Financial Instrument

Reviewed by Vishnu | Updated on Aug 26, 2020

Introduction

A financial instrument is defined as a contract between individuals/parties that holds a monetary value. They can either be created, traded, settled, or modified as per the involved parties' requirement. In simple words, any asset which holds capital and can be traded in the market is referred to as a financial instrument.

Some examples of financial instruments are cheques, shares, stocks, bonds, futures, and options contracts.

Understanding Financial Instruments

Financial instruments can be primarily classified into two types - derivative instruments and cash instruments.

Derivative instruments can be defined as instruments whose characteristics and value can be derived from its underlying entities such as interest rates, indices or assets, among others. The value of such instruments can be obtained from the performance of the underlying component. Also, they can be linked to other securities such as bonds and shares/stocks.

Cash instruments, on the other hand, are defined as instruments which can be transferred and valued readily in the market. Some of the most common examples of cash instruments are deposits and loans where the lenders and borrowers are required to be agreed upon.

Other Classifications

Financial instruments can also be classified based on the asset class, i.e. equity-based and debt-based financial instruments.

Equity-based financial instruments include securities, such as stocks/shares. Also, exchange-traded derivatives, such as equity futures and stock options, fall under the same category.

Debt-based financial instruments, on the other hand, consist of short-term securities, such as commercial paper (CP) and treasury bills (T-bills) which have a maturity period of one year or less.

Cash instruments such as certificates of deposits (CDs) also fall under this category. On the same lines, exchange-traded derivatives, such as short-term interest rate futures fall under this category.

Since the maturity period on long-term debt-based financial instruments exceeds a year, securities such as bonds fall under the category. Exchange-traded derivates include bond futures, and options are the other examples.