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.

• It 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.

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 all throughout the world’s investors.

A financial instrument is something that has value and can be bought and sold. These assets can be in the form of cash, a contractual right to deliver or receive cash or another type of FI, 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.

Understanding Financial Instruments

It 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.

Types of Financial Instruments

It 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.

Derivative Instruments (Options and Futures)

The value and characteristics of derivatives depend on the performance of the original asset. This can be based on the underlying components of the vehicle, such as the asset, interest rate, or index. They can be traded to provide capital growth value or limit risk to a business or an investment portfolio. Professional investors can use financial derivatives to hedge their investment portfolios. 

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.

Share

Companies issue shares to investors in exchange for money as a source of capital for the operation and development of the company. A legal contract between a company and a shareholder may include the payment of dividends (when the company is likely to pay interest) or benefits for the period the shareholder holds the stock.

Bonds and Loans

Bonds and loans are bonds between a company and an investor. An investor lends money to a company or government and in return, the borrower pays interest to the investor for a certain period of time, at a certain rate, and repays the capital on a certain date. 

Forex

The foreign exchange market provides a service to banks and financial institutions, individuals, businesses and governments that need to buy or sell currencies other than those in use in their home countries. Investors can also hold or trade different currencies to take advantage of exchange rates for profit. 

Insurance

An insurance policy consists of a company or individual paying a premium to an insurance company, which promises monetary compensation in the event of a loss under agreed scenarios.

Fund 

An investment fund (such as an investment company trust) is an equity fund that belongs to a group of investors. This amount is invested by the Fund in the hope that the Fund's value will increase, giving investors a capital surplus. There are many investment funds in the market like ETFs, Mutual Fund, Hedge Fund, Macro Fund,...

Types of Financial Assets

Financial instruments can also be segmented by asset class, which depends on whether they are debt- or equity-based.

Debt-based Financial Instruments

Short-term debt-based financial instruments with maturities of one year or less. These securities come in the form of bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs - certificates of deposit).

Derivatives traded under short-term debt-based financial instruments may be short-term interest rate futures. OTC derivatives are forward rate agreements.

Long-term debt-based financial instruments that last more than one year. According to securities, this is a bond. Cash equivalents are loans. The derivatives traded on the exchange are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate ceilings and floors, interest rate options, and exotic derivatives.

Equity-based Financial Instrument

Securities that are part of an equity-based financial instrument are stocks. Exchange-traded derivatives in this category include stock options and equity futures. OTC derivatives are stock options and other derivatives.

Foreign Exchange Instruments

Foreign exchange (forex, or FX) instruments include derivatives such as forwards, futures, options on currency pairs, and 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.

Why should we hold financial instruments?

• Growth and dividends: Investors buy and sell these instruments for an easy capital gain or to receive interest on bonds or stocks.

• Manage Risk: Buying assets that operate independently of each other (such as buying shares from one country and buying government bonds in another) can help reduce the risk of an investment portfolio 

• Prepare for the Unexpected: An investor wants to hedge his portfolio. Insurance can be purchased to prevent the portfolio from depreciating in value. 

What are some examples of financial instruments?

It comes in many forms and types. What makes them 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. However, commodities derivatives, such as futures, forwards, and options contracts that use a commodity as the underlying asset, would be a financial instrument.

Summary

The main financial instrument is what will provide efficient capital flow and movement for all investors in the world. For financial derivatives that will be traded, the exchange in the form of foreign exchange is currency futures contracts. 

OTC derivatives will include forex options, outright forwards and forex swaps. Because the majority of investors access the forex market through spot contracts. 

Therefore, FXCE has opened up opportunities for Traders to grasp the endless potential of this Forex market.

Accompany FXCE to join the world's largest Financial Market: https://www.fxce.com/register.

Explain 

• Capital gain: Interest earned after the sale of assets or shares.

• Risk: The possibility that the profit earned is not as expected

• Portfolio: A series of investment portfolios of an individual or institution. 

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