Financial Instruments

Financial Instruments

See Also:
What is a Bond
Required Rate of Return
Return on Asset
Commercial Paper
Hedging Risk

Financial Instruments and Securities

Financial instruments are contracts that represent value. They come in many varieties. In fact, financial managers and bankers have a lot of leeway in creating and issuing financial instruments. The Securities and Exchange Commission (SEC) regulates publicly traded financial instruments; however, the SEC less stringently regulates private placement instruments. Most financial instruments fall into one or more of the following five categories: money market instruments, debt securities, equity securities, derivative instruments, and foreign exchange instruments.

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Money Market Instruments

Money market instruments are highly marketable short-term debt securities. Furthermore, money market instruments are generally low-risk investments. Because of this, they offer yields that are lower than riskier stocks and financial instruments.
Often, investors trade money market instruments in large denominations among institutional investors. However, some money market instruments are available to individual investors via money market funds, or mutual funds that pool money market instruments.
Money market instruments include treasury bills, repurchase agreements, certificates of deposit, commercial paper, bankers’ acceptances, Eurodollars, and federal funds.

Debt Securities

Debt securities are longer-term debt instruments. With debt instruments, the issuer is essentially borrowing money from the investor. The investor plays the role of a lender lending money to the issuing entity. Longer-term debt securities often yield higher returns than money market instruments. Debt instruments also represent a claim on the assets of the issuing entity.
Debt securities are often called fixed-income securities. This is because the investor or lender often predetermines the terms of the debt instrument. For example, a debt instrument will be issued with a certain maturity, a certain principal amount, and a set coupon rate. However, while debt securities are often called fixed-income securities, this does not mean they yield a fixed stream of payments – debt securities’ returns can fluctuate and vary.
Examples of debt securities include: treasury notes, treasury bonds, inflation-protected treasury bonds, federal agency debt, international bonds, municipal bonds, corporate bonds, junk bonds, mortgages, mortgage-backed securities, and other types of debt.

Equity Securities

Equity securities represent shares of ownership in a company. In addition, equity securities often come with voting rights. They represent the shareholders’ interest in the issuing company and a residual claim on the company’s assets. This means if the issuing company goes bankrupt and has its assets liquidated, then the equity holders only get their money back after all other relevant claimants have been paid what they are owed.
Equity securities may be traded publicly on stock exchanges, they may be traded in over-the-counter (OTC) transactions, or they may be exchanged and held privately. Types of equity securities include common stock, preferred stock, and American Depository Receipts (ADR).

Financial Derivative Instruments

A financial derivative instrument is a contract that derives its value from an underlying asset or factor. In short, the value of a derivative depends on the value of something else. When the value of the underlying factor changes, the value of the derivative instrument also changes. Derivatives are often used for speculation, for leveraging a position, or for hedging risk.
Common derivatives include futures, forwards, options, and swaps. Common underlying assets or factors include stocks, bonds, currency exchange rates, commodity prices, market indices, and interest rates. However, derivatives can derive their value from almost anything, including weather data and political election outcomes.

Foreign Exchange Instruments

Another category of financial instruments is foreign exchange instruments. These are contracts involving different currencies. There are many currencies in the world, and there are several different instruments commonly used to trade in currencies.
The value of one currency relative to another depends on the exchange rate between the two currencies. Consider exchange rates either fixed or floating. Types of foreign exchange instruments include spot contracts, forward contracts, options, futures, and swaps.
Exchange foreign currencies for investment and speculative purposes and for hedging risk. You can trade foreign currencies all over the world twenty-four hours a day via banks and brokerages. The foreign exchange market is the largest market in the world. Consider speculating in foreign exchange markets very risky.
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