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.
Types of the Financial Instrument
The three types of financial instruments are mentioned below:
- Money Market Instruments: Money market instruments include call or notice money, caps and collars, letters of credit, forwards and futures, financial options, financial guarantees, swaps, treasury bills, certificates of deposits, term money, and commercial papers.
- Capital Market Instruments: It includes instruments like equity instruments, receivables, and payables, cash deposits, debentures, bonds, loans, borrowings, preference shares, bank balances, etc.
- Hybrid Instruments: It includes instruments like warrants, dual currency bonds, exchangeable debt, equity-linked notes, and convertible debentures, etc.
Example of Financial Instrument
XYZ Limited is a banking company that issues financial instruments such as loans, bonds, home mortgages, stocks and asset-based securities to its customers. These may act as a financial asset for the aforesaid banking company but for customers, these are nothing but financial liabilities that must be duly paid on time by them. On the other hand, the amount that is 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.
There are several different advantages of the Financial Instrument are as follows:
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- Liquid assets like cash in hand and cash equivalents are of great use for companies since these can be easily used for quick payments or for dealing with financial contingencies.
- Stakeholders often feel more secure in an organization that has employed more capital in their liquid assets.
- Financial instruments provide major support in funding tangible assets. This is possible through fund transfer from tangible assets that are running in surplus values to those tangible assets that are lying in deficit.
- Financial instruments allocate the risk with respect to the risk-bearing capacities of the counterparties that have participated in making an investment intangible assets.
- Companies who choose to make an investment in real assets yield higher revenues since they get a diversified portfolio, hedged inflation, and they can also hedge against uncertainties caused as a result of political reasons.
- Financial instruments like equity act as a permanent source of funds for an organization. With equity shares, payment of dividends to equity holders is purely optional. Equity shares also allow an organization to have an open chance of borrowing and enjoy retained earnings.
The different limitations and drawbacks of the Financial Instrument include the following:
- Liquid assets such as savings accounts balances and other bank deposits are limited when it comes to ROI or return of investment. This is high because of the fact that there are zero restrictions for the withdrawal of deposits in savings accounts and other bank balances.
- Liquid assets like cash deposits, money market accounts, etc might disallow organizations from making a withdrawal for months or sometimes years too or whatever is specified in the agreement.
- If an organization wishes to withdraw the money before the completion of the tenure mentioned in the agreement, then the same might get penalized or receive lower returns.
- High transactional costs are also a matter of concern for organizations that are dealing with or wish to deal with financial instruments.
- An organization must not over-rely on debts like principal and interest since these are supposed to be paid on a consequent basis.
- Financial instruments like bonds payout return much lesser than stocks. Companies can even default on bonds.
- Some of the financial instruments like equity capital are Life-long burden for the company. Equity capital acts as a permanent burden in an organization. Equity capital cannot be refunded even if the organization has a sufficient amount of funds. However, as per the latest amendments, companies can opt for buying-back its own shares for the purpose of cancellation but the same is subjected to certain terms and conditions.
- Derivatives like forwards and futures can bring huge benefits for small-sized companies but if only these are taken properly into use. If these are inappropriately used, then these might cause an organization to suffer from huge losses and bankruptcy.
- Organizations must be very careful while dealing with swaps since it carries a higher level of risk.
- Proper management of financial instruments can help firms in cutting down their material costs and maximize sales and profit figures.
- They are generally used by people who are unable to afford or do not have access to credit facilities and systematic savings.
- Informal 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 receipt or an oral agreement.
To conclude, it can be said that the financial instruments are nothing but a piece of document that acts 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 guarantees, receivables and payables, loans and borrowings, etc. Each type of financial instrument has its own advantages and disadvantages.
Financial instruments must be appropriately taken into use for deriving most benefits out of them. These can be of huge significance for companies that are looking for minimizing their costs and maximizing their revenue model. Thus, organizations must make sure that they are properly using financial instruments so that they can reap greater benefits out of it and eliminate the chances of them getting backfired.
This has been a guide to what are Financial Instruments. Here we discuss types and examples of Financial instruments along with advantages and disadvantages. You can learn more about financing from the following articles –