FINANCIAL INSTRUMENTS

Chapter No. Page No.

1 Introduction Of 2-3
Financial
Instruments
2 Types Of 4-11
Financial
Instruments
3 Classification Of 12-23
Financial
Instruments
4 Functions & 24-28
Characteristics Of
Financial
Instruments
5 Advantage Of 29-35
Financial
Instruments
6 An Overview Of 36-44
Financial
Instruments
 CHAPTER-1
INTRODUCTION
What is a 'Financial Instrument'
Financial instruments are assets that can be traded. They can also be seen as
packages of capital that may be traded. Most types of financial instruments provide
an efficient flow and transfer of capital all throughout the world's investors. These
assets can be cash, a contractual right to deliver or receive cash or another type of
financial instrument, or evidence of one's ownership of an entity.

Financial instruments are monetary contracts between parties. They can be

created, traded, modified and settled. They can be cash (currency), evidence of an
ownership interest in an entity (share), or a contractual right to receive or deliver
cash (bond).
International Accounting Standards IAS 32 and 39 define a financial instrument as
"any contract that gives rise to a financial asset of one entity and a financial liability
or equity instrument of another entity".

Financial instruments can be real or virtual documents representing a legal

agreement involving any kind of monetary value. Equity-based financial instruments
represent ownership of an asset. Debt-based financial instruments represent a loan
made by an investor to the owner of the asset. Foreign exchange instruments
comprise a third, unique type of financial instrument. Different subcategories of each
instrument type exist, such as preferred share equity and common share equity.

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, whileaccounts payable is the corresponding
liability.

The objectives of classification of financial instruments will be spelled out. The

potential dimensions by which instruments can be classified are numerous, so the
classification involves identifying the most economically crucial features. The
implicationsof a high degree of financial innovation will be discussedin particular,
that theclassification will need to define the instruments with reference to the
characteristics, not justspecific types of instrument, so that it is applicable to new
instruments and helps deal withhybrid and other borderline cases. The importance of
classification of financial assets forunderstanding financial markets and
forconsistency with other datasets, particularlymonetary and financial statistics, will
be highlighted. In addition, the financial assetclassification will be presented as the
foundation for the functional category classification,which in some cases takes into
account the type of instrument.

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.

Investors in turn have investment objectives, which may be to increase wealth

(capital growth) or to provide income. Some investors will have only one of these
objectives, some will have both. For example, a high earning private individual
probably has all the income that he or she needs from employment, and wishes to
invest surplus cash to provide capital growth. A charity, however, may need the
maximum possible income that it can get from its investments in order to fund its
activities.

There are four main classes of financial instrument that investors make use of to
achieve either income or capital growth. These are:

1.Equities, also known as stocks or shares

2.Debt instruments, also known as bonds or bills

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.
 CHAPTER-2
TYPES OF FINANCIAL
INSTRUMENTS

Financial instruments can be either cash instruments or derivative instruments:

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.
Cash instruments one type of financial instruments. Several cash market
instruments are available in the money market like, certificates of deposits,
repurchase agreements, that is, the Repos, bills of exchange, interbank loans,
commercial papers etc.will describe some of them to analyze the cash
instruments.
Cash instruments are basically financial instruments. There are different kinds of
cash instruments available in the money market. These are certificates of
deposits, repurchase agreements, that is, the Repos, bills of exchange, interbank
loans, commercial papers.
Unlike the interbank deposits, the certificates of deposits (CD), commercial
papers and federal saving bonds are negotiable instruments., that is, they can
be traded in the secondary market before the end of the whole term.

Certificates of Deposit:

It is more advantageous than the normal savings. CD documents the issuing

of a deposit at a given rate of interest for a particular term. So, the borrower
has to pay a particular amount of capital, which was agreed by the two
parties, with interest to the owner on the date of maturity.
CDs originally came from the US money market. In the Euro market,
certificates of deposits are related to common interbank deposits or loans.
Commercial Paper (CP):
These are basically short-term bonds. The issuer of a CP has to pay the
capital with the interest to bearer at maturity. For the companies, commercial
papers act as securitization, that is, they can borrow without using their bank
deposits. Mainly, the investment banks issue the commercial papers.
Treasury Bills:
These are short-term debts, maximum for one year, which are usually issued
within an auction framework. The liquidity of the treasury bills is very high, that
is why it is a very important cash instrument in the money market. The
 treasury bills do not have a fixed rate of interest, therefore it is called discount
instruments

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.

Derivative Instruments

Derivative instrument, or only derivative, is a kind of financial instrument. As the

name suggests, the value of a derivative is derived from the value of the underlying
asset. The value by using which a derivative instrument calculates its value is termed
as underlier.

Examples:

It can be explained with an example, say, and stock option. The value of the stock
option is derived from the stock value; therefore a stock option can be a derivative.

Another good example of derivative instrument is the interest rate swap, for it
calculates its value using the interest rate indices.

Classification:

Derivative instruments can be classified through several ways. One is the

difference between non-linear derivatives and linear derivatives.

The non-linear derivatives have non-linear payoffs whereas; the linear derivatives
have linear payoffs. Non-linearity occurs in case of an option.

Another two types of derivatives are exotic derivatives, which are complicated, and
vanilla derivatives, which is very common.
 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
exchange options
Foreign Spot foreign Outright forwards
N/A Currency futures
exchange exchange Foreign exchange
swaps
Currency swaps

Traders in a financial market exchange securities for money.

Securities are contracts for future delivery of goods or money,

e.g.shares,bonds,derivatives
One distinguishes between underlying (primary) and derivative(secondary)
instruments.Examples of underlying instruments are shares, bonds,
currencies,interest rates, and indexes.A derivative is a financial instruments whose
value is derived from and underlying asset.Examples of derivatives are forward
contracts, futures, options,swaps

One also distinguishes between primary and secondary markets.Securities are

issued for the first time on the primary market, andthen traded on the secondary
market. The secondary market provides important liquidity.
Borrowing and lending is done in fixedincome markets. The moneymarket is for
very shortterm debt (maturities 1 yr.)

Finally, we distinguish between the spot market and the forwardmarket.Most

transactions are spot transactions: Pay now, and receive goodsnow.
To hedge/speculate on future market movements, it is possible to sellgoods for
delivery in the future. Forward and futures contracts are derivatives which make this
possible.

Equity: Stocks, shares. Ownership of a small piece of a company.

Shareholders own a corporation. Directors act in the shareholdersbest interest.
Public limited companies are listed on a stock exchange. Ownership is easily
transferred. The shareholders share the profits of the company, but have limited
liability: At most, they can lose their investment.
Most shares pay regular dividends, whose amount varies according toprofitability
and opportunities for growth.

Short selling: Selling a share you dont own, hoping to pick them upmore
cheaply later on.
Your broker borrows the share from a client.

You may now sell these shares, even though you dont own them.
Later, you buy the shares in the market and return them to yourbroker, who
returns them to the other client. You also pay anydividends that were issued
in the interim.
Commodities: Raw materials such as metals, oil, agriculturalproducts, etc.
These are often traded by people who have no need forthe material, but are
speculating on the direction of the commodity.Most of this trading is done in
the futures market, and contracts areclosed out before the delivery date.
Currencies: FOREX.
Indices: An index tracks the changes in a hypothetical portfolio ofinstruments
(S&P500, DIJA, FTSE100, DAX30, NIKKEI225,NASDAQ100, ALSI40,
INDI25, EMBI+, GSCI). A typical indexconsists of a weighted sum of a basket
of representative stocks. Theserepresentatives and their weights may change
from time to time.
Fixedincomesecurities:
Bonds, notes, bills. These are debt instruments, and promise to pay acertain
rate of interest, which may be fixed or floating.
Example: A 10year, 5% semiannual coupon bond with a facevalue 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 anupfront
lump sum. Mortgages are an example.

The capital market, as it is known, is that segment of the financial instrument that
deals with the effective channelling of medium to long-term funds from the surplus to
the deficit unit. The process of transfer of funds is done through instruments, which
are documents (or certificates), showing evidence of investments. The instruments
traded (media of exchange) in the market are:
Debt Instrument
A debt instrument is a paper or electronic obligation that enables the issuing party to
raise funds by promising to repay a lender in accordance with terms of a contract.
Types of debt instruments include notes, bonds, debentures,
certificates, mortgages, leases or other agreements between a lender and a
borrower. These instruments provide a way for market participants to easily transfer
the ownership of debt obligations from one party to another.

A debt instrument is legally enforceable evidence of a financial debt and the promise
of timely repayment of the principal, plus any interest. The importance of a debt
instrument is twofold. First, it makes the repayment of debt legally enforceable.
Second, it increases the transferability of the obligation, giving it
increased liquidity and giving creditors a means of trading these obligations on the
market. Without debt instruments acting as a means of facilitating trading, debt
would only be an obligation from one party to another. However, when a debt
instrument is used as a trading means, debt obligations can be moved from one
party to another quickly and efficiently.

Debt instruments can be either long-term obligations or short-term obligations. Short-

term debt instruments, both personal and corporate, come in the form of obligations
expected to be repaid within one calendar year. Long-term debt instruments are
obligations due in one year or more, normally repaid through periodic instalment
payments.

Short-Term Debt Instruments

From a personal finance perspective, short-term debt instruments come in the form
of credit card bills, payday loans, car title loans and other consumer loans that have
repayment terms of less than 12 months. If a person incurs a credit card bill of
$1,000, the debt instrument is the agreement that outlines the obligated payment
terms between the borrower and the lender.

In corporate finance, short-term debt usually comes in the form of revolving lines of
credit, loans that cover networking capital needs and Treasury bills. If for example, a
corporation looks to cover six months of rent with a loan while it tries to raise venture
funding, the loan is considered a short-term debt instrument.

Long-Term Debt Instruments

Long-term debt instruments in personal finance are usually mortgage payments or
car loans. For example, if an individual consumer takes out a 30-year mortgage for
$500,000, the mortgage agreement between the borrower and the mortgage bank is
the long-term debt instrument.

However, sometimes, long-term debt instruments, like car loans become short-term
instruments when the obligation is expected to be fully repaid within one year. If a
person takes out a five-year car loan, after the fourth year, the debt becomes a
short-term instrument.

For corporations, long-term debt instruments come in the form of corporate debt.
This type of debt is used to fund growth and expansion and is classified on a
company's balance sheet.

