BASIC FINANCIAL ASSETS

Shares of stock and bonds represent claims on current and future earnings of a corporation. Bonds represent a debt or liability on the corporation's (or government's) balance sheet and typically oblige the firm to make periodic interest payments to bondholders. Bonds eventually mature and at that time the principal amount of the loan that the bond represents must be returned to the holder. The holders of a bond may passively collect interest payments over the duration of the bond's life and then receive the principal at maturity. The holder may also elect to sell the bond at any time prior to maturity. Since the bond represents a claim on a series of future payments, the bond's value can be estimated at any time as the discounted present value of those remaining payments. Thus, when the bondholder offers the bond for sale, the interest rate used to discount the remaining payments will be the primary determinant of its value. This interest rate can also be interpreted as the potential buyer's required rate of return. This required rate will be determined by a variety of factors including expectations of inflation, the default risk associated with the corporation, and interest rates offered on similar securities. This description culminates in two observations regarding the value of bonds. First, the higher the required rate of return, the lower the discounted value of the bond's required payments and hence, its value. In other words, as interest rates go up, bond prices go down. Conversely, as interest rates fall, bond prices rise. Second, these interest rates are determined in a competitive market and they will fluctuate continuously. Therefore, the market value of the bond will change constantly.

STOCKS.

Stock represents a claim on residual earnings of the corporation. Since there may be no earnings available after all other claims have been satisfied and since those earnings may be retained by the firm rather than directly distributed to stockholders as dividends, the value of stock is inherently more volatile than the value of bonds. The value of stock is also related to the expected future cash flows: dividends and future selling price. These future cash flows, however, are much more difficult to forecast. Obviously, as the market's assessment of the level of these future cash flows improves or deteriorates, the stock's price will rise or fall.

MARKET INDEXES.

There are also a variety of market indexes that measure overall price movement of the U.S. stock market (e.g., Dow Jones Industrial Average, Standard & Poor's 500), interest rate sensitive instruments such as bonds (e.g., Salomon Brothers Bond Indexes), and the level of interest rates themselves (e.g., yields on various securities issued by the U.S. Treasury, the Federal Funds rate, and the London Interbank Offered Rate, or LIBOR). There are comparable indexes for every major financial market throughout the world (e.g., the Financial Times 100 in the U.K. and the Nikkei Index in Japan). These market indexes play an important role in financial engineering. Contracts can be tied to the value of a specific index and can thereby be used to initiate cash flows between contracting parties. In this way, a contract can simulate rates of return for an index without the obligation to buy and hold the securities actually included in the index.