Question

Define these business finance terms in your own words and then give a real world example of each: Debenture, Face Value, Fisher Effect, Indenture, Interest Rate Risk.

Answer 1

Debenture : Debenture is usually unsecured bonds or debt instruments, it is unsecured becuase it has no backing by any collaterals. Thus one must rely on the credit worthiness and repulation of the issuer. Many Government and corporate use debentures to raise capital or funds for their business. Usually a debenture is of long term and are more than 10 years of term. Debentures are mainly of two types convertible and non-covertible, convertible debentures usually can be converted into equity shares of a company. e.g. US Treasurely bonds are used by the US government to raise funds for it's day to day operations.

Face Value : Face Value usually defines the nominal value or dollar value of any securities as stated by the issuer. It is also known as Par value, for bonds usually face value is actual amount paid to the holder on the date of maturity, whereas for stocks it is the orinal or actual cost. e.g if a bonds is sold at $976 and has a Par value of $1000, therefore the face value of the bond is $1000 and the holder will recieve the amount on the day of maturity.

The Fisher Effect : It is an economic theory created by economist Irving Fisher that states the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. e.g. if the nominal interest on your savings account is 7 % and expected rate of inflation in the economy is 3 %, the money in the savings account is actually growing at 4% ( 7-3 ) , thus the real interest will keep falling if inflation rises and make the growth of my savings slower.

Indenture : Indenture refers to a legal and binding agreement, contract, or document between two or more parties. Traditionally, these documents featured indented sides or perforated edges. in the past, indenture has also referred to a contract binding one person to work for another for a set period of time, particularly European immigrants. In modern day finance, the word indenture most commonly appears in bond agreements, real estate deals, and some aspects of bankruptcies. e.g. In Real estate an Indenture would be a deed between two parties agreeing to continue obligation where in one party agrees to maintain the property and one party agrees to pay for the same.

Interest Rate Risk : Interest rate risk arises when potential for investment losses that result from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-income investment will decline. The change in a bond's price given a change in interest rates is known as its duration.Interest rate risk can be reduced by holding bonds of different durations, and investors may also allay interest rate risk by hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives. e.g. say an investor buys a five-year, $500 bond with a 6% coupon. Then, interest rates rise to 7%. The investor will have trouble selling the bond when newer bond offerings with more attractive rates enter the market. The lower demand also triggers lower prices on the secondary market. The market value of the bond may drop below its original purchase price. The reverse is also true. A bond yielding a 8% return holds more value if interest rates decrease below this level since the bondholder receives a favorable fixed rate of return relative to the market.