A debt instrument is used by either companies or governments to generate funds for

capital-intensive projects. It can obtained either through the primary or secondary
market. The relationship in this form of instrument ownership is that of a borrower
creditor and thus, does not necessarily imply ownership in the business of the
borrower. The contract is for a specific duration and interest is paid at specified
periods as stated in the trust deed* (contract agreement). The principal sum
invested, is therefore repaid at the expiration of the contract period with interest
either paid quarterly, semi-annually or annually. The interest stated in the trust deed
may be either fixed or flexible. The tenure of this category ranges from 3 to 25
years. Investment in this instrument is, most times, risk-free and therefore yields
lower returns when compared to other instruments traded in the capital
market. Investors in this category get top priority in the event of liquidation of a
company.

When the instrument is issued by:

The Federal Government, it is called a Sovereign Bond;

A state government it is called a State Bond;

A local government, it is called a Municipal Bond; and

A corporate body (Company), it is called a Debenture, Industrial

Loan or Corporate Bond

Debt Instruments

Short-Term Long-Term
Debt Debt
Instruments Instruments
2. Equities (also called Common Stock)

This instrument is issued by companies only and can also be obtained either in the
primary market or the secondary market. Investment in this form of business
translates to ownership of the business as the contract stands in perpetuity unless
sold to another investor in the secondary market. The investor therefore possesses
certain rights and privileges (such as to vote and hold position) in the company.
Whereas the investor in debts may be entitled to interest which must be paid, the
equity holder receives dividends which may or may not be declared.

The risk factor in this instrument is high and thus yields a higher return (when
successful). Holders of this instrument however rank bottom on the scale of
preference in the event of liquidation of a company as they are considered owners of
the company.

3. Preference Shares

This instrument is issued by corporate bodies and the investors rank second (after
bond holders) on the scale of preference when a company goes under. The
instrument possesses the characteristics of equity in the sense that when the
authorised share capital and paid up capital are being calculated, they are added to
equity capital to arrive at the total. Preference shares can also be treated as a debt
instrument as they do not confer voting rights on its holders and have a dividend
payment that is structured like interest (coupon) paid for bonds issues.

Preference shares may be:

Irredeemable, convertible: in this case, upon maturity of the instrument, the

principal sum being returned to the investor is converted to equities even
though dividends (interest) had earlier been paid.

Irredeemable, non-convertible: here, the holder can only sell his holding in the
secondary market as the contract will always be rolled over upon
maturity. The instrument will also not be converted to equities.

Redeemable: here the principal sum is repaid at the end of a specified

period. In this case it is treated strictly as a debt instrument.

Derivative Instruments Features and Implications

Features of derivative instruments and its implications have been scripted in the
article below. The article also furnishes information about the trading of derivative
instruments in different jurisdiction.
Derivative instruments are contracts or agreements, which provides right, obligations
to contracting members on the basis of certain underlying interest.

The obligations or rights contained in a derivative contract pertaining to an

underlying interest may be in the form of:

Cash settlement
 Delivery of
Transfer of rights

Types Of Derivative Instruments That Are Traded

As far as the underlying interests pertaining to different derivative instruments are

concerned, they may be commodities, which may include wheat, gold and other
similar commodities. These commodity-trading products fall in the category of
physical assets.
Other derivative instruments may include equity indices or equities. Various debt
instruments are also included. Another category of derivative instruments, which may
determine the underlying interest, is a pricing index. The pricing index may be
considered over a period of time. The nature of the underlying interest does not alter
the characteristics of a derivative instrument. It may be a commodity or a financial
instrument.

Options Of Having Multiple Contracts

The derivative contract itself does not get transferred or does not imply a transfer of
any underlying interest. However, transfer takes place as part of a separate
transaction, in the event when the contract is not made null and void (offset). Since
there is no actual transfer of derivative instrument, at any given point of time, there
may be several contracts pertaining to any derivative instrument.

Features Of Derivative Instruments And Its Implications In Different

Jurisdiction

As a rule, the derivative instruments are standardized on exchange, which are

organized. In the event when trading of underlying interest takes place in an area
(jurisdiction) where the derivative instrument is not being traded, there may be
chances of manipulation. Another instance when there may be manipulation is when
trading of similar derivative instruments take place in two different areas
(jurisdictions).

Derivative instruments help in shifting risk. It also helps in price discovery pertaining
to underlying interest. Prices prevailing in the derivative markets can impact price of
underlying interest and this can also happen the other way round.
 CHAPTER-3
Classification of Financial Instruments

Classification of financial instruments and identification of their nature is one

of the most important phases for compilation and presentation of monetary
statistics. Like other classifications used in monetary statistics, it is also
advisable here to follow international standards that would help to make
statistics comparable across countries and ensure its unity. In carrying out
classification, there will be a need to consider features of a countrys banking
and financial system paying a due regard to their development prospects.

Financial instruments are financial contracts of different nature made between

institutional units. These comprise the full range of financial claims and
liabilities between institutional units, including contingent liabilities like
guarantees, commitments, etc.
Financial asset is defined as any contract from
which a financial claim may derive for one party and a financial liability or
participation in equity for another. Financial instrument can exist only between
two institutional units. Where financial instruments are compounded, i.e.
represent a set of several instruments, for compilation of statistics there will
be a need to distinguish them into separate instruments so that each of them
includes only a single pair of institutional units.
Financial assets are contracts that do not contain
contingency, i.e., irrespective of any conditions, generate financial claims
having demonstrable value over which ownership rights are enforced,
individually or collectively, and from which economic benefits can be derived
by using or holding them. The concept of financial instrument is wider than the
concept of financial asset as defined in the System of National Accounts,
1993. Thus, financial instruments are classified into financial assets and other
financial instruments.

Classification of financial assets is based on their two principal characteristics,

liquidity and legal characteristics.
3.1. Monetary Gold and SDRs :

Monetary gold and SDRs, issued by the IMF, are the only
financial assets for which there are no corresponding financial liabilities.

Monetary gold - Monetary gold consists only of standard bullions of gold

held by the central bank or government as part of official reserves. Monetary gold,
therefore, can be a financial asset only for the central bank or government.
Transactions with monetary gold are operations on purchase and sale of gold by
authorities implementing monetary policy. These transactions are carried out
between the central banks only or between the central banks and international
financial organizations. For commercial banks, standard bullions of gold are not
treated as monetary gold. Gold denominated deposits are treated as financial assets
and classified as gold. Assets denominated in gold, which are not treated as part of
official reserves, are classified as nonfinancial assets. Gold and gold denominated
deposits held by nonfinancial units and financial corporation (other than the central
bank) are treated as nonmonetary gold. Operations on gold carried out by other
sectors of economy are treated as operations on acquisition of values and disposal,
and it is treated as nonfinancial asset.

SDRs SDRs are international reserve assets7 created by the IMF and allocated to
member countries to supplement existing official reserves. SDRs are not treated as
the IMFs liability. SDRs are held only by the IMF member countries and by a limited
number of international financial organizations. SDR holdings are held exclusively by
official authorities, which are normally the central banks. Transactions in SDRs
between the IMF members or between the IMF and its members are treated as
financial transactions. SDR holdings represent unconditional rights to holders to
obtain foreign exchange or other reserve assets from other IMF members.

3.2 Currency and Deposits:

Currency and deposits are the most liquid financial assets consisting of notes
and coins in circulation, all types of deposits in national currency and foreign
currency.

Currency - Currency represents notes and coins in circulation, which are of

fixed nominal values and have no dates of repayment. Issued notes and coins are
considered liabilities of the central bank. Generally, currency is used for making
payments. For statistical purposes, it is always necessary to distinguish between
notes and coins issued by resident and non-resident central banks, i. e. separate
national currency from foreign currency. If national currency is the countrys (the
central banks) liability, foreign currency is other countries liability. All sectors of
economy and non-residents can hold as an asset, but only monetary authorities or
central banks are authorized to issue it. In many countries, only national currency is
included in monetary aggregates, as only the national currency can be used directly
for (local) transactions between residents. In some countries, however, foreign
currency circulates along with national currency, and hence it is important in the view
of monetary policy to consider foreign currency in circulation. Some countries issue
gold and other precious metal-made coins, which theoretically can be used as a
means of payment. Normally, such coins are held for numismatic value. If not in
active circulation, such coins should be classified as nonfinancial assets.

Deposits - Deposits include all claims on the central bank and other depository
corporations, represented as bank deposits. In some cases, other financial
corporations may also accept deposits. Deposits of depository corporations can fall
into two categories: transferable deposits and other deposits (non-transferable
deposits). Normally, separate sub-categories are used for deposits denominated in
national currency and for those in foreign currency.

Transferable deposits - Transferable deposits are deposits (in national and foreign
currency) that are i) subject to payment on demand at par and without penalty or
restriction, ii) directly usable for making payments by payment orders, checks, cards
or other payment facilities, or otherwise usable as a means of payment or circulation.
Transferable deposits comprise transferable deposits with resident and non-resident
financial corporations. This category comprises also deposits that allow direct cash
withdrawals but not direct transfers to third parties. All sectors of economy and non-
residents (the rest of the world) can open and operate transferable deposit accounts.

Other (non-transferable) deposits - Sub-category of other deposits comprises all

types of deposits (in national and foreign currency), other than the transferable
deposits. Other deposits are financial intermediaries deposits or liabilities
represented by evidence of deposit that cannot be used for making payments at any
time. These are not exchangeable with cash or transferable deposit without certain
restrictions or penalty.

Use of these deposits is subject to certain restrictions:

subject to payment after a certain period of time or at any moment, provided

certain costs are incurred

cannot serve as an instrument for making direct payments

other restrictions (frozen accounts, pledged assets, etc.) can occur. All sectors of
economy and non-residents (the rest of the world) can open and operate such
accounts. Category of other deposits typically represent time deposits,
 non-transferable deposits denominated in foreign currency,

repurchase agreements that are included in the national measures of broad money.

3.3. Securities Other Than Shares

Securities other than shares are negotiable instruments in the financial market
serving as evidence that units issuing such instruments have assumed obligations to
settle by means of providing cash, other financial instrument or some other item of
economic value. Securities included in this category are different from shares since
these do not vest the security holder with the ownership right over the issuer.
Common types of securities are government treasury bills, government bonds,
corporate bonds and debentures, commercial paper, certificates of deposits issued
by depository corporations and similar other instruments that are normally sold in
financial markets. Loans or liabilities that have become negotiable de facto should
also be classified under this category.

A security provides evidence of financial claim on its issuer, and specifies the
schedule for interest payments and principal repayments. In the monetary statistics,
securities are classified as follows:

coupon basis securities, whose interest or coupon payments are made during the
life of the instrument, and the principal is repaid at maturity;

amortized basis securities, whose interest and principal payments are made in
installments during the life of the instrument;

discount, or zero coupon, basis securities, that are issued and allocated at a price
below the face value and repaid at maturity on face value;

deep discount basis securities, that are issued and allocated at a price below face
value, and the principal and a substantial part of the interest is paid at maturity;

indexed basis securities, which tie the amount of interest and/or principal payment
to a reference index such as a price index or an exchange rate index.

