STRATHMORE UNIVERSITY

STRATHMORE INSTITUTE OF MATHEMATICAL

SCIENCE (SIMS)

FINANCIAL ECONOMICS (BBS FE)

2ND YEAR 2ND SEMESTER

FINANCIAL MATHEMATICS 2

GROUP ASSIGNMENT

INVESTMENT PRODUCTS

DONE BY:
MWANGI RUTH MUTHONI
AKUNGA ELIZABETH JANE
KIBOGY BRIAN KIBET
MUGAMBI LINCOLN MUNENE
SANG STACEY JEBET
 CERTIFICATE OF DEPOSIT (CD)

It is a short-term time deposit issued by banks and credit unions. It is a certificate stating that
some money has been deposited. The degree of security and marketability will depend on the
issuing bank. A CD is especially beneficial for a risk-averse investor who is looking to save
and will not need funds until the instrument reaches maturity.

Types of CDs

1. Liquid/”no penalty” CDs: Liquid CDs allow you to pull your funds out at any time
without paying an early withdrawal penalty. This flexibility allows you to move your
funds to a higher paying CD if the opportunity arises.
2. Bump-up CDs: You get to keep your existing CD account and switch to a new, higher
rate.
3. Step-up CDs: These come with regularly scheduled interest rate increases so you're
not locked into the rate that was in place at the time you bought your CD.
4. Brokered CDs: Sold in brokerage accounts. You can buy brokered CDs from
numerous banks and keep them all in one place instead of opening an account at a
bank and using their selection of CDs. This gives you some ability to pick and choose.
5. Jumbo CDs: They have a very high minimum balance requirement.

Characteristics

1. Short-term (the range is 28 days to 6 months).

2. Interest is payable on maturity.
3. Investors can redeem bank-issued CDs prior to maturity. However, you will typically
be charged an early withdrawal penalty. These penalties are set by each bank and
differ nationwide.
4. The investment is locked in at a specific rate, even if interest rates increase.
5. Risk free. It is insured “money in the bank.”
6. There is an active secondary market in certificates of deposit.
7. Technically earn much higher interest than money in a normal savings account.
 CONVERTIBLE PREFERENCE SHARES

Convertible preferred stock is a type of preferred stock that gives holders the option to
convert their preferred shares into a fixed number of common shares after a specified date.

Preferred stock, unlike common stock, is typically given to investors in young companies,
and the company and the investors negotiate the terms. Venture capitalists typically receive
convertible preferred stock when they invest in a start-up.

For example, say a company issues convertible preferred shares to an investor that have a par
value of $100 each, pay a 5 percent dividend annually, and have a conversion ratio of 6.  The
worst that investors in this issue can do is get the 5 percent dividend, which comes out to $5
per year for every share they own.

However, if the common stock prices are rising, the investors can do even better. They can
exchange their convertible shares for common shares and get six common shares for every
share of convertible preferred they own, based on the conversion ratio.  

For the investor to make money on this exchange, the common shares must be trading at a
price greater than the purchase price of a share of the preferred common stock divided by the
conversion ratio. In this example, the common stock would have to be trading higher than
$100/6, which equals $16.67 per share, for the conversion to be profitable.

Risk and return

There is a slightly higher risk that a company may default on preferred stocks, especially if
the company has poor credit and the price of preferred stock may drop when interest rates
rise.  On the other hand, the price may rise when interest rates fall.

Advantages to investors

1. Preferred stockholders receive a fixed, guaranteed dividend payment. Common

shareholders have no guarantee that they will receive dividends. However, if the
earnings of a company increase, the company may choose to raise the dividends that it
pays on common stock. Meanwhile, the preferred stockholders still get the same fixed
rate.
2. In time, the dividend rate paid on common stocks may surpass the rate paid to
preferred shareholders. In that case, the ability to convert their shares to common
 shares is an advantage. It lets the preferred stockholders share in the company’s
increased earnings.
3. With convertible preferred stocks, investors can enjoy the bond-like stability of
preferred stocks for a period of time. Then, if the company is doing well, investors in
convertible preferred stocks can convert their stocks to common stocks and gain the
benefit of the stock appreciation.
4. If the company does poorly, convertible preferred stockholders do not have to convert
their shares to common stocks. They can keep their convertible stocks. Then, if the
company goes bankrupt, they will be paid from whatever assets remain before
common shareholders get a chance. So, they have the chance to gain from a
company’s success while still maintaining some protection from a company’s failure.

