102 : FINANCIAL MARKETS
Contents
Real Estate Investment Trust ‘REIT’
Real Estate Operating Company ‘REOC’
Financial
instruments are contracts for monetary assets that can be purchased, traded,
created, modified, or settled for. In terms of contracts, there is a
contractual obligation between involved parties during a financial instrument’s
transaction that gives rise to a financial asset for one party and a financial
liability or equity instrument to another party. Financial instruments come in
many forms and types i.e.,
1.
Cash
and cash equivalents
2.
Currencies
3.
Fixed
income securities
4.
Equity
instruments
5.
Alternative
investments
6.
Derivatives
We will take a look
at these categories individually.
The values of cash
instruments are directly influenced and determined by the markets. These can be
securities that are easily transferable.
Cash and cash
equivalents help companies with their working capital needs since these liquid
assets are used to pay off current liabilities.
Cash equivalents
are investments that can readily be converted into cash. The investment must be
short term, usually with a maximum investment duration of three months or less,
be highly liquid and easily sold on the market.
The amount of cash
equivalents must be known. Therefore, all cash equivalents must have a known
market price, should not be subject to price fluctuations and must not be
expected to change significantly before redemption or maturity.
Cash yields also
allows a company to strategically hold low-risk investments for future use
while still attempting to preserve purchasing power better than holding cash
directly.
Treasury bills
Treasury bills are
commonly referred to as “T-bills." These are securities issued by a country’s
treasury that mature in one year or less. Companies, financial institutions,
and individuals who buy T-bills lend the government money which the government
pays back upon maturity. T-bills are sold at a discount and redeemed at face
value. The yield of T-bills is the difference between the purchase price and
the value at redemption.
Commercial
Paper
This is a short-term
(less than a year), unsecured debt used by big companies to raise funds to meet
short-term liabilities such as payroll. Corporations issue commercial paper at
a discount from face value and promise to pay the full-face value on the
maturity date designated on the note. Maturities range from 1 to 270 days.
Money
Market Funds
Money market funds
are mutual funds that invest only in cash and cash equivalents. They are very
liquid investments with excellent credit quality. Money market funds are an
efficient and effective tool that companies and organizations use to manage
their money since they tend to be more stable compared to other types of funds,
such as mutual funds. Money market funds invest in cash equivalents.
Short-Term
Government Bonds
Short-term
government bonds are considered by some to be cash equivalents because they are
very liquid, actively traded securities. They are issued by a government to
fund government projects. Investors should be sure to consider political risks,
interest rate risks, and inflation when investing in government bonds.
Certificate
of Deposit (CD)
A certificate of
deposit is a type of savings account with a financial institution. It
represents a certain amount of a saver's capital that can't be accessed by the
saver for a specific period of time. In return for the use of their capital,
the financial institution pays savers a fixed rate of interest. Savers can
choose from CD terms ranging from one-month to five-years. A CD is considered a
very safe investment and is usually insured. Should the saver need their money,
they may be able to break the CD contract by paying a fee or interest penalty.
Banker's
Acceptance
A banker's
acceptance is a form of payment that is guaranteed by a bank rather than an
individual account holder. Because the bank guarantees payments, this
short-term issuance by a bank is considered to be cash. Bankers' acceptances
are frequently used to facilitate transactions where there is little risk for
either party.
Currency is a
medium of exchange for goods and services i.e., it is money, in the form of
paper and coins, usually issued by a government and generally accepted at its
face value as a method of payment.
Currency is the
primary medium of exchange in the modern world, having long ago replaced
bartering as a means of trading goods and services.
Currency
Pairs
The exchange rate
is the current value of any currency relative to another currency. As a result,
rates are quoted for currency pairs, such as the EUR/USD (euro to U.S. dollar).
Exchange rates fluctuate constantly in response to economic and political
events.
The forex (FX), is
the largest investment market in the world and continues to grow annually, with
more than $5 trillion in notional value exchanged daily
Forex exchanges
allow for 24/7 trading in currency pairs, making it the world's largest and
most liquid asset market.
Cryptocurrencies
Cryptocurrency is
a digital or virtual currency secured by cryptography, which makes it nearly
impossible to counterfeit or double-spend. Many cryptocurrencies are
decentralized networks based on blockchain technology.
Not all e-commerce
sites allow purchases using cryptocurrencies. In fact, cryptocurrencies, even
popular ones like Bitcoin, are hardly used for retail transactions. However,
cryptocurrency values have made them popular as trading and investing
instruments. To a limited extent, they are also used for cross-border
transfers.
Fixed Income
securities are debt instruments that pay a fixed amount of interest, in the
form of coupon payments, to investors. The interest payments are commonly distributed
semiannually, and the principal is returned to the investor at maturity. Bonds
are the most common form of fixed-income securities.
Bonds can either
be investment-grade or non-investment-grade bonds. Investment grade bonds are
issued by stable companies with a low risk of default and, therefore, have
lower interest rates than non-investment grade bonds. Non-investment grade
bonds, also known as junk bonds or high-yield bonds, have lower credit ratings
due to a probability of default by the issuer. Investors receive a higher
interest rate from investing in junk bonds for assuming the higher risk of
these debt securities.
