What are financial instruments?

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What are financial instruments?

In editorial 1, I wrote: A financial system includes three very important pieces in the “puzzle”.  …….. The system includes a range of financial institutions, a range of financial instruments and various markets that allow the free flow of funds.

In editorial 2 yesterday, I covered the various financial institutions categories. In this editorial, I will cover the range of financial instruments.

A financial instrument is a document that can be placed as an asset on the balance sheet. There are three types of financial instruments: equity (including hybrid instruments), debts and derivatives.

Equity can take many different forms. Shares that we buy in either the primary or secondary markets are the principle form of equity.  Another form of equity is known as hybrid security.  This is a security that has the characteristics of equity and debt. Preference shares are an example of hybrid securities.

The second type of financial instruments is debt.  It is known as a loan that needs to be paid back. The types of debt instruments issued include debentures, unsecured notes, term loans and commercial bills. Overdrafts and mortgage loans are also considered debt type.

The third type of financial instruments is derivatives. They became very popular in recent years because of the leverage they provide. They are used to manage risk.  There are four type of derivatives. They are futures, forwards, options and swaps.

– A future contract is a contract to buy or sell a specified amount of a commodity or financial instrument at a price determined today for delivery or payment at a future date.

– A forward contract is similar to a future contract but it is more flexible and is negotiated over the counter with a commercial bank or investment bank.

–  An option contract gives the buyer of the option the right, but not the obligation which is given to the seller, to buy or sell the designated asset at a specified date and a specified price during the life of the option.

– A Swap contract is an arrangement to exchange specified future cash flows. With an interest rate swap as an example, there is an exchange of the future interest payments for a specified amount.

See Part 4 in my next editorial: the various markets that make up the financial system.