Disadvantages to investors

1. When convertible preferred stockholders convert their stock to common stock, they
get to share in the company’s growth. However, that advantage comes with
disadvantages, because the investor will lose the advantages that preferred stocks have
over common stocks – priority in getting paid dividends, priority in asset distributions
if a company goes bankrupt, a guaranteed, fixed-rate, and generally higher dividend.
2. Also, before conversion, convertible preferred stockholders may receive a lower
dividend rate than other preferred stockholders. This is because the convertible
holders have received something of value, their ability to convert their stocks.  To
compensate, the dividend rate may be lowered.

Advantage to startups of convertible preferred stock

1. When companies issue preferred stock, they become obligated to pay dividends for as
long as the company exists.  However, if a convertible preferred shareholders converts
to common stock, then the company’s obligation comes to an end.  This is because
companies have no obligation to ever pay dividends to common stock holders.
2. Some agreements allow companies to force investors to convert their shares.

Disadvantage to startups of convertible preferred stock

1. When convertible preferred stockholders choose to convert their stocks to common

stocks, the stocks they receive are newly issued. This increases the total number of
common shares. Because the number of common shares increases while the value of
 the company remains the same, the value of existing shares goes down. In other
words, the new common shares dilute the value of all the common shares, which
drives down the share price.
2. Companies will sometimes offer to buy back the converted shares to prevent dilution.

When to convert

Holders of convertible preferred stock have the right, but not the obligation to convert their
shares into common stock shares. Venture capitalists who hold this type of stock will
typically convert on two occasions, after the company makes an initial public offering (IPO)
or after the company is acquired by another company.

DEBENTURES

Debentures are a debt instrument used by companies and government to issue a loan. The loan
is issued to corporates based on their reputation at a fixed rate of interest. Since debentures
have no collateral backing, debentures must rely on the creditworthiness and reputation of the
issuer for support.

Example

APPLE INC, DL-NOTES 2017(17/27) with fixed interest at 3% , Moody rating AA1,
starting date 12/20/2017, end date 6/19/2027

Types of debentures

Convertible debentures

 They are bonds that can convert into equity shares of the issuing corporation after a
specific period.
 Convertible debentures are hybrid financial products with the benefits of both debt
and equity.
 Companies use debentures as fixed-rate loans and pay fixed interest payments.
However, the holders of the debenture have the option of holding the loan until
maturity and receive the interest payments or convert the loan into equity shares.
 Convertible debentures are attractive to investors that want to convert to equity if they
believe the company's stock will rise in the long term. However, the ability to convert
 to equity comes at a price since convertible debentures pay a lower interest rate
compared to other fixed-rate investments.

Non- convertible debentures

 They are traditional debentures that cannot be converted into equity of the issuing
corporation.
 To compensate for the lack of convertibility investors are rewarded with a higher
interest rate when compared to convertible debentures.

Credit Rating

The company's credit rating and ultimately the debenture's credit rating impacts the interest
rate that investors will receive. Credit-rating agencies measure the creditworthiness of
corporate and government issues. These entities provide investors with an overview of the
risks involved in investing in debt.

Credit rating agencies, such as Standard and Poor's, typically assign letter grades indicating
the underlying creditworthiness. The Standard & Poor’s system uses a scale that ranges from
AAA for excellent rating to the lowest rating of C and D. Any debt instrument receiving a
rating of lower than a BB is said to be of speculative-grade or junk bonds. It boils down to the
underlying issuer being more likely to default on the debt.

Characteristics of debentures

1. Debenture holders may face inflationary risk. Here, the risk is that the debt's interest
rate paid may not keep up with the rate of inflation. As an example, say inflation
causes prices to increase by 3%, should the debenture coupon pay at 2%, the holders
may see a net loss, in real terms.
2. Debentures also carry interest rate risk. In this risk scenario, investors hold fixed-rate
debts during times of rising market interest rates. These investors may find their debt
returning less than what is available from other investments paying the current,
higher, market rate. If this happens, the debenture holder earns a lower yield in
comparison.
3. They may carry credit risk and default risk. As stated earlier, debentures are only as
secure as the underlying issuer's financial strength. If the company struggles
 financially due to internal or macroeconomic factors, investors are at risk of default
on the debenture.
4. Debenture holder would be repaid before common stock shareholders in the event of
bankruptcy.

