Types of Financial Instruments

Financial Instruments are intangible assets, which are expected to provide future benefits in the form of a claim to future cash. It is a tradable asset representing a legal agreement or a contractual right to evidence monetary value / ownership interest of an entity.

Under the subject of Finance Management, Financial Instrumentscan be classified as cash instruments and derivative instruments. Financial Instruments are typically traded in financial marketswhere price of a security is arrived at based on market forces.

Cash Instruments:

Cash Instruments are tradable and derive their value from financial markets. Cash Instruments can be further classified into equity instruments and debt instruments.

Equity Instruments refer to instruments which represent ownership of the asset. Types of Equity Instruments are as follows:

  • Common Shares: Common (ordinary) shares represent partial ownership of the company and provide their holders claims to future streams of income, paid out of company profits and commonly referred to as dividends.
  • Preferred shares is a financial instrument, which represents an equity interest in a firm and which usually does not allow for voting rights of its owners. Typically the investor into it is only entitled to receive a fixed contractual amount of dividends and this make this instrument similar to debt. Preferred shares can also be non-cumulative, redeemable, convertible, participating etc.
  • Private Equity: When companies are organized as partnerships and private limited companies, their shares are not traded publicly. The form of equity investments, which is made through private placements, is called private equity. The most important sources of private equity investments come from venture capital funds, private equity funds and in the form of leveraged buyouts.
  • ADRs, GDRs: Investors may invest into foreign shares by purchasing shares directly, purchasing American Depository Receipts (ADRs), Global Depository Receipts (GDRs).
  • Exchange traded funds (ETFs) are passive funds, that track specific index. Thus investor can invest into a specific index, representing a country’s (e.g. foreign) stock market.

Debt Instruments represent debt/ loan given by a financial investor to the owner of the asset. The types of bonds issued in debt capital markets include Callable and Potable bonds, Convertible bonds, Eurobonds, Floating rate notes, foreign bonds, Index linked bonds, Junk bonds, Strips etc.

Derivative Instruments:

Investments based on some underlying assets are known as derivatives. In general derivatives contracts promise to deliver underlying products at some time in the future or give the right to buy or sell them in the future. Types of derivative instruments are as follows:

  • Forward Contract: A forward contract gives the holder the obligation to buy or sell a certain underlying instrument at a certain date in the future at a specified price.
  • Futures Contract: Futures contracts are forward contracts traded on organized exchanges. A futures contract is a legally binding commitment to buy or sell a standard quantity at a price determined in the present (the futures price) on a specified future date.
  • Swaps: A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The cash amount of the payments exchanged is based on some predetermined principal amount.
  • Options: An option is a contract in which the option seller grants the option buyer the right to enter into a transaction with the seller to either buy or sell an underlying asset at a specified price on or before a specified date.

Financial Markets:

  • A financial market is a market where financial instruments are exchanged or traded. Financial markets provide three major economic functions i.e. Price discovery, Liquidity and Reduction of transaction costs
  • Price Discovery refers to transactions between buyers and sellers of financial instruments in a financial market determine the price of the traded asset. It is these functions of financial markets that signal how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments.
  • Liquidity function provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off.
  • The function of reduction of transaction costs is performed, when financial market participants are charged and/or bear the costs of trading a financial instrument. In market economies the economic rationale for the existence of institutions and instruments is related to transaction costs, thus the surviving institutions and instruments are those that have the lowest transaction costs.

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