UNIT 4: FINANCIAL INSTRUMENTS

Aims: Consider the different types of bonds

Consider the use of stocks and shares and the ways of talking about price changes
Discuss different possible investments
Consider the uses and discuss the dangers of derivatives

If you have money to invest, what are the advantages and disadvantages of:
• Putting it under the mattress
• Buying a lottery ticket
• Taking it all to Las Vegas
• Depositing it in a bank
• Buying gold
• Buying a painting (Matisse, Van Gogh,...)
• Investing in property or real estate
• Buying bonds
• Buying stocks or shares
• Investing in a hedge fund

I. READING:
READING 1:
FINANCIAL SECURITIES:
Financial assets include securities (stocks and bonds), derivative contracts, and currencies. Real
assets include real estate, equipment, commodities, and other physical assets.
Financial securities can be classified as debt or equity. Debt securities are promises to repay
borrowed funds. Equity securities represent ownership positions.
Public (publicly traded) securities are traded on exchanges or through securities dealers and are
subject to regulatory oversight. Securities that are not traded in public markets are referred to as
private securities. Private securities are often illiquid and not subject to regulation.

Derivative contracts have values that depend on (are derived from) the values of other assets.
Financial derivative contracts are based on equities, equity indexes, debt, debt indexed, or other
financial contracts. Physical derivative contracts derive their values from the values of physical
assets such as gold, oil, and wheat.

Securities:
Securities can be classified as fixed income or equity securities, and individual securities can be
combined in pooled investment vehicles. Corporation and governments are the most common
issuers of individual securities. The initial sale of a security is called an issue when the security is
sold to the public.
Fixed income securities typically refer to debt securities that are promises to repay borrowed money
in the future. Short-term fixed income securities generally have a maturity of less than one or two
years; long-term maturities are longer than five to ten year, and intermediate term maturity fall in
the middle of the maturity range.
Although the terms are used loosely, bonds are generally long term, whereas notes are intermediate
term, Commercial paper refers to short-term debt issued by firms. Governments issue bills and
banks issue certificate of deposit. In repurchase agreements, the borrower sells a high-quality asset
and has both the right and obligation to repurchase it (at a higher price) in the future. Repurchase
agreements can be for terms as short as one day.
Convertible debt is debt that an investor can exchange for a specified number of equity shares of the
issuing firm.
Equity securities represent ownership in a firm and include common stock, preferred stock, and
warrants.
- Common stock is a residual claim on a firm’s assets. Common stock dividends are paid
only after interest is paid to debt-holders and dividends are paid to preferred stockholders.
 Furthermore, in the event of firm liquidation, debt-holders and preferred stockholders have
priority over common stockholders and are usually paid in full before common stockholders
receive any payment.
- Preferred stock is an equity security with scheduled dividends that typically do not change
over the security’s life and must be paid before any dividends on common stock may be
paid.
- Warrants are similar to options in that they give the holder the right to buy a firm’s equity
shares (usually common stock) at a fixed exercise price prior to the warrants expiration.
Pooled investment vehicles include mutual funds, depositories, and hedge funds. The term refers to
structures that combine the funds of many investors in a portfolio of the investor’s ownership
interests are referred to as shares, units, depository receipts, or limited partnership interests

QUESTIONS:
1. What are the differences between publicly traded securities and private securities?
2. What are fixed income securities? Give example
3. What are the similarities and differences between common stock and preferred stock?
4. What are pooled investment vehicles?

