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.
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. or an oral agreement.
Table of contents
- 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., 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. 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 them to reap greater benefits from it and eliminate the chances of them getting backfired.
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Let us understand financial instruments classification by understanding its types.
- 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 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., 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., bank balances, etc.
- Hybrid Instruments: It includes warrants, dual currency bonds, convertible debt, equity-linked notes, convertible debentures, etc.
Let us understand the concept of innovative financial instruments with the help of a couple of examples.
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. 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.
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.
Let us understand the importance of financial instrument classifications through the discussion below.
- 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 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 cut down their material costs and maximize sales and profit figures.
- They are generally used by people who cannot afford or do not have access to Credit 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. 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.
Let us understand the advantages of innovative financial instruments through the discussion below.
- 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 itsLiquid 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. 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 AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.. It is possible through fund transfer from tangible assets that are running in surplus values to those lying in deficit.
- Financial instruments allocate the risk concerning the risk-bearing capacities of the counterparties participating in investing 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 that invest in real assetsThat Invest 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 of hedged inflation. They can also hedge against uncertainties caused as a result of political reasons.
- These sources like equity act as a permanent source of funds for an organization. Equity shares also allow an organization to have an open chance of borrowing and enjoyRetained 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. 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.. With equity shares, payment of dividends to equity holders is purely optional.
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.
- Liquid assets such as savings accounts balances and other bank deposits are limited for ROI or investment return. It is high because 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 years, too, or whatever is specified in the agreement.
- If an organization wishes to withdraw the money before completing 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 dealing with or wishing 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 less than stocks. Companies can even default on bonds.
- Some financial instruments like equity capital are a Life-long burden for the company. Equity capitalEquity CapitalEquity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company. acts as a permanent burden in an organization. Equity capital cannot be refunded even if the organization has sufficient funds. However, as per the latest amendments, companies can buy back their shares for cancellation, but the same is subjected to certain terms and conditions.
Frequently Asked Questions
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.
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.
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 –