A PROJECT REPORT ON

FINANCIAL INSTRUMENTS

SUBMITTED TO

UNIVERSITY OF MUMBAI

IN PARTIAL FULFILMENT

SEMESTER - VI

IN ACCOUNTING AND FINANCE STUDIES

SUMITTED BY

MAMTA VIJAY YADAV

UNDER THE GUIDANCE OF

PROF. NEHA MISHRA

RAMANAND ARYA D.A.V. COLLEGE

C.G.S COLONY, BHANDUP (E), MUMBAI 400042

ACADEMIC YEAR 2018-2019

 DECLARATION

I, MISS. MAMTA VIJAY YADAV the student of T.Y.B.com (Accounting and

Finance) Semester VI of the Batch (2018-2019) hereby declares that I have
completed my Project on “FINANCIAL INSTRUMENTS”. The Information
submitted is true and best to its Knowledge.

Signature of Student,
 ACKNOWLEDGEMENT

I want to thank the following people for making this project a success. They Mean
a lot to me and have bought this project into existence.

Principal DR. AJAY M. BHAMARE for allowing me to frame my talent by

allowing me to present my project in front of you.

PROF. CHANDRAKALA SHRIVASTAV, our course co-ordinator for

providing me constant help and support while preparing this project.

My project guide PROF.NEHA MISHRA who has given shape to this project by
giving the required guidance to prepare the project as per the requirement of
university.

I would not like to forget my parents who have played a vital role behind the
scenes so that the project would be worth presenting in front of you.
 INTRODUCTION

Financial instruments are monetary contracts between parties. They can be

created, traded, modified and settled. They can be cash (currency), evidence of an
ownership interest in an entity (share), or a contractual right to receive or deliver
cash (bond).

International Accounting Standards IAS 32 and 39 define a financial instrument

as "any contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity".

The definition is broad and will cover the instruments used in the treasury
management activity of an authority, including the borrowing and lending of
money and the making of investments. However, it also extends to include such
things as receivables and payables and financial guarantees. At the other extreme
are a number of complex arrangements: derivatives (swaps, forwards, options, etc)
and embedded derivatives (derivatives hosted within a wider contract). Embedded
derivatives that might be encountered by local authorities, and which might need to
be accounted for separately, include PFI1 deals where an element of the unitary
payment varies in accordance with an underlying measure (such as RPI plus a
percentage) and fuel contracts which include a multiplier based on an underlying
price index. The derivative elements might need to be accounted for separately
because the increase is not based on a relevant index, but a multiplier of a relevant
index. Where the increase is based on a relevant index (such as RPI in the PFI
example above), the derivative is likely to be closely related to the host contract
and will not need to be accounted for separately.

Exemptions from the Definition

Some rights and obligations that would otherwise be financial instruments are
excluded from the requirements of as they are covered by more specific provisions
about their recognition, measurement and disclosure.

 Interests in subsidiaries, associates and joint ventures (provided that the

entities are included within the authority’s group accounts); such interests
are to be carried separately from financial instruments in the Balance Sheet
at cost (less any provision for losses) or fair value.
 Rights and obligations arising from leases and PFI, PPP and similar
schemes, except for:
 lesser’ lease receivables in relation to the derecognition and
impairment provisions of chapter seven of the Code
 lessees’ lease payables in relation to derecognition provisions and
derivatives that are embedded into any lease arrangement
 payables under PFI, PPP and similar schemes with respect to the
derecognition provisions, and
 Derivatives that are embedded in leases and PFI, PPP and similar
schemes.
 Employers’ rights and obligations under employee benefit plans
 Loan commitments, unless they can be settled net or there is a past practice
of selling the resulting loans shortly after origination or the commitment is
to provide at below market interest rate.
 Contracts to buy or sell non-financial items (e.g. commodity futures
contracts) are outside.
 Financial instrument contracts and obligations under share-based
transactions (those that are settled by the transfer of equity instruments)
  Rights and obligations arising under an insurance contract as defined in
IFRS 4 Insurance Contracts other than a financial guarantee contract that
meets the definition of a financial guarantee contract.
 Rights to receive reimbursement of expenditure required to be made to settle
a liability recognized as a provision in accordance with section 8.2 of the
Code, or for which in an earlier period was recognized as a provision.
 Forward contracts between an acquirer and a selling shareholder to buy or
sell an acquire that will result in a business combination at a future
acquisition date.

Amounts relating to such things as council tax, non-domestic rates, general rates,
etc are outside the scope of the accounting provisions as they are statutory debts
and do not arise from contracts.

What is financial instrument?

Financial instruments are assets that can be traded. They can also be seen as
packages of capital that may be traded. Most types of financial instruments provide
an efficient flow and transfer of capital all throughout the world's investors. These
assets can be cash, a contractual right to deliver or receive cash or another type of
financial instrument, or evidence of one's ownership of an entity.

Need for financial instrument

 Financial instruments act as a means of payment (like money).
 Employees take stock options as payment for working.
 Financial instruments act as stores of value (like money).
 Financial instruments generate increases in wealth that are larger than from
holding money.
 Financial instruments can be used to transfer purchasing power into the
future.
 Financial instruments allow for the transfer of risk (unlike money).
  Futures and insurance contracts allow one person to transfer risk to another.

Types of Financial Instruments

Financial Instruments are intangible assets, which are expected to provide future
benefits in the form of a claim to future cash. It is a tradable asset representing a
legal agreement or a contractual right to evidence monetary value / ownership
interest of an entity.

Under the subject of Finance Management, Financial Instruments can be classified

as cash instruments and derivative instruments. Financial Instruments are
typically traded in financial markets where price of a security is arrived at based on
market forces.

FINANCIAL INSTRUMENT TYPES AND THEIR INHERENT RISKS

The customer should be fully aware:

• That he is responsible for making the decision to invest in one or another

financial instrument and he himself shall assume the risks related to the investment

• Of the need to investigate the documents related to the investment services

(including the Bank’s rules, policies, List of Conditions), as well as other
information related to the respective services, for example, the information on the
country of the investment, the issuer of the financial instrument, etc.

• Of the need to check the instructions for transactions before submitting them for
execution and immediately inform the bank on mistakes made therein, if any

• Of the need to constantly follow the value of his investment and act without delay
for example, selling the financial instruments, in which he has invested, to reduce
the risk of possible loss

The Bank, to comply with the legal requirements and to help customers make
an investment decision, hereby offers the summaries description of certain types of
financial instruments and their inherent risks. This description is designed so as to
be understandable to investors who are non-professional customers (i.e. customers
who have been granted the status of a private customer) with minimum knowledge
of investment products.

General information about the risks

The investor's primary goal is to get a positive return on the investments.
However, every investment is related to market risk, because the financial
instrument transaction gains may be less than expected or even negative. Usually
the probability of profit is directly related to the probability of loss - the higher the
expected return, the greater the risk. Investments made in the long term, reduce the
possibility of receiving a negative yield result, because the increase in the value in
the short term offset value reductions.

The most significant risks that the investor should take into account:

Liquidity risk - the risk that the investor may incur losses if within the certain
period the financial instruments cannot be sold at the desired price. Liquidity risk
is topical, if in the market the number of buyers of the specific financial instrument
is not sufficient.

Counterparty credit risk - the risk that the investor may incur losses if
counterparties who has obligations to the investor or to the bank for the benefit of
the investor is unable meet its obligations.

Issuer risk - the risk that the investor may suffer a loss if the bond value varies
depending on the creditworthiness of the issuer: if the ability to pay deteriorates,
the security’s price decreases, and vice versa. If the issuer of the financial
instruments, in which the investor has invested funds, fails to meet its obligations,
there is a risk of full loss of investment.

Interest rate risk - the risk that an investor may suffer a loss if because of changes
in market interest rates the value of a financial instrument changes as well. The
value of debt securities decreases when interest rates rise, and vice versa.
Currency risk - the risk that an investor may incur losses if investments in
financial instruments are denominated in foreign currencies. The customer should
be aware that the value of investments may fall as a result of unfavorable
fluctuations of exchange rates.

Other risks - risks related to force majeure (natural calamities and disasters, acts
of war, strikes, and disturbances of communication and information systems), the
risks associated with legal and / or tax regime changes, cash flow risk, information
risk, foreign law enforcement risk, etc.

There are several ways to limit the risk - for example, it is advisable to invest in
several financial instruments different in terms of risk, not just in one or some
financial instruments of the same or similar risk. In this way, the risk is spread
more evenly to avoid simultaneous and equal negative impact on all financial
instruments owned by an investor.

Financial instruments by their structure and inherent risks can be divided into non-
complex and complex financial instruments. Non-complex financial instruments
are, for example, common shares, bonds with no embedded derivatives, as well as
a separate investment funds, such as UCITS. All financial instruments that are not
non-complex financial instruments are considered to be complex financial
instruments (including noncomplex financial instruments that are purchased on
credit or borrowed funds)

If the investor is using borrowed funds (also those from credit institutions) for the
purchase of financial instruments, and the financial instruments purchased for
borrowed funds have not brought down the amount of profit the investor has
expected, the investor in any case will have to repay the borrowed funds to the
creditor under the loan agreement between the parties. Investors should be aware
that the yield on financial instruments purchased for borrowed funds may not be
sufficient for the investor to cover the loan costs (including the loan interest and
front-end fees, if any)
 Non-complex financial instruments
1. SHARES

Shares are capital share securities. Owner of shares or the shareholder is the
company co-owner. If the company makes a profit, in certain cases, a portion of it
shall be paid out to shareholders in the form of dividends. The more shares are
owned by the shareholder, the greater the stake it owns, and the higher the portion
of the distributable profits is due. It should be remembered that when the
company's operation brings a loss, its equity should be reduced, resulting in a
decrease in the value of shareholders' investment. If the company goes bankrupt,
there is a possibility for a partial or complete loss of investments in its shares.
There are common and preferred shares. Holder of common shares is entitled to
participate in the company's administration, by exercising the right to vote at
shareholders' meetings. In turn, preferred shares give to its owner the prior right to
receive dividends, but usually do not give the voting rights. Shares are most often
traded in regulated market i.e. at a stock exchange. Particular company's stock
price depends on the supply and demand interaction determined by a number of
various factors, such as:

1) The company's current situation (including sales, organizational structure,

productivity, etc.), as well as future prospects. As it is not possible to accurately
predict how successfully the company will operate in the future (it depends on, for
example, technology, applicable legal requirements, competition), the stock price
is largely determined by investors' estimates of the company's operations in the
future.

2) Market interest rates. First, higher interest rates mean higher debt service
costs for the company, thus reducing its profits and growth opportunities. Second,
an increase in interest rates will increase the yield on debt securities and investors'
demand for shares decreases, thus negatively affecting the stock price

3) Stock turnover, or total number of shares to be bought or sold at a stock

exchange. If the company's stock turnover is high, the difference between the price
that the buyers are willing to pay and the price demanded by the seller decreases.
Such shares are easy to buy and sell. Conversely, if the turnover is low, the
customer may have difficulties with the purchase or sale of shares at the desired
price.

Market players often have different opinions about the company's prospects,
resulting in a balanced market, because some market players may want to sell the
shares, the others - to buy. If the majority of market players have a common
viewpoint on the share price in future, the situation leading to more rapid changes
in stock prices occurs, because the demand for shares increases or decreases.
Declines in stock prices have a negative impact on the investor's returns.

2. DEBT SECURITIES

Debt securities, such as bonds, confirm one party's (the issuer's) debt obligations to
the other party (the holder of the bond). The bond issuer's obligations to the bond
holders are set forth in the bond prospectus. Usually the issuer is obliged to repay
to bondholders the face value of bonds acquired on a certain date (the bond
maturity date), and to pay the interest (make coupon payments) from time to time
(for example, once or twice a year). However, there are bonds with no fixed
maturity and bonds, the issuer of which is not required to pay coupons to bond
holders (known as T-bills, zero or zero-coupon bonds).

