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 instrumentsMoney Market InstrumentsThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders. 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., 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.", 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., 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., 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..
- Capital Market Instruments: It includes instruments like equity instruments, receivables, and 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., 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 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. 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:
- Liquid assets like cash in hand and cash equivalentsCash EquivalentsCash equivalents are highly liquid investments with a maturity period of three months or less that are available with no restrictions to be used for immediate need or use. These are short-term investments that are easy to sell in the public market.. 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 assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet..
- Financial instruments provide major support in funding tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment.. 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 assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. .
- Companies who choose to make an investment in real assetsAn Investment In Real AssetsReal Assets are tangible assets that have an inherent value due to their physical attributes. These assets include metals, commodities, land, and factory, building, and infrastructure 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 earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company..
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 accountsMoney Market AccountsMoney Market Account is the account which receives all the interests from the instruments in the money market according to the agreed-upon terms. This account is separate from that of securities account, it only accounts for the proceeds., 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.
- DerivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. 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 facilitiesCredit FacilitiesCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. 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 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. 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 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., 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 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. 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 –