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Financial Instruments
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- 2. MEANING OF FINANCIALINSTRUMENTS 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 instruments are contracts that gives rise to financial asset to one equity, and a financial liability or and equity instument to another entity. • Financial instruments include primary financial instruments like receivables, payables loans and advances, debentures and bonds, investment in equity instruments, cash and bank balances, derivative instruments like options, futures,swaps,cap,collar,floor, forward rate agreement(FRA) etc.
- 3. TYPES OF FINANCIALINTRUMENTS • Deposits • SDRs • Borrowings • Loans • Shares and other equity • Debentures or bonds • Other account receivables and payables • Financial derivatives • Letter of guarantee • Letter of credit • Financial commitments • Pledged financial assets
- 4. DEPOSITS Deposits include allclaims 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.
- 5. SDRs(Special Drawing Rights) SDRsare international reserve assets created by the IMF and allocated to member countries to supplement existing official reserves. SDRs are not treated as the IMF’s 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.
- 6. BORROWINGS Normally, borrowings arenot 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.
- 7. LOANS Loans are financialassets that are • created when a creditor lends funds directly to a debtor (borrower), • evidenced by non-negotiable documents. 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.
- 9. SHARES AND OTHEREQUITY 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. 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.
- 11. DEBENTURES OR BONDS Theterm ‘creditorship securities’ also known as ‘debt capital’ represents debentures and bonds. They occupy a significant place in the financial plan of the company. A debenture or a bond is an acknowledgement of A debt. It is a certificate issued by a company under its seal acknowledging A debt due by its holders. Types of debentures and bonds • Unsecured and secured debentures • Redeemable and irredeemable debentures • Zero interest bonds/debentures • Zero coupon bonds • Guaranteed debentures • Collateral debentures
- 12. OTHER ACCOUNT RECEIVABLESAND PAYABLES 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 nonresidents). 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.
- 14. FINANCIAL DERIVATIVES Financial derivativesare 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
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- 16. FORWARDS In a forwardcontract, 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. FUTURES A future contract is an agreement between seller and the buyer that calls for the seller to deliver to the buyer a specific quantity, grade of an identified commodity at a fixed time in the future and at a price agreed to when the contract is first entered into.
- 17. OPTIONS The buyer ofan 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.
- 18. SWAPS A swap representsa spot purchase (sale) of a financial asset with a condition of forward sale (purchase). Swap agreement is 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. Types of SWAPs • Interest rate Swaps • Currency Swaps
- 19. LETTER OF GUARANTEE Guaranteeinvolves an obligation by the economic entity to assume the other entity’s 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 sheet items. LETTER OF CREDITS 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
- 20. FINANCIAL COMMITMENTS Financial commitmentsinvolve 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 fulfilment of the terms of the contract, in case of the commitments. Nonfinancial commitments will not be treated as financial instruments. 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.
- 21. INNOVATIVE FINANACIAL INSTRUMENTS •Equity Warrants- The equity warrants is a paper attached to a bond preferred stock that gives the holder the right to buy a fixed number of company’s equity shares at a predetermined price at a future date. • Secured Premium Notes(SPNs)- The secured premium note is a tradable instrument with detachable warrant against which the holder gets equity shares after a fixed period of time. • Callable Bond- A callable bond is a bond that can be called in and paid off by issuer at a price, called the ‘call price’ stipulated in the bond contract. It gives the advantage to issuer company to call the existing bonds if the interest rates fall in the market below the bond’s coupon rate. • Floating/Variable or Adjustable Rate Bonds- The rate of interest payable on these bonds varies periodically depending upon the market rate of interest payable on the gilt-edged securities. • Deep Discount Bonds(DDBs)- The deep discount bond does not carry any interest but it is sold by the issuer company at a deep discount from its eventual maturity(normal) value.
- 22. • Inflation AdjustedBonds(IABs)- These are the bonds on which both interest as well as principal are adjusted in line with the price level changes or the inflation rate.