FR - Complex Financial Instrument (Overview)

Question 1

What is defined as a complex financial instrument

Answer 1

• Provide the same contractual right to receive or deliver a financial asset, structured in a way that requires additional analysis of their nature
  Includes: Convertible debt
  Perpetual debt
  Convertible preferred shares
  Mandatorily redeemable or retractable preferred share

Question 2

What are the types of the complex financial instrument

Answer 2

1. Convertible debt:
   Compound financial instrument - a financial instrument that includes at least two elements
   Convertible securities - are financial instruments that enable their holder to exchange one type of financial instrument for another
   Convertible debt - has attributes of both debt and equity, exchange the debt for a predetermined number of common share

Question 3

Explains the two types of convertible bonds

Answer 3

1. Debt - the bonds pay interest at the specified rate and pay the face amount at maturity
2. Equity - The option the exchange the bond for a common share
   - Residual value method - values for the liability component is determined first, by determine FV bond

Question 4

Explain Perpetual debt

Answer 4

• Provides the holder with a contractual right to receive payment of interest on account at fixed dates into the future
• Consider an entity that has issued a perpetual bond at its face value of 1,000,000 Coupon of 4% annually. Transaction cost = 40000. Bond issue = $960000

Question 5

Explain what convertible preferred shares

Answer 5

• Preferred shares that provide the investor with the option to convert the preferred shares to common shares at a specified point in time
• Necessary to account for preferred shares as part debt and part equity

Question 6

What is the difference between redeemable and retractable preferred shares

Answer 6

Redeemable shares - issuer of shares must redeem the shares on or before a specified date, substance financial instrument, rather than its legal form
- There is an obligation on the part of the issuer to redeem the shares at or after particular date for a fixed determinable amount

Retractable share - is an obligation on the part of issuer to provide another financial asset to the holder if the holder requires the entity to redeem the share

Question 7

Explain what warrants are and how they are used with bonds and shares

Answer 7

Warrant - Form of option that entitle the holder to buy or sell the underlying shares of the issuing entity at a fixed price on specified date or if warrant expires
Bonds with warrant - Recorded as a liability and warrant recorded as equity
Shares with a warrant - Shares are preferred are classified as a liability

Question 8

Explain what derivatives are

Answer 8

• Values change in response to a rate such as interest rate, commodity price, foreign exchange rate, credit rating
• REquires non-initial investment

Question 9

Provide what option is used for and contract

Answer 9

Option - contract that have gives the holder the right to buy and sell a specified amount of something for a specified price and for specified period of time
Put option - gives the holder the right to sell an underlying instrument such as common share to a corporation
Call option - Gives the holder the right to buy a specified instrument, such as common share at a specified price

Forward contract - a contract between parties to buy or sell an asset on specific date in the future, specified price
Future contract - forward contract at standardized price and settlement date, traded at stock market