The bond coupon is expressed as an annual percentage of the face value of bonds.
It can be either fixed or variable (floating). Bond issuers may be national
governments, banks, companies and other market players. The bond holder may
sell their bonds before their maturity date. In this case one should expect that the
bond price may be higher or lower than the purchase price of the bond. Bond
prices are affected by several factors, and the bondholders have to take account of
the following ones:

1) The issuer's creditworthiness. The better the issuer's financial results,

the lower its borrowing costs. Consequently, the price of such issuer's bonds is
higher. If the issuer's creditworthiness deteriorates, the price of bonds decreases, so
the bond holders may suffer a loss. If the issuer becomes insolvent, the holders of
its bonds may partially or even completely lose their investment, despite the fact
that they have held their investment in bonds until maturity.
 2) Market interest rates. When the market interest rates grow, the prices of
bonds decline, so their holders may incur a loss, if they want to sell the bonds
before their maturity date. The fluctuations of market interest rates will mostly
affect the long-term bond prices.

3) Bond trade turnover. If the number of buyers is not sufficient in the

market, the sale of bonds at the desired price may be difficult.

3. CERTIFICATES OF CERTAIN INVESTMENT FUNDS

Investment funds can be both non-complex and complex financial instruments.

An investment fund is a combination of many investors' monetary funds, which is

managed by a professional specialist (fund manager) with the aim to get a profit
from the growth of the investment value. In order to ensure the growth of
investment value, the fund manager invests in various assets, such as stocks,
bonds, term deposits and real estate. The fund manager's right to invest in one or
another asset class is defined in the investment fund's prospectus. The prospectus
also covers the remuneration that the fund manager receives for his work. It is from
time to time charged on the fund's assets.

Investment fund certificates are securities that confirm the investor's participation
in the fund and the resulting investor's rights. When buying fund certificates, the
investor becomes a fund participant and is entitled to claim the appropriate share of
the fund profits. However, investors must take into account that the investment
fund shares neither have a guaranteed nominal value, nor guaranteed yield. This
means that the investor may lose partially or entirely the money invested in the
fund. It should also be noted that the investment fund has the same risks that are
inherent to assets, in which the fund existing resources are deployed.

The most common types of investment funds:

 MONEY MARKET FUNDS

A money market fund (also called a money market mutual fund) is an open-
ended mutual fund that invests in short-term debt securities such as US Treasury
bills and commercial paper. Money market funds are widely (though not
necessarily accurately) regarded as being as safe as bank deposits yet providing a
higher yield. Regulated in the United States under the Investment Company Act of
1940, money market funds are important providers of liquidity to financial
intermediaries.

Securities in which money markets may invest include commercial

paper, repurchase agreements, short-term bonds and other money funds. Money
market securities must be highly liquid and of the highest quality.

FEATURES OF MONEY MARKET FUNDS:

 Over the Counter:

Money markets across the world essentially operate over the counter, which
essentially means that these trades cannot be made online. Therefore investments
in these markets are made physically by authorized representatives or in person
and a physical certificate is issued to the buyer of the money market instrument.

 Wholesale Market:

This essentially means that money markets are designed to provide and accept bulk
orders, thus few retail investors have enough capital to directly participate in
money markets. However, individual investors can choose to invest in debt mutual
funds that invest in money markets in order to invest in this market.

 Multiple Instruments:

Unlike capital markets which usually trade in one single type of instrument such as
securities, money markets trade is multiple instruments. These instruments feature
different maturities, debt structure, credit risk and even currencies to name a few.
As a result of this diversity, money market instruments are ideal for diversification
through distribution of exposure.

 High Liquidity:
The main feature that makes money markets unique is the high level of liquidity
that they offer. It is easy to make money market trades across currencies,
maturities, debt structure as well as credit risk, which makes it ideal for institutions
seeking to borrow or invest for the short term.

Key Functions of Money Markets:

Money Markets have continued to exist in modern economies due to their

unique features as well as their ability to carry out some key functions that other
financial markets cannot. The five leading functions that a money market carries
out in the modern economic system include:

Trade Financing:

Modern day money markets play a vital role in ensuring that there is adequate
capital available to institutions engaged in domestic as well as international trade.
Internationally, short term funding for ventures may be available to traders through
“bills of exchange” apart from other routes. These are instruments that are
discounted by the bill market. In common practice, discount markets and
acceptance houses are engaged in financing overseas trading ventures using these
“bills of exchange”.

Industrial Financing:

Many industries issue bonds on the bond market or shares on the stock market in
order to receive long term financing of their operations. However, many industrial
houses are actively involved with money markets too. There are two ways in which
money markets help with industrial financing – providing short term funding and
producing an impact on capital markets. Short term funding from money markets
can help industries finance day to day operations and meet working capital
requirements using commercial papers, finance bills, etc. Long term capital is
obtained by industries through issue of bonds or shares on applicable capital
markets. However, capital markets are impacted by money market movements.
This is because the rate applicable to short term lending plays a key role in
determining the applicable yield of long term capital market instruments such as
bonds.
Profitable Investments:

The money market offers institutions such as commercial banks, a lucrative low
risk route to use their excess funds in order to earn additional income. The main
reason why commercial banks need to generate this additional income is to ensure
that they have sufficient liquidity to meet uncertain demands such as withdrawal of
consumer deposits. Usually commercial banks invest their funds in near money
assets that have a short maturity period which can be easily converted to cash to
provide high liquidity to the investor. This way the banking sector is able to
generate additional income while maintaining sufficient liquidity.

Self Sufficiency of Banks:

Commercial banks operating in developed money markets have ample

opportunities to invest and generate further income such that their self sufficiency
improves in the long term. Banks can always borrow from central banks when they
face a dire cash crunch hence RBI is considered to be the lender of last resort.
However, it is always desirable for banks to be able to manage their own monetary
requirements in the short term as well as the long term. This, money market can
help the bank achieve through availability of funds at rates that are lower than
those charged by the central bank. Thus money markets provide a two pronged
benefit – helping banks earn additional income and also as a source funds to the
bank when required.

Aiding Central Banks:

Central Banks globally are involved in maintaining and controlling markets –

both money markets as well as capital markets. Thus even though a central bank
such as RBI can influence monetary policy without having to take the help of
money markets, the presence of this improves their efficiency by a great deal. As
these markets operate using short term interest rates, they serve as an excellent
indicator of the country’s overall economic health. Such information can provide
accurate guidance to the central bank regarding how it should act to rectify any
problems that might be occurring in the current situation. In the present day all
markets are linked, therefore actions taken by the central bank in money markets
will have an impact on capital markets. Thus, in the presence of a developed
money market, the central bank has access to a secure, quick as well as effective
way to influence various sub markets without having to overextend itself.

Money Market Instruments Used in India

The money market in India is considered to be an agglomeration of multiple

sub markets each featuring a different instrument that can differ based on maturity
interval, risk level, etc. The following are some key money market instruments
available in India:

Call Money

Traded in a sub-market termed as the call money market, call money essentially
represents a short term loan with maturities ranging from 1 day to 14 days and is
repayable on demand. The main uses of this instrument include providing short
term loans to banks primarily for the purpose of making stock exchange
transactions and bullion deals. Key participants in this market include
NABARD, UTI mutual fund and LIC mutual fund who are only engaged in
lending to the other participants. The call money market participants are allowed to
both lend and borrow using the call money instrument are STCI (Securities
Trading Corporation of India), DFHI (Discount and Finance House of India), co-
operative banks as well as Indian and foreign commercial banks.

Call money loans feature a fixed interest rate, termed as call rate, which being
closely related to changes of demand and supply, is quite volatile. Due to the high
level of volatility, call money market is considered to be the most sensitive section
of India’s money market. At present two separate call rates are in use in India – the
DFHI lending rate and interbank call rate. India’s major call money markets are
located at Ahmadabad, Chennai, Delhi, Kolkata and Mumbai.

Treasury Bills

Treasury Bills are by far the oldest of money market instruments and they are
still used heavily not just in Indian money markets but also the world over.
Treasury Bills or T-Bills in India are short term borrowing instruments issued by
the Government of India that do not pay any interest but are available at a discount
from their face value at the time of issue. The difference between the discounted
issue price and the face value at which these bills are redeemed provide the
“interest” payout to the buyer of the bill i.e. the lender. As T-Bills are issued by the
government, the returns are guaranteed and they are considered to be zero default
risk investments.

T-Bills are commonly classified in two ways – based on maturity and based on
type. The maturity classification of treasury bills names these as 10 day TBs, 91
day TBs, 182 day TBs and 364 day TB. The other classification categories of these
government-issued promissory notes include auction bills, tap bills and ad hoc
bills. Ad hoc bills are no longer available in India however they were only
available to foreign central banks, semi-government departments, central and state
government for investment purposes. Auction bills follow a multiple price system
in order to ensure fair pricing. Auction bills and tap bills are also termed as regular
bills as they are available for investment by banks as well as other participating
institutions.

Ready Forward Contract (Repo)

The term repo is derived from the phrase “repurchase agreement” which
essentially is an agreement that simultaneously mentions sale and purchase of an
asset. In the Indian context, repo agreements are made between banks as well as
between a bank and the RBI for short term loans. In case such borrowing
agreements are made internationally, the commonly used rate is the LIBOR
(London Inter Bank Offered Rate), while in case of a domestic repo agreement
between two Indian financial institutions the applicable rate is termed as the repo
rate. Repo rate may thus be defined as the rate at which domestic Indian banks
borrow from other Indian banks or from the RBI. The repo rate is fixed by the
Reserve Bank of India and it is one of the most powerful monetary control tools
that the central bank possesses. Decreasing the repo rate makes it cheaper for
banks to borrow money from other banks or the central bank. This theoretically
allows the bank to pass on the lower rate benefit to customers in the form of loans
provided at reduced rates.

Money Market Mutual Funds

This is actually an alternate term for liquid funds, which are in fact debt
funds featuring the lowest possible risk. Because the money market is largely over
the counter and mainly features block deals, it is largely closed off to the general
public and this is where liquid funds fill the gap. Individual investors can put their
money in a liquid fund, which invests in block over the counter deals carried out
on money markets. Though money markets themselves are overseen by the RBI,
liquid funds are regulated by SEBI (Securities Exchange Board of India).

As a general rule, liquid funds primarily invest in money market instruments

with a maturity of up to 91 days. Because of the potentially low level of risk
associated with short maturity money market instruments, liquid funds are
considered to be a low risk investment option even though they provide higher
returns than bank deposits. Moreover, these funds are highly liquid making them
ideal for short term parking of excess funds for not only individual investors but
also for institutional investors. Examples of money market mutual funds available
in India include Aditya Birla Sun Life Floating Rate Fund by Aditya Birla sun life
mutual fund – Short Term Plan and Axis Liquid Fund by Axis Bank Mutual Fund.

Interest Rate Swaps

This is the newest money market instruments in use in India today. Interest rate
swap is a financial transaction in which two parties sign a deal in which one pays a
fixed rate of interest, while the other pays a floating rate of interest. The fixed rate
of interest payable is calculated using a notional principal amount, while the
floating rate of interest is paid on the actual principal lent out/borrowed with the
rate varying on the basis of market conditions. In India interest rate swaps are
mainly used by commercial banks however, these are separate products that are not
directly linked to the bank’s assets such as money lent to customers in the form of
loans. This money market instrument protects the borrower from interest rates
changes even though the borrower is on the hook for any variable mark up
payments not covered by the interest rate swap agreement.

 BOND FUNDS

A bond fund or debt fund is a fund that invests in bonds, or other debt securities.
Bond funds can be contrasted with stock funds and money funds. Bond funds
typically pay periodic dividends that include interest payments on the fund's
underlying securities plus periodic realized capital appreciation. Bond funds
typically pay higher dividends than CD sand money market accounts. Most bond
funds pay out dividends more frequently than individual bonds.

FEATURES OF BOND FUNDS:

There are several factors that go into selecting an appropriate bond fund. Below
is a relevant breakdown of those factors.

1. Credit Rating:

A bond’s credit rating is one of the most useful tools in determining the fund’s
overall quality. Credit ratings are usually issued by one of the major credit rating
agencies, such as Moody’s, Standard & Poor’s and Fitch.

