What is a Financial Instrument?

How good is your promise to pay? A financial instrument is a piece of paper known as a monetary contract. It is made between two parties, can be traded and settled. The contract represents an asset to one party (the buyer) and a financial liability to the other party (the seller). Accordingly, you can find them listed on a balance sheet as either a financial asset, financial liability, or equity instrument. You may recognize them as cash, shares or bonds.

In the aftermath of the 2008 global financial crisis, regulators grew increasingly concerned about consumer protection. Over time, the number of new financial instrument types grew in complexity ahead of investor sophistication. The Lehman Minibond crisis showed that many investors who bought such investments did not have a clear understanding of the product’s features. Part of the reason is that such products are quite complex and embed features that are difficult to understand. This suggests that if the inherent risk and the complexity of a product’s structure are not clearly understood by investors, they would not be able to make informed investment decisions.

While not all financial instruments are hard to understand, the truth is it often takes years of specialized expertise and experience to value complex financial instruments.

Let us first describe financial instruments by asset class before discussing how to value them.

Financial Instruments Types by Asset Class

An asset class refers to a group of investments that exhibit similar characteristics and are subject to the same laws and regulations. An asset class refers to the form a financial instrument takes, e.g. share, bond, derivative, forex or commodity. Financial instruments can be separated according to asset class and can be further divided by whether they are complex or non-complex.

There are four main asset classes: equities (shares), fixed income (bonds), cash equivalents, and alternative investments (commodities, real estate, financial derivatives, private equity). Different asset classes react differently to news. For example, if there was news of a recession, equities prices may fall, while investment-grade debt and alternative investment, e.g. gold, prices may rise.

exhibit 1: financial asset classes

Equities

Equity instruments are shares in the ownership of a business. There are several types of equity instruments:(a) Common (ordinary) shares represent a partial ownership of the company. This type of share gives the stockholder the right to share in the profits of the company, and to vote on matters of corporate policy and the composition of the members of the board of directors.(b) Preferred shares are financial instruments that represent an equity interest in a company but may not allow its owners voting rights. Preferred stocks are senior (i.e., higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company) and may have priority over common stock (ordinary shares) in the payment of dividends and upon liquidation.

Fixed income

Fixed income securities are a type of debt instrument. It provides returns by way of regular, or fixed, interest payments. It also repays the principal when the security reaches maturity. These instruments are issued by governments, corporations, and other entities to finance their operations. They differ from equity, as they do not entail an ownership interest in a company, but they confer a seniority of claim, as compared to equity interests, in cases of bankruptcy or default. Examples of fixed income instruments include bonds, Treasury notes (“T-notes”) and Treasury bills (“T-bills”). They are marketable securities sold by a government to pay off debt and raise cash. The difference between each is based on the length of time held by an investor and the interest they pay:

• Bonds have terms longer than 10 years, e.g. 20-30 years. They pay interest bi-annually and offer investors the highest interest payments to maturity.
• T-notes are issued in two, three, five and 10 year terms. It pays interest bi-annually.
• T-bill, is a short-term investment. It has the shortest maturity term—from four weeks to a year. A T-bill pays no interest and is sold at a discount to its face value. So, the investor pays a is less than the face value for the T-bill and gets face value at the maturity date. The difference between the purchase price and face value is the investor’s return on the investment.

Cash and cash equivalents

Cash and cash equivalents are the most liquid current assets found on a business’s balance sheet. They are short-term, highly liquid investments with a maturity date that was 3 months or less at the time of purchase. In other words, there is very little risk of collecting the full amount being reported.(a) Money market account is a savings account that offers you the potential to earn higher interest than an ordinary savings account.(b) Commercial paper is an unsecured promissory note, as the security is not supported by anything other than the issuer’s promise to repay the face value at the maturity date specified on the note. A commercial paper pays a fixed interest rate to the holder. Also, it is generally sold at a discount to its face value due to the somewhat risky nature of the unsecured security. The need for commercial paper often arises due to corporations facing a short-term need to cover their expenses.

Alternative investments

exhibit 2: alternative asset classes

• Financial derivatives are financial contracts whose value is linked to the value of an underlying. This underlying entity can be an asset, index, or interest rate. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.
• Private equity is an alternative investment class and consists of capital that is not listed on a public exchange. Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity. These instruments often have complex capital structures, i.e. not common shares or preferred shares. If you are interested in how to value private equity investments, this is not the right article for you. Please read our write-up on portfolio company investment valuation.

Financial instrument valuation helps businesses understand how capital markets classify and value their financial assets.

Mun Siong Yoong, Founder & CEO

What Is A Non-complex Financial Instrument?

A non-complex financial instrument is one that can be traded without a great deal of specialist knowledge. Non-complex financial instruments include shares or equity securities, as well as debt securities and certain types of investment funds[1].