Treasury
Notes
Treasury notes
(T-notes) are issued by the Treasury and are intermediate-term bonds that
mature in two, three, five, or ten years. T-Notes usually pay semiannual
interest payments at fixed coupon rates or interest rates. The interest payment
and principal repayment of all Treasurys are backed by the full faith and
credit of the government, which issues these bonds to pay debts.
Treasury
Bond
Treasury also
issues Treasury bonds (T-bond) which mature in 30 years. Treasury bonds
typically have higher par values than T-notes and are sold on auction.
Municipal
Bond
A municipal bond
is issued by states, cities, and counties to fund capital projects, such as
roads, schools, and hospitals. The interest earned from these bonds is exempt
from federal income tax. The interest earned on a "muni" bond may be
exempt from state and local taxes if the investor resides in the state where
the bond is issued. The muni bond has several maturity dates in which a portion
of the principal comes due in intervals until the entire principal is repaid.
Corporate
Bonds
Corporate bonds
are debt securities issued by companies to raise funds. Unlike company stocks,
bond investors have no voting rights or equity in the company. Bonds are
classified based on their maturity period. Short-term bonds are held for less
than three years, medium-term for four to ten years, and long-term for more
than ten years. Bonds are classified as investment or non-investment grade
depending on the company's credit rating.
Convertible
bond
A convertible bond
gives the bondholder the right to convert the bond into common shares of the
issuing company. Because this option favors the bondholder, convertible bonds
offer a lower yield and sell at a higher price than otherwise similar
non-convertible bonds.
Floating
rate notes
A floater, is a
bond whose coupon is set based on a market reference rate (MRR) plus a spread.
FRNs can be floored, capped, or collared. An inverse FRN is a bond whose coupon
has an inverse relationship to the reference rate.
Other coupon
payment structures include bonds with step-up coupons, which pay coupons that
increase by specified amounts on specified dates; bonds with credit-linked
coupons, which change when the issuer’s credit rating changes; bonds with
payment-in-kind coupons, which allow the issuer to pay coupons with additional
amounts of the bond issue rather than in cash; and bonds with deferred coupons,
which pay no coupons in the early years following the issue but higher coupons
thereafter.
Equity, typically
referred to as shareholders' equity represents the amount of money that would
be returned to a company's shareholders if all of the assets were liquidated
and all of the company's debt was paid off in the case of liquidation. In the
case of acquisition, it is the value of company sales minus any liabilities
owed by the company not transferred with the sale. In addition, shareholder
equity can represent the book value of a company. Equity can sometimes be
offered as payment-in-kind. It also represents the pro-rata ownership of a
company's shares.
Equity is used as
capital raised by a company, which is then used to purchase assets, invest in
projects, and fund operations. A firm typically can raise capital by issuing
debt (in the form of a loan or via bonds) or equity (by selling stock).
Investors usually seek out equity investments as it provides a greater
opportunity to share in the profits and growth of a firm, dividends, the right
to vote on corporate actions and elections for the board of directors.
Public and Private equity
When a company
offers its stock on the market, it means the company is publicly traded, and
each stock represents a piece of ownership. This appeals to investors, and when
a company does well, its investors are rewarded as the value of their stocks
rise. When an investment is publicly traded, the market value of equity is
readily available by looking at the company's share price and its market
capitalization.
Private equity
generally refers to such an evaluation of companies that are not publicly
traded. Private equity is often sold to funds and investors that specialize in
direct investments in private companies or that engage in leveraged buyouts
(LBOs) of public companies.
Unlike shareholder
equity, private equity is not accessible to the average individual. Only
"accredited" investors, those with a net worth of at least $1
million, can take part in private equity or venture capital partnerships.
Preferred
Stock
Companies issue
preferred stock that provides investors with a fixed dividend, set as a dollar
amount or percentage of share value on a predetermined schedule. Interest rates
and inflation influence the price of preferred shares, and shares have higher
yields than most bonds due to their longer duration.
Characteristics
common to many alternative investments, when compared with traditional
investments, include the following: lower liquidity, less regulation, lower
transparency, higher fees, limited and potentially problematic historical risk
and return data.
Alternative
investment strategies are typically active, return seeking strategies that also
often have risk characteristics different from those of traditional long-only
investments with complex legal and tax considerations and may be highly
leveraged.
Alternative
investments are attractive to investors because of the potential for portfolio
diversification resulting in a higher risk-adjusted return for the portfolio.
Real
Estate Investment Trust ‘REIT’
This is a company
that owns, operates, or finances income-generating real estate. Modeled after
mutual funds, REITs pool the capital of numerous investors. This makes it
possible for individual investors to earn dividends from real estate
investments without having to buy, manage, or finance any properties
themselves.