2. Maturity:

A bond’s maturity date is another important factor to consider. When combined

with duration, this indicator can provide an overview of how much risk is built into
the given asset. When it comes to bond funds, a maturity is simply the time until a
bond’s principal is repaid. Duration, on the other hand, measures the asset’s
sensitivity to rising and falling interest rates.

3. Coupon:
The bond’s coupon rate is the yield paid by the security on its issue date. In other
words, it is a periodic interest payment that investors receive for the duration of the
bond. Typically, coupon amounts are paid annually or semiannually. Knowing the
coupon rate can help investors calculate interest rate payments over time.

4. Use of Derivatives:
Many bond funds employ derivatives, which are contracts that allow investors to
bet on the future path of interest rates. Unlike bonds, derivatives usually require
only a small investment to enter the trade, which makes them highly attractive
when employed through leverage. Therefore, knowing if and how a bond fund
employs derivatives is crucial when evaluating a portfolio’s risk/reward ratio.

5. Tax Implications:
 The tax implications of your portfolio holdings must be evaluated before you
begin any investment strategy. When it comes to bonds and bond funds, taxes
apply in two ways: on income that’s distributed on a periodic basis and on gains
that result in selling the asset for profit. The latter is commonly referred to as a
capital gains tax. For bond mutual funds specifically, taxes on income depend
largely on the types of securities held. Like other asset classes, taxes on bond
holdings can be deferred if held in a tax-free retirement account, such as a 401(k)
or IRA.

Investors looking for tax-free income by way of a bond fund will find great value
in the T. Rowe Price Tax-Free High Yield (PRFHX), which provides exposure to
the intermediate high-yield segment of the many market.

6. Cost:
The cost of your bond fund holding is another important consideration when
deciding to invest in debt securities. When it comes to portfolio building, costs
shouldn’t just be analyzed against absolute returns, but on the relative performance
of the portfolio. Analyzing expense ratios, front- and back-end loads, and, where
necessary, management fees is extremely important.

The PRFHX fund discussed in the previous section also has a low barrier to entry
in terms of cost. This gives investors access to an actively-managed bond fund at
an affordable rate. The Vanguard Total Bond Market Index Investment
Fund (VBMFX) also provides access to a broad selection of intermediate
investment-grade debt at a very low rate.

 BALANCED FUNDS

A balanced fund is another option for intermediate-term investors. Balanced funds,

which are often called hybrid funds, own both stocks and bonds. They earn the
"balanced" moniker by keeping the balance between the two asset classes pretty
steady, usually placing about 60% of their assets in stocks and 40% in bonds.
 FEATURES OF BALANCED FUNDS:

1) Diversification:

Balanced funds are a mix of equity and debt funds and carry lesser risk when
compared to pure equity-oriented funds. Spreading the investments will reduce
overall risk but it may be tedious for an individual to choose and track the
individual investments. Balanced funds provide capital appreciation as well
stability of the investments with debt component of it.With a minimum amount of
500Rs SIP a month it would help you diversify your investments.

2) Rebalancing:

You may worry about churning your portfolio when you invest in a basket of
equity and debt asset classes. There comes the role of fund manager he does
disciplined rebalancing of the fund targeting the equity allocation to be at 65%
which makes this product superior.

3) Taxation:

Coming to tax impact, having an exposure more than 65% in equity funds
balanced funds enjoy tax-free income after a holding period of 1year.In case you
hold debt funds the capital gain is as per indexation after 3 years and capital gain is
taxed as per tax slab. Having tax free income after 1 year is making this fund
category more lucrative.

4) Fund Selection Criteria:

Choose a fund which does not have high exposure of small cap and mid cap
stocks in equity component and not to hold high duration bonds in debt
components. Ensure the fund manager is actively rebalancing the funds. Contact
your financial advisor before investing in the funds.

 EQUITY FUNDS

Equity funds aim to generate high returns by investing in the shares of companies
of different market capitalization. They generate higher returns than debt funds or
fixed deposits. How the company performance results in profit or loss decides how
much an investor can make based on his shareholdings.

FEATURES OF EQUITY FUNDS:

1) 80C tax exemption:

ELSS is the only tax-saving investment under Section 80C of the Income Tax
Act that gives you equity exposure (other than NPS). With its shortest lock-in
period of 3 years and high return potential, ELSS has a good track record. You can
invest in small but regular installments or a lump sum as per your affordability.

2) Cost of investment:

The frequent buying and selling of equity shares often impacts the expense
ratio of equity funds. Currently, SEBI has fixed the upper limit of expense ratio at
2.5% for equity funds and is planning to reduce it further. A lower expense ratio,
of course, translates into higher returns for investors.

3) Holding period:

When you redeem units of equity funds, you earn capital gains. These capital
gains are taxable in your hands. The rate of taxation depends on how long you
stayed invested in equity funds; such a period is called the holding period.

4) Cost-efficiency & diversification:

By investing in equity funds you can get exposure to a number of stocks by

investing a nominal amount.

For instance, if you have Rs 2,000 to invest, you will be able to buy one
stock of a large-cap company or one stock of 2-3 mid-cap companies. However,
your portfolio will face concentration risk. But with the same amount you can get
exposure to a lot many stocks when you invest in equity funds. This allows you to
diversify and benefit meaningfully.

Types of Equity Funds:

 You can categorize equity funds based on their investment mandate and the
kind of stocks and sectors they invest in.

Based on Sector and Themes:

Equity funds that focus their investments on a particular sector or theme fall
under this category. Sector funds invest in one particular industry, like FMCG or
Pharmacy or Technology. Thematic funds follow a particular theme, like emerging
consumer companies or international stocks.

Since sector funds and thematic funds focuses on a particular sector or theme, they
tend to be riskier. This is because their performance face sectoral as well as market
risks. However, sector and thematic funds can be diversified in terms of market
capitalization

Based on Market Capitalisation :

- Large-cap equity funds: Typically, large-cap companies are well-established

companies, making them large-cap funds stable and reliable investments.

- Mid-cap equity funds: They invest in medium sized companies.

-Mid-and-small-cap funds: There are even funds that invest in both mid-cap as
well as small-cap funds.

-Small-cap funds: Since smaller companies are prone to volatility, small-cap

funds deliver fluctuating returns.

- Multi-cap funds: Equity funds that invest across market capitalisation, which is
in large-cap, mid-cap and small-cap stocks, are called multi-cap funds.

Based on Investment:

All the funds discussed above follow active investing style, wherein the fund
manager decides the portfolio composition. However, there are funds whose
portfolio composition imitates a specific index.

Equity funds that follow a particular index are called index funds. These are
passively-managed funds that invest in the same companies, in the exact same
proportions, making up the index the fund follows.
 Example, a Sensex index fund will have investments in all 30 Sensex companies
in the same proportion in which the companies form part of the index. Index funds
are low-cost funds as they don’t require the active management of a fund manager.

 HEDGE FUNDS

Hedge funds are alternative investments using pooled funds that employ numerous
different strategies to earn active return, or alpha, for their investors. Hedge funds
may be aggressively managed or make use of derivatives and leverage in both
domestic and international markets with the goal of generating high returns (either
in an absolute sense or over a specified market benchmark). It is important to note
that hedge funds are generally only accessible to accredited investors as they
require less SEC regulations than other funds. One aspect that has set the hedge
fund industry apart is the fact that hedge funds face less regulation than mutual
funds and other investment vehicles.

Derivative instruments are used, thus increasing the investment risk degree, but at
the same time also increasing the expected profitability. Investments in hedge
funds are subject to considerable fluctuations, and at the same time it ought to be
taken into account that hedge funds may have certain trade and settlement dates, as
a result, it is possible that selling the fund certificates the investor will receive the
returns from the sale on its account over time. Hedge funds can be both
noncomplex and complex financial instruments.

Investment funds are grouped into close-end (the fund has a certain expiry date and
restricted number of certificates) and open-end (the fund expiry date is not
determined and the number of fund certificates is not limited). A separate sub-type
of investment funds is exchange-traded funds (ETFs).Its certificates are traded at
stock exchanges (like shares). Exchange-traded fund's share value may be linked to
a variety of assets such as stock or bond indices, commodities, currencies and
more. Exchange-traded funds can be both non-complex and complex financial
instruments.

FEATURES OF HEDGE FUNDS:

 Hedge fund industry in India is relatively young and it got a green flag in 2012
when Securities and Exchange Board of India (SEBI) allowed alternative
investments funds (AIF). They have following features:

1) High Net-Worth Investors:

Only qualified or accredited investors can invest in hedge funds. They are mainly
high net worth individuals (HNIs), banks, insurance companies, endowments
and pension funds. The minimum ticket size for investors putting money in these
funds is Rs 1 crore

2) Diverse Portfolio:

Hedge funds have a wide portfolio of investments ranging from investments in

currencies, derivatives, stocks, real estates, equities, and bonds. Yes,
they essentially cover all the asset classes only limited by the mandate.

3) Higher Fees:

They work on the concept of both expense ratio and management

fee. Globally, it is ‘Two and twenty’, meaning there is a 2% fixed fee and 20% of
profits. As for hedge funds in India, the management fee can well below 2% to
below 1%. And the profit sharing varies between 10% to 15% generally.

4) Higher Risks:

Hedge funds investment strategy can expose funds to huge losses. Lock-in period
generally for investment is relatively long. Leverage used by these funds can turn
investments into a significant loss.

5) Taxation:

The Category III AIF (hedge funds) is still not given pass-through status on tax.
This implies that income from these funds is taxable at the investment fund level.
Hence, the tax obligation will not pass through to the unit-holders. This is a
disadvantage for this industry as they are not on a level playing ground with
other mutual funds.

6) Regulations:
 It is not required that Hedge funds be registered with the securities markets
regulator and have no reporting requirements including regular disclosure of Net
Asset Values (NAV).

BENEFITS OF HEDGE FUNDS:

Returns from hedge funds actually stand testimony to the fund manager’s skill,
rather than the market conditions. Asset managers here do their best to
reduce/remove market exposure and generate good returns despite the market
movement. They function in small market sectors to reduce risks by more
diversification. Some of the strategies that hedge fund managers use are:

1) Sell short:
Here, the manager, hoping for the prices to drop, can sell shares to buy-back in
future at a lesser price.

2) Use arbitrage:

Sometimes the securities may have contradictory or inefficient pricing. Managers

use this to their advantage.

3) Invest towards an upcoming event:

For instance, some major market events like acquisitions, mergers, and spin-offs
among others can influence manager’s investment decisions.

4) Invest in securities with high discounts:

Some companies facing financial stress or even insolvency will sell their
securities at an unbelievably low price. The manager may decide to buy after
weighing the possibilities.

COMPLEX FINANCIAL INSTRUMENTS

 1. NON-COMPLEX FINANCIAL INSTRUMENTS ACQUIRED FOR
BORROWED FUNDS

The customer may have an opportunity to increase the size of its investment with
the funds borrowed from the Bank. In such cases, the customer's own capital
investment may be significantly less than the total face value of the investment.
However, the customer must understand that purchasing financial instruments for
borrowed funds he may lose not only his own investment, but also the borrowed
funds and stay indebted if the financial asset price developments will be
unfavorable.

2. STRUCTURED FINANCIAL INSTRUMENTS

Structured financial instruments include, for example, index-linked bonds. Index-

linked bonds typically offer a yield that is dependent on the development of a stock
index or an index basket. If the index value grows, the value of the bond grows as
well. Conversely, if the index decreases in value, the investor may not receive the
return, that is, recover only the face value of the bond. Index-linked bond issuer
guarantees the face value of bonds at maturity date, so the investor may suffer a
loss if he chooses to sell the bond before the maturity date.

Index-linked bonds have a risk of the issuer, i.e. if the bond issuer (usually a
bank) goes bankrupt, the investor may lose some or all funds invested in the bonds,
including borrowed funds, if such have been used for the purchase of the bonds.

3. CERTIFICATES OF CERTAIN INVESTMENT FUNDS

Investment funds may be both a non-complex and a complex financial

instrument.

