Financial Terminology

What is a Company?

A company is a “legal person” endowed with the capacity to conduct business with other people. Company activity is undertaken by employees who are guided by a hierarchy of managers that terminates in the corporate suite where ultimate operational control resides. The actions of the top management are periodically overseen by a board of directors appointed by the shareholders of the company.

Advantages of a company

Running any business with employees involves administrative overhead and exposes management and owners to various risks. Businesses can be created as sole proprietorships, joint partnerships, or companies. A company benefits the operators and shareholders by limiting the potential financial and legal liability. Owners have a financial liability limited to their investment in the company. Such guarantees do not exist for other business structures.

Public Company versus a Private Company

Companies can be grouped into private companies and public companies. The shares of a public company are traded on a stock exchange. The exchange provides a convenient mechanism for anonymously transferring ownership from one person to another. However unlike private companies, public companies must abide by reporting requirements that signal material changes in their condition. Insiders are also be restricted in their ability to trade stock since they are privy to information that the public does not possess. It is generally much more difficult for a shareholder to liquidate their ownership in a private company.

Company Securities

A security in a public company is a financial instrument that can be traded on an exchange. Different type of securities are offered to appeal to different types of investors. Risk averse investors who desire pre-determined rates of return will prefer bonds over stock. Risk-seeking speculators will prefer stock over bonds and options over stock.

Bonds

A bond is a debt obligation to the bond holder to pay a fixed amount of cash at a future fixed point in time. Bond generally trade at a discount to their future cash value. The yield is the interest rate implied by its market value. The market value of the bond can vary because a company always has a nonzero risk of bankruptcy, and because economic factors such as inflation and currency debasement can erode the value of money. In the event of bankruptcy, the assets of the company will be sold off to pay the debt obligations before any other owner in the company is compensated.

Financial analysts will perscribe ratings of corporate bond quality to sufficiently large companies. The higher the rating, the lower the perceived risk of non-repayment to the bond holder is.

Large companies will raise capital via corporate bonds, but smaller companies may not be able to access the bond market. Instead they may rely on private placements or convertible bonds.

Stock

A share represents fractional ownership in the company. The value of a share is the residual present value of the company modulo financial liabilities. The simplest type of share is common stock. Share values fluctuate with the expected profitability of a company. A company that introduces a new profitable product to the market that has a high demand will see the value of its stock increase.

Derivative

A derivative is a security whose value depends on the price of other commodities or securities and represents a legal contract between counterparties. A futures contract is an obligation to buy or sell a fixed amount of something at some fixed future time or set of times. An option is a contract that confers the right to buy or sell a fixed amount of something at some fixed future time or set of times. A put option will increase in value as the underlying security decreases in value, while a call option will increase in value as the underlying security increases in value. A warrant is a synonym for an option.

Utility of Derivatives

Derivatives can be used to shape the risk profile of the market participant. For example, a producer of a commodity may want to reduce risk by guaranteeing the future price and could achieve this by selling a futures contract. A company that uses commodities as inputs to its production pipeline may similiarly want to reduce financial risk by buying futures contracts. A speculator who is bullish on the price of a security can purchase call options on the security or take a long position on a futures contract. However with increased reward there is increased downside risk.

From the vantage point of an small investor in a company, derivatives can be used to generate income from the underlying security that is held by investor by writing a covered call. Or they can be used to protect against downside risk by buying a put. Or they can be used as speculative instruments. Purchase of options always entails limited risk since the holder is not obligated to any action. The worst outcome for a buyer of an option is the loss of the initial investment. On the other hand, a seller of an option is obligated to perform action the buyer demands. This can lead to unlimited liability in the case of a written call.