. In other words,
when the issuer can borrow in the open market at an interest rate which is very
much less than the coupon rate. This process of retiring expensive debt and
obtaining fresh loans at a lower rate is known as "Debt Refinancing". However,
some bonds are "call protected", that they offer a guarantee to the investors that
it will not be called for a specified period of time, from the date if issuance.
However, if a bond is called, the
investor is usually paid a premium over the par value for the inconvenience.

There are three types of yields associated with the bonds

- Coupon Yield
- Current Yield
- Yield to Maturity (YTM)

Coupon yield is the coupon rate of interest. If the bond is purchased at a


discount, the current yield is higher than the coupon yield. Similarly, if it is
purchased at a premium, the current yield is lower than the coupon yield. In
calculating the yield to maturity, either the discount or the premium paid at the
purchase price is duly amortized (discount added and premium deducted on a
prorated basis) over the remaining period of the bond.

To clarify this with an example, if we consider a bond with a 8% coupon rate of


interest and a face value of 1000 which has 5 years remaining to maturity and
currently trading at a discount price of 800.

(a) Coupon yield = 80 / 1000 = 8%

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(b) Current yield = 80 / 800 = 10%

(c) coupon amount + prorated discount 80 + (200/5)


YTM =---------------------------------------- = -------------------- = 13.3%
(face value + purchase price / 2) (1000 + 800) / 2

5.0 STOCKS (SHARES)

A company raises its initial equity by issuing shares. If it involves a reasonably


large capital, the company may seek a listing in a stock exchange and offer the
shares of the company to the general public. A company has an Authorized
capital when it is incorporated. The capital raised by way of a share issue is
known as Issued Capital. The number of shares issued by a company can be
calculated by dividing the issued capital by the Par Value (in Sri Lanka, the
most common par value of a share is Rs. 10).

Types of Shares:

- Ordinary Shares
- Preference Shares
- Non-Voting Shares
- Rights Issues
- Bonus Issues
- Primary Issues (IPOs)

Ordinary Shares:

An Ordinary Share represents the smallest unit of the equity ownership of a


company. In a listed company, these shares are traded on the Stock Exchange.
The market price of these shares is purely determined by the demand and supply
forces.

Preference Shares:

A Preference Share gives limited ownership rights to, the shareholder. However,
in the event of a liquidation the preference shares possess priority over ordinary
shares. Further, preference shareholders are entitled to receive dividends before
the ordinary shareholders.

Non Voting Shares:

Share holders do not have a right to vote at the Annual General Meeting.

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Rights Issues:

Rights Issues enable only the existing shareholders to participate in an


additional equity financing. Rights also may command a premium but they are
usually sold at a substantially lower price than the prevalent market price.

Bonus Issues:

Bonus Shares are basically dividends paid on existing shares, in shares itself
rather than in cash. Funds for capitalization of bonuses come either from the
accumulated reserves or from asset revaluations.

Primary Issues (IPOs):

When an unlisted company offers shares to the public with a prospectus filed
with the Registrar of Companies and with the approval of the Stock Exchange
for the shares to be listed and traded on the stock exchange, it is called either a
Primary Issue or an Initial Public Offering. This will be priced either at par
value or with a premium.

Gains in the Stock Market:

The gains in Stock Market come by way of


- Dividends
- Capital Gains

To clarify this with an example, suppose that an investor purchased 1000 shares
(with a par value of Rs. 10.00) of a company at Rs. 60.00. Exactly after one
year, the company declared a 30% dividend and offered 1right for every 2
shares (1:2) with a premium of Rs. 14.00 and a bonus of 3 for every 10 shares
(3:10), simultaneously. After all these events, the share is now trading at Rs.
50.00. Assuming that the investor took up all his rights, calculate the percentage
of total gain accrued to him.

Number of shares purchased = 1000


Cost of purchasing shares = 1000 x 60.00 =
60,000.00
Rights entitlement = 1000 x (1/2) = 500
Cost of buying rights = 500 x (10.00 + 14.00) = 12,000.00
Bonus entitlement = 1000 x (3/10) = 300
Total number of shares owned now = 1000+ 500 + 300= 1800
Cost of 1800 shares = 60,000.00 + 12,000.00
= 72,000.00

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Dividends received = 10,000.00x 30% =
3,000:00
Market price of shares = 1800x 50.00 = 90,000.00.
Total Gain = (90,000.00- 72,000.00)+ 3,000.00
= 21,000.00
Minimum Return On Investment = (21000/72000) x 100 = 29.16%

Risk and Return on Investment (ROI) in Stock Markets:

Risk and ROI are highly co-related. In other words, ROI is high when the
risk is high. The risks associated with stocks can be distinguished into two
categories

- Company Specific Risk


- Market Risk

Company Specific Risk:

Company Specific Risk can be reduced by diversification. It can be attributed to


the degree of exposure to consequences of actions such as lawsuits, strikes,
unsuccessful products, management changes etc. The risk associated with a
diversified portfolio (a collection with more than two types of shares) is known
as the Portfolio Risk. Larger the number of different types of shares in a
portfolio, smaller the portfolio risk is. The portfolio risk can be reduced
drastically by having companies which are negatively co-related, in view of a
specific type of risk. For example, if the domestic currency is devalued
(depreciated), it affects the profitability of the companies which are in the
business of trading imported goods. The risk of holding the shares of such
companies can be reduced by buying the shares of a company involved in
export oriented manufacturing, which will benefit from a domestic currency
devaluation. If a portfolio which consists of two shares is considered,

(a) If the two shares are perfectly negatively co-related, the portfolio risk
can be completely eliminated.

(b) If the two shares are perfectly positively co-related, the portfolio risk
cannot be changed.

Market Risk:

The part of a stock's risk which cannot be eliminated by diversification is known


as the Market Risk. This is the risk associated with the volatility of the market.
In other words, market fluctuations. The causes of market risk could be any
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change in the macro environment such as politics, changes in economic
variables like inflation, interest rates and even acts of god.

Beta Co-efficient:

The tendency of a stock to move with the market is reflected in its beta
coefficient. An average stock is defined as one that tends to move up and down
in line with the general market (measured by an index). An average stock has a
beta coefficient of 1.0. High beta values are associated with shares with high
company risk and low beta values are associated with shares with low company
risks.

6.0 UNIT TRUSTS

A Unit Trust is simply a vehicle for pooling the investments of a number of


individual investors. A Unit Trust is constituted through a document known as a
Trust Deed, which brings together and binds the three parties involved in the
deed, namely the Trustee, the Fund Manager and the Investor (Unit Holder).
The trustee holds the assets of the trust on behalf of the unit holders. The fund
manager promotes, provides investment and administrative expertise and
markets units to the public, for a management fee.

Advantages of Unit Trust Investments:

- The risk is diversified among different types of securities and assets.


- The investments are managed by professional investment managers, who
are constantly in touch with the market and economic conditions.
- Priority is assigned to Unit Trusts in the process of allocating shares in an
IPO.
- Ability to fund large investments where there is a minimum stipulated
amount for investment.
- Reduced brokerage and administrative costs on high volume transactions.
- The Unit Trusts are closely supervised by the regulatory authorities.