International Accounting Standards (IAS) defines a financial instrument as ‘a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity’ (32). In simple language, a financial instrument can be regarded as an asset whether tangible or intangible, that has agreed to make future cash payments in form of constant cash flows or otherwise.
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An investor is the owner of a financial instrument. Financial assets are classified into equity and debt based financial instrument. Examples of debt based financial statements is a loan made by an investor to the owner of the asset; it includes both government and corporate issued bonds and mortgage-backed securities (Fabozzi 20). Examples of equity based financial instruments are shares in ordinary and preference stocks which entails ownership of the asset.
Bond is an instrument where the government or corporate entities borrow money from investors in return for a predetermined rate of interest over a specified period of time; the principal amount is paid at the end of the maturity period. Common stocks refer to the representation of ownership of a corporation. Holders of common stock are basically the owners of a corporation; they are entitled to dividends at the end of the financial year. In the event of winding up of a company, common stockholders will only be paid if the preferred shareholders and other creditors have been paid in full.
Financial institutions are establishments which collect funds from investors and place them in as financial assets. Financial institutions include: commercial banks, security houses, investment dealers and insurance companies. These entities focus mainly on dealing with financial transactions such as accepting of deposits, taking out loans and exchange of currencies.
Financial markets refer to markets for the purchase and sale of trade assets such as stocks, bonds, bill of exchange and derivatives (Jorion 45). They work as exchanges for capital and credit. Examples of financial markets include: the New York Stock Exchange (NYSE), Forex markets and the Nairobi Stock Exchange (NSE). Financial instruments, institutions and markets are connected in the sense that, financial institutions operate in the financial markets in the trade of financial instruments.
Financial instruments are mainly of a long-term nature. The most popular type of financial instrument is stocks. Advantages of stocks include: High returns in relation to other investments, loss of stock is limited to the initial investment, they offer limited legal liability and they are very liquid (can be converted into cash easily). Stockholders benefit through capital gains and dividends. Capital gain is the increase in value of the initial investment while a dividend is a share of the profit generated by a company. The more stocks you hold the more dividends you enjoy. The question as to what company’s stock to invest in arises, it requires use of raw statistics and market reports to ascertain which stock gives a handsome return. A good decision is to invest in STI Exchange traded fund (STL-ETF).
Explain how ETFs operates?
Exchange Traded Fund is made up of a basket of securities that tracks an index and trades like a stock. Unlike a mutual fund, ETFs experience price changes continuously throughout the day. To trade in ETFs one needs a trading account. ETFs are bought and sold in the financial market, this is done through a licensed stockbroker, therefore the investor incurs brokerage fee. The broker executes the order in two ways; he can buy from another floor broker or buy from a specialist who ensures the liquidity in the shares.
The creation and redemption of ETFs is based on the investor demand. The buyers and sellers of ETFs trade on the market without involving the ETF’s manager directly. This contrasts with the trading of mutual fund shares. The ETF management company earns income in form of management fee from the owner of the ETF shares. In the face that ETFs track the index, comparisons between the value of the index and the price of the ETF shares is necessary.
If the value of the index is higher than the price of the ETF shares, the investor is advised to redeem the units. If the value of the index is lower than that of the ETF units, the investor is advised to create ETF units by depositing securities of a lower price. The number of outstanding ETF units increase on creation and reduce on redemption of ETF with no limit.
What are the risks and return from ETF investment?
Some of the risks involved with ETFs are trading risks, tracking risks and tax risk. Trading risks involves spreads, since ETFs trade like stocks, spreads are a problem. There is a direct connection between the ETF size and average spreads. Tracking risk refers to the difficulties encountered in following up on the ETF. Since ETF share prices changes throughout the day, the investor has to be certain that the ETF tracks the index well through frequent updates.
ETFs have more complex tax issues, this makes it hard for the investor to ascertain how much to pay as tax. Investments in ETF require patience and determination, an investor is required to employ an experienced licensed broker, and the investor has to be tactful in decision making. Mark and Mandy would be required to take into consideration the risks involved before making any financial decision.
What are the risks and return from investment in foreign currency bank deposits?
The use of bank deposits denominated in foreign currency is sometimes known as Dual Currency Deposit. Dual currency Deposit is a form of investment which generates higher returns than normal bank deposits. For example, the interest rate on 5-year Australian dollar deposits is 7% while the interest rate on 5-year Singapore dollar deposits is only 2.5%. Dual Currency deposit is a complex instrument and people are reluctant to invest in due to uncertainties.
Foreign currency risk is one of the major risks associated with Dual Currency Deposit; this is brought about by the consistent fluctuations in exchange rates (Jorion 48). Since Dual Currency Deposit is characterized by fixed maturity period and fixed interest rates, the investor may end up with a loss if at the end of the period the exchange rate is unfavorable. Dual Currency Deposits are popular in cases of short term rather than long term investments.
An investor should take into account the risks involved in Dual Cash Deposit and matching them with the expected returns in making investment decisions. Mark and Mandy need to accumulate a certain amount of money in 25 years; this would require careful financial planning. In view of the risks associated with bank deposits in foreign currency, Mark and Mandy need access to information and expert advice on the trends of the exchange currency market.
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Mark and Mindy are very particular that they require $16,000 a month during the 20 years after retirement. Show how they can achieve this by selecting the appropriate financial instruments
Experts suggest that investment in equities may be too cautious for an investor with more than twenty five years to retirement. In regards to a constant monthly cash inflow long term investments, investors should check on financial instruments volatility. Volatility is a measure of the dispersion of returns of a financial instrument over a specific period of time. Volatility of a financial instrument is determined through historical performances over a specified period of time.
Commonly, the higher the volatility of a security, the riskier the security. A lower volatility means that a security’s value changes steadily over a period of time. For long-term investors avoiding high stock volatility is encouraged. Long-term investors are advised to buy low-volatility stocks because they tend to fall a lot less in bear markets but rise in bull markets. In retirement investing, the investors are discouraged from over-concentration in an employer’s stock.
If bad things happen to the industry the investor is likely to lose his/her money on the investment together with his/her job. It is also mandatory not to confuse a good company with a good stock; a good company may have overvalued stock while a bad one may have undervalued stock (Fabozzi 38). Therefore, the investor requires information about the future prospects of the firm that are not understood by the market.
It is also advisable to hold more than one security at a time; a good retirement plan should be a combination of a variety of investments. Mark and Mandy should in this view invest not only the inherited money but part of their salary too, to the diverse range of financial instruments. In cases where expertise on a specific field is required, an investor is advised to employ professionals such as a financial planner and a legal representative. The planner identifies areas of strong economic growth and advices the investor on the appropriate actions.
Post-retirement financial planning is important as it secures the future, provides a good return on investments, and enables one to achieve various goals and living a financially secure life. Patience, skill, wisdom and common sense must be exercised in building toward proper financial security.
Fabozzi, Frank. The handbook of financial instruments. London: John Wiley and Sons, 2002. Print.
Jorion, Philippe. Financial Risk Manager Handbook. London: John Wiley and Sons, 2009. Print.