Many financial instruments are traded on the financial markets. This is why it is crucial for beginners who want to start trading or investing to figure out what financial instruments are. Financial traders and investors need to understand the product before they can even think about trading.
In this article, we will outline the most important types of financial instruments like primaries, derivatives, and combinations, as well as their characteristics. You will also learn about the advantages and disadvantages of each one. After reading this guide, you will have a better idea of how to choose the right financial instrument for different purposes.
The article covers the following subjects:
Major Takeaways
- Financial instruments are contracts that give a holder the right to receive cash, shares, or other assets. For example, a bond that pays fixed interest.
- Financial instruments fall into four categories: equity, debt, derivatives, and foreign exchange instruments.
- An interest rate swap is used to hedge against interest rate fluctuations.
- Exchange-traded funds (ETFs) allow you to invest in a range of assets through a single instrument.
- Futures and options are widely used in trading and to manage risk.
- The choice of an instrument depends on an investor’s goals, whether it is to generate income, protect funds (for instance, from inflation), or diversify the portfolio.
What Is a Financial Instrument?
International Accounting Standards (IAS) gives the definition of a financial instrument as such: a contract that results in one entity having a financial asset and another entity having a financial liability or an equity instrument.
In other words, a financial instrument is any asset that can be traded by an investor: they can buy and sell it. Contracts that we give a value to and then trade, such as securities, are financial instruments. Options contracts, futures, and bills are all financial instruments.
Examples of Financial Instruments
Here are some examples that can show the concept of a financial instrument in a nutshell.
Example 1
Imagine you put some cash on a savings account. A bank has a liability to keep your funds safe and return them when the contract ends. Cash deposits are a common type of financial instrument.
Example 2
Company A issued corporate bonds. An investor bought some of the bonds. The investor will get fixed payments during the period of maturity of the bonds. Bonds are financial instruments as the company placed them to raise cash.
Example 3
Exchange-traded funds (ETFs), such as the iShares MSCI Emerging Markets ETF, allow you to invest in a wide range of emerging markets, simplifying diversification and reducing costs.
Example 4
An interest rate swap is an agreement between two parties to exchange interest payments. One party pays a fixed rate, and the other pays a variable rate. Large companies and banks actively use such an instrument to manage risks associated with changes in interest rates. It is often used in addition to foreign exchange instruments, especially in international transactions.
Types of Financial Instruments
There are two main types of financial instruments: primary (or cash) and derivative instruments.
Primary Instruments
It is a cash instrument that has its price determined directly by the market.
Cash Deposits
Cash deposits are money a person pays to savings accounts or bank accounts. Dealing with cash deposits, you have an agreement with a bank to pay your money back on a certain date. So, the bank gets a liability. However, cash deposits are for savers rather than investors.
Bonds
They are divided into government bonds, corporate bonds, Eurobonds, and municipal bonds. When you buy government or corporate bonds, you are lending money to a government agency or a business. Eurobonds are priced in a currency that is different from the local currency of the country where the bond is issued. And municipal bonds are certificates of indebtedness issued by states, cities, or other local governments to raise funds. Your returns come in the form of the interest you receive on your loan.
Equity Instruments
They are better known as stocks or shares. When you buy equities, you are literally buying a part of a business and becoming a co-owner or shareholder of that particular firm. The returns you get come in two forms. The first one is any increase in the share price, making your investment more valuable. Secondly, you can get dividends, which is your share of the profits the business makes.
Derivatives
The price of a derivative instrument is determined by another underlying asset or variable and not the derivative contract in and of itself.
Forwards
It is a customized contract between two parties to buy or sell an asset at a specified price at a specified future date. Forwards are not traded on a central exchange, and as a result, they are not standardized to regulations, making them particularly useful for hedging.
Futures
Futures contracts are fundamentally similar to forwards. However, unlike forwards, they are standardized and regulated, which is why they may be traded on an exchange. Futures are often used to speculate on commodities.
Options
An options contract is a contract that gives the right but not the obligation to buy or sell a financial asset at a predetermined price for a specific period.
Swaps
It refers to the exchange of one security for another based on different factors for a period of time stated in the agreement. These cash flow streams are referred to as the legs of the swap. The swap agreement defines the date when the cash flows are to be paid and how they are calculated.
Foreign Exchange Instruments
Foreign exchange instruments are contracts that facilitate currency transactions, allowing entities to lock in exchange rates, exchange currencies, or mitigate currency risks. They are commonly used in trading, investing, and managing financial risks.
