FINANCIAL INSTRUMENTS

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 CHAPTER -1
INTRODUCTION
What is a 'Financial Instrument'
Financial instruments are assets that can be traded. They can also be seen as
packages of capital that may be traded. Most types of financial instruments provide
an efficient flow and transfer of capital all throughout the world's investors. These
assets can be cash, a contractual right to deliver or receive cash or another type of
financial instrument, or evidence of one's ownership of an entity.

Financial instruments are monetary contracts between parties. They can be

created, traded, modified and settled. They can be cash (currency), evidence of an
ownership interest in an entity (share), or a contractual right to receive or deliver
cash (bond).
International Accounting Standards IAS 32 and 39 define a financial instrument as
"any contract that gives rise to a financial asset of one entity and a financial liability
or equity instrument of another entity".

Financial instruments can be real or virtual documents representing a legal

agreement involving any kind of monetary value. Equity-based financial instruments
represent ownership of an asset. Debt-based financial instruments represent a loan
made by an investor to the owner of the asset. Foreign exchange instruments
comprise a third, unique type of financial instrument. Different subcategories of each
instrument type exist, such as preferred share equity and common share equity.

This section will briefly define financial instruments. The relationship between
financial assets and other financial instruments will be explained, as per MFSM para.
117.Also instruments that are not financial assets will be identified (viz.,
contingencies,guarantees, nonfinancial contracts). It will be noted that the financial
assets classificationgenerally applies to both claims (described as assets) and
obligations (described asliabilities). There are exceptions in that monetary gold and
SDRs are international financialassets with no counterpart liabilities and that
“accounts receivable” is an asset, while“accounts payable” is the corresponding
liability.

The objectives of classification of financial instruments will be spelled out. The

potential dimensions by which instruments can be classified are numerous, so the
classification involves identifying the most economically crucial features. The
implicationsof a high degree of financial innovation will be discussed—in particular,
that theclassification will need to define the instruments with reference to the
characteristics, not justspecific types of instrument, so that it is applicable to new
instruments and helps deal withhybrid and other borderline cases. The importance of
classification of financial assets forunderstanding financial markets and for
consistency with other datasets, particularlymonetary and financial statistics, will be
highlighted. In addition, the financial asset classification will be presented as the
foundation for the functional category classification,which in some cases takes into
account the type of instrument.

The investment industry exists to serve its customers. There are two main groups of
customers – investors and security issuers. Investors may be private individuals,
charities, companies, banks, collective investment schemes such as pension funds
and insurance funds, central and local governments or “supranational institutions”
such as the World Bank.

Investors in turn have investment objectives, which may be to increase wealth

(capital growth) or to provide income. Some investors will have only one of these
objectives, some will have both. For example, a high earning private individual
probably has all the income that he or she needs from employment, and wishes to
invest surplus cash to provide capital growth. A charity, however, may need the
maximum possible income that it can get from its investments in order to fund its
activities.

There are four main classes of financial instrument that investors make use of to
achieve either income or capital growth. These are:

1.Equities, also known as stocks or shares

2.Debt instruments, also known as bonds or bills

3.Cash

4.Derivatives.

Equities and debt instruments are collectively known as securities. In order for there
to be any securities for the investor to invest in, then some organisation, such as a
company, a bank, a government or a supranational institution, has to issue
securities.
 Meaning

International Accounting Standards IAS 32 and 39 define a financial instrument as

"any contract that gives rise to a financial asset of one entity and a financial liability
or equity instrument of another entity".
 Types

Financial instruments can be either cash instruments or derivative instruments:

 Cash instruments —instruments whose value is determined directly by the markets. They
can be securities, which are readily transferable, and instruments such
as loans and deposits, where both borrower and lender have to agree on a transfer.
 Derivative instruments —instruments which derive their value from the value and
characteristics of one or more underlying entities such as an asset, index, or interest rate.
They can be exchange-traded derivatives and over-the-counter (OTC) derivatives.[2]
Alternatively, financial instruments may be categorized by "asset class" depending on whether they
are equity-based (reflecting ownership of the issuing entity) or debt-based (reflecting a loan the
investor has made to the issuing entity). If the instrument is debt, it can be further categorised into
short-term (less than one year) or long-term. Foreign exchange instruments and transactions are
neither debt- nor equity-based and belong in their own category.

Instrument type
Asset class Exchange-traded
Securities Other cash OTC derivatives
derivatives
Interest rate swaps
Debt (long Bond futures Interest rate caps and
term) Bonds Loans Options on floors
> 1 year bond futures Interest rate options
Exotic derivatives
Bills, e.g. T-
Debt (short Deposits
bills Short-term interest Forward rate
term) Certificates of
Commercial rate futures agreements
≤ 1 year deposit
paper
Stock options Stock options
Equity Stock N/A
Equity futures Exotic derivatives
Foreign N/A Spot foreign Currency futures Foreign
 exchange exchange exchange options
Outright forwards
Foreign exchange
swaps
Currency swaps

Traders in a financial market exchange securities for money.

Securities are contracts for future delivery of goods or money,

e.g.shares,bonds,derivatives
One distinguishes between underlying (primary) and derivative (secondary)
instruments.Examples of underlying instruments are shares, bonds,
currencies,interest rates, and indexes.A derivative is a financial instruments whose
value is derived from and underlying asset.Examples of derivatives are forward
contracts, futures, options,swaps

One also distinguishes between primary and secondary markets. Securities are issued for the first
time on the primary market, and then traded on the secondary market. The secondary market
provides important liquidity.
Borrowing and lending is done in fixed–income markets. The money market is for very short–term
debt (maturities ≤ 1 yr.)

Finally, we distinguish between the spot market and the forwardmarket. Most transactions are spot
transactions: Pay now, and receive goods now.

To hedge/speculate on future market movements, it is possible to sell goods for delivery in the
future. Forward and futures contracts are derivatives which make this possible.

Equity: Stocks, shares. Ownership of a small piece of a company.

Shareholders own a corporation. Directors act in the shareholders best interest. Public limited
companies are listed on a stock exchange. Ownership iseasily transferred. The shareholders share
the profits of the company, but have limited liability: At most, they can lose their investment.
Most shares pay regular dividends, whose amount varies according to profitability and opportunities
for growth.

 Short selling: Selling a share you don’t own, hoping to pick them up more cheaply later on.
 Your broker borrows the share from a client.

 You may now sell these shares, even though you don’t own them.
 Later, you buy the shares in the market and return them to your broker, who returns them
to the other client. You also pay any dividends that were issued in the interim.
 Commodities: Raw materials such as metals, oil, agricultural products, etc. These are often
traded by people who have no need for the material, but are speculating on the direction of
 the commodity.Most of this trading is done in the futures market, and contracts are closed
out before the delivery date.
 Currencies: FOREX.
 Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500,
DIJA, FTSE100, DAX–30, NIKKEI225,NASDAQ100, ALSI40, INDI25, EMBI+, GSCI). A typical
index consists of a weighted sum of a basket of representative stocks. These representatives
and their weights may change from time to time.
 Fixed income securities:
 Bonds, notes, bills. These are debt instruments, and promise to pay a certain rate of interest,
which may be fixed or floating.
 Example: A 10–year, 5% semi–annual coupon bond with a face value of $1m promises to pay
$25 000 every six months for 10 years, and a balloon of $1m at maturity.
 Annuities pay out a fixed amount at regular intervals in return for an upfront lump sum.
Mortgages are an example.