Definition of Financial Instrument
Financial instruments are assets or capital bundles that may be exchanged. Most financial tools enable effective capital movement among global investors. Assets may include cash, FI, or proof of ownership.
Financial instruments include stocks, ETFs, bonds, CDs, mutual funds, loans, and derivatives contracts.
Understand Financial Instruments
FI can be actual or virtual legal agreements involving money. Equity-based financial products demonstrate asset ownership. Debt-based financial instruments are loans from investors to asset owners.
Foreign exchange instruments are distinct financial instruments. Each instrument type has subclasses, such as preferred and ordinary share equity.
According to International Accounting Standards (IAS), FI are contracts that create financial assets for one company and liabilities or equity for another firm.
Financial Instrument Types
Cash and derivatives FI exist.
- Markets immediately impact the value of monetary instruments. These can be transferable securities. Such instruments include stocks and bonds.
- Cash instruments can include deposits and loans between borrowers and lenders. Checks are currency instruments since they transfer money between bank accounts.
- The value and features of derivative instruments depend on their underlying components, like assets, interest rates, or indexes.
- An equity options contract, like a call option on a stock, is a derivative as its value comes from the underlying shares. The call option grants the right but not the obligation to acquire stock at a specific price and date. The option’s value fluctuates with the stock’s price, but not by the same proportion.
- Derivatives can be OTC or exchange-traded. Securities not listed on exchanges are priced and traded OTC.
Financial Instrument Asset Classes
FI can be categorized by asset class, depending on debt or equity.
Debt-backed financial instruments
Debt-based goods are loans from investors to owners of assets. Short-term loan assets last for one year or less. These securities are two examples of Treasury bills (T-bills) and commercial paper. CDs and bank deposits are debt-based products that pay interest to people who deposit money.
Instruments based on short-term debt, such as interest rate futures, are sold on exchanges as swaps.FRAs are an example of an over-the-counter (OTC) product.
Financial tools based on long-term debt last for more than a year. Bonds and mortgage-backed securities (MBS) make up most long-term financial products. Fixed-income futures and options are the exchange-traded alternatives to these assets. Interest rate swaps, caps, floors, and long-dated options are over-the-counter (OTC) contracts for long-term loans.
Equity-based products demonstrate asset ownership. Securities classified as equity-based FI are often standard or preferred stocks.ETFs and mutual funds can be equity-based securities.
Examples of exchange-traded derivatives are stock options and equity futures.
Foreign Exchange Tools
Forex (FX) instruments include derivatives, including forwards, futures, options, and contracts for difference (CFDs) on currency pairings. Currency swaps are a frequent forex tool. Forex traders can also convert currencies instantly in spot deals.
Examples of FI
FI are varied. Financial instruments provide the possessor with a financial obligation or right. Popular financial products include stocks, ETFs, mutual funds, REITs, bonds, derivatives, checks, CDs, bank deposits, and loans.
Are commodities financial instruments?
Although commodities like precious metals, energy goods, raw resources, and agricultural items are traded globally, they are not considered FI. They don’t impose a claim or duty. Financial products, including futures, forwards, and options contracts, employ commodities as underlying assets.
Are insurance policies financial instruments?
Insurance is a legally binding contract between the insurance firm and policyholder that offers financial benefits under specified situations, such as death in life insurance. The policy may grant ownership and dividends to a mutual insurer. Permanent insurance plans contain a fixed value for death and living benefits (e.g., cash value).
While insurance policies are not securities, they can be viewed as a financial instrument as they provide policyholders with claim rights and the insurer with responsibilities.
The Bottom Line
Whether real or virtual, FI grants a right or claim against a counterparty through payments, equity ownership, debt, currency, or derivatives. Asset classes, cash-based securities, and derivatives can be used to segment financial instruments.
Financial instruments may trade listed or OTC, depending on their kind.
- Financial instruments are actual or virtual legal agreements involving money.
- Cash and derivative financial instruments exist.
- Asset classes—which depend on debt or equity—can classify financial instruments.
- Foreign exchange instruments are a third, distinct financial instrument.