The global financial market is a complex entity that is largely subject to its own laws and principles of development. However, some of its fundamental features have long been studied and reduced to a common denominator. Financial instruments are no exception. This is a real document or a formally registered electronic form that may secure some kind of legal agreement.
In economics, a slightly different term is adopted. So, according to him, financial instruments are such an agreement that ensures the creation of a financial asset from one of its parties, as well as a financial liability (equity instrument) from another participant. They can be both legal entities and individuals.
What is what?
Their concept is quite diverse. It is generally accepted that financial instruments include:
- Financial asset. This is what money is called, the right to demand it in some situation, as well as the provision of an equity instrument or some other financial instrument.
- Financial liability. Accordingly, this is the name of the contract in which one party may require the financial assets of the other participant.
- Equity instrument. It is also a contract that gives the right to receive part of the organization’s assets.
Basic concepts
According to IAS 32, assets include all the company’s cash assets, customer debt, investments and securities. Obligations include accounts payable from suppliers, as well as all other types of such debt. The company is obliged to recognize its assets and liabilities only when it is one of the parties to the contract (financial instrument).
All of these key financial instruments are measured at fair value only. As a rule, it recognizes the value of the paid asset or the existing liability of the company.
About fair value
How to determine the size of this value as objectively as possible? For this, the value of such a transaction is used, which other parties who are well aware of market obligations and the value of the company wish to make. It is best and easiest to use the price of financial assets in free markets.
What if there is no such opportunity? In this case, you have to use any of the generally accepted assessment methods. Their general essence is the same: two parties are taken who are interested in a similar transaction, after which its possible value is calculated.
It also provides for the use of market information from independent parties that have recently made similar transactions or were interested in them, an objective analysis of discounted cash flows is carried out. It is important to use a suitable option pricing model, as otherwise the derivatives market will not be able to generate a truly objective asset value.
Classification of financial assets
To simplify all subsequent evaluations (if necessary), all identified assets are classified according to the following scheme:
- Assets to be measured based on fair value.
- All investments that must be withheld until full repayment.
- Accounts receivable and all outstanding loans to an entity.
- All available financial assets that are currently available for sale.
Consider all these positions in more detail.
Loans and receivables
Both the loan and receivables involve the transfer of goods or net cash to the debtor, provided that the latter does not intend to resell the debt to third parties. Their valuation is based on amortized cost.
This is understood as the price of a financial instrument from which the amount of debt was deducted or bad debts were written off (full or partial). Most often, it is calculated using the effective interest rate, as this allows you to more adequately determine the value of an asset, even if the latter is partially depreciated.
This makes financial instruments more efficient, and their acquisition is more profitable for enterprise investors.
Assets held for sale
All assets that can be measured at fair value and held for trading can be divided as follows:
- Acquired for the purpose of resale in the short term.
- If they are part of some kind of financial portfolio, which is again intended for sale in the short term.
- If the asset is a production tool.
Obligations and rules for their use
No organization has the right to introduce financial instruments into the category measured at fair value or to withdraw them from it. Moreover, this applies to the entire period of ownership of the tool or at the time of its release.
If we talk about investments that are held until their maturity, then they are classified as assets with fixed sizes of payments, as well as their maturity. This applies only to those investments that the organization is not only firmly committed to, but also able to hold. By the way, debt securities that have a variable interest value may also fall into this category.
Retention intent
It is assessed both upon acquisition of the asset, and at each reporting date. Moreover, the intention to hold assets is evaluated according to much more stringent criteria, if we compare it with the intention to sell them at the moment. The fact is that all organizations that act differently raise doubts about the advisability of long-term cooperation with them, and therefore can automatically be considered unreliable customers.
All this can lead to the formation of a special penalty portfolio, all investments from which the company is obliged to keep up to their full repayment. The definition of “held to maturity” is strictly prohibited for all other assets, and the restriction may apply immediately to three years after the purchase. If the company already has these types of financial market instruments, they should be transferred to the category of instruments sold at fair value with the right of subsequent sale.
The gain or loss resulting from such actions should be recognized immediately in the assets. Only after (!) The expiration of the ban the organization is entitled to independently assign to the investment or other means the concept of “held to maturity”. Simply put, an independent assessment of financial instruments in this case is not performed. In case of violation, penalties may be imposed on the company.
They can be expressed in a complete ban on investing in production, as well as in other measures that, if used, will seriously undermine the economic situation of the company.
What financial instruments can be recognized as being acquired for sale at fair value?
In this case, financial instruments of the financial market include all the following concepts and definitions:
- All derivative liabilities that under no circumstances can be used as hedging instruments.
- If they were taken to supply securities or other assets in the event that the latter were received subject to “short” positions.
- If they were taken with the intention to redeem in the very near future.
- All obligations that can only be used in association with each other. In addition, proof of the fact that the organization has already used them in the past is required, and as a result of such actions, it made a profit.
All liabilities that are recognized as held for trading at fair value should be immediately apparent upon further calculation of all profits and losses of the company for a specific period. All other financial instruments of the financial market can be measured at amortized cost, except for one point. We are talking about those liabilities that arose during the period when a financial asset cannot be recognized as “being sold at fair value” and must be used in the future.
In this case, such an obligation must be assessed taking into account the following conditions:
- If it is a combination of rights and obligations that the organization has retained from the previous owner, previously measured at amortized cost.
- If earlier it was measured at fair value, but it was transferred to the organization on some separate terms.
- If the obligation is an agreement with a bank on a loan at interest that is lower than market.
In this case, it should be evaluated at the highest value of the following indicators:
- The amount that has been determined in strict accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
- The initially recognized fair value, even taking into account the previously deducted amortization cost.
Concept classification
Today, economists say that all financial instruments can be divided into exactly two large categories. In the first case, these documents should be based on real capital, providing ownership of some assets (shares, for example), or represent debt obligations of one company to another. In this case, bonds are issued. However, most often all of them are considered in a single context, since financial markets and financial instruments cannot be practically separated in this regard.
Each such instrument is best viewed in the context of a “unit” of money capital. Moreover, each element has its own unique features, structure and conditions of use. It is their wide variety that ensures the rapid movement of capital in the global financial market and its further development. In recent years, the market for financial instruments has been developing more actively, the more promising sales areas open to manufacturers in Southeast Asia.
And now let's look at one of the types of securities that include the concept of “financial instruments”. This is a stock. There are simple and privileged varieties of them.
Common stocks
They not only give a vote in the company, but also allow the holder to receive part of the profits from the entire organization. Of course, this variety is not only the most common in the entire financial market, but also the most interesting for investors. Such securities are a stable and universal instrument, and therefore the formation of their value occurs under the influence of ordinary market factors. All stock markets allow you to not only buy them directly, but also make a profit using the services of brokers or brokerage companies.
Some of the benefits are provided exclusively by these financial instruments of financial policy. For example, the right to vote, to which many relate with some disdain, allows lobbying for the promotion of their candidates to the Board of Directors of the company, and this is an extremely important tool not only in economics, but also in politics.
Among other things, the amount of dividends on classic shares directly depends on the profitability of the company. Having successfully invested, you will not only get certain leverage, but also a solid profit. Of course, one should not forget about the growth of their value directly. This happens when the economic condition of the enterprise improves dramatically. However, the value of ordinary shares can also drop sharply, which will lead to losses for investors.
