What Is A Financial Instrument?
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."
Thus, both parties record it differently. For example, the business that issues the financial instrument records it as an asset in the accounts receivable. The purchasing party records it as a liability in the accounts payable.
It represents a legal agreement involving any monetary value. The document can be either real or virtual.
They are contracts that can be purchased, traded, created, modified, or settled. The financial instrument transaction creates a contractual obligation between the parties involved.
Some common examples of financial instruments include cheques, bonds, shares, stocks, futures, and options contracts. Broadly, there are three types of instruments- cash instruments, derivative instruments, and foreign exchange instruments.
Types of Financial Instruments
Financial instruments play a crucial role in the global economy. It enables investors to allocate their funds, manage risk, and speculate on market movements. They are bought and sold on various financial exchanges and over-the-counter markets.
Some of the types discussed below are cash instruments, derivative instruments, and foreign exchange instruments.
Cash Instruments
Cash instruments are those whose values are determined and influenced by market conditions.
Mostly, these are readily transferable. There are two types of cash instruments:
- Securities It is an instrument that represents ownership of that proportion of a publicly traded company listed on the stock exchange. The proportion depends on the number of securities held by the individual. It has monetary value and is traded on the stock market.
- Deposits and Loans They represent monetary instruments that have some contractual agreement between parties. Both the borrower and the lender have to agree on the transfer.
Derivative Instruments
A derivative is an instrument whose value depends on the value of one or more underlying assets like resources, currency, bonds, stocks, and stock indexes.
Prices for derivatives depend on the fluctuation of prices of these underlying assets. It can be traded on an exchange or over the counter.
They are usually used for hedging. The following are the most common types of derivatives:
- Synthetic Agreement for Foreign Exchange:It is an agreement that guarantees or assures a specified exchange rate during an agreed period in the over-the-counter (OTC) market.
- Forward:A forward contract is a non-standardized contract that can be customized to a commodity, amount, and delivery date between two parties to buy or sell an asset at a specified price at the end of the contract.They are over-the-counter instruments.
- Therefore, they lack a centralized clearing house and carry higher default risk.
- Future:A future is a standardized legal contract that obligates parties not yet known to each other to buy or sell an asset at a predetermined price at a specified time in the future.
- The buyer must buy the asset, and the seller must sell it at the specified time regardless of the current market price at the end of the contract. These are traded on a futures exchange.
- Options:An option is a contract that gives the right to the parties involved to buy or sell an underlying asset at a specified price, known as the strike price, on or before the specified date.
- Call options are purchased to speculate the asset's appreciation, while put options are purchased if the price is speculated to decline. It differs from a futures contract as it gives a right, not an obligation, to buy or sell the asset.
- Interest Rate Swap:An interest rate swap is a contract between two parties to exchange one stream of interest payments for another over a set period based on a specified principal amount.
- They include exchanging a fixed interest rate for a floating rate, reducing or increasing fluctuations in interest rate, or obtaining a marginally lower interest rate.These are traded over the counter.
- Credit Default Swap:A credit default swap is a financial derivative that provides the investor with the protection to swap or offset their credit risk with another investor.
- The lender buys a CDS from another investor who agrees to compensate the lender in case of the buyer defaults in return for periodic payments until the maturity date. These are over-the-counter instruments.
Foreign Exchange Instruments
They are used for trading one currency for another.
These instruments are traded on the foreign exchange market, the forex market. The Forex market is the largest and most liquid market in the world.
Three kinds of instruments are traded there:
- Spot:In this agreement, the currency exchange is done on the spot, i.e., in a short period. The instrument delivery usually takes two working days, but the contract takes place at the current price, known as the spot price.
- Outright Forwards:In this agreement, the currency exchange is done forwardly, i.e., the exchange rate is predetermined, but the exchange is done at some point in the future. It is used to protect the investor from exchange rate fluctuations.
- Currency Swap:In a foreign exchange swap, the parties borrow one currency and lend another at the rate on the initial date, i.e., thespot rate. Then, at the end of the contract, the parties swap the amounts again so that each party receives the currency they loaned and returns it at the predetermined rate.
Asset Classes of Financial Instruments
Financial instruments can also be classified based on asset classes, i.e., whether they are debt-based, equity-based, or a combination of both.
Debt-Based Financial Instruments
An entity uses debt instruments to increase a business's capital.
It provides funds to an entity with an obligation to repay the principal and the interest according to the terms of the contract. They are both short-term and long-term.
Short-term debt is that debt that is settled within one fiscal year. They are in the form of treasury bills, commercial paper, certificates of deposit, etc.
Long-term debt is that debt that takes more than one year to get settled. These include bonds, long-term loans, bond futures, etc.
Equity-Based Financial Instruments
Equity-based instruments provide ownership of the entity in proportion to the number of securities the investor holds.
The risk of issuing such instruments is significantly less than debt-based instruments for the business as there is no obligation to return the amount.
They include stocks, convertible debentures, stock options, equity futures, etc.