Preferred shares that pay a fixed income but do not provide ownership right
over the issuer are classified as securities other than shares. Bonds that are
convertible into shares should also be classified under this category.

Securitization of financial asset is sometimes used in the creation of

securities other than shares. Securitization represents the issuance of securities that
are backed by financial assets such as mortgage loans, claims on credit card holders
and other types of loans. Such financial assets continue to be shown in the balance
sheet as assets of the acquirers, while the issuers record their respective liabilities
as securities.
 Bankers acceptance is treated as a financial asset even though no funds may
have been exchanged or moved. A bankers acceptance involves the acceptance by
a financial corporation of a bill of exchange to pay a specific amount at a specified
date. The bankers acceptance represents an unconditional claim on the part of the
holder and an unconditional liability on the part of the accepting bank. An alternative
classification of short-, medium- and long-term securities other than shares is also
implemented as follows:

Short-term securities - this sub-category comprises securities with maturity

of one-year or less.

Medium-term securities criteria for classifying securities under this sub-

category depend on practices applied in financial markets of the given country.
Normally, this sub-category includes securities with maturity from 1 to 5 years.

Long-term securities - this sub-category comprises securities with maturity

longer than those of short- and medium-term securities.

3.4. Borrowings
Normally, borrowings are not considered as a separate financial instrument.
Borrowing is carried out through other financial instruments, for example, through
loans, deposits, etc. Nevertheless, because of peculiarities of Armenian Law,
borrowings in Armenia can be treated as a separate finical instrument, as these are
source of funds for credit institutions. According to Armenian Civil Code, the lender
gives the borrower money under the loan agreement, and the borrower undertakes
to return the received amount to the lender as and when specified by the agreement.
If the maturity date is not specified or it is specified as demand, the amount of the
loan shall be returned within thirty days upon the lender's request, unless otherwise
provided by the agreement. Thus, the borrowings as well as deposits can be both
demand and time.
Opposed to time deposits, borrowings are less liquid, because lender's claim
on collection of loan is due to some restrictions, unless otherwise provided by the
agreement. In a borrowing transaction, the lender will earn interest against the
amount provided.

3.5. Loans

3.5.1. Loans
Loans are financial assets that are
created when a creditor lends funds directly to a debtor (borrower),
evidenced by non-negotiable documents. This sub-category of financial
assets comprises all loans and advances (except accounts
receivable/payable, which are treated as aseparate sub-category of financial
assets) extended to various sectors of the economy by financial corporations,
governments, and, in some countries, by other sectors.
Short-term loans short-term loans normally involve loans with maturity of
one year or less. However, for reconciliation of different practices between
the countries, short-term loans can be defined including loans with maturity of
up to two years. All loans that will mature upon request are classified as
short-term, even if it is expected that these loans will not be repaid within one
year.
Medium-term loans - depending on practices applied in countries, loans with
maturity from 1 to 5 years are classified as medium-term loans.
Long-term loans long-term loans include the loans with maturity that
exceeds those of short- and medium-term loans. According to statistical
classification, repo agreements, financial
leasing, factoring operations and other similar agreements are classified under the
category of loans.

3.5.2 Repurchase Agreements

A repurchase agreement (repo) is an arrangement involving the sale of

securities by one party to another with a commitment to repurchase the same or
similar securities of the same volume on a specified future date. The party that buys
securities retains the right of carrying out transactions with repo-securities until the
repurchase (resale) date, and should resell similar securities to the other party at
expiry of the agreement. In this agreement, the condition of repurchase makes the
repo agreement similar to collateralized loans rather than to purchase andsale of
securities. Therefore, the seller of securities should continue to reflect the sold
securities in its balance sheet. However, as repo agreements contain a component
of purchase and sale of securities, in some cases, they are recorded as both
lending and purchase and sale of securities. This practice is applied also in the
banking system of the Republic of Armenia.

3.5.3. Swap agreements

Though swap agreements are treated as financial derivatives, they can in some
cases be closer to repurchase agreements, depending on the way these are
implemented and the terms of the given transaction.

The forms of swap agreements are:

Gold swaps are forms of repurchase agreements. They occur when goldis
exchanged for foreign exchange at a certain price, with a commitment to repurchase
the gold at a fixed price on a specified future date. Gold swaps should be recorded
as collateralized loans. The collateralized gold should remain on the balance sheet
of the original owner (monetary gold - in case of the Central Bank).

The Central Bank operates currency swaps when the parties agree toexchange
Armenian dram for foreign currency on spot terms provided that the forward
exchange rate is not specified but the initial cost of transaction in Armenian drams is
specified instead, including swapinterest rate as provided by the agreement. Thus,
currency swap stands very close to the loan pledged by foreign currency or to the
foreign currency repurchase agreements.
3.5.4. Leasing operations
Leasing involves an agreement whereby a party (lessor) conveys to the other
party (lessee) the right to use certain inventory (building, premises, equipment, etc)
for a specified period and on agreed terms. Normally such an arrangement
presumes periodic payments for the equipment under use in the duration of its
usage. Objects of leasing operations may include fixed assets such as vehicles,
equipment, technological facilities, means of transport, information systems and
other similar facilities.
Present economic practice provides for different types of leasing, each of which
has its peculiarity. However, the common forms of leasing are operating lease and
financial lease. Only financial lease, which is

The description of swap as derivative instrument is given in paragraph 3.8.6 of

"Contingent and Derivative Instruments".
close by its nature to loan, is classified under the sub-category of loans.
Operating lease is an agreement on current leasing. Normally, the period of this
agreement is shorter than the period of usage(amortization) of the leased asset.
Thus, the fee stipulated in the agreement does not cover full value of the asset,
therefore, the asset can be leased for several times. Specificity of operating lease
lies in premature termination of the agreement by the lessee. Common objects of the
operating lease include non-durable items (computers, copiers, various organizers,
etc.) and equipment requiring constant technical maintenance (cars, airplanes,
railroad and sea transport).
Basically, financial lease represents an alternative method of financing
acquisition of fixed assets (basically vehicles and equipment). It is a long-term
agreement between a lessor and a lessee whereby the lessor acquires the vehicles
and equipment and supplies them to the lessee. The lessee obliges to pay periodical
payments during the course of the agreement to cover all expenses of the lesser,
including full value of equipment, additional expenditures and interests
(income).Specificity of financial lease lies in third-party participation, relatively longer
period of the agreement, which is equal to the life of the equipment.
There is another peculiarity of financial lease whereby all risks and rewards
related to ownership rights over the specific asset are actually transferred from the
lessor - the legal owner of the goods - to the lessee, the user of the goods. This
implies that change of ownership has de facto occurred, and the lesser has acquired
a financial claim, instead of its property, on the lessee. Therefore, financial leasing
statistically is classified as a loan.
As was noted, financial leasing is an alternative financing for acquisition of fixed
assets. But, unlike the traditional ways of acquiring funds (bank loan, issuance of
securities, etc.), leasing operations are not shown in the lessees balance sheet,
since from a legal point of view, the owner of the asset remains the leasing company
that calculates depreciation and pays respective ownership taxes. An enterprise that
takes loan bears an obligation (i.e. repayment of the loan) similar to an enterprise
that acquires equipment does (i.e. lease fee).

3.5.5. Factoring
Factoring is obtaining of creditors rights for payment documents by a bank (a
factor) created on provisions of trade credit for selling goods and services between
economic units. This is also accompanied by accounting, information, insurance and
other services. Parties in factoring operations include the factor-bank, customer of
the factor-bank, i.e. the supplier (original lender) and the payer (debtor). The supplier
conveys legal claim on its customer to the factor-bank to receive payments by way of
transfer of such claim.
Objects of factoring may include i) financial claims that are overdue (existing
claim), and ii) financial claims to be generated at a future date (future claim).
Banks, other credit institutions and licensed commercial organizations can be
involved in factoring agreements.
Factoring operations may contain the following terms:
full or partial advance payments against liabilities in the form of factoring loan
by the factor-bank, with the right to reclaim the loan from the supplier;
acceptance of the suppliers credit risk without the right to reclaim the amount, the
factor-bank makes advance payment for liabilities that should be reimbursed by the
debtor against payment documents;
acceptance of the suppliers credit risk when the factor-bank makes no advance
payment but guarantees full payments on a specific date;
management of factoring loan, by collecting liabilities;
book-keeping of the suppliers all transactions or a part of them, during the course of
the factoring agreement.

Essentially, factoring is a type of loan, whereby the relevant organizations

acquire the suppliers receivables and collect them from the debtor.

3.6. Shares and Other Equity

Shares are financial instruments that represent or provide evidence on

ownership rights of the holders over enterprises or organizations, including financial
institutions. Shares and other equity comprise all instruments and records
acknowledging, after the claims of all creditors have been met, claims on the residual
value of a corporation (companies, corporations). Normally, these instruments entitle
the holders both of distributed profits of enterprises or organizations, and the residual
value of the assets in the event of liquidation. Ownership of equity is usually
evidenced by shares, stocks, participation's and similar documents. This category
also includes preferred shares that provide for participation in the residual value on
dissolution of an enterprise.
Dividends are a form of property income to which shareholders become
entitled. Shares do not provide predetermined property income. Nonetheless,
dividends on preferred shares are determined in advance. Types of equity are:
ordinary shares that provide for ownership right in an enterprise
or corporation;
preferred shares that provide right for claim over residual value of an enterprise,
equity participation in limited liability companies. In the context of the monetary
statistics, financial corporations

capital in the form of shares and other equity is divided into separate groups as
follows:
Funds contributed by owners include total amount from the initial and any
subsequent issuance of shares or other forms of ownership of corporations (statutory
fund).
Retained earnings constitute all after-tax profits that have not been distributed to
shareholders or appropriated as general or special reserves.
General or special reserves are appropriations of retained earnings for special
purposes.
Revaluation reserves are the banks unrealized profit/loss due to change in market
value of fixed assets, foreign currency, securities, and precious metals.
SDR allocation represents the SDRs allocated to central banks by the IMF.

3.7 Other Accounts Receivable/ Payable

Accounts receivable/payable include trade credits, advances and other

receivables or payables. Trade credits comprise trade credit extended directly to
buyers of goods and services (enterprises, government, NPISHs, households, and
non-residents). Advances are prepayments made for work that is in progress or for
purchase of goods and services. Any agreement, which does not assume direct
payment by cash or other financial instrument to purchase goods or services, will
create a trade credit extended by the seller to the buyer. Here, it does not involve
loans acquired to finance the trade credit since these credits are classified under the
category of loans. This category includes only direct trade credits and advances.
This category includes also items such as debtors and creditors, tax liabilities
and other accounts receivable/payable.

