Tutorial 5 – Financial Instruments
CHAPTER 16 - QUESTIONS
Financial instruments may be classified as
, such as accounts
receivable, accounts payable, loans receivable, loans payable and equity
securities, or as
(secondary) financial instruments, such as forward
contracts, futures contracts, options, and interest rate and currency swaps.
Derivative financial instruments have been defined as those that ‘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’. For example, an entity with accounts
payable in a foreign currency may take out a forward currency exchange
contract to reduce the risk from fluctuations in currency exchange rates.
Derivative financial instruments do not result in a transfer of the underlying
primary financial instruments when the contract is entered into, nor do they
necessarily result in a transfer of the underlying primary financial
instruments when the derivative financial instruments mature.
financial instruments comprise a single financial asset, financial
liability or equity instrument, such as a loan receivable, loan payable or
ordinary share, whereas
financial instruments comprise a
combination of characteristics of financial assets, financial liabilities and
equity instruments. For example, a debt security convertible into ordinary
shares comprises two components. They are an arrangement to deliver cash
or other financial assets and an option granting the holder the right, for a
specified period, to convert the debt security into the ordinary shares of the
The basic idea of a swap is that two borrowers agree to repay each other's loan –
that is, they swap loan commitments. The two principal forms of swap are the
interest rate swap
(discussed in Question 8).
With an interest rate swap, a loan that is charged interest on a floating rate basis
is swapped for a loan that is charged interest on a fixed-rate basis. It mimics the
effect of exchanging a floating rate loan for a fixed-rate loan.
In providing an example, it is likely that students will use an example similar to
(or the same as) Example 16.4.
For some borrowers, interest rate swaps provide access to long-term borrowing at
a lower rate of interest than if they borrowed the funds themselves. Thus, for
these borrowers, long-term funds at a fixed rate of interest are not available, or
are not available at a rate of interest that management is prepared to pay.