1/ The financial manager's job is not only to “buy” financial resources …

The financial manager is traditionally perceived as a buyer of capital. He negotiates with a variety of investors–bankers, shareholders, bond investors–to obtain funds at the lowest possible cost.

Transactions that take place on the capital markets are made up of the following elements:

• a commodity: money,
• a price: the interest rate in the case of debt; dividends and capital gains in the case of equities.

In the traditional view, the financial manager is responsible for the company's financial procurement. His job is to minimise the price of the commodity to be purchased, i.e. the cost of the funds he raises.

We have no intention of contesting this view of the world. It is obvious and is confirmed every day, in particular in the following types of negotiations:

• between corporate treasurers and bankers, regarding interest rates and value dates applied to bank balances (see Chapter 49);
• between chief financial officers and financial market intermediaries, where negotiation focuses on the commissions paid to arrangers of financial transactions (see Chapter 25).

2/ … but also to sell financial securities

That said, let's now take a look at the financial manager's job from a different angle:

• he is not a buyer but a seller;
• his aim is not to reduce the cost of the raw material he buys but to maximise a selling price;
• he practises his art not on the capital markets, but on the market for financial instruments, be they loans, bonds, shares, etc.

We are not changing the world here; we are merely looking at the same market from another point of view:

• the supply of financial securities corresponds to the demand for capital;
• the demand for financial securities corresponds to the supply of capital;
• the price, the point at which the supply and demand for financial securities are in equilibrium, is therefore the value of security. In contrast, the equilibrium price in the traditional view is considered to be the interest rate, or the cost of funds.

We can summarise these two ways of looking at the same capital market in the following table:

Depending on your point of view, i.e. traditional or financial, supply and demand are reversed, as follows:

• when the cost of money–the interest rate, for example–rises, demand for funds is greater than supply. In other words, the supply of financial securities is greater than the demand for financial securities, and the value of the securities falls;
• conversely, when the cost of money falls, the supply of funds is greater than demand. In other words, the demand for financial instruments is greater than their supply and the value of the securities rises.

The cost of capital and the value of the securities vary in opposite directions. We can summarise with the following theorem, fundamental to this entire book:

Minimising financing cost is synonymous with maximising the value of the underlying securities.

For two practical reasons, one minor and one major, we prefer to present the financial manager as a seller of financial securities.

The minor reason is that viewing the financial manager as a salesman trying to sell his products at the highest price casts his role in a different light. As the merchant does not want to sell low-quality products but products that respond to the needs of his customers, so the financial manager must understand his capital suppliers and satisfy their needs without putting the company or its other capital suppliers at a disadvantage. He must sell high-quality products at high prices. But he can also repackage his product to better meet investor expectations. Indeed, financial markets are subject to fashion: in one period convertible bonds (see Chapter 2) can be easily placed; in another period it will be syndicated loans (see Chapter 21) that investors will welcome.

The more important reason is that when a financial manager applies the traditional approach of minimising the cost of the company's financing too strictly, erroneous decisions may easily follow. The traditional approach can make the financial manager short-sighted, tempting him to take decisions that emphasise the short term to the detriment of the long term.

For instance, choosing between a capital increase, a bank loan and a bond issue with lowest cost as the only criterion reflects flawed reasoning. Why? Because suppliers of capital, i.e. the buyers of the corresponding instruments, do not all face the same level of risk.

The investor's risk must be taken into account in evaluating the cost of a source of financing.

The cost of two sources of financing can be compared only when the suppliers of the funds incur the same level of risk.

All too often we have seen managers or treasurers assume excessive risk when choosing a source of financing because they have based their decision on a single criterion: the respective cost of the different sources of funds. For example:

• increasing short-term debt on the pretext that short-term interest rates are lower than long-term rates can be a serious mistake;
• granting a mortgage in return for a slight decrease in the interest rate on a loan can be very harmful for the future;
• increasing debt systematically on the sole pretext that debt costs less than equity capital jeopardises the company's prospects for long-term survival.

We will develop this theme further throughout the third part of this book, but we would like to warn you now of the pitfalls of faulty financial reasoning. The most dangerous thing a financial manager can say is, “It doesn't cost anything.” This sentence should be banished and replaced with the following question: “What is the impact of this action on value?”

