Understanding the economic markets is a very important responsibility for all business owners and individual investors. One part of the overall economy that all people must understand is what financial instruments are.
This article will explain what a financial instrument is, what types of financial instruments there are, and what financial instruments can be used for.
What Is a Financial Instrument?
A financial instrument is ultimately a contract made between parties which involves a monetary value. These contracts have been created, amended, traded between other parties and on a public market, or completely settled.
International standards for accounting generally define a financial instrument as a contract that will create:
- An asset for one party;
- A equal liability or equity investment for another party.
What Types of Financial Instruments Are There?
There are many different types of financial instruments that consumers and businesses should be aware of.
- One of the most common financial instruments that is in use in the world today is cash. A cash financial instrument is an instrument that has its value determined by the marketplace. Some very common examples of a cash financial instrument can include a loan in which one party provides cash to another party in exchange for an agreement for repayment. Another common example of a cash financial instrument includes a deposit into a bank account. This will act as an asset for the account holder and a liability for the bank that accepts the deposit.
- Another common type of financial instruments are derivative instruments. A derivative instrument is one in which the value of it is determined by the value of underlying assets. These instruments are far more complex than cash instruments. Moreover, they can include exchange traded derivatives and over the counter derivatives.
In many situations, financial instruments are also classified into different asset classes. In general, these are:
- Long-term debt (which have commitments in excess of one year): These include bonds and loans that have commitments in excess of one year.
- Short-term debt (which have commitments of less than one year): Examples include bank accounts that have not hold requirements, short-term future contracts, and short term loans.
- Equity: These financial instruments include stock options and equity futures.
- Foreign exchanges: They include currency futures.
How Are Financial Instruments Valued?
Ultimately, a financial instrument is an investment that needs to go through proper analysis. This isto ensure that it has the correct value and that you are getting a good investment. The way that a financial instrument will be valued will vary based on the asset that is in question. Whenever the financial instrument is cash, the value is typically equal to 100% of the cash balance that is paid. Financial instruments that are loans or bonds will typically start the valuation process with the face value of the loan.
However, the value can then adjust up or down, based on a number of different factors. The value of the loan will be influenced by future expected interest and fee collections, which can increase the face value of the loan. However, if the loan has gone into some form of default, there is a risk of non-payment. Also, if the underlying collateral has depleted in value, the value of the loan likely could be much less than the face value of the note.
The market simply determines other types of financial instruments. Any investment that comes from a public traded market, including stocks, futures, options, and ETFs, might go through changes on a daily basis. The value of the underlying instrument will then focus on the perceived valuation set forth by the market.
Risks of Financial Instruments
Involving your business with financial instruments is a necessity and completely unavoidable. Like all other areas of a business, dealing with financial instruments will always provide some level of risk. The level of risk will vary considerably. This depends on what type of instrument that you are investing in. For example, cash, bonds, and other short-term assets are generally lower risk. However, these also provide you with a lower return on investment.
- Some of the higher risk financial instruments include stocks, equities, futures, and options. All of these financial instruments seem of higher risk because they are speculative. Therefore, they can vary in value considerably from one day to the next. However, they are still highly liquid and can provide you with a great return on your investment.
- Another type of financial instrument that provides some additional risk are long-term loans. Long-term loans may have less risk than equities. But they are not liquid, which means that it is not easy to exit your position once the instrument has been issued to the other party. Furthermore, there is always risk that the underlying collateral position could dilute, which could lead to a reduction in value.
How to Mitigate Risk
While there are risks of investing in financial instruments, there are normally ways to mitigate against these risks.
- One of the best ways to do this is to complete a full financial analysis and risk review of each instrument before you choose to invest. This will help to ensure that you are able to identify the issues and you can then determine if the risk/reward is acceptable to you.
- Another way to mitigate is to diversify. It is important that you never put all of your eggs in one basket or into investments that connect. This will help your business to stay afloat in the event you experience a loss.
One of the most important financial principles that all businesses, investors, and individual consumers need to understand are financial instruments and how they work. There are a wide range of financial instruments that you should understand, which can include cash, loans, bonds, and stocks.
This article provided an overview of all the different types of financial instruments and provided tips on how to analyze them and incorporate them into your business.
The images are from depositphotos.com.