Summarizing the different cashflow models
A cashflow model is a mathematical projection of the payments arising from a financial transaction, eg a loan, a share or an insurance policy.
Payments received: Income or positive cashflows
Payments made: Outgo or negative cashflows
Example: We can model the cashflows in our own bank account. As a college student we may have the inflows of stipend from internship, money received from our parents, while on the other hand outflows can be of college fees paid, money spent on daily travel and food, payments for buying books etc.
The timing and the amount of such cashflows then become important characteristics of the cashflow model, varying from one model to other.
Both the timing and the amount of payment can be certain or uncertain. When the cashflows to be received are uncertain, we can consider different scenarios and assign appropriate probabilities to them.
Example: If an employee receives her salary at the end of every month, then her salary will be certain positive cashflow. On the other hand, if we have bought a lottery ticket then receiving the prize money will become an uncertain cashflow.
Cashflows from different financial securities
- Zero Coupon Bonds
The term zero-coupon bond is used to describe a security that is simply a contract to provide a specified lump sum at some specified future date.
This security is usually a loan issued by an organization or a body to the investor. The distinguishing characteristic of such a loan is that there is no interest payments made during the term of the security. The interest is usually a part of the lump sum paid at the end.
Cashflows for the investor:
Single negative cashflow, while purchasing the security
Single positive cashflow, in terms of lump sum payment received
Certainty of the cashflows:
While there is always remains a risk of the issuing authority defaulting on the repayments of loan, such risk is negligible in case of government securities.
Hence for government zero-coupon bonds, cashflows are certain.
- Fixed-Interest Security
Fixed interest securities are similar to zero-coupon bonds, with the difference being that regular interest payments are made during the term of the loan in the case of fixed interest security.
Thus fixed interst security is issued for a stated nominal amount to be repaid to the investor in lump-sum at the date of redemption either at par, at premium or at discount.
Let’s understand what do we mean by redemption at par, at premium or at discount:
- At Par: Redemption Amount = Nominal Amount at Issue
- At Premium: Redemption Amount > Nominal Amount at Issue
- At Discount: Redemption Amount < Nominal Amount at Issue
Apart from the lump-sum being paid, regular interest payments are also made to the investor, which are termed as coupons.
Cashflows for the investor:
Single negative cashflow, while purchasing the security
Single positive cashflow, in terms of lump sum payment received
Series of small positive cashflows, in terms of the coupons at specified future dates
Certainty of the cashflows:
Fixed interest securities are usually issued by a body such as an industrial company, a local authority or the government.
The risk of default always exists however this is negligible in the case of government.
Hence cashflows can be considered to be certain.
- Index-linked bonds
Index-linked bonds are such securities where the cashflows are linked to an index which reflects the effects of inflation.
Why is there a need for such securities?
Inflation or an increase in the general price level of goods and services can diminish the purchasing power of money. Hence, investors often prefer securities where the nominal amount of cashflows increase in line with the rate of inflation.
For Example:
If inflation is 10% per time period and the regular interest payment after one time period is £500, then the payment after two time periods will be £550 ( = 500 1.1 ´ ), and the payment after three time periods will be £605 ( = ´ 2 500 1.1 ) etc.
Cashflows for the investor:
Single negative cashflow, while purchasing the security
Single unknown positive cashflow, in terms of lump sum payment received at redemption
Series of small unknown positive cashflows, in terms of coupons
Why are these cashflows unknown?
The cashflows are unknown in nominal terms, while being in known in real terms. When we are talking about real terms we are taking into consideration the effects of inflation, while nominal terms does not. Thus if the index-linked bond gurantees an interest rate of 5%, investor will know that the real cashflow would give us the promised rate of return. However, the investor would not know the nominal amount he will receive as the rate of inflation would be unknown.
Certainty of the cashflows:
Similar to fixed-interest securities or zero coupon bonds, though the risk of default exists, the cashflows are considered to be certain.
Important note: While calculating the nominal amount of coupons to be made, in practice an index from a previous time period may be used because of the lag present in the collection of data and calculation of index figures.
- Cash on Deposit
If you deposit cash in your own bank account, you are free to withdraw it whenever you want and the interest rate accrued will depend on the prevailing rate if interest.
Cashflows for the investor:
The day-to-day cashflows are completely according to the investor’s discretion.
