Complex Financial Instruments

Complex Financial Instruments - Complex financial...

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Commerce 450 Sections 101 & 102 Fall 2011 1 Complex financial instruments References: Lo and Fisher, Chapter 14
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Commerce 450 Sections 101 & 102 Fall 2011 2 Financial liabilities and equity instruments o a financial liability is any liability that is a contractual obligation to either: n deliver cash or another financial asset to another party; or n exchange financial instruments with another party under conditions that are potentially unfavourable o an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities o instruments that have more than one component are sometimes referred to as hybrid or compound financial instruments o these definitions will determine how to present the instruments.
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Derivative financial instruments o a financial instrument that is derived from some other underlying quantity (the underlying); o examples include: n options n warrants n forwards n futures n swaps Commerce 450 Sections 101 & 102 Fall 2011 3
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Commerce 450 Sections 101 & 102 Fall 2011 4 Debt, equity or both? o perpetual debt (debt that will never be repaid) has no entitlement to residual assets and has its value determined solely by the npv of future interest payments and is, therefore, debt o term or mandatorily redeemable preferred shares meet the definition of a liability as there is an obligation to pay cash
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Commerce 450 Sections 101 & 102 Fall 2011 5 Debt, equity or both? o retractable preferred shares create an obligation to deliver cash and are classed as a liability o debt with detachable stock warrants is classified as a hybrid or combined instrument; the proceeds of the issue must be split between the liability and equity components
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Commerce 450 Sections 101 & 102 Fall 2011 6 Valuing hybrid instruments o proportional method (relative fair value or option pricing method) values all components at fair value and apportions the proceeds in the ratio of the values; o incremental method (residual method) values the component(s) which easier to value (most often the liability component) with the rest of the value assigned to the other component(s)
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Commerce 450 Sections 101 & 102 Fall 2011 7 Valuing hybrid instruments o predominant component method (zero common equity method) in which all value is assigned to the dominant component which will almost always be the liability component); o IFRS recommends the incremental method; ASPE permits both the incremental method and the predominant component method.
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Commerce 450 Sections 101 & 102 Fall 2011 8 Accounting for convertible debt o at issue, the proceeds must be allocated between the liability and equity components; the portion attributable to the conversion is credited to “contributed surplus – conversion rights” and the premium or discount on the bonds is amortized over the period to maturity
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Complex Financial Instruments - Complex financial...

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