Financial Instruments | definitions | types | Overview of Financial Instruments

When you go to deposit a cheque, buy shares of a company, or when your parents invest in mutual funds for future returns, have you ever wondered what these instruments are? They are nothing but financial assets.

When you listen to music, you listen to many instruments playing together. It could be a combination of a violin, drums, guitar, and the playback singer’s voice. Together, they make beautiful music. Just like that, in the financial world, instruments like shares, bonds, and mutual funds come together to provide our financial system with different investment avenues.

What are Financial Instruments?

Financial Instruments are legally binding contracts that show the person, who owns them a claim on something. A claim in financial terms gives its holder the right to receive payments from a debtor. It is also described as a contract between two parties where rights and obligations are mentioned.

This claim can be on some income or asset of another economic unit. The Claim stores of value for which you can expect a return. In this contract, there are two parties where for one organization or investor, it is an asset (owns it), and for the other, it is a liability (owes the additional person money). 

In India, most families try to save their money for a rainy day, to secure their future, or to get good interest. The question is whether they are getting returns on their invested money? This is where financial instruments come into play.

A dry fruit seller trades in different types of dry fruits. Similarly, a financial trader or investor trades in different types of financial instruments. What is successful trading, you might ask? The meaning of Successful trading is selling something for more money than its purchasing price.

Why it is important to know about financial instruments?

When we invest in the stock market, it involves the exchange of different financial instruments. We know that the prices are up one day in the stock market, and the other day, they are down. Some people gain during a day, and others make a loss. Prices fluctuate a lot here. Few people, who actively trade in the stock market, might not own any financial instrument as they could be buying and selling on the same day. Such people are called intraday traders. Then, there are others who have long-term financial goals or interests; such people understand and use various financial instruments. Understanding financial instruments are of importance no matter what type of trader you are.

In our country, various financial instruments can help get good returns or, we can say, in “multiplying our money.” In India, many financial instruments can help in multiplying money. It is important to know what financial instruments mean and their types, to invest in these financial instruments. 

As financial investors and traders, we really need to know about the product before we enter the trading arena.

1. Where do financial instruments fall in the Indian Financial system?

To understand financial instruments better, we need to first understand where it falls in our financial system. We can look at the “Indian Financial System” as a tree, and we can say that this tree consists of four major branches. These four major branches are:

● Regulators (Ministry of Finance, Reserve Bank, SEBI, IRDA)

● Financial Intermediaries (Banks, NBFC).

● Financial Markets (Money Market, Capital Market)

● Financial Assets/ Instruments.

From the above pointers, we understand that financial instruments can be seen as the fourth branch of the financial system

We might also view financial instruments as something that shows whether the country’s financial system is mature.

How can financial instruments show whether the system is mature? Financial instruments need to suit the demands of different types of investors who want to make various investments. If a country has different types of financial instruments, then it means that country can innovate when it comes to providing its citizens with financial products.

What is the use of financial instruments?

Financial instruments can be created, traded, modified, or settled. They give traders the ability to transfer all the capital throughout the world quickly. They can be real or virtual documents representing a monetary contract.

 Financial Instruments might or might not be traded in the stock market. Cheques are also financial instruments, but they are not traded in the stock market. Some financial instruments that are traded on the stock market are shares, derivatives, or mutual funds.

 What are the layers of financial instruments?

To understand financial instruments better, let us consider financial instruments to be an onion. This onion has three layers:

Layer 1: A financial instrument is a contract. As it is a contract, it is a legal agreement that is binding on both the parties.

Layer 2: The main types of financial instruments are cash instruments or derivatives instruments. Here, one is directly valued by the market, and the latter is indirectly valued.

Layer 3: They can also be classified based on their asset type, i.e., Equity-Based or Debt Based. Asset class in finance means when financial instruments have similar features, then they are grouped together. Other asset classes are foreign exchange, commodities.

If an asset or instrument does not have a legal agreement or a contractual claim, they are not financial instruments. Some non-financial assets/instruments are lands, buildings, patents, intellectual property rights.

 What are the main types of financial instruments?

Now we can try and understand the main types of financial instruments in detail: The main types are Cash Instruments, Debt instruments, Foreign Exchange, and Commodities.

1.Cash Instrument:

Cash instruments are valued by the market directly. They are securities that are readily transferable. The different types of cash instruments are Securities, Deposits, and Loans.

In simple terms, let’s assume you go to a local shop to purchase dry fruits. You select a few items and agree to pay the price. You and the seller agree on a price and exchange the item. The transaction is fast and simple. In finance, the scale is much larger. Here, the local shops are stock exchanges, trading platforms, etc. Within Cash Instruments, the types are:

A] Securities: Securities are traded in the stock market, and if they are purchased or sold, they give you a small share of ownership in a company listed on the stock exchange. Securities have a monetary value.