3.8. Contingent and Derivative Instruments

3.8.1. Contingent Instruments

There are forms of contractual financial arrangements in which afinancial claim
depends on a certain condition or conditions. Such transactions normally do not
have a transferable value.
Although contingent instruments are not directly included in the monetary
statistics, the compilation of summary information on such instruments may be of
importance in analyzing a countrys or a sectors financial position and relations,
since such instruments could in future give rise to acquisition of various assets or
creation of liabilities that might notably affect financial flows and overall condition of
the given entity. In some cases, a need for statistical information on the potential
liabilities of entities, reflected in contingent instruments, may arise for countrys
policymaking analysis. This kind of statistics is more appropriate to collect and
classify by guarantee providers, unlike the other cases, when collection and
compilation are made by types of instruments.
Contingent financial instruments include guarantees, financial commitments,
letters of credit, financial collateral, lines of credit, etc. Claims or liabilities on all
these instruments will arise only if certain conditions are met. For instance, the bank
will make a payment on a guarantee only if the party, which is recipient of the
guarantee, fails to meet its liabilities. Payments on the letter of credit will be made in
the event when the respective documents are presented. Collateralized financial
assets may become the banks property if the party that has sold them is unable to
repurchase them. Line of credit will become a financial assets or liability only if the
funds are actually advanced.
Classification of contingent instruments depends on the nature of a specific
instrument and peculiarities of its usage in the given country.
3.8.2 Guarantees
Guarantee involves an obligation by the economic entity to assume the other
entitys financial obligation if that other party defaults. To issuer, a guarantee is not
treated as a financial liability as far as the party, to whom the guarantee has been
issued, has not shown its inability to meet such a liability. Therefore, until availability
of this condition, letters of guarantee will be recorded as off-balance sheetitems
(Appendix 7.1).
Guarantees can be provided by central banks, governments, financial
corporations and, in some cases, other organizations. These can be of certain
importance also in the context of classification of other financial instruments. For
instance, securities backed by the government guarantee may be classified in a way
other than common securities.
In the context of the monetary statistics, liabilities are always classified as the
liability of the sector that has assumed such, and not the liability of the issuer of
guarantee, unless the issuer de facto acquires a liability to make payment.
For a correct reflection of governments relationships with other sectors, it is
sometimes advisable to view guarantees issued by the government as a liability.

3.8.3. Letters of Credit

A letter of credit is an obligation to make payment against documents received.
The amounts to be paid upon receipt of the documents become liabilities of the
bank. Letters of credit are used to finance international trade operations.
While importing/exporting goods, resident enterprises will open letters of credit
with Armenian resident banks that service them. These banks are obliged to pay
amounts of the trade contracts (or present a demand for payment) to their foreign
counterpart in the event the delivery and other documents are received as stipulated
in the letter of credit. The receipt of the delivery and other documents is a stipulation
under which the resident bank acquires an obligation or claim over the foreign bank
(Appendix 7.2).

3.8.4. Financial Commitments

Financial commitments involve contracts between institutional units by which
the entities make arrangements on specific financial transactions to be carried out in
some future time. The party assuming liabilities usually is obliged to provide financial
assets to the other party if specific conditions are met. Unlike the letters of guarantee
whereby the issuer of guarantee assumes liability of an entity, the issuer of
commitment will be responsible for fulfillment of the terms of the contract, in case of
the commitments. Nonfinancial commitments will not be treated as financial
instruments.
Commitments can be of various form and nature, therefore, it is very hard to set
up a common approach of assessing the rights and obligations defined within these
commitments. Although not treated as financial assets, assessment of common
types of commitments can be important for analysis and evaluation of potential
assets and liabilities. Lines of credit and overdrafts are the most common financial
commitments.
A line of credit and/or overdraft provide the borrower with standby guarantee for
the funds within a specific limit and for a predetermined period. Nonetheless, such
funds will not be treated as financial assets until the de facto extension of loans
(Appendix 7.3).

3.8.5. Pledged Financial Assets

There is a common practice to provide loans against a certain financial asset
taken as collateral. The residual maturity of the pledged asset should be longer than
the duration of the loan. Securities, deposits, currency, shares, and similar assets
can qualify as pledged financial assets against loans. Financial assets are returned
to the original owner as the loan is repaid. Thus, the risks associated with change in
market value of pledged financial asset will stay with the original owner thereof (the
borrower) throughout the period of the collateralized loan agreement.
Considering that the lender bank is not deemed the owner of the pledged
financial asset as far as the borrower has not acknowledged his inability to repay the
loan, such assets cannot be posted in the balance sheet of the bank. Instead
extended loans are accounted as financial assets.
Loans, accrued interests and receivables written off the balance sheet are very
similar to contingent instruments. Although these claims are not treated as banks
assets, they can generate income if the borrower repays the liabilities, which have
been regarded as bad.

3.8.6. Financial Derivatives

Financial derivatives make an integral part of international financial markets.
The derivatives markets began to develop rapidly since the early 1980s, and had a
substantial influence on behaviour of financial markets. A number of questions on
how the monetary and macroeconomic issues are affected by derivatives remain
unanswered due to rapid growth of financial markets, lack of the relevant statistics,
and the absence of well-structured theories. Policymakers should have a clear
understanding of transactions with derivatives, as well as realize and evaluate the
links between derivatives and ordinary financial markets.
Financial derivatives are financial instruments that are linked to specific assets
(other financial instruments, goods). By nature, these instruments are similar to
contingent instruments. Claims and liabilities related to financial instruments will
arise after a specific period of time. In this case, contingency of an instrument relates
only to the time regardless of occurrence of any other event or condition. Derivative
instruments are not considered a financial claim or liability for the holder thereof at
the given moment. However, financial derivatives can be traded in the market and
thus they will obtain a market value, which will depend on the market price of the
underlying financial or nonfinancial asset. Thus, the price of a derivative instrument
derives from the price of the underlying asset. In the event when the contract price
of the underlying financial asset is preferable to the current market price, the
derivative would have a positive market value. If a financial derivative instrument has
a market value it must be recorded in the balance sheet as a financial asset
(respective examples are presented in Appendix 7.4).
In the context of the monetary and financial statistics of Armenia, accounting of
derivatives in banks balance sheets depends on the level of deepness of the
financial market. The derivative instruments are not yet widely used in the country,
as the financial market and the derivatives market, in particular, are
underdeveloped. The share of financial derivatives in the financial market of Armenia
is negligible.
Moreover, because of no circulation in the market, the derivative instruments do not
have market value. Nevertheless, the recording of these transactions is made in the
balance sheets of financial corporations. Balance sheet reflects the real value of the
derivative instrument, that is the difference between the contract and market prices
of the underlying asset (financial or real) times contract volume. Depending on the
difference between contract and market prices (either positive or negative) the
corresponding positions on derivative instruments can be reflected in both asset and
liability accounts.
Financial derivatives fall into the following groups: forwards, options and swaps.
Forward - In a forward contract, the counterparties agree to exchange, on a
specified date, a specified quantity of an underlying item(financial or real asset)
at an agreed-upon contract price. Execution of a forward contract is mandatory
but only in the case of expiry of the period specified in the contract. Each of the
counterparties has both claim and liability upon execution. The net value of the
instrument (difference between claims and liabilities) is zero.
Option - The buyer of an option acquires the right but not the obligation to purchase
or sell a specific asset. Options too, contain contingency: the acquirer of an
option may not wish to exercise it. The buyer pays a certain amount to the
seller of the option and thus acquires the right but not the obligation to sell or
purchase a specified item at an agreed-upon price in a specified period. The
buyer of an option can sell the option contract, i.e. the right to exercise the
option, whereby the option obtains a market value. The statistical recording of
options should be carried out in the same way as for the forwards.
Swap - A swap represents a spot purchase (sale) of a financial asset with a
condition of forward sale (purchase). The swap operation presented in this
section definitely differs from the one presented in paragraph 3.5.3, which is
operated mainly by the CBA. Swap agreements a type of a forward, in which
the parties agree to exchange different currencies, that is to buy (sell) any
currency for another currency in spot market and concluding at the same time a
repurchase agreement on sale (purchase) of these currencies in forward
market at prices determined beforehand, pursuant to the rules specified.
Derivatives can be linked up not only to financial assets but also to certain
goods. The liquidity of nonfinancial derivatives vis--vis financial derivatives is lower.
This however does not rule out the possibility of purchase and sale of the
nonfinancial derivatives. The statistical recording of nonfinancial derivative
instruments are carried out in the same way as for the financial derivatives.
Irrespective of the degree of development of the derivatives market the
statistical recording thereof is of great importance in the context of assessing impact
of potential risks on banks and on the monetary policy. Both contingent and
derivative instruments indicate the potential claims or liabilities of the bank that might
change its financial condition dramatically. Therefore, it is necessary to draw a due
attention to issues concerning development, classification, accounting and statistical
reflection of such instruments.

CHAPTER-4
 Functions and Characteristics of Financial
Instruments

FOCUS OF THE CHAPTER

This chapter provides basic information about various financial instruments traded
in money, capital, and derivative markets. In doing so, the origin, history, role, and
importance of these instruments in the Canadian financial system are also
discussed. Particular attention is paid to recent innovations in money, capital, and
derivative markets.

Learning Objectives:

Provide a general classification of the major types of financial instruments in

Canada
Explain how money, capital, and derivative market instruments originated, their
role in the Canadian financial system, and their relative importance in the
marketplace
Distinguish among the instruments discussed and choose the most important
ones for understanding how financial markets operate in Canada

SECTION SUMMARIES

The Money Market

Financial instruments with less than one year of maturity are money market
instruments.

The Overnight Market: The financial instruments with the shortest available term to
maturity are traded in this market. Funds are made available until the following
business day. In 1994, the Bank of Canada adopted an operating band for the
overnight market. The overnight rate fluctuates between the upper and lower limits of
the operating band set by the Bank of Canada. The Bank of Canada also
announces a target rate for the overnight rate. Deposit-taking institutions are the
principal borrowers in this market in which investment funds and mutual funds also
participate.

Treasury Bills: Treasury bills (known as T-bills) are debt instruments issued by the
government and sold at a discount (i.e., less than the par value). Maturities range
from 91 days to one year. In 1980 the treasury bill rate was linked to the bank rate
according to the formula: Bank rate = T-bill rate + 0.25%. Since early 1996, the bank
rate has been set at the upper limit of the overnight rate band.

