Financial Instruments

Financial Instruments

Financial Instruments –All types of instruments that are quated a an exchange to be trade on the financial markets. Examples are Stocks, Bonds, Convertibles, Options, Swaps, Futures, Forwards, etc. Companies that need capital or want to rearrange its’ dept do so on the financial markets, where they issue these instruments.

Financial products

Many financial instruments are packaged by some bank or other financial institution into financial products. As a result of today’s technology in combination with the globalised capital markets, the competition is fierce and the number of products is immense. The structurers who are putting the products together are constantly finding new ways of doing so, and new innovations are often made. This enables the individual investor to gain or hedge exposures, for a reasonable cost, which previously were possible only for large financial institutions.  However, it is rather demanding to sort out the different variables these kinds of products are made of, and the pricing of the same. This is crucial to value the product, and to make a correct investment decision.

Naturally one can’t get something for nothing. A protection will always cost more than not having a protection. How much more is the interesting question. Cheap or expensive?

Unfortunately it is not uncommon that investors have a somewhat unrealistic view about potential risks and returns. It very often pays to discuss investment strategies and ideas with an impartial financial professional, who is used to dissect these kind of financial products.

What kind of financial instruments are on the market?

Stocks

A stock is a part ownership of a company. As an owner of a share one is entitled to have ones share of the company’s profit, and vote at the general annual meeting. A share has typically a nominal value that was determined when the company was formed. As a shareholder one benefit in two ways. The whole, or part of, the profit is paid out as dividend to the shareholders, and as the dividend increases if the company is doing well, other investors are willing to pay more for getting a part of the profits, and the value of your share increase. The companies that are quoted on the stock exchange are publicly traded, which mean anybody can be an owner of its’ shares. The stock market is highly liquid which means it is easy and cheap to convert ones shares into cash, should that be needed.

When buying or selling a share one pay a commission to the broker who settles the deal. This commission could be a flat fee or a percentage of the transaction. Normally there is a minimum fee for small transactions.

Private equity

This asset class has enjoyed increased popularity over the last few years. Basically it is all about buying and selling non quoted companies. A private Equity company, or private equity fund, buys and restructure, and exit private non quoted companies. The advantage of investing with a private equity company is that the owners of that company have a skills and experience in reforming and shaping up companies. Often they also got a network of banks and investors that with access to financing, which can help the target company to expand and grow faster.  The drawbacks with investing in private equity are that the minimum investment is rather high, and the low liquidity due to the long term nature of the strategy. It is not unusual for the restructuring cycle, from acquiring a company to exiting it, taking five years.  Transaction cost re normally also higher in the Private Equity asset class since everything is done manually, outside the standardised exchanges. This is a rewarding but somewhat cumbersome asset class for private individuals to gain access to.

Bonds

To buy a bond is in many ways equal to lend someone money. In a bond, a loan or a package of loans, are bundled together into a single paper that can easily be bought and sold in the secondary market. The interest pain on the loan is called coupon and could be fixed, floating or tied to some index. Bonds are often referred to as fixed income securities as you often know in advance what your income will be, as long as no defaults occur.

There are a number of different types of fixed income securities. The most common ones are fixed coupon bonds and zero coupon bonds. The difference is that a fixed coupon bond pays an in advance known interstate to the bond holder, but the zero coupon bond holder will not get this yearly payment. Instead the zero coupon investor will see the price of the bond move up as it is getting closer to maturity, hence benefiting from the appreciation.

There are a number of important features a bond investor should examine before buying a bond. These are for example; the maturity of the bond, the rating of the bond or the issuer, the yield to maturity, the coupons and the possible optionalities embedded in the bond.

The market for corporate bonds is growing steadily. It especially took off after the financial crisis in 2008. Many banks discovered suddenly they were lending too much money out to companies, which meant that companies could not get new loans or revolve old in the banks. Hence instead they went to the capital market and borrowed by issuing bonds to investors. A corporate bond is less risky than a stock in the same company, but never the less it is tied to the company’s financial health. If the company files for bankruptcy the bondholder might not get the whole face value of the bond.

Mutual Funds

A Fund is in essence a basket of many different shares, bonds options, currencies or other financial instruments and products, that is owned collectively by the investors in the Fund. The Fund is then managed by some professional asset managers that at all times optimise and reallocate the holding in the Fund to generate as good a return as possible, given some level of risk. Funds are today by far the most popular form of investing and saving. Everyone owns some Funds in one way or another, via their insurance, via their pension plan or directly via private investments.

A Fund is not a legal person. The investor in the Fund is not liable for the Funds actions. Property in a Fund cannot be confiscated.  A Fund can be thematic like investing only in a specific country, region or type of business.  These thematic Funds put a lot of responsibility on the investor to decide when, and by how much, it is appropriate to be exposed to a certain theme and when not to. Other types of funds help the investor with decisions like these. They are called Absolute Return Funds.