If the investing in investment fund is related to certain difficulties (e.g.

investment fund units cannot be easily and quickly sold or information
comprehensible to the average customer is not available), this type of fund units
are considered to be complex financial instruments. The principal risk, contributing
to such financial instruments is the risk of a total loss of the invested funds
 A separate sub-type of investment funds is exchange-traded funds (ETFs).Their
certificates are traded at stock exchanges (like shares).The value of exchange-
traded fund shares may be linked to a variety of assets, such as stock or bond
indices, commodities, currencies and more. Exchange-traded funds can be both
noncomplex and complex financial instruments.

4. DERIVATIVE FINANCIAL INSTRUMENTS

Derivatives are financial and commodity instruments, whose price is dependent

on the value of the underlying asset. The underlying assets of derivatives can be
interest rates, exchange rates, stocks, bonds, stock indices, oil, gold, cotton, and
other commodities.

Derivatives may be used to reduce the risks associated with the underlying asset
price fluctuations, as well as to profit from the price fluctuations of derivatives
themselves. Before making a deal with derivatives, the customer should clearly
understand how the underlying asset’s prices fluctuate, which financial and other
risks are associated with these instruments, what the aims of using derivatives are
and which alternative instruments are available for reducing the risks in question.

When trading derivatives is conducted for risk reduction purposes, they may be
useful for the reduction of underlying asset price volatility effect. However, note
that the fluctuations of prices of derivatives and their underlying assets may be
different.

When trading in derivatives is conducted for profit purposes, the customer should
be aware that such a trade entails high risks. Certain derivatives are characterized
by large price fluctuations. Consequently, even small changes in the market may
have a significant negative impact on the customer's financial position.

Most settlements for derivatives are made in the future. In order to purchase or
sell derivatives, it is not always necessary to deliver funds in the full amount of the
transaction at the moment of the transaction. In certain cases, when making
transactions with derivatives, the customer must provide a guarantee or collateral
in the amount required by the bank. In case of adverse changes in the market prices
the Bank shall be entitled to request the customer to increase the amount of the
guarantee or collateral provided earlier. If the client does not make the supplement
mentioned above, the Bank has the right to terminate the derivative transaction
before due date.

The customer who wants to make derivative transactions should have adequate
knowledge of the derivative instruments nature, principles and associated risks.
Each derivative type is characterized by specific risks, and the customer's
knowledge and experience in making transactions with one type of derivatives
derivative do not guarantee the understanding of other derivatives.

The term to maturity of derivative transactions may be different - ranging from a

few days to several years.

The most common derivatives are as follows: forwards, options, swaps.

Foreign exchange forward contracts (FX forwards) and currency swaps

(FX swaps)

General Information

Forward exchange contracts (forwards) are agreements to conduct foreign

exchange transactions at a fixed price at a future date.

Currency swaps are the agreements to make two currency exchange transactions
simultaneously, one of which is a transaction of currency purchase / sale at the
settlement date in accordance with the rate fixed as of the date of the transaction
and the other is the opposite deal for the sale / purchase of the same amount of
currency in future. The exchange rates for both transactions are fixed at the
moment of the transaction and depend on the difference in the interest rates of the
respective currencies.

Related risks

To make the foreign exchange forward contracts or currency swaps, it is not

always required to reserve the full cash value of the concluded transaction at the
time of the transaction. In certain cases, when making the transaction, the customer
must provide a guarantee or collateral in the amount required by the bank. In case
of adverse changes in the market prices the Bank shall be entitled to require the
increase of the guarantee or collateral provided by the customer earlier. If the client
does not make the increase specified above, the Bank has the right to terminate the
respective transaction before due date. If the transaction is terminated prior to
maturity, the customer may incur losses and other additional expenses. If the
transactions with FX derivative financial instruments are carried out for the
purposes of gaining profit, the customer should be aware that such transactions are
subject to high risk. The client may incur unlimited losses as the result of
unfavorable exchange rate fluctuations.

Options

General Information

Options are derivatives, which create an obligation for the seller of an option and
give a right (but not an obligation) to the buyer of the option to buy (call option) or
sell (put option) the contractual amount of underlying assets at a specified price at
any date from the contract date to the maturity date (American option) or on the
maturity date

The option buyer pays a premium to acquire an option. The amount of premium
paid depends on the volatility of the underlying asset (exchange rate, interest rate,
equity or equity index price, commodity and price), time till maturity of the option,
the option’s agreement strike price, as well as on other factors.

Related Risks

The seller of an option contract assumes the financial risks in order to provide to
the buyer the right to request the execution of the contract.

Risks assumed by the customer in case of entering into the options agreement can
vary considerably, depending on whether the customer is the buyer or the seller of
the option. When buying a call or put option the option buyer pays the seller a
premium, and his costs do not exceed the premium paid.
The option seller receives the payment i.e. the option premium from the buyer, and
his income is limited to the amount of premiums received. In certain cases, when
making the option sale transaction, the customer must provide a guarantee or
collateral in the amount required by the bank. In case of unfavorable changes in the
market prices the Bank shall be entitled to request the customer to increase the
guarantee or collateral provided earlier. If the client does not make the increase
mentioned above, the Bank has the right to terminate the transaction before due
date. If the transaction is terminated prior to maturity, the customer may incur
losses and other additional expenses.

If option sale transactions are carried out for the purposes of gaining profit, the
customer should be aware that such transactions are subject to high risk. In case of
adverse fluctuations of exchange rates the customer may incur substantial losses.

Interest rate swaps

General Information

Interest rate swaps are agreements, according to which the cash flow based on a
fixed interest rate, for the calculation of which the notional principal amount is
used, is being replaced by cash flows based on a floating interest rate, for the
calculation of which the same notional principal is used, or vice versa.

Related Risk

To make the interest rate swaps, it is not always required to reserve the full cash
value of the concluded transaction at the time of the transaction. In certain cases,
when making the transaction, the customer must provide a guarantee or collateral
in the amount required by the bank. In case of adverse changes in the market prices
the Bank shall be entitled to require the increase of the guarantee or collateral
provided by the customer earlier. If the client does not make the increase specified
above, the Bank has the right to terminate the respective transaction before due
date.
 If the transaction is terminated before due date, it is revaluated at market rates. If
the customer is a fixed-rate payer and the interest rate market has come down, then
the transaction will have a negative value in most cases, and the customer upon the
bank's request will have to cover the full amount on the transaction early
termination date. Consequently, if the transaction is terminated before the due date,
the customer may incur losses and other additional expenses.

Commodity swaps

General Information

Commodity swaps are agreements, under which the cash flow based on a fixed
price, for the calculation of which the notional value of the goods is used, is being
replaced by cash flows based on a floating price, for the calculation of which the
same notional value of the goods is used, or vice versa.

Related Risks

If the transactions are concluded for the purpose of making a profit, the price at
the moment of execution may differ from the price fixed at the transaction date,
and the customer may incur substantial losses.

Entering into commodity swaps the customer has to pay attention to the
underlying commodity prices, which can fluctuate differently than commodity
derivative’s prices.

The funds equal to the total value of the deal made do not necessarily have to be
reserved at the moment of closing the transaction. In certain cases, when entering
into the transaction the customer must provide a guarantee or collateral in the
amount required by the bank. In case of adverse changes in the market prices the
Bank shall be entitled to require the increase of the guarantee or collateral provided
by the customer earlier. If the client does not make the increase specified above,
the Bank has the right to terminate the respective transaction before due date. If the
transaction is terminated prior to maturity, the customer may incur losses and other
additional expenses.

Functions of financial instruments

(1) Mobilization of Savings and their Channelization into more Productive
Uses:
Financial market gives impetus to the savings of the people. This market
takes the uselessly lying finance in the form of cash to places where it is really
needed. Many financial instruments are made available for transferring finance
from one side to the other side. The investors can invest in any of these instruments
according to their wish.

(2) Facilitates Price Discovery:

The price of any goods or services is determined by the forces of demand and
supply. Like goods and services, the investors also try to discover the price of their
securities. The financial market is helpful to the investors in giving them proper
price.

(3) Provides Liquidity to Financial Assets:

This is a market where the buyers and the sellers of all the securities are available
all the times. This is the reason that it provides liquidity to securities. It means that
the investors can invest their money, whenever they desire, in securities through
the medium of financial market, they can also convert their investment into money
whenever they so desire.

4) Reduces the cost of Transactions:

Various types of information are needed while buying and selling securities.
Much time and money is spent in obtaining the same. The financial market makes
available every type of information without spending any money. In this way, the
financial market reduces the cost of transactions.

Classification
Classification of financial assets

An entity shall classify financial assets as subsequently measured at

amortized cost, fair value through net assets/equity or fair value through
surplus or deficit on the basis of both:

(a) The entity’s management model for financial assets and

(b) The contractual cash flow characteristics of the financial asset.

A financial asset shall be measured at amortized cost if both of the following

conditions are met:

(a) The financial asset is held within a management model whose objective is to
hold financial assets in order to collect contractual cash flows and

(b) The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.

A financial asset shall be measured at fair value through net assets/equity if

both of the following conditions are met:

(a) The financial asset is held within a management model whose objective is
achieved by both collecting contractual cash flows and selling financial assets and

(b) The contractual terms of the financial asset give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.

For the purpose of applying:

 (a) Principal is the fair value of the financial asset at initial recognition. Provides
additional guidance on the meaning of principal.

(b) Interest consists of consideration for the time value of money, for the credit
risk associated with the principal amount outstanding during a particular period of
time and for other basic lending risks and costs, as well as a profit margin provides
additional guidance on the meaning of interest, including the meaning of the time
value of money.

A financial asset shall be measured at fair value through surplus or deficit

unless it is measured at amortized cost in accordance at fair value through net
assets/equity. However an entity may make an irrevocable election at initial
recognition for particular investments in equity instruments that would
EXPOSURE DRAFT, FINANCIAL INSTRUMENTS otherwise be measured
at fair value through surplus or deficit to present subsequent changes in fair
value in net assets/equity.

Option to Designate a Financial Asset at Fair Value through Surplus or

Deficit:

An entity may, at initial recognition, irrevocably designate a financial asset as

measured at fair value through surplus or deficit if doing so eliminates or
significantly reduces a measurement or recognition inconsistency (sometimes
referred to as an ‘accounting mismatch’) that would otherwise arise from
measuring assets or liabilities or recognizing the gains and losses on them on
different basis.

Classification of Financial Liabilities:

An entity shall classify all financial liabilities as subsequently measured at

amortized cost, except for:

(a) Financial liabilities at fair value through surplus or deficit. Such liabilities,
including derivatives that are liabilities, shall be subsequently measured at fair
value.
 (b) Financial liabilities that arise when a transfer of a financial asset does not
qualify for derecognition or when the continuing involvement approach applies.
Paragraphs 26 and 28 apply to the measurement of such financial liabilities.

(c) Financial guarantee contracts. After initial recognition, an issuer of such a

contract shall subsequently measure it at the higher of:

(i) The amount of the loss allowance determined in accordance with

(ii) The amount initially recognized less, when appropriate, the cumulative
amount of amortization recognized in accordance with the principles of IPSAS 9.

(d) Commitments to provide a loan at a below-market interest rate. An issuer of

such a commitment shall subsequently measure it at the higher of:

(i) The amount of the loss allowance determined in accordance

(ii) The amount initially recognized less, when appropriate, the cumulative
amount of amortization recognized in accordance with the principles of IPSAS 9.

(e) Contingent consideration recognized by an acquirer in a public sector

combination to which IPSAS 40 applies. Such contingent consideration shall
subsequently be measured at fair value with changes recognized in surplus or
deficit.

Option to Designate a Financial Liability at Fair Value through Surplus or

Deficit:

An entity may, at initial recognition, irrevocably designate a financial liability as

measured at fair value through surplus or deficit when permitted by or when doing
so results in more relevant information, because either:

(a) It eliminates or significantly reduces a measurement or recognition

inconsistency (sometimes referred to as ‘an accounting mismatch’) that would
otherwise arise from measuring assets or liabilities or recognizing the gains and
losses on them on different basis or

(b) A group of financial liabilities or financial assets and financial liabilities is

managed and its performance is evaluated on a fair value basis, in accordance with
a documented risk management or investment strategy, and information about the
group is provided internally on that basis to the entity’s key management personnel
for example, the entity’s governing body and chief executive officer.

