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Financial Instrument

Financial instrumentA financial instrument is one of the key concepts of trading.

What Is a Financial Instrument?

It is a monetary contract between parties. It is an asset or package of capital that we can trade. In other words, we can buy and sell financial instruments. Contracts that we give a value to and then trade, such as securities, are FIs. Checks, options contracts, futures, and bills of exchange are other examples.

Types of Financial Instruments

There are 2 main types: cash and derivatives. Cash instruments are valued by the markets directly. Securities that are readily transferable are cash instruments. They also include loans and deposits where both the lender and borrower agree on a transfer.

Cash FIs include:

  • Equity

  • Bonds, loans, and borrowings

  • Receivables and payables

  • Cash deposits

Derivative instruments are those whose worth is derived from the value of at least one underlying asset. Derivative FIs include:

  • Forwards and futures

  • Financial options

  • Swaps

  • Caps and collars

  • Financial guarantees

  • Letters of credit

  • Indexes

  • Interest rates

Depending on the asset class, financial instruments are divided into debt based and equity based.

  • Debt based FIs reflect a loan that the investor made to the issuing entity. They can include corporate and government bonds as well as collateralized securities such as collateralized debt obligations.

  • Equity based FIs refer to shares in companies and reflect the ownership of the issuing Entity.

Debt-Based

Short-term debt-based FIs expire in one year or less.

  • Securities of this type are T-bills and commercial paper.

  • Cash equivalents of this kind can be deposits and certificates of deposit.

  • Exchange traded derivatives can be short-term interest rate futures.

  • OTC derivatives are forward rate agreements.

Long-term debt-based FIs last for over a year.

  • Securities of this category are bonds.

  • Cash of this type is loans.

  • Exchange traded derivatives include bond futures and options on bond futures.

  • OTC derivatives are interest rate swaps, caps and floors, options, and exotic derivatives.

Equity-Based

  • Securities of this type are stocks.

  • Exchange traded derivatives of this kind are equity futures and stock options.

  • OTC derivatives are exotic derivatives and stock options.

Complexity

Depending on the level of trading expertise, FIs can also be divided into complex and non-complex ones. The most common complex FIs are derivatives such as contracts for difference (CFDs), futures contracts, options, and spread bets. Non-complex FIs are those that require only an initial investment and then a third party, e.g. a fund manager, makes investments on your behalf. Such instruments include shares or equity securities, as well as debt securities and specific types of investment funds, e.g. the hedge and mutual funds.

Example

If you order a specific amount of oil with the intention of taking physical delivery, then it is not a financial instrument. However, if, instead of physical delivery, you settle in cash (pay or receive the difference in market prices between the contract date and the delivery time), then it is a financial instrument.

Summary

FIs are monetary contracts between two parties regarding the asset or capital that can be traded. If you have no intention to accept the delivery of an asset that you have ordered, preferring to settle in cash instead, then it is a financial instrument.

There are 2 main types: cash and derivatives. It is also possible to classify FIs by asset class (debt based and equity based) as well as by complexity (complex and non-complex).