Financial Instruments

Question 1

What is the definition of a financial instrument?

Answer 1

AASB 132 Financial Instruments: Presentation defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Such a definition, in turn, generates a need to define a financial asset, a financial liability and an equity instrument.

Question 2

What is the definition of a financial asset?

Answer 2

AASB 132 paragraph 11 provides the definition of a financial asset:
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.

Question 3

What is an example of a cash financial asset?

Answer 3

Cash on hand or
Deposit of cash with a bank or similar financial institution

Question 4

What is an example of an equity instrument of another entity asset?

Answer 4

Shares held in another entity

Question 5

What is an example of a contractual right asset to receive cash or another financial asset from another entity?

Answer 5

Trade receivables
Loans or advances to other entities
Bills of exchange held
Promissory notes held
Secured, unsecured or convertible notes held
Debentures held
Bonds held
Right to cash from a guarantor

Question 6

What is an example of a contractual right asset that exchanges financial assets or financial liabilities with another entity under conditions that ar potentially favorable to the entity?

Answer 6

Purchased call or put options for shares in another entity
Interest rate or currency rate swap agreements
Forward exchange contracts
Forward rate agreements
Futures contracts

Question 7

What is an example of a non-derivative contract that will or may be settled in the entity’s own equity instruments?

Answer 7

A contract to receive at a future date as many of the entities own equity instruments as are equal in value to $100 million.

Question 8

What is an example of a derivative contract that will or may be settled in the entity’s own equity instruments?

Answer 8

A contract to receive at a future date a variable number of the entity’s own equity instruments that are equal in value to 100 ounces of gold at that date.

Question 9

What is the definition of a financial liability?

Answer 9

Financial liabilities are defined from the perspective of the issuing entity. Paragraph 11 of AASB 132 states:
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s own
equity instruments. For this purpose, rights, options or warrants to acquire a
fixed number of the entity’s own equity instruments for a fixed amount of any
currency are equity instruments if the entity offers the rights, options or warrants
pro rata to all of its existing owners of the same class of its own non-derivative
equity instruments. Also, for these purposes the entity’s own equity instruments
do not include puttable financial instruments that are classified as equity
instruments in accordance with paragraphs 16A and 16B, instruments that
impose on the entity an obligation to deliver to another party a pro rata share of
the net assets of the entity only on liquidation and are classified as equity
instruments in accordance with paragraphs 16C and 16D, or instruments that are
contracts for the future receipt or delivery of the entity’s own equity instruments.

Question 10

What is an equity instrument?

Answer 10

Paragraph 11 of AASB 132 states:
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Question 11

What is an example of a contractual obligation to deliver cash or another financial asset to another entity?

Answer 11

Bank overdraft
Trade Payables
Loans or advances from other entities
Bills of exchange issued
Promissory notes issued
Secured, unsecured or convertible notes issued
Debentures issued
Redeemable preference shares issued
Obligation to pay cash as a guarantor

Question 12

What is an example of a contractual obligation to exchange financial assets or financial liabilities with another entity that are potentially unfavorable to the entity?

Answer 12

Sold call or put options in another entity
Interest rate or currency rate swap agreements
Forward exchange contracts
Forward rate agreements
Exchange traded futures contracts

Question 13

What is the most common equity instrument?

Answer 13

the non-puttable ordinary share

Question 14

What is a non-puttable ordinary share?

Answer 14

The term non-puttable refers to shares that do not have an embedded put option (a put option gives the holder the right but not the obligation to sell the shares back to the issuer at a particular price)

Question 15

Is a derivative instrument an asset or a liability?

Answer 15

A derivative instrument can sometimes be a financial asset or a financial liability, depending on the circumstances at the time; e.g., if shares prices are rising or falling.

Question 16

What is a derivative instrument?

Answer 16

Derivatives are defined in appendix A of AASB 9 as a contract with three characteristics:
1. its value changes in response to the change in [the ‘underlying’, e.g an interest rate]…..
2. it requires no initial net investment or….
3. it is settled at a future date.

Question 17

What is a residual claimholder?

Answer 17

it is when an investors claim is to the net assets of the entity (ie, the assets that would remain after all liabilities are settled)

Question 18

When is an ordinary share an equity instrument?

Answer 18

Ordinary shares, as singular instruments (i.e. without any embedded derivatives, such as a put option), are always classified as equity instruments.

Question 19

Why invest in equity instruments?

Answer 19

The positive side of being the residual claimholders is that upside risk is potentially unbounded. As equity grows the value of the residual claim increases. As a shareholder, you have two potential returns for taking on the investment risk; future dividends (if paid) and increases in the value of the instrument (share price).

Question 20

What is risk in finance?

Answer 20

Risk is a measure of the estimated variation, from very large profits (not that probable) to very large losses (also not that probable). (not just downside)

Question 21

What is a debt instrument?

Answer 21

A simple financial liability, like a bank loan, gives rise to a fixed claim, consisting of the loan amount the borrower must repay together with interest (fixed or variable).

Question 22

What is the maximum value of a debt instrument?

Answer 22

The maximum value of a debt instrument is the present value of its future cash flows.
As such, the debt holder is keenly interested in the timing of the cash flows (interest and the return of the principal) and credit risk (the risk of non-payment).

Question 23

What is a primary financial instrument?

Answer 23

Primary financial instruments generate rights and obligations between the parties directly involved in the underlying transaction. For example, acquiring shares in a company gives the investor a financial asset in the company and the shares are considered an equity instrument of the company.

Question 24

What is a derivative financial instrument?

Answer 24

Derivative financial instruments have been defined as instruments which ‘create rights and obligations that have the effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument, and the value of the contract normally reflects changes in the value of the underlying financial instrument’

Question 25

Give three examples of a primary financial instrument.

Answer 25

1. Receivables
2. Payables
3. Equity securities such as shares.

Question 26

Give three examples of derivative financial instruments.

Answer 26

1. Financial Options
2. Futures
3. Forward contracts