Fundamentals of Financial Instruments. Sunil K. Parameswaran

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      Unrequited or unilateral transfers may be perceived as follows. Inward transfers are like purchases by a company, where the supplier has extended a 100% discount. On the other hand, outward transfers are like sale transactions, where the company concerned has offered a 100% discount.

      Clearly, the balance of payments must always balance. Thus, a current account deficit must be matched by a surplus in the capital account or by a depletion of reserves, or both. A surplus in the capital account would indicate that the country's foreign liabilities have gone up, or, in other words, that it has borrowed from abroad. In the case of a company, if the net income for a period is negative, then either its liabilities must correspondingly increase, or its assets must decline. However, If the net income were to be positive, it would manifest itself as a reduction in the entity's liabilities or as an increase in its assets.

      While analyzing the BOP, it is customary to study several subcategories of accounts. We will now look at two of the most important sub-classifications.

THE BALANCE OF TRADE

      The balance of trade is equal to the total of merchandise exports and imports. It consists of all raw materials and manufactured goods bought, sold, or given away. If it shows a surplus, it indicates that exports of goods from the country exceed imports into it, whereas if it shows a deficit, it would obviously indicate that imports exceed exports. The balance of trade is a politically sensitive statistic. If a country's balance of trade shows a deficit, industries that are being hurt by competition from abroad will typically raise a hue and cry about the need for a level playing field to take on the foreign competition.

THE CURRENT ACCOUNT BALANCE

      The current account balance refers to the total of the following accounts:

       Exports of goods, services, and income

       Imports of goods, services, and income

       Net unilateral transfers

      Services include tourism, transportation, engineering, and business services. Fees from patents and copyrights are also recognized under this category. Income includes revenue from financial assets, such as dividends from shares and interest from debt securities. Unilateral transfers are one-way transfers of assets, such as worker remittances from foreign countries and direct foreign aid.

The net foreign assets of a country may be defined as its foreign assets minus its foreign liabilities. If the net foreign assets are positive, then the nation may be deemed to be a creditor nation; otherwise, it is a debtor nation. The change in the current account is equal to the change in net foreign assets.

      If a country has a current account surplus, either its foreign assets will increase or its foreign liabilities will decline. On the contrary, if a country has a current account deficit, either its foreign assets will decline or its foreign liabilities will increase.

      Opinion: Finance can be made incredibly complicated in the form of exotic securities and sophisticated mathematical models. But the core issue in an economy is that some entities have more than what they want, whereas others want more than what they have. The former transfer their surplus wealth to the latter, which issues securities in return. The securities themselves, and the businesses that deploy the resources, are vulnerable to different types of risks. Consequently, risk mitigation instruments, such as financial derivatives – which, incidentally, can also be used to speculate on risk – come into existence. But if we sift through the theories and the formulas, the underlying core transaction is a transfer from a Surplus Budget Unit (SBU) to a Deficit Budget Unit (DBU).

FINANCIAL ASSETS

“A financial asset is a claim against the income or wealth of a business firm, a household, or a government agency, which is represented usually by a certificate, a receipt, a computer record file, or another legal document, and is usually created by or is related to the lending of money.”¹

      A financial claim is born in the following fashion. Whenever funds are transferred from a surplus budget unit (SBU) to a deficit budget unit (DBU), the DBU will issue a financial claim. It signifies that the party transferring the funds has a claim against the party accepting the funds. The transfer of funds from the lender may either be in the form of a loan to the borrower, or may constitute the assumption of an ownership stake in the venture of the borrower. In the case of loans, the claim constitutes a promise to pay the interest either at maturity or at periodic intervals and to repay the principal at maturity. Such claims are referred to as debt securities, or as fixed income securities. In the case of fund transfers characterized by the assumption of ownership stakes, the claims are known as equity shares. Unlike debt securities, which represent an obligation on the part of the borrower, equity shares represent a right to the profits of the issuing firm during its operation, if there is a profit, and to such assets that may remain after fully paying all creditors in the event of liquidation of the venture. It should be remembered that claims are always issued by the party that is raising funds and held by parties providing the funds.

To the issuer of the claim, the claim is a liability, for it signifies that it owes money to another party. To the lender, or the holder of the claim, it is an asset, for it signifies that the holder owns an item of value. The total of financial claims issued must be equal to the total financial assets held by investors, and every liability incurred by a party must be an asset for another investor.

      Why do investors acquire financial assets? Financial assets are essentially sought after for three reasons.

       They serve as a store of value or purchasing power.

       They promise future returns to their owners.

       They are fungible, in the sense that they can be easily converted into other assets and vice versa.

      In addition to debt securities and equity shares, we will also focus on the following assets:

       Money

       Preferred shares

       Foreign exchange

       Derivatives

       Mortgages

MONEY

      Money is a financial asset because all forms of money in use today are claims against some institution. Contrary to popular perception, money is not just the coins and currency notes handled by economic agents. For instance, one of the largest components of money supply today is the checking account balances held by depositors with commercial banks. From the banks' standpoint, these accounts obviously represent a debt obligation. Banks have the capacity to both expand and contract the money supply in an economy. Currency notes and coins also represent a debt obligation of the central bank of the issuing country, like the Federal Reserve in the United States. In today's electronic age, newer forms of money have emerged, such as credit, debit, and smart cards.

      Money performs a wide variety of important functions, thus it is sought after. In a modern economy, all financial assets are valued in terms of money and all flows of funds between lenders and borrowers occur via the medium of money.

MONEY AS A UNIT OF ACCOUNT OR A STANDARD OF VALUE

      In the modern economy, the value of every good and service is denominated in terms of the unit of currency. Without money, the price of every good