READING 2:
BONDS
Read the text and answer the questions below:
Companies finance most of their activities by way of internally generated cash flows. If they need
to raise more money to expand their operations they can either issue new shares- selling them to
their existing owners or on the stock market (equity finance)- or borrow money (debt finance),
usually by issuing bonds. Companies generally use an investment bank to issue their bonds, and to
find buyers, which are often institutional investors like insurance companies, mutual funds and
pension funds
Bondholders get back their original investment (or “principal”) on a fixed maturity date, and receive
interest payments (the “coupon”) at regular intervals (six-monthly or annually) until then. Most
bonds have fixed interest rates.
For investors, bonds are generally safer than stocks or shares, because if an insolvent or bankrupt
company sells its assets, bondholders are among the creditors who might get some of their money
back. On the other hand, in the medium or long term, shares generally pay a higher return than
bonds. For companies, the advantage of debt financing over equity financing is that bond interest is
tax deductible: companies deduct their interest payments from their profits before paying tax, while
dividends paid to shareholders come from already-taxed profits. But debt increases a company’s
financial risk: bond interest has to be paid, even in a year without any profits to deduct it from, and
the principal has to be repaid when the debt matures, whereas companies are not obliged to pay
dividends or repay share capital.
If tax revenue is insufficient, governments also issue bonds to raise money, and these are considered
to be a risk-free investment. In the US there are Treasury notes (with a maturity of two to ten years)
and Treasury bonds (with a maturity of ten to 30 years), while in Britain government bonds are
known as gilt-edged stock or just gilts.
Bonds are saleable instruments that can be traded on the secondary bond market. Banks and
brokerage companies act as market makers, quoting bid and offer prices for bonds with a very small
spread or difference between them. The price of bonds varies inversely with interest rates. If interest
rate rises, so that new borrowers have to pay a higher rate, existing bonds lose value. If interest rates
fall, existing bonds paying a higher interest rate than the market rate increase in value.
Consequently the yield of a bond- how much income it gives- depends on its purchase price as well
as its coupon.

A. QUESTIONS:
1. What are the two main ways governments can raise money?
2. What are the two main ways established companies can raise money?
 3. What are the advantages and disadvantages of bonds for companies and investors?

B. COMPREHENSION:
Are the following statements true or false?
1. Companies regularly finance their activities by issuing bonds.
2. Bond-issuing companies use investment banks to find investors.
3. Bonds are repaid at 100% when they mature, unless the borrower is insolvent.
4. Bondholders get their money back if a company goes bankrupt
5. Bond coupons are generally lower than share dividends
6. For profitable companies, there are tax advantages to issuing stocks or shares rather than
bonds
7. Governments systematically finance public spending by issuing bonds
8. A bond paying 5% interest would lose in value if interest rates fell to 4%

C. VOCABULARY:
Find words in the text that mean the following:
1. The money a company receives minus the money it spends during a certain period
2. Part ownership of a company in the form of stocks or shares.
3. Funds operated by investment companies that invest people’s money in various assets.
4. Funds that invest money that will be paid to people after they retire from work.
5. The amount of capital making up a bond or other loan
6. The length of time for which a bond is issued (until it is repaid)
7. The amount of interest that a bond pays
8. Unable to pay debts
9. People or institutions to whom money is owed
10. Payments by companies to their shareholders
11. Businesses that buy and sell securities
12. The price at which a buyer is prepared to buy a security at a particular time.
13. The price at which a seller is prepared to sell a security at a particular time.
14. The rate of income an investor receives from a security

D. Match up the verbs on the left with the nouns on the right to make common verb-noun
combinations found in the text. Some of the verbs and nouns are used more than once

Borrow raise (a rate of) interest interest payments

Deduct receive a return money
Finance repay activities principal
Issue sell assets shares
Pay bonds tax
dividends

READING 3:
A. Stocks, shares and equities:
Stocks and shares are certificates representing part ownership of a company. The people who own
them are called stockholders and shareholders. In Britain, stock is also used to refer to all kinds of
securities, including government bonds. The word equity or equities is also used to describe stocks
and shares. The places where the stocks and shares of listed or quoted companies are bought and
sold are called stock markets or stock exchanges
BrE: ordinary shares, AmE: common stocks

