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Learning Objective

The students are expected to develop an understanding of financial instruments, time value of money using the concepts of future value and present value and to apply these concepts in financial decision making.

Learning Outcomes

After going through this activity, the students would be able to understand how value of money changes over time, the application of future value and present value concepts.

Assignment Question No. 1: (5 marks)

Financial instrument is a written legal obligation of one party to transfer something of value (usually money) to another party under specified conditions at some future date. These are used to transfer resources and risk. There are many financial instruments having different characteristics and value. What features influence the value of a financial instrument? Explain each feature briefly.

Question No. 2 (5 Marks)

Your firm has a retirement plan i.e. if you contribute Rs. 2,000 per year, the company will add Rs. 1,000 to make it Rs. 3,000. The firm guarantees an 8% return on the funds. Alternatively, you can “do it yourself” and think that you can earn 11% on your money by doing it in this way. The contribution will be made at the end of each year for the next 25 years. If you want to retire in 25 years, which way will you better off?

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two ideas are emphasized: that financial instruments transfer resources from savers to investors, and that in doing so, they transfer risk to those best equipped to bear it

Which of the following are used to transfer resources from savers to investors and to transfer risk to those who best equipped it?
► Financial markets
► Financial instruments
► Financial institutions
► Banks

What is a 'Financial Instrument'
Financial instruments are assets that can be traded. They can also be seen as packages of capital that may be traded. Most types of financial instruments provide an 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.

The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.

The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates or indices. These can be over-the-counter (OTC) derivatives or exchange-traded derivatives.

Asset Classes
Financial instruments may also be divided according to asset class, which depends on whether they are debt-based or equity-based.

Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs). Exchange-traded derivatives under short-term debt-based financial instruments can be short-term interest rate futures. OTC derivatives are forward rate agreements.

Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives.

Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives.

There are no securities under foreign exchange. Cash equivalents come in spot foreign exchange. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options, outright forwards and foreign exchange swaps.

The fair value of a financial asset or liability on a given date is the amount for which it could be exchanged or settled, respectively, on that date between two knowledgeable, willing parties in an arm’s length transaction under market conditions. The most objective and common reference for the fair value of a financial asset or liability is the price that would be paid for it on an organized, transparent and deep market (“quoted price” or “market price”).

If there is no market price for a given financial asset or liability, its fair value is estimated on the basis of the price established in recent transactions involving similar instruments or, in the absence thereof, by using mathematical measurement models that are sufficiently tried and trusted by the international financial community. The estimates used in such models take into consideration the specific features of the asset or liability to be measured and, in particular, the various types of risk associated with the asset or liability. However, the limitations inherent in the measurement models and possible inaccuracies in the assumptions and parameters required by these models may mean that the estimated fair value of an asset or liability does not exactly match the price for which the asset or liability could be exchanged or settled on the date of its measurement.

The fair value of the financial derivatives included in the held-for-trading portfolios is based on daily quoted price if there is an active market for these financial derivatives. If for any reason their quoted price is not available on a given date, these financial derivatives are measured using methods similar to those used in over-the-counter (OTC) markets.

The fair value of OTC derivatives (“present value” or “theoretical price”) is equal to the sum of future cash flows arising from the instrument, discounted at the measurement date; these derivatives are valued using methods recognized by international financial markets: the “net present value” (NPV) method, option price calculation models, etc.

Determining the fair value of financial instruments


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