FINANCIAL INSTRUMENTS

Financial instruments are contracts between individuals/parties that hold a monetary value. They can either be created, traded, settled, or modified as per the involved parties' requirements.

Financial instruments can also be defined as an agreement between two parties to facilitate a transaction involving an asset at a preset price and date

In simple words, any asset that holds capital and can be traded in the market is a financial instrument. Some examples of financial instruments are cheques, shares, stocks, bonds, futures, and options contracts.

There is always a contractual obligation between involved parties during a financial instrument transaction.

For example, if a company were to pay cash for a bond, another party is obligated to deliver a financial instrument for the transaction to be fully completed. One company is obligated to provide cash, while the other is obligated to provide the bond.

Types of financial instruments

There are typically three types of financial instruments: cash instruments, derivative instruments, and foreign exchange instruments.

  1. Cash Instruments

Cash instruments are financial instruments with values directly influenced by the condition of the markets. Within cash instruments, there are two categories, thus; securities and deposits, and loans

2.  Securities

A security is a financial instrument that has monetary value and is traded on the stock market. When purchased or traded, a security represents ownership of a part of a publicly-traded company on the stock exchange.

3. Deposits and loans

Both deposits and loans are considered cash instruments because they represent monetary assets that have some sort of contractual agreement between parties.

4. Derivative Instruments

These are instruments whose characteristics and value can be derived from their underlying entities such as interest rates, indices, or assets. The value of such instruments can be obtained from the performance of the underlying component. Also, they can be linked to other securities such as bonds and shares/stocks.

The five most common examples of derivatives instruments are synthetic agreements, forwards, futures, options, and swaps. This is discussed in more detail below.

Synthetic Agreement for Foreign Exchange (SAFE): This is an agreement that guarantees a specified exchange rate during an agreed period of time.

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.

Future: A future is a derivative transaction that provides the exchange of derivatives on a determined future date at a predetermined exchange rate.

Options: An option is an agreement between two parties in which the seller grants the buyer the right to purchase or sell a certain number of derivatives at a predetermined price for a specific period of time.

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 other interest rates on their loans in different currencies.

FOREIGN EXCHANGE INSTRUMENTS

Foreign exchange instruments are financial instruments that are represented on the foreign market and primarily consist of currency agreements and derivatives.

In terms of currency agreements, they can be broken into three categories: 

 Spot: A currency agreement in which the actual exchange of currency is no later than the second working day after the original date of the agreement. It is termed spot because the currency exchange is done on the spot (limited timeframe).

Outright Forwards: A currency agreement in which the actual exchange of currency is done before the actual date of the agreed requirement. It is beneficial in cases of fluctuating exchange rates that change often.

Currency Swap: A currency swap refers to the act of simultaneously buying and selling currencies with different specified value dates.

Other classifications of Financial Instruments

Beyond the types of financial instruments listed above, financial instruments can also be categorized into two asset classes. The two asset classes of financial instruments are debt-based financial instruments and equity-based financial instruments.

Debt-Based Financial Instruments

Debt-based financial instruments are categorized as mechanisms that an entity can use to increase the amount of capital in a business. Examples include bonds, debentures, mortgages, credit cards, and lines of credit (LOC).

They are a critical part of the business environment because they enable corporations to increase profitability through growth in capital.

Equity-Based Financial Instruments

Equity-based financial instruments are categorized as mechanisms that serve as legal ownership of an entity. Examples include common stock, convertible debentures, preferred stock, and transferable subscription rights.

Equity helps businesses to grow capital over a longer period of time compared to debt-based financing.

A business that owns an equity-based financial instrument can choose to either invest further in the instrument or sell it whenever they deem necessary.

1. Common stock

Common stock is a type of security that represents ownership of equity in a company. This type of equity gives its shareholders the right to certain company assets. Owners of common stock in a company have the right to vote on corporate policies and board of director decisions. Common stock is just one type of stock traded on public exchanges.

2. Preferred stock

Preferred stock is similar to common stock. However, preferred stock owners have fewer responsibilities and no voting rights.

3. Treasury stock.

Some businesses may opt to purchase stock back from common stockholders. This is where treasury stocks come into play. Treasury stocks account for the amounts paid to buy shares back from investors. This type of equity account usually has a negative balance. In most cases, this is reflected as a deduction from total equity in the accounting books. Preferred stockholders have more ability to claim a company’s assets and earnings. And, investors can receive cash payments in the form of dividends.

Retained earnings

A retained earnings account shows the earnings your business accumulates, minus any dividend payments made to shareholders. Essentially, your retained earnings are your portion of net income that you did not pay out as dividends.

You can use your retained earnings for investments. And, you may opt to save your retained earnings for the future.