Financial Instruments
Financial Instruments
Financial instruments are either a real or virtual document representing a legal agreement involving some sort of monetary value. Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments. Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer. Derivative instruments are financial instruments which derive their value from some other financial instrument or variable. They can be divided into exchange traded derivatives and over-the-counter (OTC) derivatives. Alternatively they can be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorized into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category. Combining the above methods for categorization, the main instruments can be organized into a matrix is depicted in Appendix A.
The cost of capital is determined by the expectations of lenders and shareholders. Lenders issue debt and shareholders own equity. The cost of capital is a combination of the cost of debt and the cost of equity. The cost of capital is the amount of money that corporations need to pay back to their lenders and shareholders to satisfy their expected return. It is essential to know the nature of their expectations. Lenders and shareholders have different expectations because they assume different levels of risk. Lenders hold less risk than shareholders when both are investing in the same company. The lender loans money to a company, the company...
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