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Financial instruments are contracts which give rise to a financial asset for one entity and a financial liability or equity instrument for another entity. From: Finance, 2015
Contractual monetary assets that can be purchased, traded, created, modified, and even settled for Financial instruments are contracts for monetary assets that can be purchased, traded, created, modified, or settled for. In terms of contracts, there is a contractual obligation between involved parties during a financial instrument transaction. For example, if a company were to pay cash for a bond, another party is obligated to deliver a financial instrument for the transaction to be fully completed. One company is obligated to provide cash, while the other is obligated to provide the bond. Basic examples of financial instruments are cheques, bonds, securities. There are typically three types of financial instruments: cash instruments, derivative instruments, and foreign exchange instruments. Types of Financial Instruments1. Cash InstrumentsCash instruments are financial instruments with values directly influenced by the condition of the markets. Within cash instruments, there are two types; securities and deposits, and loans. Securities: A security is a financial instrument that has monetary value and is traded on the stock market. When purchased or traded, a security represents ownership of a part of a publicly-traded company on the stock exchange. Deposits and Loans: Both deposits and loans are considered cash instruments because they represent monetary assets that have some sort of contractual agreement between parties. 2. Derivative InstrumentsDerivative instruments are financial instruments that have values determined from underlying assets, such as resources, currency, bonds, stocks, and stock indexes. The five most common examples of derivatives instruments are synthetic agreements, forwards, futures, options, and swaps. This is discussed in more detail below. Synthetic Agreement for Foreign Exchange (SAFE): A SAFE occurs in the over-the-counter (OTC) market and is an agreement that guarantees a specified exchange rate during an agreed period of time. Forward: A forward is a contract between two parties that involves customizable derivatives in which the exchange occurs at the end of the contract at a specific price. Future: A future is a derivative transaction that provides the exchange of derivatives on a determined future date at a predetermined exchange rate. Options: An option is an agreement between two parties in which the seller grants the buyer the right to purchase or sell a certain number of derivatives at a predetermined price for a specific period of time. Interest Rate Swap: An interest rate swap is a derivative agreement between two parties that involves the swapping of interest rates where each party agrees to pay other interest rates on their loans in different currencies. 3. Foreign Exchange InstrumentsForeign exchange instruments are financial instruments that are represented on the foreign market and primarily consist of currency agreements and derivatives. In terms of currency agreements, they can be broken into three categories. Spot: A currency agreement in which the actual exchange of currency is no later than the second working day after the original date of the agreement. It is termed “spot” because the currency exchange is done “on the spot” (limited timeframe). Outright Forwards: A currency agreement in which the actual exchange of currency is done “forwardly” and before the actual date of the agreed requirement. It is beneficial in cases of fluctuating exchange rates that change often. Currency Swap: A currency swap refers to the act of simultaneously buying and selling currencies with different specified value dates. Asset Classes of Financial InstrumentsBeyond the types of financial instruments listed above, financial instruments can also be categorized into two asset classes. The two asset classes of financial instruments are debt-based financial instruments and equity-based financial instruments. 1. Debt-Based Financial InstrumentsDebt-based financial instruments are categorized as mechanisms that an entity can use to increase the amount of capital in a business. Examples include bonds, debentures, mortgages, U.S. treasuries, credit cards, and line of credits (LOC). They are a critical part of the business environment because they enable corporations to increase profitability through growth in capital. 2. Equity-Based Financial InstrumentsEquity-based financial instruments are categorized as mechanisms that serve as legal ownership of an entity. Examples include common stock, convertible debentures, preferred stock, and transferable subscription rights. They help businesses grow capital over a longer period of time compared to debt-based but benefit in the fact that the owner is not responsible for paying back any sort of debt. A business that owns an equity-based financial instrument can choose to either invest further in the instrument or sell it whenever they deem necessary. Additional ResourcesThank you for reading CFI’s guide on Financial Instrument. To help you become a world-class financial analyst and advance your career to your fullest potential, the additional resources below will be very helpful:
If you participate in the financial markets, you'll be trading various types of financial instruments. This page covers everything you need to know about them and how to choose the ones best suited to your objectives. What is a financial instrumentA financial instrument is a physical or digital document or contract that signifies ownership of an asset or a contractual right to receive something. Financial instruments can be created, modified and traded.
