1. Louis Plowden-Wardlaw 10/2007
The Legal Perspective on Financial Instruments
From a lawyers point of view, all financial instruments are combinations of ownership rights (rights to
underlying assets after payments of debt) and debt obligations (fixed financial claims upon a person, usually
with an interest element being the “price” of money paid by the borrower to the lender). The complexities
and acronyms used by market professionals tend to obscure these basic building blocks. Another taxonomy
might be ownership, debt in the sense of borrowing and derivatives contracts (options and futures), which
are also debt in the legal sense, but are fixed money contract claims derived from reference to an underlying
borrowing debt or ownership interest.
The Finance Professional’s Perspective on Financial Instruments
Cashflows and Discount Rates
The finance professional’s lens is slightly different. All that matters is the cashflows that these ownership
rights or debt claims can lead to, and the present value of a financial instrument is the expected future
cashflows discounted to the present by more or less according to the riskiness of the future cashflow, where
a high discount rate represents a high risk of the future cashflow not being paid and a low discount rate a
low risk of the future cashflow not being paid. By way of illustration, a cashflow of 100 in a years time
discounted at 10% is worth 90 today; discounted at 40% it is worth 70. The choice of discount rate is
generally a matter of judgement and can differ very greatly amongst informed professionals, with very large
effects on valuations.
Sovereign Debt as Riskless Debt
It is also useful to note that the lowest level of discount is reserved to sovereign debt issued in its own
currency, because the sovereign debtor cannot really default – even in financial difficulty, it can print more
money by fiat, though in so doing it would devalue its currency relative to other currencies. The level of
discount is still not zero in this case, because lenders still need a return on their money as they have
alternative investment opportunities. For this reason the universe of the investor is bounded by the
investment opportunities available to them. The level of discount for sovereign entities is what the state has
to pay for its borrowings, and may vary according to whether it is borrowing long term or short term ie it is
the basic interest rate, which is propagated through the rest of the financial system primarily through the
sale and purchase of government debt by banks who then reprice their other assets according to what the
state through the central bank will buy and sell government debt for as they manage their own funding
requirements.
Relative and Fundamental Pricing
Pricing of financial securities tends to be relative flowing from the sovereign rate of borrowing, and the
mathematics of deriving these relationships get complex, and are informed by assumptions about
fundamentals that are often wrong, leading to the commonplace that markets are excellent at relative value
pricing but not so good at fundamental pricing (by which we mean reference to the underlying cashflows
and their stability supporting a valuation, which are driven by real world matters such as demographics,
consumption and wage patterns, market performance of businesses, and supply and demand of different
asset classes), which tends to be lead to dramatic corrections from time to time. For this reason valuations
are a combination of some logic (deduction of mathematical relationships driving relative prices and
statistical analysis of the same from price data on the basis of efficient market theory (see next section), and
some judgement (knowing when to critique the mathematics as being based on fundamental cashflows that
are in some way misread by the market, or understanding when market agents are forced sellers or buyers
compelled by liquidity or organisational constraints to seek counterparties allowing bargaining power
dynamics to take effect, the choice of discount rates and growth rates as inputs in financial models of
underlying cashflows).
© Louis Plowden-Wardlaw 2007, Finance Introduction for Lawyers
1

2. Efficient Markets Theory and Why Investors Invest
Efficient market theory, which broadly is the idea that in securities markets all available information is
factored into the price of a security, is a standard assumption used to derive prices. In practice a great many
market participants are of the view that propagation of ideas amongst market participants takes time,
allowing those with superior insight or analysis to take profitable positions by buying or selling securities at
market prices on the basis that their true value is relatively higher or lower values than the market indicates
and waiting for the ideas, such as a view on fundamentals affecting that security, to achieve wider
dissemination. This then allows the early adopter of the idea – who has access to capital - to make a profit
as other participants in the market who collectively comprise the abstraction “the market” come to share
that view or one that has similar consequences for the price of a security, and apply their capital to it. Many
market participants believe they have such superior insights, and indeed if they did not hold such beliefs it
would be difficult for them to rationally invest in or trade anything other than indices, though unfortunately
the relative value of any index relative to other indices means that no investor can rely on market efficiency
as a complete abnegation of responsibility in making investment decisions, since there is no global index of
every asset type that exists, and in the real world, investors report to their masters or have to satisfy liabilities
in one currency or another.
Some of the Foundations of relative Pricing
Some clear relationships which drive relative pricing are that clearly corporate and other non-sovereign
borrowers pay a higher rate of interest than the state in that state’s currency, and that due to insolvency
laws, owners require a higher rate of return for their money than lenders, since they are paid only after debt
holders at times of financial distress (the extra return required by owners over debtors is known as the
“equity premium”). Sovereign borrowers issuing debt in a currency other than their own fiat money can
default on their obligations, and indeed it is one of the peculiarities of EU States that have entered the
Eurozone that they no longer have the luxury of being able to issue debt upon which they cannot, as a
matter of law, default, though they can of course raise tax revenues to satisfy their obligations within the
limits of political acceptability. More complex relationships are found by statistical analysis of historic price
data, and analysts and investors constantly assess these relationships between asset classes in view of
fundamental data relating to those same assets to make judgements. In the case of the price of stocks, the
fundamental data might be sales and costs data, in the case of debt, for a corporate the sales and costs data
(which will drive creditworthiness of a company effecting its borrowing rate and so the price of its debt)
will be supplemented by data on interest rates, which is essentially the price of government debt, and is
driven by the country’s ability to manage its exports, imports, tax revenues and social spending with the
constraints of demographics and demand for its debt in the markets.
Options
An important type of debt contract from the financiers perspective is the option. This is a contract for the
right but not the obligation to buy or sell something in the future (an asset or a security, which will itself be
a debt claim or an equity interest), and the contract itself has a value which is driven by the price of the
asset which the option relates to, the volatility (changeability) of that price over time, the time to expiry of
the option, the interest rate, and the price at which the option can be exercised.
All Financial Instruments combinations of Borrowings, Ownership and Options
Options are harder to value than simple debt claims or ownership interests, and it is the combination and
repackaging of these three types of instrument, and their relationships and relative risks and rewards, that
comprise in the first place all financial instruments, and secondly drive the sale and purchase activities of all
financial market agents. It is also worth observing that valuing ownership is often intrinsically harder than
valuing debt – it depends to a greater extent on assumptions about growth of underlying business cashflows
and their riskiness which are inherently judgment and contingency based, whereas debt claims are driven
solely by interest rates and creditworthiness, which are marginally easier to estimate, though of course
relative ease of valuation with respect to one currency does not deal with the relative value issue of foreign
exchange risk, and of course creditworthiness and interest rate risks are also basically judgments about
© Louis Plowden-Wardlaw 2007, Finance Introduction for Lawyers
2