Equity securities refer to shares in companies, while debt securities include both government and corporate bonds. Debt securities can also refer to preferred stock and forms of collateralised securities – such as collateralised debt obligations.

Investment funds include hedge funds and mutual funds. These are all instruments which enable investors to pool their money under a specialist who is in charge of the fund: the fund manager.

What Is A Complex Financial Instrument?

Complex financial instruments (“CFI”) require an in-depth knowledge for traders to be successful when trading them. Derivatives are a common example of complex financial instruments. Different derivatives have different benefits. For example, contracts for difference (“CFD”) are good for hedging.

Many studies have discussed ‘complexity’ but there is no commonly accepted definition. However, the International Organization of Securities Commissions (“IOSCO”) has provided a useful description of complex financial products. According to IOSCO, complex financial products refer to financial products:

• With terms and features which are not likely to be understood by an average retail customer, (as opposed to more traditional or plain vanilla investment instruments);
• Which are difficult to value (so that their valuations require specific skills and/or systems); and/or
• Have a very limited or no secondary market (and are therefore potentially illiquid).

Financial derivatives are examples of complex financial instruments. These include but are not limited to the following:

• Forward gives the holder the obligation to buy or sell a certain underlying instrument at a certain date in the future at a specified price;
• Futures is a forward contract traded on organized exchanges. A futures contract is a legally binding commitment to buy or sell a standard quantity at a price determined in the present (the futures price) on a specified future date;
• Swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The cash amount of the payments exchanged is based on some predetermined principal amount; and
• Option is a contract in which the option seller grants the option buyer the right to enter into a transaction with the seller to either buy or sell an underlying asset at a specified price on or before a specified date.

How To Classify A Complex Financial Instrument?

Defining a CFI can be a complex subject, let along valuing one. CFIs have distinctive features that need to be considered when valuing the security, such conversion or redemption options, vesting conditions, or embedded derivatives.

Here are five CFI behavioral characteristics that can help us identify a CFI:

exhibit 3: financial asset classification (two test technique)

exhibit 4: financial asset classification & measurement

1. Leverage: amplifies market exposure relative to an investment in the underlying instrument. Gains and losses are experienced more quickly, sometimes much more quickly, than in an un-leveraged investment. Leverage can take several different forms:

• Borrowing to fund purchase of securities
• Use of derivatives
• Non-linear and payoff structure

2. Maturity mis-match: Occurs when a company’s short-term liabilities exceed its short-term assets. It can also occur when a hedging instrument and the underlying asset’s maturities are misaligned.

3. Market liquidity: As witnessed during the Lehman Minibond crisis, market liquidity for many of these instruments didn’t just reduce but in some instances ceased to exist. In these circumstances, valuations and price verification for these instruments become challenging as they had limited evidential support.

4. Lack of price transparency: These instruments are often bespoke, and their valuations depend on proprietary financial models and the inputs that drive those models. Frequently, the inputs for these models are not directly observable in the market. In addition, even a valid model with accurate inputs will not always capture the immediate supply and demand profile of the market, meaning that the model price will not always determine the price at which a transaction will occur. In this circumstance, buyers and sellers may achieve price discovery only through actual transactions. Transactions which in this case are hard to come by.

5. Path reliance The returns at maturity assume that underlying assets’ features take certain future paths, i.e. price risk, event risk. A valuation must therefore include a robust simulation of possible outcomes or paths. Repeat calculation could give a more accurate payoff result.

Determining the Fair Value of Financial Instruments

exhibit 5: compound vs hybrid instrument

We list below suggestions on how to fair value different types of financial instruments:

• Equity: Look up the share price if the company is listed. Undertake a business valuation exercise for a non-listed company.
• Fixed income: Look up the price if the debt is listed. Conduct a discount cash flow analysis for a non-listed debt.
• Cash and cash equivalent: Fair value is equal to face value, given the short term nature of the carry amount.
• Financial derivative: Quoted market prices in an active market is the best evidence of fair value and should be used, where they exist. If a market for a financial instrument is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs and includes recent arm’s length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models. An acceptable valuation technique incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments.

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Financial instruments are a growing presence on company balance sheets, and business executives say more market awareness is needed to prevent another financial crisis, according to a recent survey by the American Institute of CPAs (AICPA)[2].

When asked about the complexity, their level of concern about the valuation and reporting of financial instruments, respondents provided the following responses:

• 69 percent expect financial instruments to become more complex over the next one to three years;
• 55 percent said they are concerned about the valuation of derivatives; and
• 56 percent said it would be easier to determine the value of complex financial instruments if they were measured and reported on a consistent and transparent basis.

Complex financial instruments historically have been difficult to value. That difficulty is seen as a major cause of the financial crisis that led to the recession of 2008. Creating standard processes for documenting and valuing these instruments will improve clarity and transparency. This in turn enhances confidence from capital markets and stakeholders.

Maintain stakeholder trust with accurate asset values.

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