We all understand that an instrument is something - a tool, mechanism or means, that allows us to do something. A musical instrument lets us make beautiful noise, surgical instruments allow doctors to perform operations and diagnostic instruments are the means used by engineers to detect signs of catastrophic failure before they happen. Financial instruments fall under the 'means of allowing' category. They aren't instruments in the classic sense; objects you can wield to understand, alter or repair a physical structure.
Financial instruments are documents that generally represent assets for one party and liabilities for another party. For instance, a mortgage loan represents an asset for the bank because it will receive interest payments in addition to getting back the money it lent. For the homebuyer, their mortgage is a liability because they must pay back the loan with interest. This is an imperfect example of how financial instruments work, even if it's perfectly apt. Every component of that transaction, the loan, the cash used to repay it, the interest and the declared value of the physical property are all financial instruments.
Before reading the more detailed explanation of financial instruments and how they're used, tuck these takeaways in the back of your mind:
- financial instruments are actual or electronic documents that represent a binding agreement between two parties over anything of monetary value
- there are three types of financial instruments: cash, derivative and foreign exchange
- financial instruments may be further classed into debt-based and equity-based categories
- each type of financial instrument has inherent pluses and minuses for both parties
Let's return to our mortgage example to explain these concepts. Pros/cons for the loan taker: they get a property that will eventually become wholly theirs as long as they satisfy the terms of the contract. However, that means they must hand over all that cash while also paying for repairs, maintenance and upkeep, and keeping taxes current. Conversely, the lenders do everything they can to limit their minuses while increasing their chance to profit. They will review your credit and payment history, verify you earn enough money to cover your payments and mandate insurance coverage to protect their interests.
Money Versus Currency
Before we can begin to understand financial instruments, we must know what money and currency are, and the distinctions between them. Many people use those terms interchangeably to describe their coins and bills but, from a finance (and economics) perspective, the two are oceans apart in meaning, usage and significance.
Yuan, yen, dollars and pounds; rands, rupees, rials and rigsdaler: these are but a few names for currencies used in different countries around the world. In themselves, they have no value; they're only worth what they're assigned. You couldn't sell a £10 note for 20, 50 or 100 pounds. However, you could trade your tenner for 1.619 Japanese Yen or the assigned value of any other currency.
The cash we carry and any notes and coins in circulation are currency. It's sometimes referred to as legal tender; it is our means of exchange for the goods and services we buy. Currency does not hold value, store value or increase in value the longer you keep it. However, it drives all of the activity in each of the three scopes of finance.
Unlike currency, money has intrinsic value, even if you can't touch it, fold it or put it in your pocket. Money, often a way to store value, represents the actual value of the goods and services we spend our cash on. Contrary to popular belief, money markets are not facilities where currency trades take place. The term 'money market' means trading in short-term debt. Money market mutual funds and the money market accounts many banks offer are relatively safe investment vehicles.
Three Types of Financial Instruments
Recall from this article's introduction that cash, derivatives and foreign exchange are the three main types of financial instruments. The preceding segment explained what cash is - currency, not money. We also know that any country's currency has its worth pinned to that country's monetary and fiscal policies; foreign policy also plays a role in deciding how much to sell their currency for (or how much they'll pay to buy foreign currency).
With those two types of instruments sorted, let's focus on the remaining one: derivatives. In general, a derivative is a financial contract between two or more parties. The contract's value depends on the asset(s) underpinning it. Futures are a good example of derivatives. For instance, corn futures may look particularly lucrative if the growing season has had a few hiccups - meaning the price for corn will go up. On the other hand, if we're enjoying a bumper year, corn futures might not be such a great investment because the supply of corn will be so great that sellers will have to lower their prices.
Derivatives are traded either on an exchange or over the counter (OTC), meaning that you trade via a broker instead of directly on an exchange. Retail investors - individuals maintaining their retirement portfolios, for instance, would more likely call on their broker for such trades. Wholesale investors may trade directly at The Baltic Exchange in London or, in the US, the Chicago Mercantile Exchange (CME).
Debt- and Equity-Based Instruments
Debt-based financial instruments can be short-term, meaning they last for a year or less. Such may include exchange-traded derivatives or securities like commercial paper - a means for corporations to meet short-term obligations (liabilities) like paying for inventory, making payroll and settling accounts payable receipts. The life of such 'paper' typically extends no longer than 270 days. From the financial theory perspective, such instruments generally fall under the heading of managerial finance.
For the average person, a short-term financial instrument might be a Certificate of Deposit (CD). However, if you've ever traded on bond futures, bought a bond or taken out a loan, you've dabbled with long-term debt-based financial instruments. These typically last for more than a year. They're usually not as volatile and offer more stable returns than short-term debt-based instruments. The flip side of these is equity-based financial instruments like stocks and stock options. Those are sometimes offered as a part of employee benefit packages.
Explaining Financial Instruments
As this article proves, managing finance-risk management, investment management and other finance-related activities is a complex undertaking that relies on many factors and conditions, some of which lie outside of investors' control. The task can be even more stymying if you're not well-versed in the instruments that underpin finance. Thus, we leave you with a recap of the most common financial instruments discussed in this article.
Money and Currency
Often (incorrectly) thought of as synonyms. Money represents the worth of something; it is intangible. Currency represents the coins and bills we use to pay our bills and buy things. While both are financial instruments, the currency is more synonymous with cash; money is an instrument of a higher order.
Stocks and Shares
These words, too, are often used interchangeably. It's acceptable to do so as long as you remember that 'shares' is the countable version of 'stocks.' You can buy 1,000 shares of (insert fav corporation's name); thus, you would own stock in that company. If you were to say "My stocks are doing well today", you imply you own stock in more than one company - provided you used the word correctly. If you only own stock in one company, use 'shares' instead of 'stocks'.
Stocks and Bonds
As noted above, stocks are 'pieces' of a company's financial profile. When corporations take their business public, they invite investors to buy shares in their company; their price is determined by a host of variables. You can sell your shares anytime you want to or keep them for the rest of your life.
By contrast, bonds are loans you make to a company - or, more commonly to the government. When the government (or company) issues bonds - generally at a set price, anyone with the money to do so may buy as many as they'd like. However, rather than selling them at will, they must keep their bond until it matures. In practical terms, buying a bond means you're lending the issuing entity the value of the bond for a specific time. Once that time is up, you reclaim your money, plus a bit of interest for your trouble.
Debts and Loans
Ask anybody "What is finance?" and there's a good bet that loan and debt will figure in their answer. Loans are the most renowned financial instruments; they're used at every level of finance from personal to inter-governmental. Remember that some financial instruments can be both assets and liabilities; loans fall under that category. Debt, of course, is always a liability.
Futures and Options
Any investor signing a futures contract must buy shares at a specified date, which implies that there must be a seller who will make those shares available. By contrast, an options contract means a buyer may buy shares on or by the specified date but is not obligated to. These instruments are typically used to hedge investors' bests against riskier investments.
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