The Essence Of Financial Instruments

What are Financial Instruments?

Financial instruments are legal contracts between the parties involved in transactions revolving around monetary assets. These assets can be bought, created, transformed, or traded. For example, if you want to purchase a company bond or equity in cash, the company or the other party would need to provide a financial instrument to complete the transaction in full. It is an asset in the form of financial investment in return for money. Some fundamental financial instruments in India are securities, bonds, and cheques.

Understanding Financial Instruments

When asked, "What do you mean by financial instruments?", the accurate answer is - financial instruments are a legal agreement with monetary value. The main categories are currency financial instruments, which include a unique third type of financial instrument, equity-based, which represents the asset's ownership, and debt-based, which is similar to a loan to the owner of the acquisition made by an investor. Some of the most commonly used financial instruments are:

1. Shares

2. Bonds

3. Indices

4. Forex

5. Commodities

6. Derivatives

Types of Financial Instruments

Three examples of financial instruments and some of their characteristics are described below:

1. Derivative Financial Instruments

These are instruments whose value can be derived or ascertained from their underlying entities, such as assets, resources, indices, currencies, interest rates, etc. The performance of these instruments in the market decides the value of these instruments, and derivative securities can be linked to other financial securities like bonds and shares/stocks.

Derivative financial instruments can be exchange-traded or OTC, or over-the-counter (where securities are priced and traded – which are not listed on formal exchanges) derivatives.

For example, one of the derivates is a stock option contract, as it retrieves its value from the original stock. That gives the right, not the obligation, and As the price of the stock goes up and down, the value of the option goes up and down, generally not abiding by the same percentage. It gives a right to the holder to buy or sell stocks at a specific price and on a particular date. Some examples of derivatives instruments in India are options, forwards, synthetic agreements, futures, and swaps.

2. Cash instruments

These are instruments that can be easily transferred and valued in the market. These are formed and influenced by the markets. Some of the most common examples of cash are loans and deposits, upon which lenders and borrowers must agree. Loans and deposits represent monetary assets and bind both parties in a contract.

3. Foreign Exchange Instruments

Foreign exchange financial instruments revolve around currency agreements and derivates. These can be represented in the foreign market. These can further be of three categories – Spot, Outright Forwards, or Currency Swap.

Foreign exchanges are known for trading international derivatives and currencies. They are the most liquidated and largest markets worldwide for trading volume, which varies in trillions of dollars. Several financial institutions, brokers, and banks deal with these instruments as the forex market is open 24 hours a day, 5 days a week, but is closed on holidays.

Various Catagories of Asset Classes of Financial Instruments

Financial instruments can be classified into debt or equity assets:

Debt-based Financial Instruments

Debt-based long-term financial instruments come in the form of bonds and have a maturity of more than one year. Cash equivalents in the form of loans and exchange-traded derivatives in the form of bond futures would also be examples of debt-based instruments. Some examples of OTC derivates are exotic derivates, interest rate swaps, caps and floors, and interest rate options. Monetary instruments such as certificates of deposit (CDs) and exchange-traded derivatives like short-term interest rate futures also come into this category. 

Equity-based Financial Instruments

The equity based instruments would include stocks and shares. The exchange-traded derivatives under this include equity futures and stock options. The OTC derivatives have exotic stock options, and are available in currency options, forward contracts, and currency swaps. There are no foreign exchange securities under the category. Additionally, cash equivalents are expressed in spot currency with the current prevailing rate.

Conclusion

Several Indian investors save money in financial securities to secure their futures. You can multiply money well by investing in financial instruments like bonds, mutual funds, deposits, cash, and cash equivalents. Financial instruments are a promising channel to invest in and raise funds.