Treasury Bill Auctions: The treasury bill rate is determined by the highest bidders
in biweekly auctions. Every other Tuesday, by 12.30 P.M., would-be buyers
(investment dealers and chartered banks) place their bids with the Bank of Canada
in Ottawa, specifying the amount to be purchased and the yield. The Bank of
Canada also puts in a reserve bid. By 1:30 P.M. the Bank of Canada ranks bids from
the highest to the lowest, and announces the successful ones. The Bank of Canada
also announces the amounts to be auctioned the next time.

The Bank of Canada and Interest Rates: In addition to influencing rates of interest
through the T-bill rate, the Bank of Canada influences interest rates in three other
ways: by manipulating government deposits, through open market operations,
and by the drawdown and redeposit technique.

Open market operations involve the buying and selling of government

securities such as T-bills in regular (open) markets. The drawdown and redeposit
technique involves shifting government deposits between chartered banks and the
Bank of Canada. The Bank of Canada uses this technique to manipulate liquidity in
the overnight market and thereby influence the overnight rate.

Large Value Transfer System (LVTS): Until recently, cheques were cleared
overnight and settled retroactively. Under such a system, large-scale defaults of
cheques can lead to a loss of confidence in the clearing and settlement mechanism,
which results in systematic risk. The LVTS is designed to reduce the time gap
between the presentation of a cheque for payment and its actual receipt in order to
speed up the clearing and settlement process and to reduce systematic risk.

Provincial and Municipal Treasury Bills: These are treasury bills issued by
provincial and municipal governments, whose rates are determined in part by the
federal government T-bill rate and by the creditworthiness of the issuer.

Government-Backed Financial Instruments: Federal and provincial Crown

corporations and agencies also sell T-bills which have little default risk.

Bank of Canada Advances: These are loans issued at a rate equivalent to the bank
rate by the Bank of Canada as the lender of last resort to members of the
Canadian Payments Association, generally for one business day, to meet
emergency shortages of funds.The terms and conditions governing these loans
have changed significantly over time.
Special Purchase and Resale Agreements: A special purchase and resale
agreement (SPRA) is a two-step transaction (i.e., the Bank of Canada purchases
securities one day and sells the following day) between the Bank of Canada and a
financial institution (usually an investment dealer). The purpose of SPRAs is to
temporarily inject liquidity into the financial system. The rate is set at the bank rate.
Reverse SPRAs, also called special sale and repurchase agreements (SSRAs), are
used to temporarily reduce liquidity. SPRAs have been used to ensure that overnight
rates stay within the operating band.

An Illustration: Suppose a chartered bank expects a shortage of liquidity and plans to

call in a loan from an investment dealer. The Bank of Canada wants to prevent a
possible increase in the overnight rate due to the shortage of liquidity. Therefore, the
Bank of Canada offers to purchase an equivalent amount of T-bills from the dealer,
who uses the proceeds to pay off the loan. The following day, the chartered bank
reverses the transaction and restores the call loan, and the SPRA expires.

The Use of SPRAs and SSRAs: After the stock market collapse of October 1987, the
Bank of Canada used SPRAs to drive short-term interest rates down by 0.75% in a
couple of weeks, and later offered SSRAs. Between 1985 and 1994, SPRAs were
used more frequently to keep interest rate levels up. From 1997 to early 1999,
SSRAs were used more often, as overnight rates rose sharply.

Purchase and Resale Agreements: Purchase and resale agreements (PRAs)

operate like SPRAs, but are initiated by money market dealers. PRAs first appeared
in Canada in 1953.

Bankers Acceptances: Bankers Acceptances (BAs) are promises to pay in future.

They are issued by non-financial firms and are guaranteed by a bank. Their term to
maturity varies from a few days to one year, and they are sold at a discount. They
are widely used in international trade-related transactions.

Illustrating the Mechanics: An importer asks its bank to prepare a letter of credit
(called a draft), intended for the exporter, in the amount of the goods purchased. The
exporter can discount the draft. The transaction is completed when the exporter's
bank stamps the original letter of credit as accepted. The stamping fee is equivalent
to an interest rate.

Use: Although BAs emerged to meet the needs of international trade, since the 1980
Bank Act, they can be issued by any public institution or borrower.

Day-to-Day Loans and Special Call Loans: These loans represent the private
overnight market. Day-to-Day Loans (DTDLs) are made primarily by chartered banks
and other financial institutions to money market dealers who have PRA facilities with
the Bank of Canada. DTDLs are being replaced increasingly by special call loans
(SCLs), which are overnight loans made by chartered banks to investment dealers.
Other Chartered Bank Instruments: Chartered Banks have created a large variety
of financial instruments that are used by individuals, other banks, and institutions.
Three types of these instruments are issued in amounts of $100,000 or more and are
traded in wholesale markets as follows:

Certificates of Deposit: These are issued for long-term deposits at a fixed interest
rate.Bearer Deposit Notes: These are a type of security not registered in the owners
name.Interbank Deposits: These are deposits that one bank deposits in another.

Eurocurrency Instruments: Financial instruments (deposits, loans, or bonds)

denominated in a currency other than the currency of the home country are called
Eurocurrency instruments (or sometimes "Euro dollars"). The government
promissory notes called Canada bills (issued in US dollars) are an example of
government Eurocurrency instruments.

Corporate and Finance Company Paper: These instruments are issued by large
firms and finance companies with good credit ratings. A corporate paper is generally
an unsecured promissory note with a specified maturity date. A finance company
paper is a note secured by instalment-debt contracts. Both these types of paper,
which are sold in denominations of $50,000, are held primarily by institutions such as
mutual funds, pension funds, and deposit-taking institutions.

The Capital Market

The markets for financial instruments with maturities of more than one year are
classified as capital markets.

Bonds: A bond is a debt instrument issued by a public entity or corporation. A bond

has a stated par value (face value) and a coupon rate which is paid to the holder
one or more times a year. Federal government bonds are considered risk-free.

Government of Canada Bonds: These bonds are issued by the federal government,
with an array of maturities and in many denominations, and have been sold at
auction since 1992. They are held by the Bank of Canada, chartered banks, the
general public, and foreigners. Since 1990, the average maturity of the Canadian
government debt has risen to more than six years, partly due to changes in the real
cost of debt. High real interest rates make short-term debt more attractive. In the fall
of 1991, the government of Canada introduced real return (indexed) bonds. In 1998,
with the elimination of federal deficits, the government of Canada launched a buy-
back program to reduce its debt. There is no national regulator to oversee the market
for bonds.
Other Bonds: Provincial, municipal, and corporate bonds are included in this
category. They are similar to government bonds in many ways (except for risk and
some other characteristics) and are less likely to be auctioned. Canada is one of the
worlds largest corporate bond markets. Debentures are a special kind of bond which
are backed by the future sales or earning power of a corporation. Bonds including
debentures are sold to the public via an underwriter.

Stocks: Issued by private corporations, these are shares of ownership. In Canada,

corporations rely on bonds and stocks in roughly equal proportion for raising funds,
though, since 1991, there has been a tendency to prefer stocks.

The Market for Derivatives

Derivatives are a group of new financial instruments derived (created) from existing
instruments which are traded in spot markets. The difficulty of predicting future
interest rates and the consequent losses to investors due to volatility of interest rates
led to the creation of derivative products.

Futures and Forwards: Futures contracts are contracts to buy and sell assets at a
predetermined future date. Forward contracts are contracts to trade an asset at a
future date at a price agreed to in advance.

Option: An option is the right, but not obligation, to buy or sell an asset on or before
a particular date. A call option is an option to buy an asset at a specified price, and a
put option is an option to sell an asset at a specified price.

When-Issued Treasury Bills: A when-issued T-bill is a contract to buy or sell, at an

agreed-upon price, stated dollar amounts of T-bills, to be sold at the next week's
auction.

Other Derivative Products: These include more recently developed derivative

products such as: 1) Interest rate swaps; 2) separate trading of registered interest
and principal of securities (STRIPS); 3) forward rate agreements (FRAs); 4) bankers
acceptances futures (BAX); and 5) securitization.

CHAPTER-5
 The Advantages of Financial Instruments
&
Financial Instruments in INDIA
ADVANTAGES:
Financial instruments are legally recognized documents that have monetary value.
Examples are bonds, equities, debentures, shares, and checks. Informal financial
instruments are agreements made to exchange finances without reference to the
legal restrictions. These are mainly used among people who do not have access or
cannot afford formal systematic savings and credit facilities. Some of the items used
as informal financial instruments are check-cashing outlets, loans from friends,
saving clubs, pawn shops and money lenders. Advantages include low interest rates,
immediate accessibility, approval of loans based on character and sequential access
to facilities.

Reduced Costs of Transactions

The cost of transacting informal financial instruments is usually lowered by the direct
interactions between sellers and buyers. This is because the borrower deals directly
with the lender and in so doing eliminates the long clearance procedures and costs
associated with brokers. For example, when it comes to saving, informal financial
instruments do not have additional charges for storing the money. Interest rates
charged on informal financial instruments are another advantage, given that they are
relatively lower than rates of formal financial instruments. Another factor that saves
money is the absence of transactional charges and clearance procedures that
increase the cost. The reduced costs make this service suitable to individuals who
are already constrained financially.

Convenience

Informal financial instruments are accessible to all because they do not have official
criteria of qualifying those applying for the service. A transaction involving informal
financial instruments may be completed within minutes of applying. A simple cash
receipt or verbal agreement is all that is needed to complete the transaction. Also,
there is no need for any special preparations or documentation to present to the
lender for a loan application to be approved. Convenience also involves the variety
of people who can access the informal financial instruments in addition to the items
that may be used as security when security is requested.
Personal Considerations

With informal financial instruments, the circumstances surrounding the applicant are
considered when the financial assistance is being offered. This offers the advantage
of having special considerations even when the criteria for lending are not met.
Informal financial instruments do not have a set standard to measure up to when the
financial services are needed, and therefore they are able to offer flexible services
according to individual needs.

Variety of Service Offerings

Informal financial instruments offer diverse services such as loans, credit, leasing,
savings, and insurance. The agreement on each transaction varies and therefore
negotiation plays a major role in determining the service someone is offered.
Although the predominant service is loaning, saving clubs enable the members to
accrue their finances for a specified period and they are not allowed to withdraw any
amount of money until the period elapses.

Repetitive Transactions

There is no limit to the number of times an individual may come back for financial
assistance in the informal financial instruments as long as the borrower is able to
come to an agreement with the lender. For example, when the funds run out before a
project is completed or sales are realized, the borrower may go back to the lender
and acquire additional funds as long as evidence is provided to show the progress
made with the previous financial assistance.

Financial Instruments of India

In this paper we will discuss about the various financial instruments, for example, G-
secs, Commercial Papers, Certificate of Deposits, Preference Shares, Call Money
Market etc, available in the Indian financial markets. This paper provides a brief
description of all of these.
Several financial instruments are available in the Indian money market. These are
government securities, or G-sec, preference shares, commercial papers, equity
shares, certificate of deposits, call money market and industrial securities.

