What is a Financial Instrument?
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 Instruments
1. Cash Instruments
Cash 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 Instruments
Derivative 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 Instruments
Foreign 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 Instruments
Beyond 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 Instruments
Debt-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 Instruments
Equity-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.
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.
In order 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: