According International Accounting Standards defines financial instruments as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”
Financial instruments are legal agreements that require one party to pay money or something else of value or to promise to pay under stipulated conditions to a counterparty in exchange for the payment of interest, for the acquisition of rights, for premiums, or for indemnification against risk. In exchange for the payment of the money, the counterparty hopes to profit by receiving interest, capital gains, premiums, or indemnification for a loss event.
A financial instrument can be an actual document, such as a stock certificate or a loan contract, but, increasingly, financial instruments that have been standardized are stored in an electronic book-entry system as a record, and the parties to the contract are also recorded. For instance, United States Treasuries are stored electronically in a book-entry system maintained by the Federal Reserve.
Some common financial instruments include checks, which transfer money from the payer, the writer of the check, to the payee, the receiver of the check. Stocks are issued by companies to raise money from investors. The investors pay for the stock, thereby giving money to the company, in exchange for an ownership interest in the company. Bonds are financial instruments that allow investors to lend money to the bond issuer for a stipulated amount of interest over a specified period.
Financial instruments can also be used by traders to either speculate about future prices, index levels, or interest rates, or some other financial measure, or to hedge financial risk. The 2 parties to these kinds of instruments are speculators and hedgers. Speculators attempt to predict future prices or some other financial measure, then buying or selling the financial instruments that would yield a profit if their view of the future should be correct. In other words, speculators bet about future prices or some other financial measure. For instance, if a speculator thought that the price of XYZ stock was going to go up, then he could buy a call option for the stock, which would be profitable if the stock does go up. If the option expires worthless, then the loss to the speculator is less than the loss that would have been incurred from actually owning the stock. Hedgers attempt to mitigate financial risk by buying or selling the financial instruments whose value would vary inversely with the hedged risk. For instance, if the owner of XYZ stock feared that the price might go down, but didn’t want to sell before a specific time for tax purposes, then she could buy a put on the stock that would increase in value as the stock declined in value. If the stock goes up, then the put expires worthless, but the loss of the put premium would probably be less than the loss incurred if the stock declined.
Examples of financial instruments:
Exchanges of money for future interest payments and repayment of principal.
- Loans and Bonds. A lender gives money to a borrower in exchange for regular payments of interest and principal.
Exchanges of money for possible capital gains or interest.
- Stocks. A company sells ownership interests in the form of stock to buyers of the stock.
- Funds. Includes mutual funds, exchange-traded funds, real estate investment trusts, hedge funds, and many other funds. The fund buys other securities earning interest and capital gains which increases the share price of the fund. Investors of the fund may also receive interest payments.
Exchanges of money for protection against risk.
- Insurance. Insurance contracts promise to pay for a loss event in exchange for a premium. For instance, a car owner buys car insurance so that he will be compensated for a financial loss that occurs as the result of an accident.