Financial instruments are a monetary contract between two parties. We can create, trade or modify them. We can also solve them. A financial instrument can be evidence of ownership of part of something, such as stocks and shares. Bonds, which are contractual rights to receive cash, are financial instruments.
Checks, futures, option contracts, and bills of exchange are also financial instruments. The securities, that is, the contracts that we value and then negotiate, are financial instruments.
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Simply put, a financial instrument is a asset or capital package that we can negotiate. The definition is broad and includes cash, deposits in other entities, trade accounts receivable, loans to other entities. Investments in debt instruments, investments in shares and other equity instruments.
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In this article you will find:
Types of financial instruments
For the most part, financial products They are classified into two main types:
Cash instruments
A cash instrument is the classification of a financial product whose value is determined by the markets. These could be values and most importantly, those that can be easily transferable. They are also more liquid.
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Derivative instruments
A derivative instrument is one whose value is derived from the underlying asset, such as the index or interest rate, including exchange rates. The term asset is commonly used, but there can only be two types of assets:
- Asset based on equity
- Debt-based asset
The exception to the case is, of course, currencies, which are not included in any of the above categories.
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The two types of financial instruments above are sub-classified into exchange-traded products or over-the-counter (OTC) products.
Therefore, combining the above, the financial instruments are the following:
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- Debt-based instruments (long-term)
- Bonds (cash or securities instrument)
- Bond futures, options (exchange traded derivatives)
- Interest rate swaps, IR options, IR limits and floors (OTC derivatives)
- Debt-based instruments (short-term)
- T invoices (cash or securities instrument)
- Interest rate futures (exchange-traded instrument)
- Forward rate agreements (OTC derivatives)
Share-based instruments
- Stocks (cash or securities instruments)
- Stop options or futures or funds (exchange traded instrument)
Foreign Exchange Market Instruments
- Currency exchange spot (other)
- Currency futures (exchange-traded instruments)
- Currency options, currency swaps (OTC derivatives)
Benefits of financial instruments
- Liquid assets such as cash and cash equivalents are very useful for companiesas they can easily be used for quick payments or to deal with financial contingencies.
- Stakeholders often feel more secure in an organization that you have used more capital on your liquid assets.
- Financial instruments provide important support for financing tangible assets. This is possible through the transfer of funds from tangible assets that are executed in surplus values to those that are in deficit.
- Financial instruments assign risk with respect to the risk capacities of the counterparties that have participated in the realization of an investment of intangible assets.
- Companies that choose to invest in real assets produce higher income as they obtain a diversified portfolio, a covered inflation and they can also guard against uncertainties caused by political reasons.
- Financial instruments like equity act as a permanent source of funds for an organization. With equity shares, the payment of dividends to shareholders is purely optional. Equity shares also allow an organization to have a open opportunity to borrow and enjoy retained earnings.
Some disadvantages
The different limitations and disadvantages of the financial instrument include the following:
- Liquid assets, such as balances in savings accounts and other bank deposits, are limited when it comes to ROI or return on investment. This is high due to the fact that there are no restrictions on withdrawing deposits from savings accounts and other bank balances.
- Liquid assets such as cash deposits, money market accounts, etc., could prevent organizations to make withdrawals for months or sometimes years or whatever is specified in the agreement.
- High transaction costs are also of concern to organizations who deal or wish to deal with financial instruments.
- An organization should not be overly reliant on debts like principal and interest as they are supposed to be paid accordingly.
- Financial instruments like bond payments have a much lower return than stocks. Companies can even default on bonds.
- Some of the financial instruments like equity capital are a lifelong burden for the company. Social capital acts as a permanent burden on an organization. The share capital cannot be repaid even if the organization has a sufficient amount of funds.
Why are there several types of financial instruments?
The fact that there are so many different types of financial instruments returns to the main point of what an investor or speculator wants. For example, some investors prefer to put their money in safe assets like bonds.
Bond markets tend to underperform typically the returns one can expect from equity markets. But, the advantage here is that the bonds are less risky and safer. In most cases, the bonds are often backed by government promises.
A investing in the stock market it may seem more ideal for an investor who prefers to take more risks. By taking this risk, the investor is, of course, compensated with higher returns. However, there is no guarantee.
Choosing to invest in the debt or equity markets also goes into a lot of detail, and investors mix their portfolios for various reasons.
When it comes to the currency markets, once again, at the end of the day, it is the investor or the choice and the ultimate targets of the speculator. For an export business, investing in currencies is more ideal, since it allows them to hedge their exchange risks. For such a business, stocks might not be that important.
Similarly, for a person looking to park some funds toward retirement, bonds (and stocks) may seem more ideal than coins.
