A financial instrument is a contract that obliges one party to transfer money or shares in a company to another party in the future in exchange for something of value. The parties can be corporations, partnerships, government agencies, or individuals.
Financial instruments can be as simple as an invoice or check, or extremely complex transactions like the derivatives called "credit default swaps" that triggered the collapse of insurance company AIG in 2008.
What Is a Financial Instrument?
A financial instrument creates a financial asset for one party, and a liability for the other party. A financial asset is a right to future cash flow, or a contractual right to purchase or sell an asset in the future.
For example, an invoice due in 30 days creates a future cash flow to the business that issued it, and a liability to the business that receives it. A loan creates a future cash flow to the lender, and a liability for the borrower. Financial instruments have to include specific terms and conditions that detail the time frame and amounts due.
Financial instruments are a part of our everyday life. If you have a mortgage, the mortgage agreement is the financial instrument. The lender transferred cash to you, and you are obligated to make payments over the term of the mortgage. The check you write to pay the utility company is a financial instrument. It represents the bank's obligation to pay funds and the utility company's right to receive them.
How Do Financial Instruments Work?
Financial instruments are the interstate highways for money and capital to move from place to place. Financial instruments are used for a variety of purposes.
Payments
On a regular basis, we all use financial instruments to make payments for goods and services that we need. Apartment leases, auto financing agreements, mortgages, and doctor bills are all examples of this.
As further illustrations, we use credit cards to make routine purchases for which payment is usually owed within a monthly cycle. Businesses send out invoices due by a certain date. Customers send payments by check, draft, or electronic means, including digital currencies. Digital currencies use smart contracts.Companies reward employees with stock option plans.
Note
All financial instruments represent a contract with the right to a future cash flow, a liability, and include terms and conditions.
Raising Capital
Government and businesses use financial instruments to raise capital. Companies issue stocks and bonds, which are sold to investors in exchange for rights to ownership, or interest payments, and a promise to repay the principal or original amount invested. Federal, state, and local governments issue financial instruments in the form of securities for bonds to fund projects.
Storing Value
Financial instruments have value and can be bought and sold. Receivables represented by outstanding invoices can be sold to “factoring” companies, which then collect amounts owed. Delinquent credit card debts can be sold to collection agencies. Stocks, bonds, and other securities can be traded on exchanges.
Transferring Risk
Investors purchase financial instruments like stock options and interest-rate swaps to protect against losses. International companies buy currency futures to offset the risk of changes in exchange rates. Each of these contracts exchanges a right to buy something, sell something, or receive cash flow in the future, in exchange for payment according to terms and conditions.
Speculation
Investors purchase options contracts—which give the right, but not the obligation, to buy or sell stocks, currency, and commodities such as gold within a set period of time in the future—because those investors believe they will profit from a price change.
Types of Financial Instruments
Cash
Cash instruments have their own market value. Common cash instruments are stocks, bonds, loan agreements, and certificates of deposit. Equity instruments represent ownership in a company. Stocks are equity instruments. Debt instruments represent an obligation to pay interest. Bonds, mortgages, andloan agreements are debt instruments.
Derivatives
The value of derivative instruments is based on the underlying cash instrument. The price of a stock option changes in line with the price of the underlying stock. Stock options, commodity futures, and interest rate swaps are some varieties of derivative instruments. The value of derivative instruments is also influenced by the terms of the contract.
Why Investors Need to Know About Financial Instruments
The term "financial instrument" covers common investments such as publicly traded stocks and bonds, as well as highly complex customized transactions that occur between financial institutions.
Note
However simple or complicated, investors need to understand the terms, conditions, and risks of their investments.
Publicly traded securities have standardized terms and conditions that are regulated by the Securities and Exchange Commission (SEC). Derivatives instruments and their trade in the U.S. are overseen by the Commodity Futures Trading Commission (CFTC).
At the same time, rating agencies and company analysts produce research on many publicly traded securities to help investors understand the risks and rewards of an investment. Other types of financial instruments that are not as strictly regulated, like crowdfunding of startups, and smart contracts for cryptocurrencies may have restrictions and risks that are less clear.
Key Takeaways
- Financial instruments are part of everyday life.
- They involve contracts with obligations, rights, terms, and conditions.
- A financial instrument creates a financial asset for one party and a liability for the other.
- Future cash flows, or contractual rights to purchase or sell an asset in the future, are at the heart of a financial instrument.
