Financial Instruments

A contractual money asset that can be purchased, traded, created, modified, and even settled.

What are Financial Instruments?

A financial instrument is a contract of financial assets that can be purchased, traded, created, modified or settled. With regard to contracts, there are contractual obligations between the parties involved in financial product transactions. For example, if a company pays cash on a bond, the other party is obligated to provide an instrument to complete the transaction. One company is obligated to provide cash and the other company is obligated to offer bonds.

Basic examples of financial instruments are checks, bonds and securities. There are generally three types of financial instruments: cash instruments, derivatives instrument and foreign exchange instruments.

Types of financial products:

1. Cash instrument

These instruments are financial instruments whose value is directly influenced by market conditions. There are two types of monetary products. Securities and deposits and loans.

Securities: Securities are financial instruments with a monetary value and are traded on the stock exchange. When bought or traded, a stock represents the ownership of a portion of a publicly traded company.

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

2. Derivative Instruments:

   These are financial instruments whose value is determined on the basis of underlying assets such as resources, currencies, bonds, equities and stock indices. The five most common examples of derivatives are synthetic agreement, forwards, futures, options, and swaps. This is discussed in more detail below.

Synthetic Foreign Exchange Agreement (SAFE): SAFE is executed in the over-the-counter (OTC) market and is an agreement that guarantees a specific exchange rate within an agreed period.

Forward: A forward contract is a contract between two parties that provides adjustable derivatives where the exchange takes place at the end of the contract at a specified price.

Future: A future is a derivative transaction in which derivatives are exchanged on a specified date in the future 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:

   These 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 where the actual currency exchange is no later than the second business day after the original trade date. It is called "spot" because the exchange happens "on spot" (for a limited time).

Outright Forwards: A currency agreement contract where the actual exchange of currency is made 'forward' and before the actually agreed date of the requirement. It is useful in the case of fluctuating exchange rates that change frequently.

Currency Exchange: Currency Swap refers to the simultaneous buying and selling of currencies with different 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). It is an important part of the business environment as it allows companies to increase their profitability through capital growth.

2. Equity Financial Instruments-
   

   Instruments classified as mechanisms that act as legal property of legal entities. Examples include common stock, convertible debentures, preferred stock and transferable subscription rights. They help companies grow their capital over a longer period of time than their debt base, but have the advantage that the owners are not responsible for paying the debts.

Companies that own equity-based financial instruments can invest in or sell their financial instruments whenever they deem it necessary.