Solution:

In the given scenario, Z Limited has entered into an arrangement with Target Limited for settlement of the loan against the issue of equity shares of Target Limited. This arrangement involves a contractual obligation to deliver equity shares, which would be a financial instrument under IAS 32.

The financial instrument in this case would be classified as "equity instrument" under IAS 32, as it represents a residual interest in the assets of Target Limited after deducting its liabilities. The equity instrument would be initially recognized at fair value, which would be determined based on the market price of the shares of Target Limited at the future settlement date.

The variable nature of the number of shares to be issued does not impact the classification of the financial instrument as an equity instrument. However, it may impact the measurement of the financial instrument. The fair value of the equity instrument would be based on the market price of the shares of Target Limited at the future settlement date, which is not known at the initial recognition date. Therefore, the fair value of the equity instrument would be measured at cost initially, which would be the amount of the loan to be settled, i.e. $10,00,000.

Upon settlement of the contract, if the fair value of the equity shares is more than the loan amount, the excess amount would be recognized as a gain for Z Limited, and if the fair value is less than the loan amount, the shortfall would be recognized as a loss for Z Limited. The equity instrument would be derecognized upon settlement of the contract.

In conclusion, the arrangement between Z Limited and Target Limited involves a financial instrument that is classified as an equity instrument under IAS 32 and would be initially measured at cost. The fair value of the equity instrument would be determined at the future settlement date based on the market price of the shares of Target Limited.