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. The main types of derivative financial instruments are as follows:
Futures contracts. A futures contract is a standardized agreement to buy or sell an asset at a predetermined price on a specific future date. These are traded on exchanges and commonly used to hedge against price fluctuations in commodities, currencies, or financial instruments.
Forward contracts. A forward contract is a customized, over-the-counter (OTC) agreement between two parties to buy or sell an asset at a specific price on a future date. Unlike futures, forwards are not standardized or traded on exchanges, and carry more counterparty risk.
Options contracts. An options contract gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a set price before or on a specific date. These are widely used for hedging or speculative purposes in stock, currency, and commodity markets.
Swaps. A swap is a contract in which two parties agree to exchange cash flows or other financial instruments over time. Common types include interest rate swaps and currency swaps, often used to manage exposure to interest rate or exchange rate fluctuations.
Credit derivatives. Credit derivatives are financial contracts that transfer credit risk of an underlying entity (like a borrower or bond issuer) from one party to another. The most common type is the credit default swap (CDS), which acts like insurance against default.
Warrants. Warrants are long-term derivatives that give the holder the right to buy a company’s stock at a specific price before expiration. Unlike options, they are typically issued by the company itself and can dilute existing shares if exercised.
Convertible securities. Convertible securities are hybrid instruments that can be converted into a predetermined number of common shares. They include an embedded derivative component, giving investors flexibility to benefit from stock price appreciation.
Caps, floors, and collars. These are interest rate derivatives used to set limits on the range of interest rate fluctuations. A cap sets a maximum rate, a floor sets a minimum, and a collar combines both to manage borrowing cost volatility.