Any aspiring trader or investor will have come across the term “financial instrument” before. But do you understand what it is? In this article, we will define the meaning of this term before examining some of the different types of financial instruments in detail.
What Is a Financial Instrument?
International Accounting Standards define a financial instrument as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". In other words, financial instruments normally involve obligations on one party (like a commitment to make specific payments), and benefits for the other party (like the right to receive specific payments, or evidence of ownership in a company).
Financial instruments can normally be traded among parties, making them less risky to hold (as you are able to sell them if you subsequently need the money) and creating the possibility of making gains and losses on such trades.
The Different Types of Financial Instruments
Financial instruments can be classified in many different ways. In this article we will put them into two different types of financial instruments: cash instruments and derivative instruments. In the following sections, we will examine the different classifications of financial instruments and look at some examples.
Cash Financial Instruments
Cash financial instruments are typically generated, or issued, by organisations (mostly governments and corporates) in order to raise capital. In this context, those organisations are often referred to as issuers.
The prices for cash instruments are, either, set by the issuer (after advice from financial professionals), or arrived at by negotiation between the issuer and investors, who typically buy financial instruments on the expectation of making a profit.
Once issued and sold, the holders (traders and investors) can trade them openly in the financial markets, at a price set by supply and demand.
Below, we describe the main cash types of financial instruments.
Stocks and Shares
As the name implies, a share represents a share of ownership in a company. If a company issues 100 shares and you buy 1 of them, you own 1/100th, or 1%, of the company. From that point on, until you sell the share, you will be entitled to 1% of any dividends paid by that company, 1% of the votes at shareholder meetings, etc.
This last point is a simplification, as companies sometimes have multiple share classes, with each class having different rights assigned to them.
Bonds
A bond is like an IOU, a certificate that the issuer (or borrower) gives an investor in return for some cash. In the case of a bond, the document will specify the terms and conditions, including the size and frequency of the coupon (or interest) payments and the date when the bond has to be repaid; called the maturity date.
Failing to pay coupons on time, or to repay the bonds on maturity, exposes the issuer to a risk of being put into default by the bond holders.
As governments do not issue shares, bonds are the “go to” financial instrument that governments rely on to raise money from investors. At any one time there will be trillions of dollars of government bonds in circulation.
Loans
Loans are made by banks and other credit institutions to organisations such as companies, sovereign governments, or government agencies. From the borrowers’ point of view, loans look fairly similar to bonds but because there are fewer parties involved (normally only one bank, sometimes a handful) they are much easier and quicker to negotiate and document than bonds, which could have thousands of investors involved.
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Convertible Bonds
A convertible bond, or just convertible, is a bond which will either be repaid or converted into shares at a date in the future. Convertible bonds, therefore, look like a bond for the first part of their life, then they are either repaid or converted into shares for the second part of their life.
The terms for convertible bonds will define the size and frequency of coupon payments (if any); and the terms and the date for repayment or conversion.
Instead of a specific date, convertible bonds often convert to equity on a “trigger” event, the most common one being the issue and sale of new shares by the company.
Convertible Loans
A convertible loan is a loan which will either be repaid or convert into equity at a date in the future. The terms for convertible loans will determine the size and frequency of interest payments (if any); and the terms and the date for repayment or conversion.
As with convertible bonds, instead of a specific date, the loan often converts to equity when a “trigger” event takes place.
Derivative Financial Instruments
As the name suggests, derivative financial instruments, or simply derivatives, derive their value from something else. That something else is referred to as the underlying asset, or simply the underlying.
The most common underlying assets are shares, bonds, indices (like the S&P 500), interest rates, commodities (like coffee or oil) and currency pairs.
Different types of derivative financial instruments have different characteristics, but they have two things in common that make them popular with traders and investors.
Firstly, a small fee often allows the derivative holder to take a large position in the markets. In other words, they offer the opportunity for traders to leverage their trades, magnifying the potential gains or losses.
Secondly, derivatives make it easy not only to go long, or buy, an underlying asset when you think the price will go up; but also to go short, or sell, an underlying asset when you think the price is likely to fall.
Below, we take a look at the most common derivative derivative types of financial instruments.
Options
Owning an option, gives you the option, but not the obligation, to buy (or to sell) the underlying asset at a specific price, known as the strike price.
Options that give you the right to buy the underlying asset are sometimes referred to as “calls” and those that give you the right to sell as “puts”.
When an option holder decides to go ahead and buy (or sell) the underlying, they are said to exercise the option.
Every option has an expiration date. If the holder does not exercise the option before that date then the option ceases to exist and the holder loses the fee paid to acquire it. This is quite common as options are only exercised when they are likely to make a profit for the option holder.
Futures
Futures work in the same way as options, except that they don’t give you an option but an obligation. In other words, the holder does not have a choice and the future has to be exercised on or before the maturity date; whether or not the transaction will work in favour of the holder of the future.
CFDs
Contracts For Difference (CFDs) are an agreement, or contract, made between two parties to exchange the difference in the price of an asset from when the contract starts to when it ends.
Like other derivatives, CFDs can be used to speculate on rising and falling prices. However, unlike the other derivative products listed above, CFDs are purely speculative, the underlying asset will never change hands at the end of the contract.
