2.5.3 Financial InstrumentsFinancial instruments are tradable assets of any kind embedded with a perceived monetary value. These instruments act as a midway in transferring money from surplus parties to deficit party. Where, these instruments are legal obligations in which one party agrees to transfer something of value, usually money to another party at a future date, under certain conditions. These instruments can be cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash or another financial instrument.The main characteristics of the financial instruments includes;• Risk – The future outcome of the instruments is not known with certainty.
Example – uncertainty of the price, default risk of the capital or income stream. • Liquidity – Ease and speed at which a financial instrument can be turned into cash without a significant delay and loss. • Real Value certainty – Effect of changes of the general price level (Inflation or deflation)• Terms of maturity – Financial Instruments vary widely according to their maturity. Current deposits at bank have zero term to maturity, as they can be withdrawn on demand.• Currency denomination – The return on non-domestic instruments are affected on the appreciation or depreciation of the relevant exchange rates.• Divisibility – The degree to which the instruments can be subdivided into small units for transaction purposes.
Example – Stocks, Unit trustFinancial instruments of Sri Lanka can easily categorized as money market instruments and capital market instruments as in section 2.5.2 above. Treasury bill/bondsThese are government short term debt securities that have a maturity period of up to one year.
The CBSL public debt department issues treasury bills on behalf of the government of Sri Lanka for its short term financial needs. Treasury bills are initially issued by the CBSL to the primary dealers operating in the primary market on the day of the Treasury bill auction conducted weekly by CBSL. These are considered very liquid assets since it can be traded easily in the secondary market for all the other investors including the general public. Treasury bills are issued in maturities of 91 days, 182 days and 364 days.
These are zero coupon securities issued at a discount to the face value at a market determined interest rate but earns no periodic interest payment. Treasury bills have only one stream of cash flow viz, the face value paid at the end of the maturity period. The difference between the purchase price (purchase at a discount to the face value) and the face value is the interest income to the owner of the security.
Treasury bonds are medium and long-term government securities and are issued in maturities ranging from 2 years to 20 years. Unlike treasury bills, T-bonds are interest bearing securities which pays interest bi-annually.Treasury bills and bonds are guaranteed by the Government and are the safest of all investments, as they are default risk free.Repurchase (Repo)/ Reverse Repurchase (Reverse – Repo)This is an agreement between the two parties where, one party sell the security/ securities for cash to another party with the agreement of buying the same or similar securities back at a fixed price on a specified future date. The difference between the sale price and the repurchase price is the interest income.
These securities are usually overnight basis, where the seller buys back the security on the following day.Reverse Repo are the opposite of the Repo purchases when viewed from the buyers side of the securities. That is, it is an agreement in which the buyer make with the seller of the security to sell the security back at a fixed price on a specified future date.Commercial Papers (CP)These are non-collateralized (unsecured) securities issued by the private companies to finance short-term fund requirements by banks or other financial intermediaries. These securities are normally issued by high credit rated and well established corporates with additional bank guarantees of payment.
CPs are usually sold at a discount, although some are interest bearing.Fixed DepositsFixed deposits or term deposits are a facility provided by banks to its customers to deposit cash at a higher interest rate (higher rate of interest than a regular savings account) for a specified period of time. That is the depositor freeze the money for a specific time period until the maturity. The minimum maturity period of these deposits are three months.
Not like in a regular savings account, the deposit holder cannot withdraw cash out of the fixed deposit until its maturity or they can perhaps withdraw money with prior notice but subjected to some terms and conditions specific to the bank.