What are financial instruments?
If you participate in the financial markets, you'll be trading various types of financial instruments. This page covers everything you need to know about them and how to choose the ones best suited to your objectives.
What is a financial instrument
A financial instrument is a physical or digital document or contract that signifies ownership of an asset or a contractual right to receive something. Financial instruments can be created, modified and traded.
Financial instruments are typically tradable. How easily they can be traded depends on liquidity and the amount of information available.
An example to help define financial instruments
If you have a contract to buy or sell something, but you can't sell the contract, it's not a financial instrument. If you can sell the contract, it's probably a financial instrument.
Types of financial instruments
Financial instruments can be categorised. Firstly, they represent either equity, debt or a currency. Secondly, they are either primary (cash instruments) or derivative instruments. The following is a list of examples sorted according to whether they are primary or derivative ones.
Primary financial instruments
Primary instruments are also known as cash instruments. They represent actual ownership of an asset or the right to a future cash flow.
Shares
Shares are also known as equities and stocks. A share represents ownership of a percentage of a publicly listed company. Shareholders have certain rights, including a claim on assets if the company is liquidated, the right to receive dividends and the right to vote on important company matters.
ETFs (Exchange Traded Funds)
Strictly speaking, ETFs are a type of share, and they are traded just like the shares of listed companies. However, ETFs indicate partial ownership in a portfolio of securities rather than in a single company.
Bonds
Bonds are long-term debt instruments with maturities of more than one year. Governments, municipalities and companies issue bonds to raise money in the form of debt. A bond has a face value due to the holder when the bond matures and a coupon reflecting the interest paid each year.
Money market instruments
Money market instruments are similar to bonds but have maturities shorter than one year. There are many different types of such, including commercial paper, certificates of deposit, repurchase agreements, banker's acceptances, and treasury bills.
Cash
Currencies are also regarded as financial instruments. They are recorded on balance sheets at face value or in another currency. Cash is the most liquid form of financial instrument.
Other basic financial instruments
Some other items listed on company balance sheets are also classified as financial instruments from an accounting standpoint. These include trade debtors, trade creditors and bank loans.
Derivative financial instruments
Derivatives are financial instruments that derive their price in some way from other financial instruments or assets. Some derivatives are relatively simple, while exotic ones are very complex.
Futures
A futures contract is a contract between two parties to exchange cash or other securities on a future date and at an agreed-upon price. Futures contracts are traded on exchanges and have standardised terms that dictate the quantity of the underlying asset, the expiry date and the method of exchange.
Options
An option gives the holder the right but not the obligation to buy or sell an underlying asset at a specific price on a specific date in the future.
Options are traded on exchanges and in OTC (over the counter markets)
Forwards
Forwards are like futures contracts but aren't traded on exchanges and don't have standardised terms. Forwards are traded in the OTC market, usually between institutions and corporations.
CFDs (Contracts for Difference)
CFDs are similar to futures but are traded in the OTC market between brokers and their clients. Unlike futures which have expiry dates, CFDs are rolled forward each day until closed. CFDs are settled for cash.
Swaps
A swap is an agreement to exchange cash flows based on foreign exchange rates, interest rates or equity returns. Swaps are traded between banks, institutions, and corporations in the OTC market to hedge currency and interest rate exposure.
Convertible instruments
Convertible instruments can be turned from one type of instrument to another if or when certain conditions are met. The most common of these are convertible bonds that can be transformed into shares.
Characteristics of financial instruments
Each type of financial instrument has its own characteristics that determine whether it's suitable for investing, trading, or conducting business activities.
Exchange or OTC traded
Financial instruments listed and traded on exchanges usually have standardised terms and an extra layer of oversight.
This means less due diligence and less flexibility.
Instruments traded over the counter offer more flexibility but carry counterparty risk.
Liquidity
The liquidity of financial instruments depends on the size of the market, supply, demand, and the way they are traded. Some instruments have deep, liquid markets, while others have none. Liquidity, in turn, affects the transaction costs for trading or transferring an instrument.
Liquidity for cash instruments depends on supply or demand, while it depends on both for derivative ones.
Risk
Financial instruments carry unique risks.
- Counterparty risk refers to a counterparty not being able to meet its obligations.
- Liquidity risk refers to the potential costs resulting from low liquidity or the chance that an instrument can't be sold.
- Volatility and market risk are the probability that the instrument's price may be lower when selling it.
- Tax risk differs according to the way gains may be taxed for each instrument.
- Currency risk refers to the effect changes in certain exchange rates may affect an instrument.
Regulation
The regulatory environment determines the level of protection investors have. The way financial instruments are managed depends on the regulatory bodies they fall under. Instruments marketed for trading purposes are typically governed by the SEC in the US or the FSA in the UK.
Instruments that are listed on exchanges are subject to an extra layer of oversight.
Why knowing types of financial instruments is essential?
Certain financial instruments are better for trading, while some are preferable for long-term investing. Others are used in the course of business but have little relevance to traders or investors.
Before investing in a financial instrument, it's important to understand its characteristics, advantages and disadvantages and how it suits your objectives. It's also critical to know the regulatory landscape under which an instrument falls.
