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ECFS867 Financial Instruments

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ECFS867 Financial Instruments

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Course Code: ECFS867
University: Macquarie University is not sponsored or endorsed by this college or university

Country: Australia

1. Explain and assess the characteristics and uses of various financial instruments such as forwards, futures, swaps, and options2. Analyse financial risks and develop appropriate hedging strategies to manage those risks
Investing on financial instrument is the most currently embraced business in most financial sectors in the world. Various firms prefer engaging is such type of investment that can be carried out all over the world. The firm is currently experiencing great competition from another big financial organization that offers a new investment product which has attracted a number of several investors. The firm can also manufacture its own similar product using the financial instruments as discussed in the report. In addition, the firm might face various financial risks as a result of carrying out this type of business. The risks include; market risk, operational risk, legal and regulatory risk, credit risk, liquidity risk and inflation risk. Various ways of managing the risk that the firm is likely to face is also discussed in detail and the firm is advised accordingly on how to ensure the measures that are put in place have been followed for its own benefit.
The firm is however recommended to engage is such type of investment, with all measures and strategies put in place for better outcome in the long, which basically is maximizing on profit as well as attaining a great competitive advantage. 

According to the current press release, one of the organization’s greatest competitors has brought into attention the introduction of new structured investment product.
The product is issued by HSBC Bank Australia Limited and it’s a capital protected investment product.
The product is not incorporated to HSBC but it is a liability to HSBC. Investing in this product has its own advantages and disadvantages as well (Akhmetov  2015)1.
However, the product is also subjected to various risks which need critical strategies to be implemented in order to manage the risks involved. In addition, HSBC and its related bodies corporate do not guarantee any return on investment nor repay any capital lost on investment. (Brownhilder Ngek 2017)2 This therefore concludes that, none of HSBC offers assurance in case of any investment shortcomings. 

Analysis of the product
The features of the product

The investment is issued by HSBC Bank Australia Limited and its capital protected purchase agreement.
The product investment is a liability of HSBC and no deposits is made to HSBC for the investment or any government agency or its corporate bodies.
The product is subjected to various risks of investment such as loss of income and delay in repayment of capital invested.(Ferrando, Marchica and Mura 2016)3
The performance of the investment is not guaranteed by HSBC or any of its related corporate bodies.
Once the investment matures, the return you are supposed to receive and the amount invested will be delivered inform of delivery asset. The particular delivery assets are selected on or before the maturity date by HSBC. The delivery assets can as well be sold on behalf of the investor and cash given to the investor.(Ferson 2012)4
The term for investment for the product is four years and six months.
The investment is subject to 100% capital protection at maturity 

The return on the investment

The potential  investment return is determined by the underlying index performance in the course of the investment term.
The HSBC determines the return on investment cap on the issue date which will be determined by the prevailing condition of the market, which are the underlying index volatility as well as the Australian interest rates (Kaserer and Klein 2018)5. However, no investment return will be included in the investment amount that matures, if the average level in the end will be equal or less than the original index level.  
If the return is included then the maturity amount will equal the investment amount. In addition, the issue price for investment of the product is one dollar per investment with a total minimum investment of ten thousand dollars and a minimum additional amount is one thousand dollars.

Objective of the investment
The main objective of the product is to provide Australian investors with exposure to the return potential of the Australian equities market, while offering 100% capital protection at maturity. (Kosov 2018)6
How the organization can manufacture similar products by the use of financial instruments

In the current market field, most financial institutions are embracing the use of various financial instruments such as shares, bonds and currency in order to provide an efficient flow of capital and transfer of capital for both local and international investors.
It is therefore a great idea for the organization to also manufacture an investment product that will be embraced by most investors and enabling the organization achieves a great competitive advantage in the financial field, as well as increasing its profitability.
The firm can achieve this by introducing an investment product which can be acquired by investors through exchange of shares with currency (Krylov 2018)7. An investor in this case will have to deposit minimum of one thousand dollars in exchange for the company shares.