1/ Issuance or creation of securities

There is a great variety of financial instruments, each of which has the following characteristics:

• it is a contract …
• … executed over time, and …
• its value derives solely from the series of cash flows it represents.

Indeed, from a mathematical and more theoretical viewpoint, a financial instrument is defined as a schedule of future cash flows.

Holding a financial security is the same as holding the right to receive the cash flows, as defined in the terms and conditions of the issue that gave rise to the financial instrument. Conversely, for the issuer, creating a financial instrument is the same as committing to paying out a series of cash flows. In return for this right to receive cash flows or for taking on this commitment, the company will issue a security at a certain price, enabling it to raise the funds needed to run its business.

A financial security is a contract …

You've undoubtedly heard people say that the financial manager's stock-in-trade is “paper”. Computerisation has now turned financial instruments from paper documents into intangible book entries, reducing them to the information they contain, i.e. the contract. The essence of finance is, and will always be, negotiation between an issuer seeking new funds and the investors interested in buying the instruments that represent the underlying obligations. And negotiation means markets, be they credit markets, bond markets, stock markets, etc.

… executed over time …

Time, or the term of the financial security, introduces the notion of risk. A debt instrument that promises cash flows over time, for example, entails risk, even if the borrower is very creditworthy. This seems strange to many people who consider that “a deal is a deal” or “a man's word is his bond”. Yet, experience has shown that a wide variety of risks can affect the payment of those cash flows, including political risk, strikes, natural disasters and other events.

… and materialised by cash flows.

Further on in this book you will see that financial logic is used to analyse and choose among a firm's investment options. The financial manager transforms flows of goods and services, deriving from the company's industrial and other business assets, into cash flows. You will soon understand that the world of finance is one of managing rights on the one hand and commitments on the other, both expressed in terms of cash flows.

In a market for financial instruments, it is not the actual flows that are sold, but the rights associated with them. The investor, i.e. the buyer of the security, acquires the rights granted by the instrument. The issuing company assumes contractual obligations deriving from the instrument, regardless of who the owner of the instrument is.

For example, commodity futures markets make it possible to perform purely financial transactions. You can buy sugar “forward”, via financial instruments called futures contracts, knowing full well that you will never take delivery of the sugar into your warehouse. Instead, you will close out the position prior to maturity. The financial manager thus trades on a market for real goods (sugar), using contracts that can be unwound prior to or at maturity.

A property investor acts similarly. After acquiring real property, the value of which fluctuates, he can lease it or resell it. Viewed this way, real property is as fungible as any other property and is akin to a financial asset.

Clearly, these assets exhibit different degrees of “financiality”. To take the argument one step further, you turn a painting into a financial instrument when you put it in your safe in the hope of realising a gain when you sell it.

The distinction between a real asset and a financial asset is therefore subtle but fundamental. It lies either in the nature of the contract or in the investor's motivation, as in the example of the painting.

Lastly, the purchase of a financial security differs from the purchase of a durable good in that the financial security is undifferentiated. A large number of investors can buy the same financial security. In contrast, acquiring a specific office building or building an industrial plant is a very specific, unique investment.

In conclusion, every financial instrument represents a series of cash flows to be received according to a set timetable. Mathematically, it can be expressed as a series of future cash flows F₁, F₂, F₃, F₄ …, F_n over n periods.

2/ Types of financial securities

1/ From the primary market to the secondary market

Once launched by its issuer, a financial security lives a life of its own. It is sold from one investor to another, and it serves as support for other transactions. The instrument itself evolves, but the terms of the contract under which it was issued do not.

The life of a financial security is intimately connected with the fact that it can be bought or sold at any moment. For example, shares issued or created when a company is founded can later be floated on a stock exchange, just as long-term bonds may be used by speculators for short-term strategies.

The new issues market (i.e. creation of securities) is called the primary market. Subsequent transactions involving these securities take place on the secondary market. Both markets, like any market, are defined by two basic elements: the product (the security) and the price (its value).

From the point of view of the company, the distinction between the primary and secondary markets is fundamental. The primary market is the market for “new” financial products, from equity issues to bond issues and everything in between. It is the market for newly-minted financial securities where the company can raise fresh money.

