Financial instruments are agreements involving the exchange of an asset with a monetary value for another asset. These agreements involve multiple parties, such as individuals, corporations, or government entities.
There are different types of financial instruments, with different types representing different asset classes. The term “financial instrument” has applications for investing but it also applies to accounting in business settings.
What Is a Financial Instrument?
Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash, evidence of an ownership interest in a company or other entity, or a contract.
In order for the contract definition to apply, the contract must do two things:
• Impose a contractual obligation on one entity to delivery cash or another financial instrument to a second entity OR exchange other financial instruments with the second entity
• Convey to the second entity a right to receive cash or another financial instrument from the first entity OR exchange other financial instruments with the first entity
Broadly speaking, when it comes to investing, financial instruments can include stocks, equity interests, options, forward or futures contracts, and derivatives. Investors can trade these instruments on a public exchange. The New York Stock Exchange (NYSE) is an example of a spot market in which investors can trade financial instruments for immediate delivery.
Outside of investing, a mortgage is another type of financial instrument. A mortgage loan represents a contract between a lender and a home buyer, in which one party agrees to lend money and the other agrees to repay it. Even a basic check is a financial instrument, since it represents the obligation of one party to pay another.
Financial Instrument vs Security
A security is a type of financial instrument with a fluctuating monetary value that carries a certain amount of risk for the individual or entity that holds it. Investors can trade securities through an exchange or over-the-counter. The federal government regulates securities and the securities industry under a series of laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
Like financial instruments, securities fall into different groups or categories. The four types of securities include:
• Equities. Equities represent an ownership interest in a company. Stocks and mutual funds are examples of equity securities.
• Debt. Debt refers to money lent by investors to corporate or government entities. Corporate and municipal bonds are two examples of debt securities.
• Derivatives. Derivatives are financial contracts whose value is tied to an underlying asset. Futures and stock options are derivative instruments.
• Hybrid. Hybrid securities combine aspects of debt and equity. Convertible bonds are a type of hybrid instrument.
All securities are financial instruments but not all financial instruments are securities.
Uses of Financial Instruments
Financial instruments facilitate the movement of capital through the markets and the broader economic system. While this may take different forms, the flow of capital remains a central feature.
Investors and businesses may use financial instrument for the following purposes:
1. As a Means of Payment
You already use financial instruments in your everyday life. When you write a check to pay a bill or use cash to buy groceries, you’re exchanging a financial instrument for goods and services. Likewise, business entities may charge purchases to a business credit card. They’re borrowing money from the credit card company and paying it back at a later date, often with interest.
2. Risk Transfer
Investors use financial instruments to transfer risk when trading options and other derivative instruments, such as interest rate swaps. With options, for example, an investor has the option to buy or sell an underlying asset at a specified price on or before a predetermined date. A contract exists between the individual who writes the option and the individual who buys it. This type of financial instrument allows an investor to speculate about which way prices for a particular security may move in the future.
3. To Store Value
Businesses often use financial instruments in this way. For example, say you default on a credit card balance. Your credit card company can write off the amount as a bad debt and sell it to a debt collector. Meanwhile, businesses with outstanding invoices they’re awaiting payment on can use factoring or accounts receivables financing to borrow against their value.
4. To Raise Capital
Companies may issue stocks or bonds in order to get access to capital that they can invest in their business. In this case, the financial instruments could be a means of raising capital for one party and a store of value for the other.
Types of Financial Instruments
Financial instruments are not all alike. There are different types of financial instruments in different asset classes. Certain financial instruments are more complex in nature than others, meaning they may require more knowledge or expertise to handle or trade.
1. Cash Instruments
Cash instruments are financial instruments whose value fluctuates based on changing market conditions. Cash instruments can be securities traded on an exchange, such as stocks, or other types of financial contracts. For example, a certificate of deposit account (CD) is a type of cash instrument. Loans also fall under the cash instrument heading as they represent an agreement or contract between two parties where money is exchanged.
2. Derivative Instruments
Derivative instruments or derivatives draw their value from an underlying asset. As mentioned, options are a type of derivative instrument. Interest rate swaps are another type of derivative. With this type of arrangement, two parties agree to “swap” interest payments on loans for a set time period.
3. Foreign Exchange Instruments
Foreign exchange instruments are financial instruments associated with international markets. For example, in forex trading investors trade currencies from different currencies through global exchanges.
4. Debt-Based Financial Instruments
Companies use debt-based financial instruments as a means of raising capital. For example, say a municipal government wants to launch a road improvement project but lacks the funding to do so. They may issue one or more municipal bonds. Investors buy these bonds, contributing the capital needed for the road project. The municipal government then pays the investors back their principal at a later date, along with interest.
5. Equity-Based Financial Instruments
Equity-based financial instruments convey some form of ownership of an entity. If you buy 100 shares of common stock in XYZ company, for example, you’re purchasing an equity based instrument. Equity-based instruments can help companies raise capital, but the company does not have to pay anything back to investors. Instead, investors can receive dividends from the stock shares they own or realize profits if they’re able to sell those shares for a capital gain.
Importance of Financial Instruments
Financial instruments are central to not only the stock market but also the financial and economic system as a whole. They keep the financial markets moving but they also help businesses to keep their doors open and consumers to manage their finances.
For example, a checking account is one of the basic tools you might use to pay bills or make purchases. You may also have a savings account that you use to hold your emergency fund, an Individual Retirement Account (IRA) that you use to save for retirement and a taxable brokerage account for trading stocks. You might be paying down a mortgage or student loans while occasionally using credit cards to spend. All of these financial instruments allow you to direct the flow of money from one place to another.
Are Cryptocurrencies Financial Instruments?
GAAP standards do not consider Bitcoin and other cryptocurrencies financial instruments. Those rules view cryptocurrency as an intangible asset, with no physical substance, rather than a financial asset. Bitcoin is not a security either, per guidance from the Securities and Exchange Commission.
Some traders view Bitcoin differently. For some, it’s an investment. For others, it’s a currency or a commodity. At this time, cryptocurrencies are not widely regulated by the government and they’re generally considered to be a highly volatile investment option. If you’re considering Bitcoin or other crypto options for your portfolio, it’s important to understand the risks involved.
Financial instruments are an important part of the trading markets but they also play a significant part in business transactions and day-to-day financial management. If you trade stocks, invest in an IRA, or write checks to your landlord, then you’re contributing to the movement of capital with financial instruments.
If you’d like to build a portfolio of financial instruments a great way to start is via the SoFi Invest® investment platform. You can use that account to trade fractional shares of stock, trade and sell ETFs, experiment with cryptocurrency, or invest in IPOs.
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