Financial instruments are defined as legal agreements between parties. These can be created, modified, traded, and settled. It could be in the form of cash (currency), shares or bonds. According to the International Accounting Standards (IAS) a financial instrument is defined as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”.
Table of Contents
Types
- Cash Instruments
Cash instruments are instruments whose value is decided by the markets. They can be classified into securities, loans, and deposits. Securities are readily transferable, whereas, loans and deposits can be transferred only when both borrower and lender agrees for the transfer.
Cash Instruments often offer complete capital security, but it’s also subjected to credit risk. As a result, the capital value of cash instruments won’t fluctuate if interest rates fluctuate. Since these have high liquidity, it can be used by institutions with very long term liabilities.
- Derivative Instruments
Derivative Instruments are financial instruments which get their value or change in value from the value and features of the underlying assets. They can be classified into exchange-traded derivatives and over-the-counter (OTC) derivatives.
They are excellent means for maximizing return on an investment, and for successfully hedging a financial portfolio. Derivative instruments are also associated with risk because any event or market movement that has a negative impact on the value of the underlying security will also cause the instrument to lose value.
Asset Classes
Financial instruments can also be divided according to asset class, which depend on whether they are debt-based or equity-based.
- Debt-based
This asset class is divided into two types: Short term debt-based and long term debt-based.
Short term debt-based instruments last only for a year or less. T-bills and Commercial papers are some of the examples for Securities. Cash of this kind can be deposits and certificates of deposits (CD’s). Exchange-traded derivatives under this category can be short-term interest rate futures, while OTC derivatives are forward rate agreements.
Long term debt-based instruments last for more than a year. Bonds are under securities, cash equivalents are loans. Exchange traded derivatives are bond futures and option on bond futures. OTC derivatives are interest rate swaps, interest rate options, interest rate caps and floors, and exotic derivatives.
- Foreign Exchange
Foreign exchange has no securities. Cash equivalents are spot foreign exchange, exchange-traded derivatives will be currency futures and OTC derivatives come in foreign exchange options, outright forwards and foreign exchange swaps.