Embedded Derivatives

An embedded derivative is a component of a hybrid contract that also includes a

non-derivative host—with the effect that some of the cash flows of the combined
instrument vary in a way similar to a stand-alone derivative. An embedded
derivative causes some or all of the cash flows that otherwise would be required by
the contract to be modified according to a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index, or other variable, provided in the case of a non-
financial variable that the variable is not specific to a party to the contract. A
derivative that is attached to a financial instrument but is contractually transferable
independently of that instrument, or has a different counterparty, is not an
embedded derivative, but a separate financial instrument.

Hybrid Contracts with Financial Asset Hosts:

If a hybrid contract contains a host that is an asset within the scope of this
Standard, an entity shall apply the requirements to the entire hybrid contract.

Other Hybrid Contracts:

If a hybrid contract contains a host that is not an asset within the scope of this
Standard, an embedded derivative shall be separated from the host and
accounted for as a derivative under this Standard if, and only if:

(a) The economic characteristics and risks of the embedded derivative are
not closely related to the economic characteristics and risks of the host

(b) A separate instrument with the same terms as the embedded derivative
would meet the definition of a derivative; and

(c) The hybrid contract is not measured at fair value with changes in fair
value recognized in surplus or deficit (i.e., a derivative that is embedded in a
financial liability at fair value through surplus or deficit is not separated).
If an embedded derivative is separated, the host contract shall be accounted for in
accordance with the appropriate Standards. This Standard does not address whether
an embedded derivative shall be presented separately in the statement of financial
position.

Reclassification:

When and only when, an entity changes its management model for financial
assets it shall reclassify all affected financial assets in accordance with

An entity shall not reclassify any financial liability.

The following changes in circumstances are not reclassifications for the purposes:

(a) An item that was previously a designated and effective hedging

instrument in a cash flow hedge or net investment hedge no longer qualifies as
such;

b) An item becomes a designated and effective hedging instrument in a

cash flow hedge or net investment hedge; and

(c) Changes in measurement in accordance.

Measurement

Initial Measurement

At initial recognition, an entity shall measure a financial asset or financial

liability at its fair value plus or minus, in the case of a financial asset or financial
liability not at fair value through surplus or deficit, transaction costs that are
directly attributable to the acquisition or issue of the financial asset or financial
liability.

When an entity uses settlement date accounting for an asset that is subsequently
measured at amortized cost, the asset is recognized initially at its fair value on the
trade date.

Subsequent Measurement of Financial Assets

After initial recognition, an entity shall measure a financial asset in accordance

 (a) Amortized cost;

(b) Fair value through net assets/equity; or

(c) Fair value through surplus or deficit.

An entity shall apply the impairment requirements to financial assets that are
measured at amortized cost in accordance to financial assets that are measured at
fair value through net assets/equity in accordance

An entity shall apply the hedge accounting requirements (for the fair value hedge
accounting for a portfolio hedge of interest rate risk) to a financial asset that is
designated as a hedged item.

Subsequent Measurement of Financial Liabilities

After initial recognition, an entity shall measure a financial liability in

accordance.

An entity shall apply the hedge accounting requirements to a financial liability

that is designated as a hedged item.

Fair Value Measurement Considerations

In determining the fair value of a financial asset or a financial liability for the
purpose of applying this Standard, IPSAS 28 or IPSAS 30, an entity shall apply
Appendix A.

The best evidence of fair value is quoted prices in an active market. If the
market for a financial instrument is not active, an entity establishes fair value by
using a valuation technique. The objective of using a valuation technique is to
establish what the transaction price would have been on the measurement date in
an arm’s length exchange motivated by normal operating considerations. Valuation
techniques include using recent arm’s length market transactions between
knowledgeable, willing parties, if available, reference to the current fair value of
another instrument that is substantially the same, discounted cash flow analysis and
option pricing models. If there is a valuation technique commonly used by market
participants to price the instrument and that technique has been demonstrated to
provide reliable estimates of prices obtained in actual market transactions, the
entity uses that technique. The chosen valuation technique makes maximum use of
market inputs and relies as little as possible on entity-specific inputs. It
incorporates all factors that market participants would consider in setting a price
and is consistent with accepted economic methodologies for pricing financial
instruments. Periodically, an entity calibrates the valuation technique and tests it
for validity using prices from any observable current market transactions in the
same instrument (i.e., without modification or repackaging) or based on any
available observable market data.

The fair value of a financial liability with a demand feature (e.g., a demand
deposit) is not less than the amount payable on demand, discounted from the first
date that the amount could be required to be paid.

Monetary Gold and SDRs:

Monetary gold and SDRs, issued by the IMF, are the only financial assets for
which there are no corresponding financial liabilities.

Monetary gold: Monetary gold consists only of standard bullions of gold held by
the central bank or government as part of official reserves. Monetary gold,
therefore, can be a financial asset only for the central bank or government.
Transactions with monetary gold are operations on purchase and sale of gold by
authorities implementing monetary policy. These transactions are carried out
between the central banks only or between the central banks and international
financial organizations. For commercial banks, standard bullions of gold are not
treated as monetary gold. Gold denominated deposits are treated as financial assets
and classified as “gold”. Assets denominated in gold, which are not treated as part
of official reserves, are classified as nonfinancial assets. Gold and gold
denominated deposits held by nonfinancial units and financial corporations (other
than the central bank) are treated as nonmonetary gold. Operations on gold carried
out by other sectors of economy are treated as operations on acquisition of values
and disposal, and it is treated as nonfinancial asset.

SDRs: SDRs are international reserve assets7 created by the IMF and allocated to
member countries to supplement existing official reserves. SDRs are not treated as
the IMF’s liability. SDRs are held only by the IMF member countries and by a
limited number of international financial organizations. SDR holdings are held
exclusively by official authorities, which are normally the central banks.
Transactions in SDRs between the IMF members or between the IMF and its
members are treated as financial transactions. SDR holdings represent
unconditional rights to holders to obtain foreign exchange or other reserve assets
from other IMF members.

Currency and Deposits

Currency and deposits are the most liquid financial assets consisting of notes
and coins in circulation, all types of deposits in national currency and foreign
currency.

Currency:
Currency represents notes and coins in circulation, which are of fixed nominal
values and have no dates of repayment. Issued notes and coins are considered
liabilities of the central bank. Generally, currency is used for making payments.
For statistical purposes, it is always necessary to distinguish between notes and
coins issued by resident and nonresident central banks, i. e. separate national
currency from foreign currency. If national currency is the country’s (the central
bank’s) liability, foreign currency is other countries’ liability. All sectors of
economy and nonresidents can hold as an asset, but only monetary authorities or
central banks are authorized to issue it. In many countries, only national currency
is included in monetary aggregates, as only the national currency can be used
directly for (local) transactions between residents. In some countries, however,
foreign currency circulates along with national currency, and hence it is important
in the view of monetary policy to consider foreign currency in circulation. Some
countries issue gold and other precious metal-made coins, which theoretically can
be used as a means of payment. Normally, such coins are held for numismatic
value. If not in active circulation, such coins should be classified as nonfinancial
assets.

Deposits:

Deposits include all claims on the central bank and other depository
corporations, represented as bank deposits. In some cases, other financial
corporation’s may also accept deposits. Deposits of depository corporations can
fall into two categories: transferable deposits and other deposits (nontransferable
deposits). Normally, separate sub-categories are used for deposits denominated in
national currency and for those in foreign currency.

Transferable deposits:

Transferable deposits are deposits (in national and foreign currency) that are:

i) subject to payment on demand at par and without penalty or restriction,

ii) Directly usable for making payments by payment orders, checks, cards or other
payment facilities, or otherwise usable as a means of payment or circulation.
Transferable deposits comprise transferable deposits with resident and nonresident
financial corporations.

This category comprises also deposits that allow direct cash withdrawals but
not direct transfers to third parties. All sectors of economy and nonresidents (the
rest of the world) can open and operate transferable deposit accounts.

Other (nontransferable) deposits:

Sub-category of other deposits comprises all types of deposits (in national and
foreign currency), other than the transferable deposits. Other deposits are financial
intermediaries’ deposits or liabilities represented by evidence of deposit that
cannot be used for making payments at any time. These are not exchangeable with
cash or transferable deposit without certain restrictions or penalty. Use of these
deposits is subject to certain restrictions:

• Subject to payment after a certain period of time or at any moment, provided

certain costs are incurred

, • cannot serve as an instrument for making direct payments,

• Other restrictions (frozen accounts, pledged assets, etc.) can occur. All sectors of
economy and nonresidents (the rest of the world) can open and operate such
accounts.

Categories of other deposits typically represent:

• Time deposits,
 • Nontransferable deposits denominated in foreign currency,

• Repurchase agreements that is included in the national measures of broad

money.

Securities Other Than Shares:

Securities other than shares are negotiable instruments in the financial market
serving as evidence that units issuing such instruments have assumed to obligations
settle by means of providing cash, other financial instrument or some other item of
economic value. Securities included in this category are different from shares since
these do not vest the security holder with the ownership right over the issuer.
Common types of securities are government treasury bills, government bonds,
corporate bonds and debentures, commercial paper, certificates of deposits issued
by depository corporations and similar other instruments that are normally sold in
financial markets. Loans or liabilities that have become negotiable de facto should
also be classified under this category.

A security provides evidence of financial claim on its issuer, and specifies

the schedule for interest payments and principal repayments. In the monetary
statistics, securities are classified as follows:

• Coupon basis securities, whose interest or coupon payments are made during the
life of the instrument, and the principal is repaid at maturity;

• Amortized basis securities, whose interest and principal payments are made in
installments during the life of the instrument;

• Discount, or zero coupon, basis securities, that are issued and allocated at a price
below the face value and repaid at maturity on face value;

• Deep discount basis securities, that are issued and allocated at a price below face
value, and the principal and a substantial part of the interest is paid at maturity;

• Indexed basis securities, which tie the amount of interest and/or principal
payment to a reference index such as a price index or an exchange rate index.
 Preferred shares that pay a fixed income but do not provide ownership right
over the issuer are classified as securities other than shares. Bonds that are
convertible into shares should also be classified under this category.

Securitization of financial asset is sometimes used in the creation of securities

other than shares. Securitization represents the issuance of securities that are
backed by financial assets such as mortgage loans, claims on credit card holders
and other types of loans. Such financial assets continue to be shown in the balance
sheet as assets of the acquirers, while the issuers record their respective liabilities
as securities.

Bankers acceptance is treated as a financial asset even though no funds may

have been exchanged or moved. A banker’s acceptance involves the acceptance by
a financial corporation of a bill of exchange to pay a specific amount at a specified
date. The banker’s acceptance represents an unconditional claim on the part of the
holder and an unconditional liability on the part of the accepting bank.

An alternative classification of short-, medium- and long-term securities other

than shares is also implemented as follows:

Short-term securities - this sub-category comprises securities with maturity of

one-year or less.

Medium-term securities – criteria for classifying securities under this sub-category

depend on practices applied in financial markets of the given country. Normally,
this sub-category includes securities with maturity from 1 to 5 years.

Long-term securities - this sub-category comprises securities with maturity longer

than those of short- and medium-term securities.

Borrowings:

Normally, borrowings are not considered as a separate financial instrument.

Borrowing is carried out through other financial instruments, for example, through
loans, deposits, etc. Nevertheless, because of peculiarities of Armenian Law,
borrowings in Armenia can be treated as a separate finical instrument, as these are
source of funds for credit institutions. According to Armenian Civil Code, the
lender gives the borrower money under the loan agreement, and the borrower
undertakes to return the received amount to the lender as and when specified by the
agreement. If the maturity date is not specified or it is specified as demand, the
amount of the loan shall be returned within thirty days upon the lender's request,
unless otherwise provided by the agreement. Thus, the borrowings as well as
deposits can be both demand and time.

