What is Financial Instruments?
Financial instruments are assets that are tradeable or they may be thought of as capital bundles that can be traded. The majority of financial instruments allow for the easy flow and transfer of capital among investors all over the world.
Cash, a contractual right to give or receive cash or another sort of financial instrument or proof of one’s ownership of a business are all examples of assets. There are four major types of financial instruments, namely equity (stocks/shares), debt instruments, cash and derivatives.
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Investors make use of financial instruments to generate income or capital growth. Organisations can use financial instruments to mitigate the exposure to different business risks such as fluctuations in exchange rates, interest rates and commodity prices.
The International Accounting Standards (IAS) defines financial instrument as any contract that results in a financial asset for one company and a financial obligation or equity instrument for another firm.
Nature of Financial Instruments
Financial instruments can be in physical or digital form representing a particular amount of money. For example, a person may own an asset represented as a equity-based financial instrument. On the other hand, a loan given by an investor to an asset’s owner is represented through debt-based financial instruments. Equity and debt, both have different sub-categories of instruments that vary in their features. For example, in case of equity, there are sub-categories such as ordinary shares, preferred shares and common equity share.
All financial instruments or products have some associated level of risk. It should be kept in mind that low-risk financial instruments and techniques are not without danger. Past results are not a good predictor of future outcomes. The value of a financial instrument as well as the income received from it, can undergo a change and investors may not earn back the full amount they had invested. There is no guarantee that an investor’s projected or targeted returns will be realised, as predictions are not always a dependent indicator of future results. Even though a return is stated to be guaranteed, an investor is still subject to the risk of the underlying guarantor defaulting.
Even when a certain financial instrument works as expected, changes in the rate of exchange or taxation may have a negative impact on the price or value of the financial instrument, as well as the income received from it.
Financial instruments (even the ones with comparable characteristics) may be subject to various risks, distinct combinations of risks or varying degrees of exposure to those risks. Where a portfolio contains two or more financial instruments, the portfolio’s aggregate risk usually differs from the risks of the individual financial instruments that make up the portfolio.
Many risks listed above are applicable to all financial instruments. Specific financial products may be affected by several risks. Various risks include currency risk, legal and regulatory risk, non-domestic market risk, emerging market risk, issuer risk, liquidity risk and market risk. All these risks affect the performance of financial instruments.
From time to time, investors may inquire about the financial instruments by going through certain extra terms and conditions which can appear in a variety of papers, including prospectus, offering memorandums, information memorandums, final terms and terms and conditions. These documents may bear additional risk descriptions that pertain to the specific financial instrument, which you should study.
Other risks may arise as a result of the terms and circumstances of those financial instruments and the relevant financial instrument to which they apply may contain aspects that are not frequently seen in the relevant financial instrument.
Purpose of Financial Instruments
The majority of financial instruments allow for the easy flow and transfer of capital among investors all over the world. Cash, a contractual right to send or receive cash or another sort of financial instrument or evidence of one’s ownership of a business are examples of these assets.
Properly functioning and well-developed financial markets play a critical part in a country’s prosperity and efficiency. It supports the accumulation of capital and contributing to the creation of goods and services by facilitating the efficient direct flow of savings and investments in the economy.
Financial instruments are used for a variety of objectives such as:
Hedging purpose
Hedging means altering an existing risk profile to which an entity is exposed. This involves:
- Purchasing or selling currency in advance to fix a future exchange rate.
- Using swaps to convert future interest rates to fixed or floating rates.
- Purchasing option contracts to protect an entity against a specific price movement, including contracts that may involve embedded derivatives.
Trading purpose
Trading allows anybody to be ready to bear a risk position in order to profit from short-term market moves.
Investing purpose
Investment allows an entity to profit from long-term investment returns. Financial instruments can be used to mitigate exposure to specific business risks, such as fluctuations in exchange rates, interest rates and commodity prices or a combination of these risks. However, intricacies of some financial products may result in increased risks.
Some other important purposes or uses of financial instruments are:
- Liquid instruments such as cash are used by organisations for dealing with contingency situations and for making quick payments
- Financial instruments allocate risks according to the risk-bearing capacities of the counterparties
- Equity and instruments based on equity are a great source of funds for businesses
Types of Financial Instruments in India
In India, many families save aside money each month from their earnings in order to ensure their future. Putting money in a savings account or a locker will not assist it to grow. Investing allows one to increase their money. Individuals can invest their money in a variety of financial products accessible in India.
