CHAPTER 4

FINANCIAL INSTRUMENTS
NATURE OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.

The contract in the definition refers to an agreement between two or more parties that has clear
economic consequences that the parties have little, if any, discretion to avoid, usually because the
agreement is enforceable by law. Contracts, and thus financial instruments, may take a variety of
forms and need not be in writing.

Financial instruments include primary instruments and derivative financial instruments.

Based on the definition, financial instruments include financial assets, financial liabilities, equity
instruments and derivatives. Derivatives include financial options, futures and forwards, interest
rate swaps and currency swaps.

A Financial Asset is any asset that is

● Cash
● Equity instrument of another entity (e.g., investment in ordinary share of a corporation)
● Receivable accounts, notes and loans receivable)

Some of the most commonly encountered Financial Instruments representing Financial Assets
are the following:
a. Cash on Hand and in Banks
i. Petty cash. Refers to cash balances kept on hand at various locations to pay for
minor expenditures such as postage and other small out-of pocket expenditures.
ii. Demand, savings and time deposits. Represent amounts on deposit in checking,
savings and time deposit accounts respectively. Time deposits are placements
covering a relatively long period of time.
iii. Undeposited checks. Are checks payable to the enterprise but not yet presented
to the bank for payment.
iv. Foreign currencies
v. Money orders are financial instruments similar to bank drafts are drawn
generally from authorized post offices or other financial institutions.
vi. Bank drafts are commitments by banking institutions to advance funds on
demand by the party to whom the draft was directed
 b. Accounts, notes and loans receivable and investment in bonds and debt instrument
issued by other entities:
i. Trade-receivables (signed delivery receipts and sales invoice)
ii. Promissory notes
iii. Bond certificates

c. Interest in shares or other equity instruments issued by other entities

i. Stock certificates
ii. Publicly listed securities

d. Derivative Financial Assets

i. Futures Contracts
ii. Forward Contracts
iii. Call Options
iv. Foreign Currency Futures
v. Interest Rate Swaps
vi. Financial Liabilities

A financial liability is any liability that is

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 unfavorable 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 obligated 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.

Examples of Financial Liabilities are the following:

● Accounts and notes payable, loans from other entities and bonds and other debt
instruments issued by the entity
● Derivative financial liabilities.
● Obligations to deliver own shares worth a fixed amount of cash
● Some derivatives on own equity instruments.
Equity Instruments
An equity instrument is any contract that evidence a residual interest in the assets of an entity
after deducting all of its liabilities
Examples of Equity Instruments are:
● Ordinary Shares
● Preference Shares
● Warrants or written call options that allow the holder to subscribe or purchase ordinary
shares in exchange for a fixed amount of each or another financial asset.

Derivative Financial Instruments

Derivatives are financial instruments that "derive" their value on contractually required cash
flows from some other security or index. For instance, a contract allowing a company to
purchase a particular asset (say gold, flour, or coffee bean) at a designated future date, at a
predetermined price is a financial instrument that derives its value from expected and actual
changes in the price of the underlying asset.

Examples of Derivatives
1. Futures Contracts
A futures contract is an agreement between a seller and a buyer that requires that seller to
deliver a particular commodity (say corn, gold soya beans) at a designated future date, at
a predetermined price. These contracts are actively treated on regulated future exchanges
and are generally referred to as "commodity futures contract." When thhe "commodity"
is a financial instrument such as a Treasury bill or commercial paper, the agreement is
referred to as a financial future contract. Futures contracts are purchased either as an
investment or hedge against the risks of future price changes.
2. Forward Contracts
A forward contract is similar to a futures contract but differs in three ways:
a. A forward contract calls for delivery on a specific date, whereas a futures contract
permits the seller to decide later which specific day within the specified month
will be the delivery date (if it gets as far as actual delivery before it is closed out).
b. Unlike a futures contract, a forward usually is not traded on a market exchange.
c. Unlike a futures contract, a forward contract does not call for a daily cash
settlement for price changes in the underlying contract. Gains and losses on
forward contracts are paid only when they are closed out.
3. Call Options
Options give its holder the right either to buy or sell an instrument, say a Treasury bill, at
a specified price and within a given time period. Options frequently are purchased to
hedge exposure to the effects of changing interest rates. Options serve the same purpose
 as futures in that respect but are fundamentally different. Importantly, though, the
option holder has no obligation to exercise the option. On the other hand, the holder of
a futures contract must buy or sell within a specified period unless the contract is
closed out before delivery comes due.
4. Foreign Currency Futures
Foreign loans frequently are denominated in the currency of the lender (Japanese yen,
Swiss franc, German mark, and so on). When loans must be repaid in foreign currencies,
a new element of risk is introduced. This is because if exchange rates change, the peso
equivalent of the foreign currency that must be repaid differs from the peso equivalent of
the foreign currency borrowed.
5. Interest Rate Swaps
There are contracts to exchange cash flows as of a specified date or a series of specified
dates based on a notional amount and fixed and floating rates.

Samples/Specimens of Financial Instruments

LOCAL CURRENCY: PHILIPPINE PESOS
FOREIGN CURRENCY: US DOLLARS

FOREIGN CURRENCY: EUROS

FOREIGN CURRENCY: JAPANESE YEN

FOREIGN CURRENCY: QATAR RIYALS

FOREIGN CURRENCY: THAI BAHT

TIME DEPOSIT CERTIFICATE

CORPORATE CHECK

PERSONAL CHECK

SAVINGS ACCOUNT PASSBOOK evidencing savings deposit with a Commercial bank

BANK STATEMENT evidencing existent of demand/current deposit with a Commercial
bank

EQUITY INSTRUMENTS
STOCK CERTIFICATE evidencing investment in Common Stock or Ordinary Equity
Share

STOCK CERTIFICATE evidencing investment in Preferred Stock

DEBT INSTRUMENTS
Certificate evidencing investment in Treasury bonds

Certificate evidencing investment in Bonds

PROMISSORY NOTE evidencing Receivable of City Finance Company (Lender) from
Jane Monroe (Borrower)

INSURANCE CERTIFICATE representing investment in an insurance policy

FORWARD CONTRACT

INDEX DERIVATIVE CONTRACT SPECIFICATION