Financial Instrument

Updated on March 27, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What are Financial Instruments?

Financial instruments are certain contracts or any document that acts as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and these solely taken into use for trading purposes.

Financial-Instrument

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Informal and innovative financial instruments offer highly flexible services as per the needs of an individual. It can be initiated and completed within a few minutes of applying as it merely needs a simple cash receiptCash ReceiptA cash receipt is a small document that works as evidence that the amount of cash received during a transaction involves transferring cash or cash equivalent. The original copy of this receipt is given to the customer, while the seller keeps the other copy for accounting purposes.read more or an oral agreement.

Key Takeaways

  • Financial instruments refer to contracts or documents representing financial assets, such as bonds, shares, and derivatives, which transfer obligations or risks between organizations. 
  • They can take various forms, such as debentures, bonds, cash equivalents, equity shares, swaps, etc.
  • They provide companies with liquid assets, which can be used for quick payments or dealing with contingencies.
  • Money market instruments, capital market instruments, and hybrid instruments are common categories of financial instruments.

Financial Instruments Explained

Financial instruments are documents that act as financial assets to one organization and as a liability for another organization. These can either be in the form of debentures, bonds, cash, and cash equivalents, bank deposits, equity shares, preference shares, swaps, forwards and futures, call or notice money, letters of credit, caps and collars, financial guaranteesFinancial GuaranteesA financial guarantee is a promise undertaken by a third party to cover any financial obligation of another organization or individual, acting as a guarantor for any unpaid financial debts. If the concerned party is unavailable, authorities contact guarantors.read more, receivables and payables, loans and borrowings, etc. Each type of financial instrument has its advantages and disadvantages.

Financial instruments classification must be appropriately taken into use to derive the most benefits. These can be of huge significance for companies looking to minimize their costs andRevenue maximization is the method of maximizing a company's sales by employing methods such as advertising, sales promotion, demos and test samples, campaigns, references. It aims to capture a larger market share in an industry. Technically, revenue is maximized when MR (Marginal Revenue) equals zero.read more maximizing their revenueMaximizing Their RevenueRevenue maximization is the method of maximizing a company's sales by employing methods such as advertising, sales promotion, demos and test samples, campaigns, references. It aims to capture a larger market share in an industry. Technically, revenue is maximized when MR (Marginal Revenue) equals zero.read more model. Thus, organizations must make sure that they are properly using them to reap greater benefits from it and eliminate the chances of them getting backfired.

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Types

Let us understand financial instruments classification by understanding its types.

Types of Financial Instrument

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  1. Money Market Instruments: Money market instrumentsMoney Market InstrumentsThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more include call or notice money, caps and collars, letters of creditLetters Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf.read more, forwards and futuresForwards And FuturesForward contracts and future contracts are very similar. Still, the key distinction is that futures contracts are standardized contracts traded on a regulated exchange, whereas forward contracts are OTC contracts, which stand for "over the counter."read more, financial options, financial guarantees, swapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more, treasury bills, certificates of depositsCertificates Of DepositsA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period.read more, term money, and commercial papersCommercial PapersCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note.read more.
  2. Capital Market Instruments: It includes equity instruments, receivables, payables, cash deposits, debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more, bonds, loans, borrowings, preference sharesPreference SharesA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more, bank balances, etc.
  3. Hybrid Instruments: It includes warrants, dual currency bonds, convertible debt, equity-linked notes, convertible debentures, etc.

Examples

Let us understand the concept of innovative financial instruments with the help of a couple of examples.

Example #1

XYZ Limited is a banking company that issues financial instruments such as loans, bonds, home mortgages, stocks, and asset-backed securities to its customers. These may act as a financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more for the banking, as mentioned earlier, company. Still, for customers, these are nothing but financial liabilities that must be duly paid on time by them. On the other hand, the amount deposited by the customers in the bank acts as a financial asset for the customers depositing the same, whereas a financial liability for a banking company.

Example #2

In March 2023 due to a global banking crisis, the stock markets across the world fell quite sharply for a couple of weeks. Amidst these turbulent times for economies, the interest rates on financial instruments were hiked and the markets did not receive it very well.

In a situation where the stock market grew by one step and fell by two steps on a regular basis, the statements from the Federal Reserve and Treasury secretary Janet Yellen’s statements about banks not being the safest place to place money, the sentiments only soared even further among investors and experts.

Importance

Let us understand the importance of financial instrument classifications through the discussion below.

Advantages

Let us understand the advantages of innovative financial instruments through the discussion below.

Disadvantages

Despite acting as a prime source of financial aid for many, it has a few factors that act as a hurdle for its users. Let us understand the disadvantages through the points below.

Frequently Asked Questions

What is the forgery of a financial instrument? 

Check/money order forgery of a financial instrument arises if an instrument like a check or money order is modified, duplicated, or copied from an original document in the absence of such document or the actual document is modified. 

What are international financial instruments?

International financial instruments refer to financial products or securities traded on international financial markets or used in cross-border financial transactions. These can include stocks, bonds, currencies, derivatives, and other financial products used to manage risk or generate returns globally.

What is a long-term and short-term financial instrument?

Long-term financial instruments have a maturity period of more than one year, while short-term financial instruments have a maturity period of less than one year. Long-term financial instruments include bonds, mortgages, and certain types of loans, while short-term financial instruments include treasury bills, commercial paper, and short-term loans.

This has been a guide to what are Financial Instruments. Here we explain types and examples of Financial instruments along with advantages and disadvantages. You can learn more about financing from the following articles –

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