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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Investors need to make a return on their money.
That return can come from a
− yield
− capital gain
− Both
The amount of return they require depends on the
− level of risk that they perceive they are taking
Within this simple framework there is a vast panoply
of financial instruments that can be created to serve
the different needs of companies and their investors.

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Risk and Return

 Investment in Company
− Debt (Bonds)
− Equity (Shares)
 there is huge volatility in the expected return from an
investment in shares
 That volatility of anticipated return is the risk we take, and it is
for this that we need to be compensated.
 If debt pays us 6%, we will demand a much higher return from
our shares
 it is also worth noting that individual investors perceive risk in
different ways, and thus demand different levels of return for
what is technically the same amount of risk.

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Risk and Return

 One of you has a very low risk threshold for personal

investment,
 preferring the certainty of a secure retirement to the possible
glory of earning millions on speculative investment.
 a venture capitalist may see the risk/return spectrum in an
entirely different way.
 Such an investor is really not interested in low-risk
investments,
 as their whole raison d’etre (justification for being) is in
making high gains on more speculative investments.

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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 A FINANCIAL INSTRUMENT

 the return investors require is dependent on their perception

of the risk inherent in their investment.
 That return will comprise some combination of yield and the
upside which comes normally from a capital gain.
 Thus, the three building blocks are:
−● Risk
−● Yield
−● Upside

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RISK

 In order to reduce the return that the company has to pay,

 the risk to the Investor has to be managed down
1. Giving the investor a way out
− one way to reduce investors ’ risk is assure them of a way out, by
• repayment or redemption, or
• conversion into another valuable asset.
2. Providing security :
− The company can provide security to the investor, often referred to
− as a ‘ charge’ on the company’s assets,
− such that if it fails to meet the terms of the agreement, the investor
can protect their downside in some way. (Collaterals, Securities)

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Types of Securities, Collaterals

 Under current UK law, security comes in two flavours

− fixed
− floating
 fixed charge is one over specific assets such as buildings or
fixed plant
 floating charge is a charge over assets which change on a
daily or weekly basis, such as inventories
 In a liquidation,
− the holder of a fixed charge can use the proceeds of selling those
specific assets in order to recover their due debts.
− Holders of floating charges can be repaid from the monies released by
selling these assets, but they have a lower priority to the fixed charge
holders and to various statutory creditors

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RISK

3. Providing a third party guarantee:

• If the company is unable to provide the assurance, it is possible that
a third party could do so
• For example,
 a holding company or a major shareholder might agree to guarantee the loan
as might, for a fee, a bank, or insurance company.
4. Covenants:
• Covenants are conditions in a loan contract which protect the lender
by stating what the borrower may or may not do
• Types of Covenants:
 Positive Covenants:
 Negative Covenants:

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RISK

− Positive Covenants:
• Positive covenants are loan conditions which state what the
borrower must do.
• For example,
 the borrowing company must deliver management accounts within
a certain period after the month end;
 must deliver audited annual accounts within a given timeframe;
 must maintain agreed levels of accounting figures and ratios (such
as the level of equity or the working capital ratios).

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RISK

− Negative Covenants:
• Negative covenants are clauses which prevent the borrower
from undertaking certain actions.
• For example,
 negative covenants will prevent directors’ remuneration being increased
above a pre-agreed level, so that the business loan is not immediately
transferred to the directors’ benefit.
 there will be covenants preventing large dividends being paid, or setting a
maximum level of pay for other employees.
 covenants in place preventing a company from taking further loans, which
may have precedence in repayment, unless the lender gives consent.
 Negative covenants will also prevent the company from spending large
amounts on fixed assets that have not been previously agreed with the
bank: this ensures that the monies borrowed are spent on the new factory
rather than the director’s Ferrari!

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RISK

 The main use of covenants is that a breach of the

covenant terms can enable the lender to demand
repayment of the loan, even though its term is not yet
due.

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YIELD

 The yield of a security includes any payment made

to the investors during the period for which the
investment is outstanding, other than payments which
reduce the capital balance.
 Examples:
− interest on loans and
− dividends on shares.
 Share repurchases or loan redemptions would not be
included in yield, as they are capital items.

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YIELD

 The yield can be a regular payment, such as contracted

quarterly interest, or can be on a more irregular basis, such
as an occasional dividend.
 Yields are often linked to an underlying reference point.
 For example,
− interest rates on debt may be fixed rate or floating.
− Floating rate loans charge interest based on a premium
over a reference rate such as
• LIBOR (London Inter Bank Offered Rate).
 the contracted interest rate might be set at LIBOR plus a
premium of 1%

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YIELD

 If LIBOR is 5%, then the interest rate paid on the loan will
be 6%;
 if LIBOR rises to 5.5%, the loan will be charged at 6.5%.
 Floating rate interest can reduce risk for the lender, as it
ensures that the lender will always receive ‘ market ’ rates
on the loan.
 However, it leaves the borrowing company vulnerable to rises
in market rates
 example , were LIBOR to rise to say 15% (which was the
case in the late 1980s), the company would have to pay 16%

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 INTEREST RATE MANAGEMENT TOOLS

 Interest rate management tools are used to lower the

financing risk for companies which have borrowed at a
floating rate.
 If the reference rate falls, the company will pay less interest.
 unexpected increases in market interest rates could lead to
the company having to pay a much larger than anticipated
charge
 Reference rate
− In the UK the reference rate most commonly used is LIBOR (London
Inter Bank Offered Rate – the rate at which banks lend to each other
in London).

