Chapter 4 - Financial Instruments PDF

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Summary

Financial InstrumentsCities of Mandaluyong and Pasig1. Nature of Financial Instruments 2. Financial Assets 3. Financial Liabilities 4. Equity Instruments 5. Derivatives Financial Instruments 6. Samples and specimens of Financial InstrumentsThis part serves as the introduction of the module and descr...

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RIZAL TECHNOLOGICAL UNIVERSITY Cities of Mandaluyong and Pasig

SESSION NO. 4 / WEEK NO. 4

MODULE NO. 4: Financial Instruments

1. Nature of Financial Instruments 2. Financial Assets 3. Financial Liabilities 4. Equity Instruments 5. Derivatives Financial Instruments 6. Samples and specimens of Financial Instruments

Overview This part serves as the introduction of the module and describes its scope and rationale. It is a general statement about the nature of the module and its relation to the course as a whole. It should not only introduce the topic of the module, but should also forecast the content and organization of the module itself. Moreover, this part summarizes the contents and importance of the module. This is needed to prepare the mental set-up and to motivate the students.

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Study Guide

Learning Outcomes

After studying the chapter, you should be able to 1. Describe what a financial instrument is 2. Describe and give examples of primary and derivative financial instruments 3. Explain what financial asset is; what a financial liability is 4. Give and describe examples of financial assets and financial liabilities 5. Describe equity financial instruments 6. Give and describe examples of derivative financial instrument

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Topic Presentation

NATURE OF FINANCIAL INSTRUMENTS A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. The contract in the definition refers to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing Financial instruments include primary instruments and derivative financial instruments. Based on the definition, financial instruments include financial assets, financial liabilities, equity instrument and derivatives. Derivatives include financial options, futures and forwards, interest rate swaps and currency swaps. A Financial Asset is any asset that is Cash Equity instrument of another entity (e.g., investment in ordinary share of a corporation) Receivable (accounts, notes and loans receivable) Some of the most commonly encountered Financial Instruments representing Financial Assets are the following: (a) Cash on Hand and in Banks 1. Petty cash. Refers to cash balances kept on hand at various locations to pay for minor expenditures such as postage and other small out-of pocket expenditures. 2. Demand, savings and time deposits. Represent amounts on deposit in checking, savings and time deposit accounts respectively. Time deposits are placements covering a relatively long period of time. 3. Undeposited checks. Are checks payable to the enterprise or bearer but not yet presented to the bank for payment. 4. Foreign currencies S. Money orders are financial instruments similar to bank drafts but are drawn generally from authorized post offices or other financial institutions. 6. Bank drafts are commitments by banking institutions to advance funds on demand by the party to whom the draft was directed.

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RIZAL TECHNOLOGICAL UNIVERSITY Cities of Mandaluyong and Pasig (b) Accounts, notes and loans receivable and investment in bonds and other debt instrument issued by other entities: 1. Trade-receivables (signed delivery receipts and sales invoice) 2. Promissory notes 3. Bond certificates (c) Interest in shares or other equity instruments issued by other entities 1. Stock certificates 2. Publicly listed securities (d) Derivative Financial Assets 1. Futures Contracts 2. Forward Contracts 3. Call Options 4. Foreign Currency Futures 5. Interest Rate Swaps Financial Liabilities A financial liability is any liability that is (a) A contractual obligation (i) To deliver cash or another financial asset to another entity; or (ii) To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or (b) A contract that will or may be settled in the entity's own equity instruments and is: A non-derivative for which the entity is or may be obligated to deliver a variable number of the entity's own equity instruments: or A derivative that will or may be settled other than by the exchange (ii) (i) of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments. Examples of Financial Liabilities are the following: Accounts and notes payable, loans from other entities and bonds and other debt instruments issued by the entity.

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RIZAL TECHNOLOGICAL UNIVERSITY Cities of Mandaluyong and Pasig • Derivative financial liabilities. • Obligations to deliver own shares worth a fixed amount of cash. • Some derivatives on own equity instruments. Equity Instruments An equity instrument is any contract that evidence a residual interest in the assets of an entity after deducting all of its liabilities. Examples of Equity Instruments are: Ordinary Shares Preference Shares Warrants or written call option that allow the holder to subscribe or purchase ordinary shares in exchange for a fixed amount of each or another financial asset.