The shares should be redeemed after a minimum period of six months. The firm on the other hand will be trading with the currency received from investors. That is, the firm can exchange currency received in respect to the market trend of foreign currency exchange to keep the flow of currency active as well as earning profit from the trade.(Kuzheliev and Nechyporenko 2018) 
After six months, the investor should be allowed to sell the shares or exchange back to the firm with currency. The firm at this point should ensure the investor gets back the equal amount of capital invested in case no profit is made to avoid investors incurring losses that could drive them away from investing in the firm.(Leote 2014)9   

Financial risks the firm would face

Financial risk mainly involves a financial business loss that occurs as a result of unstable financial market caused by fluctuation of interest rates, currency and prices of market stock.
If the firm invests in this investment product (shares), the firm is likely to face various financial risks which can either be general risk or risk of investment. The following are the common financial risks that the firm would face.(L. Kobo and C. Ngwakwe 2017)10

Market risk

This type of financial risk occurs as a result of fluctuation of the financial instrument price.
In most cases, the return on investment is basically linked to the underlying performance index.

Underlying index performance depends on equity market performance of a country. 

However, the equity price may sometimes fall or sometimes rise affecting the company shares in the end.
The company performance may also result in fluctuation of the company’s shares. (Nguyen, Nguyen and Yin 2014)11Various factors like environmental condition, political instability, economic conditions and management also affect the firm’s performance that is both internally and externally.

The investment is however subjected to risks of depreciation of the underlying index especially if there is unfavourable market condition. This will always live the firm not able to provide 100% of the capital invested. The amount that will be received at maturity in such case will be less than the amount invested with. 
Currency risk.

It is also known as foreign exchange risk or exchange rate risk. It occurs due to fluctuation in exchange rates. In this case, when the firm uses a different currency other than the normal one .
The risk therefore occurs when the exchange rate of the used currency fluctuates in relation to the base currency of the firm.
Fluctuation might cause depreciation of return in investment which in turn affects the amount of capital invested on the product.

Commodity risk

The risk occurs as a result of future market uncertainty. The uncertainty might cause commodity price to fluctuate thus exposing the firm to a great financial risk.
The firm faces such risk if it does not make proper prediction of the price of investment.

Conflict of interest

Most of the firms that invest in financial instruments prefer using financial institutions to act as its transaction or trade agent.

 This is always seen as a fair decision however it displays conflict of interest risk, which might affect either the firm itself or the investors. (Smith 2015)12

Since the financial institution makes all decision about the investment which mainly favours the institution’s own interests, most firms will be forced to follow that decision even if it leads to incurring losses in the long run.
The firm is prone to be affected by the unfavourable market condition since it wholly depends on the decision made by the financial institution.

Inflation risk
The firm is most likely to be subjected to inflation risk since the investment involves cash flow throughout the period of investment. Fluctuation of cash flow always leads to inflation, which is great risk that faces the firm. If such risk occurs, the investor will not be guaranteed full return on investment. Instead, there will be depreciation on the underlying index and amount invested will be less than expected at maturity date due to inflation. (O. Al-Smadi 2018)13
Credit risk

This is a risk that occurs when one party fails to fulfil its responsibility as agreed in the contract.
This can either be due to foreign exchange restrictions or refusal to fulfil ones obligation as agreed after the other party has made payment.
In this scenario, the investor might not fulfil the obligation of paying fully for the equivalent amount of shares given by the firm to that particular investor.

Liquidity risk
The risk occurs as a result of the firm inability to perform transaction. The firm in this case, might end up not having enough investors for the product, therefore facing liquidity risk.
Legal, tax and regulatory risk

The changes made on rules, laws and regulations as well as changes in taxation systems during an investment term, greatly affects return on investment for the firms and investors during that period.
The country keeps on changing the taxation systems, rules and laws governing its operation which exposes most firms and investors to a great risk.
Investing on shares might be adversely affected by changes made on taxation systems since this will directly affect value of the currency at that particular time.

Operational risk

This is the risk that occurs as a result of failure of the systems, the processes and people. Such failure occurs due to inadequate information, improper management of the people and the systems and lack of adequate knowledge on how to carry out the firm’s operations.
For instance, if the institution does not have its system properly placed and well managed, a withdrawal for shares might be requested and due to the ineffective systems in place, the process will end up taking long thus adversely affecting the investment.(Yildirim 2015)14 

Ways of managing the financial risk

The market risk can be managed by; first, observing carefully the market trend though one cannot be so accurate with the trend, but keen observation of how the market condition fluctuates will help minimise market risk experienced in investment. (Ray 2011)15 secondly, the firm can invest in both long term and short term investments so as to avoid loss while only concentrating on one term investment. Short term and long term investment will help cover up for each term in case of price fluctuation.
The risk of conflict of interest can be managed through the firm agreeing with the involved parties to carry out a transaction with open interest and allow decision making to be made and agreed on by both parties. Each party should be given right to decision making including the trade agent or institution. 