Spot Contracts
An agreement to buy or sell a currency at its current market rate, with the transaction typically settling within two business days. This type of contract is commonly used for prompt currency exchanges and immediate financial settlements.
Currency Forwards
Contracts to buy or sell currency at a fixed rate in the future. Such contracts help protect funds from exchange rate fluctuations.
Interest Rate Swap
An agreement to exchange interest payments, often in different currencies. It is used to reduce interest rate and currency risks.
Financial Instruments: Types of Asset Classes
The type of asset class can affect the typology of financial instruments. Thus, there can be debt- and equity-based instruments.
Financial Instruments Based on Debt
They help different institutions and businesses to increase their capital. These instruments can be short and long-term. Short-term instruments based on debts usually last up to a year. T-bills and commercial paper are examples of these instruments. Long-term debt-based financial instruments have a maturity period of more than a year. They include bonds and debentures.
Financial Instruments Based on Equity
Such kinds of instruments assist businesses in growing capital in the long run better than debt-based financial instruments. However, in this case, the debt isn’t paid by the owner, as they bear no responsibility. Stocks, equity futures, and transferable subscription rights are typical equity-based financial instruments.
Characteristics of Financial Instruments
They are the major determinants to choose one business over another.
Liquidity
This is a measure of how easily an asset can be exchanged; it essentially means how quickly you get money out of an asset. The quicker you can convert your investments into cash, the stronger their liquidity. That is why cash and stocks usually have the highest liquidity. Real estate is less liquid because it is much more difficult to sell.
There is no specific liquidity formula. However, there are two common measures you can use: current ratio and quick ratio. For both ratios, high results indicate high liquidity and general financial health.
Expected Return
It is the expected value of a return; however, it is not based on what you believe. It can be approximately forecasted by looking at the average price of the asset and the history of the market, but still, there are no guarantees. It’s just the average of what has happened over history.
Risk
This is a possibility of an investment bringing a result other than anticipated. You may lose some or all of your invested funds, even though you anticipated a profit. You can also gain something but less than you have expected. It is important to realize that every investment entails some risk. There are several types of risk: inflation risk, interest rate risk, political risk, currency risk, and credit risk. That is why if you want to buy or sell, for example, on Forex, you should pay constant attention to the general market situation and carefully consider each investment in terms of risk.
Advantages and Disadvantages of Financial Instruments
Before trading or investing, you should assess the potential risks and benefits of each financial instrument you want to use:
|
Financial instrument |
Advantages |
Disadvantages |
|
Bonds |
Receive income through the interest payments Hold the bond to maturity and get all your principal back You can profit if you resell the bond at a higher price |
Bonds pay out lower returns than stocks Companies can default on bonds |
|
Stocks |
Receive income through dividends Deliver high returns over time High level of liquidity |
The amount of dividends is not fixed A company can go bankrupt They can lose their value dramatically |
|
Currency |
Easy instrument High level of liquidity |
High volatility is caused by political and economic factors |
|
Commodities |
The best protection against inflation Potentially high returns Not correlated with stocks and bonds |
May be highly volatile No constant income is generated |
|
Indices |
Low fees No need to do a lot of research High level of diversification |
Passive management Lack of flexibility |
How to Choose the Right Financial Instrument
Financial instruments come in a variety of shapes and sizes. Here are a few things to remember in order to choose the best ones.
Step 1: Determine Why You Need This Financial Instrument
Financial tools can help you achieve your financial goals, but you must first identify them. These might be short-term goals, such as obtaining funds to buy a new computer, or long-term goals, such as funding an early retirement.
Step 2: Assess Your Attitude Toward Risk-Taking
We all can be affected by risk in different ways. It depends on different psychological elements such as risk tolerance and anxiety. For example, low-risk government bonds with lower pay-outs are a better choice for those who are too afraid of risk.
Step 3: Take Into Consideration the Attributes of Each Financial Instrument
All financial instruments have advantages and disadvantages. Before making any choice, you should weigh all aspects connected to your purpose, level of risk, amount of time, and so on. In other words, you should study how those instruments work.
Best Financial Instruments for Trading
Trading has the potential to make you money in a matter of hours, days, weeks, or even months. However, it is much riskier because your bet on the price either works out or it doesn’t in that time period. Here is a list of financial instruments for trading:
Forex (Currencies)
Many investors and traders don’t know that the foreign exchange or Forex market is actually the largest in the world. There are plenty of currency pairs that you can buy and sell, but for short-term strategies, it is better to focus on a few of them to be able to learn as much as you can.
