Financial Instruments Explained: Types and Asset Classes

What Is a Financial Instrument?

Financial instruments are assets that can be traded or exchanged. Some examples of financial instruments include stock shares, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), mutual funds, loans, and derivatives contracts.

Financial instruments provide efficient flow and transfer of capital among the world’s investors. They are assets that may be in the form of cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of ownership in some entity.

Understanding Financial Instruments

Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt-based financial instruments represent a loan made by an investor to the owner of the asset.

Foreign exchange instruments comprise a third, unique type of financial instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity.

Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and derivative instruments.

Cash Instruments

• The values of cash instruments are directly influenced and determined by the markets and can be readily brought and sold. Stocks and bonds are examples of such primary instruments.
• Cash instruments may also be deposits and loans agreed upon by borrowers and lenders. Checks are an example of a cash instrument because they transmit payment from one bank account to another.

Derivative Instruments

• The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
• An equity options contract—such as a call option on a particular stock, for example—is a derivative because it derives its value from the underlying shares. The call option gives the right, but not the obligation, to buy shares of the stock at a specified price and by a certain date. As the price of the underlying stock rises and falls, so does the value of the option, although not necessarily by the same percentage.
• There are over-the-counter (OTC) derivatives and exchange-traded derivatives. OTC is a market or process whereby securities not listed on formal exchanges are priced and traded.

Types of Asset Classes of Financial Instruments

Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Debt-based instruments are essentially loans made by an investor to the issuer in return for a payment of interest.

Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of Treasury bills (T-bills) and commercial paper. Bank deposits and certificates of deposit (CDs) are technically debt-based instruments because they earn depositors interest payments.

Exchange-traded derivatives are traded for short-term, debt-based financial instruments such as short-dated interest rate futures. There also are OTC derivatives such as forward rate agreements (FRAs).

Long-Term Debt Instruments

Long-term debt-based financial instruments last for more than a year.

Long-term debt securities are typically issued as bonds or mortgage-backed securities (MBS). Exchange-traded derivatives on these instruments are traded in the form of fixed-income futures and options.

OTC derivatives on long-term debts include interest rate swaps, interest rate caps and floors, and long-dated interest rate options.

Equity-Based Financial Instruments

Equity-based instruments represent ownership of an asset.

Stocks are equity-based instruments as are ETFs and mutual funds that are invested in stocks.

Exchange-traded derivatives in this category include stock options and equity futures.

Foreign Exchange Instruments

Foreign exchange (forex or f/x) instruments include derivatives such as forwards, futures, and options on currency pairs, as well as contracts for difference (CFDs).

Currency swaps are another common form of forex instrument.

In addition, forex traders may engage in spot transactions for the immediate conversion of one currency into another.

The Bottom Line

A financial instrument is effectively a monetary contract (real or virtual) that confers a right or claim against some counterparty in the form of a payment (checks, bearer instruments), equity ownership or dividends (stocks), debt (bonds, loans, deposit accounts), currency (forex), or derivatives (futures, forwards, options, and swaps).

Financial instruments can be categorized by asset class and as cash-based, securities, or derivatives.

Depending on their type, financial instruments may be exchangeable on listed or over-the-counter markets.