CP

Derivatives can be used either to reduce risks or to speculate. As an example of a risk-

reducing usage, suppose an importer’s net income tends to fall whenever the dollar

falls relative to the yen. That company could reduce its risk by purchasing derivatives

that increase in value whenever the dollar declines. This would be called a hedging op-

eration,and its purpose is to reduce risk exposure. Speculation, on the other hand, is

done in the hope of high returns, but it raises risk exposure. For example, Procter &

The Financial Markets 15

TABLE 1-1 Summary of Major Financial Instruments

Original Interest Rates

Instrument Major Participants Risk Maturity on 9/27/01a

U.S. Treasury Sold by U.S. Treasury Default-free 91 days to 1 year 2.3%

bills

Banker’s A firm’s promise to pay, Low if strong Up to 180 days 2.

acceptances guaranteed by a bank bank guarantees

Commercial Issued by financially secure Low default risk Up to 270 days 2.

paper firms to large investors

Negotiable Issued by major Depends on Up to 1 year 2.

certificates of banks to large investors strength of issuer

deposit (CDs)

Money market Invest in short-term debt; Low degree of risk No specific 3.

mutual funds held by individuals and maturity

businesses (instant liquidity)

Eurodollar market Issued by banks outside U.S. Depends on Up to 1 year 2.

time deposits strength of issuer

Consumer credit Loans by banks/credit Risk is variable Variable Variable

loans unions/finance companies

Commercial Loans by banks Depends on Up to 7 years Tied to prime

loans to corporations borrower rate (6.0%) or

LIBOR (2.6%)d

U.S. Treasury Issued by U.S. government No default risk, but 2 to 30 years 5.

notes and price falls if interest

bonds rates rise

Mortgages Loans secured by property Risk is variable Up to 30 years 6.

Municipal Issued by state and local Riskier than U.S. Up to 30 years 5.

bonds governments to government bonds,

individuals and but exempt from

institutions most taxes

Corporate bonds Issued by corporations to Riskier than U.S. Up to 40 yearsb 7.

individuals and government debt;

institutions depends on

strength of issuer

Leases Similar to debt; firms Risk similar to Generally 3 to Similar to

lease assets rather than corporate bonds 20 years bond yields

borrow and then buy them

Preferred stocks Issued by corporations to Riskier than corporate Unlimited 7 to 9%

individuals and institutions bonds

Common stocksc Issued by corporations to Riskier than Unlimited 10 to 15%

individuals and institutions preferred stocks

aData are fromThe Wall Street Journal(http://interactive.wsj.com/documents/rates.htm)or theFederal Reserve Statistical Release,http://www.federal
reserve.gov/releases/H15/update.Money market rates assume a 3-month maturity. The corporate bond rate is for AAA-rated bonds.
bJust recently, a few corporations have issued 100-year bonds; however, the majority have issued bonds with maturities less than 40 years.
cCommon stocks are expected to provide a “return” in the form of dividends and capital gains rather than interest. Of course, if you buy a stock, your
actualreturn may be considerably higher or lower than your expectedreturn. For example, Nasdaq stocks on average provided a return of about
39
percent in 2000, but that was well below the return most investors expected.
dThe prime rate is the rate U.S. banks charge to good customers. LIBOR (London Interbank Offered Rate) is the rate that U.K. banks charge one another.

An Overview of Corporate Finance and the Financial Environment 13