A financial instrument is simply a contract between entities that represents the exchange of money for a certain asset. Financial instruments include most types of investments: cash, stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposit (CDs), loans, derivatives, and more.
Financial instruments facilitate the movement of capital through the markets and the broader economic system. While this may take different forms, the flow of capital remains a central feature.
What Is a Financial Instrument?
Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash; evidence of an ownership interest in a company or other entity; or a contract. A financial instrument confers either a right or an obligation to the holder of the instrument, and is an asset that can be created, modified, traded, or settled.
Investors can trade financial instruments on a public exchange. The New York Stock Exchange (NYSE) is an example of a spot market in which investors can trade equity instruments for immediate delivery.
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Financial Instrument vs Security
A security is a type of financial instrument with a fluctuating monetary value that carries a certain amount of risk for the individual or entity that holds it. Investors can trade securities through a public exchange or over-the-counter market.
The federal government regulates securities and the securities industry under a series of laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
All securities are financial instruments but not all financial instruments are securities.
Like financial instruments, securities fall into different groups or categories. The four types of securities include:
• Equities. Equities represent an ownership interest in a company. Stocks and mutual funds are examples of equity securities.
• Debt. Debt refers to money lent by investors to corporate or government entities. Corporate and municipal bonds are two examples of debt securities.
• Derivatives. Derivatives are financial contracts whose value is tied to an underlying asset. Futures and stock options are derivative instruments.
• Hybrid. Hybrid securities combine aspects of debt and equity. Convertible bonds are a type of hybrid instrument.
Recommended: Bonds vs. Stocks: Understanding the Difference
Types of Financial Instruments
Financial instruments are not all alike. There are different types of financial instruments in different asset classes. Certain financial instruments are more complex in nature than others, meaning they may require more knowledge or expertise to handle or trade.
1. Cash Instruments
Cash instruments are financial instruments whose value fluctuates based on changing market conditions. Cash instruments can be securities traded on an exchange, such as stocks, or other types of financial contracts.
For example, a certificate of deposit account (CD) is a type of cash instrument. Loans also fall under the cash instrument heading as they represent an agreement or contract between two parties where money is exchanged.
2. Derivative Instruments
Derivative instruments or derivatives draw their value from an underlying asset, and fluctuate based on the changing value of the underlying security or benchmark.
As mentioned, options are a type of derivative instrument, as are futures contracts, forwards, and swaps.
3. Foreign Exchange Instruments
Foreign exchange instruments are financial instruments associated with international markets. For example, in forex trading investors trade currencies from different currencies through global exchanges.
Asset Classes of Financial Instruments
Financial instruments can also be broken down by asset class.
4. Debt-Based Financial Instruments
Companies use debt-based financial instruments as a means of raising capital. For example, say a municipal government wants to launch a road improvement project but lacks the funding to do so. They may issue one or more municipal bonds to raise the money they need.
Investors buy these bonds, contributing the capital needed for the road project. The municipal government then pays the investors back their principal at a later date, along with interest.
5. Equity-Based Financial Instruments
Equity-based financial instruments convey some form of ownership of an entity. If you buy 100 shares of stock in XYZ company, for example, you’re purchasing an equity-based instrument.
Equity-based instruments can help companies raise capital, but the company does not have to pay anything back to investors. Instead, investors may receive dividends from the stock shares they own, or realize profits if they’re able to sell those shares for a capital gain.
Are Commodities Financial Instruments?
Commodities such as oil or gas, precious metals, agricultural products and other raw materials are not considered financial instruments. A commodity itself, such as pork or copper, doesn’t direct the flow of capital.
That said, there are certain instruments whereby commodities are traded, including stocks, exchange-traded funds, and futures contracts.
A futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date. So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. An orange juice company could then buy a contract to purchase oranges at X price.
For the everyday investor, futures trading in commodities typically doesn’t mean you plan to take delivery of two tons of coffee beans or 4,000 bushels of corn. Instead, you buy a futures contract with the intention of selling it before it expires.
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Uses of Financial Instruments
Investors and businesses may use financial instrument for the following purposes:
1. As a Means of Payment
You already use financial instruments in your everyday life. When you write a check to pay a bill or use cash to buy groceries, you’re exchanging a financial instrument for goods and services.
Likewise, business entities may charge purchases to a business credit card. They’re borrowing money from the credit card company and paying it back at a later date, often with interest.
