Lecture 2 - financial instruments

Question 1

What is a financial instrument?

Answer 1

Any contract that gives rise to a financial asset of one enterprise and a financial liability to another

Question 2

What is a financial asset?

Answer 2

Any asset that is:
- Cash or contractual right to receive cash or a financial asset
- A contractual right to exchange financial instruments with another enterprise under conditions that are favourable
- An equity instrument of another enterprise

Question 3

What is a Financial liability?

Answer 3

A liability that is a contractual obligation:
- to deliver financial instrument to another enterprise
- exchange instruments with another enterprise under unfavourable conditions

Question 4

What is an equity instrument?

Answer 4

A contract that evidences a residual interest in the assets of an entity after deducting all its liabilities

Question 5

What is a derivative?

Answer 5

A financial instrument that’s value changes in response to an underlying item

Question 6

When are derivatives settled?

Answer 6

At a future date

Question 7

What are some examples of derivatives?

Answer 7

• Financial options
• futures
• forwards
• interest rate swaps
• currency swaps

Question 8

How can reflecting financial instruments in financial statements be problematic?

Answer 8

• sometimes hard to identify financial instruments
• How do you measure financial assets and liabilities?
• Historic cost vs fair value

Question 9

What creates a liability rather than equity?

Answer 9

An obligation

Question 10

Is 2m 50p, 3% bonds payable in 2018 a financial liability or equity?

Answer 10

Liability as there are contractual obligations

Question 11

Is 12m ordinary shares of 50p a financial liability or equity?

Answer 11

Equity, as although expect to receive shares, there is no obligation until dividends are declared

Question 12

What is a convertable bond?

Answer 12

Gives the owner the right for cash or shares

Question 13

Why would a company rather issue shares rather than cash?

Answer 13

As they can class it as equity rather than a liability

Question 14

How would we measure the liability from a convertible bond?

Answer 14

By deriving the fair value of a similar liability without the conversion option

Question 15

How would we measure the equity of a convertible bond?

Answer 15

residual equity FV = total fair value - liability fair value

Question 16

Definition of a liability?

Answer 16

present obligation, past event, outflow of economic benefits