Financial Instrument
Financial instrument refers to a contract between two companies that gives one party the right for a financial asset. On the other hand, the other party is obliged to deliver cash to another entity or issue an equity instrument. Financial instruments are the means of investing and distributing capital. They can also represent means of payment, and individuals can lend them to each other. Examples of financial instruments include cash, a contractual right to exchange financial assets, and proof of ownership of the business entity.
Financial Instruments explained
Financial instrument is an agreement between two parties that outlines terms related to the purchase, sale, delivery or transfer of securities and other assets. As a result of the acquisition of an equity financial instrument, the company receives financial assets and the buyer can hold the asset. A debt instrument is considered a debt obligation in electronic or paper form that reflects the financial relationship between the borrower, who is referred to as the issuer, and the lender who invests funds.
Besides, the third category of financial instruments is foreign exchange instruments. The definition of foreign exchange instruments comprises the diversity of objects of trade. These include world currencies, as well as various foreign currency contracts and other foreign exchange products.
Overview of Financial Instruments
There are primarily two types of instruments:
Cash instruments. Market fluctuations have a great impact on their values. Such instruments are assets that can be freely exchanged in the markets. They also include bank deposits, money or securities that are held at a bank for a specific period of time, and loans, the transfer of financial assets or tangible objects by one participant of financial relations (lender) to another (borrower).
Derivative instruments. The value of a derivative instrument reacts to the changes in the interest rate, underlying asset, the price of a commodity, etc.
For instance, an option contract is considered a derivative financial instrument as its value is based on the value of the underlying stock. One of the parties, which is commonly referred to as the option buyer, has the right to buy a certain stock in the future at an agreed-upon price. If a stock's price goes up or down, the value of the option contract changes based on these fluctuations.
Derivatives are divided into two categories: over-the-counter (OTC) derivatives or exchange-traded derivatives. Standardized contracts with quotations that are available to the public are traded on the exchange-traded derivatives market, while OTC derivatives are traded directly between two market participants, as a rule, without any third parties.
Asset Classes of Financial Instruments
Instruments may also be categorized by an asset class.
The first type of a financial instrument is a debt instrument. Short-term debt instruments are assets that are issued by municipal, treasury or private companies, traded on the stock market. Such instruments include commercial papers, certificates of deposit, euronotes. They have a maturity date of less than 12 months.
Long-term debt obligations are obligations that are due no earlier than in 12 months. Long-term obligations include bank loans with a maturity greater than a year, taking into account interest and registration costs, and bonds, promissory notes, the maturity of which exceeds one year.
The second type comprises equity instruments. An equity instrument refers to the legal document reflecting any right or obligation of the parties of the transaction and is traded between the participants of joint-stock companies. Example of an equity-based instrument is a stock.