The firm should avoid concentrating fully on long term investment but subdivide its shares and invest some of it on a short term period and others on a long term period; this will help the firm in hedging the inflation risk.(Sandler 2010)16
In order for the firm to manage credit risk, it should ensure clear terms of the investment agreement are put in place before starting the business. The firm should also go through the credit records of the potential investors thoroughly to get to know well about the investor credit score and payment history with other firms. In addition, the firm can also use the first period of investment to build a good customer relationship that will lead to lasting trust between the parties.
The firm should carry out thorough research and identify exactly what investors want to avoid liquidity risk. 

The procedure of investment should be well analysed to avoid contradiction with the laws and regulation of the country when carrying out the transaction. This helps the firm in managing the legal and regulatory risk involved in the process of investment.
Operational risk that mainly occurs due to inadequate training of the people in the firm and improper management of the systems. This type of risk can be managed by training and providing enough knowledge to the people about the investment procedures. The systems should also be well monitored to avoid risks involved if the systems are prone to hacking.(Solarz 2017)17
Currency risk can be managed by the firm through ensuring that it carries out the transaction on the spot instead of waiting for a longer period to do the exchange. 

Commodity risk can be managed by the firm through conducting thorough market research on commodity price. The firm might also evaluate future movement of the commodity price.  

The above discussed measures of managing the financial risk will only be effective if put in practise and the firm strictly adhere to the measures in place. In addition, the firm should not only concentrate on financial risks alone, it should widely identify all the risks it’s prone to and narrow it down to make it easy to manage them all. Some elements of risks that most firms assume but affect them on one way or another are supposed to be carefully identified and categorized for easy controlling of such risks from affecting the operation of the firm. The firm should be well informed about these categories of element of risks surrounding its daily business operations. They include;

Performance, risks that affects the firms performance includes; safety, quality, legal, and compliance risk. 

Financial, involves credit risk, capital, revenue structure and cost structure risk. These risks affect the firm’s financial position.
External, includes regulatory risk which affects the firms external operations.
Strategic, the strategy of a firm can be affected by market risk, reputational risk and relational risk.


Most of the financial institutions, firms and various organizations have been identified to engage more in investing on financial instruments.
The investment is identified as the most effective way ensuring resources are utilized and profit maximized. It’s therefore recommended for firms to discover more financial instruments which can be combined to come up with a product that a firm can rely on and use it as investment products.
The firm should also keenly identify some of the risks likely to face while investing on the products identified.
Before the firm engage in offering the investment product, it should first carry out a thorough research on the risks likely to occur. Find out how the risk can be managed or mitigated and the cost incurred for managing such risks.

If the cost of managing the risk is too high, the firm should avoid investing on such a product and come up with another product that have low risk cost.(Turnbull 2009)18
The firm should also put in to consideration a long term ways of managing risks in order to cut on regular cost incurred in managing the risks in a short term basis.
Other ways of managing risks such as training should also be greatly embraced by the firm early enough to avoid future losses, which may occur as a result of inadequate knowledge. 

The firm should as well ensure a critical analysis of products before largely   investing on the products.
The return on investment of the product should be critically analysed to ensure no capital is lost on that particular investment. (Volkman Wise 2013)19


The firms that have adopted the financial instrument investment have however gained various advantages despite the shortcomings of the investment.
It is therefore advisable for this particular firm to engage largely in such investments. More production can be created and invested on it by the firm to maximize on its profit.
The risks involved with such investment can also be easily managed if the firm put the various measurements of managing financial risk at an early stage.
The firm should also keenly identify some of the risks likely to face while investing on the products identified. Before the firm engage in offering the investment 

Product, it should first carry out a thorough research on the risks likely to occur.
Find out how the risk can be managed or mitigated and the cost incurred for managing such risks .
Therefore, if the firm fully engage in this type of business, it should consider all the outcomes that will result from this type of investment and focus on gaining a higher competitive advantage, as well as maximizing on its profit.
This will only be achieved if the firm follows strictly all the measures put in place to govern the business operations. Investing in financial instruments is highly recommended for fast growth of the business.(TITMAN 2013)20 

