Financial Instrument

Definition:

A financial instrument is a contract that represents the promise of payment or delivery of financial assets or liabilities in the future. It is a tangible or intangible asset that gives rise to a legally enforceable obligation to pay or receive payments or deliver or receive assets.

Types of Financial Instruments:

• Debt securities: Bonds, Treasury bills, government securities, loans.
• Equity securities: Stocks, shares, preferred stock.
• Derivative securities: Futures, options, swaps, forwards.
• Money market instruments: Treasury bills, commercial paper, money market funds.
• Foreign exchange: Foreign currency exchange contracts.

Key Features:

• Obligation: Financial instruments create an obligation between two parties to fulfill certain financial obligations.
• Valuation: Financial instruments are valued based on their market value, which can fluctuate over time.
• Maturity: Some financial instruments have a maturity date, at which they are paid off or settled.
• Interest: Interest payments are made on some financial instruments, typically as a percentage of the principal amount.
• Collateral: Collateral is sometimes required for financial instruments, such as mortgages or secured loans.
• Counterparty: The other party to the financial instrument is called the counterparty.

Examples:

• A bond is a debt security that represents a loan from the investor to the issuer.
• A stock is an equity security that represents ownership in a company.
• A futures contract is a derivative security that obligates the buyer to purchase or sell an asset at a specified price in the future.
• A foreign exchange contract is a derivative security that obligates the buyer to exchange foreign currency at a specified rate.

Uses:

• To raise capital
• To hedge against risk
• To speculate on markets
• To manage risk
• To provide collateral for loans