7 – What financial instrument – Bonds, Stocks, Loans, deposits, currency etc really is?

What are financial instruments such as Bonds, Stocks, Loans, Currency and Bank deposits etc. really is? 

In fact, they’re not complicated. All of them are promissory notes.

Section I : What is a promissory note?

Anyone can make any kind of promise. For example: “I promise to complete the work today”, “I promise to bring you to movie today”, “I promise to pay you back RM 100,000 after 5 years with 7% interest every year”, “I promise to pay you back RM 50 I borrowed from you tomorrow” etc. But the hard part is, how are we going to convince others to accept our promise?

Let’s think about we choose to accept somebody’s promise. If he/she often lies to people, always not fulfilling his promise, naturally we will not accept his promise or we will only accept his promise by requiring more rewards from him. In other words, we choose to accept somebody’s promise because of their credibility.

“Some promises are casual, while others are formal, but all of them involve trust in the ability and willingness of the issuer of a promise to fulfill that promise. Promissory notes are formal promises that carry the weight of the law, either through contractual agreements or through legislations.” (Tymoigne, 2017)

“A promissory note may be financial or nonfinancial depending on the nature of the promise made. A free-pizza coupon is a nonfinancial promissory note, while a mortgage note merely involves future monetary transfers. The world of finance establishes a legal framework to record the creation and fulfillment of formal promises that are financial in nature. Finance measures more or less accurately the credibility of these financial promises by pricing promissory notes (“financial instruments”) that embed these promises.” (Tymoigne, 2017)

The way a promissory note is structured varies widely depending on the needs of their issuer, but common questions that a promise must answer are: 

  1. Who is the issuer? That is, who made the promise?
    • The mark of the issuer (name, portrait, etc.) is present so bearers know who is supposed to fulfill the promise embedded in the promissory note. 
  2. What is the unit of account? 
    • Promissory notes cannot exist before there is a unit of measurement for transactions and outstanding balances. 
  3. When will the issuer take back its promissory note? That is, how long will it take the issuer to fulfill the promise? 
    • There is a term to maturity. At maturity, the issuer must take back the promissory note it issued (and then destroy it to make sure nobody can reacquire it to have a claim on the issuer). 
    • The term can go from zero (issuer takes back its promissory note whenever the bearer demand it) to infinity (issuer takes back its promissory note at its discretion). 
  4. At what price will the issuer take back its promissory note?
    • A face value specifies the number of units of account the promissory note carries. 
  5. How will the issuer take back its promissory notes? How can bearers redeem the notes?
    • This deals with the expected means that will be used by the issuer to fulfill their promises, also called the “reflux mechanisms/channels.”
  6. What is (are) the benefit(s) for those willing to trust the issuer? 
    • These benefits could include gaining an income, voting rights, settling debts owed to issuer, avoiding prison, etc. 
  7. Are there any protections for bearers in case the issuer is unable or unwilling to fulfill the promise? 
    • Promissory notes may be secured (using collateral).
    • In case the issuer is unable to fulfill his promise, the collateral can be used to compensate bearer.
    • When the issuer is unable to fulfill his financial promise, we said the issuer “defaults”.
  8. Is it possible to transfer the promissory note to another bearer? 
    • Promissory notes may be negotiable; that is, the person to whom the promise has to be fulfilled can be changed by transferring ownership of the promissory note. 
    • Some promissory notes are not transferable because they name the beneficiary (e.g., savings bonds issued by US Treasury) and cannot be endorsed to someone else. Some, like checks, have limited transferability through endorsement. 

Depending on how these questions are answered, the name of a promissory note changes. When the issuer issues promissory notes and promises to take back the promissory notes at face value and rewards the bearer with certain % of interest on a periodic basis, then the promissory notes issued is known as bonds or loans. For example, when a household wanted to purchase high-valued asset such as a house, the household issue a promissory note to the banks and promises to take back (i.e. buy back) the promissory notes at face value and also rewards the bank with certain % of interest on a periodic basis, and if he/she failed to do so, he allowed the banker to re-possess his house. The promissory note issued by the household is known as secured loan.

When the issuer issues promissory notes but do not promises to take back the promissory notes at face value or rewards the bearer on a periodic basis, the promissory notes issued is known as stocks. So, what’s the promise of a stock? I guess it’s something like: “I promise you that in 5 years, you can sell this to others at a far higher price! In case we profit, we’ll share some penny dividends with you!” 

When the issuer issues promissory notes that promises the bearer to take back the promissory notes at face value and reduce their tax liabilities they originally owe to the issuer by the same amount, the promissory note is known as currency. Yes, the paper money you have in your wallet is also promissory notes issued by the government. For example, a promissory note with face value of $10 issued by government (i.e. $10 currency) promises that the government will take back the promissory notes at $10 and reduce your tax liabilities you originally owe to the government at $10 as well.

