What Are Financial Instruments?
The financial world can undoubtedly be enigmatic, especially to the average people. If you are here to learn some basics about financial instruments, then you’ve landed in the right place.
A market is a trading place. What happens is that you purchase what others are selling or you sell what others are buying.
Like in other types of markets, there are different types of products. In simple terms, the product I am trying to emphasize here can be traded in the financial market. It is known as financial instruments.
The financial market helps to bring many people across the globe to trade through financial instruments.
Being very popular in the market, there are many instruments or securities that one can use and benefit from price movements hence, making a substantial profit.
In this piece, we are going to discuss, what financial instruments entail, their characteristics, different types of financial instruments, and finally, we will point out some benefits of financial instruments.
What are Financial Instruments?
The financial instrument is a contract, document, or tangible assets that can be traded, giving rise to a monetary asset of one party and financial equity or liability of the other party.
From this definition, a contract is that agreement between the two parties. Equity or liability instrument is the contract or document that shows a residual interest in the asset of one party after all liabilities have been deducted.
A liability or asset that does not obey contract rules is not a financial instrument, even if it results in the delivery of cash or receipt.
All the parties should understand well the specific definitions of these three terms so that they can have an idea of what should be accounted for as financial instruments.
Back to our definition of financial document, it reflects a simple and straightforward accounting equation starting that the equity equals the assets fewer liabilities.
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Characteristics of Financial Instruments
Financial instruments have common characteristics. Some can be inherited in the financial assets that are partly used to evaluate the pricing in the financial market.
Some aspects are outlined below:
What does this mean? Well, it implies that they can easily be changed to cash in a short time.
The transaction cost involved in keeping your funds safe before they mature can be linked-to agency cost apart from the discount cost, which reduces their face value.
Financial instruments are, however, referred to as near money due to their easy trading nature with the cash.
Some good examples are treasury certificates, commercial papers, treasury bills, trade bills, certificates of deposits, etc.
This characteristic means that a financial instrument can be transformed into another asset class. This asset is retained by the business entity that originally used to boost funds for business functions.
Shares for example, can take any form, preference shares converted into shares, bond converted into bond, and business bonds converted into liability or equity shares of the business.
The ability of the financial instruments to change into other financial assets is entrenched in the agreement that must be written to regulate the company’s behavior using the money from the instruments.
However, this can be negotiated in case the owner discovers that the company has manipulated operations and financial date to reduce the funds.
We’ve seen that financial instruments are moneyness. They can be converted into money in a short time.
Again, the transaction cost involved in keeping the money safe can be linked-to agency, and this reduces their face value.
Therefore, these financial instruments are said to be near money because they are liquid, meaning they can be traded easily.
Some good examples of high liquid instruments are treasury certificates, bill of exchange, treasury bills, certificates of deposits, shares, etc.
However, not all the financial instruments can be converted into money whenever someone wants the cash. Therefore, they are regarded as illiquid because they should be retained until they mature.
Alternatively, some people trade them for small value in the capital market, where they are people willing to keep them as stock securities.
Financial instruments are very reversible as far as deposits on the customer’s account are concerned. This means that the investment cost in financial instruments and changing them to money is negligible.
Therefore, the reversibility of financial instruments is considered as the cost of conversion.
The highest cost of conversion is related to the financial instrument known as the bid-ask spread in which the price of a commission of delivering is determined.
Financial markets that are well organized are responsible for taking risks associated with financial instruments when inventorying financial assets or creating the demand.
Therefore, charging of the spread on the market makers depends on the financial instruments traded.
Classification and Types of Financial Instruments
Financial instruments can either be derivative instruments or cash instruments. Let’s have a close look at these two:
These are instruments whose value is derived from the characteristics and importance of one or more entities like index, asset, or interest rates. They can also be over-the-counter derivatives or exchange-traded derivatives.
These are instruments whose value is directly determined by the market. They can be loans, securities, and transferable deposits.
Besides, financial instruments are classified as debt-based or equity-based class assets. Debts based are further classified as long-term debt and short-term debt.
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Importance of financial instruments
1. They help to minimize the cost of the transaction
Some transactions are required while selling or buying securities. A lot of cash and time is spent in getting the same. The financial instruments ensure that information is available without spending money. In this regard, the financial tool helps to reduce transaction costs.
2. Offer liquidity to the financial assets
A financial market is basically where sellers and buyers of all types of securities are found. For this reason, it makes liquidity to all securities. This implies that investors can use their money whenever they want. It also means that they can convert their assets to cash whenever they want.
3. Facilitate price discovery
The force of demand and supply helps to determine the prices of goods and services. Just like what we do to discover the cost of products and services, investors as well try to determine the best rate of their securities.
Financial instruments are helpful to investors because they get a reasonable price for their securities and maximizing profit is the end goal here.
That is all we have about financial instruments. Remember that financial market instruments help to provide a safe place to invest your money.
They have short maturity, high liquidity, and relatively safe compared to other types of investments.