A financial instrument is a contract between two parties that has a monetary value and could be traded or exchanged. Financial instruments are vital to the global economy as they provide a way for companies and individuals to manage risk, borrow money, and make investments. Examples of financial instruments include stocks, bonds, derivatives, and currencies.
- Stocks: Stocks are units of ownership in a company, entitling the holder to receive dividends and vote on important company matters. Stocks can be bought and sold on the stock market, where the price of the stock is determined.
- Bonds: Bonds are debt instruments, where an investor lends money to a company in return for a fixed income for a set period of time. When the bond matures, the company repays the loan plus interest.
- Derivatives: Derivatives are financial instruments whose value is derived from an underlying asset such as stocks, commodities, or currencies. Common derivatives include futures, options, and swaps.
- Currencies: Currencies are forms of money issued by a government. Currencies are traded on the foreign exchange market, where their value is determined by supply and demand.
Example of Financial instrument
An example of a financial instrument is a bond. Bonds are debt instruments, where an investor lends money to a company in return for a fixed income for a set period of time. When the bond matures, the company repays the loan plus interest. The amount of interest paid on the bond is determined by the market, and the bond can be traded on the secondary market. Bonds are one of the most common financial instruments used by companies and individuals to raise money.
When to use Financial instrument
Financial instruments are used when an individual or company needs to manage risk, borrow money, or make investments. For example, a company may use stocks to raise capital, bonds to borrow money, derivatives to hedge against market fluctuations, or currencies to make international transactions. Individuals may use stocks to invest in companies, bonds for passive income, derivatives for speculative trading, and currencies for international payments. Financial instruments are also used to transfer risk from one party to another, such as with insurance contracts, or to facilitate transactions, such as with credit cards. In summary, financial instruments are used for a variety of purposes, from raising capital to speculative trading.
Cycle of life of Financial instrument
The steps of a financial instrument typically include the following:
- Issuance: An issuer will issue a financial instrument, such as a stock or bond, to the public to raise capital.
- Trading: After the instrument has been issued, it can be traded on the open market. Investors can buy and sell the instrument, and its value is determined by the market.
- Settlement: When a trade is made, the instrument must be settled. This involves exchanging the instrument for cash or another asset.
- Maturity: When the instrument matures, the issuer is obligated to repay the investors’ principal and any interest.
Advantages of Financial instrument
Financial instruments offer a number of advantages to companies and individuals. They provide an efficient way to transfer funds, mitigate risk, and access capital. Some of the major advantages of financial instruments include:
- Liquidity: Financial instruments are generally liquid, meaning that they can be easily bought and sold on the market. This makes them a great way to access cash quickly.
- Risk Management: Financial instruments can be used to mitigate risk by hedging against losses or taking advantage of opportunities. For example, derivatives can be used to protect against price changes in an underlying asset.
- Access to Capital: Financial instruments can be used to access capital for investments or to finance operations. This can be done through borrowing or raising capital through the sale of securities.
Limitations of Financial instrument
Financial instruments have several limitations. First, they often have high transaction fees associated with buying and selling. Second, they can be complex, making them difficult to understand. Third, they are subject to market volatility, meaning their value can change quickly and without warning. Lastly, they are often illiquid, meaning they cannot be easily converted into cash. As a result, investors should carefully consider the risks associated with financial instruments before investing.
- Insurance: Insurance is a form of risk management in which an insurer agrees to pay for any losses incurred by the insured in exchange for a premium. Insurance is used to protect against the financial risks of death, disability, property damage, and other losses.
- Mutual Funds: Mutual funds are investment funds that pool together the money of multiple investors to invest in a variety of securities. Mutual funds are professionally managed and typically have a wide range of investments, making them a popular choice for long-term investors.
- Exchange Traded Funds (ETFs): Exchange Traded Funds (ETFs) are investment funds that are traded on a stock exchange, similar to stocks. ETFs are typically passively managed and typically track an index or a basket of securities, making them a popular choice for investors who want exposure to a particular market or sector.
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- Kothari, V. (2006). Securitization: the financial instrument of the future (Vol. 385). John Wiley & Sons.