Definition of Financial Instruments
Financial instruments are assets that can be traded in the marketplace. They can be cash, a contractual right to deliver or receive cash, another financial instrument, or evidence of one’s ownership interest in an entity. Financial instruments may be categorized by the asset class into which they fall or whether they fall into either the debt or equity classification.
Some common types of financial instruments include:
- Cash Instruments: These include physical currency or deposits in banks.
- Equity Instruments: Shares or stocks representing ownership in an entity.
- Debt Instruments: Long-term or short-term bonds or notes.
- Derivatives: Contracts whose value derives from the performance of an underlying entity such as options, futures, and swaps.
Examples of Financial Instruments
Example 1: Bonds
A bond represents a loan made by an investor to a borrower (typically corporate or governmental). Bond details include the end date when the principal of the loan is due to be paid to the bond owner and the terms for variable or fixed interest payments made by the borrower.
Example 2: Stocks
Stocks represent ownership in a company and a claim on part of the company’s assets and earnings. There are two main types of stock: common and preferred.
Example 3: Futures Contracts
A futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future. The contracts are traded on a futures exchange.
Example 4: Options
An options contract offers the buyer the opportunity to buy or sell an asset at a later date at an agreed-upon price.
Frequently Asked Questions (FAQs)
What are financial instruments?
Financial instruments are contracts that give rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
What types of financial instruments are there?
The main types of financial instruments include cash, equity securities, debt securities, and derivatives.
Are bank deposits considered financial instruments?
Yes, bank deposits fall under cash instruments, representing a claim on the bank, which is obliged to repay the depositor on demand.
How are financial instruments traded?
Financial instruments can be traded on public exchanges or over-the-counter (OTC) markets.
What is the role of financial instruments in financial markets?
Financial instruments facilitate the flow of capital and risk throughout the financial system, aiding in investment, growth, and economic stability.
Related Terms
Debt Instrument
Contracts that oblige the borrower to pay the lender a fixed amount on fixed dates.
Equity Instrument
Documents that signify ownership in a firm, typically stocks or shares.
Derivative
A financial security whose value is dependent upon or derived from an underlying asset or group of assets—a benchmark.
Marketable Security
A financial instrument that can be easily converted into cash or is readily traded on markets.
Liquidity
The ease with which an asset can be converted into cash without significantly impacting its price.
Online Resources
- Investopedia on Financial Instruments
- The Basics of Financial Instruments
- U.S. Securities and Exchange Commission
Suggested Books for Further Studies
- Understanding Financial Instruments by Kevin D. Peterson
- Financial Instruments: Equities, Debt, Derivatives, and Alternative Investments by Michael de Chasnac and Morad Machrouh
- Financial Markets, Instruments, and Institutions by Anthony Santomero and David Babbel
- The Handbook of Financial Instruments by Frank J. Fabozzi
Accounting Basics: “Financial Instruments” Fundamentals Quiz
Thank you for exploring the world of financial instruments with us and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
