What Is a Financial Instrument?
Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital throughout the world’s investors. These assets can be in the form of cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership in some entity.
Examples of financial instruments include stocks, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), mutual funds, loans, and derivatives contracts, among others.
Key Takeaways
- A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value.
- Financial instruments may be divided into two types: cash instruments and derivative instruments.
- Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.
- Foreign exchange instruments comprise a third, unique type of financial instrument.
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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.”
Types of Financial Instruments
Financial instruments may be divided into two types: cash instruments and derivative instruments.
Cash Instruments
- The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Stocks and bonds are common examples of such instruments.
- Cash instruments may also be deposits and loans agreed upon by borrowers and lenders. Checks are an example of a cash instrument because they transmit payment from one bank account to another.
Derivative Instruments
- The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
- An equity options contract—such as a call option on a particular stock, for example—is a derivative because it derives its value from the underlying shares. The call option gives the right, but not the obligation, to buy shares of the stock at a specified price and by a certain date. As the price of the underlying stock rises and falls, so does the value of the option, although not necessarily by the same percentage.
- There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a market or process whereby securities—which are not listed on formal exchanges—are priced and traded.
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.
Debt-Based Financial Instruments
Debt-based instruments are essentially loans made by an investor to the owner of the asset. 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 also technically debt-based instruments that credit depositors with interest payments.
Exchange-traded derivatives exist for short-term, debt-based financial instruments, such as short-dated interest rate futures. OTC derivatives also exist, such as forward rate agreements (FRAs).
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. 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. Securities that trade under the banner of equity-based financial instruments are most often stocks, which can be either common stock or preferred shares. ETFs and mutual funds may also be equity-based instruments.
Exchange-traded derivatives in this category include stock options and equity futures.
Foreign Exchange Instruments
Foreign exchange (forex, or FX) 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. 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?
Financial instruments come in many forms and types. What makes them financial instruments is that they confer a financial obligation or right to the holder. Common 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.
Are Commodities Financial Instruments?
While commodities themselves, such as precious metals, energy products, raw materials, or agricultural products, are traded on global markets, they do not typically meet the definition of a financial instrument. That’s because they do not confer a claim or obligation over something else. But commodities derivatives are financial instruments, They include futures, forwards, and options contracts that use a commodity as the underlying asset.
Are Insurance Policies Financial Instruments?
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 (e.g., death in the case of life insurance). If the insurer is a mutual company, the policy may also confer ownership and a claim to dividends.Insurancepolicies also have a specified value in terms of both the death benefit and living benefits (e.g., cash value) for permanent policies.
Insurance policies are not considered securities, but one could possibly view them as an alternative type of financial instrument because they confer a claim and certain rights to the policyholder and obligations to the insurer.
The Bottom Line
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). Financial instruments can be segmented by asset class and as cash-based, securities, or derivatives.
Depending on their type, financial instruments may be exchangeable on listed or OTC markets.
