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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.”

Or in simple terms, “financial instruments are legal agreements that require one
party to pay money or something else of value or to promise to pay under
stipulated conditions to a counter party in exchange for the payment of interest,
for the acquisition of rights, for premiums, or for indemnification against risk. In
exchange for the payment of the money, the counterparty hopes to profit by
receiving interest, capital gains, premiums, or indemnification for a loss event.”

A “financial instrument can be an actual document, such as a stock certificate or a


loan contract, but, increasingly, financial instruments that have been standardized are
stored in an electronic book-entry system as a record, and the parties to the contract
are also recorded. For instance, United States Treasuries are stored electronically in a
book-entry system maintained by the Federal Reserve.”

“Some common financial instruments include checks, which transfer money from the
payer, the writer of the check, to the payee, the receiver of the check. Stocks are
issued by companies to raise money from investors. The investors pay for the stock,
thereby giving money to the company, in exchange for an ownership interest in the
company. Bonds are financial instruments that allow investors to lend money to the
bond issuer for a stipulated amount of interest over a specified period.”

“Financial instruments can also be used by traders to either speculate about future
prices, index levels, or interest rates, or some other financial measure, or to
hedge financial risk.”

The two parties to these kinds of instruments are speculators and hedgers.
i) “Speculators attempt to predict future prices or some other financial measure,
then buying or selling the financial instruments that would yield a profit if
their view of the future should be correct. In other words, speculators bet
about future prices or some other financial measure. For instance, if a
speculator thought that the price of XYZ stock was going to go up, then he
could buy a call option for the stock, which would be profitable if the stock
does go up. If the option expires worthless, then the loss to the speculator is
less than the loss that would have been incurred from actually owning the
stock.”
ii) “Hedgers attempt to mitigate financial risk by buying or selling the financial
instruments whose value would vary inversely with the hedged risk. For
instance, if the owner of XYZ stock feared that the price might go down, but
didn't want to sell before a specific time for tax purposes, then she could buy
a put on the stock that would increase in value as the stock declined in value.
If the stock goes up, then the put expires worthless, but the loss of the put
premium would probably be less than the loss incurred if the stock declined.”

Types of Financial Instruments

There are many types of financial instruments. Many instruments are custom
agreements that the parties tailor to their own needs. However, many financial
instruments are based on standardized contracts that have predetermined
characteristics.

Some of the most common examples of financial instruments include the following:

 Exchanges of money for future interest payments and repayment of principal.


o Loans and Bonds. A lender gives money to a borrower in
exchange for regular payments of interest and principal.
o Asset-Backed Securities. Lenders pool their loans together and
sell them to investors. The lenders receive an immediate lump-
sum payment and the investors receive the payments of interest
and principal from the underlying loan pool.
 Exchanges of money for possible capital gains or interest.
o Stocks. A company sells ownership interests in the form of stock to
buyers of the stock.
o Funds. Includes mutual funds, exchange-traded funds, real estate
investment trusts, hedge funds, and many other funds. The fund
buys other securities earning interest and capital gains which
increases the share price of the fund. Investors of the fund may also
receive interest payments.

 Exchanges of money for possible capital gains or to offset risk.


