What Is a Financial Instrument?
Financial instruments are assets that can be traded or exchanged. Some examples of financial instruments include stock shares, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), mutual funds, loans, and derivatives contracts.
Financial instruments provide efficient flow and transfer of capital among the world’s investors.
They are assets that may be in the form of cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of ownership in some entity.
Key Takeaways:
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A financial instrument is a real or virtual document representing a legal agreement that involves any kind of monetary value.
- Financial instruments may be divided into two types: cash and derivatives.
- They also are categorized by asset class, which depends on whether they are debt-based or equity-based.
- Foreign exchange instruments comprise a third, unique type of financial instrument.
In corporate accounting, assets are reported on a company's balance sheet and can be broadly categorized into current (or short-term) assets, fixed assets, financial assets, and intangible assets.
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) define 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.”
International Accounting Standards (IAS) define 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.”
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.
An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.
Equities (e.g., stocks), fixed income (e.g., bonds), cash and cash equivalents, real estate, commodities, and currencies are common examples of asset classes.
Debt-Based Financial Instruments
Debt-based instruments are essentially loans made by an investor to the issuer in return for a payment of interest.
Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of Treasury bills (T-bills) and commercial paper. Bank deposits and certificates of deposit (CDs) are technically debt-based instruments because they earn depositors interest payments.
Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR).
Lenders may earn interest for using their funds or paid by borrowers for using those funds.
Exchange-traded derivatives are traded for short-term, debt-based financial instruments such as short-dated interest rate futures. There also are OTC derivatives such as forward rate agreements (FRAs).
Long-Term Debt Instruments
Long-term debt-based financial instruments last for more than a year.
Long-term debt securities are typically issued as bonds or mortgage-backed securities (MBS). Exchange-traded derivatives on these instruments are traded in the form of fixed-income futures and options.
A bond is referred to as a fixed-income instrument since bonds traditionally pay a fixed interest rate or coupon to debtholders. Mortgage-backed securities (MBS) are investments that represent claims on the money generated by pools of mortgage loans.
OTC derivatives on long-term debts include interest rate swaps, interest rate caps and floors, and long-dated interest rate options.
Equity-Based Financial Instruments
Equity-based instruments represent ownership of an asset.
Stocks are equity-based instruments, as are ETFs and mutual funds that are invested in stocks.
An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock. A mutual fund is a portfolio of stocks, bonds, or other securities purchased with the pooled capital of investors.
Exchange-traded derivatives in this category include stock options and equity futures.
Foreign Exchange Instruments
Foreign exchange (forex or f/x) instruments include derivatives such as forwards, futures, and options on currency pairs, as well as contracts for difference (CFDs).
Currency swaps are another common form of forex instrument.
A swap is a derivative contract that involves the exchange of cash flows related to a financial security.
Interest rate swaps are the most commonly used swaps and usually involve a fixed interest rate and a variable interest rate.
Credit default swaps contributed to the causes of the 2008 financial crisis.
In addition, forex traders may engage in spot transactions for the immediate conversion of one currency into another.
What Are Some Examples of Financial Instruments?
A financial instrument is any document, real or virtual, that confers a financial obligation or right to the holder.
Examples of financial instruments include stocks, exchange-traded funds (ETFs), mutual funds, real estate investment trusts (REITs), bonds, derivatives contracts (such as options, futures, and swaps), checks, certificates of deposit (CDs), bank deposits, and loans.
REITs own, run, use, work, or finance income-producing properties. Most REITs are publicly traded like stocks, which makes them highly liquid, unlike traditional real estate investments.
Are Commodities Financial Instruments?
Commodities such as precious metals, energy products, raw materials, and agricultural products are traded on global markets, but they do not typically meet the definition of a financial instrument. That’s because they do not confer a claim or obligation.
Investors and traders can buy and sell commodities directly in the spot (cash) market or via derivatives such as futures and options.
Hard commodities refer to energy and metals products, while soft commodities are often agricultural goods.
However, commodities derivatives are financial instruments. They include futures, forwards, and options contracts that use a commodity as the underlying asset.
Is an Insurance Policy a Financial Instrument?
Insurance policies are not considered securities, but they could be viewed as an alternative type of financial instrument because they confer a claim and certain rights to the policyholder and obligations to the insurer.
An insurance policy is a legally binding contract established with the insurance company and policy owner that provides monetary benefits if certain conditions are met (such as death in the case of life insurance).
Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies or perils. The core components that make up most insurance policies are the premium, deductible, and policy limits.
If the insurer is a mutual company, the policy may also confer ownership and a claim to dividends. Insurance policies also have a specified value in terms of both the death benefit and living benefits (e.g., cash value) for permanent policies.
A financial instrument is effectively a monetary contract (real or virtual) that confers a right or claim against some counterparty in the form of a payment (checks, bearer instruments), equity ownership or dividends (stocks), debt (bonds, loans, deposit accounts), currency (forex), or derivatives (futures, forwards, options, and swaps).
Investing can be a daunting prospect for beginners, with an enormous variety of possible assets to add to a portfolio. Many investment specialists recommend diversifying one's portfolio.
Financial instruments can be categorized by asset class and as cash-based, securities, or derivatives.
Depending on their type, financial instruments may be exchangeable on listed or over-the-counter markets.