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13.1. Portfolio investment consists of international equity and debt securities not classified to either direct investment or reserve assets

13.2. The financial transactions and the overall levels of Australia’s portfolio investment assets and liabilities are illustrated in table 13.1. The following features are demonstrated in the table:

• since Australia relies on overseas funds to finance its current account deficit, Australia’s portfolio liabilities are traditionally much greater than portfolio assets;

• equity securities make the greatest contribution to Australia’s portfolio investment assets;

• debt securities make up the largest part of Australia’s portfolio investment liabilities and, within this component, the largest contributor is bonds and notes (i.e. long-term securities);

• in 1996-97, Australia’s holdings of financial derivatives abroad, on account of transactions, fell by over $900 million. However, in terms of the level at the end of the period, the assets and liabilities for financial derivatives were largely offsetting.

	13.1 PORTFOLIO INVESTMENT TRANSACTIONS AND LEVELS, 1996-97
			Financial transactions			Position at end of period
			Assets	Liabilities		Assets	Liabilities
			($m)	($m)		($m)	($m)
	Portfolio investment		-3,548	16,927		-69,441	295,816
	Equity securities		-4,278	2,601		-47,980	86,323
	Debt securities		730	14,326		-21,460	209,494
		Bonds and notes	-426	12,905		-8,907	160,538
		Money market instruments	214	273		-3,288	38,735
		Financial derivatives	942	1,148		-9,266	10,220
	Source: Tables 26, 32 and 33 from Balance of Payments and International Investment Position, Australia, March quarter 1998 (Cat. no. 5302.0).

	13.2 MAIN TYPES OF FINANCIAL DERIVATIVES
	Recent international statistical standards recognise financial derivatives as financial instruments within the system of national accounts and balance of payments statistics. These are secondary instruments linked to, but separate from, a specific financial instrument or indicator, or commodity, and through which specific financial risk can be traded in its own right. They are used for a number of purposes including risk management, hedging, arbitrage between markets, and speculation. Derivatives may be included under the direct investment, portfolio investment or reserve assets categories. Some of the more common financial derivatives are described below.
	Options and warrants Options are contracts in which both the price and time for buying or selling are specified, and give the holder the right, but not an obligation, to buy (call options) or sell (put options) a particular financial instrument or commodity from or to another entity (the option writer). They can relate to equities, commodities, foreign currencies, interest rates, etc. Creating and exercising the option contracts, as well as secondary trading in options, all constitute transactions for balance of payments purposes where the holder and the writer are residents of different countries. Payment of the option price is treated in the balance of payments, under the financial derivatives component of portfolio debt securities, as an increase in financial assets of the buyer and an increase in financial liabilities of the seller. Theoretically, the option price consists of a financial asset and a service charge, and the latter component should be considered as a financial service. However, it is not possible to isolate the service component, and the full purchase price is recorded in the financial account. Corresponding treatments are accorded options in the international investment position statement, where the value recorded in the transactor’s books is used. Warrants are a form of option; they are usually written by an enterprise on its own shares, and are treated similarly to other options.
	Futures Futures are contracts between two parties to exchange, at a specified time and price, a real or financial asset for another financial asset. Such contracts can cover commodities, equities, currencies, interest rates and other financial instruments, and are all considered to be financial in character. Where the two parties are residents of different countries, tradable futures are recorded in both the balance of payments and international investment position in a manner similar to options.
	Swaps Swaps are contracts, usually relating to interest rates or currencies, between two entities who agree to exchange cash flows over time on a notional amount of principal. Interest rate swaps involve the exchange of cash flows related to interest rates that are different in nature, e.g. fixed and floating rates, two different floating rates. Cross currency interest rate swaps, sometimes known as currency swaps, involve the exchange of cash flows related to interest rates and an exchange of principal amounts at an agreed exchange rate at the end of the contract. There may also be an exchange of principal at the beginning of the contract with subsequent payments to amortise the principal over time in accordance with the swap contractual terms. While the BPM5 treatment was to include in the current account the net cash flows related to interest rate swaps, more recently agreement has been reached internationally to change the standard and record such net settlements under the financial derivatives component of the financial account in a similar manner to other derivatives. Where a swap has been undertaken to hedge a loan or other commitment, the underlying repayments of the principal of the primary investment are valued and classified to the financial account in accordance with the relevant debt instrument, and not at the hedged rate in the derivative.
	Forward rate agreements Forward rate agreements are arrangements associated with interest rates, in which two entities agree on a settlement cash flow based on the difference between an agreed interest rate and prevailing rates, at a future date, applied to a notional amount of principal. The settlement amount is recorded in the financial account at the time of settlement in a similar way to swaps (again this is different to the recommendation in BPM5, but is consistent with later international agreements on revisions to the standards). The international investment position will include the market value of the forward rate agreements in levels, price changes to that level over time, and the final settlement transaction.
	Forward foreign exchange contracts Forward foreign exchange contracts involve the exchange of funds in one currency for funds in another currency at a specified rate at a future date.
	The values recorded for all financial derivatives do not include fees paid to financial intermediaries to establish or trade in them. Such fees are classified as financial services in the current account. Similarly, margin payments made between two entities as security against future obligations are recorded in the other liabilities component of other investment, rather than as financial derivatives.