What are Financial Instruments?
A financial instrument is a legal contract between the parties who are a part of the transaction that holds a monetary value. The monetary assets can be traded, created, modified or settled as per the parties’ requirements. In other words, any asset that holds capital and trades in the financial market can be termed a financial instrument. Some common examples of financial instruments in India are cheques, bonds, stocks, etc.
For instance, if a company has to pay cash for a bond, then the other party has to deliver the financial instrument. This completes the transaction. Thus, one party (company) has to pay cash while the other party must deliver the bond.
Types of Financial Instruments
The following are the three types of financial instruments –
Cash instruments can easily be transferred and valued in the market. Also, market conditions directly influence the value of these financial instruments. The two types of cash instruments are –
- Securities: This financial instrument has a monetary value and trade on the stock market. While purchasing security (share), it represents a part of the ownership of a publicly traded company on the stock exchange.
- Deposits and Loans: Both are cash instruments because they represent monetary assets and bind both parties in a contractual agreement.
Derivative instruments derive their value from the underlying asset such as resources, currency, bonds, stocks, indices, etc. The performance of derivatives instruments is dependent on the performance of the underlying assets. The following are the most common types of derivative instruments –
- Forward: A forward contract is a customized agreement. It is between two parties that involve the exchange of an underlying asset at a specific exchange during a specific time period.
- Future: This is a derivative contract that involves the exchange of derivatives on a future date at a predetermined exchange rate.
- Options: An option is a derivative contract between two parties. Here, the buyer gets the right to purchase or sell the underlying asset at a predetermined price for a specific time period. However, there is no obligation to exercise the right.
- Synthetic Agreement for Foreign Exchange (SAFE): This agreement occurs in the over the counter(OTC) market. It guarantees a specific exchange rate during a specific period of time.
- Interest Rate Swap: This is a derivative contract between two parties. It involves the exchange of interest rates where one party agrees to pay the other party’s interest rate on their loans in different currencies.
Foreign Exchange Instruments
Foreign exchange instruments are represented in foreign markets and consist of currency agreements and derivatives. These are the most liquidated and most significant markets for trading volume in the world. The trading volume varies in trillions of dollars. Many financial institutions, brokers and banks deal with these instruments as the forex market is open 24 hours a day but closed on holidays.
They are further divided into three categories –
- Spot: In this currency agreement the actual exchange of currency is no later than the second working day after the original date of the agreement. This is referred to as ‘spot’ because the currency exchange is done on the spot (limited timeframe).
- Outright Forwards: In this currency agreement, the actual exchange of currency is done ‘forwardly’ and before the actual date of the agreed requirement. This is beneficial in case of fluctuating exchange rates.
- Currency Swap: It refers to the simultaneous buying and selling of currencies with different specified value dates.
Asset Classes of Financial Instruments
The financial instruments can be divided into two asset classes –
- Debt-Based: Through these financial instruments a company or entity can use to raise the amount of capital in a business. They come with a fixed maturity period. They enable companies to increase their profitability through capital growth. Some common examples are bonds, debentures, etc.
Cash instruments in the form of loans and exchange-traded derivatives in the form of bond futures are an example of debt-based financial instruments. Monetary instruments like certificates of deposits (CDs) and exchange-traded derivatives like short-term interest rate futures also come under this category.
- Equity-Based: These financial instruments serve as legal ownership of a company. Typical examples are stocks, convertible debentures, preferred stock and transferable subscription rights. They help companies to grow over a period of time. Unlike debt, they are not responsible for paying back the holders. Therefore, any company that owns an equity-based instrument can either choose to invest further in the instrument or sell it whenever necessary.