Financial instrument definition
/What is a Financial Instrument?
A financial instrument is an investment that confers on its owner a claim on the income or change in value of the issuer, or some underlying component of the instrument. Financial instruments can usually be traded, thereby allowing for the efficient transfer of capital between investors.
Financial instruments that cannot be easily traded typically have a higher risk premium associated with them, since their holders have a greater risk of loss. This risk premium reduces their market value.
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Types of Financial Instruments
The main types of financial instruments are noted below:
Bonds. Bonds represent a loan by the investor to the issuer, in exchange for a series of interest payments. Bonds are usually issued at a coupon rate that approximates the market interest rate on the issuance date. If investors want a higher return, then they bid a lower price to buy the bonds, resulting in a higher effective interest rate. Conversely, if the coupon rate is higher than the market rate, then investors may bid more than face value for the bonds, resulting in a lower effective interest rate.
Shares. Shares represent an ownership interest in the issuer. Common shares give investors a direct ownership interest in a corporation, allowing them to share in the cash flows of the business by being paid dividends. However, if the business fails, they are the last to be reimbursed, and so are at the greatest risk of loss.
Derivatives. Derivative valuations are based on their underlying components, such as changes in a stock index. These investments can result in very high profits and losses, depending on the changes in the underlying components. They are considered to be a more advanced financial instrument, to be used by knowledgeable investors.