These are discussed below.

Government Securities:
In India, mainly the institutional investors buy the government securities. The
government, both State and Central, and the government authorities, for example,
state electricity boards, municipalities etc issue it.
Commercial banks are the biggest investors who buy the G-secs. The government
collects money through the G-secs to finance its several new infrastructure
development projects or to meet its present needs. The government itself issues the
risk of default for G-sec, for it.

Preference Shares:
These carry a fixed dividend rate and a special right to dividends over the private
equity holders. Currently, all the preference shares in the Indian market are
`redeemable&rsquo, that is, they have a fixed period of maturity. Therefore,
sometimes they are termed as `hybrid variety

Commercial Papers (CP):

These are issued mainly by the corporate businessmen to fund their working capital
needs. Commercial Papers are issued generally for short-term maturities.
Commercial papers are not secure and subject to market risks, so those corporate
bodies that have a good credit history will only be able to use this financial
instrument.

Equity Shares:
It is a high return risk instrument. Equity shares dont have any fixed return rate and
thereby, no period of maturity.

Certificate of Deposits (CD):

These are very similar to the Commercial papers. But the CDs are issued mainly by
the commercial banks.

Call Money Market:

The loans made in the call money market are mainly short term in nature. Call
money market mainly deals with the interbank markets. Those banks that are
suffering from a short-term cash deficit borrow cap from the call money market. The
interest rate varies with the market rate and depends upon the banking system.

Industrial Securities:
Normally the big corporate bodies are used to issue this to fulfill their long-term
requirements regarding working capital. The debentures, equity shares fall under
this category

Markets in Financial Instrument Directive

In this paper we will discuss about the Markets in Financial instrument directive. It is
basically a law introduced by the European Union, in 2004, to control the financial
market operations in the member countries. The Committee of Wise Men whose
chairman is Baron Alexandre Lamfalussy had enacted the law.
The Markets in Financial Instruments Directive (MFID), that is been corrected every
now and then, is a law introduced by the European Union. It provides a regulatory
regime to run investment services across the member countries of the European
Economic Area.

The main aim of MFID is to increase competition and also, consumer protection in
the investment services. The law had been introduced in November 2007. The
Markets in Financial Instruments Directive is the basic foundation of the European
Commissions Financial Services Action Plan, which operates the financial market
activities in the European Union countries.
The Committee of Wise Men whose chairman is Baron Alexandre Lamfalussy
enacted the law. Companies covered by the Markets in Financial Instruments
Directive will be governed and authorized in their own country, that is, in which their
registered offices are situated.
After getting the authorization, the companies can use the passport to facilitate their
customers with trade licenses for starting businesses in the EU member countries.

The MFID is used to categorize the clients of those companies who have been
authorized by it. This increases the protection level, which is needed to match the
clients with the types of investment products. The law needs information regarding
client orders so that it can ensure the fact that the companies are serving the clients
best interests.

MFID advises the firms to publish the price and volume of all trades in the listed
shares, even for those trades that are executed outside the regulated market. It also
ensures the best possible result out of the firms while delivering the orders for their
clients. However, the MFID is also active in the security industries of UK.

Model Uncertainty And Its Impact On Financial Instrument

Model uncertainty and its impact on financial instrument cannot be ignored. The
reason being unless an optimum pricing model is selected, it can give rise to several
disadvantages. Few instances of the same have been mentioned in the article. Two
approaches to nullify the ill effects of model risk have also been suggested.
When the question of evaluating a portfolio of options arises, there may be
uncertainties with regard to the model selected for pricing the options. This may
cause a model risk.

There have been instances In the past when owing to the selection of the wrong
pricing model, the entities had to suffer losses. Two such instances are mentioned
below.

Instances exemplifying model uncertainty and its impact on financial

instrument:
In the year 1997, Nat West Capital Markets declared that they had suffered a loss of
50 million.
This loss may be attributed to the fact that they had opted for United Kingdom and
German rate of interest options, which were mispriced. Also responsible was a UK
trader dealing with single derivatives who had extended swaptions.
In the month of March 1997, Bank of Tokyo declared that the banks derivative unit
based in New York had incurred losses worth $83 million. This was due to the fact
that the model related to internal pricing had overvalued a swap portfolio as well as
options pertaining to rates of interest in the United States of America.

Statistics have proved that as much as $5 billion was the loss incurred for adopting a
faulty pricing model pertaining to derivatives (1999).
Importance of pricing models in derivative markets:
Since new quantitative methods pertaining to risk management are attracting focus
and new derivative products are making their appearance in the derivative markets,
mathematical models for option pricing have gained significant stand. These models
help in taking vital financial decisions not only in matters related to pricing but also in
matters related to derivative instrument hedging. However, just as these models are
serving as vital tools in making investors and the players of the derivative markets
realize the varied market risks, they have given birth to a new risk, referred to as
model risk.

There are two distinguishable approaches, which have been adopted by economists
for treating model uncertainty and its impact on financial instrument.

Accounting Principles Of Derivative Instruments

There are certain accounting principles of derivative instruments, which are taken
care of by the FAS 133 or the Financial Accounting Standards Board Statement
No.133. The article below highlights certain facts pertaining to the same.
The FAS 133 takes into account hedging activities in addition to the accounting
methods of derivative instruments also. Derivative instruments are financial
instruments or financial contracts, which have their values derived from values
pertaining to underlying assets, also known as underliers. It may also be an
underlying index.

These may include:

Indexes
Debt instruments
Interest rates
Commodities
Exchange rates
Equities

FAS or Financial Accounting Standards:

The FAS 133 or Financial Accounting Standards Board Statement No. 133 has been
formulated for the accounting of hedging activities as well as derivative instruments.
FAS 133 set reporting standards for accounting of derivative instruments. The
derivative instruments also include few derivative instruments, which remain
embedded in other contracts. They are referred to as embedded derivatives.

The following concepts make up the accounting principles of derivative

instruments:
Balance sheet:

All derivatives should be recognized as either liabilities or assets by the entities in

the financial position statement. The derivative instruments are to be measured at
fair value.

Income statement:

The designation pertaining to the derivative instruments impact the income

statement. A derivative instrument is not designated unless few requirements are
fulfilled.

Designation of derivatives may be as under:

Fair Value Hedge
Foreign Currency Hedge
Cash Flow Hedge

Scope of the accounting principles of derivative instruments:

The Financial Accounting Standards Board Statement No.133 or FAS 133

accounting principles of derivative instruments is applicable to all financial
institutions. There are certain non-profit organizations as well as certain pension
benefit programs, which ought to consider alterations in fair value as change
pertaining to net assets during a period of change. This is true for all derivatives.

Fair Value Accounting for Financial Instruments

The process of Fair Value Accounting is followed almost everywhere in the world,
including USA, UK, Australia and European Union. In USA, Financial Accounting
Standards Board or FASB supervises the Fair Value Accounting for Financial
Instruments.
Fair Value Accounting for Financial Instruments is prevalent in most of the countries
of the world. But, the accounting standards vary from country to country. USA, UK,
European Union and Australia all have set their specific accounting standard for Fair
Value Accounting for Financial Instruments.

They have issued these accounting standards, in order to recognize the amounts of
Balance Sheet at fair value. They were also guided by the objective of recognizing
the changes in the fair values in income.

The Case of USA

In USA, the accounting standards for Fair Value Accounting for Financial
Instruments, are set keeping in mind certain requirements. These requirements refer
to the necessity of recognizing derivatives at their fair value. There is also the
requirement of recognizing some investment securities.
Other than setting the accounting standards, the Financial Accounting Standards
Board (FASB) of USA, has also made many balance sheet amounts dependent on
the partial application of the Fair Value Rules.
These Fair Value Rules depend on the following things:
The ad hoc circumstances.
Goodwill and Loans
Whether changes in fair Value are hedged using the derivatives

The Financial Accounting Standards Board (FASB) of USA works along with
International Accounting Standards Board (IASB), in order to ensure the feasibility of
recognizing all the assets and liabilities at their fair value. In fact, in USA, the
Securities and Exchange Commission supports the recognition of all financial
liabilities and assets at their Fair Value.

The Commission supports the fair value recognition on the following grounds:
The Securities and Exchange Commission believes that, the fair value recognition of
financial instruments will reduce the use of those transaction structures which are
accounting motivated.
According to the Securities and Exchange Commission, the fair value accounting of
financial assets and liabilities will lower the complexity level of financial reporting.

CHAPTER-6
 OVERVIEW OF FINANCIAL INSTRUMENTS

roadly speaking, an asset is any possession that has value in an exchange.

Assets can be classied as tangible or intangible. A tangi-ble asset is one whose
value depends on particular physical properties examples are buildings, land, or
machinery. Intangible assets, by con-trast, represent legal claims to some future
benet. Their value bears no relation to the form, physical or otherwise, in which
these claims are recorded. Financial assets are intangible assets. For nancial
assets, the typical benet or value is a claim to future cash. This book deals with the
various types of nancial assets or nancial instruments.
The entity that has agreed to make future cash payments is called the issuer of
the nancial instrument; the owner of the nancial instru-ment is referred to as the
investor. Here are seven examples of nancial instruments:

A loan by Fleet Bank (investor/commercial bank) to an individual

(issuer/borrower) to purchase a car

A bond issued by the U.S. Department of the Treasury

A bond issued by Ford Motor Company
A bond issued by the city of Philadelphia
A bond issued by the government of France
A share of common stock issued by Microsoft Corporation, an American company
A share of common stock issued by Toyota Motor Corporation, a Japanese company

In the case of the car loan by Fleet Bank, the terms of the loan establish that the
borrower must make specied payments to the commercial bank over time. The
payments include repayment of the amount borrowed plus interest. The cash ow for
this asset is made up of the specied payments that the borrower must make.
In the case of a U.S. Treasury bond, the U.S. government (the issuer) agrees to
pay the holder or the investor the interest payments every six months until the bond
matures, then at the maturity date repay the amount borrowed. The same is true for
the bonds issued by Ford Motor Company, the city of Philadelphia, and the
government of France. In the case of Ford Motor Company, the issuer is a
corporation, not a government entity. In the case of the city of Philadelphia, the
issuer is a municipal government. The issuer of the French government bond is a
central government entity.
The common stock of Microsoft entitles the investor to receive dividends
distributed by the company. The investor in this case also has a claim to a pro rata
share of the net asset value of the company in case of liquidation of the company.
The same is true of the common stock of Toyota Motor Corporation.

