Financial Instruments

Course on Balance of Payments and International Investment Position Manual

(BPM6)

IMF-PFTACNadi

November 22-December 1

BP08

GENERAL OVERVIEW I - Introduction

Main changes from BPM5

II - Definitional issues What is a financial instrument ?

III - Classification of financial instruments Three broad categories

References: BPM6 Chapters 5, 6, and 8

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INTRODUCTION Changes in the treatment of specific instruments:

Special Drawing Right allocations to be classified as a liability.

So-called unallocated gold accounts to be classified as a deposit (or monetary gold if held in reserves). So gold bullion is the only financial asset in the system without a counterpart liability.

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INTRODUCTION (2)

Arrears now recorded as part of the value of the instrument and not a separate transaction. (Arrears related to Exceptional Financing are a memorandum item and are included in the “analytical presentation.”)

Employee stock options to be included in the category, “financial derivatives and employee stock options.”

Investment fund shares to be separately identified. Money market funds are separately identified as a supplementary item.

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DEFINITIONAL ISSUES What is a financial instrument ?

Financial instruments comprise the full range of financial contracts made between institutional units

Financial instruments are classified as financial assets or as other financial instruments

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DEFINITIONAL ISSUES (2) What is an economic asset ?

Economic assets are resources over which ownership rights are enforced and from which future economic benefits may flow to the owner. These benefits include:

(a) the ability to use assets, such as buildings or machinery, in production;(b) the generation of property incomes: for example, interest and dividends received by the owners of financial assets; and(c) the potential to sell and thus realize holding gains.

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DEFINITIONAL ISSUES (3) There are two categories of economic assets: non financial

and financial assets

Distinction between non financial and financial assets: a financial asset is a claim on another party. The existence of this counterpart liability distinguishes financial assets from other economic assets, such as land, dwellings, machinery and equipment, etc.

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DEFINITIONAL ISSUES (4) Scope of financial assets in BPM6

Financial assets consist of claims and the gold bullion component of monetary gold.

What is the gold bullion component of monetary gold ?: when held as monetary gold, gold bullion is a financial asset that is not created by an instrument and that does not represent a claim on another entity. It is considered to be a financial asset because of its role as a means of international payments and store of value for use in reserves.

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DEFINITIONAL ISSUES (5) Other financial instruments

Besides financial assets, there are other financial instruments which are not recognized as economic assets. These other instruments are contingent assets and liabilities

Contingent assets are not recognized as economic assets because they do not give rise to unconditional requirements either to make payments or to provide other objects of value. However, by conferring certain rights or obligations that may affect future decisions, they can produce an economic impact on the parties involved.

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DEFINITIONAL ISSUES (6) Examples of contingent assets or liabilities:

One-off guarantees of payment by third parties are contingent since payment is only required if the principal debtor defaults.

Lines of credit, letters of credit, and loan commitments assure that funds will be made available, but no financial asset (i.e., loan) is created until funds are actually advanced.

“Provisions” for future liabilities or future expenditures – recorded in financial accounts but not recognized as economic assets

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Classification of financial instruments Three broad categories are used to classify financial assets and

liabilities:

(1) equity and investment fund shares,

(2) debt instruments,

(3) other financial assets/liabilities.

This classification is based primarily on the legal characteristics that describe the form of the underlying relationship between the parties to an instrument, which are also related to their liquidity and economic purpose.

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Classification of financial instruments (2)

Equity and investment fund shares  Equity Investment fund shares/units

Debt instruments  Special Drawing Rights Currency and deposits Debt securities Loans Insurance, pension, and standardized guarantee schemes Trade credit and advances Other accounts payable/receivable

Other financial assets and liabilities  Monetary gold* Financial derivatives and employee stock options

*Gold bullion has no counterpart liability. However, the counterpart liability of unallocated gold accounts is in deposits.

The detailed classification of financial assets and liabilities is harmonized with the SNA

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Equity and investment fund shares

Equity comprises all instruments and records acknowledging, after the claims of all creditors have been met, claims on the residual value of a corporation or quasicorporation.

Equity is treated as a liability of the issuing institutional unit (a corporation or other unit).

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Equity and investment fund shares (2)

Equity: Equity securities and Other equity

Equity securities comprise listed shares and unlisted shares. Listed shares are those listed on an exchange. They are also referred to as quoted shares. Unlisted shares can also be called private equity; venture capital also usually takes this form.

Other equity is equity that is not in the form of securities. It can include equity in quasi-corporations, such as branches, trusts, limited liability and other partnerships, unincorporated funds, and notional units for ownership of real estate and other natural resources.

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Equity and investment fund shares (3)

Investment funds shares

Investment funds shares are collective investment undertakings through which investors pool funds for investment in financial and/or nonfinancial assets.

These funds issue shares (if a corporate structure is used) or units (if a trust structure is used).

Investment funds include money market funds (MMF) and non-MMF investment funds.