An example to help define financial instrumentsIf you have a contract to buy or sell something, but you can't sell the contract, it's not a financial instrument. If you can sell the contract, it's probably a financial instrument. Types of financial instrumentsFinancial instruments can be categorised. Firstly, they represent either equity, debt or a currency. Secondly, they are either primary (cash instruments) or derivative instruments. The following is a list of examples sorted according to whether they are primary or derivative ones. Primary financial instrumentsPrimary instruments are also known as cash instruments. They represent actual ownership of an asset or the right to a future cash flow. SharesShares are also known as equities and stocks. A share represents ownership of a percentage of a publicly listed company. Shareholders have certain rights, including a claim on assets if the company is liquidated, the right to receive dividends and the right to vote on important company matters. ETFs (Exchange Traded Funds)Strictly speaking, ETFs are a type of share, and they are traded just like the shares of listed companies. However, ETFs indicate partial ownership in a portfolio of securities rather than in a single company. BondsBonds are long-term debt instruments with maturities of more than one year. Governments, municipalities and companies issue bonds to raise money in the form of debt. A bond has a face value due to the holder when the bond matures and a coupon reflecting the interest paid each year. Money market instrumentsMoney market instruments are similar to bonds but have maturities shorter than one year. There are many different types of such, including commercial paper, certificates of deposit, repurchase agreements, banker's acceptances, and treasury bills. CashCurrencies are also regarded as financial instruments. They are recorded on balance sheets at face value or in another currency. Cash is the most liquid form of financial instrument. Other basic financial instrumentsSome other items listed on company balance sheets are also classified as financial instruments from an accounting standpoint. These include trade debtors, trade creditors and bank loans. Derivative financial instrumentsDerivatives are financial instruments that derive their price in some way from other financial instruments or assets. Some derivatives are relatively simple, while exotic ones are very complex. FuturesA futures contract is a contract between two parties to exchange cash or other securities on a future date and at an agreed-upon price. Futures contracts are traded on exchanges and have standardised terms that dictate the quantity of the underlying asset, the expiry date and the method of exchange. OptionsAn option gives the holder the right but not the obligation to buy or sell an underlying asset at a specific price on a specific date in the future. Options are traded on exchanges and in OTC (over the counter markets) ForwardsForwards are like futures contracts but aren't traded on exchanges and don't have standardised terms. Forwards are traded in the OTC market, usually between institutions and corporations. CFDs (Contracts for Difference)CFDs are similar to futures but are traded in the OTC market between brokers and their clients. Unlike futures which have expiry dates, CFDs are rolled forward each day until closed. CFDs are settled for cash. SwapsA swap is an agreement to exchange cash flows based on foreign exchange rates, interest rates or equity returns. Swaps are traded between banks, institutions, and corporations in the OTC market to hedge currency and interest rate exposure. Convertible instrumentsConvertible instruments can be turned from one type of instrument to another if or when certain conditions are met. The most common of these are convertible bonds that can be transformed into shares. Characteristics of financial instrumentsEach type of financial instrument has its own characteristics that determine whether it's suitable for investing, trading, or conducting business activities. Exchange or OTC tradedFinancial instruments listed and traded on exchanges usually have standardised terms and an extra layer of oversight. This means less due diligence and less flexibility.
LiquidityThe liquidity of financial instruments depends on the size of the market, supply, demand, and the way they are traded. Some instruments have deep, liquid markets, while others have none. Liquidity, in turn, affects the transaction costs for trading or transferring an instrument. Liquidity for cash instruments depends on supply or demand, while it depends on both for derivative ones. RiskFinancial instruments carry unique risks.
