Understanding Financial Instruments and Derivatives: Types, Asset Classes, and Contracts, Assignments of Contemporary History

Download Understanding Financial Instruments and Derivatives: Types, Asset Classes, and Contracts and more Assignments Contemporary History in PDF only on Docsity! KA MPALA INTERNATIONAL UNIVERSITY COLLEGE OF ECONOMICS AND MANAGEMENT NAME : NASINGULA DONAM REG NO : 2020-01-01153 COURSE : BBA-FA COURSE UNIT : CONTEMPORAY ISSUES YEAR : THREE SEMESTER : TWO SESSION : WEEKEND LECTURER : MADAM IRAU FLORENCE QUESTION Derivatives under financial instruments and examples Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form of currency (forex); debt (bonds, loans); equity (shares); or derivatives (options, futures, forwards). International Accounting Standards IAS 32 and 39 define a financial instrument as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". Financial instruments may be categorized by "asset class" depending on whether they are equity- based (reflecting ownership of the issuing entity) or debt-based (reflecting a loan the investor has made to the issuing entity). If the instrument is debt it can be further categorized into short-term (less than one year) or long-term. Foreign exchange instruments and transactions are neither debt- nor equity-based and belong in their own category. Financial instruments are contracts for monetary assets that can be purchased, traded, created, modified, or settled for. Basic examples of financial instruments are cheques, bonds. stocks. Two of the most common asset classes for investments are, securities. Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world's investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one's ownership of an entity. Types of Financial Instruments Financial instruments may be divided into two types: cash instruments and derivative instruments. Cash Instruments  The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Lastly, future contracts are highly standardized contracts; they are traded in the secondary markets. In the secondary market, participants in the futures can easily buy or sell their contract to another party who is willing to buy it. In the contrast, forwards are unregulated, so there is essentially no secondary market for them. CHARACTERISTIC S FUTURES CONTRACT FORWARDS CONTRACT Meaning A futures contract is a standardized contract, traded on exchange, to buy or sell underlying instrument at certain date in future, at specified price. A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future. Structure Standardized contract Customized contract Counterparty Risk Low High Contract size Standardized/Fixed Customized/depends on the contract term Regulation Stock exchange Self regulated Collateral Initial margin required Not required Settlement On daily basis On maturity date Options Contracts Option is the most important part of derivatives contract. An Option contract gives the right but not an obligation to buy/sell the underlying assets. The buyer of the options pays the premium to buy the right from the seller, who receives the premium with an obligation to sell the underlying assets if the buyer exercises his right. Options can be traded in both OTC market and exchange traded markets. Options can be divided into two types - call and put. We shall explain these types in detail in our next article on Options. Swaps A swap is a derivative contract made between two parties to exchange cash flows in the future. Interest rate swaps and currency swaps are the most popular swap contracts, which are traded over the counters between financial institutions. These contracts are not traded on exchanges. Retail investors generally do not trade in swaps. Interest Rate Swaps Interest rate swaps are another hedging instrument. Such agreements stipulate exchanging, or swapping, one type of interest rate payment for another. A corporation may have an obligation to pay floating interest rates to a bank, for example. The company may have borrowed $100,000 and has to make annual interest payments for the next five years, which are determined by the average rates banks are charging on newly initiated loans for that year. To eliminate the risk of having to pay a higher sum as a result of interest rates climbing, the company may sign a swap agreement. The agreement would allow the company to pay another corporation a fixed annual sum and receive in return the floating rate on $100,000, which would exactly equal its obligation to the bank and thus eliminate risk. References Derivatives (Report). Office of the Comptroller of the Currency, U.S. Department of Treasury. Retrieved February 15, 2013. A derivative is a financial contract whose value is derived from the performance of some underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, or equity prices. Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof.  "Derivative Definition", Investopedia Koehler, Christian (May 31, 2011). "The Relationship between the Complexity of Financial Derivatives and Systemic Risk". pp. 10–11. SSRN 2511541. Crawford, George; Sen, Bidyut (1996). Derivatives for Decision Makers: Strategic Management Issues. John Wiley & Sons. ISBN 9780471129943. Retrieved June 15, 2016.