3. underlying cashflows of companies and nations and their ability to sell products or raise revenues.
Why Efficient Market Theory Derived Prices and Fundamental Prices May Differ
In the broadest terms, efficient market theory demands of its proponents something of an act of faith in
the infallibility of markets as to pricing. Since efficient markets theory assumes they incorporate all the
available price sensitive information relating to that asset (for if they did not someone with that information
would immediately, if the price was too high, borrow the asset from someone with it for cash collateral, sell
it, wait for the price to drop, rebuy it at the lower price, return it to the lender and so take the profit; and if
the price was too low, borrow cash to buy the asset, wait for the price to rise, sell it, repay the loan and so
take the profit) the question is not whether prices are right, but on what set of assumptions are they right?
Sometimes it is hard to discern the link between market prices and fundamental prices. For example, many
are of the opinion that much of the world is in the middle of a property boom, where the present value of
the rental incomes that are expected from many properties is much less than the present value of the
interest that one would expect to pay if one bought the relevant property on credit. This implies that the
normal relationship between rent and interest has broken down since normally one would earn a profit for
borrowing cash to buy a rental property or one would not do it. Instead one would keep the money in the
bank and lend the money risklessly for a higher return, or look for another asset that does not require
painting and repairs and other payments, like a stockmarket index or a government bond. In looking for an
explanation of this, arguments are made about supply and demand and demographics to justify the world
of perpetually rising prices that is required to balance the equation. This may be true, but many think it may
be more that the drivers of such prices are (a) that people have to live somewhere, a (b) there is imperfect
substitution between a rented and an owned property, so (a) and (b) effectively create forced buyers, (c)
banks are keen to inflate their balance sheets by offering cheap money on collateralised loans and are driven
by their stockholders to increase market share and assets rather than conduct fundamental analysis of their
customers, (d) there are tax incentives to buy this asset class (for example in the US deductibility of interest
from income, in the UK tax free capital gains) and (e) there is no other way for private individuals to take
substantial geared bets on a generally prosperous economy, and the fact that they all take it at once leads to
some self-fulfillment, unless and until the perpetually rising prices part of the equation becomes hard to
believe in due to a period of price stagnation or interest rate rises or a raising of lending criteria reverse the
whole process.
Such apparently aberrational pricing offers an opportunity to the person who wishes to put their or their
institution’s money behind their view. Many financial instruments are designed to allow people to take a
view cheaply; for example the person with the view that the property market is overheated might look for a
supplier of a property company which they could short sell, or buy put options for property stocks. In
either case, they would buy the instrument at the current market price on the hope that it would change as
more people came to share their view and underlying asset prices adjusted to reflect that view.
Stock prices and trends in interest rate movements can develop similar mechanics in the institutional
market.
Technical Analysis
Whilst academics and more sophisticated finance practitioners tend to favour efficient markets theory and
its assumption of perfect prices leavened with fundamental analysis, many practitioners engage in what is
known as technical analysis of prices. Such investors follow the pattern of prices, and seek to draw
conclusions about future movements from trying to discern movement over time in prices which is
revelatory of investor behaviour or patterns in price over time which suggests that it might be a good time
to buy or sell an asset. If it looks historically cheap they might consider it a good time to buy, if it looks
historically expensive they might consider it a good time to sell. In practice, such practitioners probably
make their profit from having a good sense of the supply and demand for a particular asset and from using
such arguments to generate deal flow when they are really in a market making role making money off the
bid-offer spread not an asset management role. Since much price behaviour does seem to be cyclical, this
may seem to make sense, and such investors would probably argue with the efficient market hypothesis that
all present prices incorporate all available information by saying that part of the relevant information is past
price behaviour which they are expert in interpreting because they specialise in it, and that it is therefore
© Louis Plowden-Wardlaw 2007, Finance Introduction for Lawyers
3

4. rational for them to take positions based on their view that an asset is historically cheap or expensive.
© Louis Plowden-Wardlaw 2007, Finance Introduction for Lawyers
4