o Options and Futures. “Options and futures are bought and sold either
for capital gains or to limit risk. For instance, the holder of XYZ stock
may buy a put, which gives the holder of the put the right to sell XYZ
stock for a specific price, called the strike price. Hence, the put increases
in value as the underlying stock declines. The seller of the put receives
money, called the premium, for the promise to buy XYZ stock at the
strike price before the expiration date if the put buyer exercises her
rights. The put seller, of course, hopes that the stock stays above the
strike price so that the put expires worthless. In this case, the put seller
gets to keep the premium as a capital gain.”
o Currency. “Currency trading, likewise, is done for capital gains or to
offset risk. It can also be used to earn interest, as is done in the carry
trade. For instance, if a trader believed that the Euro was going to decline
with respect to the United States dollar, then he could buy dollars with
Euros, which is the same thing as selling Euros for dollars. If the Euro
does decline with the respect to the dollar, then the trader can close the
position by buying more Euros with the dollars received in the opening
trade.”
o Swaps. “Swaps are an exchange of interest rate payments calculated as a
percentage of a notional principal that is paid at periodic intervals. One
leg of the swap pays a fixed rate of interest and the other leg pays a
floating rate of interest. However, only the net amount is exchanged. For
instance, if the interest based on the floating rate is $1000 greater than
the interest based on the fixed-rate on a payment date, then the party
receiving the fixed rate would pay $1000 to the party receiving the
floating rate. The receiver of the fixed rate of interest enters into the
swap usually to offset risk while the receiver of the floating rate
generally hopes to profit from changes in the market interest rate.
Usually, the floating rate is calculated as a spread above LIBOR or some
other benchmark, such as Treasuries with comparable terms. If both legs
of the swap pay in the same currency, and the swap is known as
an interest rate swap, since both the fixed-rate and the floating rate are
paid in the same currency. By contrast, a currency swap is the exchange
of interest rate payments paid in different currencies, so the net amount is
calculated based on the exchange rate on the payment date.”
 Exchanges of money for protection against risk.
o Insurance. “Insurance contracts promise to pay for a loss event
in exchange for a premium. For instance, a car owner buys car
insurance so that he will be compensated for a financial loss
that occurs as the result of an accident.”

Primitive Securities and Financial Derivatives

“A custom agreement can better suit the needs of the parties involved; however, such
instruments are extremely illiquid precisely because they are tailored to specific
parties.1 Furthermore, such instruments would take time for anyone to completely
understand the details, which would be necessary to assess the profit potential and

1
https://www.chicagofed.org/publications/understanding-derivatives/index
risk. The solution to this illiquidity is to create financial instruments based on
standardized contracts with standard terms and conditions”.2

“Such financial instruments are called securities, which can be easily traded
in financial markets, such as organized exchanges and in the over-the-counter market.
Furthermore, they are more easily stored in an electronic book-entry system, which
saves the cost of storing and transporting the instruments for clearing and settlement.
Examples of securities include stocks, bonds, options, and futures.”

“Securities are classified as to whether they are based on real assets or on other
securities or some other benchmark. Primitive securities are based on real assets or
on the promise or performance of the issuer. For example, bonds are based on the
issuer's ability to pay interest and principal and stocks depend on the performance of
the company that issued the stock. Financial derivatives are based on
the underlying asset which consists of other financial instruments or some
benchmark, such as stock indexes, interest rates, or credit events. For example, the
value of stock options depends on the price of the underlying stock, and mortgage-
backed securities depend on an underlying pool of mortgages”.3

Valuation of Financial Instruments

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

Obviously, the greater the expected return of the instrument, the greater its value.
This is why the stock of a fast-growing company is highly valued, for instance.

“A financial instrument that has less risk will have a higher value than a similar
instrument that has more risk—the greater the risk, the more it lowers the value of the
security because risk requires compensation. This is why United States
Treasuries which have virtually no credit default risk command higher prices (lower

2
https://thismatter.com/money/banking/financial-instruments.htm
3
https://www.chicagofed.org/publications/understanding-derivatives/index
yields) than junk bonds with the same principal. So an investor would pay less money
for a junk bond with a $1,000 principal than for a Treasury with the same $1,000
principal and coupon rate since there is a much greater risk that the junk bond may
default. So, by paying less money for the junk bond, the junk bond pays a higher
yield.”