CONVERTIBLE UNSECURED LOAN STOCK

An irredeemable convertible unsecured loan stock (ICULS) is a hybrid security that has some
qualities of a debt instrument and some characteristics of an equity warrant.

Example

 Advance Synergy Berhad issued a 10-year Irredeemable Convertible Unsecured

Loan Stocks with interest coupon at 2%. The issue date was 31 Jan 2008 and the
maturity date was set at 26 Jan 2018 (~10 years).

Characteristics

1. Pays a fixed interest like a bond and the payments are made at a predetermined rate.
2. The ICULS can be converted to equities at a ratio known as the conversion ratio at
any time up to the expiration date. Some ICULS's require a mandatory conversion
when they mature. On this date, conversion is done automatically, regardless of
whether the holder of the security surrenders them or not.
3. The loan given to an ICULS issuer is not secured by collateral. The investors
therefore suffer from default risk.
4. Since they are unsecured and can't be cashed in, ICULS are ranked low on the
hierarchy of claims and are subordinate to all other debt obligations of the company.
5. Provide higher income than ordinary shares and lower income than conventional loan
stock or preference shares.
6. Low price volatility.
 DERIVATIVES

It is a financial contract that derives its value from an underlying asset.

Present day forwards, futures, options and interest rate swaps are a product of ancient
business practices. Derivatives can also be divided into interest rate derivatives, currency
derivatives, credit derivatives, equity derivatives and commodity derivatives.

A. Forward contract

A forward contract obliges its purchaser to buy a given amount of a specified asset at some
stated time in the future at the forward price which the seller is also obliged to deliver.

Characteristics of forward contracts

1. They are over-the-counter (OTC) contracts therefore they are not traded on
exchanges. Due to this nature they are privately negotiated between two parties.
2. No cashflows are involved therefore there is risk of default for both counterparties
because there is a possibility that one of the parties will not fulfill its obligation.
3. Credit risk also presents itself because the counterpart may not deliver the asset to you
at the time of delivery.
4. The profit or loss from a forward contract depends on the difference between the
forward price and the spot price of the asset when the forward contract matures.
5. Forward contracts are settled only at maturity.
6. Non-delivery forwards (NDF) are settled at maturity and no delivery of primary assets
is assumed.

Examples

 The Athenians used shipping contracts that stipulated pricing, commodity type,

volume and time considerations.
 If you plan to grow four acres of cabbages next year, you could sell your cabbages
for whatever the price is when you harvest it, or you could lock in a price now by
selling a forward contract that obligates you to sell the four acres of cabbages to, say,
Foodplus after the harvest for a fixed price. By locking in the price now, you
eliminate the risk of falling cabbage prices. On the other hand, if prices rise later,
you will get only what your contract entitles you to.
  If you are Foodplus, you might want to purchase a forward contract to lock in prices
and control your costs. However, you might end up overpaying or (hopefully)
underpaying for the cabbages depending on the market price when you take delivery
of the cabbages.
 In Poland forward contracts are nonstandardized transactions that call for the
exchange of some quantity of a foreign currency at a future date.

B. Futures contract

A futures contract is a legal agreement to buy or sell a particular commodity or asset at a

predetermined price at a specified time in the future.

Characteristics of futures contract

1. Futures contracts are standardized for quality and quantity to facilitate trading on
a futures exchange which acts as mediator and facilitator between the parties.
2. The buyer (long) of a futures contract is taking on the obligation to buy the underlying
asset when the futures contract expires.
3. The seller (short) of the futures contract is taking on the obligation to provide the
underlying asset at the expiration date. 
4. In the beginning both the parties are required by the exchange to put beforehand a
nominal account as part of contract known as the margin.

