Financial Instruments Explained for Dummies

 

What is a financial instrument?

  A financial instrument is a contract whose value is measured and expressed in cash as a monetary asset or a monetary liability and that can be either created, traded, settled for, or modified as per the requirements of the parties involved. A financial instrument can be a virtual or real document, representing a legal contract that holds any kind of monetary value. Financial instruments are contracts, considered binding between the parties involved, representing an asset to the one party (the buyer) and a liability to the other party (the seller). IAS 32 of the International Accounting Standards (IAS) describes a financial instrument as follows: ‘A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.’ A financial instrument constitutes a contractual right to buy or sell an asset in the future or a right to a future cash flow.  

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Types of financial instruments

  Basically, financial instruments comprise two different types: cash instruments and derivative instruments.  

Cash instruments

  Cash instruments, also referred to as non-complex financial instruments, have, inter alia, the following features:

• They can be transferred easily in the financial markets.
• Their values are directly affected and determined by the markets.
• They can be traded without broad specialist knowledge.

  Typically, cash instruments are categorised into securities and deposits, and loans.  

• Securities

  Securities include equity securities and debt securities. Equity securities refer to shares in companies, representing ownership of a part of a publicly-traded company on a stock exchange. The investor that buys the shares of an entity acquires a financial asset (an investment), while the entity that issues the shares in order to raise capital, has to account for an equity instrument. IAS 32 defines an equity instrument as ‘any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.’ Debt securities comprise, inter alia, bonds (government and corporate), and mortgages.  

• Deposits and loans

  Deposits and loans are also considered cash instruments, representing monetary assets and liabilities agreed upon by borrowers and lenders. Some analysts also include certain types of investment funds, such as hedge funds and mutual funds, under cash instruments. Investment funds enable investors to pool their money in a fund that is managed by a fund manager. The fund manager acts on behalf of the investors, buying and selling securities. Each investor maintains control and retains ownership of his or her own shares.  

Derivative instruments

  Derivative instruments, also called derivatives, and considered complex financial instruments, have, inter alia, the following characteristics as financial instruments:

• Their value is based on the underlying cash instruments (underlying assets), such as shares (stocks), currencies, bonds, interest rates, and stock exchange indices, among others.
• Successful trading in derivatives requires in-depth knowledge from traders.
• Their value is affected by the terms of the contract involved in their trading.

  IAS 32 refers to derivatives in the following way:  

• Regarding a financial asset and a financial liability:

  A derivative is described as any financial asset or financial liability that is ‘a contract that will or may be settled in the entity’s own equity instruments and is: A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments.’ (Accentuations in the quotation is by the article writer.)   Common examples of derivative instruments are:  

• Futures contract: An agreement that enables the exchange of derivatives at a predetermined price at a specified future date.
• Forward contract: A customised contract between two parties to purchase or sell customisable derivatives at a predefined price on a specified date at the end of the contract.
• Options contract: A contract between the buyer and seller in which the buyer is granted the right to buy or sell a specific number of derivatives at a specified price for a specific period of time.
• Interest rate swap: A type of forwarding derivative contract in which one stream of future interest payments is exchanged for another, based on a defined principal amount. Typically, an interest rate swap includes the exchange of a fixed interest rate for a floating interest rate.

  In addition, a swap can also involve the exchange of two floating interest rates, which is referred to as a basis rate swap or base swap. The goal of a basis rate swap is for an entity to limit its interest rate risk, arising from having different borrowing and lending interest rates.  

• Contract for Difference (CFD): A financial derivative contract that enables traders to speculate on short-term price movements, paying the differences in the settlement price between the entry and closing prices.

  For instance, if the closing price of the specific trade is higher than the entry price, the seller is obliged to pay the buyer the difference, resulting in a profit for the buyer. On the contrary, if the closing price of the particular asset is lower than its opening price, the seller, instead of the buyer, will benefit from the transaction. CFDs are used by traders for hedging.  

Financial instruments categorised into asset classes

  Besides the two types of financial instruments described above, financial instruments can also be categorised into two asset classes, namely debt-based financial instruments, and equity-based financial instruments.  

Debt-based financial instruments

  Debt-based financial instruments are means that an entity can utilise to increase the amount of capital in the business for various reasons, such as expanding business operations. Short-term debt-based financial instruments are used for periods less than a year. Examples are commercial paper, certificates of deposit (CDs), and short-term interest rate futures. Long-term debt-based financial instruments last for periods of a year and longer. Examples are bonds, mortgages, and long-term loans.  

Equity-based financial instruments

  Equity-based financial instruments are instruments that allow a company to acquire capital and enable investors to share in the ownership of a company. This asset class includes, among others, shares (ordinary and preference), equity futures, and convertible debentures.  

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