Akhmetov, R. R. 2015. “IFRS PRINCIPAL MEASURES OF FINANCIAL STABILITY AS AN INSTRUMENT FOR INVESTMENT ANALYSIS”. Business Strategies, no. 1: 2. doi:10.17747/2311-7184-2015-1-2.
Brownhilder Ngek, Neneh. 2017. “Performance Implications Of Financial Capital Availability On The Financial Literacy – Performance Nexus In South Africa”. Investment Management And Financial Innovations 13 (2): 354-362. doi:10.21511/imfi.13(2-2).2016.10.
Ferrando, Annalisa, Maria-Teresa Marchica, and Roberto Mura. 2016. “Financial Flexibility And Investment Ability Across The Euro Area And The UK”. European Financial Management 23 (1): 87-126. doi:10.1111/eufm.12091.
Ferson, Wayne E. 2012. “Ruminations On Investment Performance Measurement”. European Financial Management 19 (1): 4-13. doi:10.1111/j.1468-036x.2012.00657.x.
Kaserer, Christoph, and Christian Klein. 2018. “Systemic Risk In Financial Markets: How Systemically Important Are Insurers?”. Journal Of Risk And Insurance. doi:10.1111/jori.12236.
Kosov, M.E. 2018. “Evaluation Of The Energy Sector’s Investment Projects As A Risk Management Instrument”. Economic Analysis: Theory And Practice 17 (5): 856-870. doi:10.24891/ea.17.5.856.
Krylov, Sergey. 2018. “Target Financial Forecasting As An Instrument To Overcome Financial Difficulties”. SSRN Electronic Journal. doi:10.2139/ssrn.3206470.
Kuzheliev, Mykhaylo, and Alina Nechyporenko. 2018. “Mechanism Of Implementation Of Regional Investment Programs As Financial Instrument Of Stimulation Of Regional Development”. Skhid 0 (6(152): 22-27. doi:10.21847/1728-9343.2017.6(152).122184.

Kobo, Kgabo, and Collins C. Ngwakwe. 2017. “Relating Corporate Social Investment With Financial Performance”. Investment Management And Financial Innovations14 (2): 367-375. doi:10.21511/imfi.14(2-2).2017.08.

Leote, Joseph A. 2014. “Financial Instrument Generation In The U.S. Financial System”. SSRN Electronic Journal. doi:10.2139/ssrn.2458563.
Nguyen, Tu, H.G. Lily Nguyen, and Xiangkang Yin. 2014. “Corporate Governance And Corporate Financing And Investment During The 2007-2008 Financial Crisis”. Financial Management 44 (1): 115-146. doi:10.1111/fima.12071.

Al-Smadi, Mohammad. 2018. “Determinants Of Foreign Portfolio Investment: The Case Of Jordan”. Investment Management And Financial Innovations15 (1): 328-336. doi:10.21511/imfi.15(1).2018.27.

Ray, Russ. 2011. “Managing Financial Risk Via Prediction Markets”. SSRN Electronic Journal. doi:10.2139/ssrn.1905097.
Sandler, Maria. 2010. “Managing Litigation And Dispute Risk In The Financial Services Markets”. Law And Financial Markets Review 4 (2): 166-169. doi:10.1080/17521440.2010.11428109.
Smith, Kurt. 2015. “The Financial Economic Risk In Financial Engineering Models”. Wilmott2015 (79): 50-55. doi:10.1002/wilm.10447.
Solarz, Jan K. 2017. “Managing Financial Risk Of Longevity”. Europa Regionum 30: 33-47. doi:10.18276/er.2017.30-03.
TITMAN, SHERIDAN. 2013. “Financial Markets And Investment Externalities”. The Journal Of Finance 68 (4): 1307-1329. doi:10.1111/jofi.12072.
Turnbull, Stuart. 2009. “Measuring And Managing Risk In Innovative Financial Instruments”. The Journal Of Credit Risk 5 (2): 87-114. doi:10.21314/jcr.2009.093.
VolkmanWise, Jacqueline. 2013. “Managing Longevity Risk: The Need For Financial Literacy And The Role Of The Financial Advisor”. Journal Of Business & Financial Affairs 02 (03). doi:10.4172/2167-0234.1000e133.
Yildirim, Ismail. 2015. “Financial Risk Measurement For Turkish Insurance Companies Using Var Models”. Journal Of Financial Risk Management 04 (03): 158-167. doi:10.4236/jfrm.2015.43013.

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