Financial Instuments

8/8/2019 Financial Instuments

http://slidepdf.com/reader/full/financial-instuments 1/18



¾ Definition

¾ Main Groups¾ Characteristics

¾ Uses of Financial Instruments

¾

Types of Financial Instruments.¾ Valuation

¾ Factors Affecting



Financial instruments can be classified into two main groups;

Underlying instruments are used by savers/lenders to transfer

resources directly to borrowers. Examples of underlying FIs includestocks and bonds. Bonds and shares offer payments based solely

on the issuer¶s status. Bonds for example make payments

depending on the solvency of the firm that issued them.

Derivative instruments are instruments whose values are derivedfrom ±the behaviour of the underlying asset. The main use of

derivatives is to shift risk among investors. The most common

derivative instruments are options and futures.



Options A call option gives the holder the right (not

obligation) to buy a particular security at a particular time for a stated price.

A put option gives the holder the right (not obligation) to sell a particular security at a particular time for a stated price.

F utures A future is the obligation to buy a particular security

at a particular time for a stated price. These are used a lot in commodity markets

because of the volatility of these markets.



Divisibility : Refers to the size of the units inwhich the asset can be purchased. Generallyinvestors prefer assets that are highly divisible.

T ransactions costs: Costs of purchasing andselling assets.

E.g. a bank loan. Negotiation costs,information costs, etc.

Liquidity : The ability to convert an asset quicklyinto cash without experiencing a significantreduction in its value.



S tandardization: Financial agreements can be complex. To overcome the potential costs of complexity financial instruments tend to be standardized. E.g. It would be

difficult to sell shares if the shares sold to one investor differed from those sold to another.

Communicate Information: Continuous monitoring of the

issuer of the FI is very costly. The FI summarizes certain essential information about the issuer.



M eans of Payment : E.g. company stock as payment for working. (No FI is as yet as good as money).

S tore of Value: Transfer purchasing power into the future.

Allow trading of risk : Transfer risk from one person or companyto another. E.g. an insurance contract are used to store valueand those used for trading risk.



Money Market Instruments :- are short-term debtinstruments that have maturity of one year or less. They

generally have a relatively high degree of liquidity. They tendto have a low expected return but also a low degree of riskas compared to the capital market instruments. Examplesinclude: treasury bills, commercial paper, repurchaseagreements etc.

Capital Market Instruments :- are securities with maturity greater than 1 year and those with no designated maturity at all. Examples include: government bonds, municipal bonds, corporate bonds etc.



Government securities: are sovereign securities which are issued by the Reserve Bank of India on behalf of Government of India

Inter corporate deposits are deposits made by one company with another company, and usually carry a term of six months. The three types of inter -corporate deposits are: three month deposits, six month deposits, and call deposits.

Treasury bills: A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13weeks)

or six

months

(26weeks).



Certificates of deposits has a specific, fixed term (often three months, six months, or one to five years), and, usually, a fixed interest

rates. It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.

Money at call and short notice:Next in liquidity after cash, money at call is a loan that is repayable on demand, and money at short

notice is repayable within 14 days of serving a notice.

Commercial bills: A written order from one person (the payor) to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at some fixed future date, a certain sum of money, to either the person identified as payee, or to any person presenting the bill of exchange.

Commercial paper : An unsecured, short-term debt instrument issued by a corporation, typically for meeting short-term liabilities. Maturities rarely range any longer than 270 days. It is usually issued at a discount, reflecting prevailing market interest rates.



Equities: Equities are a type of security that represents the ownership in a company. Equities are traded (bought and sold) in stock markets.

Alternatively, they can be purchased (IPO) route. Investing in equities is a good long-term investment option.

Mutual funds: A mutual fund allows a group of people to pool their money together and have it professionally managed, in keeping with a predetermined investment objective.

This investment avenue is popular because of its cost-efficiency, risk-diversification, professional management and sound regulation.

Deposits: Investing in bank or post-office deposits is a very common way of securing surplus funds. These instruments are at the low end of the risk-return spectrum.



Bank loans: ± the borrower needs funds to use while the lender is looking for a way to store value into the future.

Bonds: are fixed income instruments which are issued for the purpose of raising capital. Both private entities, such as companies, financial institutions, and the central or state government

and other government institutions use this instrument as a means of garnering funds. Bonds issued by the Government carry the lowest level of risk but could deliver fair returns.



H ome mortgages: ± In exchange for the funds the borrower promises to make a series of

payments. The house is the collateral for the loan.

Stocks : When you buy stocks, you own a part of the company¶s assets.

If the company does well, you may receive periodic dividends and/or be able to sell your stock at a profit. If the company does poorly, the stock price may fall and you could lose some or all of the money you invested.



1. Futures - This is the type of currency that have standard sizes as well as dates of maturity. The contract has an average length of 3 months roughly. The contracts usually include interest of any amount.

One example is 500,000 British pounds for next December at a rate previously agreed upon.

2. Forward Transaction - In this type of transaction, one's money doesn't change the hands actually not until

there is an agreed upon date in the future. The buyer and the seller agree on an exchange rate for a date anytime in the future, and the deal occurs on that particular date, and this is regardless of what the rates in the market would be then. Duration of trading could be carried out in a few days, months and even years.



3. Spot - This type of transaction is defined by its two-day delivery which when compared to the future type of contracts that have the duration of usually three months.

The spot trade represents the "direct exchange"between two kinds of currencies. The spot has the shortest length of time. It involves money or cash rather than the contract.

4. Swap - The currency swap consists of two parties exchanging

currencies for a period of time. The two parties agree to reverse the trade at a certain later date. The Swap however is not considered as contracts and swaps are not traded through the exchange.



The value of any financial instrument depends on how much it is expected to pay, and the present value of the payment.

Obviously, the greater the expected return of the instrument, the greater its

value. This is why the stock of a fast-growing company is highly valued, for instance.

A financial instrument that has less risk will have a higher value than a similar instrument that has more risk²the greater the risk, the more it lowers the value of the security because r isk r equir es compensation.

The pr esent value of a payment is determined by when the payment will be made. The greater the amount of time until payment, the less the present value of the security, and, hence, the lower its value. So a zero coupon bond that was going to pay its $1,000 principal 1 year from now will obviously have a greater value than a zero that will pay its principal 10 years from now



The maturity of the instrument: generally the longer the maturity the more risky it is.

The creditworthiness of the issuer.

The liquidity of the instrument and the type of

market in which it is traded.

Financial Instuments

Documents

Transcript of Financial Instuments