5. Financial Instruments
Definition of a Financial Instrument
Any contract causing a financial asset
for one entity
and a financial liability or equity instrument
for another entity
Two types of financial instruments:
1. Primary instruments (cash, receivables, investments)
2. Secondary (derivative) instruments (financial options)
two-sided contract definition:
all financial instruments will give rise to a financial asset of one party, with a financial liability / equity instrument of another party
Example of a two sided contract
sales contract gives rise to a receivable in the sellers books and a payable in the purchasers books.
Derivative definition
Derivatives transfer financial risks of the underlying primary financial instrument.
Describe the one party of a derivative
One party acquires a right to exchange a financial asset or liability with another party under potentially favorable conditions.
Describe the other party of a derivative
The other party takes on the right to exchange under potentially unfavorable conditions.
Derivate meaning
An instrument whose value is derived from underlying item such as share price, interest rate etc.
The three main characteristics of a derivative are:
1. Value changes in response to the change in a specified variable (interest rate, foreign currency, etc)
2. Requires no / minimal net investment
3. Settled at some time in the future
Why is f.e. a legal obligation not a Financial Instrument?
Because there is no contract
Economic consequences of debt-equity classification (2)
Debt classification gives higher gearing
Debt classification gives lower income
Economic consequences of debt-equity classification (2)
Effect on debt covenant ratios.
Effect on regulatory capital.
Economic consequences of debt-equity classification (2)
Effect on dividend distribution possibilities.
Tax consequences.
Debt / equity definition
IFRS: if an entity cannot avoid to pay dividend or to redeem: debt, otherwise equity. Irrespective of legal form.
Defintion of compound financial instruments
Compound financial instruments are instruments that contain both the characteristics of equity and liability, e.g., convertible bond. Has to be split into equity and liability component.
How do you calculate a compound financial instrument?
Calculate liability component, remainder is equity