Financial Instruments

Definition:

Financial Instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity;or a contractual right to receive, or deliver, cash or another financial instrument.

-Financial Instrument is a contract which results in financial asset for one party and financial liability for another party.

Financial Instruments as per money market and capital market instruments

Money Market Instruments- Includes short term(maturity),

marketable, liquid, low risk debt securities.-Money market instruments sometimes

are called cash equivalents.

Types of Money Market Instruments-Treasury BillsBills issued by the Government to raise money from the public.

Investors buy the bills at a discount from the stated maturity value.

At the bill’s maturity, the holder receives from the government a payment equal to the face value of the bill.

The difference between the purchase price and maturity value constitutes the investor’s earnings.

T-bills are issued with maturities of 28, 91 or 182 days.

-Certificates of DepositCD is a promissory note issued by a bank.CD are low risk and low return investments.CD is a time deposit that restricts holders from withdrawing funds on demand.

Bank pays interest and principal to the depositor only at the end of the fixed term of the CD.

Short-term CDs are highly marketable.CDs maturity ranges from a month to 1 year.

-Commercial Paper Commercial paper (CP) is a promissory note (a written

promise to pay) issued by a large creditworthy corporation. As CP is issued by highly rated companies, defaults are rare

and thus considered it to be safe investment. Most CP is backed by bank lines of credit, which means bank

is ready to pay the obligation if the issuer is unable to do so. CP may be either interest bearing or sold on discounted

basis. Issued in multiples of large denomination. Maturity period for CP ranges between 15 days and 1 year.

-Bankers Acceptance A banker’s acceptance starts as an order to a bank by a

bank’s customer to pay a sum of money at a future date, typically within 6 months.

When the bank accepts to an order of the drawer (bank’s customer), it will have an unconditional liability to pay the holder of the acceptance.

They are widely used in a foreign trade where the credit worthiness of one trader is unknown to the trading partner.

BA’s are traded at discounts from face value in the secondary market.

-Repos and Reverses Dealers in government securities use repos (repurchase

agreements) as a form of short term borrowing. The dealer agrees to sell govt. securities to an investor

on an overnight basis with an agreement to buy back those the next day at higher price.

Term repo is an identical transaction, except that the term of the loan can be 30 days.

In reverse repo, dealer finds an investor holding govt. securities and buys them, agreeing to sell them back at a specified higher price on a future date.

Capital Market InstrumentsCapital market instruments are long term and riskier in nature.

Equity Securities Common Stock

Securities representing ownership shares in a corporation.

Holder of the common stock has right to vote. Holder have claims on variable future streams of

income, known as dividends. Residual claim on earnings and assets (dividend

and liquidation)

Preferred StockA security that shows ownership in a corporation and gives the holder a claim, prior to the claim of common stockholders, on earnings and on capital in the event of liquidation.

-feature similar to both equity (potential appreciation) and debt (fixed dividend) as it promises to pay its holder a fixed amount of income each year.

-Its holders usually do not have voting rights.

-Types- (cumulative, non-cumulative, callable, convertible etc)

Long term debt instrumentsBonds-Bond is an debt instrument created to raise capital. -It is form of loan or IOU-Holder of the bond is investor (lender/creditor), issuer is borrower, who is obligated to pay a specified amount of money at future specified dates. - Types of Bonds- Treasury bonds, municipal bonds,

corporate bonds, fixed rate, floating rate, zero-coupon, convertible bonds etc

Debentures –a debt security issued by a corporation that is not secured by any collateral, but rather by the general credit of the corporation. 

Bond features:

Maturity: the term of the loan agreement.Par value: the principal amount of the fixed income security that the bond issuer promises to pay the bondholders over the life of the bond.Coupon rate: the rate used to determine the periodic interest to be paid on the principal amount. Interest can be paid annually or semi annually, depending on the terms. Rates may be fixed or variable.

Derivative InstrumentsDerivative is a financial instrument whose value is derived from the underlying asset.Types of Derivatives-

Forward, Futures, Option, Swaps