Types of futures

 Futures on commodities (grains, metals, food),

 Futures on currencies
 Futures on interest bearing instruments (Eurodollar deposits, treasury bonds, notes
and bills)
 Futures on stocks
 Futures on stock indexes

Future prices are not constant but they change daily therefore the difference in price is settled
on a daily basis from the margin. If the margin is used up, the contractee has to replenish the
margin back in the account in a process called marking to market. Consequently on the day of
delivery it is only the spot price that is used to decide the difference as all other differences
had been previously settled.

Riskiness of future contracts

i. Interest rate risk

It refers to changes in the value of the investment due to a change in the absolute level of
interest rates. A rise in interest rates during the investment period may result in reduced
prices of the held securities.

ii. Liquidity risk

Level of liquidity in a contract affects the decision to trade or not. There may not be enough
opposite interest in the market at the right price to initiate a trade and when trade is executed,
there is always a risk that it can become difficult or costly to exit from positions in illiquid
contracts

iii. Settlement and delivery risk

Daily settlement takes the form of automatic debits and credits between accounts with any
shortfalls being recovered through margin calls. Brokers are obligated to fulfill all margin
calls. Use of electronic systems with online banking has reduced the risks of failed daily
settlements. However, non-payment of margin calls by clients poses a serious risk for
brokers.

Similarly, the risk of non-delivery occurs for physically delivered contracts. Brokers need to
ensure that they allow only those clients access to trade deliverable contracts till maturity
who have the capacity and ability to make good on delivery obligations.

iv. Leverage

Lack of respect for leverage and the risks associated with it is often the most common cause
for losses in futures trading. Exchange sets margins at levels which are deemed appropriate
for managing risks at clearinghouse level however traders can take large exposures with little
upfront cost.
Examples of futures contracts

 In the ancient times  The Sumerians used clay tokens stored in a clay vessel, and later
clay writing tablets, to represent commodities, recording delivery dates for goods
being traded. 
 Companies may use futures contracts to hedge their exposure to certain types of risk.
For example, an oil production company may use futures to manage risk associated
with fluctuations in the price of crude oil.

C. Options

Options are traded on exchanges and OTC market. An option is a derivative security that
gives the buyer (holder) the right, but not the obligation, to buy or sell a specified quantity of
a specified asset within a specified time period at the exercise price. An option contract
differs from the futures contract in that the option contract gives the buyer the right, but not
the obligation, to purchase or sell a security at a later date at a specified price.

One way of creating options is through single contracts that are individually negotiated
between parties, usually firms and their banks (OTC options). Organized option exchanges
provide the advantages of liquidity, low transaction costs, and safety through the
standardization of the assets on which the contracts are based and of the contract sizes and
maturity dates.

Types of options

1. European: Gives owner the right to exercise the option only on the expiration date.
2. American: Gives owner the right to exercise the option on or before the expiration
date.

Application

i. Real estate option contract

A real estate purchase option is a contract on a specific piece of real estate that allows the
buyer the exclusive right to purchase the property.

Once a buyer has an option to buy a property, the seller cannot sell the property to anyone
else. The buyer pays for the option to make this real estate purchase. The option usually
includes a predetermined purchase price and is valid for a specified term such as six months
to a year. However, the buyer does not have to buy the property, whereas the seller is
obligated to sell to the buyer within the terms of the contract.

Options have to be bought at an agreed-upon price. If the buyer doesn’t buy within the time
frame, the seller keeps the money used to buy the option.

Advantages for the buyer

1. A real estate purchase option can be great for buyers. For example, if you want to buy
a lot of land to build a new home, a purchase option can be used to keep the lot
available for a certain amount of time, until you have funding.
2. The landowner cannot sell the plot to anybody else during the term of the option. At
the end of the term, the landowner must sell the land at the price agreed upon, even if
property values have risen in the interim.
3. Investors can use real estate options to secure high-profit investments at relatively low
risk.
4. An investor notes that a specific plot of land is in a prime location for further
development such as subdivisions or a shopping plaza. Instead of purchasing the land
outright and then selling it to developers, the investor purchases exclusive rights to the
land through an option. With the option in place, he approaches investors and
developers, offering them the land at a much higher price than his locked-in option
purchase price. Once his higher offer is accepted, he either sells the option itself for
the purchase price or purchases the land and then flips it to the developer, pocketing
the difference.

