Financial Instruments

Financial Instruments

Financial instruments are contracts for monetary assets that can be purchased, traded, created, modified, or settled for. In terms of contracts, there is a contractual obligation between involved parties during a financial instrument transaction.

Information about financial instruments is important to users, as it provides insight into the risks related to financial assets and financial liabilities including the exposure to risks arising from these to the entity and how they are managed. Such information can influence a user’s assessment of the financial position and financial performance, as well as provide insight into the amount, timing, and uncertainty of an entities future cash flows.

The extent and nature of financial instruments held by public sector entities varies significantly from entities that have few financial instruments (e.g., a government department whose only financial instruments are accounts receivable and accounts payable) and those that have many and complex financial instruments (e.g., a financial institution whose assets and liabilities are comprised mostly of financial instruments). The complexity and extent of the requirements for presentation, recognition, measurement, and disclosures of financial instruments depend on the extent of the entity’s use of financial instruments and of its exposure to risk. 

It is common for public sector entities to use derivatives in managing interest rate risk, credit risk, and risks associated with fluctuating market prices of commodities. This module addresses the recognition of derivatives acquired to off et these risks and their measurement.

A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. 

Assets and liabilities in the public sector arise out of both contractual and non-contractual arrangements. Assets and liabilities arising out of non-contractual arrangements do not meet the definition of a financial asset or a financial liability. For example, provisions accounted for in accordance with IPSAS 19, Provisions, Contingent Liabilities and Contingent Assets would generally not be a financial instrument. Physical assets (such as inventories, property, plant, and equipment), leased assets and intangible assets (such as patents and trademarks) are not financial assets. Similarly, prepaid assets are not financial assets because they represent economic benefits in the form of future receipt of goods or services. 

Constructive obligations do not arise from contracts and are therefore not financial liabilities. 

A contract is an agreement between two or more parties that has clear economic consequences that the parties have little if any, discretion to avoid, usually, because the agreement is enforceable by law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing. 

Public sector entities may enter into arrangements that have the substance of contracts. Application The guidance explains the factors an entity should consider in assessing whether an arrangement is contractual or non-contractual. 

An entity considers the substance rather than the legal form of an arrangement in determining whether it is a contract that meets the definition of a financial instrument. Contracts are generally evidenced by the following (although this may differ from jurisdiction to jurisdiction): 

a) Contracts involve willing parties entering into an arrangement; 

b) The terms of the contract create rights and obligations for the parties to the contract and those rights and obligations need not result in equal performance by each party; and 

c) The remedy for non-performance is enforceable by law.

Common examples of financial assets representing a contractual right to receive cash in the future: 

a) Accounts receivable; 

b) Notes receivable; 

c) Loans receivable; 

d) Equity securities; and 

e) Bonds receivable. 

A financial liability is any liability that is: 

a) A contractual obligation: 

(i) To deliver cash or another financial asset to another entity; or 

(ii) To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity. 

b) A contract that will or may be settled in the entity’s own equity instruments The material does not cover the item.

(b), a contract that will or may be settled in the entity’s own equity instruments.

Types of Financial Instruments

1. SHARES 

Shares are capital share securities. The owner of shares or the shareholder is the company co-owner. If the company makes a profit, in certain cases, a portion of it shall be paid out to shareholders in the form of dividends. The more shares are owned by the shareholder, the greater the stake it owns, and the higher the portion of the distributable profits are due. It should be remembered that when the company's operation brings a loss, its equity should be reduced, resulting in a decrease in the value of shareholders' investment. If the company goes bankrupt, there is a possibility for a partial or complete loss of investments in its shares. 

There are common and preferred shares. Holder of common shares is entitled to participate in the company's administration, by exercising the right to vote at shareholders' meetings. In turn, preferred shares give to their owner the prior right to receive dividends, but usually do not give the voting rights. Shares are most often traded in the regulated markets i.e. at a stock exchange. Particular company's stock price depends on the supply and demand interaction determined by a number of various factors, such as: 

1) the company's current situation (including sales, organizational structure, productivity, etc.), as well as future prospects. As it is not possible to accurately predict how successfully the company will operate in the future (it depends on, for example, technology, applicable legal requirements, competition), the stock price is largely determined by investors' estimates of the company's operations in the future. 

2) market interest rates. First, higher interest rates mean higher debt service costs for the company, thus reducing its profits and growth opportunities. Second, an increase in interest rates will increase the yield on debt securities, and investors' demand for shares decreases, thus negatively affecting the stock price.