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

Types of Financial Instruments used in India

1. Equities: “It is a type of security that represents the ownership of a company. Equities are
traded in stock markets. It can also be purchased through Initial Public Offerings (IPO),
whenever a company issues shares to the public for the first time. In India, share trading
actively happens in stock exchanges; prominent ones are BSE (Bombay Stock Exchange) and
NSE (National Stock Exchange).4 It is one of the best options to invest in equities over an
extended period as it will fetch good returns. It is also subject to market-related risk, and one
needs to do thorough research before investing in equities. Equity shares constitute
permanent capital for the firm and it cannot be redeemed during the lifetime of the company
and as per the Companies Act of 1956, a company cannot purchase its own shares during its
existence. At the time of liquidation, the equity shareholders can demand the refund of their
capital amount and the same will be paid after meeting the entire prior claim including
preference shareholders”.5

4
https://www.goodreturns.in/classroom/2018/01/financial-instruments-india-664311.html
5
https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-
resources/f7/technical-articles/what-financial-instrument.html
2. Mutual Funds: “Mutual fund is a professionally managed investment fund that pools money
from many investors to purchase securities. These investors may be retail or institutional in
nature. Mutual funds have advantages and disadvantages compared to direct investing in
individual securities. The primary advantages of mutual funds are that they provide
economies of scale, a higher level of diversification, they provide liquidity, and they are
managed by professional investors. On the negative side, investors in a mutual fund must pay
various fees and expenses. Primary structures of mutual funds include open-end funds, unit
investment trusts, and closed-end funds. Exchange-traded funds (ETFs) are open-end funds
or unit investment trusts that trade on an exchange. Mutual funds are also classified by their
principal investments as money market funds, bond or fixed income funds, stock or equity
funds, hybrid funds or other. Funds may also be categorized as index funds, which are
passively managed funds that match the performance of an index, or actively managed funds.
Hedge funds are not mutual funds; hedge funds cannot be sold to the general public and are
subject to different government regulations”.6
“In India, Mutual Funds are top-rated because the initial investment amount is very less and
the risk is diversified. Mutual funds allow a group of individuals to invest their money
together. The investment avenue is famous because of cost-efficiency, risk-diversification,
professional management and sound regulation. The minimum amount to be invested can be
as small as INR 500, and the frequency of investment is usually monthly or quarterly”.

3. Bonds: “The bond is a debt security, under which the issuer owes the holders a debt and
(depending on the terms of the bond) is obliged to pay them interest (the coupon) or to repay
the principal at a later date, termed the maturity date.7 Interest is usually payable at fixed
intervals (semiannual, annual, and sometimes monthly).8 Very often the bond is negotiable,
that is, the ownership of the instrument can be transferred in the secondary market. This
means that once the transfer agents at the bank medallion stamp the bond, it is highly liquid
on the secondary market. Thus a bond is a form of loan or IOU: the holder of the bond is the

6
https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-
resources/f7/technical-articles/what-financial-instrument.html
7
O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in action. Upper Saddle River, New Jersey
07458: Pearson Prentice Hall. pp. 197, 507. ISBN 0-13-063085-3.
8
http://www.businessmanagementideas.com/markets/capital-market/financial-instruments-used-in-a-capital-market-
financial-management/17105
lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the
interest. Bonds provide the borrower with external funds to finance long-term investments,
or, in the case of government bonds, to finance current expenditure. Certificates of deposit
(CDs) or short-term commercial paper are considered to be money market instruments and
not bonds: the main difference is the length of the term of the instrument. Bonds are fixed
income instruments which are issued to raise working capital 9. Both private entities, such as
companies, financial institutions, and the central and state government institutions issue this
to raise funds. The bonds issued by the government carries the lower rate of risk but
guarantees returns. The bonds issued by private institutions have high risks.”

4. Deposits: “A deposit encompasses two different meanings. One kind of deposit involves a
transfer of funds to another party for safekeeping. Using this definition, deposit refers to the
money an investor transfers into a savings or checking account held at a bank or credit union.
A deposit can be made by individuals or entities such as corporations. In this usage, the
money deposited still belongs to the person or entity that deposited the money, and that
person or entity can withdraw the money at any time, transfer it to another person’s account,
or use the money to purchase goods.10 Often, a person must deposit a certain amount of
money in order to open a new bank account, known as a minimum deposit. Depositing
money into a typical checking account qualifies as a transaction deposit, which means that
the funds are immediately available and liquid, without any delays. Investing the money in
banks or post-office is one of the standard method of savings followed in India. The risk
factor involved is zero, and the return on investment is guaranteed.”

