Financial instruments

Learning objectives

After studying this chapter the learner should / should be able to:

• Define financial instruments.

• Distinguish primary and indirect securities.

• Discuss the broad categories of financial instruments.

• Differentiate marketable and non-marketable instruments.

• Categorize all forms of securities.

• Describe all types of securities.




Financial instruments are comprised of evidences (= claims on the issuers) of:

• Debt (= claims on ultimate borrowers).

• Deposits (= claims on banks).

• Shares / equity (= claims on companies).

• Participation interests (PIs) (= claims on investment vehicles).

• Derivatives.

The latter, strictly speaking, are not financial instruments - if one defines financial instruments as instruments representing the debt, shares / equity, etc. of borrowers - whereas, derivative instruments are contracts which may lead to profits / losses. In other words derivatives are not instruments of debt, shares / equity and so on, but hedging and speculation instruments.

The mainstream financial instruments are issued by borrowers (defined broadly11). They are therefore part of the share capital / liabilities of the issuers and, as such, represent the "claims" of the holders on the issuers.

The evidences exist in one of two ways: a certificate (see Box 1 for an example) or a computer printout of an electronic register entry issued by some institution (in the case of dematerialized or immobilized certificates / scrip12). We cover these instruments and issues related to them under the following sections:

• Financial instrument types.

• Share instruments.

• Debt instruments.

• Deposit instruments.

• Instruments of investment vehicles.

• Derivative instruments.

Financial instrument types

As an introduction, it may be useful to be reminded of the financial system: see Figure 1. Lenders lend and borrowers borrow. Financial intermediaries borrow and lend. Financial instruments are borrowing instruments held by lenders (ultimate and financial). How does one categories financial instruments? Some tantalizing questions in this regard:

• Are there two categories: primary securities (issued by ultimate borrowers) and indirect securities (issued by financial intermediaries)?

• Are there two categories: debt and shares / equity, because they are fundamentally different?

• Are there two categories: marketable and non-marketable?

• Are shares / equities borrowing instruments or are they evidences of ownership of companies?

• Do preference shares represent ownership of companies or are they just long-term loans?

• If equity finance in the form of ordinary (common) shares is regarded as permanent capital, are perpetual bonds not the same in nature?

• Are deposit instruments debt instruments?

• Are the liabilities of the investment vehicles debt instruments?

• What do the QFIs issue to fund themselves?

financial system (simplified)

Figure 1: financial system (simplified)

These questions are posed to indicate that there is no definitive answer as to how financial instruments should be categorized. However, in our opinion the most logical and technically correct categorization is:

• Evidences of shares / equity (because the majority of shares represent ownership of companies and they pay dividends). (Discussed further below.)

• Evidences of debt (because the majority of debt is non-perpetual and they pay interest).

• Evidences of deposits (because they are the liabilities of specialist companies and carry a different risk profile).

• Evidences of investments in investment vehicles (because they are fundamentally different to the rest of the financial instruments).

In addition there are derivative instruments, which, although they do not represent lending and borrowing, cannot be called anything but financial instruments. We discuss each of these in some detail. However, before we do so, we present a further discussion on whether shares / equities can be regarded as financial instruments.

Economic sticklers would maintain that shares / equities are not financial instruments. This is based on the premise that shares represent part-ownership of a company and that they are not redeemable. They would also maintain that finance means debt, not shares / equity.

There are a number of reasons to classify shares / equities (from here on called shares) as financial instruments:

• Companies may repurchase their own shares (up to a limit), i.e. they are redeemable, although only up to a specified limit.

• It is conventional wisdom to regard shares as financial instruments, and the share exchange in each country is regarded as a financial exchange / market.

• Companies have two kind of finance available, shares and debt; thus, they are substitutes for one another.

• Certain types of shares, preference shares, are closer in nature to debt instruments than to ordinary shares (see later).

This fruitless debate will not be entertained further here. We regard shares as financial instruments.

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