Financial Instrument
A financial instrument is a document, either physical or virtual, that signifies monetary value or a financial contract between parties. These instruments can generally be categorized into equity instruments, such as stocks, which represent ownership in companies, and debt instruments, like bonds, that signify a loan made to an issuer. Financial instruments are typically tradable on various markets, allowing holders to sell or purchase them. This trading can occur directly with issuers or on secondary markets, including major stock exchanges.
There are also foreign exchange instruments focused on the trading of currencies, often utilized by institutional investors. Additionally, derivative instruments are a specialized category that derive their value from underlying assets, such as stock options and bond futures. They tend to be more speculative, allowing investors to bet on price movements without directly owning the underlying asset. Overall, financial instruments play a critical role in the economy by facilitating investment, raising capital, and providing opportunities for income and speculation.
Subject Terms
Financial Instrument
A financial instrument is a document, either physical or virtual, that represents monetary value or a financial contract between at least two parties. Financial instruments are typically tradable, meaning that someone who holds such a document may sell it to another party or purchase additional instruments on the secondary market. Although there are numerous types of financial instruments available in the United States, most can generally be divided into the categories of equity instruments, which notably include stocks, and debt instruments, which include bonds and loans. The category of foreign exchange instruments consists of a number of somewhat less common financial instruments based on the trading of international currencies. Many of the most common financial instruments are valued based on the price at which the market is willing to trade them, but some other instruments are valued based on the price or other aspects of some underlying security. The latter instruments, which include stock options and bond futures, are known as derivative instruments.
Background
For hundreds of years, human beings have made contracts promising the exchange of money between two parties. The sale of government bonds was a relatively common practice in the medieval Italian states, where they were frequently used to raise funds needed to expand or protect their territories. In the early seventeenth century, the Dutch East India Company, seeking to raise the necessary capital to outfit its fleet, became the first known company to issue shares of stock. Instruments such as annuities likewise originated long before the foundation of the first American stock exchanges.
By the twenty-first century, numerous financial instruments were available to investors in the United States. Many such instruments are known as cash instruments, as their value is determined based solely on the market. For example, a certain company’s stock price may rise to twenty dollars per share based on the market’s willingness to trade the stock at that price. The value of other instruments, conversely, are based on the value or other characteristics of some underlying asset. For example, when a company’s stock price rises to twenty dollars per share, the value of an options contract—a contract to buy or sell shares of a stock for a certain price on or by a certain date—associated with that particular stock may rise or fall depending on its specific terms. The value of the options contract, then, is based not on the fluctuations of the options-trading market but on the movement of the underlying stock.
Some financial instruments may be purchased directly from the issuing company or entity, as in the case of government bonds, but a large portion of trading takes place on the secondary market. Examples of secondary markets include the major American stock exchanges, where investors purchase shares of stock from other investors rather than directly from the companies in question, as during an initial public offering (IPO) of stock. Derivative instruments such as stock options are also frequently traded on the secondary market. Some less common financial instruments, such as foreign exchange instruments, are typically traded on more specialized markets.
Overview of Financial Instruments
Numerous financial instruments are available to twenty-first-century American investors, but many opt to trade in only a select few instruments, or even in only one. Because of this fact, a number of financial instruments are considerably more common than others among average traders. These include equity and debt instruments, both cash and derivative.
Equity instruments are financial instruments that represent ownership of something. Stocks are perhaps the best-known example of equity instruments, as they represent shares of ownership of a company. Typically, the shares held by investors grant partial ownership of a publically held company. When a company transitions from private to public, in a process known as going public, it offers public investors the ability to purchase shares of stock for the first time in what is known as an initial public offering (IPO). This allows the company to raise operating capital as well as to gain public awareness and media attention. IPOs are open only to investors who meet certain qualifications, but after a company has gone public, other investors gain the ability to purchase shares of stock on the secondary market. Some private companies similarly issue shares of stock. Because of the private nature of those companies, selling such shares is often difficult and subject to various restrictions.
Although often viewed as merely instruments to be traded, shares of stock do grant certain benefits of partial ownership of a company. For example, some companies pay dividends, regular payments that are allocated to all shareholders of the company based on the number of shares they possess. If a public company transitions back into a private company, it must purchase all publicly held shares of stock in order to return to private ownership.
Essentially the opposite of equity instruments, debt instruments are financial instruments that represent a debt that the person who possesses the instrument holds. Bonds are one of the best-known examples of debt instruments. When an investor purchases a bond, he or she essentially lends a sum of money to the bond issuer. In return, the issuer pays the investor interest payments on a set schedule, ensuring that the investor receives steady income—provided that the issuer does not default on the bond. Bonds may be issued by corporations as well as government entities, most notably the US Department of the Treasury. In addition to purchasing bonds directly from issuers, investors may buy and sell bonds on the secondary market.
Numerous other forms of debt instruments are also available to investors. These include several instruments that are infrequently used by individual investors, such as mortgages and loans, as well as common instruments such as certificates of deposit (CD). When an investor buys a CD, he or she deposits funds for a set period of time, typically between several months and several years, and cannot withdraw the funds early without paying a penalty. In exchange, the investor receives a certain amount of interest, often significantly higher than that offered by a savings account, at the end of the deposit period. Because the funds the investor deposits are inaccessible and effectively on loan to the bank, CDs are considered debt instruments.
Foreign exchange instruments are less commonly used than equity instruments or debt instruments and tend to be preferred by institutional and specialized investors. Essentially, foreign exchange instruments are based on the exchange of global currencies. Investors may choose to exchange one currency for another to take advantage of fluctuating exchange rates or speculate on future fluctuations. Such fluctuations are based not only on the economies of specific countries but also on changes in the global economy.
Derivative instruments are a subcategory of financial instruments that are valued based not on the market but on the value or other aspects of an underlying instrument. Derivatives may be based on equity, debt, or foreign exchange instruments and often are more speculative in nature than their underlying securities. Such instruments include stock options, bond futures, and currency futures. Options are contracts that give an investor the right to purchase or sell a certain number of shares of stock for a particular price on or by a specific date. For example, an investor might purchase an option that gives him or her the right to purchase one hundred shares of stock at twenty dollars per share. If the stock price then increases to twenty-five dollars per share, the investor can exercise the option and then sell the shares at the new price to make a profit. Options contracts are typically divided into puts, which give the right to sell, and calls, which give the right to buy. They are commonly traded on the secondary market, and the price they command is based not on the market but on the value of the underlying stock.
Bond futures are similar to options in that they feature contracts that allow an investor to buy or sell a bond for a specific price on a particular date. Investors have the opportunity to speculate on bond market fluctuations, often the result of fluctuations in interest rates, by buying and selling bond futures on the secondary market. Speculators familiar with foreign exchange instruments likewise trade currency futures, which are derivative instruments based on underlying currencies.
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