Concepts of Shares and Loans

Shares and Loans- What are they? How are they different? Let us analyse them in detail.

• Shares

To fulfill the demand of capital, shares can be issued. The buyer of the shares becomes partly owner of the corporation. One would like to be the owner of a company if he/she expects the corporation to be successful and generate future profits. Corporate profits can be paid to the owner as dividend. Also, there can be higher demand for shares of corporations that are successful. As a result, the investor can sell the shares for a higher price. However, if the corporation is not successful, its shares would drop in value. Since there is no right of repayment if you buy the share and future profit depends on many factors, the buying of shares is a risky investment. Investors expect a higher return if they buy shares. Thus, expectations about the future performance are important. Indicators for issued shares are privileged by exchanges. A well know benchmark is the indicator of the New York Stock Exchange (NYSE), the Dow Jones. The share prices can be very volatile. Share prices generally go down if an economy is facing problems. If the economic outlook improves, the investors will start buying shares in the expectations of increasing profits and returns.

• Loans

Loans are the alternative to raise capital, by lending money. They can be thought of as a product type to connect supply and demand of capital. A loan is also a deposit for the capital supplier. In their contract, the borrower and lender make agreements about the maturity and yearly compensation levels. These agreements make loans less risky as compared to shares. The lower risk makes it easier to raise capital by borrowing as compared to issuing shares. Maturity is the moment when the loan is repaid. Loans can be tradable, such as bonds and commercial paper. Commercial paper has a maturity of maximum 2 years. Bonds are long term tradable loans. Because of the substantial issue expenses, tradable loans are only issued by big corporations and large financial institutions. Also, government deficits are normally financed by issuing tradable loans such as treasury bonds, notes & bills. If a loan is not tradable, it increases the risk of the lender of not being repaid- the default or credit risk. Interest, is the agreed compensation to the lender for capital supply at risks. The question which arises is- What factors influence the interest rates? The main factor influencing the interest rate is default or credit risk. The higher the default risk, higher is the interest rate. To assess credit risk is a complex task that requires data mining analysis and expertise. Commercial external rating agencies assess the default risk for the issuer. Some well known rating agencies are- Moody’s, Standard & poor, Fitch. Investors rely on these ratings for their investment decisions and interest compensation levels. Besides the above, all of the factors like inflation, economic factors, politics and central bank policy also have an impact on the interest rates.

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