Previous Year Question

A financial instrument is generally a contract that gives rise to a financial asset for one entity and a financial liability or equity instrument for another entity.

Statement 1 is correct. An Exchange-Traded Fund is an investment fund whose units are bought and sold on a stock exchange in the same manner as shares.

An ETF may track the performance of an index, commodity, bond or another basket of assets. The investor holds a financial asset in the form of ETF units. Therefore, an ETF is a financial instrument.

Statement 2 is incorrect. A motor vehicle is a physical or tangible asset used for transportation. It may be subject to depreciation over time.

A vehicle may be purchased through a loan or used as security for borrowing, but this does not make the vehicle itself a financial instrument. The loan agreement used to finance the vehicle may constitute a financial instrument; the vehicle remains a tangible non-financial asset.

Statement 3 is correct. A currency swap is a derivative contract under which two parties agree to exchange specified cash flows denominated in different currencies.

A currency swap may involve exchange of principal at the beginning, exchange of interest payments during the contractual period and re-exchange of principal at maturity. It creates contractual financial rights and obligations for both parties and is therefore a financial instrument.

For example, an Indian company requiring dollars and a foreign company requiring rupees may enter into a currency swap to obtain the required currencies and manage exchange-rate and interest-rate risks.