DEBT VERSUS EQUITY INSTRUMENTS

Financial instruments can be classied by the type of claim that the holder has on
the issuer. When the claim is for a xed dollar amount, the nancial instrument is
said to be a debt instrument. The car loan, the U.S. Treasury bond, the Ford Motor
Company bond, the city of Philadelphia bond, and the French government bond are
examples of debt instruments requiring xed payments.
In contrast to a debt obligation, an equity instrument obligates the issuer of the
nancial instrument to pay the holder an amount based on earnings, if any, after the
holders of debt instruments have been paid. Common stock is an example of an
equity claim. A partnership share in a business is another example.
Some securities fall into both categories in terms of their attributes. Preferred
stock, for example, is an equity instrument that entitles the investor to receive a xed
amount. This payment is contingent, however, and due only after payments to debt
instrument holders are made.
Another combination instrument is a convertible bond, which allows the investor to
convert debt into equity under certain circumstances. Both debt instruments and
preferred stock that pay xed dollar amounts are called xed-income instruments.

CHARACTERISTICS OF DEBT INSTRUMENTS

As will become apparent, there are a good number of debt instruments available to
investors. Debt instruments include loans, money market instruments, bonds,
mortgage-backed securities, and asset-backed securi-ties. In the chapters that
follow, each will be described. There are features of debt instruments that are
common to all debt instruments and they are described below. In later chapters,
there will be a further discussion of these features as they pertain to debt
instruments of particular issuers.

Maturity
The term to maturity of a debt obligation is the number of years over which the issuer
has promised to meet the conditions of the obligation. At the maturity date, the issuer
will pay off any amount of the debt obli-gation outstanding. The convention is to refer
to the term to maturity as simply its maturity or term. As we explain later, there
may be provisions that allow either the issuer or holder of the debt instrument to alter
the term to maturity.
The market for debt instruments is classied in terms of the time remaining to its
maturity. A money market instrument is a debt instru-ment which has one year or
less remaining to maturity. Debt instru-ments with a maturity greater than one year
are referred to as a capital market debt instrument.

Par Value
The par value of a bond is the amount that the issuer agrees to repay the holder of
the debt instrument by the maturity date. This amount is also referred to as the
principal, face value, redemption value, or maturity value. Bonds can have any par
value.
Because debt instruments can have a different par value, the practice is to quote
the price of a debt instrument as a percentage of its par value. A value of 100 means
100% of par value. So, for example, if a debt instrument has a par value of $1,000
and is selling for $900, it would be said to be selling at 90. If a debt instrument with a
par value of $5,000 is selling for $5,500, it is said to be selling for 110. The reason
why a debt instrument sells above or below its par value is explained in Chapter 2.
Coupon Rate
The coupon rate, also called the nominal rate or the contract rate, is the interest rate
that the issuer/borrower agrees to pay each year. The dollar amount of the payment,
referred to as the coupon interest payment or simply interest payment, is determined
by multiplying the coupon rate by the par value of the debt instrument. For example,
the interest pay-ment for a debt instrument with a 7% coupon rate and a par value of
$1,000 is $70 (7% times $1,000).
The frequency of interest payments varies by the type of debt instrument. In the
United States, the usual practice for bonds is for the issuer to pay the coupon in two
semiannual installments. Mortgage-backed securities and asset-backed securities
typically pay interest monthly. For bonds issued in some markets outside the United
States, coupon payments are made only once per year. Loan interest payments can
be customized in any manner.

Zero-Coupon Bonds
Not all debt obligations make periodic coupon interest payments. Debt instruments
that are not contracted to make periodic coupon payments are called zero-coupon
instruments. The holder of a zero-coupon instrument realizes interest income by
buying it substantially below its par value. Interest then is paid at the maturity date,
with the interest earned by the investor being the difference between the par value
and the price paid for the debt instrument. So, for example, if an investor purchases
a zero-cou-pon instrument for 70, the interest realized at the maturity date is 30. This
is the difference between the par value (100) and the price paid (70).
There are bonds that are issued as zero-coupon instruments. Moreover, in the
money market there are several types of debt instruments that are issued as
discount instruments. These are discussed in Chapter 6.
There is another type of debt obligation that does not pay interest until the
maturity date. This type has contractual coupon payments, but those payments are
accrued and distributed along with the maturity value at the maturity date. These
instruments are called accrued coupon instruments or accrual securities or
compound interest securities.

Floating-Rate Securities
The coupon rate on a debt instrument need not be xed over its lifetime. Floating-
rate securities, sometimes called oaters or variable-rate securi-ties, have coupon
payments that reset periodically according to some reference rate. The typical
formula for the coupon rate on the dates when the coupon rate is reset is:

Reference rate Quoted margin

The quoted margin is the additional amount that the issuer agrees to pay above
the reference rate (if the quoted margin is positive) or the amount less than the
reference rate (if the quoted margin is negative). The quoted margin is expressed in
terms of basis points. A basis point is equal to 0.0001 or 0.01%. Thus, 100 basis
points are equal to 1%.
To illustrate a coupon reset formula, suppose that the reference rate is the 1-
month London interbank offered rate (LIBOR)an interest rate described in Chapter
6. Suppose that the quoted margin is 150 basis points. Then the coupon reset
formula is:

1-month LIBOR + 150 basis points

So, if 1-month LIBOR on the coupon reset date is 5.5%, the coupon rate is reset for
that period at 7% (5% plus 200 basis points).
The reference rate for most oating-rate securities is an interest rate or an
interest rate index. There are some issues where this is not the case. Instead, the
reference rate is the rate of return on some nancial index such as one of the stock
market indexes discussed in Chapter 4. There are debt obligations whose coupon
reset formula is tied to an ination index.
Typically, the coupon reset formula on oating-rate securities is such that the
coupon rate increases when the reference rate increases, and decreases when the
reference rate decreases. There are issues whose coupon rate moves in the
opposite direction from the change in the reference rate. Such issues are called
inverse floaters or reverse floaters .
A oating-rate debt instrument may have a restriction on the maxi-mum coupon
rate that will be paid at a reset date. The maximum cou-pon rate is called a cap.
Because a cap restricts the coupon rate from increasing, a cap is an unattractive
feature for the investor. In contrast, there could be a mini-mum coupon rate specied
for a oating-rate security. The minimum coupon rate is called a oor. If the coupon
reset formula produces a coupon rate that is below the oor, the oor is paid instead.
Thus, a oor is an attractive feature for the investor.

Provisions for Paying off Debt Instruments

The issuer/borrower of a debt instrument agrees to repay the principal by the stated
maturity date. The issuer/borrower can agree to repay the entire amount borrowed in
one lump sum payment at the maturity date. That is, the issuer/borrower is not
required to make any principal repay-ments prior to the maturity date. Such bonds
are said to have a bullet maturity. An issuer may be required to retire a specied
portion of an issue each year. This is referred to as a sinking fund requirement.
There are loans, mortgage-backed securities, and asset-backed secu-rities pools
of loans that have a schedule of principal repayments that are made prior to the nal
maturity of the instrument. Such debt instru-ments are said to be amortizing
instruments.
There are debt instruments that have a call provision. This provi-sion grants the
issuer/borrower an option to retire all or part of the issue prior to the stated maturity
date. Some issues specify that the issuer must retire a predetermined amount of the
issue periodically. Var-ious types of call provisions are discussed below.

Call and Refunding Provisions

A borrower generally wants the right to retire a debt instrument prior to the stated
maturity date because it recognizes that at some time in the future the general level
of interest rates may fall sufciently below the coupon rate so that redeeming the
issue and replacing it with another debt instrument with a lower coupon rate would
be economically bene-cial. This right is a disadvantage to the investor since
proceeds received must be reinvested at a lower interest rate. As a result, a
borrower who wants to include this right as part of a debt instrument must
compensate the investor when the issue is sold by offering a higher coupon rate.
The right of the borrower to retire the issue prior to the stated maturity date is
referred to as a call option. If the borrower exercises this right, the issuer is said to
call the debt instrument. The price that the borrower must pay to retire the issue is
referred to as the call price.
When a debt instrument is issued, typically the borrower may not call it for a
number of years. That is, the issue is said to have a deferred call. The date at which
the debt instrument may rst be called is referred to as the rst call date.
If a bond issue does not have any protection against early call, then it is said to
be a currently callable issue. But most new bond issues, even if currently callable,
usually have some restrictions against certain types of early redemption. The most
common restriction is prohibiting the refunding of the bonds for a certain number of
years. Refunding a bond issue means redeeming bonds with funds obtained through
the sale of a new bond issue.
Many investors are confused by the terms noncallable and nonre-fundable. Call
protection is much more absolute than refunding protec-tion. While there may be
certain exceptions to absolute or complete call protection in some cases, it still
provides greater assurance against pre-mature and unwanted redemption than does
refunding protection. Refunding prohibition merely prevents redemption only from
certain sources of funds, namely the proceeds of other debt issues sold at a lower
cost of money. The bondholder is only protected if interest rates decline, and the
borrower can obtain lower-cost money to pay off the debt.

Prepayments
For amortizing instrumentssuch as loans and securities that are backed by loans
there is a schedule of principal repayments but indi-vidual borrowers typically have
the option to pay off all or part of their loan prior to the scheduled date. Any principal
repayment prior to the scheduled date is called a prepayment. The right of borrowers
to prepay is called the prepayment option. Basically, the prepayment option is the
same as a call option.

Options Granted to Bondholders

There are provisions in debt instruments that give either the investor and/or the
issuer an option to take some action against the other party. The most common type
of embedded option is a call feature, which was discussed earlier. This option is
granted to the issuer. There are two options that can be granted to the owner of the
debt instrument: the right to put the issue and the right to convert the issue.
A debt instrument with a put provision grants the investor the right to sell it back
to the borrower at a specied price on designated dates. The specied price is called
the put price. The advantage of the put pro-vision to the investor is that if after the
issuance date of the debt instru-ment market interest rates rise above the debt
instruments coupon rate, the investor can force the borrower to redeem the bond at
the put price and then reinvest the proceeds at the prevailing higher rate.
A convertible debt instrument is one that grants the investor the right to convert or
exchange the debt instrument for a specied number of shares of common stock.
Such a feature allows the investor to take advantage of favorable movements in the
price of the borrowers com-mon stock or equity.

VALUATION OF A FINANCIAL INSTRUMENT

Valuation is the process of determining the fair value of a nancial instrument.