B. Ordinary and preference shares:

If a company has only one type of share these are ordinary shares. Some companies also have
preference shares whose holders receive a fixed dividend (e.g. 5% of the shares nominal value) that
must be paid before holders of ordinary shares receive a dividend. Holders of preference shares
have more chances of getting some of their capital back if a company goes bankrupt- stops trading
because it is unable to pay its debts. If the company goes into liquidation- has to sell all its assets
to repay part of its debts- holders of preference shares are repaid before other shareholders, but after
owners of bonds and other debts. If shareholders expect a company to grow, however, they
generally prefer ordinary shares to preference shares, because the dividend is likely to increase over
time

II. EXERCISE:

1. Discussion:
A. Have you ever speculated in anything? What happened?
B. Do you think that it’s always dangerous to speculate in stocks and shares?
C. There were two big stock market crashes in the twentieth century. Do you know when?
D. Do you know why and how companies issue shares?
E. Do you possess any shares? Why did you buy them? How did you buy them?

2. You are going to read about share prices. Before you read, check your understanding
of the words and phrases in the box by matching them with their definitions (1-10):

Bankruptcy Bubble Collateral Institutional investor Raise capital

Bears Bulls Issue Day traders shares

1. A name for investors who buy shares because they expect their price to rise.
2. A name for shareholders who sell because they expect the price to fall
3. A period of rapidly rising share prices, followed by a quick collapse
4. Assets a borrower uses to secure or guarantee a loan
5. Certificates representing part-ownership of a company
6. Financial organizations that own a lot of shares
7. People who buy and re-sell shares in a very short time, often just a few hours
8. To get money from investors with which to run a business
9. To offer securities for sale, to financial institutions and the public
10. When you have no money to pay your debts, so you have to sell your assets.

3. Match up the half-sentences below, which make up a text about stocks and shares:

1. Successful companies can issue stocks or shares (certificates representing part ownership of
the company)
2. Offering these stocks for sale to financial institutions and the general public changes the
business
3. Selling stocks for the first time is called an IPO or initial public offering in the US
4. Companies use an investment bank to find buyers, and to underwrite the stock issue,
5. Stocks and shares are also known as equity or equities; the most common form
6. After shares have been issued they can be traded on the secondary market at
7. Some stock exchanges have automatic computerized trading systems that match up buyers
and sellers, others have market makers-
8. Stock prices rise and fall depending on supply and demand,
9. Consequently the nominal value of a share- the price written on it- is rarely the same as its
market price-
10. Companies either distribute part of their profits to shareholders as an annual dividend
11. Stock markets are measured by stock indexes (or indices),
12. A period during which most stocks (and the stock index) are rising is called a bull market,

A. and a flotation or an IPO in Britain

 B. and on in which most of them fall in value is a bear market.
C. The stock exchange on which the company is listed or quoted.
D. From a private to a public company, and is called going public.
E. i.e how many sellers and buyers there are.
F. i.e. to guarantee to buy the stocks if there are not enough other buyers
G. is called common stock in the US, and ordinary shares in Britain.
H. Or keep the profits in the company, which also causes the value of the stocks to rise
I. The price it is currently being traded at on the stock exchange.
J. To raise capital to expand their operations.
K. Traders I stocks who quote bid (buying) and offer (selling) prices
L. Which show changes in the average prices of a selected group of important stocks.

4. Write “up” or “down” next to each sentences which talk about share prices:

A. Share prices rocketed

B. Share prices slumped
C. Share prices recovered
D. Share prices hit a new peak
E. Share prices soared
F. Share prices dropped dramatically
G. Share prices ballooned
H. Share prices crashed
I. There was a sizeable drop in share prices

5. DERIVATIVES:
Lead-in: What are the main types of derivatives?
What are they used for?

Before reading about derivatives, match up the half-sentences below which define some basic
terms.
1. Derivatives are financial instruments whose prices are dependent upon, or derived from,
2. A future is a contract agreement to buy or sell a security, commodity or financial instrument
3. An option offers the buyer the right, but not the obligation,
4. Commodities are raw materials or primary products such as
5. Hedging means making contracts to buy or sell commodities or financial assets
6. Speculation, on the contrary, means buying assets in the hope of making a capital gain
7. An interest rate swap is an agreement to exchange future interest payments
8. A currency swap is an agreement between two parties who exchange principal and fixed
rate interest payments