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 INTEREST RATE MANAGEMENT TOOLS

 types of LIBOR,
− representing money being lent for varying periods
• 3 month LIBOR
• 6 month LIBOR
 Example:
− As an example, CapCo might borrow say £1 million for 2 years at a rate of 3-month
LIBOR plus 2% (200 basis points). On the first day of the loan, 3-month LIBOR
might be 5%; this means that CapCo will pay interest at 7% (5% + 2%) for 3
months.
− At the end of the 3 months, the new rate for 3-month LIBOR would be used to set
the rate of interest due for the next 3-month period.
− If 6-month LIBOR had been used as the reference rate, CapCo’s interest would
have remained at that level for 6 months

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 CAPS, FLOORS, AND COLLARS

 current LIBOR is 5%
 Upper Limit of LIBOR is 9%
− Rate is 11% (9%+2%)
 at levels above that (9%) there may be problems in meeting interest
payments.
 In order to protect its position, the company can buy an interest rate
cap .
 This is in effect an insurance policy that prevents the company having to
pay interest at more than a given rate.
 The Firm can buy LIBOR cap at 9% by paying some amount

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 CAPS, FLOORS, AND COLLARS

 several points to note about buying the cap

− the cap need not be acquired from the Bank, who provided the loan.
• In fact, the Loan providing Bank need not even know about the existence
of the cap
• CapCo has in fact bought it from an other bank, and it is a separate
financial transaction to the loan.
− technically, having a cap does not prevent the company having to pay
high interest rates to its lender
• it just means that it can offset this extra interest by the receipts from the
bank which sold it the cap.
• if LIBOR were to rise to 12%, CapCo would have to pay Landing Bank
interest at 14%, but would receive interest back from ScotWest amounting
to 3%, leaving it paying a net 11%.

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 CAPS, FLOORS, AND COLLARS

 several points to note about buying the cap

− although the loan is for £1 million, the cap could be for less than that
amount, or more
• if CapCo wishes to speculate on interest rates.
 If LIBOR rises to 12% then interest rate will be 14%
 So above the caped LIBOR 3% (12% - 9%) will be compensated
by the other Bank.
 Leaving the firm to paying actual interest 11% (9% LIBOR plus
2%) only.


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 CAPS, FLOORS, AND COLLARS

 Acquiring the cap will cost CapCo an up-front payment, the level
of which depends on
− the rate capped, and t
− he time for which it is needed
 For example,
− if our company wanted to cap LIBOR at 6%, it would be a great deal
more expensive than capping at 9%;
− similarly, a 6-month cap would be cheaper to buy than a 2-year cap.

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 CAPS, FLOORS, AND COLLARS

 Should CapCo wish to avoid paying for its cap,

 it could enter into a transaction to sell a floor to a bank.
 Just as buying a cap means that the company’s interest rate will
never move above a certain amount,
 selling a floor means that even if market rates fall the company will
not be able to take full advantage of it.
 So CapCo might sell ScotWest (or another bank) a LIBOR oor at
4%.
 This would mean that should LIBOR fall to say 3%, CapCo would
be paying Barland interest on its loan at 5% (3% + 2%) but
would also be paying 1% (4% + 3%) to ScotWest which owns
the floor.

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 CAPS, FLOORS, AND COLLARS

 The purchase of a cap and a floor together is known as a collar.

 Terms can be set such that the amount that the company has to
pay for purchasing the cap can be exactly offset by the amount the
bank is paying it for the floor. This is known as a zero cost collar.

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Caps, floors, and collars

cap

collar

floor

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SWAP

 Another type of interest rate management tool is

− an interest rate swap.
 example,
− a company which has borrowed at a floating rate agrees to swap interest
rate payments with a counter-party which has borrowed at a fixed rate.
 There may be several reasons for doing this
− perhaps our company cannot borrow floating rate in the market,
− or perhaps the other company is changing its financing strategy and wants to
move out of fixed interest.
 Alternatively, the swap might be done because both parties can
make money on it
− based on comparative advantage.

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SWAP

 Each company wants to borrow £1 million.

 SwapCo would like fixed rate funds, and
 FixCo would like floating rate funds.
 If each of them were to borrow the types of funds they wanted, the
total rate they would pay would be LIBOR plus 9.5%.
 However, if SwapCo were to borrow floating rate and FixCo at a
fixed rate, the total they paid would be LIBOR plus 8%. It is thus
worthwhile for them to borrow at the combined lower rate, and
then to swap payments.
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SWAP

 So, SwapCo will borrow £1 million

 at a floating rate, paying LIBOR plus 2%.
 FixCo will borrow £1 million at 6% fixed.
 Then the swap agreement will ensure that SwapCo makes the
payments at 6% fixed, and
 FixCo pays at LIBOR plus 2%.
 The overall saving of 1.5% can be split between the two, and used
to reduce FixCo’s payment to (at most) the LIBOR plus 1.5% that
it would have paid on its own.

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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

Counterparty

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 UPSIDE

 The investor obtains an upside from selling the security for an

amount greater than was originally invested in it;
 the upside is the capital gain.
 The upside can come from various different sources:
1. Sale of the financial instrument to another investor .
2. Redemption of the instrument at a premium by the
investee company, the premium being paid in cash or in
the securities of the investee company.
3. Redemption by the investee company with a premium in
securities of another company or in another asset

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The building blocks of financial instruments

Risk v Return
Downside protection Yield
Repayment Fixed / Floating / Other

Security Discretionary or by right?

Guarantees Upside
Sale / Redemption /
Covenants
Exchange?
Voting rights
Depends on markets or on
Veto rights the company?
Board representation Guaranteed? Discretionary?

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Characteristics of debt and equity

  Debt Equity
Risk to the investor Low, protected by High
security and
covenants
Yield Interest, normally Dividends, at the
contractually agreed discretion of the
directors
Potential upside to None Very high
the investor

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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 100% 100%
supplied by yield gain
yield

0%
Perceived risk

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