Valuation is also referred to as pricing a nancial instru-ment. Once this process is
complete, we can compare a nancial instru-ments computed fair value as
determined by the valuation process to the price at which it is trading for in the
market (i.e., the market price). Based on this comparison, an investor will be able to
assess the invest-ment merit of a nancial instrument.
There are three possibilities summarized below along with their investment
implications.
 Market Price versus Fair Value Investment Implications
Market price equal to fair value Financial instrument is fairly priced Market price is
less than fair value Financial instrument is undervalued Market price is greater than
fair value Financial instrument is overvalued

A nancial instrument that is undervalued is said to be trading cheap and is a

candidate for purchase. If a nancial instrument is over-valued, it is said to be
trading rich. In this case, an investor should sell the nancial instrument if he or she
already owns it. Or, if the nancial instrument is not owned, it is possible for the
investor to sell it anyway. Selling a nancial instrument that is not owned is a
common practice in some markets. This market practice is referred to as selling
short. We will discuss the mechanics of selling short in Chapter 4. The two reasons
why we say that it is possible for an investor to sell short are (1) the investor must be
permitted or authorized to do so and (2) the market for the nancial instrument must
have a mechanism for short selling.

FINANCIAL MARKETS

A nancial market is a market where nancial instruments are exchanged (i.e.,

traded). Although the existence of a nancial market is not a neces-sary condition for
the creation and exchange of a nancial instrument, in most economies nancial
instruments are created and subsequently traded in some type of nancial market.
The market in which a nancial asset trades for immediate delivery is called the spot
market or cash market.

Role of Financial Markets

Financial markets provide three major economic functions. First, the interactions of
buyers and sellers in a nancial market determine the price of the traded asset. Or,
equivalently, they determine the required return on a nancial instrument. Because
the inducement for rms to acquire funds depends on the required return that
investors demand, it is this feature of nancial markets that signals how the funds in
the nancial market should be allocated among nancial instruments. This is called
the price discovery process.
Second, nancial markets provide a mechanism for an investor to sell a nancial
instrument. Because of this feature, it is said that a nancial market offers liquidity,
an attractive feature when circumstances either force or motivate an investor to sell.
If there were not liquidity, the owner would be forced to hold a nancial instrument
until the issuer initially contracted to make the nal payment (i.e., until the debt
instru-ment matures) and an equity instrument until the company is either vol-untarily
or involuntarily liquidated. While all nancial markets provide some form of liquidity,
the degree of liquidity is one of the factors that characterize different markets.
The third economic function of a nancial market is that it reduces the cost of
transacting. There are two costs associated with transacting: search costs and
information costs. Search costs represent explicit costs, such as the money spent to
advertise ones intention to sell or purchase a nancial instrument, and implicit costs,
such as the value of time spent in locating a counterparty. The presence of some
form of organized nancial market reduces search costs. Information costs are costs
asso-ciated with assessing the investment merits of a nancial instrument, that is,
the amount and the likelihood of the cash ow expected to be generated. In a price
efcient market, prices reect the aggregate infor-mation collected by all market
participants.

Classification of Financial Markets

There are many ways to classify nancial markets. One way is by the type of
nancial claim, such as debt markets and equity markets. Another is by the maturity
of the claim. For example, the money market is a nancial market for short-term debt
instruments; the market for debt instruments with a maturity greater than one year
and equity instruments is called the capital market.
Financial markets can be categorized as those dealing with nancial claims that
are newly issued, called the primary market, and those for exchanging nancial
claims previously issued, called the secondary mar-ket or the market for seasoned
instruments.
Markets are classied as either cash markets or derivative markets. The latter is
described later in this chapter. A market can be classied by its organizational
structure: It may be an auction market or an over-the-counter market. We describe
these organizational structures when we discuss the market for common stocks in
Chapter 4.

BORROWING FUNDS TO PURCHASE FINANCIAL INSTRUMENTS

Some investors follow a policy of borrowing a portion or all of the
funds to buy nancial instruments. By doing so an investor is creating

nancial leverage or simply leverage. We rst describe the principle of leverage and
then explain how an investor can create a leveraged posi-tion in nancial markets.

Principles of Leverage
The objective in leveraging is to earn a higher return on the funds borrowed than it
cost to borrow those funds. The disadvantage is that if the funds borrowed earn less
than the cost of the borrowed funds, then the investor would have been better off
without borrowing.
Here is a simple example. Suppose an investor can invest $100,000 today in a
nancial instrument. The investor puts up his own funds to purchase the nancial
instrument and this amount is referred to as the investors equity. Suppose that the
nancial instrument at the end of one year provides a cash payment to the investor
of $5,000. Also assume that the value of the nancial instrument has appreciated
from $100,000 to $110,000. Thus, the investors return is $5,000 in the form of a
cash payment plus capital appreciation of $10,000 for a total of $15,000. The return
this investor realized is 15% on the $100,000 investment. Instead of an appreciation
in price for the nancial instru-ment, suppose its value declined to $97,000. Then the
investors return would be $2,000 ($5,000 cash payment less the depreciation in the
value of the nancial instrument of $3,000) or a 2% return.
Now lets see where leverage comes in. Suppose that our investor can borrow
another $100,000 to purchase an additional amount of the nancial instrument.
Consequently, $200,000 is invested, $100,000 of which is the investors equity and
$100,000 of which is borrowed funds. Lets suppose that the cost of borrowing the
$100,000 is 7%. In the case where the nancial instrument appreciated, the
investors return on equity is summarized below:
 Investment in nancial instrument = $200,000
Cash payment = $10,000
Values of nancial instrument at end of year = $220,000
Appreciation in value of nancial instrument = $20,000
Cost of borrowed funds = $7,000 (7% $100,000)
Dollar return = $10,000 + $20,000 $7,000 = $23,000
Return on investors equity = 23% (= $23,000/$100,000)
Thus the investor increased the return on equity from 15% (when no funds were
borrowed) to 23% (when $100,000 was borrowed). The reason should be obvious.
The investor borrowed $100,000 at a cost of 7% and then earned on the $100,000
borrowed 15%. The difference of 8% between the return earned on the money
borrowed and the cost of the money borrowed accrued to the benet of the investor
in terms of increasing the return on equity.
Lets try this one more time assuming that the investor borrowed $200,000 at a
cost of 7% and the value of the nancial instruments increased. The results are
summarized below:
Investment in nancial instrument = $300,000 Cash payment = $15,000
Value of nancial instrument at end of year = $330,000 Appreciation in
value of nancial instrument = $30,000 Cost of borrowed funds = $14,000
(7% $200,000) Dollar return = $15,000 + $30,000 $14,000 = $31,000
Return on investors equity = 31% (= $31,000/$100,000)
By borrowing $200,000, the investor has increased the return on equity compared to
the case of no borrowing or borrowing just $100,000.
That is the good news and occurs if the return earned on the borrowed funds
exceeds the cost of borrowing. But there is a risk that this will not occur. For
example, take the case where the investor borrows $100,000 but the nancial
instruments value declines. Then we have the following situation:
Investment in nancial instrument = $200,000 Cash payment = $10,000
Value of nancial instrument at end of year = $194,000 Depreciation in
value of nancial instrument = $6,000 Cost of borrowed funds = $7,000
(7% $100,000) Dollar return = $10,000 6,000 $7,000 = $3,000
Return on investors equity = 3% (= $3,000/$100,000)
The return on investors equity in this case is 3%. This is less than the investor
would have realized if no funds were borrowed (2%). The rea-son is that the investor
earned 2% on the $100,000 borrowed and had to pay 7% to borrow the funds. The
difference of 5% between the cost of borrowing and the return on the $100,000
borrowed works against the investor in terms of reducing the return on the investors
equity.
It is easy to see why the more borrowed in this scenario, the more it would have
decreased the return on investors equity.

Collateralized Borrowing in the Financial Markets

How does an investor create leverage? One obvious way is to take out a loan from a
nancial institution. However, there is a standard mechanism in most sectors of the
nancial market that allows an investor to create leverage. The investor can use the
nancial instrument purchased with the borrowed funds as collateral for the loan.
In the stock market, the form of collateralized borrowing is referred to as buying
on margin. This will be explained in Chapter 4. In the bond market, there are various
forms of collateralized borrowing. For individual investors, typically the mechanism is
buying on margin. For institutional investors, a repurchase agreement is used. This
agreement will be explained in Chapter 6. It is actually a short-term investment to the
entity that wants to lend funds (hence it is called a money market instrument) and a
source of funds for an investor who wants a collateralized loan.
There is a specialized type of repurchase agreement in the mortgage-backed
securities market called a dollar roll. This will be explained in Chapter 14.

DERIVATIVE MARKETS
So far we have focused on the cash market for nancial instruments. With some
nancial instruments, the contract holder has either the obli-gation or the choice to
buy or sell a nancial instrument at some future time. The price of any such contract
derives its value from the value of the underlying nancial instrument, nancial index,
or interest rate. Consequently, these contracts are called derivative instruments.
The primary role of derivative instruments is to provide investors with an
inexpensive way of controlling some of the major risks that we will describe in this
book. We will take a closer look at this in Chapter
28. Unfortunately, derivative instruments are too often viewed by the general
publicand sometimes regulators and legislative bodiesas vehicles for pure
speculation (that is, legalized gambling). Without derivative instruments and the
markets in which they trade, the nancial systems throughout the world would not be
1
as efcient or integrated as they are today.

1
A May 1994 report published by the U.S. General Accounting Office (GAO) titled
Financial Derivatives: Actions Needed to Protect the Financial System recognized
the importance of derivatives for market participants. Page 6 of the report states:

Derivatives serve an important function of the global financial market-place,

providing end-users with opportunities to better manage financial risks
associated with their business transactions. The rapid growth and in-creasing
complexity of derivatives reflect both the increased demand from end-users
for better ways to manage their financial risks and the innovative capacity of
the financial services industry to respond to market demands.
Types of Derivative Instruments
The two basic types of derivative instruments are futures/forward con-tracts and
options contracts. A futures contract or forward contract is an agreement whereby
two parties agree to transact with respect to some nancial instrument at a
predetermined price at a specied future date. One party agrees to buy the nancial
instrument; the other agrees to sell the nancial instrument. Both parties are
obligated to perform, and neither party charges a fee. The distinction between a
futures and forward contract is explained in Chapter 29.
An option contract gives the owner of the contract the right, but not the obligation,
to buy (or sell) a nancial instrument at a specied price from (or to) another party.
The buyer of the contract must pay the seller a fee, which is called the option price.
When the option grants the owner of the option the right to buy a nancial instrument
from the other party, the option is called a call option. If, instead, the option grants
the owner of the option the right to sell a nancial instrument to the other party, the
option is called a put option. Options are more fully explained in Chapter 28.
Derivative instruments are not limited to nancial instruments. In this book we will
describe derivative instruments where the underlying asset is a nancial asset, or
some nancial benchmark such as a stock index or an interest rate, or a credit
spread. Moreover, there are other types of derivative instruments that are basically
packages of either forward contracts or option contracts