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Financial Instruments (DOC download)

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Financial Instruments (DOC download) Powered By Docstoc
					A financial instrument is either cash; evidence of an ownership interest in an entity; or a
contractual right to receive, or deliver, cash or another financial instrument.

Contents
[hide]

        1 Categorization
            o 1.1 A table
        2 Measuring Financial Instrument's Gain or Loss
        3 See also
        4 External links



[edit] Categorization
Financial instruments can be categorized by form depending on whether they are cash
instruments or derivative instruments:

        Cash instruments are financial instruments whose value is determined directly by
         markets. They can be divided into securities, which are readily transferable, and other
         cash instruments such as loans and deposits, where both borrower and lender have to
         agree on a transfer.
        Derivative instruments are financial instruments which derive their value from the value
         and characteristics of one or more underlying assets. They can be divided into exchange-
         traded derivatives and over-the-counter (OTC) derivatives.

Alternatively, financial instruments can 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 it 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.

[edit] A table

Combining the above methods for categorization, the main instruments can be organized into a
table as follows:

                                                  Instrument Type
 Asset Class                                             Exchange-traded
                     Securities       Other cash                                 OTC derivatives
                                                           derivatives
                                                                                 Interest rate swaps
 Debt (Long                                             Bond futures             Interest rate caps
   Term)          Bonds             Loans               Options on bond          and floors
  >1 year                                               futures                  Interest rate options
                                                                                 Exotic instruments
                  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 instruments
                                                                                 Foreign exchange
                                                                                 options
   Foreign                          Spot foreign                                 Outright forwards
                  N/A                                   Currency futures
  Exchange                          exchange                                     Foreign exchange
                                                                                 swaps
                                                                                 Currency swaps

Some instruments defy categorization into the above matrix, for example repurchase agreements.

[edit] Measuring Financial Instrument's Gain or Loss
The table below shows how to measure a financial instrument's gain or loss:


Instrument
   Type            Categories        Measurement                      Gains and losses
                                                        Net income when asset is derecognized or
                Loans and                               impaired (foreign exchange and
   Assets                          Amortized costs
                receivables                             impairment recognized in net income
                                                        immediately)
                Available for
                                   Deposit account - Other comprehensive income (impairment
   Assets       sale financial
                                   Fair value        recognized in net income immediately)
                assets


[edit] See also
What Does Financial Instrument Mean?
A real or virtual document representing a legal agreement involving some sort of monetary value. In
today's financial marketplace, financial instruments can be classified generally as equity based,
representing ownership of the asset, or debt based, representing a loan made by an investor to the
owner of the asset. Foreign exchange instruments comprise a third, unique type of
instrument. Different subcategories of each instrument type exist, such as preferred share equity and
common share equity, for example.




Government Securities( G-Sec ) :

In India G- Secs are issued by the Central Government , State Governments and Semi
Government Authorities such as municipalities, port trusts, state electricity boards and public
sector corporations. The Central and State Governments raise money through these securities to
finance the creation of new infrastructure as well as to meet their current cash needs. Since these
are issued by the government, the risk of default is minimal. Therefore, interest rates on these
securities often serve as a benchmark for the level of interest rates in the economy. Other issuers
may price their offerings by `marking up’ this benchmark rate to reflect the credit risk specific
to them.

These securities may have maturities ranging from five to twenty years. These are fixed income
securities, which pay interest every six months. The Reserve Bank of India manages the issues
of the securities. These securities are sold in the primary market mainly through the auction
mechanism. The RBI notifies issue of a new tranche of securities. Prospective buyers submit
their bids. The RBI decides to accept bids based on a cut off price.

The G -secs are primarily bought by the institutional investors. The biggest investors are
commercial banks who invest in G-secs to meet the regulatory requirement to maintain a certain
percentage of Statutory Liquidity Ratio (SLR) as well as an investment vehicle. Insurance
companies, provident funds, and mutual funds are the other large investors. The Primary Dealers
perform the function of market makers through buying and selling activities.

The Government of India also borrows short term funds for up to one year. This is through the
issue of Treasury Bills which are sold at a discount to the face value and redeemed at the full
face value.

Industrial Securities:

These are securities issued by the corporate sector to finance their long term and working capital
requirements. The Major Instruments that fall under Industrial Securities are
• Debentures,
• Preference Shares And
• Equity Shares.
Debentures

Debentures have a fixed maturity and pay a fixed or a floating rate of interest during their
lifetime. The company has an obligation to pay interest and the principal amount on the due
dates regardless of its profitability position. The debenture holders are not members of the
company and do not have any say in the management of the company. Since these carry a
predefined rate of return, there is no scope for any major capital appreciation. However, in case
of fixed rate debentures, their market price moves inversely with the direction of interest rates.
The debenture issues are rated by the professional credit rating agencies regarding the payment
of interest and the repayment of the capital amount. Apart from the `plain vanilla’ variety of
debentures (periodic payment of interest during their currency and repayment of capital on
maturity), a number of variations have been devised. For example, zero coupon bonds are issued
at a discount to their face value and redeemed at the full face value. The difference constitutes
return for the investor.

Preference Shares

Preference Shares carry a fixed rate of dividends. These carry a preferential right to dividends
over the equity shareholders. This means that equity share holders cannot be paid any dividends
unless the preference dividend has been paid in full. Similarly on the winding up of the
company, the preference share holders get back their capital before the equity share holders. In
case of cumulative preference shares, any dividend unpaid in past years accumulates and is paid
later when the company has sufficient profits. Now all preference shares in India are
`redeemable’, i.e. they have a fixed maturity period. Thus, preference shares are sometimes
called a `hybrid variety’ – incorporating features of debt as well as equity.

Equity Shares

Equity Shares are regarded as high return high risk instruments. These do not carry any fixed
rate of return and there is no maturity period. The company may or may not declare dividend on
equity shares. Equity shares of major companies are traded on the stock exchanges. The major
component of return to equity holders usually consists of market appreciation.

Call Money Market:

The loans made in this market are of a short term nature – overnight to a fortnight . This is
mostly inter-bank market. Those banks which are facing a short term cash deficit, borrow
funds from the cash surplus banks. The rate of interest is market driven and depends on the
liquidity position in the banking system.

Commercial Paper (CP) and Certificate of Deposits (CD) :

CPs are issued by the corporates to finance their working capital needs. These are issued for
short term maturities. These are issued at a discount and redeemed at face value. These are
unsecured and therefore only those companies who have a good credit standing are able to access
funds through this instrument. The rate of interest is market driven and depends on the current
liquidity position and the creditworthiness of the issuing company.

The characteristics of CDs are similar to those of CPs except that CDs are issued by the
commercial banks.