If you're an investor, the long-term value and investor protection are of particular importance.
If you're a trader, liquidity and transaction costs are most important. Volatility can be an advantage as there may be more trading opportunities. Investor protection is also critical.
How to choose the right financial instrument
Choosing the suitable instruments to meet your objectives requires finding the right combination of financial instruments, asset class and strategy. The following steps will help you:
Step 1: Decide on the asset class you're interested in
Asset classes include equities, bonds, currencies, commodities and real estate. Asset classes with higher returns, like equities, carry more risk, while those with lower returns, like cash and bonds, are less risky. Your choice of asset class will also depend on your knowledge and interests.
Step 2: Decide on your objectives
Some financial instruments are better for long-term investing, while others are suitable for trading (see below). Investors often choose more than one asset class, while traders tend to specialise in a single one.
Step 3: Choose the instrument that suits your objectives and covers the asset class you're interested in
Some instruments only exist within a single asset class, while derivative instruments can have any underlying asset. These are more versatile, especially for trading.
Advantages and disadvantages of tradable financial instruments:
The following are advantages and disadvantages of financial instruments available to retail investors and traders:
Shares
| Advantages | Disadvantages |
| Good long-term returns | No multiplier |
| Wide choice available | Difficult to short sell |
Bonds
| Advantages | Disadvantages |
| Steady long-term returns | Interest rates are currently very low |
| Low volatility | Difficult to short sell |
Currencies
| Advantages | Disadvantages |
| Major currencies are very liquid | Typically have low long-term returns |
| Low transaction costs | Some currencies aren't very liquid |
Futures
| Advantages | Disadvantages |
| Built-in multiplier as they're traded on margin | Contract prices are typically quite high and require a lot of capital |
| Wide range of asset classes | High level of risk |
| Easy to sell short | |
| .Can be traded on indexes that can't be traded directly |
CFDs
| Advantages | Disadvantages |
| Wide range of asset classes | Like any leveraged instrument, trading CFDs can be risky |
| Built-in multiplier as they're traded on margin | CFDs aren't available in some countries |
| Easy to short sell | Financing charges reduce returns over long periods |
| Not much capital required to get started | |
| Can be traded on indexes that can't be traded directly |
Options
| Advantages | Disadvantages |
| If you buy an option, the downside is limited to the premium you pay | Options are sophisticated instruments that require trading experience and skills |
| Options can provide significant leverage | Writing (selling short) options is very risky |
The best financial instruments for trading
The following four instruments are the best for active trading:
CFDs
CFDs are ideal for active traders due to the number of asset classes they can be used to trade. They also have a built-in multiplier and are easy to short sell.
Currencies
Currencies can be traded directly or with CFDs. The Forex market is very liquid and offers short-term traders many opportunities.
Futures
Futures share many of the advantages of CFDs but are better for larger accounts due to the minimum capital requirements.
Options
Options can be used for sophisticated trading strategies. They are best for traders with a lot of experience and relatively large trading accounts.
The best financial instruments for investing
The following three instruments are ideal for long-term investors:
Shares
Shares are the most important instruments for long-term investment portfolios. Shares allow investors to participate in the growth of companies and the economy over the longer term.
Bonds
Bonds allow investors to diversify their portfolios to reduce volatility. While returns are low, they're higher than for cash, with lesser risk than for shares.
ETFs
ETFs allow investors to plough in a wide variety of asset classes and instruments using just a few products. They also offer the advantage of diversification and low fees.
Conclusion
The wide number of financial instruments available today means the world of investing and trading is now accessible to anyone. Furthermore, modern trading platforms make all the information and tools you'll need available at no cost.
If you would like to find out more about financial markets and instruments, Libertex is a broker offering CFDs on stocks, currencies, commodities, indices, ETFs and cryptocurrencies. That means you can trade and learn about all these asset classes with just one account and on one platform. But please note that trading CFDs with a multiplier can be risky and can lead to losing all of your invested capital.
With no risk, you can open a free demo account to learn more about these asset classes and all the tools available on the platform. The platform also offers free trading tutorials to help you get started.
FAQ
What are the types of financial instruments?
Financial instruments are either cash or derivative instruments. The price of cash instruments is determined by market supply and demand. These include shares, bonds and currencies. The price of derivative instruments is determined by the price of other instruments. Derivative instruments include futures, options and CFDs.
What are basic financial instruments?
Basic financial instruments include cash, trade debtors, trade creditors, bank loans. Shares and bonds can also be regarded as basic financial instruments.
What are the uses of financial instruments?
Financial instruments are used to raise capital for investment purposes, hedging and speculating. They can be modified, traded or settled.
Why are financial instruments important?
Financial instruments formalise financial agreements between parties. This establishes a higher level of certainty about the instrument's value and that obligation will be met. Ownership of most financial instruments can also be transferred, increasing liquidity.
Are all financial instruments tradable?
In theory, all instruments can be traded, but for some, it may be difficult. Instruments like debtors and creditors on a company's balance sheet may be difficult to buy or sell.
Disclaimer: The information in this article is not intended to be and does not constitute investment advice or any other form of advice or recommendation of any sort offered or endorsed by Libertex. Past performance does not guarantee future results.
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