Definition
A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. It can be a document representing a legal agreement involving any kind of monetary value. The types of financial instruments can range from investments in stocks and bonds, loans and mortgages, futures, options and forward contracts.
Key Takeaways
- A Financial Instrument is a contract between two parties that represents a financial asset for one party and a liability or equity for the other. They are tradable assets or packages of capital that can be traded.
- There are many types of Financial Instruments including cash instruments and derivative instruments. Cash instruments value is determined by the markets. Derivative instruments derive their value from underlying entities such as an asset, index, or interest rate.
- Financial Instruments play a critical role in global economy and can include a variety of products, ranging from Treasury bills and bonds, to mortgages, company shares, insurance policies and derivatives. They are used for a range of purposes, including to raise capital, to manage financial risk, or to create investments.
Importance
Financial instruments are fundamental to the financial market and are key components in structuring any financial system.
They provide a method for efficient flow of capital in the economy, facilitating the transfer of funds from investors to borrowers.
Financial instruments include assets, liabilities, and contract rights, with various forms such as shares, bonds, or derivatives.
They are also used as a tool for risk management in areas like interest rate risk, credit risk, and price risk, which helps maintain market stability.
Their importance therefore lies in their ability to manage and allocate risk, facilitate investment, and help in the creation of diversified portfolios.
Explanation
Financial instruments function as a critical tool in the economy, facilitating the flow of capital in the marketplace. Their essential purpose is to allow the transfer of funds from entities or individuals who have surplus funds to those who need them.
In this manner, financial instruments fuel investment and spending, thereby promoting economic growth. They may be created as packages of capital and expected profits (e.g., loans or bonds), or as agreements allowing businesses to trade specific volumes at specified prices.
Financial instruments are also used as risk management tools through hedging activities. For example, derivatives such as future contracts, options, and swaps allow an investor or firm to hedge their risk exposure by enabling them to lock in prices or rates now for transactions that will occur in the future, potentially mitigating any adverse movements.
But beyond risk management, these instruments open doors for speculators looking at profit possibilities by trading these instruments based on their views of future price movements. Many financial instruments are traded in organized financial markets and can help ensure efficient price discovery, making them essential instruments for global economic dynamics.
Examples of Financial Instrument
Stocks: These are arguably the most well-known type of financial instrument. Companies issue stocks to raise capital and individuals buy them with the expectation of earning dividends or selling the stocks at a higher price in the future.
Bonds: Bonds are another common type of financial instrument. They are basically debt securities, similar to IOUs. When you buy a bond, you’re lending money to the entity issuing the bond (usually a corporation or government). In return, the issuer promises to repay the principal amount on a specific date and to pay you regular interest payments.
Derivatives: Derivatives are financial instruments that derive their value from underlying assets, indexes, or interest rates. Common examples of derivatives include options, futures, and swaps. They are often used for hedging risks or for speculation on price movements of the underlying asset.
FAQs about Financial Instrument
What is a financial instrument?
A financial instrument is a contract between parties that can be traded and settles a transaction financially. Financial instruments can be either cash instruments or derivative instruments.
What are examples of financial instruments?
Some examples of financial instruments include cash, evidence of ownership in an entity, or a contractual right to receive or deliver cash or another financial instrument. Stocks, bonds, derivatives, banknotes, and loans are all examples of financial instruments.
What is the purpose of financial instruments?
Financial instruments provide a way for entities to raise capital, trade in existing assets, transfer risk, and provide a wide range of investment strategies. They play a crucial role in facilitating economic trade and investment activities.
What are the two types of financial instruments?
Financial instruments can broadly be divided into two types: cash instruments and derivative instruments. Cash instruments include loans granted and deposits received, investments in debt, and equity securities. Derivative instruments include forward contracts, futures contracts, options, and swaps.
Risks involved with financial instruments?
Like any investment, financial instruments carry a degree of risk. This may include market risk, credit risk, liquidity risk, and operational risk. It’s essential for investors to understand these risks before engaging with financial instruments.
Related Entrepreneurship Terms
- Bonds
- Stocks
- Derivatives
- Commodities
- Foreign Exchange
Sources for More Information
- Investopedia: A comprehensive online resource with detailed explanations and examples of financial instruments.
- CFA Institute: This is an organization for finance professionals offering deep insight into financial instruments and other finance topics.
- International Monetary Fund (IMF): This international organization provides information and research on financial instruments and global finance topics.
- Financial Accounting Standards Board (FASB): This board sets accounting standards in the US and offers resources and documentation on various finance subjects, including financial instruments.