A. at a predetermined price, at a predetermined point in the future

B. by selling them later at a higher price )or selling them in the hope of buying them back at a
lower price)
C. In the future, at a pre-arranged price, as a protection against price changes.
D. Metals, cereals, coffee, etc., that are traded on special markets.
E. To buy (call option) or sell (put option) an asset at an agreed-upon price (the strike price),
either during a certain period of time, or on a specific date.
F. Underlying assets such as stocks, bonds, commodities, currencies, interest rates and market
indices
G. On a loan in one currency for principal and fixed rate interest payments on an equal loan in
another currency
H. With another company or financial institution, e.g. a floating rate loan for a fixed interest
rate loan
 III. LISTENING:
1. Bonds and subprime mortgages:
Listen to Teresa La Thangue of the Financial Services Authority in London talking about how
subprime mortgages affected bonds in the US. Answer these questions. (Listening 2.2)
1. What terms does Teresa La Thangue use to describe totally safe government bonds?
2. Why were mortgage-backed securities traditionally considered to be very safe?
3. How does she explain the term “subprime”?
4. What happened to mortgage-backed bonds in the US?
5. What did the credit rating agencies do wrong?
6. What has been the consequence of this?

2. Hedge funds:
Listen to Teresa La Thangue of the Financial Services Authority, which regulates the
financial industry in Britain, talking about hedge funds and structured products, and answer
the questions. (Listening 2.4)
1. Why can’t individuals (retail investors) invest in hedge funds in Britain?
2. In what way have hedge funds changed since they began?
3. What are the five forms of investment that Teresa La Thangue mentions in relation to hedge
funds?
4. Retail investors can buy structured products from banks. What constraint must banks obey
when developing these products?

IV. READING COMPREHENSION AND TRANSLATE INTO VIETNAMESE

READING 1:
FUTURES:
A. Commodity futures:
Forward and futures contracts are agreements to sell an asset at a fixed price on a fixed date in the
future. Futures are traded on a wide range of agricultural products (including wheat, maize,
soybeans, pork, beef, sugar, tea,...) industrial metals (aluminium, copper, lead,..), precious metals
(gold, silvers,..) and oil. These products are known as commodities. Futures were invented to enable
regular buyers and sellers of commodities to protect themselves against losses or to hedge against
future changes in the prices.

READING 2:
Hedge funds are private investment funds for wealthy investors that trade in securities and
derivatives, and try to get high returns whether markets move up or down. Read the following
extract from Geraint Anderson’s book Cityboy, which explains one of the major strategies of
hedge duns, and answer the questions:
HEDGE FUNDS:
The rise of hedge funds began in earnest around 2001. By then stock markets had been in decline
for around a year after the bursting of the tech bubble. With no eand to be bear market in sight
investors wanted to make returns that were not geared to the performance of the stock market. They
wished to make an absolute return even if stock markets fell. They demanded what Cityboys, in
their never-ending mission to confuse the general public, like to call “alpha” not “beta”. Hence,
hedge funds became increasingly popular since, unlike conventional “long-only” funds, they can
“short” shares. That is to say, they can sell shares they don't own by borrowing them off a
conventional fund so that when the share price falls they make a profit by buying them back at a
cheaper price, As the bear market continued cash began pouring into these funds.
As these hedge funds multiplied and grew, investment banks had no choice but to prioritize them
relative to their old, traditional long-only clients because some of these crazy guys really like
trading shares. Whilst your typical pension funds might, on average, hold on to a share for a year or
more I’ve seen certain hedge funds buy in the morning and sell in the afternoon. Hell, I’ve seen buy
and sell orders in the same stock within an hour! On certain days, one of the biggest hedge funds,
GLG, has been said to be behind five percent of all trades in the FTSE 100.
[Vocabulary note: Alpha: A risk-adjusted measure of active return on an investment; Beta: A
measure of the elasticity or relative volatility of a security]
Questions:
1. What does the bursting of the tech bubble mean?
2. Anderson calls the people working in the financial industry “Cityboys”. What implied
meanings does this word convey?
3. What is Anderson implying by their never ending mission to confuse the general public?
4. Explain in your own words how hedge funds make more money by shorting shares?
5. Why did investment banks have no choice but to prioritize hedge funds?

