Financial Instruments for Projects and Trading


Financial Instruments

As professional financial experts, we specialize in designing, structuring, and issuing a diverse range of financial instruments through our affiliated entities to address the unique challenges and preferences of our esteemed clients.

These instruments facilitate the seamless flow and transfer of capital globally, fostering economic growth and development. They can also serve as a means of securing financing for various projects, ensuring the successful completion of ventures across industries.

Financial instruments can encompass a wide array of assets, including cash, contractual rights to deliver or receive cash or other financial instruments, or evidence of ownership in an entity. They may take the form of tangible or intangible documents, embodying legal agreements with inherent monetary value. These instruments can generally be classified into equity-based or debt-based categories.

  1. Equity-based financial instruments: These instruments signify ownership interests in a particular asset, enabling investors to participate in the growth and profitability of the underlying entity.
  2. Debt-based financial instruments: These instruments represent loans extended by investors to the asset owners, entitling them to interest payments and principal repayment as specified in the lending agreement.


In addition to these primary categories, our offerings encompass foreign exchange instruments, which facilitate currency conversions and international transactions, as well as various other specialized instruments, such as:

  1. Bank Guarantees (BG): These instruments serve as a guarantee from a bank, ensuring the fulfillment of a debtor's obligations to a creditor in the event of non-payment or default.
  2. Standby Letters of Credit (SBLC): These instruments function as a secondary payment method, offering a financial safety net for transactions between parties.
  3. Notes, including Medium Term Notes (MTNs): These debt instruments have a fixed maturity period, providing borrowers with a source of financing and investors with a predictable income stream.
  4. Or any creative combination of those and with a multitude of underlyings (including exotic underlyings).

 


Our expertise lies in tailoring these financial instruments to meet the diverse needs of our clients, ensuring they achieve their financial objectives and contribute to the global flow of capital.

Decision Tree

  • High credit quality firms opt for public bond offerings.
  • Small, creditworthy firms lean towards traditional private debt issuing.
  • Moderate credit quality firms use bank loans extensively.
  • Poor credit quality firms preferentially issue debt according to Rule 144A or Regulation S in the USA and in Europe have to comply with MiFID II requirements for management functions and MiFIR regulating the operation of trading venues and structures.

Cash Instruments 

  • The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable.
  • Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.


Derivative Instruments 

  • The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
  • An equity options contract, for example, is a derivative because it derives its value from the underlying stock. The option gives the right, but not the obligation, to buy or sell the stock at a specified price and by a certain date. As the price of the stock rises and falls, so too does the value of the option although not necessarily by the same percentage.
  • There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a market or process whereby securities–that are not listed on formal exchanges–are priced and traded.


Types of Asset Classes of Financial Instruments

Financial instruments can be categorized based on their asset class, which is typically determined by whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Debt-based financial instruments can be further classified into short-term and long-term instruments.

  1. Short-term debt-based financial instruments: These instruments have a maturity of one year or less and include securities such as Treasury bills (T-bills) and commercial paper. Cash equivalents in this category encompass deposits and certificates of deposit (CDs). Exchange-traded derivatives include short-term interest rate futures, while over-the-counter (OTC) derivatives feature forward rate agreements.
  2. Long-term debt-based financial instruments: These instruments have a maturity of more than one year. Securities in this category consist of bonds, while cash equivalents include loans. Exchange-traded derivatives comprise bond futures and options on bond futures. OTC derivatives encompass interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives.

Equity-Based Financial Instruments

Equity-based financial instruments involve ownership stakes in assets. Securities in this category include stocks. Exchange-traded derivatives consist of stock options and equity futures. OTC derivatives feature stock options and exotic derivatives.

Special Considerations: Foreign Exchange Instruments

Foreign exchange instruments warrant special attention as they do not have securities. Cash equivalents in this category are represented by spot foreign exchange, reflecting the current prevailing rate. Exchange-traded derivatives include currency futures, while OTC derivatives consist of foreign exchange options, outright forwards, and foreign exchange swaps.

Margins of Bank MTNs

A Bank-MTN (bank medium-term note) is a debt instrument that is issued by a bank and backed by its assets, such as loans, mortgages, or securities. A Bank-MtN typically matures in 2 to 5 years and pays a fixed or variable interest rate to investors. A Bank-MTN issue is usually arranged by the issuing bank itself or by another bank that acts as a dealer or an underwriter for the issuer. The bank that arranges the Bank-MTN issue charges a margin or a fee for its services, which is deducted from the proceeds of the Bank-Mtn issue. The margin is usually expressed as a percentage of the face value or the principal amount of the Bank-MTN.

Primary Market

The margin for a new Bank-MTN issue in the primary market depends on various factors, such as the credit rating of the issuing bank, the maturity and currency of the Bank-MTN, the market conditions and demand for the Bank-MtN, and the negotiation between the issuer and the arranger. The margin may also vary depending on whether the Bank-MTN issue is underwritten or placed by the arranger. Underwriting means that the arranger guarantees to buy all or a portion of the Bank-MTN issue from the issuer and then sell it to investors at a higher price. Placing means that the arranger acts as an agent for the issuer and tries to find investors who are willing to buy the Bank-MTN issue at a specified price. Underwriting involves more risk for the arranger, so they usually charge a higher margin than placing.

