Last Updated on May 24, 2022 by Aradhana Gotur

Knowing financial instruments meaning can help investors make the right choice of investments to grow their money. A financial instrument can be defined as a monetary contract made between two individuals. These instruments can be created, traded, modified, or settled for. They are legal agreements that hold monetary value and provide for an efficient flow and transfer of capital among investors around the world. Let’s deep dive into what are financial instruments, the types of financial instruments and their pros and cons.

What are financial instruments?

Financial instruments are intangible instruments that provide monetary benefits in the future. These instruments are commonly traded in the financial markets and the price of these instruments is determined by market forces of demand and supply. Some of the common financial instruments include equity, bonds, and cheques.

There are different types of financial instruments and they serve particular purposes and cater to the varying needs and risk profiles of the investors. For example, a long-term investor could have an inclination towards dividend stocks, bonds and so on, while short-term investors may look to volatile instruments to make quick profits.

Types of financial instruments

Financial instruments are majorly classified as cash instruments, derivative instruments, and foreign exchange instruments.

Cash instruments

The value of cash instruments is determined by the market’s demand and supply. These cash instruments are easily transferable and are mainly of two types: securities, and deposits and loans.

  • Securities are traded on the stock exchanges and have a monetary value attached to them. A security can refer to a right to ownership. 
  • Deposits and loans are contractual obligations wherein both the lender and borrower are subjected to various terms and conditions.

Derivative instruments

Derivative instruments are a complex phenomenon. These instruments derive their value from underlying entities that could be a stock, index or others. Some of the most common examples of derivative instruments include:

  • Forward contract: It is a contract between two parties that can have tailormade conditions in which exchange happens at the end of a contract and at a specific predetermined price. 
  • Futures: A future facilitates the exchange of derivatives on a future date at predetermined prices. 
  • Swaps: This is an interest rate derivative and involves the exchange of interest rates between two parties.
  • Options: Options give the buyers the right but are not an obligation to buy or sell the underlying asset.

Foreign Exchange Instruments

These are instruments that are represented on foreign markets and consist broadly of currency agreements and derivatives. Currency agreements classify into spot, outright forward and currency swap. 

  • Spot is a currency agreement where currency exchange is done on the spot and no later than the second working day of the agreement. 
  • Currency agreements are where the actual exchange of currency is done before the actual date of agreed requirement is an outright forwards agreement. 
  • Currency swap is a contract between two parties for exchanging interest rates and principal payments at a predetermined rate of exchange.

Advantages and disadvantages of financial instruments

Liquid financial instruments come in handy for individuals and businesses alike and in times of emergency. Stakeholders often feel safe when companies invest their money in highly liquid instruments, however, financial instruments may also spread the risk across various asset classes such as equity, bonds and real estate. These asset classes not only provide capital gains but also regular income in form of dividends, interests and rental income.

There are a few disadvantages to these instruments as well. For example, there is a lock-in period in many bond investments which may not help the investor in case of contingencies. Also if the investor wants to withdraw before the completion of the maturity of the product, then there might be deductions as fines. Sometimes, there are high transactional costs and risk of inadequate returns which investors construed as missed opportunities.

Asset classes of financial instruments

Financial instruments can be categorised into two asset classes:

  1. Debt-based financial instruments: To raise capital, organizations and even governments might issue debt. Debt helps them in financing particular requirements or fund specific projects while using the additional capital effectively. In exchange, investors are offered a fixed rate of return and a promise of repayment of the capital invested at a later date. Examples are bonds and debentures. 
  1. Equity-based financial instruments: They provide a piece of ownership to investors and mostly include common stock, preference shares and convertible debentures. They help companies in raising capital and do not have a payback period, unlike debt instruments. 

Private equity is another form of equity investing, most suited to high net worth individuals and angel investors. It allows investors to invest in upcoming start-ups to grow corpus alongside the growth of the start-up, or engage in the buyout of such companies should the investor see it fit.

Another type of equity instrument is ETF, also known as Exchange Traded Funds. They are preferred by passive investors who do not have the bandwidth for monitoring the market.

Financial instruments form a very important part of the financial world. Every financial instrument can cater to a variety of traders, investors, businesses, companies and individuals. It is important for each of these parties to realise their risk appetite and select an instrument in accordance with the same.