What Is a Financial Instrument?

What Is a Financial Instrument?

Let me explain what a financial instrument is. It's a real or virtual legal agreement with monetary value that you can trade or exchange, and it might be an asset like stocks, bonds, derivatives, or loans.

Financial instruments are assets you can trade or exchange. Examples include stock shares, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), mutual funds, loans, and derivatives contracts.

These instruments ensure an efficient flow and transfer of capital among investors worldwide. They can be cash assets, a contractual right to deliver or receive cash or another financial instrument, or evidence of ownership in an entity.

Key Takeaways

A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value. You can divide them into two types: cash and derivatives. They are also categorized by asset class, depending on whether they are debt-based or equity-based. Foreign exchange instruments form a third, unique type.

Understanding Financial Instruments

Financial instruments can be real or virtual documents representing a legal agreement with any kind of monetary value. Equity-based ones represent ownership of an asset. Debt-based ones represent a loan you make as an investor to the asset's owner.

Foreign exchange instruments are a third, unique type. Each type has subcategories, such as preferred share equity and common share equity.

International Accounting Standards define financial instruments as any contract that gives rise to a financial asset for one entity and a financial liability or equity instrument for another.

Types of Financial Instruments

You can divide financial instruments into two types: cash instruments and derivative instruments.

Cash Instruments

The values of cash instruments are directly influenced and determined by the markets, and you can readily buy and sell them. Stocks and bonds are examples of such primary instruments. Cash instruments may also include deposits and loans agreed upon by borrowers and lenders. Checks are an example because they transmit payment from one bank account to another.

Derivative Instruments

The value and characteristics of derivative instruments come from underlying components, such as assets, interest rates, or indices. An equity options contract, like a call option on a particular stock, is a derivative because it derives its value from the underlying shares. This call option gives you the right, but not the obligation, to buy shares at a specified price by a certain date. As the stock price rises and falls, the option's value changes, though not necessarily by the same percentage.

There are over-the-counter (OTC) derivatives and exchange-traded derivatives. OTC involves a market where securities not listed on formal exchanges are priced and traded.

Types of Asset Classes of Financial Instruments

You can also divide financial instruments by asset class, depending on whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Debt-based instruments are essentially loans you make as an investor to the issuer in return for interest payments. Short-term ones last for one year or less, like Treasury bills (T-bills) and commercial paper. Bank deposits and certificates of deposit (CDs) are technically debt-based because they earn interest.

Exchange-traded derivatives for short-term debt include short-dated interest rate futures, and OTC ones include forward rate agreements. Long-term debt-based instruments last more than a year, typically issued as bonds or mortgage-backed securities. Exchange-traded derivatives here are fixed-income futures and options. OTC derivatives include interest rate swaps, caps, floors, and long-dated interest rate options.

Equity-Based Financial Instruments

Equity-based instruments represent ownership of an asset. Stocks are equity-based, as are ETFs and mutual funds invested in stocks. Exchange-traded derivatives in this category include stock options and equity futures.

Foreign Exchange Instruments

Foreign exchange instruments include derivatives like forwards, futures, options on currency pairs, and contracts for difference. Currency swaps are another common form. Forex traders may also engage in spot transactions for immediate currency conversion.

What Are Some Examples of Financial Instruments?

A financial instrument is any document, real or virtual, that confers a financial obligation or right to the holder. Examples include stocks, ETFs, mutual funds, real estate investment trusts, bonds, derivatives contracts like options, futures, and swaps, checks, certificates of deposit (CDs), bank deposits, and loans.

Are Commodities Financial Instruments?

Commodities like precious metals, energy products, raw materials, and agricultural products are traded on global markets, but they do not typically meet the definition of a financial instrument because they do not confer a claim or obligation. However, commodity derivatives are financial instruments, including futures, forwards, and options contracts that use a commodity as the underlying asset.

Is an Insurance Policy a Financial Instrument?

Insurance policies are not considered securities, but you could view them as an alternative type of financial instrument because they confer a claim and certain rights to the policyholder and obligations to the insurer. An insurance policy is a legally binding contract with the insurance company that provides monetary benefits if certain conditions are met, such as death in life insurance. If the insurer is a mutual company, the policy may confer ownership and a claim to dividends. Policies also have specified value in terms of death benefits and living benefits like cash value for permanent policies.

The Bottom Line

A financial instrument is effectively a monetary contract, real or virtual, that confers a right or claim against a counterparty in the form of payment like checks, equity ownership or dividends like stocks, debt like bonds, loans, or deposits, currency like forex, or derivatives like futures, forwards, options, and swaps. You can categorize them by asset class and as cash-based, securities, or derivatives. Depending on the type, they may be exchangeable on listed or over-the-counter markets.