ACCT 3340 Lecture Notes - Lecture 16: Underlying, Financial Instrument, Market Risk

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Primary financial instruments: include most basic financial assets and liabilities (receivables, payables), equity instruments (shares) Derivative instruments: they derive (get) their value from an underlying primary instrument, index or non-financial item. Where there is a market for the derivative, it is easier to value. Create rights and obligations that have the effect of transferring, between parties to the instrument, one or more financial risks that are inherent in an underlying primary instrument. Transfer risks without either party having to hold any investment in the underlying. Value changes in response to the underlying instrument. Measured at fair value with gains and losses booked through net income. Many layers of costs relating to the use of derivatives: Transaction costs normally incurred, bank/service charges, brokerage fees, insurance premiums. Visible costs charged by an intermediary or other party. Activity of researching, analyzing and executing the transactions. Use of too many complicated financial instruments increases complexity of financial statements and reduces the transparency and understandability.

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