 B] Deposits and Loans: If both lender and borrower agree on trade by deciding the timing and other important exchange details, then deposits and loans are considered cash instruments. They represent monetary value and are legally binding contracts.

 C] Bonds: Bonds provide fixed income to the investor, depending on their maturity dates.

2.Derivative Instrument:

A derivative instrument is where the price is indirectly determined. It is determined by another asset or variable and not by the derivative contract itself. It derives value from its underlying assets. Hence, it is called a derivative.

Derivatives are financial contracts that solve the primary purpose of hedging asset price fluctuations. There are various types of derivatives. These include exchange-traded funds, over-the-counter, called OTC, Forward, Future, Options, Interest Rate Swaps.

To understand derivatives better, let us again take the example of a dry fruits seller.

 Let’s say that you and your friend are standing near a dry fruit seller shop and watching a customer enter and buy a few items. You and your friend placed a bet on the prices of the item the customer has purchased. This agreement between you two would be derivative. The underlying asset would be the dry fruits, which neither you nor your friends own. Also, you have no influence on the price that the seller or customer decides.

A] Forward: A forward is a contract between two parties that involves customizable derivatives, in which the exchange occurs at the end of the contract at a specific price.

B] Future and Options: Futures and options are considered derivative instruments, as they depend on the future performance of the stock price. It is a predetermined contractual agreement as the transaction takes place in the future at a particular time.

C] Interest Rate Swap: An interest rate swap is a derivative agreement between two parties that involves the swapping of interest rates, where each party agrees to pay the other interest rates on their loans in different currencies

3.Foreign Exchange:

The Foreign exchange instruments are financial instruments that are represented in the foreign market.

4.Commodities:

The Commodities are divided into two parts: soft or hard. Soft commodities are agriculture or livestock goods, and hard commodities are natural resources that can be extracted, such as oil, gold. These instruments involve buying, selling, and trading primary products by investing in companies that have exposure to these commodities.

One of the financial instruments that is extremely popular in India is Mutual Funds. It is popular in India because the investment required for it is very less, and the risk is low. Mutual Funds are professionally managed and allow customers to pool their funds together.

 Financial Instrument: Asset Class Types?

As we have seen above, Financial Instruments can be classified based on either cash and derivative instruments, or we can classify them based on their asset type. The two main types of financial instruments based on the assets are Equity-Based and Debt-based instruments.

Here, we discuss the asset-based classification of financial instruments in detail.

1.   Equity-Based: What is Equity? You are a tiny owner of shares in the corporation!

Equity is the type of security where ownership in the company can be represented. You can trade equities in the stock market. It means you can buy and sell them in the stock market. They have a good amount of returns on investment, but there is also a risk. If you don’t know much about equities, it is better not to invest in them without adequate knowledge.

Equity-based financial instruments show ownership of an asset. Major share trading platforms in India are the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Equity-based financial instruments are depository receipt, common stock, convertible debentures, and preferred stock.

2.Debt-Based: What is Debt? If you take a loan, then you have to pay it back with interest!

We can say that a debt instrument is when an investor (Person A) lends money to person B (This can be a corporate, bank, government, individual). The investor who gave his money gets an interest or returns for it.

Debt-based financial instruments tell about the loan made by an investor to the owner of the asset. In India, public provident fund, provident fund, and debt mutual funds are examples of Debt-based financial instruments.

Provident fund is a concept that has been popular in Southeast Asian nations. It is a scheme wherein the government helps its citizens to build their retirement budget. In India, the Public provident fund was introduced in 1968 by the National Savings Institute of the Ministry of Finance. Anyone can save up to 1.5 lakh every year at a fixed, tax-free return rate in this scheme.

 Financial Instrument- An example:

Let us assume that AB is a banking company giving a financial instrument, namely, loans to its clients. Clients receiving these instruments are a liability that needs to be paid back, but it is a financial asset for the bank.

Similarly, whatever a customer deposits in the bank is a liability to the bank and an asset to the customer.

What is the purpose of financial instruments?

●      For Hedging: We can minimize the risks involved in stock markets through financial instruments. This can include protection against price fluctuations through the purchase of options contract or buying and selling currency at a fixed future date through a futures contract.

●      Trading purposes: Knowledge of financial instruments can be useful to investors who want to benefit from short-term market movements by allowing them to take risk positions.

●       Investment purposes: Investors with long-term goals such as receiving good returns from their investment will benefit from knowing which financial instrument to use.

In the end, financial instruments are the main pillars for all the market operations, whether it is associated with short-term or long-term investment. The financial instruments create the core strength of the county’s economy.

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