Why and How Financial Instruments are created?
In an increasingly borderless business environment, companies that are able to take advantage of every opportunity to grow and scale up are the best positioned to succeed.
Financial Instruments are a contemporary means for modern companies to increase their capital, or to manage risk involving foreign currency transactions.
International Accounting Standards (IAS) define financial instruments as: Any contract that gives rise to a Financial Asset for one entity and a Financial Liability or Equity Instrument for another entity.
Financial Instruments are mainly classified into two asset classes – namely, Debt-based instruments and Equity-based instruments; a unique third type are the Foreign Exchange instruments.
- Debt-Based Financial Instruments
Debt-based financial instruments represent a loan made by an investor. They are used by corporate entities to strengthen the capital base of a business. Debt-based financial instruments can be short-term or long-term.
The short-term instrument typically lasts for one year or less. They include instruments like treasury bills and certificates of deposit – or derivative instruments such as short-dated interest rate futures and forward rate agreements.
Long-term instruments typically last for over one year. They include instruments like bonds – or derivatives like interest rate swaps and long-dated interest rate options.
Debt-based financial instruments play a critical role in the business world because they enable enterprises to increase profitability through growth in capital.
- Equity-Based Financial Instruments
Equity-based financial instruments represent ownership of an asset. They represent the legal ownership of an entity. Examples include common stock and shares in a company, convertible debentures, and transferable subscription rights – or derivatives like stock options and equity futures. The owner of an equity-based financial instrument can choose to invest further in the instrument or to sell it whenever they wish to. Equity-based financial instruments help businesses grow capital over a longer period of time compared to debt-based instruments – and benefit owners because they are not liable to pay it back.