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Equity and investment fund shares (4)

Investment fund shares: MMFs and Non-MMFs

MMFs are collective investment schemes invested primarily in money market instruments, MMF shares/units, transferable debt instruments with a residual maturity of less than one year. MMFs shares or units may be regarded as close substitutes for deposits.

Non-MMF are invested predominantly in long-term financial assets and nonfinancial assets (usually real estate). Investment fund shares or units are generally not close substitutes for deposits.

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Equity and investment fund shares (5)

Retained earnings of investment funds

Unlike equity investment, investment income attributable to the owners of investment fund shares include dividends payable to them as well as retained earnings.

This is a strong difference from BPM5, where reinvested earnings where recorded for direct investment only.

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Debt instruments Debt instruments are those instruments that require the payment

of principal and/or interest at some point(s) in the future.

Debt instruments comprise: - Special Drawing Rights, - currency and deposits, - debt securities, - loans, - insurance technical reserves and provision for calls under

standardized guarantees, - and other accounts receivable/payable

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Debt Instruments (2) The term debt instrument applies to liability and

the corresponding claim Differ from equity and investment fund shares in

nature of liability and risk Greater risk with equity, depends on economic

performance of issuer Predefined formula for obligation to pay principal and

interest. Short or long term classification may be useful

Special Drawing Rights (SDRs)

SDRs are international reserve assets. They represent unconditional rights to obtain foreign exchange or other reserve assets from other IMF members. SDRs are held only by the monetary authorities of IMF members and a limited number of international financial institutions that are authorized holders.

Holdings of SDRs by an IMF member are recorded as an asset, while the allocation of SDRs is recorded as the incurrence of a liability of the member receiving them. This is a change from BPM5.

The holdings and allocations should be shown gross, rather than netted.

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Currency and deposits Currency consists of notes and coins that are of fixed

nominal values and are issued or authorized by central banks or governments.

Deposits include all claims that are (1) on the central bank, a deposit-taking corporation other than the central bank, and, in some cases, other institutional units; and (2) are represented by evidence of deposit.

3 categories of deposits can be distinguished: transferable deposits, interbank deposits and other deposits

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Debt securities

Debt securities are negotiable instruments serving as evidence of a debt. They include bills, bonds, certificates of deposit, commercial paper, debentures, asset-backed securities, and similar instruments normally traded in the financial markets.

Debt securities include some specific instruments such as asset backed securities, stripped securities, index-linked securities, bankers acceptances.

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Debt securities (2)

Asset-backed securities, collateralized debt obligations, and collateralized mortgage obligations are arrangements under which payments of interest and principal are backed by payments on specified assets or income streams. They are used for mortgages, home equity loans, student loans, and other debts as well as pools of leased property.

Index-linked securities are those where the principal and/or coupons are linked to another non-interest item, such as a price index or exchange rate.

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Debt securities (3) Stripped securities are securities that have been transformed

from a principal amount with coupon payments into a series of zero-coupon bonds, with a range of maturities matching the coupon payment date(s) and the redemption date of the principal amount(s).

Bankers’ acceptances involve the acceptance by a financial corporation, in return for a fee, of a draft or bill of exchange and the unconditional promise to pay a specific amount at a specified date. Much international trade is financed this way.

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Loans

Loans are financial assets that (1) are created when a creditor lends funds directly to a debtor, and (2) are evidenced by documents that are not negotiable.

This category includes all loans including overdrafts, except accounts receivable/payable, which are treated as a separate category of financial assets.

Loans that have become debt securities are also excluded from loans (evidence of secondary market trading, and frequent quotations of the instrument).

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Loans (2)The category of loans includes some specific

transactions:

Financial leases Repurchase agreements (Repos) and gold swaps Debt assumption Credit and loans with the Fund

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Loans (3) Securities repurchase agreement and gold swaps

A securities repurchase agreement is an arrangement involving the provision of securities in exchange for cash with a commitment to repurchase the same or similar securities at a fixed price either on a specified future date or with an open maturity

A gold swap involves an exchange of gold for foreign exchange deposits with an agreement that the transaction be reversed at an agreed future date at an agreed gold price.

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Loans (4) Financial leases

Under a financial lease, the legal owner is shown as issuing a loan to the lessee with which the lessee acquires the asset

The asset is shown on the balance sheet of the lessee and not the lessor

The corresponding loan is shown as an asset of the lessor and a liability of the lessee

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Loans (5)

Financial leases (continued) At inception of the lease a liability is imputed for the lessee,

as counter-entry for the change of ownership of goods in the current account

The payments during the contract include not only the principal, but also interest, and FISIM (if financial intermediary is involved)

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Insurance, pension, and standardized guarantee schemes

Insurance, pension, and standardized guarantee schemes comprise:

(a) nonlife insurance technical reserves; (b) life insurance and annuity entitlements; (c) pension entitlements, claims of pension funds

on sponsors, and entitlements to nonpension funds; and

(d) provisions for calls under standardized guarantees.