Opposed to time deposits, borrowings are less liquid, because lender's claim
on collection of loan is due to some restrictions, unless otherwise provided by the
agreement. In a borrowing transaction, the lender will earn interest against the
amount provided.

Loans:

Loans are financial assets that are:

• created when a creditor lends funds directly to a debtor (borrower),

• evidenced by non-negotiable documents.

This sub-category of financial assets comprises all loans and advances (except
accounts receivable/payable, which are treated as a separate sub-category of
financial assets) extended to various sectors of the economy by financial
corporations, governments, and, in some countries, by other sectors.

Short-term loans:

Short-term loans normally involve loans with maturity of one year or less.
However, for reconciliation of different practices between the countries, short-term
loans can be defined including loans with maturity of up to two years. All loans
that will mature upon request are classified as short-term, even if it is expected that
these loans will not be repaid within one year.

Medium-term loans:

Depending on practices applied in countries, loans with maturity from 1 to 5

years are classified as medium-term loans.

Long-term loans:
 Long-term loans include the loans with maturity that exceeds those of short- and
medium-term loans. According to statistical classification, repo agreements,
financial leasing, factoring operations and other similar agreements are classified
under the category of loans.

A repurchase agreement (repo) is an arrangement involving the sale of

securities by one party to another with a commitment to repurchase the same or
similar securities of the same volume on a specified future date. The party that
buys securities retains the right of carrying out transactions with repo-securities
until the repurchase (resale) date, and should resell similar securities to the other
party at expiry of the agreement. In this agreement, the condition of repurchase
makes the repo agreement similar to collateralized loans rather than to purchase
and sale of securities. Therefore, the seller of securities should continue to reflect
the sold securities in its balance sheet. However, as repo agreements contain a
component of purchase and sale of securities, in some cases, they are recorded as
both “lending” and “purchase and sale of securities”. This practice is applied also
in the banking system of the Republic of Armenia.

Swap agreements:

Though swap agreements are treated as financial derivatives, they can in some
cases be closer to repurchase agreements, depending on the way these are
implemented and the terms of the given transaction.

The forms of swap agreements are:

Gold swaps are forms of repurchase agreements. They occur when gold is
exchanged for foreign exchange at a certain price, with a commitment to
repurchase the gold at a fixed price on a specified future date. Gold swaps should
be recorded as collateralized loans. The collateralized gold should remain on the
balance sheet of the original owner (monetary gold - in case of the Central Bank).

The Central Bank operates currency swaps when the parties agree to exchange
Armenian dram for foreign currency on spot terms provided that the forward
exchange rate is not specified but the initial cost of transaction in Armenian drams
is specified instead, including swap interest rate as provided by the agreement.
Thus, currency swap stands very close to the loan pledged by foreign currency or
to the foreign currency repurchase agreements.

Leasing operations:

Leasing involves an agreement whereby a party (lesser) conveys to the other

party (lessee) the right to use certain inventory (building, premises, equipment, etc)
for a specified period and on agreed terms. Normally such an arrangement
presumes periodic payments for the equipment under use in the duration of its
usage. Objects of leasing operations may include fixed assets such as vehicles,
equipment, technological facilities, and means of transport, information systems
and other similar facilities.

Present economic practice provides for different types of leasing, each of which
has its peculiarity. However, the common forms of leasing are operating lease and
financial lease. Only financial lease, which is close by its nature to loan, is
classified under the sub-category of loans.

Operating lease is an agreement on current leasing. Normally, the period of this

agreement is shorter than the period of usage (amortization) of the leased asset.
Thus, the fee stipulated in the agreement does not cover full value of the asset;
therefore, the asset can be leased for several times. Specificity of operating lease
lies in premature termination of the agreement by the lessee. Common objects of
the operating lease include non-durable items (computers, copiers, various
organizers, etc.) and equipment requiring constant technical maintenance (cars,
airplanes, railroad and sea transport).

Basically, financial lease represents an alternative method of financing

acquisition of fixed assets (basically vehicles and equipment). It is a long-term
agreement between a lesser and a lessee whereby the lesser acquires the vehicles
and equipment and supplies them to the lessee. The lessee obliges to pay periodical
payments during the course of the agreement to cover all expenses of the lesser,
including full value of equipment, additional expenditures and interests (income).
Specificity of financial lease lies in third-party participation, relatively longer
period of the agreement, which is equal to the life of the equipment.
 There is another peculiarity of financial lease whereby all risks and rewards
related to ownership rights over the specific asset are actually transferred from the
lesser - the legal owner of the goods - to the lessee, the user of the goods. This
implies that change of ownership has de facto occurred, and the lesser has acquired
a financial claim, instead of its property, on the lessee. Therefore, financial leasing
statistically is classified as a loan.

As was noted, financial leasing is an alternative financing for acquisition of

fixed assets. But, unlike the traditional ways of acquiring funds (bank loan,
issuance of securities, etc.), leasing operations are not shown in the lessee’s
balance sheet, since from a legal point of view, the owner of the asset remains the
leasing company that calculates depreciation and pays respective ownership taxes.
An enterprise that takes loan bears an obligation (i.e. repayment of the loan)
similar to an enterprise that acquires equipment does (i.e. lease fee).

Factoring:

Factoring is obtaining of creditor’s rights for payment documents by a bank (a

factor) created on provisions of trade credit for selling goods and services between
economic units. This is also accompanied by accounting, information, insurance
and other services. Parties in factoring operations include the factor-bank,
customer of the factor bank, i.e. the supplier (original lender) and the payer
(debtor). The supplier conveys legal claim on its customer to the factor-bank to
receive payments by way of transfer of such claim.

Objects of factoring may include

i) Financial claims that are overdue (existing claim), and

ii) Financial claims to be generated at a future date (future claim).

Banks, other credit institutions and licensed commercial organizations can be

involved in factoring agreements.

Factoring operations may contain the following terms:

• Full or partial advance payments against liabilities in the form of factoring loan
by the factor-bank, with the right to reclaim the loan from the supplier;
• Acceptance of the supplier’s credit risk without the right to reclaim the amount,
the factor-bank makes advance payment for liabilities that should be reimbursed by
the debtor against payment documents;

• Acceptance of the supplier’s credit risk when the factor-bank makes no advance
payment but guarantees full payments on a specific date;

• Management of factoring loan, by collecting liabilities;

• Book-keeping of the supplier’s all transactions or a part of them, during the

course of the factoring agreement.

Essentially, factoring is a type of loan, whereby the relevant organizations

acquire the supplier’s receivables and collect them from the debtor.

Shares and Other Equity:

Shares are financial instruments that represent or provide evidence on

ownership rights of the holders over enterprises or organizations, including
financial institutions. Shares and other equity comprise all instruments and records
acknowledging, after the claims of all creditors have been met, claims on the
residual value of a corporation (companies, corporations). Normally, these
instruments entitle the holders both of distributed profits of enterprises or
organizations, and the residual value of the assets in the event of liquidation.
Ownership of equity is usually evidenced by shares, stocks, participation's and
similar documents. This category also includes preferred shares that provide for
participation in the residual value on dissolution of an enterprise.

Dividends are a form of property income to which shareholders become

entitled. Shares do not provide predetermined property income. Nonetheless,
dividends on preferred shares are determined in advance.

Types of equity are:

• Ordinary shares that provide for ownership right in an enterprise or

corporation;

• preferred shares that provide right for claim over residual value of an
enterprise,
 • Equity participation in limited liability companies.

In the context of the monetary statistics, financial corporations’ capital in the

form of shares and other equity is divided into separate groups as follows:

• Funds contributed by owners include total amount from the initial and any
subsequent issuance of shares or other forms of ownership of corporations
(statutory fund).

• Retained earnings constitute all after-tax profits that have not been distributed
to shareholders or appropriated as general or special reserves.

• General or special reserves are appropriations of retained earnings for special

purposes.

• Revaluation reserves are the bank’s unrealized profit/loss due to change in

market value of fixed assets, foreign currency, securities, and precious metals.

• SDR allocation represents the SDRs allocated to central banks by the IMF.

Other Accounts Receivable/ Payable:

Accounts receivable/payable includes trade credits, advances and other

receivables or payables. Trade credits comprise trade credit extended directly to
buyers of goods and services (enterprises, government, NPISHs, households, and
nonresidents). Advances are prepayments made for work that is in progress or for
purchase of goods and services. Any agreement, which does not assume direct
payment by cash or other financial instrument to purchase goods or services, will
create a trade credit extended by the seller to the buyer. Here, it does not involve
loans acquired to finance the trade credit since these credits are classified under the
category of loans. This category includes only direct trade credits and advances.

This category includes also items such as debtors and creditors, tax liabilities
and other accounts receivable/payable.

Contingent and Derivative Instruments:

Contingent Instruments:
 There are forms of contractual financial arrangements in which a financial
claim depends on a certain condition or conditions. Such transactions normally do
not have a transferable value.

Although contingent instruments are not directly included in the monetary

statistics, the compilation of summary information on such instruments may be of
importance in analyzing a country’s or a sector’s financial position and relations,
since such instruments could in future give rise to acquisition of various assets or
creation of liabilities that might notably affect financial flows and overall condition
of the given entity. In some cases, a need for statistical information on the potential
liabilities of entities, reflected in contingent instruments, may arise for country’s
policymaking analysis. This kind of statistics is more appropriate to collect and
classify by guarantee providers, unlike the other cases, when collection and
compilation are made by types of instruments.

Contingent financial instruments include guarantees, financial commitments,

letters of credit, financial collateral, lines of credit, etc. Claims or liabilities on all
these instruments will arise only if certain conditions are met. For instance, the
bank will make a payment on a guarantee only if the party, which is recipient of
the guarantee, fails to meet its liabilities. Payments on the letter of credit will be
made in the event when the respective documents are presented. Collateralized
financial assets may become the bank’s property if the party that has sold them is
unable to repurchase them. Line of credit will become a financial assets or liability
only if the funds are actually advanced.

Classification of contingent instruments depends on the nature of a specific

instrument and peculiarities of its usage in the given country.

Guarantees:

Guarantee involves an obligation by the economic entity to assume the other

entity’s financial obligation if that other party defaults. To issuer, a guarantee is not
treated as a financial liability as far as the party, to whom the guarantee has been
issued, has not shown its inability to meet such a liability. Therefore, until
availability of this condition, letters of guarantee will be recorded as off-balance
sheet items.
 Guarantees can be provided by central banks, governments, financial
corporations and, in some cases, other organizations. These can be of certain
importance also in the context of classification of other financial instruments. For
instance, securities backed by the government guarantee may be classified in a way
other than common securities.

In the context of the monetary statistics, liabilities are always classified as the
liability of the sector that has assumed such, and not the liability of the issuer of
guarantee, unless the issuer de facto acquires a liability to make payment.

For a correct reflection of government’s relationships with other sectors, it is

sometimes advisable to view guarantees issued by the government as a liability.

Letters of Credit:
A letter of credit is an obligation to make payment against documents
received. The amounts to be paid upon receipt of the documents become liabilities
of the bank. Letters of credit are used to finance international trade operations.

While importing/exporting goods, resident enterprises will open letters of

credit with Armenian resident banks that service them. These banks are obliged to
pay amounts of the trade contracts (or present a demand for payment) to their
foreign counterpart in the event the delivery and other documents are received as
stipulated in the letter of credit. The receipt of the delivery and other documents is
a stipulation under which the resident bank acquires an obligation or claim over the
foreign bank.

Financial Commitments:
Financial commitments involve contracts between institutional units by which
the entities make arrangements on specific financial transactions to be carried out
in some future time. The party assuming liabilities usually is obliged to provide
financial assets to the other party if specific conditions are met. Unlike the letters
of guarantee whereby the issuer of guarantee assumes liability of an entity, the
issuer of commitment will be responsible for fulfillment of the terms of the
contract, in case of the commitments. Nonfinancial commitments will not be
treated as financial instruments.
 Commitments can be of various form and nature, therefore, it is very hard to set
up a common approach of assessing the rights and obligations defined within these
commitments. Although not treated as financial assets, assessment of common
types of commitments can be important for analysis and evaluation of potential
assets and liabilities. Lines of credit and overdrafts are the most common financial
commitments.

