What are financial instruments?
If you participate in the financial markets, you will be trading various types of financial instruments. This page covers everything you need to know about financial instruments, and how to choose the ones best suited to your objectives
What is a financial instrument
A financial instrument is a physical or digital document or contract that signifies ownership of an asset or a contractual right to receive something. Financial instruments can be created, modified and traded.
Financial instruments are typically tradable. Just how easily they can be traded depends on liquidity and the amount of information available.
An example to help define financial instruments
If you have a contract to buy or sell something, but you cannot sell the contract, it is not a financial instrument. If you can sell the contract, it is probably a financial instrument.
Types of financial instruments
Financial instruments can be categorized in two ways. Firstly, they represent either equity, debt or a currency. Secondly, they are either primary (cash instruments) or derivative instruments. The following is a list of examples categorized according to whether they are primary or derivative instruments.
Primary financial instruments
Primary instruments are also known as cash instruments. They represent actual ownership of an asset or the right to a future cash flow.
Shares are also known as equities and stocks. A share represents ownership of a percentage of a publicly listed company. Shareholders have certain rights, including a claim on assets if the company is liquidated, the right to receive dividends and the right to vote on important company matters.
ETFs (Exchange Traded Funds)
Strictly speaking, ETFs are a type of share and they are traded just like the shares of listed companies. However, ETFs indicate partial ownership in a portfolio of securities, rather than in a single company.
Bond are long term debt instruments with maturities of more than one year. Governments, municipalities and companies issue bonds to raise money in the form of debt. A bond has a face value which is due to the holder when the bond matures, and a coupon which reflects the interest that is paid to the holder each year.
Money market instruments
Money market instruments are similar to bonds but have maturities shorter than one year. There are lots of different types of money market instruments, including commercial paper, certificates of deposit, repurchase agreements, banker’s acceptances, and treasury bills.
Currencies are also regarded as financial instruments. They are recorded on balance sheets at face value, or in another currency. Cash is the most liquid form of financial instrument.
Other basic financial instruments
Some other items that are listed on company balance sheets are also classified as financial instruments from an accounting standpoint. These include trade debtors, trade creditors and bank loans.
Derivative financial instruments
Derivatives are financial instruments that derive their price in some way from other financial instruments or assets. Some derivatives are relatively simple, while exotic derivatives are very complex.
A futures contract is a contract between two parties to exchange cash or other securities on a future date and at an agreed upon price. Futures contracts are traded on exchanges and have standardized terms that dictate the quantity of the underlying asset, the expiry date and the method of exchange.
An option gives the holder the right, but not the obligation to buy or sell an underlying asset at a specific price, on a specific date in the future.
Options are traded on exchanges and in OTC (over the counter markets)
Forwards are like futures contracts but are not traded on exchanges and don’t have standardized terms. Forwards are traded in the OTC market, usually between institutions and corporations.
CFDs (Contracts for Difference)
CFDs are similar to futures but are traded in the OTC market between brokers and their clients. Unlike futures which have expiry dates, CFDs are rolled forward each day until closed. CFDs are settled for cash.
A swap is an agreement to exchange cash flows based on foreign exchange rates, interest rates, or equity returns. Swaps are traded in the OTC market between banks, institutions, and corporates. They are frequently used by institutions and corporations to hedge currency and interest rate exposure.
Convertible instruments can be converted from one type of instrument to another if or when certain conditions are met. The most common of these are convertible bonds that can be converted to shares.
Characteristics of financial instruments
Each type of financial instrument has its own characteristics which determine whether or not it is suitable for investing, trading or conducting business activities.
Exchange or OTC traded
Financial instruments that are listed and traded on exchanges usually have standardized terms and an extra layer of oversight.
This means less due diligence is required, but there is less flexibility.
Instruments that are traded ‘over the counter’ offer more flexibility but carry counterparty risk.
The liquidity of financial instruments depend on the size of the market, supply, demand, and the way they are traded. Some instruments have deep, liquid markets, while others have no market. Liquidity in turn affects the transaction costs for trading or transferring an instrument.
Liquidity for cash instruments depends on supply and demand. For derivative instruments, liquidity depends on both
Financial instruments each carry unique risks.
- Counterparty risk refers to the risk that a counterparty won’t be able to meet their obligations.
- Liquidity risk refers to thepotential costs that can result from low liquidity, or the chance that an instrument cannot be sold.
- Volatility and market risk refer to the probability that the price of the instrument may be lower when it comes to selling the instrument.
- Tax risk differs according to the way gains may be taxed for each instrument.
- Currency risk refers to the affect changes in certain exchange rates may affect an instrument.
The regulatory environment determines the level of protection investors have. The way financial instruments are regulated depends on the regulatory bodies they fall under. Instruments that are marketed for trading purposes typically fall under bodies like the SEC in the US or the FSA in the UK.
