WHAT IS A FINANCIAL INSTRUMENT? (Genuine and direct providers of financial instrument).
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash, evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form of currency; debt; equity; or derivatives.
A Financial Instrument may be difined as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world’s investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.
Understanding Financial Instruments.
Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt-based financial instruments represent a loan made by an investor to the owner of the asset.
A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value.
Financial instruments may be divided into two types: cash instruments and derivative instruments.
Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.
Foreign exchange instruments comprise a third, unique type of financial instrument.
Types of financial instruments.
There are typically three types of financial instruments: cash instruments, derivative instruments, and foreign exchange instruments.
1. Cash Instruments
Cash instruments are financial instruments with values directly influenced by the condition of the markets. Within cash instruments, there are two types; securities and deposits, and loans.
Securities: A security is a financial instrument that has monetary value and is traded on the stock market. When purchased or traded, a security represents ownership of a part of a publicly-traded company on the stock exchange.
Deposits and Loans: Both deposits and loans are considered cash instruments because they represent monetary assets that have some sort of contractual agreement between parties.
2. Derivative Instruments
Derivative instruments are financial instruments that have values determined from underlying assets, such as resources, currency, bonds, stocks, and stock indexes.
The five most common examples of derivatives instruments are synthetic agreements, forwards, futures, options, and swaps. This is discussed in more detail below.
Synthetic Agreement for Foreign Exchange (SAFE): A SAFE occurs in the over-the-counter (OTC) market and is an agreement that guarantees a specified exchange rate during an agreed period of time.
Forward: A forward is a contract between two parties that involves customizable derivatives in which the exchange occurs at the end of the contract at a specific price.
Future: A future is a derivative transaction that provides the exchange of derivatives on a determined future date 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
Foreign exchange instruments 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 in which the actual exchange of currency is no later than the second working day after the original date of the agreement. It is termed “spot” because the currency exchange is done “on the spot” (limited timeframe).
Outright Forwards: A currency agreement in which the actual exchange of currency is done “forwardly” and before the actual date of the agreed requirement. It is beneficial in cases of fluctuating exchange rates that change often.
Currency Swap: A currency swap refers to the act of simultaneously buying and selling currencies with different specified value dates.
Asset Classes of Financial Instruments.
In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having to do with financial assets.
Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments. Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies to the asset class mix.
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).
They are a critical part of the business environment because they enable corporations to increase profitability through growth in capital.
2. Equity-Based Financial Instruments
Equity-based financial instruments are categorized as mechanisms that serve as legal ownership of an entity. Examples include common stock, convertible debentures, preferred stock, and transferable subscription rights.
Most types of financial instruments provide efficient flow and transfer of capital all throughout the world’s investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.
They help businesses grow capital over a longer period of time compared to debt-based but benefit in the fact that the owner is not responsible for paying back any sort of debt.
A business that owns an equity-based financial instrument can choose to either invest further in the instrument or sell it whenever they deem necessary.
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 for investment purposes, hedging and speculating. They can be modified, traded or settled.
Why are financial instruments important?
Financial instruments formalise financial agreements between parties. This establishes a higher level of certainty about the instrument’s value and that obligation will be met. Ownership of most financial instruments can also be transferred, increasing liquidity.
Are all financial instruments tradable?
In theory, all instruments can be traded, but for some, it may be difficult. Instruments like debtors and creditors on a company’s balance sheet may be difficult to buy or sell.
Purpose and risks of financial instrument.
The use of financial instruments can reduce exposures to certain business risks, for example changes in exchange rates, interest rates and commodity prices, or a combination of those risks. On the other hand, the inherent complexities of some financial instruments also may result in increased risk.
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