AFM391 Chapter Notes - Chapter 16: Financial Instrument, Interest Rate Risk, Underlying
21 Feb 2017
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Financial instruments are contracts that create both a financial asset for one party and a financial liability or equity instrument for the other party; can be either primary or derivative. Primary financial instruments include basic financial assets and financial liabilities, such as receivables and payables, as well as equity instruments, such as shares. Derivatives have three characteristics: their value changes in response to the underlying instrument, they require little or no initial investment, they are settled at a future date. Options, forwards, and futures are common types of derivatives. Derivatives are measured at fair value with gains and losses booked through net income. Derivatives help companies manage risk, especially financial risk. Three categories of costs related to derivatives: direct costs. Transaction costs, bank service charges, brokerage fees, and insurance premiums. Employee time spent on analyzing derivatives: other costs. Too many complex financial instruments make financial statements less transparent, in which case the market might raise the cost of capital.
