Erin Mae A.

Ricalde
BSBA FM2 – G2

Review Questions – Page 57

Questions:

1. Define Financial Instrument.

As defined by the book, the financial instrument is any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity. It is a contract between
parties that holds monetary value. They can either be created, traded, settled, or modified as per the
involved parties' requirements. It includes financial assets, financial liabilities, equity instruments,
and derivatives.

A financial instrument is a term used in finance to describe any tradable asset or contract that
represents a financial value. These instruments are used for various purposes in the financial
markets, including investment, hedging, and speculation. Financial instruments play a crucial role in
the global financial system by facilitating capital allocation, risk management, and investment
strategies. They are bought and sold in financial markets, allowing investors and institutions to
manage their financial assets and liabilities efficiently. The value and risk associated with financial
instruments can vary widely depending on the specific type and characteristics of the instrument.

2. Give examples of primary financial instruments.

Primary financial instruments, also known as basic or traditional financial instruments, are
foundational assets that serve as building blocks in financial markets. These instruments are
relatively straightforward and typically include:

 Cash: Physical currency (coins and banknotes) and digital money held in bank accounts,
which serves as a medium of exchange and a store of value.

 Bank Deposits: Funds deposited in bank accounts, such as savings accounts and checking
accounts, which earn interest and are subject to withdrawal.

 Stocks (Equity Instruments): Also known as shares or equities, stocks represent ownership
in a company. Shareholders have a claim on the company's assets and earnings, and they
may receive dividends.

 Bonds (Debt Instruments): Bonds are debt securities issued by governments, corporations,
or other entities to raise capital. Bondholders lend money to the issuer in exchange for
periodic interest payments (coupon) and the return of the principal amount at maturity.

 Money Market Instruments: These are short-term debt securities with high liquidity and low
risk. Examples include Treasury bills (T-bills), commercial paper, and certificates of deposit
(CDs).

 Derivative Instruments: Derivatives derive their value from an underlying asset or reference
point and include options, futures contracts, swaps, and forwards. They are often used for
hedging, speculation, and risk management.
  Preferred Stocks: Preferred stocks combine characteristics of both equity and debt. They
represent ownership in a company and typically offer a fixed dividend, but they have a
higher claim on assets and earnings than common stocks.

 Real Estate Investment Trusts (REITs): REITs are investment vehicles that allow investors to
own a share of income-generating real estate properties, such as office buildings, apartment
complexes, and shopping centers.

 Mutual Funds: Mutual funds pool money from multiple investors to invest in a diversified
portfolio of stocks, bonds, or other securities. Investors own shares in the mutual fund
rather than the individual assets.

 Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds but trade on stock
exchanges like individual stocks. They offer diversification and can track various indices or
asset classes.

 Commodities: Physical goods or raw materials, such as gold, oil, agricultural products, and
metals, that can be traded on commodity markets. Commodity futures contracts are often
used for price hedging.

 Foreign Exchange (Forex): The foreign exchange market facilitates the trading of currencies
from different countries. Forex trading involves exchanging one currency for another at
prevailing exchange rates.

 Treasury Securities: Government-issued debt instruments, including Treasury bills (T-bills),

Treasury notes, and Treasury bonds, which are considered among the safest investments.

These primary financial instruments form the core of financial markets and serve various purposes,
from raising capital and managing risk to providing investment opportunities for individuals and
institutions. Investors often construct diversified portfolios using these instruments to achieve their
financial objectives.

3. Explain the nature of a derivative.

Derivatives are financial instruments that “derive” their value on contractually required cash flows
from some other security or index. Derivatives derive their value from an underlying asset and its
value is determined by fluctuations in the underlying asset. The underlying assets could include
stocks, bonds, foreign currency, or interest rates. The basic principle behind entering into derivative
contracts is to earn profits by speculating on the value of the underlying asset in the future.

4. Indicate whether the following instruments are examples of money market or capital market
securities.
 BSP treasury bills - Money market securities
 Long-term corporate bonds – Capital Market securities
 Ordinary shares (common stocks) - Capital Market securities
 Preferred shares - Capital Market securities
 Dealer commercial paper - Money market securities

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