Any trader or investor has to start with a "financial instrument." But, do you understand what the main financial instruments are? If not, this is the best platform to learn about the Financial Market and related topics. In this article, we will pen down different types of financial instruments in the financial markets.
Let's begin with
Overview of Instruments of the Financial Market
The instrument of a Financial Market is defined as a contract between individuals/parties that possess a monetary value. They can be created, traded, settled, or modified as per the parties' requirements. Simply, any asset that holds capital and can be traded in the market is a financial instrument. Below- mentioned are a few of the financial instruments-
- Futures, and
- Options contracts.
Financial Instrument as per International Accounting Standards
International Accounting Standards defines a financial instrument as "any contract that gives rise to a financial asset of one entity and a financial obligation or equity instrument of another entity." To keep it simple, we can say that financial instruments typically include obligations on one party (an obligation to make specific payments) and benefits for the other party (such as the right to receive special payments or ownership in a company).
Different Types of Financial Instruments
Primarily, Financial instruments can be classified into two types :
- Cash Instrument
- Derivative Instrument
Derivative instruments are instruments whose characteristics and value can be derived from their underlying entities, such as interest rates, indices, or assets. The value of such instruments can be fetched from the performance of the underlying component. Also, they can be linked to other securities such as bonds and shares/stocks.
On the other hand, Cash instruments are defined as instruments that can be transferred and valued readily. Some of the most common examples of cash instruments are deposits and loans, which the lenders and borrowers are required to be agreed upon.
Now we will examine the different classifications of Cash Instrument and Derivative instruments-
Cash Financial Instruments
To raise capital, cash financial instruments are generated or issued by organizations (mostly governments and corporates). In this context, those organizations are often called issuers. Cash financial instrument prices are either set by the issuer or are reached by negotiation between the issuer and investors, who typically purchase the financial instrument to make a profit. Once issued and sold, holders (traders and investors) can freely trade in financial markets based on supply and demand.
Below- mentioned are a few of the Cash financial instruments.
As the name suggests, a share reflects ownership in a company. For instance,If a company issues 100 shares and you buy 1 of them, you own 1/100th of 1% of the company. There you will be entitled to 1% of any dividends paid by that company, plus a 1% voting right at shareholder meetings.
A bond is like an IOU, a certificate that the issuer (or borrower) gives to an investor in exchange for some cash. In the case of a bond, the document will specify the terms and conditions, including the size and frequency of coupon (or interest) payments and when the bond has to be repaid called the maturity date. The inability to pay coupons on time or repay bonds at maturity exposes the issuer to the risk of being placed in default by bondholders.
As governments do not issue shares, governments rely on bonds to raise money from investors. As a result, government bonds worth hundreds of millions of dollars will be in circulation at any one time in the world.
A convertible bond is a bond that will either be repaid or converted into shares at some future date. Simply, we can say that Convertible bonds initially look like a bond, then they are either repaid or converted into shares after a certain period. The terms for convertible bonds will define the size and frequency of coupon payments (if any); and the terms and date of repayment or conversion.
Instead of a specific date, convertible bonds often convert to Equity on an event called a "trigger," the most common issue is the company's publication and sale of new shares.
Banks and other credit institutions make loans to organizations such as companies, sovereign governments, or government agencies. From the borrower's point of view, loans look very similar to bonds, but because fewer parties are involved, the loans are much easier and quicker to negotiate, and fewer documents are required than bonds.
Derivative Financial Instruments
As the name suggests, derivative financial instruments mean an instrument that derives its value from another asset. Derivative Instruments are also known as the underlying asset.
The most common underlying assets are-
- Indices (like the S&P 500),
- Interest rates,
- Commodities (like gold or oil) and
- Currency pairs.
Different types of derivative financial instruments have other characteristics, but they have two things in common that make them popular among traders and investors.
First, a smaller fee often allows the derivative holder to take a more prominent market position. In other words, they provide traders with the opportunity to leverage their trades, magnifying potential gains or losses. Secondly, Derivatives make it easier to not only go long or buy when you believe the value of an underlying asset will rise, but it is also helpful to short or sells when the price is likely to fall. Now let's discuss, the most common types of financial derivative instruments.
The owner of an option gives you the option, but not the obligation, to buy (or sell) the underlying asset at a particular price. This price is known as the strike price. Options that give you the right to buy the underlying asset are called "call options," and those that give you the right to sell are called "put options." When the holder of an option decides to go ahead and buy (sell) the underlying, they are said to exercise the option. Every option has an expiry date. If the holder does not exercise the option before that date, the option ceases to exist, and the holder forfeits the fee paid to acquire it. This is quite common because options are exercised only when they are likely to make a profit for the option holder.
Futures work just like options, except they give you an obligation, not an option. In other words, the holder does not have an option on or before the future maturity date whether he will do the transaction or not. Instead, futures are financial derivative contracts that obligate the parties to transact an asset at a pre-determined future date and price.
A contract for difference (CFD) is an agreement, or contract, between two parties to exchange the difference in the price of an asset from start to finish. Like other derivatives, CFDs can be used to speculate on rising and falling prices. However, unlike the other derivative products listed above, CFDs are purely speculative, with the underlying asset never changing hands at the end of the contract.
A forward contract is a type of Derivative contract, a customized contract between two parties, where settlement takes place on a definite date in the future at a price agreed today. Forward Contracts are bilateral contracts and hence exposed to counter-party risk. These contracts are custom designed, and that is why it is unique in terms of-
- Contract size,
- Expiration date and
- Asset type and quality.
The future contract price is generally not available in the public domain and has to be settled by delivery of the asset on the expiration date. In case of reversal of the Future contract, it has to compulsorily go to the same counterparty, which, being in a monopoly situation, can ask for the price they want.
SWAP is a derivative instrument through which two parties to the contract exchange the cash flows or liabilities from two different financial instruments. Mainly, SWAP involves cash flow dependent on a notional principal amount like-
- Loan or
- Bond, even though the instrument can be almost anything.
This exchange takes place at a prespecified time, as mentioned in the contract. A swap aims to alter one scheme of payments into another one of a different nature which is more suitable for the parties to the contract.
There are various financial instruments in the market, but each instrument serves a different purpose and needs; the bond market would be a better option than Equity investing. Similarly, investing in the currency market is based on the choice and objective of the investor.