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What Does a Financial Instrument Mean?

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Synopsis:

Financial instruments encompass a whole range of different types of assets that can be traded or exchanged. Here is a look at everything you need to know about them.

Any assets that can be exchanged or traded are known as financial instruments. Assets like stocks, shares, ETFs or exchange-traded funds, bonds, etc are examples of financial instruments. 

Financial instruments are traded or exchanged among traders worldwide and this is why these instruments allow for the transfer of capital efficiently and effortlessly. Financial instruments could be in the form of (a) cash, (b) a contract that enables traders to deliver or receive cash or another financial instrument, or (c) evidence of ownership in the market.

Types of Financial Instruments 

The types of financial instruments can be divided into cash and derivatives. Below is more detail about the two.

1. Cash Instruments:

Cash instruments are financial instruments that organisations issue and entities to raise capital. Cash instruments can be traded in both primary and secondary markets. Primary there are three types of cash instruments in the market. These include:

  • Shares:

  1. Shares are ways for investors to own a stake in public companies. 

  2. Selling shares helps raise funds for a company and usually begins with the launch of the company’s IPO or Initial Public Offering. 

  3. After the launch of the IPO, company shares are available on the stock exchange(s) for traders.

  • Bonds:

  1. Bonds are debt instruments that organisations issue. 

  2. Bonds are not similar to equity funding as they are debt-based

  3. Investors can purchase bonds that will act as a loan for the issuing company. 

  4. The company will pay interest to investors at frequent intervals on the loan received.

  • Loans:

  1. Loans are also a type of debt security

  2. Companies can also opt for loans from financial institutions. 

  3. Loans reduce the number of parties involved to two, in most cases

2.Derivatives:

Derivatives are financial contracts that help traders participate in hedging and speculation in the price of assets. The potential for Investors to earn multi-fold is high in derivatives. Below is a list of the two most popular types of derivative instruments for investors:

  • Futures:

  1. Financial contracts that let investors buy/sell an underlying asset. 

  2. Both the price of the underlying asset and its date of expiration are predetermined. 

  • Options:

  1. Options work like Futures. 

  2. However, in Options, investors are not obligated to buy/sell the underlying asset. 

  3. The expiration dates on the underlying asset can be ignored by an investor.

Types of Asset Classes of Financial Instruments

Another way that financial instruments are divided is according to asset class. An asset class is categorised in two ways; (a) debt-based and (b) equity-based. Below are more details about both these categorizations.

Debt-Based Financial Instruments

They are loans supplied by an investor to the issuer, usually a company. In return for this loan, regular interest payments are made to the investor. Examples of debt-based instruments include bank deposits or certificates of deposit (CDs) as they provide depositors with regular interest payments.`

There are two types of debt-based financial instruments:

  • Short-term debt-based financial instruments:

  1. Are valid for one year or less

  2. Usually exist as Treasury bills (T-bills) and commercial papers

  3. The exchange-traded derivatives on short-term debt instruments are traded as short-term interest rate futures

  • Long-Term Debt Instruments

  1. Are valid for more than a year

  2. Issued as bonds or mortgage-backed securities (MBS)

  3. The exchange-traded derivatives on long-term debt instruments get traded as fixed-income futures and options

Equity-Based Financial Instruments

  • Any financial instruments that represent ownership of an asset are equity-based. 

  • Stocks and ETFs are two examples of equity-based financial instruments. 

  • Mutual funds when invested in stocks also come under the equity-based instrument umbrella

  • The exchange-traded derivatives include stock options and equity futures.

Foreign Exchange Instruments

  • Forex includes derivatives like futures and options and forwards on currency pairs and contracts for difference.

  • Currency swaps also come under the forex instrument umbrella.

  • Forex traders can indulge in spot transactions to immediately convert one currency into another.

What Are Some Examples of Financial Instruments? 

Some common examples of financial instruments include:

  1. Stocks:

    Stocks are also known as equity and are a type of security available for trading in the stock market. A stock can represent the ownership of a portion of the company issuing it. A bunch of stocks are called shares. Investors owning shares are entitled to a proportion of the profits of the company issuing the stocks. This profit should be equal to the stock they own.

    Stocks form a crucial base for any investor to get started on their investment journey in the stock market and help them build their portfolio. 

  2. Exchange-Traded Funds or ETFs

    An exchange-traded fund or ETF through a pooled investment security, can still operate like individual stocks. These financial instruments can track the price of a commodity to various securities.

    When done right, an ETF can also track specific investment strategies. ETFs are customised to help investors generate income, speculate the price of securities and aid price increases to help with hedging in their portfolios. 

  3. Real Estate Investment Trust or REIT

    Companies that own or financially support incoming-producing real estate across various property sectors are known as REITs or Real Estate Investment Trusts. With the help of REITs, investors can earn through real estate without buying or even managing a property on their own. 

  4. Mutual Funds:

    Mutual funds are another example of a pooled investment. These financial instruments are overseen by professional money managers. Mutual funds can easily be traded on the stock exchanges while letting investors access several types of assets. 

Conclusion

Think of financial instruments as any asset that can be traded on the stock exchanges. These include assets like stocks, shares, ETFs or exchange-traded funds, bonds, etc. Financial instruments enable the transfer of capital efficiently and effortlessly internationally. 

There are two types of classification when it comes to financial instruments. They include asset class-based and cash-based, securities, or derivatives.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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