Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world’s investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.
- A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value.
- Financial instruments may be divided into two types: cash instruments and derivative instruments.
- Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.
- Foreign exchange instruments comprise a third, unique type of financial instrument.
Understanding Financial Instruments
Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt-based financial instruments represent a loan made by an investor to the owner of the asset.
Foreign exchange instruments comprise a third, unique type of financial instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity.
International Accounting Standards (IAS) defines financial instruments as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”1
Types of Financial Instruments
Financial instruments may be divided into two types: cash instruments and derivative instruments.
- The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable.
- Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.
- The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
- An equity options contract, for example, is a derivative because it derives its value from the underlying stock. The option gives the right, but not the obligation, to buy or sell the stock at a specified price and by a certain date. As the price of the stock rises and falls, so too does the value of the option although not necessarily by the same percentage.
- There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a market or process whereby securities–that are not listed on formal exchanges–are priced and traded.
Types of Asset Classes of Financial Instruments
Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.
Debt-Based Financial Instruments
Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs).
Exchange-traded derivatives under short-term, debt-based financial instruments can be short-term interest rate futures. OTC derivatives are forward rate agreements.
Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives.
Equity-Based Financial Instruments
Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives.
There are no securities under foreign exchange. Cash equivalents come in spot foreign exchange, which is the current prevailing rate. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options, outright forwards, and foreign exchange swaps.