Complex financial instruments are used by companies to manage risk, raise capital, and minimize the cost of capital and taxes. Complex financial instruments include derivatives (such as options and warrants, forwards, and futures) and hybrid/compound instruments (such as convertible debt, debt with detachable warrants, and perpetual debt). The value of a derivative is derived from the value of its underlying primary financial instrument, index, or non-financial item. Hybrid/compound instruments have both debt and equity characteristics, and may have a debt component as well as an equity component. Stock options are often included in employee share-based compensation plans, which are also discussed in this chapter.
Primary financial instruments include most basic financial assets and financial liabilities such as accounts receivable, accounts payable, and long-term debt. The value of these instruments is based on their contractual right to receive or obligation to pay cash in the future. In contrast, derivative financial instruments “derive” their value from an underlying primary financial instrument, index, or non-financial item. Derivatives are defined as financial instruments that create rights and obligations that have the effect of transferring, between parties to the instrument, ...