Riskiness of an option

1. As an options holder, you risk the entire amount of the premium you pay.
2. As an options writer, you take on a much higher level of risk. For example, if you
write an uncovered call, you face unlimited potential loss, since there is no cap on
how high a stock price can rise.
 D. Swaps

A swap is a derivative contract through which two parties exchange the cash flows or

liabilities from two different financial instruments. Most swaps involve cash flows based on
a notional principal amount such as a loan or bond, although the instrument can be almost
anything. Usually, the principal does not change hands. Each cash flow comprises one leg of
the swap. One cash flow is generally fixed, while the other is variable and based on a
benchmark interest rate, floating currency exchange rate or index price.

Swaps are considered to be interest rate risk management tools because they give an efficient
means of adjusting the interest rate exposure of a company’s assets and liabilities. Swaps are
long-term OTC instruments. A great flexibility in setting the terms of the swap agreement
makes it a very effective instrument in risk management.

Examples of swaps

1. Corporate finance professionals may use swap contracts to hedge risk and minimize
the uncertainty of certain operations. For example, sometimes projects can be exposed
to exchange rate risk and the Company’s CFO may use a currency swap contract as a
hedging instrument.
2. Companies can use swaps as a tool for accessing previously unavailable markets. For
example, a US company can opt to enter into a currency swap with a British company
to access the more attractive dollar-to-pound exchange rate, because the UK-based
firm can borrow domestically at a lower rate.

Riskiness of swaps

i. Price risk

Arises due to the movement of the underlying index so that the free present value of the
future payments changes. The price risk can be hedged by taking offsetting positions using
related derivative instruments, like interest rate futures, currency futures, etc.

ii. Default risk

Defined to be the exposure to the risk of failure of the other counterparty. Unlike forward
contracts, swaps are over-the-counter contracts so they are not backed by the guarantee of a
clearing house or an exchange. Swap default may be due to early termination of the swaps
contract, or defaulting on some other obligation or filing for bankruptcy. Early termination
may be due to the non-performance of obligations under the swap contract, for example,
defaulting on a swap payment.

PROPERTY

In investment terms, property is a legal title to the use of land and buildings. Return from
investing in property comes from rental income and from capital gains (which may be
realised on sale). Rents and capital values might be expected to increase broadly with
inflation in the long term, which makes the returns from property similar in nature to those
from ordinary shares.

Types of properties

1. Office
2. Industrial properties such as factories and warehouses
3. Shops

Characteristics of property investments

1. Large unit sizes leading to less flexibility than investment in shares. Indivisibility may
prevent smaller investment funds from investing in property, or lead them to invest in
property indirectly – for example, via property company shares.
2. Each property is unique, so can be difficult to value.
3. Valuation is expensive, because of the need to employ an experienced surveyor.
4. Actual value obtainable on sale is uncertain. Values in property markets can fluctuate
just as stock markets can. Property valuation is both subjective and expensive and
therefore the “true” market value of a property may be known only when a sale
occurs. In addition, as sales are infrequent and prices agreed are normally treated with
a degree of confidentiality, it may be difficult to place a certain value upon a
particular property. This difficulty could again reduce the appeal of direct property
investment to certain investors.
5. Buying and selling expenses are higher than for shares and bonds.
6. Net rental income may be reduced by maintenance expenses. For example, the cost of
rent collection and rent review.
7. A property may be void. This means that there may be periods when the property is
unoccupied therefore no income is received.
 8. Poor marketability because each property is unique and because buying and selling
incur high costs.

The running yield on property is the rental income net of all management expenses
divided by the cost of buying the property gross of all purchase expenses. Running yield
from property investment is higher than that of ordinary shares because:
i. Dividends usually increase annually, whereas rents are reviewed less often (rent is
reviewed at specific intervals such as after every 3-year or 5-year period)
ii. Property is much less marketable
iii. Expenses associated with property investment are much higher.
iv. Large, indivisible units of property are much less flexible.
 References
CT1-PC-16
https://www.toppr.com/guides/business-studies/sources-of-business-finance/debentures/

https://www.investopedia.com/terms/d/debenture.asp

https://www.investopedia.com/terms/i/iculs.asp