3) stock turnover, or a total number of shares to be bought or sold at a stock exchange. If the company's stock turnover is high, the difference between the price that the buyers are willing to pay and the price demanded by the seller decreases. Such shares are easy to buy and sell. Conversely, if the turnover is low, the customer may have difficulties with the purchase or sale of shares at the desired price. 

Market players often have different opinions about the company's prospects, resulting in a balanced market, because some market players may want to sell the shares, the others - to buy. If the majority of market players have a common viewpoint on the share price in the future, the situation leading to more rapid changes in stock prices occurs, because the demand for shares increases or decreases. Declines in stock prices have a negative impact on the investor's returns.

2. DEBT SECURITIES 

 Debt securities, such as bonds, confirm one party's (the issuer's) debt obligations to the other party (the holder of the bond). The bond issuer's obligations to the bondholders are set forth in the bond prospectus. Usually, the issuer is obliged to repay to bondholders the face value of bonds acquired on a certain date (the bond maturity date), and to pay the interest (make coupon payments) from time to time (for example, once or twice a year). However, there are bonds with no fixed maturity and bonds, the issuer of which is not required to pay coupons to bondholders (known as T-bills, zero or zero-coupon bonds). The bond coupon is expressed as an annual percentage of the face value of bonds. It can be either fixed or variable (floating). Bond issuers may be national governments, banks, companies, and other market players. 

The bondholder may sell their bonds before their maturity date. In this case, one should expect that the bond price may be higher or lower than the purchase price of the bond. Bond prices are affected by several factors, and the bondholders have to take account of the following ones: 

1) the issuer's creditworthiness. The better the issuer's financial results, the lower its borrowing costs. Consequently, the price of such issuer's bonds is higher. If the issuer's creditworthiness deteriorates, the price of bonds decreases, so the bondholders may suffer a loss. If the issuer becomes insolvent, the holders of its bonds may partially or even completely lose their investment, despite the fact that they have held their investment in bonds until maturity. 

2) market interest rates. When the market interest rates grow, the prices of bonds decline, so their holders may incur a loss, if they want to sell the bonds before their maturity date. The fluctuations of market interest rates will mostly affect the long-term bond prices. 

3) bond trade turnover. If the number of buyers is not sufficient in the market, the sale of bonds at the desired price may be difficult. 

3. CERTIFICATES OF CERTAIN INVESTMENT FUNDS 

Investment funds can be both non-complex (such as UCITS, an open-end fund "DNB Reserve Fund" certificates), and complex financial instruments. 

An investment fund is a combination of many investors' monetary funds, which is managed by a professional specialist (fund manager) with the aim to get a profit from the growth of the investment value. In order to ensure the growth of investment value, the fund manager invests in various assets, such as stocks, bonds, term deposits, and real estate. The fund manager's right to invest in one or asset class is defined in the investment fund's prospectus. The prospectus also covers the remuneration that the fund manager receives for his work. It is from time to time charged on the fund's assets.

Investment fund certificates are securities that confirm the investor's participation in the fund and the resulting investor's rights. When buying fund certificates, the investor becomes a fund participant and is entitled to claim the appropriate share of the fund profits. However, investors must take into account that the investment fund shares neither have a guaranteed nominal value, nor guaranteed yield. This means that the investor may lose part or entirely the money invested in the fund. It should also be noted that the investment fund has the same risks that are inherent to assets, in which the fund existing resources are deployed. The most common types of investment funds:

• Money market funds - investors' funds are placed in term deposits and short-term bonds. These funds have the lowest risk. 
• Bond funds - investors' funds are placed in debt securities. 
• Balanced funds - investors' assets are placed in both bonds and equities. 
• Equity funds - investors' funds are deployed inequities. 
• Hedge funds - in addition to traditional investments in stocks and/or bonds the investments in derivative instruments are used, thus increasing the investment risk degree, but at the same time also increasing the expected profitability. Investments in hedge funds are subject to considerable fluctuations, and at the same time it ought to be taken into account that hedge funds may have certain trade and settlement dates, as a result, it is possible that by selling the fund certificates the investor will receive the returns from the sale on its account over time. Hedge funds can be both non-complex and complex financial instruments. 

Investment funds are grouped into close-end (the fund has a certain expiry date and restricted number of certificates) and open-end (the fund expiry date is not determined and the number of fund certificates is not limited). 