Derivative Financial Instruments Derivatives are financial instruments that "derive" their value on contractually required cash flows from some other security or index. For instance, a contract allowing a company to purchase a particular asset (say gold, flour, or coffee bean) a designated future date, at a predetermined price is a financial instrument that derives its value from expected and actual changes in the price of the underlying asset. Examples of Derivatives 1. Futures Contracts futures contract is an agreement between a seller and a buyer that A requires that seller to deliver a particular commodity (say corn, gold, or soya beans) at a designated future date, at a predetermined price. These contracts are actively treated on regulated future exchanges and are generally referred to as "commodity futures contract." When the "commodity" is a financial instrument such as a Treasury bill or commercial paper, the agreement is referred to as a financial futures contract. Futures contracts are purchased either as an investment or as a hedge against the risks of future price changes. 2. Forward Contracts A forward contract is similar to a futures contract but differs in three ways: a. A forward contract calls for delivery on a specific date, whereas a futures contract permits the seller to decide later which specific day within the specified month will be the delivery date (if it gets as far as actual delivery before it is closed out). b. Unlike a futures contract, a forward usually is not traded on a market exchange.

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RIZAL TECHNOLOGICAL UNIVERSITY Cities of Mandaluyong and Pasig c. Unlike a futures contract, a forward contract does not call for a daily cash settlement for price changes in the underlying contract. Gains and losses on forward contracts are paid only when they are closed out.

3. Call Options Options give its holder the right either to buy or sell an instrument, say a Treasury bill, at a specified price and within a given time period. Options frequently are purchased to hedge exposure to the effects of changing interest rates. Options serve the same purpose as futures in that respect but are fundamentally different. Importantly, though, the option holder has no obligation to exercise the option. On the other hand, the holder of a futures contract must buy or sell within a specified period unless the contract is closed out before delivery comes due. 4. Foreign Currency Futures Foreign loans frequently are denominated in the currency of the lender (Japanese yen, Swiss franc, German mark, and so on). When loans must be repaid in foreign currencies, a new element of risk is introduced. This is because if exchange rates change, the peso equivalent of the foreign currency that must be repaid differs from the peso equivalent of the foreign currency borrowed. 5. Interest Rate Swaps There are contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates.

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SAMPLE AND SPECIMEN OF FINANCIAL INSTRUMENTS

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Guided Exercises / Learning Activities

REVIEW QUESTIONS

Questions 1. Define financial instrument. 2. Give examples of primary financial instruments. 3. Explain the nature of a derivative. 4. Indicate whether the following instruments are examples of money market or capital market securities. -BSP treasury bills Long-term corporate bonds -Ordinary shares (common stocks) -Preferred shares -Dealer commercial paper 5. Distinguish between financial assets and non-financial assets 6. Give examples of financial instruments represented by financial assets and explain each briefly. 7. Distinguish between financial liabilities and non-financial liabilities. 8. Give examples of financial equity instruments and explain each briefly. 9. Give examples of derivatives and explain each briefly.

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Matching Quiz Match the following terms with the correct definitions: a. restructuring b. capital market c. money market d. real capital e. inflation

f. primary market g. secondary market h. disinflation i. financial capital

_______1. This form of capital is found in the statement of financial position under long-term liabilities and equity. _______2. The purchasing power of the peso shrinks over time. _______3. A market where the securities being traded are new public offerings _______4. Securities with a maturity of less than 1 year. _______5. Redeploying the asset and liability structure of the firm. _______6. A leveling off or slowing down of price increases. _______7. Market composed of common stock, preferred stock, commercial and government bonds and other long-term securities _______8. This market trades previously issued securities. _______9. The high inflation rates of the 1980s caused this form of capital to hold its value better than other forms of capital during this time period.

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Assessment

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Assignment

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References

BOOK: FINANCIAL MARKETS AND INSTITUTION Author/s: Ma. Elenita Balatbat Cabrera, BBA, MBA, CPA, CMA Gilbert Anthony B. Cabrera, BBA, MBA, CPA

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