Certainty of the cashflows:
While the timing of the deposits and withdrawls from the bank account may be known to the investor, but the interest accrued is uncertain since it depends on the prevailing current rate of interest.
- Equity or Common Stock
Equity shares are securities held by the owners of the organization. These shares denote a fraction of the company’s capital. So if a company issues 4000 shares (so that 1 share = 1/4000th part of the company), and you as an investor purchase 1000 shares, you own 25% (4000/1000) of the company.
Equity shares do not provide you with a fixed rate of interest, rather an equity holder is entitled to a share in the company’s profit. This share in the profit is proportional to the number of shares held by the shareholder.
The distribution of profits to shareholders takes the form of regular payments known as dividends.
Cashflows for the investors:
There is an initial negative cashflow when the investor buys the share. Following this there are a series of positive cashflows in the form of dividends. If the investor does not sell his share and provided that the company does not fail, these dividends are expected to be continued till perpetuity.
If the investor sells his share then there will be a positive cashflow in terms of the sale proceeds received.
Moreover, if the company fails, the equity shareholder will be entitled to a proportionate share in company’s assets, after the creditors and preference shareholders have been paid.
Certainty of the cashflows:
The timing and amount of the positive cashflows received by the investor are both uncertain. This is so as the rate of dividend declared by the company on the designated date is at the discretion of the company and is not fixed. The rate of dividend can depend on various factors such as profits earned by the company, its investment plan etc.
Moreover the timing of the dividend payment becomes uncertain as the company may decide to not make dividend payments in a particular quarter/year.
The timing for sale proceeds also becomes uncertain as the investor cannot know for sure beforehand when will he sell his share. It is most likely to be dependant on the prevailing market conditions.
- Annuity – Certain
Under this cashflow schedule, the investor makes an initial payment (known as a premium) and receives a series of regular payments in return.
The cashflows under annuity-certain are almost identical to that of a fixed-interest security, except for the fact that there is no redemption amount.
Examples of annuity certain can be: say you provide a friendly loan to a neighbor of $100, and receive monthly payments for a fixed number of months of $10, then this will be an example of annuity certain.
Cashflows for the investor:
An initial negative cashflow followed by a series of positive cashflows.
Certainty of the cashflows:
The precise payment amount along with the number of years till which the annuity is supposed to be paid is clearly specified. Hence both the amount and timing of the cashflows are certain.
- ‘Interest-only’ Loan
An ‘interest-only’ loan is a loan that is repayable by a series of interest payments followed by a return of the initial loan amount. In this case, the full capital borrowed remains outstanding throughout the term of the loan.
Cashflows for the investor:
An initial positive cashflow (in terms of the amount borrowed), followed by a series of negative cashflows (in terms of interest repaid and the final repayment).
Certainty of the cashflows:
If the interest rate and the timing of payment is fixed in advance, the cashflows will be certain. However, this is not always necessary, as in practice the interest rate may not be fixed in advance and the it may be possible for the loan to be repaid early, in this case cashflows will become uncertain.
- Repayment loan or Mortgage
A repayment loan is a loan that is repayable by a series of payments that include partial repayment of the loan capital in addition to the interest payments.
On every repayment, the interest will be calculated on the loan amount outstanding at the previous repayment date. Hence the interest and capital components of every repayment can hugely vary.
Cashflows for the investor:
An initial positive cashflow (in terms of the loan amount) followed by a series of negative cashflows.
Certainty of the cashflows:
Mostly, the payment schedule is in the form of annuity certain, with the repayment amounts and timing fixed. Hence the cashflows become certain.
Cashflows from Insurance contracts
Cashflows under insurance contracts differ from those under financial securities since these cashflows are contingent on the occurrence of an event and hence posses a greater degree of uncertainty.
- Pure Endowment
Under this type of insurance policy, the policyholder is paid a lump-sum amount if she survives till the end of the term. In return of this benefit, the policyholder pays a series of regular payments for a specified period of time, known as premium payments.
The premium payment can also be in the form of a lump-sum payment at the outset rather than a series of payments.
Cashflows for the investor:
A series of negative cashflows (in case of regular premium payments) or an initial negative cashflow at the outset (in case of lump-sum premium payment).
Certainty of the cashflows:
The premium payments are made till the policyholder is alive, and the benefit payment is contingent on the policyholder’s survival till the end of the term. Hence the payment of survival benefit is uncertain. The timing of premium payments is certain but the number of premium payments received is uncertain as they cease when the policyholder dies.
