Types of Financial Instruments

What are Financial Instruments?

Financial instruments are assets investors can trade, transfer, or exchange in the financial markets. These are contractual agreements between parties that involve a monetary value. Financial instruments can be categorized into various types based on their characteristics and features serving different purposes. A company issues financial instruments to raise capital. For investors, these are classified as assets. Investors and institutions use financial instruments for investment, risk management, and speculations.

Geeky Takeaways:

• Financial instruments are assets that investors trade in financial markets.
• These instruments can be categorized into various types such as equity instruments, debt instruments, derivatives, etc.
• Most financial instruments carry fixed interest rates that can act as a source of income for investors.

Types of Financial Instruments

1. Equity Instruments

Equity instruments are those instruments that represent ownership of the instrument holder in the company. It entitles the holder to a share of the company’s profit through a dividend. These instruments are highly liquid, i.e., they can be easily converted into cash. Equity instruments include shares (equity shares and preference shares), share warrants, convertible securities, and rights issues to existing shareholders.

Features

• Ownership Stake: Equity instruments, such as common stock, represent ownership stakes in a company. Shareholders have ownership rights, including voting rights and the right to receive dividends.
• Dividends: Holders of equity instruments may be entitled to receive dividends, which represent a portion of the company’s profits distributed to shareholders. Dividend payments are typically discretionary and are declared by the company’s board of directors.
• Capital Appreciation: Equity instruments provide the opportunity for capital appreciation, as their value can increase over time based on factors such as company performance, market conditions, and investor sentiment.

Advantages

• Liquidity: Equity instruments are generally highly liquid, i.e., they can be easily converted into cash. Investors can convert these shares into money by selling them in the secondary market at the market price.
• Ownership: Equity instruments represent ownership of the instrument holder in companies. Shareholders may enjoy voting rights in the company’s general meetings and the right to get a share in the profit.
• Dividend Income: Many equity instruments, particularly common stocks, offer dividend income to investors. Companies having adequate profits may decide to declare the dividend to their shareholders.

Disadvantages

• Risk of Loss: Investing in equities carries the risk of loss of capital because these are easily influenced by market conditions. The value of stocks can decline leading to losses for investors. Sometimes, internal factors of the company can affect the value of equity instruments.
• Dividend Uncertainty: Providing dividends to the investors is not an obligation of the company, except in the case of preference shares. Companies may reduce or suspend dividend payments when they decide to expand the business or in the event of financial distress. This uncertainty can affect the investor’s return on investment.
• Volatility: Equity markets can be highly volatile which means they are always fluctuating. This volatility can lead to significant short-term price swings and potential losses for investors, especially those with a short-term investment ambit.

Example

An example of an equity instrument is common stock, which represents ownership in a company and provides shareholders with various rights and features.

2. Debt Instruments

Debt is the borrowed capital of the company. It can be classified into short-term borrowing or long-term borrowing. Debt instruments represent the loan or obligations of the borrower who is required to pay the principal amount to the lender according to the terms of the agreement. Generally, debt instruments carry an interest rate, that is required to be paid on the maturity with the principal amount by the borrower. Debt instruments include debentures, bonds, bills payable, bank loans, mortgages, etc.

Features

• Principal: Debt instruments involve the lending of a principal amount, which is the initial sum of money loaned by the investor to the borrower.
• Interest: Borrowers agree to pay interest to lenders as compensation for the use of their funds. The interest rate, also known as the coupon rate, is typically fixed or variable and is specified in the debt instrument.
• Maturity Date: Debt instruments have a specified maturity date, which is the date when the borrower is obligated to repay the principal amount in full. Maturity periods can range from short-term (e.g., less than one year) to long-term (e.g., several years or decades).

Advantages

• Lower Risk: Debt instruments generally carry low risk because they have a defined repayment schedule and get priority of payment in case of bankruptcy. Sometimes, these securities carry fixed charges to avoid any future losses.
• Returns: Debt securities offer predictable returns, making them suitable for investors with specific income needs or investment goals. People who want to have a constant source of income with low risk tend to invest in debt instruments having fixed interest rates.
• Diversification: Including debt instruments in an investment portfolio can help diversify the risk, as they often have low or negative correlation with other asset classes like stocks.

Disadvantages

• Liquidity Risk: Most of the debt instruments have limited liquidity, especially those issued by smaller companies or with longer maturities. Liquidity can be a challenging factor in debt securities as they have a fixed maturity period.
• Risk of Default: Investors in debt instruments face the risk of not receiving their principal or interest payments if the issuer defaults. This risk is higher for debt instruments with lower credit ratings.
• Inflation Risk: Debt instruments with fixed interest rates are easily influenced by inflation. If inflation rises faster than anticipated, the purchasing power of the interest payments and principal repayment may decrease.

Example

One common example of a debenture. Debentures are the debt instruments issued by the company to raise capital. it carries a fixed rate of interest.

3. Derivatives

Derivatives derive their value from the underlying asset. These underlying assets can be stocks, bonds, commodities, and even intangible assets. These are primarily used for hedging against risks, speculating on price movements, and gaining exposure to different markets. Derivatives can be of different types such as futures, options, swaps, caps, floors, collars, etc.

Features

• Underlying Asset: Derivatives are based on an underlying asset, which can include commodities (e.g., oil, gold), financial assets (e.g., stocks, bonds), currencies, interest rates, or market indices (e.g., S&P 500).
• Leverage: Derivatives allow investors to control a large position with a relatively small amount of capital, as they only need to deposit a fraction of the contract’s total value (margin requirement). This leverage amplifies both potential gains and losses.
• Types of Derivatives: There are various types of derivatives, including options, futures contracts, forwards, swaps, and structured products. Each type has unique characteristics and purposes.

