What are Financial Instruments?

Financial instruments are certain contracts or any document that acts as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc to one organization and as a liability to another organization and these solely taken into use for trading purposes.

Financial-Instrument

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Types of the Financial Instrument

The three types of financial instruments are mentioned below:

Types

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  1. Money Market Instruments: Money market instrumentsThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability.read more include call or notice money, caps and collars, letters of creditA letter of credit is a payment mechanism in which the issuers bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk.read more, forwards and futuresForward contracts and future contracts are very similar. Still, the key distinction is that futures contracts are standardized contracts traded on a regulated exchange, whereas forward contracts are OTC contracts, which stand for over the counter.read more, financial options, financial guarantees, swapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more, treasury bills, certificates of deposits, term money, and commercial papersCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note.read more.
  2. Capital Market Instruments: It includes instruments like equity instruments, receivables, and payables, cash deposits, debentures, bonds, loans, borrowings, preference shares, bank balances, etc.
  3. Hybrid Instruments: It includes instruments like warrants, dual currency bonds, exchangeable debt, equity-linked notes, and convertible debentures, etc.

Example of Financial Instrument

XYZ Limited is a banking company that issues financial instruments such as loans, bonds, home mortgages, stocks and asset-based securities to its customers. These may act as a financial assetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more for the aforesaid banking company but for customers, these are nothing but financial liabilities that must be duly paid on time by them. On the other hand, the amount that is deposited by the customers in the bank acts as a financial asset for the customers depositing the same whereas a financial liability for a banking company.

Advantages

There are several different advantages of the Financial Instrument are as follows:

Disadvantages

The different limitations and drawbacks of the Financial Instrument include the following:

  • Liquid assets such as savings accounts balances and other bank deposits are limited when it comes to ROI or return of investment. This is high because of the fact that there are zero restrictions for the withdrawal of deposits in savings accounts and other bank balances.
  • Liquid assets like cash deposits, money market accountsMoney Market Account is the account which receives all the interests from the instruments in the money market according to the agreed-upon terms. This account is separate from that of securities account, it only accounts for the proceeds.read more, etc might disallow organizations from making a withdrawal for months or sometimes years too or whatever is specified in the agreement.
  • If an organization wishes to withdraw the money before the completion of the tenure mentioned in the agreement, then the same might get penalized or receive lower returns.
  • High transactional costs are also a matter of concern for organizations that are dealing with or wish to deal with financial instruments.
  • An organization must not over-rely on debts like principal and interest since these are supposed to be paid on a consequent basis.
  • Financial instruments like bonds payout return much lesser than stocks. Companies can even default on bonds.
  • Some of the financial instruments like equity capital are Life-long burden for the company. Equity capital acts as a permanent burden in an organization. Equity capital cannot be refunded even if the organization has a sufficient amount of funds. However, as per the latest amendments, companies can opt for buying-back its own shares for the purpose of cancellation but the same is subjected to certain terms and conditions.

Important Points

Conclusion

To conclude, it can be said that the financial instruments are nothing but a piece of document that acts as financial assets to one organization and as a liability for another organization. These can either be in the form of debentures, bonds, cash and cash equivalents, bank deposits, equity shares, preference shares, swaps, forwards and futures, call or notice money, letters of credit, caps and collars, financial guaranteesA financial guarantee is a promise undertaken by a third party to cover any financial obligation of another organization or individual, acting as a guarantor for any unpaid financial debts. If the concerned party is unavailable, authorities contact guarantors.read more, receivables and payables, loans and borrowings, etc. Each type of financial instrument has its own advantages and disadvantages.

Financial instruments must be appropriately taken into use for deriving most benefits out of them. These can be of huge significance for companies that are looking for minimizing their costs and maximizing their revenueRevenue maximization is the method of maximizing a companys sales by employing methods such as advertising, sales promotion, demos and test samples, campaigns, references. It aims to capture a larger market share in an industry. Technically, revenue is maximized when MR (Marginal Revenue) equals zero.read more model. Thus, organizations must make sure that they are properly using financial instruments so that they can reap greater benefits out of it and eliminate the chances of them getting backfired.

This has been a guide to what are Financial Instruments. Here we discuss types and examples of Financial instruments along with advantages and disadvantages. You can learn more about financing from the following articles –

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