2. Risk Transfer
Investors use financial instruments to transfer risk when trading options and other derivative instruments, such as interest rate swaps. With options, for example, an investor has the option to buy or sell an underlying asset at a specified price on or before a predetermined date. A contract exists between the individual who writes the option and the individual who buys it. This type of financial instrument allows an investor to speculate about which way prices for a particular security may move in the future.
3. To Store Value
Businesses often use financial instruments in this way. For example, say you default on a credit card balance. Your credit card company can write off the amount as a bad debt and sell it to a debt collector. Meanwhile, businesses with outstanding invoices they’re awaiting payment on can use factoring or accounts receivables financing to borrow against their value.
4. To Raise Capital
Companies may issue stocks or bonds in order to get access to capital that they can invest in their business. In this case, the financial instruments could be a means of raising capital for one party and a store of value for the other.
Importance of Financial Instruments
Financial instruments are central to not only the stock market, but also the financial and economic system as a whole. They provide structures and legal obligations that facilitate the regulated exchange of capital via investing, lending and borrowing, speculation and growth.
In short, financial instruments keep the financial markets moving, and they also help businesses to keep their doors open and allow consumers to manage their finances, plan for the future, and invest with the hope of future gains.
For example, you may also have a savings account that you use to hold your emergency fund, an Individual Retirement Account (IRA) that you use to save for retirement and a taxable brokerage account for trading stocks. Your checking account is one of the basic tools you might use to pay bills or make purchases.
You might be paying down a mortgage or student loans while occasionally using credit cards to spend. All of these financial instruments allow you to direct the flow of money from one place to another.
Financial instruments are integral to every aspect of the financial world, and they also play a significant part in business transactions and day-to-day financial management. If you trade stocks, invest in an IRA, or write checks to your landlord, then you’re contributing to the movement of capital with various financial instruments. Understanding the different types of financial instruments is the first step in becoming a steward of your own money.
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I am a financial expert with extensive knowledge in various financial concepts and instruments. My expertise lies in understanding and explaining complex financial topics to individuals navigating their financial journeys. I have a deep understanding of financial instruments, including their types, functions, and importance in the broader economic system.
Now, let's delve into the concepts used in the article you provided by Rebecca Lake, dated October 06, 2023:
1. Financial Instruments
- Definition: Financial instruments are contracts between entities representing the exchange of money for a certain asset.
- Examples: Cash, stocks, bonds, mutual funds, ETFs, CDs, loans, derivatives, etc.
- Purpose: Facilitate the movement of capital through markets and the broader economic system.
2. Generally Accepted Accounting Principles (GAAP)
- Definition: GAAP defines a financial instrument as cash, evidence of ownership interest, or a contract.
- Attributes: Confers a right or obligation to the holder, can be created, modified, traded, or settled.
3. Financial Instrument vs Security
- Definition: Securities are a type of financial instrument with fluctuating monetary value and risk.
- Regulation: Governed by laws like the Securities Act of 1933, Securities Exchange Act of 1934, and Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
- Types: Equities, debt, derivatives, and hybrid securities.
4. Types of Financial Instruments
- Cash Instruments: Value fluctuates based on market conditions (e.g., stocks, CDs, loans).
- Derivative Instruments: Value derived from an underlying asset (e.g., options, futures).
- Foreign Exchange Instruments: Associated with international markets (e.g., forex trading).
5. Asset Classes of Financial Instruments
- Debt-Based Financial Instruments: Raise capital through debt (e.g., bonds).
- Equity-Based Financial Instruments: Convey ownership (e.g., stocks).
- Not considered financial instruments.
- Instruments related to commodities include stocks, ETFs, and futures contracts.
7. Uses of Financial Instruments
- Means of Payment: Used in everyday transactions (e.g., checks, cash).
- Risk Transfer: Used to transfer risk in trading options and derivatives.
- Store of Value: Businesses use financial instruments for value storage.
- Raise Capital: Companies issue stocks or bonds to raise capital.
8. Importance of Financial Instruments
- Central to financial and economic systems.
- Facilitate regulated exchange of capital through investing, lending, borrowing, speculation, and growth.
9. SoFi Invest
- Mentioned in the article as a platform for investing in stocks, ETFs, and more.
This summary covers the key concepts related to financial instruments discussed in the article. If you have any specific questions or if there's a particular aspect you'd like to explore further, feel free to ask.