Understanding ‘Financial Instrument’
Financial instruments are basically assets that can be easily traded. Most of these are also deemed as tradable capital packages. Many types of financial instruments offer efficient transfer as well as the flow of capital across investors of the world. The assets may be anything from cash, a different type of financial instrument, evidence of entity ownership, one’s right to deliver as per a contract, or receive cash.
Virtual or real documents that represent a legal agreement are also financial instruments. The agreement may involve any type of monetary value. All financial instruments (equity-based) symbolize asset ownership.
Financial instruments (debt-based) represent a loan by an investor to the asset owner. Instruments of foreign exchange include a third, distinct variety of financial instruments. According to the International Accounting Standards, financial instruments are defined as a contract that gives birth to a financial asset of a single entity and equity instrument or a financial liability of a different entity.
Various Types of Financial Instruments
Financial instruments are categorized into the following two types:
– Cash Instruments
– Derivative Instruments
The values of cash instruments offered by financial instrument providers are directly subjective o and determined by markets. These instruments may be easily transferable securities or deposits and loans agreed upon by both lenders and borrowers.
Derivative instrument’s characteristics and value are based on the underlying components of the vehicle, including indices, assets, or interest rates. These are also offered as exchange-traded or over-the-counter (OTC) derivatives.
All financial instruments can be categorized into asset class depending on:
– Equity-based instruments
– Debt-based instruments
Most short-term financial instruments (debt-based) last only for a year or less. These kinds of securities are available in the form of commercial papers or T-bills. The type of cash may either certificates of deposit (CDs) or deposits.
All exchanges-traded derivatives, falling under short-term financial instruments (debt-based) are short-term interest rate futures.
All of the long-term financial instruments (debt-based) last for over a year. These act as bonds under the securities. The cash equivalents are referred to as loans. The derivatives of exchange-traded instruments are known as bond futures. Under this category, the OTC derivatives are as stated below:
– Interest rate options
– Interest rate swaps
– Interest rate caps and floors
– Exotic derivatives
Stocks are securities under financial instruments (equity-based). The exchange-traded derivatives under this category include the following:
– Equity futures
– Stock options
The derivatives of OTC are exotic derivatives and stock options. No securities are present under foreign exchange. Cash equivalents are available in spot foreign exchange. Currency futures are derivatives of exchange-traded instruments under foreign exchange. All OTC derivatives are available as foreign exchange swaps, outright forwards, and foreign exchange options.
The financial investment with price based directly on its market value are primary instruments such as bills, bonds, stocks, certificates of deposit, and everything else with its own value. On the contrary, derivative instruments price includes futures, options, and swaps are based on the overall value of their essential assets.
Although markets have already established many hundreds of instruments to ease capital flow of capital and risk management, most primary investments such as stocks are the first thing that most investors think of when they consider investing. The reason behind this is that investment in primary instruments demands basic knowledge about market principles of investment.
A non-primary instrument can be defined as a call option that provides the owner the right to buy underlying stock at a specific price. In case, the stock price moves up, value of call option also rises. Value of call is based on the value of something else. However, it is not the primary instrument.