What is a Financial Instrument and How Does it Work?

Financial instruments are contracts between two parties that have a monetary value or record a monetary transaction. They can be cash, evidence of ownership, or a contractual right to receive or deliver currency. Examples of financial instruments include stocks, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), mutual funds, loans, and derivative contracts. When obtaining funding, the issued instrument will be a financial liability if it contains a repayment obligation.

This means that the issuance of a bond creates a financial liability since the money received must be repaid, while the issuance of ordinary shares creates an equity instrument. An equity instrument is any contract that evidences a residual interest in an entity's assets after deducting all of its liabilities. Financial instruments based on short-term debt include Treasury bills, while bonds are financial instruments based on long-term debt. Both types can be marketed in different ways.

It is important to correctly classify the instrument as a financial liability (debt) or an equity instrument (shares) when raising finance as this distinction will directly affect the calculation of the leverage ratio and the measurement of profits. Cash-based financial instruments are directly influenced by current market conditions. Accounting for a financial liability at amortized cost means that the liability's effective interest rate is charged as a financial cost to the profit or loss statement and changes in market interest rates are ignored. When an invoice is issued for the sale of goods on credit, the entity that sold the goods has a financial asset (the account receivable), while the buyer has to account for a financial liability (the payable one). The entity that subscribes to the shares has a financial asset (an investment), while the issuer of the shares that obtained funding must account for an equity instrument (the share capital).In addition, insurance policies may be considered an alternative type of financial instrument because they confer a claim and certain rights on the policyholder and obligations on the insurer.

Exchange-traded derivatives exist for debt-based short-term financial instruments, such as short-term interest rate futures. Financial liabilities can still be designated as valued in the FVTPL when it contains one or more implied derivatives that would require separation. In conclusion, financial instruments are assets that can be traded and are used by companies when they want to increase their capital. While commodities themselves are traded on world markets, they do not usually meet the definition of a financial instrument. Financial instruments are essential tools for businesses to raise capital and manage risk. They provide investors with an opportunity to diversify their portfolios and access different markets.

Understanding how these instruments work is essential for businesses to make informed decisions about their finances.