Advantages

• Leverage: Derivatives require a smaller initial investment compared to investing directly in the underlying asset. This allows investors to gain exposure to potential returns with a smaller capital outlay.
• Portfolio Diversification: Derivatives offer opportunities for investors to diversify their portfolios. They can gain exposure to various underlying assets, indices, or rates through derivatives. It also helps in reducing overall portfolio risk.
• Price Discovery: Derivatives markets provide valuable insights about the future expectations of market participants. The prices of derivatives reflect the collective judgement of investors, which can help in price discovery and improve market efficiency.

Disadvantages

• Complexity: Derivatives can be complex financial instruments as they require a deep understanding of the risks involved and potential outcomes. For many investors navigating the complexities of derivatives can be challenging.
• Liquidity Risk: Some derivatives may have high liquidity risk. In times of market stress or uncertainty, liquidity in derivatives markets can diminish, making it difficult for investors to trade at desired prices.
• Potential for Losses: While derivatives offer profit opportunities, they also entail the risk of significant losses. Investors can lose more than their initial investment in adverse market conditions. They must have proper risk management strategies to overcome these uncertainties.

Example

There are various types of derivatives, including options, futures contracts, forwards, swaps, and structured products. Each type has unique characteristics and purposes.

4. Money Market Instruments

Money market instruments are short-term debt securities having a maximum maturity period of one year. These instruments provide liquidity and have high credit quality. They are commonly used by governments, financial institutions, and corporations for short-term borrowing. It helps in providing short-term funding to companies. Money market instruments include treasury bills, commercial papers, certificates of deposits and a few other documents.

Features

• Short-Term Maturity: Money market instruments typically have short-term maturities, ranging from overnight to one year. This short duration ensures quick turnover and liquidity.
• High Liquidity: Money market instruments are highly liquid, meaning they can be easily bought and sold in the market with minimal impact on their prices. This liquidity makes them attractive for investors needing quick access to cash.
• Low Risk: Money market instruments are considered low-risk investments because they are typically issued by creditworthy entities, such as governments, corporations, and financial institutions, and have short maturities, reducing the risk of default.

Advantages

• Liquidity: Money market instruments are generally highly liquid, i.e., they can be easily converted into cash. These instruments have a short period of maturity, allowing the investors to convert them into cash within one year.
• Government Backing: Some money market instruments, such as Treasury bills, are backed by the government, making them among the safest investments available.
• Yield Potential: While money market instruments typically offer lower yields compared to other fixed-income securities, they still provide a source of income for investors.

Disadvantages

• Low Returns: Money market instruments offer lower returns as compared to other fixed-income securities. This can limit the potential for capital appreciation and may not keep pace with inflation over the long term.
• Inflation Risk: Money market instruments do not give higher returns and are not influenced by inflation. This can decrease the purchasing power of investors’ funds, especially in periods of high inflation.

Example

A common example of a money market instrument is a Treasury bill. These are short-term debt securities issued by the government to raise funds and manage short-term liquidity needs. Treasury bills have maturities ranging from a few days to one year.

5. Foreign Exchange Instruments

Foreign exchange instruments (Forex) are financial instruments used for trading currencies in the global foreign exchange market. This market is decentralized and operates 24 hours a day, five days a week, allowing participants to trade and speculate on currencies. Foreign exchange instruments are also used in arbitrating and hedging of the funds. These instruments include spot delivery, future and options, swaps, etc.

Features

• Currency Pairs: Forex instruments involve the exchange of one currency for another, forming currency pairs. Each currency pair consists of a base currency and a quote currency, with exchange rates representing the relative value between the two currencies.
• Liquidity: The forex market is the largest and most liquid financial market globally, with round-the-clock trading activities across different time zones. High liquidity ensures that traders can buy and sell currencies quickly without significant price fluctuations.
• Market Participants: Various participants engage in forex trading, including central banks, commercial banks, multinational corporations, institutional investors, retail traders, and speculators.

Advantages

• Accessibility: The forex market is accessible to a wide range of participants. Most forex trading is conducted electronically, allowing participants to have an internet connection to trade globally from anywhere.
• Arbitrage Opportunities: Arbitrage helps investors to gain profit from the price difference between two stock exchanges. The difference occurs for a short period due to certain reasons. It helps maintain efficient pricing in the forex market and contributes to market liquidity.
• Leverage: Forex trading often involves leverage that allows traders to control large positions with a relatively small amount of capital. It can provide opportunities for higher returns for traders who manage risk effectively.

Disadvantages

• Volatility: The forex market is highly volatile as the exchange rates are influenced by various factors such as economic indicators, geopolitical events, central bank policies, etc. Rapid fluctuations in price can result in significant gains or losses for traders.
• Currency Risk: Currency risk can impact the profitability of international trade, investments, and hedging strategies, particularly in volatile or uncertain market conditions. Trading in foreign exchange instruments exposes to currency risk.
• Complexity: Forex trading involves a complex set of factors that influence exchange rate movements. Investors are required to have a deep understanding of factors and technical analysis techniques.

Example

• A multinational company based in the United States has its business operations in Europe and is concerned about the risk of adverse currency movements between the US dollar (USD) and the Euros(EUR).
• To mitigate this risk, the company decides to hedge its exposure by entering into a forex futures contract. The forex futures contract serves as a hedging instrument for the entities.

Conclusion

A company issues financial instruments to raise capital. Investors and institutions use financial instruments for investment, risk management, and speculations. These are assets investors can trade, transfer, or exchange in the financial markets. These instruments include equities, such as stocks, which signify ownership stakes in corporations and entitle holders to a portion of profits. Financial instruments can be categorized into various types based on their characteristics and features such as equity instruments, debt instruments, Foreign exchange instruments, etc.