A Fund that invests 75%or more in the equity market is called an equity fund. An investor can benefit from owning shares via a Fund compared to owning then privately. In specialised or far away markets is also wise to delegate the investments to a Fund as it could be difficult to know which individual stocks in China that are attractive.

To own a Fund is often more cost efficient than buying and selling stocks or bonds privately, despite the annual fee to the Fund for its services.

Hedge Fund

A hedge fund is a type of fund with more liberal trading mandates compared to a common fund. The manger of a hedge fund has the possibility to preserve capital should that be necessary. An normal equity fund are not allowed to have less than 75% stocks in the Fund, i.e. maximum 25% cash. So if the manager sees the stock market falling, he is actually not allowed to sell the stocks and preserve the capital in cash while a financial crisis is blowing over. A hedge fund manager is allowed to sell everything and stay in cash until the equity market calms down and bottoming out.

Some hedge funds can even deliver a positive return when the markets are falling. This is possible thanks to the liberal mandates of hedge funds, and is done via shorting the whole, or parts of, the market. Some hedge fund managers are having an Absolute return target, which means that they are not following an index, like normal funds, but rather always aiming to create a positive return in all market conditions, be that rising or falling.

Another interesting feature that distinguishes hedge funds from traditional funs is that the manager often has performance related remunerations. That means that if the fund is delivering good returns to the investors, the manger gets paid. If the manager do not deliver any return to the investors in the fund, the manager do not get paid. The effect of this incentive structure which is common in hedge funds is that the manager and investors are sitting in the same boat, working in the same direction, with aligned interests. This is not the case in traditional mutual funds.

It is often a good idea to have some hedge fund in a portfolio as they often have a low correlation to other asset classes, and stabilise the portfolio.

Structured products

Structured products are a type of financial products that have increased dramatically in popularity over the last 10 years. Actually the inflow into structured products in 2009 was greater than the inflow into mutual funds in Sweden. This is a vast family of products where the individual issues can differs immensely regarding payoff structure, costs, risk and liquidity.  The appealing feature with some of the more popular issues is the protection and “money back” guarantee. This enables the investor to gain exposure to a the stock market, or some commodity, but with less risk than buying it outright since there often some kind of built in protection in the structured product. Of course this neat safety net feature is not for free, and sometimes comes with a hefty price.

Basically many structured products are much like a bond bundled together with an option. Bur instead of paying a fixed coupon, the payoff structure depends on how for example a stock index develops. If the index would fall, the investor gets the money back, minus the transaction costs. If the index should go up the investor gets a part of the index performance.

Needles to say, structured products can give significant possibilities to take part in the financial markets with limited risk. It is possible to achieve higher returns than in the bond market, but lower risk than in the equity market. The options part of the structured product is naturally risky as there are no guarantees that the chosen underlying index will develop positively, but the bond part of the will see to that the invested sum is paid back to the investor should the market fall. However, the capital protection depends on that the issuing company or bank is able to fulfil its agreements at the end of the life of the product. If the bank is in bankruptcy, the investor will get hurt. Fortunately it is highly unusual that big banks file for bankruptcy and that makes structured products with a capital guarantee a low risk investment.

Options

An option is just what is says, a possibility but an obligation to do something. The buyer of an option has the option of doing something, or not. What the “something” is depends on what the underlying instrument is. It could be a stock, a bond, a commodity or an index. Options belong to the Derivatives family. They have no value of their own, but instead their value is derived from the movement of the underlying security. To trade options is actually to trade probabilities. The probability that the underlying security will reach a certain level within a certain time.

With options is it easy to increase or decrease the risk in a portfolio. It is possible to generate positive returns in a flat market or even in a falling market, by using options. Option can also be used to leverage a portfolio with limited committed capital. An example, the Volvo share trades at 100 SEK and a call option with a strike at 90 SEK cost 10 SEK. If the investor expects Volvo to rise, she can choose between buying the stock and buying a call option on Volvo. If Volvo rise to 110, the investor would have gained 10/100= 10% owning the stock. With Volvo trading now at 110, the price of the option is 20 SEK. Using the option to gain exposure to Volvo would have given a return of 10/10= 100%.

ETF, Open end Certificates, etc

This family of products are the latest innovation within financial products, and it’s a kind of “back to basics” products that fast gains in popularity. These products are traded on the world’s exchanges which often give them a satisfying liquidity. An ETF is much like a future. There is no asymmetric optionality. Just like a future the ETF or Certificate are linked to an underlying security.  The link can be straight 1:1 i.e. the investor who own an ETF on Nasdaq 100 index is getting a return mirroring that index. Some ETF could also be geared 1:2 or 1:4, in which case the investor gets double or quadruple the development of the underlying security. Other ETF could give the revere of the underlying, i.e. buying a reverse, or short, EFF on Nasdaq 100 index will give the investor the opposite of the index development. This is useful when the stock market is falling as a -10% move in the index will give the investor +10%.

ETF have given private investors access to markets otherwise reserved for professionals, like the Stock index market, Commodity market and Fixed income spread market. The yearly cost of holding an EFT is normally between 0,5%-1.0% per year.