Financial Instruments - Decide Which Instrument Suits You Best!

Cash, deposits, stocks, bonds, derivatives, debentures, currencies, commodities and many more – For a beginner, the financial world appears daunting. Worry not! We have you covered. 

There are various kinds of investment products in the market. When you invest in a product essentially two parties are entering into a monetary contract. These contracts are called financial instruments. 

To create music, you need a musical instrument. To create wealth, you need a financial instrument. Let’s learn which financial instrument suits you best and start creating wealth with Aliceblue.

OUTLINE

• Financial Instruments Meaning

• Types of Financial Instruments

• Cash Instruments 

• Equity Instruments

• Debt Instruments

• Derivative Instruments

• Financial Instruments Examples

• Conclusion

Financial Instruments Meaning

Whatever be the investment product, there will always be a party receiving the money and another giving the money. For example, if a company needs some funding to run a project, it may raise it from the public. 

The investors lending the money will enter into a binding agreement that after a predefined period the company will return the money at a certain interest rate. This binding agreement is a financial instrument.

Your deposits in the bank, loans, cheques, investment in stocks, bonds or mutual funds are all types of financial instruments. International Accounting Standards (IAS) defines a financial instrument as a “contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.” In simpler words, one entity receives the money while the other owes it to the former. 

Types of Financial Instruments

There are two major categories of financial market instruments – Cash Instruments and Derivative Instruments – under which various types of financial instruments exist. Let’s understand them all:

1. Cash Instruments 

Cash instruments are those which are easily transferred and whose value is determined directly by market players based on buyers and sellers. These are classified into two types:

a. Equity Instruments 

Equity instruments are those in which investors get an ownership in the company. The most commonly known equity instruments include equity shares and mutual funds. There are others such as preference shares, rights shares and warrants. 

b. Debt based Financial Instruments 

Debt instruments are obligatory contracts in which the borrower entity promises to pay the principal amount along with some interest amount to the lender. Types of debt instruments include Bonds, Certificates of Deposit, Commercial Papers, Debentures, Fixed Deposit (FD), G - Secs (Government Securities) and National Savings Certificate (NSC). 

2. Derivative Instruments 

Derivative instruments derive their value from an underlying asset that could be stocks, indices, currency or even interest rates, among others. Future and options, forwards and interest rate swaps are the most popular examples of it. 

Financial Instruments Examples

Here goes the most popular list of financial instruments:

1. Stocks 

When you have to put money in a company as an equity shareholder, you go for stock investing. 

2. Mutual Funds

Fund houses pool in money from various investors to invest in a basket of stocks. This basket is your mutual fund scheme. 

3. Bonds 

Bonds are issued when the promoters do not wish to dilute their shareholding. These are fixed-income products in which you earn returns at a specified rate. 

4. Bank Deposits 

The money you keep in savings accounts or fixed deposits are also a type of cash financial instrument. 

5. Government Securities 

The RBI issues government securities such as treasury bills and government bonds as a financial instrument to raise money from the public. 

6. Futures and Options

F&Os are two most popular financial instruments of the derivatives market. In future contracts, a buyer (or seller) has an obligation to buy (or sell) a certain quantity of shares at a specific price at a future date. In option contracts, a buyer (or seller) has the right, but no obligation, to buy (or sell) a share at a predetermined price at a specific date.

Conclusion 

The gambit of financial instruments is quite wide. Fresher financial instruments keep coming. Whenever you come across a product, you must classify it among the types and subtypes that you have just learned.

Equity instruments are for risk-takers, debt instruments give you lower than equity returns but typically your capital remains safe. Derivative financial instruments are even riskier. Choose a financial instrument as per your risk appetite. A balance among all instruments is the way to go.