READING 3:
BONDS:
A. Government and corporate bonds:
Bonds are loans to local and national governments and to large companies. The holders of bongs
generally receive fixed interest payments, once or twice a year, and get their money- known as the
principal- back on a given maturity date. This is the date when the loans ends.
Governments issue bonds to raise money and they are considered to be a risk-free investment. In
Britain, government bonds are known as gilt-edged stock or just gilts. In the US they are called
Treasury notes, which have a maturity of 2-10 years, and Treasury bonds, which have a maturity of
10-30 years.
Companies issue bonds, called corporate bonds, because they can usually pay less interest to
bondholders than they would have to pay if they raised the same money by a bank loan.

B. Prices and yields:

Bonds are traded by banks which act as market makers for their customers, quoting bid and offer
prices with a very small spread or difference between them. The price of bonds varies inversely
with interest rate, existing bonds lose value. If interest rates fall, existing bongs paying a higher
interest rate than the market rate increase in value. Consequently the yield of a bond- how much
income it gives- depends on its purchase price as well as its coupon, or interest rate. There are also
floating-rate notes- bonds whose interest rate varies with market interest rates.

C. Other types of bonds:

When interest rates are high, some companies issue convertible shares or convertibles, which are
bonds that the owner can later change into shares. Convertibles pay lower interest rates than
ordinary bongs, because the buyer gets the chance of making a profit with the convertible option.
There are also zero coupon bonds that pay no interest but are sold at a big discount on their par
value, which is 100%, and repaid at 100% at maturity. Because they pay no interest, their owners
don’t receive money every year, instead they make a capital gain at maturity
Bonds with a low credit rating (and a high chance of default), but paying a high interest rate, are
called junk bonds. Some of these are known as fallen angels- bonds of companies that were
previously in a good financial situation, while others are issued to finance leveraged buyouts.

1. Match the words in the box with the definitions below.

Coupon Maturity date Credit rating Gilt-edged stock Treasury bonds
Default Insolvent Treasury notes Principal yield
1. The amount of capital making up a loan
2. An estimation of a borrower’s solvency or ability to pay debts
3. Bonds issued by the British government
4. Non-payment of interest or a loan at the scheduled time
5. The day when a bond has to be repaid
6. Long-term bonds issued by the American government
7. The amount of interest that a bond pays
8. Medium-term (2-10 years) bonds issued by the American government
 9. The rate of income an investor receives from a security
10. Unable to pay debts

2. Are the following statements true or false? Find reasons for your answers in A,B, and
C opposite
1. Bonds are repaid at 100% when they mature, unless the borrower is insolvent.
2. Bondholders are guaranteed to get all their money back if a company goes bankrupt.
3. AAA bonds are a very safe investment
4. A bond paying 5% interest would gain in value if interest rates rose to 6%
5. The price of floating-rate notes does’nt vary very much, because they always pay market
interest rates.
6. The owners of convertibles have to change them into shares
7. Some bonds do not pay interest, but are repaid at above their selling price.
8. Junk bonds have a high credit rating, and a relatively low change of default.

TERMINOLOGY:
Vocab Meaning
Bull
Common Stock
Corporate Bonds
Credit Rating
Currency Swap
Debt Securities
Default
Derivative
Equity Securities
Forward
Futures
Government Bonds
Hedge Fund
Individual/ Retail Investor
Insolvent
Institutional Investor
Interest Rate Swap
Liquidity
Maturity Date
Mutual Fund
Options
Pooled Investment Vehicles
Preferred Stock
Speculate
Swap
Warrants
Yield