Real
Estate Operating Company ‘REOC’
This is a
publicly-traded company that actively invests in properties—generally
commercial real estate. Unlike REITs, REOCs reinvest the money they earn back into
their business and are subject to higher corporate taxes than REITs.
Mutual funds
Mutual funds are
investment funds managed by professional managers who allocate the funds
received from individual investors into stocks, bonds, and/or other assets.
Hedge
funds
Hedge funds are
investment vehicles for high-net-worth individuals or institutions designed to
increase the return on investors’ pooled funds by incorporating high-risk
strategies such as short selling, derivatives, and leverage.
Index
Funds
An index fund is a
mutual fund that seeks to replicate the performance of an index, often by
constructing its portfolio to mirror that of the index itself. Index investing
is considered a passive strategy since it does not involve any stock picking or
active management.
Government
bond funds
Government bond
funds are for investors looking to put their money away in low-risk investments
through Treasury securities such as Treasury bonds or agency-issued debt.
Exchange-Traded
Fund ‘ETF’
ETF is a type of
pooled investment security that operates much like a mutual fund. Typically,
ETFs will track a particular index, sector, commodity, or other assets, but
unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same
way that a regular stock can. ETFs offer low expense ratios and fewer broker
commissions than buying the stocks individually and can be a popular choice for
diversification.
Commodities
These are real assets and mostly natural
resources, such as agricultural products, oil, natural gas, and precious and
industrial metals. Commodities are considered a hedge against inflation, as
they're not sensitive to public equity markets. Additionally, the value of
commodities rises and falls with supply and demand, higher demand for
commodities results in higher prices and, therefore, investor profit. Usually
traded in the futures and forwards market.
A derivative is a
financial instrument that derives its performance from the performance of an
underlying asset, the underlying asset, called the underlying, trades in the
cash or spot markets and its price is called the cash or spot price. Derivatives
consist of two general classes: forward commitments and contingent claims. They
can be created as standardized instruments on derivatives exchanges or as
customized instruments in the over-the-counter market.
Exchange-traded
derivatives are standardized, highly regulated, and transparent transactions
that are guaranteed against default through the clearinghouse of the
derivatives exchange.
Over-the-counter
derivatives are customized, flexible, and more private and less regulated than
exchange-traded derivatives, but are subject to a greater risk of default.
Forward
A forward contract
is an over-the-counter derivative contract in which two parties agree that one
party, the buyer, will purchase an underlying asset from the other party, the
seller, at a later date and at a fixed price they agree upon when the contract
is signed.
Futures
A futures contract
is similar to a forward contract but is a standardized derivative contract
created and traded on a futures exchange. In the contract, two parties agree
that one party, the buyer, will purchase an underlying asset from the other
party, the seller, at a later date and at a price agreed on by the two parties
when the contract is initiated. In addition, there is a daily settling of gains
and losses and a credit guarantee by the futures exchange through its
clearinghouse.
Swap
A swap is an
over-the-counter derivative contract in which two parties agree to exchange a
series of cash flows whereby one party pays a variable series that will be
determined by an underlying asset or rate and the other party pays either a
variable series determined by a different underlying asset or rate or a fixed
series.
Options
An option is a
derivative contract in which one party, the buyer, pays a sum of money to the
other party, the seller or writer, and receives the right but not the
obligation to either buy or sell an underlying asset at a fixed price either on
a specific expiration date or at any time prior to the expiration date. A call
is an option that provides the right to buy the underlying. A put is an option
that provides the right to sell the underlying.
Credit
Default Swap
A credit default
swap is the most widely used credit derivative. It is a derivative contract
between two parties, a credit protection buyer and a credit protection seller,
in which the buyer makes a series of payments to the seller and receives a
promise of compensation for credit losses resulting from the default of a third
party.
Asset-Backed
Securities ‘ABS’
Asset-backed
Securities (ABS) are derivative securities backed by financial assets that have
been “securitized,” such as credit card receivables, auto loans, or home-equity
loans. ABS represents a collection of such assets that have been packaged
together in the form of a single fixed-income security. For investors, asset-backed
securities are usually an alternative to investing in corporate debt.
Warrants
Just like options,
warrants give the holder the right, but not the obligation, to buy (call
warrants) or sell (put warrants) the underlying investment in the future. The
company issues the warrants to the holders of its bonds or preferred stock as
an incentive to buying the issue.
Contract
or differences (CFD)
A contract for
differences (CFD) is an arrangement made in financial derivatives trading where
the differences in the settlement between the open and closing trade prices are
cash-settled. There is no delivery of physical goods or securities with CFDs.
They are used in advanced trading strategy by experienced traders and is not
allowed in the United States. A CFD is a financial contract that pays the
differences in the settlement price between the open and closing trades. CFDs
essentially allow investors to trade the direction of securities over the very
short-term and are especially popular in FX and commodities products.
Derivatives are
issued on equities, fixed-income securities, interest rates, currencies,
commodities, credit, and a variety of such diverse underlyings as weather,
electricity, and disaster claims. Derivatives can also be combined with other derivatives
or underlying assets to form hybrids.
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