Financial instruments are documents that act as a financial asset for one organization and a liability for another. They are used to facilitate trading and investment activities, and come in many forms. Common examples of financial instruments include stocks, ETFs, mutual funds, REITs, bonds, derivative contracts (such as options, futures, and swaps), checks, CDs, bank deposits, and loans. Bonds are the most popular financial instrument used by governments to raise money from investors.
At any given time, there will be trillions of dollars in government bonds in circulation. Banks and other credit institutions provide loans to organizations such as companies, sovereign governments, or government agencies. Loans are quite similar to bonds but involve fewer parties and are easier and faster to negotiate and document. A convertible bond is a bond that can be repaid or converted into shares at a future date.
The terms of convertible bonds will define the amount and frequency of coupon payments (if any); and the terms and date of repayment or conversion. A convertible loan is a loan that can be repaid or converted to equity at a future date. The terms of convertible loans will determine the amount and frequency of interest payments (if any); and the terms and date of repayment or conversion.
Derivative Financial InstrumentsDerivative financial instruments are contracts based on underlying assets such as stocks, bonds, indices (such as the S&P 500), interest rates, commodities (such as coffee or oil), and currency pairs. Mutual funds are popular instruments of the Indian stock market because they involve the mutual trading of financial instruments in the stock market with lower risk than trading stocks alone.
Classifying Financial InstrumentsFinancial instruments can also be classified into two asset classes: cash instruments and contracts.
Cash instruments are exchanged for cash while contracts involve two parties exchanging a financial instrument for another. Organizations must ensure that they properly use financial instruments to obtain greater benefits and eliminate the possibilities that they will prove counterproductive.