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Insurance, pension, and standardized guarantee schemes (2)

Nonlife insurance technical reserves comprise:

(a) Reserves for unearned insurance premiums, which are prepayment of premiums. On an accrual basis, the premiums are earned through the policy period, so that the initial payment involves a prepayment or advance.

(b) Reserves against outstanding claims, which are amounts identified by insurance corporations to cover what they expect to pay out arising from events that have occurred but for which the claims are not yet settled.

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Insurance, pension, and standardized guarantee schemes (3)

Life insurance and annuity entitlements

Life insurance and annuity entitlements are used to provide benefits to policyholders upon the expiry of the policy, or to compensate beneficiaries upon the death of policyholders.

Therefore, these entitlements are kept separate from shareholders’ funds, and are regarded as liabilities of the insurance companies and assets of the policyholders and beneficiaries.

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Insurance, pension, and standardized guarantee schemes (4)

Pension entitlements

Pension entitlements show the extent of financial claims both existing and future pensioners hold against either their employer or a fund designated by the employer to pay pensions earned as part of a compensation agreement between the employer and employee.

The accrued obligations of pension entitlements are recognized as economic assets and liabilities, including unfunded pension schemes (para. 5.64)

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Insurance, pension, and standardized guarantee schemes (5)

Provisions for calls under standardized guarantees

Standardized guarantees are defined as those that are not provided by means of a financial derivative (such as credit default swaps), but where the probability of default can be well established

These guarantees cover similar types of credit risk for a large number of cases

Examples include export credit guarantees or student loan guarantees issued by governments

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Other accounts receivable/payable Other accounts receivable/payable consist of (i) trade

credit and advances and (ii) other

Trade credit and advances comprises (1) trade credit extended directly by the suppliers of goods and services to their customers and (2) advances for work that is in progress (or is yet to be undertaken) and prepayment by customers for goods and services not yet provided.

The other category includes liabilities for taxes, purchase and sale of securities, wages and salaries, dividends, and social contributions that have accrued but not yet paid. It also includes prepayments of those items.

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Other financial assets and liabilities

This category includes:

- Monetary gold - Financial derivatives - Employee stock options

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Other financial assets and liabilities (2)

Monetary gold Monetary gold is gold to which the monetary

authorities (or others who are subject to the effective control of the monetary authorities) have title and is held as reserve assets. It comprises gold bullion (including gold held in allocated gold accounts) and unallocated gold accounts with nonresidents that give title to claim the delivery of gold.

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Other financial assets and liabilities (3)

Allocated and unallocated gold accounts

Allocated gold accounts provide a record of title to specified gold. These accounts typically offer purchasing, storing, and selling investment grade bars and coin to order. Accounts of this type constitute full outright ownership of the metal.

In contrast, unallocated gold accounts represent a claim against the account operator to deliver gold. Unallocated accounts are the method through which much of the trading in gold is undertaken in financial markets.

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Other financial assets and liabilities (4)

Financial derivatives

A financial derivative contract is a financial instrument that is linked to another specific financial instrument or indicator or commodity and through which specific financial risks (such as interest rate risk, foreign exchange risk, equity and commodity price risks, credit risk, etc.) can be traded in their own right in financial markets.

There are two broad categories of financial derivatives: forward contracts and options.

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Other financial assets and liabilities (5)

Forward-type contracts

A forward-type contract (forward) is an unconditional contract by which two counterparties agree to exchange a specified quantity of an underlying item (real or financial) at an agreed-upon contract price (the strike price) on a specified date.

Forward-type contracts include futures and swaps. Futures are forward-type contracts traded on organized exchanges. Forward rate agreements and forward foreign exchange contracts are common types of forward-type contracts.

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Other financial assets and liabilities (6)

Option contracts

In an option contract, the purchaser acquires from the seller a right to buy or sell a specified underlying item at a strike price on or before a specified date. The purchaser of an option pays a premium to the writer of the option.

In return, the buyer acquires the right but not the obligation to buy (call option) or sell (put option) a specified underlying item (real or financial) at an agreed-upon contract price (the strike price) on or before a specified date.

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Other financial assets and liabilities (7)

Employee stock options

Employee stock options (ESOs) are options to buy the equity of a company, offered to employees of the company as a form of remuneration. ESOs are a financial instrument, recognized at the grant date.

At the time of granting, the entity receiving ESOs incurs a liability in the form of other accounts payable equal to the value of the ESOs. The value of ESOs at the time of granting provides the measure of compensation of employees that should be accrued during the granting and vesting dates.

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Other financial assets and liabilities (8)

Employee stock options

There may be a few cases where the company that issues the option is a resident of a different economy from the employee (e.g., the employer is a branch or subsidiary of the company to which the option relates)

If a stock option granted to employees can be traded on financial markets without restriction, it is classified as a financial derivative.

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