Stock (CFD)
When you buy a usual individual stock, you become a shareholder — but when you purchase a stock CFD, it doesn’t mean that you own a part of a company. Instead, you buy a contract to track the performance of an underlying stock. A stock CFD is traded just like a currency on Forex.
Commodities (CFD)
Just like with stock CFD, buying and selling commodity CFD doesn’t make you actually own metals or oil. You buy a contract that reflects the price movement of the asset it is based on. You can both buy and sell a commodity, profiting from both actions.
Stock Indices (CFD)
They are a great alternative to purchasing individual stocks. Index CFDs help speculators to benefit from changes in the price of a set of stocks. S&P 500 and DJIA are the most popular indices.
Don’t worry if you don’t know how to start trading these instruments. LiteFinance can help you in trading to get benefits from price movements.
Best Financial Instruments for Investing
Being a long-term investor means holding your investments for many years at a time. In this case, you don’t have to worry about day-to-day fluctuations in the value of your portfolio. Here’s a list of financial instruments for investing:
ETFs
Basically, an ETF is a basket of multiple investments, and this could include bonds, stocks, or commodities. It trades like a single stock on the stock exchange. ETFs can also track a certain industry of stocks, like the technology industry, banking industry, etc. Investing in ETFs is a very cheap way of diversifying your investments, and it is a lot safer than individual stocks.
Blue Chip Stocks
For beginners, it is recommended to invest in large-cap companies. These are companies with market capitalizations greater than $10 billion. Large-cap companies are notoriously safer than smaller and more speculative companies because they have proven a great track record of increasing their earnings.
Index Funds
An index fund is basically a pooled type of investment that you can buy within your brokerage account. They are great for those who want to buy and hold without paying massive fees for active management. Index funds allow you to grow your money passively. If you are new to investing, having investments in just one of such funds as one of your core holdings is a great idea.
Bonds
Government bonds are regarded as one of the safest asset classes, which is why they are perfect for long-term investing. Governments use these bonds to fund their projects or infrastructure. In return, they make fixed interest rate payments at intervals specified by the bond coupon. When the bond expires, you get your original investment back. You can consider corporate bonds as well. However, be careful when choosing a company. Pay attention to its ratings.
Debt Funds
Many institutions borrow money to support their financing needs. These include the central government, banks, infrastructure finance companies, and many others. A debt fund is any pool of fixed-income investments. Choose companies and institutions that have strong revenue, cash flows, and profits, as they can service their debt obligations easily. They are given the highest rating by credit rating agencies.
Conclusion
Financial instruments play an important role in trading and investing. That is why it is very important for beginners to understand what they are and how they work in the market. There are plenty of instruments available to novice investors, and all of these instruments can be used differently. The most crucial thing here is to choose the right strategy that will help you achieve your long- or short-term goals. However, it becomes possible only after choosing the right Forex broker. LiteFinance is for you.
Financial Instruments FAQ
Generally speaking, there are two main types of financial instruments. They are cash and derivative instruments. They differ from each other in the way they are priced. Cash instruments are priced directly, while derivatives get their price indirectly.
You have probably heard of most of the basic instruments. They include bonds, stocks, mutual funds, commodities, options, and futures. All of them have their own features and help to achieve different goals. That is why you need to learn about their pros and cons before investing in them.
Financial instruments help to earn extra money for various purposes. You can buy and sell them to profit from fluctuations in the price. However, if you aren’t fond of trading, you can invest in them to make money in the future.
The most important things to take into consideration are liquidity, expected return, and risk. These three characteristics are crucial when it comes to choosing the right financial instrument. They show how easily an asset can be converted into cash, what possible profit one can gain, and how risky it is to invest in an instrument.
If you plan to become a trader or investor, you should understand the essence of financial instruments. They are the main tools for earning money in the financial market. The more you know about them, the more confident you feel while investing or trading.
Yes, commodities such as gold or oil become financial instruments when traded through futures, options, or exchange-traded funds. They act as underlying assets for derivative contracts.
Technically, yes, because a policy is a contract with financial value and potential future benefits. However, it is more often referred to as a risk management tool rather than an asset traded in the market.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance broker. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2014/65/EU.
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