5. Cash and Cash Equivalents: “Cash and cash equivalents are a group of assets owned by a
company. For simplicity, the total value of cash on hand includes items with a similar nature
to cash.11 If a company has cash or cash equivalents, the aggregate of these assets is always
shown on the top line of the balance sheet. This is because cash and cash equivalents are the
most liquid assets. All cash and cash equivalents must be current assets. These are relatively

9
Eason, Yla (June 6, 1983). "Final Surge in Bearer Bonds" New York Times.
10
Call Deposit, http://www.deposits.org, accessed 2018-10-14
11
Denis, Durant (22–23 January 2013). "IAS 7 Statement of Cash Flows- identification of cash equivalents" (PDF).
IFRS.
safe and highly liquid investment options. All the securities that can be immediately
converted into cash within three months are known as cash and cash equivalents. Treasury
bills, gold, money market funds are cash equivalents.”12

Key Advantages of Financial Instruments

Overcoming Market Inefficiencies13

 “Financial Instruments provide financing to target groups of final recipients that have
limited access to financing from the private sector. Such financing would generate a
positive effect through the support provided to the final recipients and will contribute to
the goals of the respective Operational Programme.”
 “The financial products supplied by means of FIs are tailored to the needs and
requirements of the target final recipients and offer, in general, more favourable terms,
including with respect to pricing, maturity and/or collateral requirements.”

Leverage Effect

 “In addition to the resources from the Operational Programmes, FIs mobilise additional
private financing which increases the total amount of the support available to the final
recipients.”

Revolving Funds

 Resources paid back by the financed projects, and the potential other revenue generated
from them, can be reused to provide support to other eligible final recipients and projects.

Fiscal Discipline

12
What Is Included in a Cash & Cash-Equivalent Calculation Statement?". Small Business - Chron.com. Retrieved
2015-11-04.
13
http://www.fmfib.bg/en/page/9-financial-instruments
 The resources made available via the instruments require that the final recipients pay
them back, which leads to a more efficient use of public resources compared to grant
support, and reduces the chances that final recipients may grow addicted to public
support.

Expertise

 Final recipients can benefit from the expertise of the financial intermediaries and other
private sector partners in structuring economically viable projects.

Tax attributes of financial instruments in India:

Exit or disposal of instruments: “Taxability of instruments are based on various factors under
Indian domestic tax laws. However, characterization of gains from exit of such instruments plays
a vital role in determining income tax liability.”14
“Profits arising from the instruments held with the intention of business or stock are treated as
business income, subject to a maximum base tax rate of 30%/40%. Instruments held for
investment purpose would qualify as capital assets, and sale thereof would constitute transfer of
capital asset, resulting in capital gains tax liability.”

“Concessional rate of capital gains tax at 20%/10% may be applicable, depending on the period
of holding ranging from 12-to-36 months. In case of listed securities where securities transaction
tax is paid, no capital gains tax is payable in India.”

Conversions/repayment of debt not a transfer: “Ideally, Mezz instruments have dual


characteristics where the hybrid instrument is converted from debt to equity or permissible
instruments. The event of conversion would trigger transfer of asset. Under Indian domestic
laws, conversion of specific instruments such as convertible debenture or preference shares to

14
https://www.livemint.com/Money/tF8GOU0oUbbcZSNGBeHs1N/Financial-instruments-and-taxability.html
equity is tax-neutral. Repayment of debt on a principal to principal basis would not have tax
consequences.”

Others: “Settlement of derivatives with underlying asset is treated as rights for capital gains tax
purposes. Rights associated to business where the contract for purchase or sale is settled
otherwise than by actual delivery may be considered as business income. Importantly, income of
non-residents is chargeable to tax in India or subject to the tax treaty entered between the
country, whichever is more beneficial.”