Usually the amount of the premiums to be paid along with the survival benefit is pre-determined, hence the amount of the payment is certain.
- Endowment Assurance
This insurance policy is similar to pure endowment, except the fact that here a benefit is paid to the policyholder on his/her death as well, if death occurs within the term of the policy. There is a series of regular premium payments in return for the benefit payment promised by the policyholder.
The amount of death benefit can be different than that of the survival benefit.
Cashflows for the investor:
There are a series of negative cashflows (in terms of regular premium payments) followed by a positive cashflow (on survival till the end of the term or death within the term period).
Certainty of the cashflows:
Though the payment of the benefit amount is certain, the timing remains uncertain as the payment is made on survival or on earlier death. The timing of premium payments is certain but the number of premium payments received is uncertain as they cease when the policyholder dies.
Usually the amount of the premiums to be paid along with the benefit is pre-determined, hence the amount of the payment is certain.
- Term Assurance
A term assurance is an insurance policy which provides a lump sum benefit on death before the end of a specified term usually in return for a series of regular premiums.
An endowment assurance policy can thus be thought of as a combination of pure endowment and term assurance policy.
Cashflows for the investor:
There are a series of negative cashflows (in terms of regular premium payments) followed by a positive cashflow (on the condition that the policyholder dies within the term of the policy).
Certainty of the cashflows:
Here the payment of death benefit is uncertain, as no payment is made if the policyholder does not die within the term of the policy. The timing of premium payments is certain but the number of premium payments received is uncertain as they cease when the policyholder dies.
Usually the amount of the premiums to be paid along with the benefit is pre-determined, hence the amount of the payment is certain.
- Contingent Annuity
Such type of policy is similar to annuity certain but the annuity payments are contingent on the occurrence of certain events.
Examples of contingent annuity:
A reversionary annuity: based on 2 lives; regular payments start on the death of first live if the second life is alive at that time. This can be in the case when the annuity is paid to wife on husband’s death, provided she is alive at that time.
Cashflows for the investor:
There is usually an initial negative cashflow (in terms of lump-sum premium) followed by a series of positive cashflows starting on the occurrence of an event or paid till a particular event (for example death of the policyholder).
Certainty of the cashflows:
Here though the initial cashflow is certain, the annuity payments are uncertain since their timing depends on the occurrence of an event.
The amount of the cashflows however are pre-determined and hence certain.
- Car Insurance Policy
Car insurance policies usually last for a period of one year. They usually include a ‘property cover’ but can also include ‘liability cover’. Let’s understand their meaning:
Property cover: the insurer provides cover to pay for damage to the insured vehicle or fire or theft of the vehicle.
Liability cover: the insurer provides cover for compensation payable to third parties for death, injury or damage to their property caused by the insured car.
The method of settlement can also vary depending on the term of the agreement.
The insurer may settle claims directly with the policyholder or with another party. For example in case of theft, the insurer may pay the claim directly to the policyholder while in case of damage to a third-party vehicle, it may pay the claim directly to the third party.
Cashflows for the investor:
There is usually an initial negative cashflow (in terms of lump-sum premium). This can be followed by:
- A positive cashflow: if the insurer pays out claim amount to policyholder
- A negative cashflow followed by a positive cashflow: if there is some time lag in the payment made by the insurer
- No further cashflow: if no claim is made, or if insurer directly settles with the third-party
Certainty of the cashflow:
Here though the initial cashflow is certain, the claim payments are uncertain since they are contingent on the occurrence of some loss.
- Health Insurance Policy
A typical health insurance contract lasts for one year. In return for a premium, the policyholder is entitled to benefits which may include hospital treatment either paid for in full or in part, and/or cash benefits in lieu of treatment, such as a fixed sum per day spent in hospital as an in-patient.
Cashflows for the investor:
There is usually an initial negative cashflow (in terms of lump-sum premium).
This can be followed by:
- A positive cashflow: if the insurance company pays claim amount to the policyholder
- No cashflow: if the insurance company directly pays the expense bills
- A negative cashflow followed by a positive cashflow: if there is some time lag in the payment made by the insurer
Certainty of the cashflow:
Here though the initial cashflow is certain, the claim payments are uncertain since they are contingent on the occurrence of some event.
1 Comment
You should be a part of a contest for one of the greatest sites on the net. I will recommend this blog!