Financial instruments are assets that can be traded, or they can be viewed as capital bundles that can be traded. Most financial instruments provide an efficient flow and transfer of capital to investors worldwide. These assets can be cash, a contractual right to deliver or receive currency or another sort of financial instrument, or proof of ownership of a company.
Financial Instruments: An Introduction
Financial instruments can be physical or virtual papers that constitute a legal agreement with any monetary value. Equity-based financial products demonstrate asset ownership. Debt-based financial instruments are loans made by an investor to the asset’s owner.
Foreign exchange instruments are a third and distinct form of financial instrument. Each instrument type has different subcategories, such as preferred share equity and common share equity.
Financial Instrument Types
There are two sorts of financial instruments: cash instruments and derivative instruments.
Cash instruments
- Markets directly impact and determine the values of cash instruments. These can be easily transferable securities.
- Cash instruments can also be agreed-upon deposits and loans between borrowers and lenders.
Derivative Instruments
- The underlying components of derivative instruments, like assets, interest rates, or indexes, determine their value and features.
- For example, an equity option contract, since its value is derived from the underlying stock. The option grants the right, but not the duty, to purchase or sell the shares at a predetermined price and by a predetermined date. As the stock price increases and falls, so does the value of the option, though not always by the same percentage.
- There are also exchange-traded derivatives and over-the-counter (OTC) derivatives. An OTC is a market or procedure for pricing and trading securities that are not listed on traditional exchanges.
Classifications of Financial Instruments
Financial instruments can also be classified into asset classes based on whether they are debt-based or equity-based.
Financial Instruments Based on Debt
Short-term debt-based financial instruments have a maturity period of one year or less. T-bills and commercial paper are examples of such securities. Deposits and certificates of deposit can be used to fund this type of cash (CDs).
Short-term interest rate futures can be exchange-traded derivatives under short-term, debt-based financial instruments. Forward rate agreements are what OTC derivatives are.
Long-term debt-based financial instruments have a maturity period of more than a year. Bonds are classified as securities. Loans are cash equivalents. Bond futures and options on bond futures are examples of exchange-traded derivatives. Interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives are examples of OTC derivatives.
Financial Instruments Based on Equity
Stocks are securities that are part of equity-based financial instruments. Stock options and equity futures are examples of exchange-traded derivatives in this category. Stock options and exotic derivatives are examples of OTC derivatives.
Additional Considerations
Foreign exchange securities do not exist. Cash equivalents are available in spot foreign exchange, which is the current rate. Currency futures are exchange-traded derivatives on foreign exchange. Foreign exchange options, outright forwards, and foreign exchange swaps are examples of OTC derivatives.