To illustrate how margins are calculated by banks, let us look at an example of a new Bank-MTN issue by Deutsche Bank, one of the largest banks in Germany and Europe. According to its annual report, Deutsche Bank issued EUR 12 billion worth of Bank-Mtns in 2022, with maturities ranging from 2 to 5 years and interest rates ranging from 0.25% to 1.75%. Assuming that these Bank-Mtns were underwritten by another bank at a margin of 0.5% of their face value, then the bank would pay Deutsche Bank EUR 11.94 billion (EUR 12 billion minus 0.5% of EUR 12 billion) for these Bank-Mtns and then sell them to investors at their face value of EUR 12 billion, earning EUR 60 million (0.5% of EUR 12 billion) as its fee.

Secondary Market

The margin for trading a Bank-MTN in the secondary market is the difference between the bid and ask prices of the Bank-MTN. The bid price is the highest price that a buyer is willing to pay for a Bank-MTN, and the ask price is the lowest price that a seller is willing to accept for a Bank-MTN. The margin reflects the liquidity and volatility of the Bank-MTN, as well as the supply and demand for it. The margin may also vary depending on whether the Bank-MTN is traded over-the-counter (OTC) or on an exchange. OTC trading means that buyers and sellers negotiate directly with each other or through intermediaries, such as brokers or dealers. Exchange trading means that buyers and sellers use a centralized platform that matches orders and executes trades. Exchange trading usually offers more transparency and standardization, so it may have lower margins than OTC trading.

To illustrate how margins are calculated in the secondary market, let us look at an example of trading a Bank-MTN issued by Deutsche Bank on an exchange. According to its quarterly results, Deutsche Bank had EUR 55 billion worth of outstanding Bank-Mtns as of June 2023, with maturities ranging from 2023 to 2027 and interest rates ranging from 0% to 2%. Assuming that one of these Bank-Mtns had a face value of EUR 100,000, a maturity date of December 2025, and an interest rate of 1%, then its price would depend on its yield-to-maturity (YTM), which is the annualized return that an investor would earn if they bought the Bank-MTN at its current price and held it until its maturity date. The YTM is inversely related to the price of the Bank-Mtn: if the YTM goes up, then the price goes down, and vice versa. For example, if the YTM of this Bank-Mtn was 0.75%, then its price would be EUR 102,564, which is calculated by discounting its future cash flows (interest payments and principal repayment) by its YTM using this formula:

where C is the annual coupon payment (EUR 1,000), F is the face value (EUR 100,000), YTM is expressed as a decimal (0.0075), and n is the number of years until maturity (2.5).


If this Bank-Mtn was traded on an exchange, then its bid and ask prices would be determined by the market forces of supply and demand. For example, if the bid price was EUR 102,500 and the ask price was EUR 102,600, then the margin would be EUR 100, which is the difference between the bid and ask prices. The margin would represent the profit that a dealer or a broker would make by buying the Bank-MTN at the bid price and selling it at the ask price. The margin would also reflect the liquidity and volatility of the Bank-MTN: if the Bank-MTN was highly liquid and stable, then the margin would be low, and if the Bank-Mtn was illiquid and volatile, then the margin would be high.

SBLCs & BGs

Standby Letters of Credit (SBLCs) and Bank Guarantees (BGs) are utilized in various situations, primarily in international trade and finance, due to their ability to manage risk and provide financial security. Here are some typical scenarios where SBLCs or BGs are used:

1. International Trade:

  • SBLCs are frequently employed in international trade transactions to provide security to the seller. In cases where the buyer and seller are in different countries and may not have established trust, an SBLC guarantees payment to the seller if the buyer defaults.
  • BGs can also be used in international trade, particularly as performance bonds to ensure that the contractual terms, such as timely delivery and quality standards, are met by the seller.


2. Project Financing:

  • SBLCs are used to guarantee the repayment of loans or financial obligations related to large projects, ensuring that financiers or investors will receive their due payments.
  • BGs are often utilized to ensure the completion of projects, especially in construction and development sectors. They provide a guarantee that contractors or developers will meet their project delivery commitments.


3. Construction Contracts:
Performance BGs assure the project owner that the contractor will fulfill their obligations under the contract, such as completing a project within the agreed timeframe and specifications.

4. Advance Payment Scenarios:
Advance Payment Guarantees (BGs) are common in contracts where the buyer makes an advance payment to the seller. They ensure the refund of the advance payment in case the seller fails to deliver the goods or services.

5. Bid/Tendering Processes:
In bidding or tender processes, particularly in government contracts, Bid Bonds (a type of BG) are used. They guarantee that the bidder will undertake the contract at the bid price if they are awarded the contract.

6. Securing Credit Lines:
SBLCs can be used as collateral to secure credit lines or loans, particularly when the borrower does not have sufficient collateral in the form of physical assets.

7. Lease Agreements:
In commercial lease agreements, BGs may be required as security deposits to guarantee the lease payments and adherence to the terms of the lease agreement.

8. Insurance and Reinsurance Obligations:
SBLCs can also be used to guarantee insurance and reinsurance obligations.

9. Financial Transactions and Investments:
In certain financial transactions and investment scenarios, SBLCs are used to enhance creditworthiness and provide assurance of payment or performance.

These instruments are versatile and can be adapted to a wide range of financial and contractual arrangements. Their use, however, requires careful consideration of the terms, risks, and regulatory compliance issues involved. It is essential for parties in such transactions to consult with financial and legal experts to ensure these instruments are structured appropriately for their specific needs.

Do you want to read more to understand how Financial Instruments are calculated ?

The Handbook of Financial Instruments


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Financial Instruments and Derivatives Modelling, Valuation and Risk Issues

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