Conversely, the secondary market is the market for “used” financial products. Securities bought and sold on this market have already been created and are now simply changing hands, without any new securities being created.

The primary market enables companies, financial institutions, governments and local authorities to obtain financial resources by issuing securities. These securities are then listed and traded on secondary markets. The job of the secondary market is to ensure that securities are properly priced and traded. This is the essence of liquidity: facilitating the purchase or sale of a security.

The distinction between primary and secondary markets is conceptual only. The two markets are not separated from each other. A given financial investor can buy either existing shares or new shares issued during a capital increase, for example.

If there is often more emphasis placed on the primary market, it is because the function of the financial markets is, first and foremost, to ensure equilibrium between financing needs and the sources of finance. Secondary markets, where securities can change hands, constitute a kind of financial “innovation”.

2/ The function of the secondary market

Financial investors do not intend to remain invested in a particular asset indefinitely. From the moment they buy a security (or even before), they begin thinking about how they will exit. As a result, they are constantly evaluating whether they should buy or sell such and such an asset.

Monetising is relatively easy when the security is a short-term one. All the investor has to do is wait until maturity. The need for an exit strategy grows with the maturity of the investment and is greatest for equity investments, whose maturity is unlimited. The only way a shareholder can exit his investment is to sell his shares to someone else.

As an example, the successful business person who floats his company on the stock exchange, thereby selling part of his shares to new shareholders, diversifies his own portfolio, which before flotation was essentially concentrated in one investment.

The secondary market makes the investor's investments liquid.

Liquidity refers to the ability to convert an instrument into cash quickly and without loss of value. It affords the opportunity to trade a financial instrument at a “listed” price and in large quantities without disrupting the market. An investment is liquid when an investor can buy or sell it in large quantities without causing a change in its market price.

The secondary market is therefore a zero-sum game between investors, because what one investor buys, another investor sells. In principle, the secondary market operates completely independently from the issuer of the securities.

A company that issues a bond today knows that a certain amount of funds will remain available in each future year. This knowledge is based on the bond's amortisation schedule. During that time, however, the investors holding the bonds will have changed.

Secondary market transactions do not show up in macroeconomic statistics on capital formation, earning them the scorn of some observers who claim that the secondary market does nothing to further economic development, but only bails out the initial investors.

We believe this thinking is misguided and reflects great ignorance about the function of secondary markets in the economy. Remember that a financial investor is constantly comparing the primary and secondary markets. He cares little whether he is buying a “new” or a “used” security, so long as they have the same characteristics.

The secondary market plays the fundamental role of valuing securities.

In fact, the quality of a primary market for a security depends greatly on the quality of its secondary market. Think about it: who would want to buy a financial security on the primary market, knowing that it will be difficult to sell it on the secondary market?

The secondary market determines the price at which the company can issue its securities on the primary market, because investors are constantly deciding between existing investments and proposed new investments.

We have seen that it would be a mistake to think that a financial manager takes no interest in the secondary market for the securities issued by his company. On the contrary, it is on the secondary market that his company's financial “raw material” is priced every day. When the raw material is equities, there is another reason the company cannot afford to turn its back on the secondary market: this is where investors trade the voting rights in the company's affairs and, by extension, control of the company.

3/ Derivative markets: futures and options

Derivative markets are where securities that derive their value from another asset (share, bond, commodity or even climate index) are traded. There are two main types of derivative products: options (which we will develop in Chapter 23 as they have become a key matter in financial theory and practice) and futures (Chapter 50).

Derivatives are instruments for taking positions on other instruments, or “contracts on contracts”. They let you take significant short or long positions on other assets with a limited outlay of funds.

Derivative instruments are tailored especially to the management of financial risk. By using derivatives, the financial manager chooses a price – expressed as an interest rate, an exchange rate or the price of a raw material – that is independent of the company's financing or investment term. Derivatives are also highly liquid. The financial manager can change his mind at any time at a minimal cost.

Options and futures allow one to take important risks with a reduced initial outlay due to their leverage effect (this is called speculation), or on the contrary to transfer risks to a third party (hedging).