LESSON 8
FINANCIAL INSTRUMENTS
Finance and Financial Markets| 1st Semester
PRIMARY INSTRUMENTS
NATURE OF FINANCIAL INSTRUMENTS
Primary financial instruments
A financial instrument is any contract represent direct claims or obligations.
that gives rise to a financial asset of They are used for raising funds or
one entity and financial liability or investing in assets. These instruments
equity instrument of another entity. are not derived from other
instruments; they are basic,
A financial instrument is a contract straightforward securities.
between parties that can be traded
and has a monetary value. These Examples of Primary Instruments:
instruments can represent ownership Representing Financial Assets:
of an asset, a right to income, or a
claim on future payments. Equity (Stocks): Represents ownership
in a company. Investors who buy
The contract in the definition refers to shares in a company become part-
an agreement between two or more owners and may receive dividends.
parties that has clear economic ● Example: Apple Inc. common
consequences that the parties have stock (AAPL), traded on the
little, if any, discretion to avoid, usually NASDAQ.
because the agreement is enforceable
by law. Contracts, and thus financial Cash Instruments
instruments, may take a variety of - These include money or
forms and need not be in writing. instruments like certificates of
deposit (CDs) or bank deposits,
Financial Instruments include: which can be immediately
● Primary instruments turned into cash.
● Derivative financial Instruments
Cash on hand and in Banks
Primary instruments and derivative ● Petty Cash
financial instruments are key ● Demand, savings and time
components of financial markets. They deposits Undeposited checks
differ in their structure and purpose but
are interconnected in many ways
LESSON 8
FINANCIAL INSTRUMENTS
Finance and Financial Markets| 1st Semester
● Foreign currencies Bonds pay periodic interest and
● Money orders (drawn generally return the principal at maturity.
from authorized post offices or
other financial institutions) ● Example: U.S. Treasury bonds (T-
● Bank draft - are commitments Bonds) or Corporate bonds
by banking institutions to issued by companies like
advance funds on demand by General Motors.
the party to whom the draft was
directed. Loans
- A direct lending agreement
Receivable between a borrower and a
- Accounts, notes, and loans lender. This can include
receivables personal, commercial, or
mortgage loans.
1. Trade receivables (signed
delivery receipts and sales ● Example: A home mortgage
invoice) provided by a bank to an
2. Promissory notes individual.
3. Bond certificates
Equity Instruments
Interest - An equity instrument is any
- in shares of other equity contract that evidence a
instruments issued by other residual interest in the assets of
entities. an entity after deducting all of
its liabilities.
1. Stock Certificates
2. Publicly listed securities Examples of Equity Instruments are:
● Ordinary Shares
Representing Financial Liabilities ● Preferred Shares
● Warrants
Debt (Bonds) - or written call option that
- Represents a loan made by an allows the holder to
investor to a borrower (usually subscribe or purchase
corporate or governmental). ordinary shares in
LESSON 8
FINANCIAL INSTRUMENTS
Finance and Financial Markets| 1st Semester
exchange for a fixed contracts are actively
amount of each or treated on regulated
another financial asset. future exchanges and are
generally referred to as
“commodity future
DERIVATIVE FINANCIAL INSTRUMENT
contracts.” Future
Derivatives are financial instruments
contracts are purchased
that “derive” their value on
either as an investment or
contractually required cash flows from
as a hedge against the
some other security or index. For
risks of future price
instance, a contract allowing a
changes.
company to purchase a particular
asset (say gold, flour, or coffee bean)
2. Forward Contracts
at a designated future date, at a
- A forward contract is similar to a
predetermined price is a financial
future contract but differs in
instrument that derives its value from
three ways: A forward contract
expected and actual changes in the
calls for delivery on a specific
price of the underlying asset.
date, whereas a future contract
permits the seller to decide later
A financial contract reflecting value
which specific day within the
changes based on an underlying
specified month will be the
asset, group, or benchwork, involving
delivery date (if it gets as far as
two or more parties.
actual delivery before it is
closed out). 1. Unlike a futures
Examples of Derivatives
contract, a forward contract
1. Future Contracts
usually is not traded on a
- A future contract is a
market exchange. 2. Unlike a
standardized contract to
futures contract, a forward
buy or sell an asset at a
contract does not call for a daily
predetermined price on a
cash settlement for price
specified future date.
exchange in the underlying
Futures obligate both
contract. Gains and losses on
parties to complete the
forward contracts are paid only
transaction. These
when they are closed out.
LESSON 8
FINANCIAL INSTRUMENTS
Finance and Financial Markets| 1st Semester
- Companies that conduct
3. Call Options international business use
- Options give its holder the right, currency futures to
but not obligation, either to buy protect against
or sell an instrument, say a unfavorable fluctuations
Treasury Bill, at a specific price in exchange rates. For
and within a given time period. example, a U.S. exporter
Options frequently are expecting payment in
purchased to hedge exposure to euros (EUR) can lock in
the effects of changing interest the current EUR/USD
rates. Example: A call option on exchange rate to avoid
Tesla stock (TSLA), giving the losses if the euro
holder the right to buy Tesla depreciates.
shares at $250 before a certain
date. ● Speculation
- Traders and investors
4. Foreign Currency Futures speculate on future
- Foreign currency futures are movements in currency
standardized contracts traded exchange rates to profit
on an exchange to buy or sell a from price fluctuations.
specific amount of a foreign
currency at a predetermined 5. Interest Rate Swaps
price on a set future date. These - There are contracts to exchange
contracts are primarily used for cash flows as of a specified date
hedging against foreign or a series of specified dates
exchange (forex) risk or based on a notional amount
speculating on currency price and fixed and floating rates.
movements
Purpose of Foreign Currency Futures:
● Hedging
