Financial instrument

Financial Instrument

A financial instrument is a monetary contract between parties. These instruments can be created, traded, modified, and settled. They can be cash (currency), evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash or another financial instrument. Financial instruments are typically classified as either cash instruments or derivative instruments.

Types of Financial Instruments

Financial instruments can be broadly categorized into two types:

Cash Instruments

Cash instruments are financial instruments whose value is determined directly by the markets. They can be divided into two main types:

• Securities: These are tradable financial assets such as stocks and bonds. Equity securities represent ownership in a company, while debt securities represent a loan from the investor to the issuer.
• Deposits and Loans: These are agreements where one party lends money to another. The terms of the loan or deposit determine the interest rate and repayment schedule.

Derivative Instruments

Derivative instruments are financial contracts whose value is derived from the value of an underlying asset, index, or rate. Common types of derivatives include:

• Options: Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price on or before a certain date.
• Futures: Standardized contracts to buy or sell an asset at a predetermined price at a specified time in the future.
• Swaps: Contracts in which two parties exchange cash flows or other financial instruments for a certain period.

Functions of Financial Instruments

Financial instruments serve several key functions in the economy:

• Facilitation of Trade: They enable the transfer of risk and capital between parties, facilitating trade and investment.
• Price Discovery: Financial markets help in determining the price of financial instruments through supply and demand dynamics.
• Risk Management: Instruments like derivatives allow parties to hedge against potential losses from fluctuations in prices, interest rates, or exchange rates.

Regulation of Financial Instruments

Financial instruments are subject to regulation to ensure transparency, fairness, and stability in the financial markets. Regulatory bodies such as the Securities and Exchange Commission (SEC) in the United States oversee the issuance and trading of financial instruments to protect investors and maintain market integrity.

See Also

• Financial market
• Investment
• Risk management
• Monetary policy

References

• "Financial Instruments: A Comprehensive Guide to Accounting and Reporting" by Steven M. Bragg
• "Options, Futures, and Other Derivatives" by John C. Hull