What about deposit in the bank accounts? Are they promissory notes as well? Yes they are. Deposit in the bank accounts can be classified into time deposits and demand deposits. Time deposits are promissory notes issued by the bank saying: “Bank owe you $100. And after 1 year, the bank promised to take back this promissory note from you at face value with interest.” Demand deposits are promissory notes issued by the bank saying: “Bank owe you $100. The bank promised to take back this promissory note at face value whenever you demand it.”   

Since bank deposits are usually insured by government such as under FDIC insurance, the promises on the promissory note can be extended to: “If the bank fail to take back this promissory note due to insolvency, the government will take them back on their behalf at face value.” 

Section II: What is the value of a promise ? 

Let’s say we have a bond (i.e. a promissory note) issued by a firm promises that: “I will take back my promissory notes at RM 100,000 after 5 years and pay you 5% interest annually before maturity.”

In other words, this promissory note promise to pay its bearer/holder RM 100,000 after 5 years, with 5% interest annually.

Here we know several things about the promissory notes (bond):

  • Maturity date: 5 years later
  • Face Value: RM 100,000
  • Rewards: 5% interest annually

You’re interested in buying the promissory notes (bond), how much should you pay for it? What is the nominal value of the bond?

Noted important differences between nominal value and face value:

Face value of the promissory notes = Value/amount of money the issuer promised to pay

Nominal value of the promissory notes = Value of the promise (This is the price we want to pay for)

The nominal value of the promissory notes depends on the face value, maturity date, coupon rate (interest promised by the issuer) and the credibility of the issuer. 

The bearer can calculate the fair nominal value of the promissory notes offered by the issuer using the formula below:

Text

Description automatically generated with low confidence

Where the subscript indicates the present time; Pt is the current fair value; Yn is the nominal income promised at a future time nFVN is the face value that will prevail at maturity; Et indicates current expectations of bearers about income and face value of time ndt is the current discount rate imposed by bearers; and is the term to maturity (= 0 is the issuance time). 

dt , the discount rate is a measure of the credibility of the issuer. If the bearer thinks the issuer is very credible (based on track record of the issuer), the lower the discount rate imposed by bearer. If the bearer thinks the issuer is less credible, the higher the discount rate imposed.1

Using the example of bond above, in the case the bearer believes the issuer is very credible and impose a discount rate of 3% to the bond, the fair nominal value of the bond would be:

To the bearer, the promissory notes worth RM 104,846. If the issuer offers the promissory notes to the bearer at its face value RM 100,000, it’s a sure buy from the bearer, because it’s a free bargain for the bearer.

In the case the bearer believes the issuer is not credible and impose a discount rate of 10% to the bond, the fair nominal value of the bond would be:

To the bearer, the promissory notes only worth RM 77,941. If the issuer offers the promissory notes to the bearer at its face value RM 100,000, it’s a sure rejection from the bearer, because the bearer perceived the bonds only worth RM 77,941 only, he won’t pay higher than RM 77,941 for the bond.

What can the issuer do to make the bearer accept his promissory notes? Looking at the formula, i think of two ways:

  1. Offer a higher coupon rate such as 10% or above (increases Yn)
  2. Instead of offering the bonds at its face value, offer it at a price less than the face value.

That’s why a less credible bond issuer (i.e. borrower) always has to pay higher interest when they borrow money because the bearer (i.e. the lender) won’t accept it otherwise.

To the bearer, if the calculated:

  1. Fair nominal value = Offer price by the issuer 
    • The financial instrument is said to be offered at par.
  2. Fair nominal value > Offer price by the issuer
    • The financial instrument is said to be offered at discount. (good deal)
  3. Fair nominal value < Offer price by the issuer
    • The financial instrument is said to be offered at a premium. (bad deal)

The above calculation can be repeated for any financial promissory notes such as stocks, currency and bank deposits. Each with promises of different characteristics written on it and therefore offer at different price by the issuer. The potential bearer can estimate the fair nominal value of the promise with their own risk-adjusted discount rate and see if the promissory notes is offered at par, at discount or at premium.

At the end of the day, the lessons are:

  1. Financial instruments such as Bonds, Stocks, Loans, Currency and Bank deposits etc. are promissory notes with different promises made by the issuer.
    1. These promises have different face value, maturity, collateral, rewards and issuer. 
  2. Given a promissory note, the potential bearer can estimate its fair nominal value (fair value of the promise) based on the discount rate the bearer imposed after assessing the credibility of the issuer.
    • So, different potential bearer of the promissory notes will have different fair nominal value estimation because their perception of risk and credibility of the issuer are different.
    • Hence, a promissory note may be thought as offered at premium to a group of investors, but the same promissory note may be thought as offered at discount to another group of investor due to their perception of risk and credibility of the issuer.

Add-ons:

  • 1 Determining the discount rate for a financial instrument is another huge world of knowledge to be learnt.

References:

  1. Eric Tymoigne, 2017. “On the Centrality of Redemption: Linking the State and Credit Theories of Money through a Financial Approach to Money,” Economics Working Paper Archive wp_890, Levy Economics Institute.

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