Financial
Instruments
Chapter 4
Learning Outcomes:
• Describe what a financial instrument is
• Describe and give examples of primary and derivative financial
instruments
• Explain what financial assets is; what a financial liability is
• Give and describe examples of financial assets and financial
liabilities
• Describe equity financial instruments
• Give and describe examples of derivative financial instruments
Nature of Financial
Instruments
▪ A financial instrument is any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity.
o Contract – refers to 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.
▪ Financial instruments include:
▪ (a) Primary instruments (financial assets, financial liabilities, equity
instrument); and
▪ (b) derivative financial instruments (financial options, futures and
forwards, interest rate swaps and currency swaps)
Common Financial Instruments
FINANCIAL ASSETS
A Financial Asset is any asset that is:
• Cash
• Equity instrument of another entity (e.g., investment in ordinary
share of a corporation)
• Receivable (accounts, notes and loans receivable)
Common Financial Instruments
FINANCIAL ASSETS
A. Cash on Hand and in Banks
1) Petty cash – refers to cash balances kept on hand at various locations
to pay for minor expenditures such as postage and other small out-
of-pocket expenditures.
2) Demand, savings and time deposits – represents amounts on
deposit in checking, savings and time deposit accounts respectively.
Time deposits are placement covering a relatively long period of
time.
3) Undeposited checks – are checks payable to the enterprise or bearer
but not yet presented to the bank for payment
Common Financial Instruments
FINANCIAL ASSETS
A. Cash on Hand and in Banks
4) Foreign currencies
5) Money orders – financial instruments similar to bank drafts but are
drawn generally from authorized post offices or other financial
institutions.
6) Bank drafts – are commitments by banking institutions to advance
funds on demand by the party to whom the draft was directed.
Common Financial Instruments
FINANCIAL ASSETS
B. Accounts, notes, and loans receivable and investment in bonds and
other debt instrument issued by another entities:
1) Trade receivables (signed delivery receipts and sales invoice)
2) Promissory notes
3) Bond certificates
C. Interest in shares or other equity instruments issued by other entities
1) Sales certificates
2) Publicly listed securities
Common Financial Instruments
FINANCIAL ASSETS
D. Derivative Financial Assets
1) Future contracts
2) Forward Contracts
3) Call Options
4) Foreign Currency Futures
5) Interest Rate Swaps
Common Financial Instruments
FINANCIAL LIABILITIES
A financial liability is any liability that is:
1) A contractual obligation
a. To deliver cash or another financial asset to another entity; or
b. To exchange financial assets to financial liabilities with
another entity; under conditions that are potentially
unfavorable to the entity; or
Common Financial Instruments
FINANCIAL LIABILITIES
A financial liability is any liability that is:
2) A contract that will or may be settled in the entity’s own equity
instruments and is-
a. A non-derivative for which the entity is or may be obligated
to deliver a variable number of the entity’s own equity
instruments; or
b. A derivative that will or may be settled other than the
exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments.
Common Financial Instruments
FINANCIAL LIABILITIES
Examples:
1) Accounts and notes payable, loans from other entities and
bonds and other debt instruments issued by the entity.
2) Derivative financial liabilities
3) Obligations to deliver own shares worth a fixed amount of cash
4) Some derivatives on own equity instruments
Common Financial Instruments
EQUITY INSTRUMENTS
An Equity Instrument is any contract that evidence a residual
interest in the assets of an entity after deducting all of its liabilities.
Examples:
• Ordinary shares
• Preference shares
• Warrants or written call option that allow the holder to subscribe
or purchase ordinary shares in exchange for a fixed amount of
each or another financial asset.
DERIVATIVE FINANCIAL
INSTRUMENTS
DERIVATIVES
– are financial instruments that “derive” their
value on contractually required cash flows
from some other security or index.
DERIVATIVE FINANCIAL
INSTRUMENTS
1. Futures Contracts – is an agreement between a seller
and a buyer that requires that seller to deliver a particular
commodity at a designated future date, at a
predetermined price.
- Futures contracts are purchased either as an investment
or as a hedge against the risks of future price changes.
DERIVATIVE FINANCIAL
INSTRUMENTS
2. Forward Contracts – similar to future contracts but differs in:
a. A forward contract calls for delivery on a specific date,
whereas a future contract permits the seller to decide later
which specific day within the specified month will be the
delivery date.
b. Unlike futures contract, a forward usually is not traded on a
market exchange.
c. Unlike a futures contract, a forward contract does not call for
a daily cash settlement for price changes in the underlying
contract. Gains and losses on forward contracts are paid only
when they are closed out.
DERIVATIVE FINANCIAL
INSTRUMENTS
3. Call options– options give its holder the right either
to buy or sell an instrument at a specified price
and within a given time period.
▪ Options frequently are purchased to hedge
exposure to the effects of changing interest
rates.
▪ The option holder has no obligation to exercise
the option.
DERIVATIVE FINANCIAL
INSTRUMENTS
4. Foreign Currency Futures
▪ Foreign loans frequently are denominated in the
currency of the lender,
▪ When loans must be repaid in foreign currencies, a
new element of risk is introduced. This is because if
exchange rates change, the peso equivalent of the
foreign currency that must be repaid differs from the
peso equivalent of the foreign currency borrowed.
DERIVATIVE FINANCIAL
INSTRUMENTS
5. Interest Rate Swaps
▪ There are contract to exchange cash flows as of a
specified date or a series of specified dates based on
a notional amount and fixed and floating rates.
THANK YOU
References:
Cabrera, E. B., Cabrera, G. B., & Cabrera, B. B. (2022). Financial Markets and Institutions. Manila, Philippines: GIC Enterprises & Co., Inc.