Financial Instruments The transfer of available funds takes place through the buying and selling of financial instruments

or securities. Your book offers the following definition of a financial instrument (36):

A financial instrument is the written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions.
This is a mouthful, but breaking it down, we see several key features. First, this is a binding, enforceable contract under the rule of law, protecting potential buyers. Second, there is the transfer of value between two parties, where a party can be a bank, insurance company, a government, a firm, or an individual. The future dates may be very specific (like a monthly mortgage payment) or may be quite uncertain and depend on certain events (like an insurance policy). Financial instruments, like money, can function as a means of payment or a store of value. As a means of payment, financial instruments fall well short of money in terms of liquidity, divisibility, and acceptance. However, they are considered better stores of value since they allow for greater increases in wealth over time, but with higher levels of risk. A third function of these instruments is risk transfer. For certain instruments, buyers are shifting risk to the seller, and are basically paying the seller to assume certain risks. Insurance policies are a prime example of this. Most financial instruments are standardized in that they have the same obligations and contract for buyers. Google stock shares are the same obligation, regardless of buyer. Car loan and mortgage loans contracts use uniform legal language, differing only in specific loan amounts and terms. This standardization reduces costs (since the same types of contracts are used over and over) and makes it easier for buyers and sellers to trade these instruments over and over. In addition to this standardization, financial instruments must provide certain relevant information about the issuer, the characteristics and the risks of the security. This information requirement is a way to even the playing field among different parties and reduce unfair advantages.

'Time Value of Money - TVM'

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future. For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate.

How To Calculate Required Rate Of Return

The required rate of return (RRR) is a component in many of the metrics and calculations used in corporate finance and equity valuation. It goes beyond just identifying the return of the investment, and factors in risk as one of the key considerations to determining potential return. The required rate of return also sets the minimum return an investor should accept, given all other options available and the capital structure of the firm. To calculate the required rate, you must look at factors such as the return of the market as a whole, the rate you could get if you took on no risk (the risk-free rate of return), and thevolatility of the stock or the overall cost of funding the project. Here we examine this metric in detail and show you how to use it to calculate the potential returns of your investments. Required Rate of Return in Corporate Finance Capital Structure Equity and Debt

between absolute and relative method of valuation?

There are two basic methods of valuing stocks. The most frequently used method is relative valuation, which compares a stock's valuation with those of other stocks or with the company's own historical valuations. For example, if you were considering the relative valuation for Dow Chemical DOW, you would compare its stock's price/earnings ratio (or its price/sales ratio, etc.) with that of other chemicals makers or with that of the overall stock market. If Dow has a P/E ratio of 16 and the average for the industry is closer to, say, 25, Dow's shares are cheap on a relative basis. You could also compare Dow's P/E with the average P/E of an index, such as the S&P 500, to see whether Dow still looked cheap. (With the S&P 500's P/E in the low 30s at the end of 1999, Dow was cheap all right.) The problem with relative valuations is that not all companies are made alike--not even all chemicals makers. There could be very good reasons why Dow has a lower P/E than its average peer. Maybe the company doesn't have the growth prospects of other chemicals companies. Maybe the possible liability from breast-implant litigation rightly puts a damper on the stock's price. After all, a Hyundai has a lower sticker price than a Mercedes, but for very good reasons. The key is to research your stocks well and be aware of the factors that might justifiably make them cheaper or more expensive than similar stocks Absolute Valuation _________________ The second basic method of valuing stocks uses absolute, or intrinsic, value. Usually, absolute value is estimated by calculating the present value of the company's future free-cash flows (cash flow minus capital spending). The present value of that future-income stream is the theoretically correct value of the

stock. This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools. Calculating the absolute value of a stock isn't easy. It's tough to forecast how fast a company's free cash flows will grow, how long they'll grow, and at what rate they should be discounted back to the present. At Morningstar, we estimate stocks' absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model. The result is an analyst-driven estimate of a stock's fair value in absolute terms

Measuring Return and Risk

What risks are there? What would cause an investment to unexpectedly over- or underperform? Starting from the top (the big picture) and working down, there are

economic risks, industry risks, company risks, asset class risks, market risks.