A line of credit and/or overdraft provide the borrower with a standby guarantee
for the funds within a specific limit and for a predetermined period. Nonetheless,
such funds will not be treated as financial assets until the de facto extension of
loans.

Pledged Financial Assets:

There is a common practice to provide loans against a certain financial asset

taken as collateral. The residual maturity of the pledged asset should be longer than
the duration of the loan. Securities, deposits, currency, shares, and similar assets
can qualify as pledged financial assets against loans. Financial assets are returned
to the original owner as the loan is repaid. Thus, the risks associated with change in
market value of pledged financial asset will stay with the original owner thereof
(the borrower) throughout the period of the collateralized loan agreement.

Considering that the lender bank is not deemed the owner of the pledged
financial asset as far as the borrower has not acknowledged his inability to repay
the loan, such assets cannot be posted in the balance sheet of the bank. Instead
extended loans are accounted as financial assets.

Loans, accrued interests and receivables written off the balance sheet are very
similar to contingent instruments. Although these claims are not treated as bank’s
assets, they can generate income if the borrower repays the liabilities, which have
been regarded as bad.

Financial Derivatives:

Financial derivatives make an integral part of international financial markets.

The derivatives’ markets began to develop rapidly since the early 1980s, and had a
substantial influence on behavior of financial markets. A number of questions on
how the monetary and macroeconomic issues are affected by derivatives remain
unanswered due to rapid growth of financial markets, lack of the relevant statistics,
and the absence of well-structured theories. Policymakers should have a clear
understanding of transactions with derivatives, as well as realize and evaluate the
links between derivatives and ordinary financial markets.

Financial derivatives are financial instruments that are linked to specific assets
(other financial instruments, goods). By nature, these instruments are similar to
contingent instruments. Claims and liabilities related to financial instruments will
arise after a specific period of time. In this case, contingency of an instrument
relates only to the time regardless of occurrence of any other event or condition.
Derivative instruments are not considered a financial claim or liability for the
holder thereof at the given moment. However, financial derivatives can be traded
in the market and thus they will obtain a market value, which will depend on the
market price of the underlying financial or nonfinancial asset. Thus, the price of a
derivative instrument “derives” from the price of the underlying asset. In the event
when the contract price of the underlying financial asset is preferable to the current
market price, the derivative would have a positive market value. If a financial
derivative instrument has a market value it must be recorded in the balance sheet as
a financial asset.

In the context of the monetary and financial statistics of Armenia, accounting of

derivatives in banks’ balance sheets depends on the level of deepness of the
financial market. The derivative instruments are not yet widely used in the country,
as the financial market and the derivatives’ market, in particular, are
underdeveloped. The share of financial derivatives in the financial market of
Armenia is negligible. Moreover, because of no circulation in the market, the
derivative instruments do not have market value. Nevertheless, the recording of
these transactions is made in the balance sheets of financial corporations. Balance
sheet reflects the real value of the derivative instrument, that is the difference
between the contract and market prices of the underlying asset (financial or real)
times contract volume. Depending on the difference between contract and market
prices (either positive or negative) the corresponding positions on derivative
instruments can be reflected in both asset and liability accounts.

Financial derivatives fall into the following groups:

 Forwards, options and swaps.

Forward:
In a forward contract, the counterparties agree to exchange, on a specified date, a
specified quantity of an underlying item (financial or real asset) at an agreed-upon
contract price. Execution of a forward contract is mandatory but only in the case of
expiry of the period specified in the contract. Each of the counterparties has both
claim and liability upon execution. The net value of the instrument (difference
between claims and liabilities) is zero.

Option:

The buyer of an option acquires the right but not the obligation to purchase or
sell a specific asset. Options too, contain contingency: the acquirer of an option
may not wish to exercise it. The buyer pays a certain amount to the seller of the
option and thus acquires the right but not the obligation to sell or purchase a
specified item at an agreed-upon price in a specified period. The buyer of an option
can sell the option contract, i.e. the right to exercise the option, whereby the option
obtains a market value. The statistical recording of options should be carried out in
the same way as for the forwards.

Swap:

A swap represents a spot purchase (sale) of a financial asset with a condition of

forward sale (purchase). The swap operation presented in this section definitely
differs from the one presented in paragraph 3.5.3, which is operated mainly by the
CBA. Swap agreement is a type of a forward, in which the parties agree to
exchange different currencies, that is to buy (sell) any currency for another
currency in spot market and concluding at the same time a repurchase agreement
on sale (purchase) of these currencies in forward market at prices determined
beforehand, pursuant to the rules specified.

Derivatives can be linked up not only to financial assets but also to certain
goods. The liquidity of nonfinancial derivatives vis-à-vis financial derivatives is
lower. This however does not rule out the possibility of purchase and sale of the
nonfinancial derivatives. The statistical recording of nonfinancial derivative
instruments is carried out in the same way as for the financial derivatives.
 Irrespective of the degree of development of the derivatives market the statistical
recording thereof is of great importance in the context of assessing impact of
potential risks on banks and on the monetary policy. Both contingent and
derivative instruments indicate the potential claims or liabilities of the bank that
might change its financial condition dramatically. Therefore, it is necessary to
draw a due attention to issues concerning development, classification, accounting
and statistical reflection of such instruments.

Variable Rate Financial Instruments

There are two main types of financial instrument under which interest payable
might vary over the instrument’s life:

Those where interest is programmed to vary in accordance with an underlying

measure that reflects the cost of borrowing (such as LIBOR) – as variations in
interest rates cannot be predicted, these loans are accounted for as fixed interest,
until the rate actually changes. At this point, the loan will be reassessed against the
new schedule of cash flows that will now take place over the remaining term and a
new amortization schedule established. However, if there are no significant
additional costs that have been added to the fair value on initial measurement, the
new amortization schedule should be the same as the new amounts of interest
payable under the contract.

Those where the variation in the interest payable is programmed at the start of the
contract (such as a stepped interest loan) – as these variations can be predicted,
they should be programmed into the calculation of the effective interest rate, which
will then spread the incidence of interest more fairly across the life of the liability.
„ Other types of liability that might have variable payments, such as those where
there is an option to charge a higher rate of interest that might or might not be
exercised (e.g. certain types of LOBOs) or where variations might be linked to a
variable that does not reflect the cost of borrowing (e.g. a derivative).

Expected Life and Cash Flows of a Financial Instrument

The calculation of the effective interest rate and amortized cost at initial
measurement is required to be carried out using estimates of the cash flows and the
life of an instrument. Authorities are required to make their best assessment of
what these might be at the time that a liability is taken on and to make any
necessary adjustments when these estimates need to be revised.

This process has the following features:

1) All the contractual terms should be considered, including any for early
repayment and other options.
2) Where there are options in a contract, these would have been assessed for a
separate treatment as embedded derivatives when the contract was taken out.
In most cases in local government, the embedded derivative will be closely
related to the debt host and not accounted for separately. Where the option is
accounted for separately as an embedded derivative, it is not taken into
account in the estimation of cash flows, which are then scheduled on the
basis that the option is not available. For example, if the embedded
derivative relates to early repayment, the effective interest rate would have
been calculated on the basis that the instrument will be held for its full term.
3) Where there are uncertainties as to future economic conditions that cannot
reasonably be predicted (the most obvious example being future interest
rates), then changes in these conditions should not be programmed into
projections of cash flows until they become likely. In many cases, such as
changes in interest rates, this will not be until they actually occur.
4) Authorities may have experience of particular instruments that will allow
them to estimate that the instrument will have a shorter term than that in the
contract. For local government, the most reasonable assumption is that an
instrument will be held for its full term unless the authority has a specified
intention to repay/call in early or reliable experience of similar instruments
being derecognized before the full term.
5) It is important that best estimates are made at the initial measurement
because the effective interest rate of an instrument is not changed once it has
been calculated. Where estimates change, the initial effective interest rate is
used to assess the impact rather than itself being recalculated.
6) When estimated cash flows change, the impact is assessed by discounting
these new cash flows at the original effective interest rate. Where this results
in a difference between the new amortized cost and the carrying amount in
the Balance Sheet, this gain or loss is taken to the Surplus or Deficit on the
Provision of Services.
Derecognition of a Financial Liability
 Derecognition is the stage at which a financial liability is removed from the
Balance Sheet – the point at which obligations under the contract are
discharged, cancelled or expire. This will usually be the date that an
authority settles its liabilities to the creditor, e.g. by repaying a loan.
 It is becoming more common for authorities to have debt repaid on their
behalf. For instance, where an authority transfers housing stock and the net
proceeds are less than the PWLB loans the authority is deemed to have
outstanding in relation to capital investment in that stock, the government
will pay these loans off on behalf of the authority and finance any premiums
payable. These loans will be derecognized at the point at which the PWLB
releases the authority from its contractual obligations.
 The consideration paid to extinguish a liability will normally equal its
carrying amount. Even where charges to the Surplus or Deficit on the
Provision of Services in the Comprehensive Income and Expenditure
Statement have not been based on contractual cash flows the effective
interest rate, the calculations will usually ensure that the amortized cost of
the liability at the end of the contract is the principal repayable. If there is a
difference between the carrying amount of the extinguished financial
liability and the consideration paid to extinguish it, this difference will be
debited or credited to the Surplus or Deficit on the Provision of Services.
 In local government, differences most commonly arise when loans are
repaid early and premiums become payable or discounts become receivable.
These circumstances are discussed. The following example illustrates the
treatment of a gain arising from the cancellation of a loan.

Types of Financial Instruments in India

In India there are many families who save money on monthly basis from their
income to make their future more secure. They simply put all their money in the
savings account or in their locker, but the question is, Their money remains in the
bank account over the years and the amount remains somewhat same. What can we
do to multiply our savings? INVEST. Many people confuse savings with
investment, both the things are different and both have different purposes.

Money kept aside to meet the future need is called savings. Savings can be done
to buy a new vehicle, to buy a new electronic device or anything for that matter.

Investments help you to meet your long time needs and larger financial goals.
The main reason why people refrain from investing is that there is some amount of
risk attached to it. The higher the risk, the higher is the return on investment and
investing smartly can multiply your savings and can help you to fulfill your
financial goals in the long-run.

For investments there are many financial instruments that are available in
India where the investor can invest to get the best returns. Choosing the right type
of financial instrument to match your purpose is very essential.

1. Equities:

Equities are the type of security where ownership in a company can be

represented. Equities are traded (bought and sold) in the stock market. In India
share trading actively takes place in NSE and BSE. Some people trade on a daily
basis as their profession, whereas normal investors invest in stock market and hold
a stock for couple of months/years to book their profit.

Equities give a good amount of return on investment among all the other
instruments, but there is also a substantial risk in investing in equities, if you invest
without knowledge. Getting trained in stock trading and analysis can help you
earn good amount of side income.

Equity= Assets- Liabilities

Owner's equity:

When starting a business, the owners fund the business to finance

various operations. Under the model of a private limited company, the business
and its owners are separate entities, so the business is considered to owe these
funds to its owners as a liability in the form of share capital. Throughout the
business's existence, the equity of the business will be the difference between its
assets and debt liabilities; this is the accounting equation.

When a business liquidates during bankruptcy, the proceeds from the assets are
used to reimburse creditors. The creditors are ranked by priority, with
secured creditors being paid first, other creditors being paid next, and owners being
paid last. Owner's equity (also known as risk capital or liable capital) is this
remaining or residual claim against assets, which is paid only after all other
creditors are paid. In such cases where even creditors could not get enough money
to pay their bills, the owner's equity is reduced to zero because nothing is left to
reimburse it.

Accounting:

In financial accounting, owner's equity consists of the net assets of an entity. Net
assets are the difference between the total assets and total liabilities. Equity appears
on the balance sheet (also known as the statement of financial position), one of the
four primary financial statements.