Instruments that are listed on exchanges are subject to an extra layer of oversight.
Why should you know about the types of financial instruments?
Certain financial instruments are better suited to trading, while others are suited to long term investing. Others are used in the course of business but have little relevance to traders or investors.
Before investing in a financial instrument, it is important to understand its characteristics, advantages and disadvantages and how well suited it is to your objectives. It’s also critical to understand the regulatory landscape under which an instrument falls.
If you are an investor, the long-term value and investor protection are of particular importance.
If you are a trader, liquidity and transaction costs are most important. Volatility can also be an advantage as there may be more trading opportunities. Investor protection is also critical.
How to choose the right financial instrument
Choosing the right instruments to meet your objectives requires you to find the right combination of financial instrument, asset class and strategy. The following steps will help you decide:
Step 1: Decide on the asset class you are interested in
Asset classes include equities, bonds, currencies, commodities and real estate. Assets classes with higher returns, like equities carry more risk, while asset classes with lower returns, like cash and bonds carry less risk. Your choice of asset class will also depend on your knowledge and interests.
Step 2: Decide on your objectives
Some financial instruments are better suited to long term investing, while others are better suited to trading (see below). Investors often choose more than one asset class, while traders may specialize in a single asset class.
Step 3: Choose the instrument that suits your objectives and covers the asset class you are interested in
Some instruments only exist within a single asset class, while derivative instruments can have any underlying asset. These instruments are more versatile, especially for trading.
Advantages and disadvantages of tradable financial instruments:
The following are some of the advantages and disadvantages of financial instruments available to retail investors and traders:
- Good long-term returns.
- Wide choice available.
- No leverage.
- Difficult to short sell.
- Steady long-term returns.
- Low volatility.
- Interest rates are currently very low.
- Difficult to short sell.
- Major currencies are very liquid.
- Low transaction costs.
- Typically have low long-term returns.
- Some currencies are not very liquid.
- Built in leverage as they are traded on margin.
- Wide range of asset classes.
- Easy to sell short.
- Can be traded on indexes which cannot be traded directly.
- Contract sizes are typically quite high and require quite a lot of capital.
- High level of risk.
- Wide range of asset classes.
- Built in leverage as they are traded on margin.
- Easy to short sell.
- Not much capital required to get started.
- Сan be traded on indexes which cannot be traded directly.
- Like any leveraged instrument, trading CFDs can be risky.
- CFDs are not available in some countries.
- Financing charges reduce returns over long periods.
- If you buy an option the downside is limited to the premium you pay.
- Options can provide significant leverage.
- Options are sophisticated instruments and require experience and skills to trade.
- Writing (selling short) options is very risky.
The best financial instruments for trading
The following four instruments are best suited for active trading:
CFDs are ideally suited to active traders due to the number of asset classes they can be used to trade. They also have built in leverage and are easy to short sell.
Futures share many of the advantages of CFDs but are better suited to larger accounts due to the minimum capital requirements.
Options can be used for sophisticated trading strategies. They are best suited to traders with a lot of experience and relatively large trading accounts.
The best financial instruments for investing
The following three instruments are ideal for long term investors:
Shares are the most important instruments for long term investment portfolios. Shares allow investors to participate in the growth of companies and the economy over the longer term.
Bonds allow investors to diversify their portfolios to reduce volatility. While returns are not very high, they are higher than for cash, with less risk than shares.
ETFs allow investors to invest in a wide variety of asset classes and instruments using just a few products. They also offer the advantage of diversification and low fees.
The wide number of financial instruments available today means the world of investing and trading is now accessible to anyone. Furthermore, modern trading platforms make all the information and tools you will need available at no cost.
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What are the different types of financial instruments?
Financial instruments are either cash or derivative instruments. The price of cash instruments is determined by market supply and demand. These include shares, bonds and currencies. The prices of derivative instruments is determined by the price of other instruments. Derivative instruments include futures, options and CFDs.
What are basic financial instruments?
Basic financial instruments include cash, trade debtors, trade creditors, bank loans. Shares and bonds can also be regarded as basic financial instruments.
What are the uses of financial instruments?
Financial instruments are used to raise capital, in the course of business, for investment purposes and for hedging and speculating. They can be modified, traded or settled.
Why are financial instruments important?
Financial instruments formalize financial agreements between parties. This establishes a higher level of certainty about the value of an instrument and the likelihood that obligations will be met. Ownership of most financial instruments can also be transferred which increases liquidity.
Are all financial instruments tradable?
In theory all instruments can be traded, however for some it may be difficult. Instruments like debtors and creditors on a companies balance sheet may be difficult to buy or sell.