Professional Documents
Culture Documents
Financial Instruments Project
Financial Instruments Project
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 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.
There are four main classes of financial instrument that investors make use of to
achieve either income or capital growth. These are:
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
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
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.
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.