Financial Instruments: Definition, Types & How They Work

Financial instruments are contracts for monetary assets that can be purchased, traded, created, modified, or settled for. In terms of contracts, there is a contractual obligation between involved parties during a financial instrument transaction.

For example, if a company were to pay cash for a bond, another party is obligated to deliver a financial instrument for the transaction to be fully completed. One company is obligated to provide cash, while the other is obligated to provide the bond.

Basic examples of financial instruments are cheques, bondsBonds vs StocksFor prospective investors and many others, it is important to distinguish between bonds vs. stocks. Two of the most common asset classes for investments are, securities.

There are typically three types of financial instruments: cash instruments, derivative instruments, and foreign exchange instruments.

Types of Financial Instruments

1. Cash Instruments

Cash instruments are financial instruments with values directly influenced by the condition of the markets. Within cash instruments, there are two types; securities and deposits, and loans.

Securities: A security is a financial instrument that has monetary value and is traded on the stock market. When purchased or traded, a security represents ownership of a part of a publicly-traded company on the stock exchange.

Deposits and Loans: Both deposits and loans are considered cash instruments because they represent monetary assets that have some sort of contractual agreement between parties.

2. Derivative Instruments

Derivative instruments are financial instruments that have values determined from underlying assetsUnderlying AssetUnderlying asset is an investment term that refers to the real financial asset or security that a financial derivative is based on. Thus, the, such as resources, currency, bonds, stocks, and stock indexes.

The five most common examples of derivatives instruments are synthetic agreements, forwards, futures, options, and swaps. This is discussed in more detail below.

Synthetic Agreement for Foreign Exchange (SAFE): A SAFE occurs in the over-the-counter (OTC) market and is an agreement that guarantees a specified exchange rate during an agreed period of time.

Forward: A forward is a contract between two parties that involves customizable derivatives in which the exchange occurs at the end of the contract at a specific price.

Future: A future is a derivative transaction that provides the exchange of derivatives on a determined future date at a predetermined exchange rate.

Options: An option is an agreement between two parties in which the seller grants the buyer the right to purchase or sell a certain number of derivatives at a predetermined price for a specific period of time.

Interest Rate Swap: An interest rate swap is a derivative agreement between two parties that involves the swapping of interest rates where each party agrees to pay other interest rates on their loans in different currencies.

3. Foreign Exchange Instruments

Foreign exchange instruments are financial instruments that are represented on the foreign market and primarily consist of currency agreements and derivatives.

In terms of currency agreements, they can be broken into three categories.

Spot: A currency agreement in which the actual exchange of currency is no later than the second working day after the original date of the agreement. It is termed “spot” because the currency exchange is done “on the spot” (limited timeframe).

Outright Forwards: A currency agreement in which the actual exchange of currency is done “forwardly” and before the actual date of the agreed requirement. It is beneficial in cases of fluctuating exchange rates that change often.

Currency Swap: A currency swapForeign Exchange SwapA foreign exchange swap (also known as a FX swap) is an agreement to simultaneously borrow one currency and lend another at an initial date, refers to the act of simultaneously buying and selling currencies with different specified value dates.

Asset Classes of Financial Instruments

Beyond the types of financial instruments listed above, financial instruments can also be categorized into two asset classes. The two asset classes of financial instruments are debt-based financial instruments and equity-based financial instruments.

1. Debt-Based Financial Instruments

Debt-based financial instruments are categorized as mechanisms that an entity can use to increase the amount of capital in a business. Examples include bonds, debentures, mortgages, U.S. treasuries, credit cards, and line of credits (LOC).

They are a critical part of the business environment because they enable corporations to increase profitability through growth in capital.

2. Equity-Based Financial Instruments

Equity-based financial instruments are categorized as mechanisms that serve as legal ownership of an entity. Examples include common stockCommon StockCommon stock is a type of security that represents ownership of equity in a company. There are other terms – such as common share, ordinary share, or voting share – that are equivalent to common stock., convertible debentures, preferred stock, and transferable subscription rights.

They help businesses grow capital over a longer period of time compared to debt-based but benefit in the fact that the owner is not responsible for paying back any sort of debt.

A business that owns an equity-based financial instrument can choose to either invest further in the instrument or sell it whenever they deem necessary.

Additional Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, the additional resources below will be very helpful:

• DebenturesDebentureA Debenture is an unsecured debt or bonds that repay a specified amount of money plus interest to the bondholders at maturity. A debenture is a long-term debt instrument issued by corporations and governments to secure fresh funds or capital. Coupons or interest rates are offered as compensation to the lender.
• Interest Rate SwapInterest Rate SwapAn interest rate swap is a derivative contract through which two counterparties agree to exchange one stream of future interest payments for another
• Options: Calls and PutsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price.
• Preferred SharesPreferred SharesPreferred shares (preferred stock, preference shares) are the class of stock ownership in a corporation that has a priority claim on the company’s assets over common stock shares. The shares are more senior than common stock but are more junior relative to debt, such as bonds.