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3. Instruments and financial markets – part 2

In the first partof our article we talked about the different types of financial markets and their main characteristics. Apart from those it is important to understand that each market has certain financial instruments which can be traded. There are two main classes of instruments:

• Instruments that generate credit reports
• Instruments that generate property reports

The instruments that generate credit reports are instruments that are traded on the money market or the fixed income instruments market.

With regard to the money market we have the following instruments at our disposal:

• Deposits
• Certificates of deposit
• Treasury certificates
• Commercial papers
• Repurchase agreements

All these are usually issued with maturities of one year and pay an interest (usually as a percentage) when they mature. There are other types of instruments on the monetary market, but they are aimed at trading in the interbanking system.

Deposits are pretty much well known by almost everybody.

We can have:

• Classical deposits – which pay an interest when they mature
• Non-classical deposits – which can pay an interest in advance
• Structured deposits – which are dependent on a certain events

 
At the same time, classical deposits can be:

• With accumulation
• With automatic extension
• With capitalization

A certificate of deposit is an instrument that works as a deposit, has a maturity of 6 months maximum, but can be sold before it matures.

A treasury certificate is an instrument issued at a discount from its face value (without interest). For example, when it matures it pays 1000 dollars, but on the market it can be traded for prices below 1000 dollars. If a person buys such an instrument for 950 dollars, when it matures he receives 1000 dollars. The 50 dollar difference is considered interest.

Commercial papers are instruments issued by companies either directly to the public or through banks. They usually have a maturity of maximum 270 days. They are similar to treasury certificates, but the way the price is established can differ from country to country. Companies that want to issue commercial papers must have a rating.

A repurchase agreement is actually a loan guaranteed by bonds. It is a highly liquid instrument in the banking system, but private companies can access it as well. When this loan is given by the Central Bank to commercial banks, it is called a system repo and it is a way through which the Central Bank can intervene in the monetary market to lower or increase liquidity.

When it comes to the fixed income instruments market, most of them are bonds. These can be issued with large maturities, more than 30 years. Classic bonds pay a fixed interest called coupon which can be paid annually, semi-annually, every three months etc. For example, if we have a bond with a nominal value of 1000 dollars which pays a semi-annual coupon of 6%, this means we get 30 dollars every 6 months. When it matures it will pay the face value of 1000 dollars. Bonds can be issued by the government, municipalities and companies. There are some bonds with different characteristics from the classical ones.

For example some can pay a coupon which is linked to an interest index: instead of paying a fixed interest their pay EURIBOR 6 months + 1.50%. In this case we are talking about a bond with floating interest.

Some bonds can be redeemed by the issuer before maturity. Others can offer the owner the right to sell them back to the issuer before maturity.

Convertible bonds don’t pay the face value when they mature, they are converted into stocks issued by the same issuer based on a predetermined conversion report.

Entities which want to issue bonds must draw up a prospect with information that is required by the regulatory authority of that particular country. Only if this institution approves the prospect can the company go further to issuing the so called bonds.

The instruments which generate proprietary reports are the stocks issued by companies. They can be split into common and preferred stocks.

Common stocks give owners the right to receive dividends proportional with the number of stocks they have. They also have the right to vote in Stockholder meetings where they have one vote per each stock.

It is important to know that, in general, companies don’t have an obligation to offer dividends even when they make a profit. Dividends and how much they are, are decided by the General Meeting of Stockholders.

Preferred stocks have a maturity and don’t give you the right to vote. They do however give their owners the right to a preferential dividend which is paid annually until maturity.

This dividend is guaranteed. It is possible for the issuer not to pay this dividend one year but the next one he must pay both that year’s dividends as well as the dividends which have not been paid the year before. This a cumulative preferred stock.

A preferred stock which pays an additional dividend in case the company that issues it generates a profit above a certain level is call a participative preferred stock.

In some cases, a company can decide to issue right issues. The purpose of this activity is to increase the capital. A classic example is the situation when a company gives existing stock holders the chance to buy a number of stocks based on the number of stocks they already own. For example a stock holder has the right to buy 2 new stocks for every 5 stocks he already owns. The price he pays is smaller than the market price.

Some rights issues can be tradeable. In this case all stock holders receive their specific number of rights which they can trade on the market at a price which depends on the demand. As a result new stock holders can buy subscription rights. Generally the subscription right can be exercised in a period of around a couple of months.

There are other instruments which offer the right to buy shares at a smaller price then the price of the market, but with a maturity of more than a year. These are called warrants and are usually attached to an issue of stocks or bonds.

The instruments which we talked about above are traded on the spot market. We remind you that the spot market is a market with immediate delivery where the buyer pays the value of what he bought in full and the seller delivers in full. Also the exchange of money and financial instruments is done two days after the date of the transaction.

Valentin Cioraneanu
Investment Banking Specialist