The assets of an entity can be both tangible and intangible items. Intangible assets
include items such as brand names, copyrights or goodwill. Tangible assets include
land, equipment, and cash. The types of accounts and their description that
comprise the owner's equity depend on the nature of the entity and may include:

 Share capital (common stock)

 Preferred stock
  Capital surplus

 Retained earnings

 Treasury stock

 Stock options

 Reserve

Book value:

The book value of equity will change in the case of the following events:

 Changes in assets relative to liabilities. For example, a profitable firm

receives more cash for its products than the cost at which it produced these
goods, and so in the act of making a profit, increases its retained earnings,
therefore its shareholders' equity.

 Issue of new equity in which the firm obtains new capital increases the total
shareholders' equity.

 Share repurchases, in which a firm returns money to investors, reducing on

the asset side its financial assets, and on the liability side the shareholders'
equity. For practical purposes (except for its tax consequences), share
repurchasing is similar to a dividend payment. Rather than giving money to
all shareholders immediately in the form of a dividend payment, a share
repurchase reduces the number of shares outstanding.

 Dividends paid out to preferred stock owners are considered an expense to

be subtracted from net income (from the point of view of the common share
owners).

 Other reasons - Assets and liabilities can change without any effect being
measured in the Income Statement under certain circumstances; for example,
changes in accounting rules may be applied retroactively. Sometimes assets
bought and held in other countries get translated back into the reporting
currency at different exchange rates, resulting in a changed value.

Shareholders' equity:
 When the owners are shareholders, the interest can be called shareholders' equity;
the accounting remains the same, and it is ownership equity spread out among
shareholders. If all shareholders are in one and the same class, they share equally
in ownership equity from all perspectives. However, shareholders may allow
different priority ranking among themselves by the use of share classes and
options. This complicates analysis for both stock valuation and accounting.

Shareholders' equity is obtained by subtracting total liabilities from the total

assets of the shareholders. These assets and liabilities can be:

 Equity (beginning of year)

 + net income

 − dividends

 +/− gain/loss from changes to the number of shares outstanding.

 = Equity (end of year) if one gets more money during the year or less or not
anything

Equity stock:

Equity investments:

An equity investment generally refers to the buying and holding of shares

of stock on a stock market by individuals and firms in anticipation of income
from dividends and capital gains. Typically, equity holders receive voting rights,
meaning that they can vote on candidates for the board of directors (shown on
a diversification of the funds and to obtain the skill of the professional fund
managers in charge of the fund). An alternative, which is usually employed by
large private investors and pension funds, is to hold shares directly; in the
institutional environment many clients who own portfolios have what are
called segregated funds, as opposed to or in addition to the pooled mutual fund
alternatives.
 A calculation can be made to assess whether an equity is over or underpriced,
compared with a long-term government bond. This is called the yield gap or Yield
Ratio. It is the ratio of the dividend yield of equity and that of the long-term bond.

Market value of equity stock:

In the stock market, market price per share does not correspond to the equity per
share calculated in the accounting statements. Equity stock valuations, which are
often much higher, are based on other considerations related to the
business' operating cash flow, profits and future prospects; some factors are
derived from the accounting statement. While accounting equity can potentially be
negative, market price per share is never negative since equity shares represent
ownership in limited liability companies. The principle of limited liability
guarantees that a shareholder's losses may never exceed his investment.

Merton model:

Under the "Merton model", the value of stock equity is modeled as a call
option on the value of the whole company (including the liabilities), struck at the
nominal value of the liabilities. Here, the equity market value depends on the
volatility of the market value of the company assets.

This is the first example of a "structural model", where bankruptcy is modeled

using a microeconomic model of the firm's capital structure - it
treats bankruptcy as a continuous probability of default, where, on the random
occurrence of default, the stock price of the defaulting company is assumed to go
to zero. This microeconomic approach, to some extent, allows us to answer the
question "what are the economic causes of default?"(Structural models are distinct
from "reduced form models" - such as Jarrow–Turnbull - where bankruptcy is
modeled as a statistical process.)

Equity in real estate:

The notion of equity as it relates to real estate derives from the concept
called equity of redemption. This equity is a property right valued at the difference
between the market value of the property and the amount of any mortgage or other
encumbrance.

2. Futures and Options:

Derivatives Instruments are a Financial Contracts which solve the primary

purpose of hedging the asset price fluctuation. It Derives value from its underlying
assets, hence it is called as derivatives. There are various types of derivative used
worldwide, but in India currently we have Two Exchange Traded Derivatives
namely Futures and Options

Apart from hedging, trader uses these instruments as it offers better leverage,
convenience in holding Long and Short positions, Low Cost to trade compared to
Equity delivery and enable traders to profit sideways movement using options.

1. Futures contracts gives Rights with Obligations to the Traders, hence the
open position is settled on the maturity date.

2. Option Contracts gives Rights to the Buyer with NO OBLIGATION, hence

he needs to pay some premium to the seller to get the contract. Seller of the
Option has the Obligations

1. Call Option Buyers – Has Rights to Buy

2. Put Option Buyers – Has Rights to Sell

A Futures Contract is a legally binding agreement to buy or sell any underlying

security at a future date at a pre determined price. The Contract is standardized in
terms of quantity, quality, delivery time and place for settlement at a future date (In
case of equity/index futures, this would mean the lot size). Both parties entering
into such an agreement are obligated to complete the contract at the end of the
contract period with the delivery of cash/stock.

Each Futures Contract is traded on a Futures Exchange that acts as an

intermediary to minimize the risk of default by either party. The Exchange is also a
centralized marketplace for buyers and sellers to participate in Futures Contracts
with ease and with access to all market information, price movements and trends.
Bids and offers are usually matched electronically on time-price priority and
participants remain anonymous to each other. Indian equity derivative exchanges
settle contracts on a cash basis.

To avail the benefits and participate in such a contract, traders have to put up an
initial deposit of cash in their accounts called as the margin. When the contract is
closed, the initial margin is credited with any gains or losses that accrue over the
contract period. In addition, should there be changes in the Futures price from the
pre agreed price, the difference is also settled daily and the transfer of such
differences is monitored by the Exchange which uses the margin money from
either party to ensure appropriate daily profit or loss. If the minimum maintenance
margin or the lowest amount required is insufficient, then a margin call is made
and the concerned party must immediately replenish the shortfall. This process of
ensuring daily profit or loss is known as mark to market. However, if and ever a
margin call is made, funds have to be delivered immediately as not doing so could
result in the liquidation of your position by the Exchange or Broker to recover any
losses that may have been incurred.
When the delivery date is due, the amount finally exchanged would hence, be the
spot differential in value and not the contract price as every gain and loss till the
due date has been accounted for and appropriated accordingly.

For example, on one hand we have A, who holds equity of XYZ Company,
currently trading at Rs 100. A expects the price go down to Rs 90. This ten-rupee
differential could result in reduction of investment value.

3. Mutual Funds:
 In India mutual funds are very popular because the initial investment is very less
and moreover risk is also diversified. Mutual fund allows a group of people to
invest money together and have it professionally managed. Mutual funds also have
sound regulation so there is no question of insecurity. There are many thematic
mutual funds to choose from, the risk and return ratio may differ according to the
plan.

Advantages and disadvantages to investors:

Mutual funds have advantages and disadvantages compared to investing directly

in individual securities:

Advantages

 Low Cost: Affordable investment option for people who do not want to
make a large initial investment.
 Increased diversification: A fund diversifies holding many securities.
This diversification decreases risk.
 Daily liquidity: Shareholders of open-end funds and unit investment trusts
may sell their holdings back to the fund at regular intervals at a price equal
to the net asset value of the fund's holdings. Most funds allow investors to
redeem in this way at the close of every trading day.
 Professional investment management: Open-and closed-end funds hire
portfolio managers to supervise the fund's investments.
  Ability to participate in investments that may be available only to larger
investors. For example, individual investors often find it difficult to invest
directly in foreign markets.
 Service and convenience: Funds often provide services such as check
writing.
 Government oversight: Mutual funds are regulated by a governmental body.
 Transparency and ease of comparison: All mutual funds are required to
report the same information to investors, which makes them easier to
compare to each other.

Disadvantages:

Mutual funds have disadvantages as well, which include:

 Fees
 Less control over timing of recognition of gains
 Less predictable income
 No opportunity to customize

Share classes:

A single mutual fund may give investors a choice of different combinations of

front-end loads, back-end loads and distribution and services fee, by offering
several different types of shares, known as share classes. All of them invest in the
same portfolio of securities, but each has different expenses and, therefore, a
different net asset value and different performance results. Some of these share
classes may be available only to certain types of investors.

Typical share classes for funds sold through brokers or other intermediaries in the
United States are:

 Class A shares usually charge a front-end sales load together with a small
distribution and services fee.
  Class B shares usually do not have a front-end sales load; rather, they have a
high contingent deferred sales charge (CDSC) that gradually declines over
several years, combined with a high 12b-1 fee. Class B shares usually
convert automatically to Class A shares after they have been held for a
certain period.
 Class C shares usually have a high distribution and services fee and a
modest contingent deferred sales charge that is discontinued after one or two
years. Class C shares usually do not convert to another class. They are often
called "level load" shares.
 Class I is usually subject to very high minimum investment requirements
and is, therefore, known as "institutional" shares. They are no-load shares.
 Class R are usually for use in retirement plans such as 401(k) plans. They
typically do not charge loads, but do charge a small distribution and services
fee.

No-load funds in the United States often have two classes of shares:

 Class I shares do not charge a distribution and services fee

 Class N shares charge a distribution and services fee of no more than 0.25%
of fund assets.

Turnover:
Turnover is a measure of the volume of a fund's securities trading. It is expressed
as a percentage of average market value of the portfolio's long-term securities.
Turnover is the lesser of a fund's purchases or sales during a given year divided by
average long-term securities market value for the same period. If the period is less
than a year, turnover is generally annualized.

4. Bonds:

Bonds are issued by both private and government entities to raise their working
capital. Bonds are also called as fixed income instruments. Central and state
government both issue bonds and private organizations like private companies,
private financial instruments also issue bonds to garner their funds. Government
bonds carry the lowest amount of risk but they take time to give the returns. As far
as return on investment is concerned private bonds offers betters returns but they
carry high amount of risk.

Collateralised Bond Obligations--A bond that uses high-yielding junk bonds

as collateral.
Commercial Paper -- A short-term commercial bond that matures in less than three
months.
Convertible Bond -- A bond that can be exchanged for other investment securities.
Covenant -- The specific promises the bond issuer sets in the contract.
Credit Rating -- A grade assigned to a bond to indicate how risky it is.
Debentures -- An unsecured bond not backed by collateral.
Maturity Date -- The specified date when the bond issuer must pay back the
investor's principal.
Municipal Bond -- A bond issued by a state or local government.
Treasury bond -- Long-term bonds issued by the U.S. Treasury.

5. Deposits:

Almost every Indian family has a savings account or fixed deposit or post-office
deposits. This is one of the most common ways to keep their surplus funds and to
earn with that money.

The return on investment is very low but it is almost risk free and secured.
Keeping money in deposits cannot fulfill your long term financial goal. Investing
your money smartly is very essential.
Bank Deposits:

Bank deposits are money placed into deposit accounts at a banking institution,
such as savings accounts, checking accounts and money market accounts.

Core Deposits:

Core deposits are the deposits that form a stable source of funds for a lending
bank.

Direct Deposit:

Direct deposit is the deposit of electronic funds directly into a bank account
rather than through a physical paper check.

Nonperson Time Deposit:

A nonperson time deposit account is an account held by corporate bank

customers that pays a fixed amount of interest for a specified time period.

Interbank Deposits:

In an interbank deposit, one bank holds funds on behalf of another bank.

6. Cash and cash equivalents:

All the securities that can be readily converted to cash within 3 months can be
called as cash and cash equivalents. In Case of immediate requirement the cash /
bank balance helps a lot, so it is good to create corpus in saving account which can
be used only in case of financial emergency. Gold can be purchased in Demat
format under ETF schemes, this are available in India, Traded in NSE and an
investor as buy even just 1/2 Gram