A financial instrument is a contract between parties that can generate assets to one entity and liabilities or equity instruments to another. It’s essentially any tradable asset or negotiable item that represents a financial value. Financial instruments can be either cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver, cash or another financial instrument.
There are two main types of financial instruments:
- Primary or Cash Instruments: These are the securities that are directly issued by entities to investors to raise capital and are subsequently traded between investors. They can be divided into:
- Debt-based Financial Instruments (both short and long term): These include bonds, debt securities, leases, and bank deposits. They represent a loan made by an investor to the owner (issuer).
- Equity-based Financial Instruments: These include shares or other equivalents (like American Depositary Receipts or Global Depositary Receipts). They represent ownership interest held by shareholders in an entity (company).
- Derivative Instruments: These are financial contracts that derive their value from underlying primary instruments. Derivatives can be used for hedging risks, for speculation, or getting access to otherwise hard-to-trade assets or markets. Common types of derivatives include:
- Futures and Forward Contracts: These are agreements to buy or sell a certain asset at a future date for a specified price.
- Options: These are contracts that give the holder the right (but not the obligation) to buy or sell an asset at a certain price within a specified period.
- Swaps: These are agreements between two parties to exchange sequences of cash flows for a set period.
These instruments can be used for a variety of purposes, including risk management, to facilitate borrowing, and to invest in businesses. They are generally traded over-the-counter (OTC) or on exchanges.
Example of a Financial Instrument
Here are examples of both primary and derivative financial instruments:
Primary Financial Instruments
- Debt Instruments: Let’s say a tech company, TechFuture Inc., wants to expand its operations but needs more capital. They decide to issue corporate bonds to raise this capital. These bonds are debt instruments. Investors who buy the bonds are essentially lending money to TechFuture Inc., which promises to repay the principal amount along with interest at specified dates.
- Equity Instruments: Suppose a young startup, FreshStart, decides to go public to raise capital and accelerates its growth. It issues shares of its stock in an Initial Public Offering (IPO). Investors who buy these shares gain partial ownership in FreshStart. Here, the shares are equity instruments.
Derivative Financial Instruments
- Futures Contract: Imagine a farmer who grows wheat and a bakery that needs wheat as a raw material for its products. They enter a futures contract, where the farmer agrees to sell a certain amount of wheat to the bakery at a predetermined price on a future date. This contract helps both parties hedge against the risk of price fluctuations in the wheat market.
- Options Contract: An investor anticipates that the price of shares in SolarPower Corp., a company that manufactures solar panels, will rise in the next six months. They purchase a call option, which gives them the right (but not the obligation) to buy SolarPower Corp. shares at a specified “strike price” within the next six months. If the shares’ price rises as expected, the investor can exercise the option to buy at the lower strike price and profit from the difference.
- Interest Rate Swap: Suppose there are two companies, FixedInc with a fixed interest rate loan and FloatCo with a floating interest rate loan. FixedInc anticipates that interest rates will fall, while FloatCo is concerned that rates will rise. They enter into an interest rate swap contract where FixedInc agrees to pay FloatCo’s floating interest rate in exchange for FloatCo paying FixedInc’s fixed rate. This allows each company to hedge against their respective interest rate risks.
In all these examples, the financial instrument serves as a contract or an agreement facilitating the flow of capital, investment, or risk management between parties.