Understanding the Different Types of Financial Instruments

Topics Covered:

• What is a Financial Instrument?
• Types of Financial Instruments

What is a Financial Instrument?

Financial instruments are tradable assets in financial assets or the portfolio of investors. These instruments facilitate the flow of capital in several markets. Investors (individuals and organisations) can purchase or sell these financial instruments for monetary profits. A financial instrument can be an asset (digital or physical) or a contract. You might have heard of financial contracts based on underlying securities in India.

Every financial instrument will have a market price, which changes with time. For instance, the value of a company’s stocks might change with time. The value of financial instruments usually depends on demand, supply, economic conditions, and other factors. Even though you are interested in a particular asset, you must be familiar "with different types of financial instruments. It will allow you to make informed decisions and build a diverse investment portfolio.

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Types of Financial Instruments

Here are the types of financial instruments you must know:

Cash Financial Instruments

Cash financial instruments are issued by organisations and entities to raise capital. They are tradable in the primary and secondary markets. Organisations can issue cash financial instruments in the primary market, whereas investors can trade with each other in secondary markets. The organisations or entities issuing cash financial instruments are usually called issuers. Since cash instruments have high liquidity (easily traded), they are preferred by many investors. Besides the primary markets (like IPOs), investors can find cash financial instruments on stock exchanges. Here are the popular cash instruments in the market for investors:

• Shares

  Shares or stocks are ownership stakes of public companies. Such companies sell their ownership stakes to investors and raise funds. A company in India might start by launching its IPO ( Initial Public Offering ). After the IPO, the company’s shares will be available on the stock exchange(s) for traders.

• Bonds

  Bonds are debt instruments issued by organisations. It is different from equity funding as it involves debt. Investors can purchase the debt securities from the issuer. Bonds are loans provided to the issuer by investors. The issuer is responsible for paying interest to investors at frequent intervals.

• Loans

  When a company issues debt securities, several investors might offer funds. However, the company can also secure a loan from a financial institution. In such a case, the number of parties involved is less, usually two parties.

Derivatives

Derivatives or financial contracts are popular assets for traders. These financial contracts can help investors indulge in hedging and price speculation. Investors can also earn multi-fold returns by investing in derivatives. The value of a financial contract will depend on the underlying asset. The underlying asset could be stock, currency, or bond. A financial derivative could also be based on a market index , like Sensex or Nifty50. Here are the two popular types of derivative instruments for investors:

• Futures

  These are financial contracts that allow investors to buy/sell an underlying asset at a predetermined price. Also, the date of expiration is predetermined for a futures contract.

• Options

  These financial contracts work similarly to futures. The only difference is that the investor is not obligated to buy/sell the underlying asset on the expiration date. Investors can choose to ignore options contracts on expiration dates.

Foreign Exchange Instruments

Foreign exchange instruments include currency pairs and derivatives based on them. Foreign Exchange (FX) instruments are the most liquid assets in the world. You can find currency pairs in an FX market. The currency pair will consist of a base and a quote currency. For instance, the INR/USD pair has INR as the base currency and the other as a quote currency. Besides trading currency pairs, you can also find futures, forwards, options, currency swaps, and spot forex contracts in an FX market.

Collective Investment Schemes

Collective investment schemes involve funds from multiple investors. The AMC (Asset Management Company) or the fund manager will collect funds from interested investors. The pooled money is then invested into diverse securities. A collective investment scheme will have predetermined investment objectives. Here are two popular types of collective investment schemes for investors:

• Mutual Funds

  A mutual fund invests in a diverse portfolio consisting of different financial instruments. Since the entire mutual fund portfolio is vast, individuals purchase its units. You can purchase mutual fund units directly or invest through Systematic Investment Plans (SIPs). A mutual fund is perfect for investors willing to purchase a basket of diversified securities.

• ETFs (Exchange Traded Funds)

  These are similar to mutual funds but have a lower expense ratio. However, ETFs are designed to track market indices, industry sectors, commodities, or particular assets. Similar to mutual funds, Exchange Traded Funds also offer exposure to a diversified portfolio of assets.

Money Market Instruments

Money market instruments are debt securities issued by governments, banks, and other organisations. However, they are different from other debt securities like bonds. Money market instruments usually have shorter terms and fewer risks. The credit quality for money market instruments is usually high. For the same rationale, investors consider them safe. Treasury Bill (T-Bill), CP (Commercial Paper), CD (Certificates of Deposit), call money, notice money, Repo (Repurchase Agreement), reverse repo, and T-CMBs (Treasury Cash Management Bills) are some money market instruments available for investors in India.