RegulationThe regulatory environment determines the level of protection investors have. The way financial instruments are managed depends on the regulatory bodies they fall under. Instruments marketed for trading purposes are typically governed by the SEC in the US or the FSA in the UK.
Why knowing types of financial instruments is essential?Certain financial instruments are better for trading, while some are preferable for long-term investing. Others are used in the course of business but have little relevance to traders or investors. Before investing in a financial instrument, it's important to understand its characteristics, advantages and disadvantages and how it suits your objectives. It's also critical to know the regulatory landscape under which an instrument falls. If you're an investor, the long-term value and investor protection are of particular importance. If you're a trader, liquidity and transaction costs are most important. Volatility can be an advantage as there may be more trading opportunities. Investor protection is also critical. How to choose the right financial instrumentChoosing the suitable instruments to meet your objectives requires finding the right combination of financial instruments, asset class and strategy. The following steps will help you: Step 1: Decide on the asset class you're interested inAsset classes include equities, bonds, currencies, commodities and real estate. Asset classes with higher returns, like equities, carry more risk, while those with lower returns, like cash and bonds, are less risky. Your choice of asset class will also depend on your knowledge and interests. Step 2: Decide on your objectivesSome financial instruments are better for long-term investing, while others are suitable for trading (see below). Investors often choose more than one asset class, while traders tend to specialise in a single one. Step 3: Choose the instrument that suits your objectives and covers the asset class you're interested inSome instruments only exist within a single asset class, while derivative instruments can have any underlying asset. These are more versatile, especially for trading. Advantages and disadvantages of tradable financial instruments:The following are advantages and disadvantages of financial instruments available to retail investors and traders: Shares
Bonds
Currencies
Futures
CFDs
Options
The best financial instruments for tradingThe following four instruments are the best for active trading: CFDsCFDs are ideal for active traders due to the number of asset classes they can be used to trade. They also have a built-in multiplier and are easy to short sell. CurrenciesCurrencies can be traded directly or with CFDs. The Forex market is very liquid and offers short-term traders many opportunities. FuturesFutures share many of the advantages of CFDs but are better for larger accounts due to the minimum capital requirements. OptionsOptions can be used for sophisticated trading strategies. They are best for traders with a lot of experience and relatively large trading accounts. The best financial instruments for investingThe following three instruments are ideal for long-term investors: SharesShares are the most important instruments for long-term investment portfolios. Shares allow investors to participate in the growth of companies and the economy over the longer term. BondsBonds allow investors to diversify their portfolios to reduce volatility. While returns are low, they're higher than for cash, with lesser risk than for shares. ETFsETFs allow investors to plough in a wide variety of asset classes and instruments using just a few products. They also offer the advantage of diversification and low fees. Conclusion
If you would like to find out more about financial markets and instruments, Libertex is a broker offering CFDs on stocks, currencies, commodities, indices, ETFs and cryptocurrencies. That means you can trade and learn about all these asset classes with just one account and on one platform. But please note that trading CFDs with a multiplier can be risky and can lead to losing all of your invested capital. With no risk, you can open a free demo account to learn more about these asset classes and all the tools available on the platform. The platform also offers free trading tutorials to help you get started. FAQWhat are the types of financial instruments?Financial instruments are either cash or derivative instruments. The price of cash instruments is determined by market supply and demand. These include shares, bonds and currencies. The price of derivative instruments is determined by the price of other instruments. Derivative instruments include futures, options and CFDs. What are basic financial instruments?Basic financial instruments include cash, trade debtors, trade creditors, bank loans. Shares and bonds can also be regarded as basic financial instruments. What are the uses of financial instruments?Financial instruments are used to raise capital for investment purposes, hedging and speculating. They can be modified, traded or settled. Why are financial instruments important?Financial instruments formalise financial agreements between parties. This establishes a higher level of certainty about the instrument's value and that obligation will be met. Ownership of most financial instruments can also be transferred, increasing liquidity. Are all financial instruments tradable?In theory, all instruments can be traded, but for some, it may be difficult. Instruments like debtors and creditors on a company's balance sheet may be difficult to buy or sell. |