A separate sub-type of investment funds is exchange-traded funds (ETFs). Its certificates are traded at stock exchanges (like shares). An exchange-traded fund's share value may be linked to a variety of assets such as stock or bond indices, commodities, currencies, and more. Exchange-traded funds can be both non-complex and complex financial instruments. 

COMPLEX FINANCIAL INSTRUMENTS 

1. NON-COMPLEX FINANCIAL INSTRUMENTS ACQUIRED FOR BORROWED FUNDS 

 The customer may have an opportunity to increase the size of its investment with the funds borrowed from the Bank. In such cases, the customer's own capital investment may be significantly less than the total face value of the investment. However, the customer must understand that purchasing financial instruments for borrowed funds he may lose not only his own investment but also the borrowed funds and stay indebted if the financial asset price developments will be unfavorable.

2. STRUCTURED FINANCIAL INSTRUMENTS 

Structured financial instruments include, for example, index-linked bonds. Index-linked bonds typically offer a yield that is dependent on the development of a stock index or an index basket. If the index value grows, the value of the bond grows as well. Conversely, if the index decreases in value, the investor may not receive the return, that is, recover only the face value of the bond. 

The index-linked bond issuer guarantees the face value of bonds at the maturity date, so the investor may suffer a loss if he chooses to sell the bond before the maturity date. Index-linked bonds have a risk of the issuer, i.e. if the bond issuer (usually a bank) goes bankrupt, an investor may lose some or all funds invested in the bonds, including borrowed funds, if such has been used for the purchase of the bonds.

3. CERTIFICATES OF CERTAIN INVESTMENT FUNDS 

Investment funds may be both a non-complex (such as UCITS business certificates, an open-end fund "DNB Reserve Fund" certificates), and a complex financial instrument. 

If investing in the investment fund is related to certain difficulties (e.g. investment fund units cannot be easily and quickly sold or information comprehensible to the average customer is not available), this type of fund unit is considered to be a complex financial instrument. The principal risk, contributing to such financial instruments are the risk of a total loss of the invested funds. 

A separate sub-type of investment funds is exchange-traded funds (ETFs). Their certificates are traded at stock exchanges (like shares). The value of exchange-traded fund shares may be linked to a variety of assets, such as stock or bond indices, commodities, currencies, and more. Exchange-traded funds can be both non-complex and complex financial instruments.

4. DERIVATIVE FINANCIAL INSTRUMENTS 

Derivatives are financial and commodity instruments, whose price is dependent on the value of the underlying asset. The underlying assets of derivatives can be interest rates, exchange rates, stocks, bonds, stock indices, oil, gold, cotton, and other commodities. 

Derivatives may be used to reduce the risks associated with the underlying asset price fluctuations, as well as to profit from the price fluctuations of derivatives themselves. Before making a deal with derivatives, the customer should clearly understand how the underlying asset’s prices fluctuate, which financial and other risks are associated with these instruments, what the aims of using derivatives are, and which alternative instruments are available for reducing the risks in question.

When trading derivatives is conducted for risk reduction purposes, they may be useful for the reduction of underlying asset price volatility effect. However, note that the fluctuations of prices of derivatives and their underlying assets may be different.

When trading in derivatives is conducted for for-profit purposes, the customer should be aware that such a trade entails high risks. Certain derivatives are characterized by large price fluctuations. Consequently, even small changes in the market may have a significant negative impact on the customer's financial position.

Most settlements for derivatives are made in the future. In order to purchase or sell derivatives, it is not always necessary to deliver funds in the full amount of the transaction at the moment of the transaction. In certain cases, when making transactions with derivatives, the customer must provide a guarantee or collateral in the amount required by the bank. In case of adverse changes in the market prices, the Bank shall be entitled to request the customer to increase the amount of the guarantee or collateral provided earlier. If the client does not make the supplement mentioned above, the Bank has the right to terminate the derivative transaction before the due date.

The customer who wants to make derivative transactions should have adequate knowledge of the derivative instruments' nature, principles, and associated risks. Each derivative type is characterized by specific risks, and the customer's knowledge and experience in making transactions with one type of derivatives derivative do not guarantee the understanding of other derivatives

Special Considerations

There are no securities under foreign exchange. Cash equivalents come in spot foreign exchange, which is the current prevailing rate. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options, outright forwards, and foreign exchange swaps.