Financial instruments are defined by International Accounting Standards as any contract that creates a financial asset for one entity and a financial obligation or equity instrument for another. Financial products serve as conduits for money to be invested. Various financial products are now accessible on the market. It serves as a means of raising revenue. There are several ways to save money for investing purposes. To get the highest return on investment, an investor must pick the finest investment option.
Financial tools facilitate the efficient flow of money and capital throughout the globe. These tools might be physical or virtual documents that reflect any type of monetary arrangement. It has a monetary value and is a legally binding agreement between two or more parties involving the payment of money.
Financial Instruments are classified into two types, namely:
- Cash instruments: The markets directly impact and decide the value of cash instruments. These are the types of securities that can be easily traded.
- Derivative instruments: Derivative instruments’ value and attributes are determined by the underlying components, such as assets, interest rates or indexes. Over-the-counter (OTC) derivatives and exchange-traded derivatives are both options.
Following are the types of financial instruments in india:
Equities
It is a sort of security that symbolises a company’s ownership. Stock exchanges are where equities are exchanged. It may also be acquired through Initial Public Offerings (IPOs), which occur when a firm first issues shares to the general public. In India, share trading takes place on stock exchanges such as the BSE (Bombay Stock Exchange) and the NSE (National Stock Exchange).
It is one of the greatest ways to invest in shares over a long period of time since it yields significant profits. It is also vulnerable to market risk, thus careful research is required before investing in shares. Equity shares are the firm’s permanent capital, they cannot be redeemed during the company’s lifespan and a business cannot buy its own shares throughout its existence, according to the Companies Act of 1956.
At the moment of liquidation, equity owners can request a return of their capital, which will be reimbursed once all other earlier claims, including those of preference shareholders, have been satisfied.
Mutual funds
Mutual Funds are the most popular investing option in India since the initial investment is low and the risk is spread out. Mutual funds allow a group of people to pool their money and invest it collectively.
Because of its cost-effectiveness, risk diversification, expert management and strong regulation, this investment channel has become well-known. The smallest sum that may be invested is `500 and the frequency of investment is commonly monthly or quarterly.
Debt instruments
Debt instruments are assets wherein the debtor has to legally pay interest and principal payments to the lender. Debt instruments provide high and fixed interest. The borrower of funds can utilise the funds for his business. Debt instruments include bonds, debentures, leases, certificates, bills of exchange and promissory notes.
Fixed income
Securities are securities that offer a fixed rate of return. In effect, these financial instruments are loans to the issuer and the holder of these instruments becomes a creditor of the fixed income security’s issuer. Holders of fixed income securities are likely to be allowed to take share in the proceeds of the issuer’s asset liquidation before holders of equity securities in the event of the issuer’s insolvency.
A nominal (or face) value is assigned to fixed income securities. This is the amount (or principal) that will be repaid to investors at the conclusion of the security’s tenure or in its maturity date. The maturity date may change depending on whether or not the instruments include a provision for early redemption.
For example, early redemption may be allowed in case the interest rates are falling. Fixed income instruments typically entitle the holder to periodic interest payments, also called coupons rate of inter- est, in addition to repayment of the principle amount at maturity.
The price at which a fixed income instrument is bought or sold in the secondary market usually differs from its nominal value due to the following reasons:
- Interest rate to be paid on the fixed income security in relation to current and expected future market rates
- Security’s maturity date
- Issuer’s creditworthiness, including any applicable credit rating and anticipated changes
- Rate of inflation
Bonds are also a type of debt
Bonds may be convertible or non-convertible. It means that bonds may or may not be converted into cash. Non-convertible bonds are purely debt-based instruments. However, convertible bonds are a hybrid instrument.
Convertible or exchangeable bonds means that the bond’s principal (the amount that would otherwise be payable to the bond holder at maturity) can be converted into or exchanged for a specific number of another financial instrument (usually the issuer’s ordinary shares) at a specific or determinable price or ratio, usually within a specified period and under certain conditions.
Conversion or exchange may be optional for the issuer or bondholder or it may be required, depending on the bond’s terms (for example, at maturity). A convertible bond’s basic structure combines a fixed-income instrument with an equity option. Convertible bonds, by virtue of their hybrid form, include characteristics of both equities and bonds, involving the risks of both and the factors that influence the convertible bond’s market price (including the prevailing interest rate, the price of the underlying equity and the credit rating of the issuer).
Some convertible bonds are subject to “call risk,” which is the risk that the issuer would redeem the bond early, denying the investor the opportunity to convert the bond into equity or the bond will be converted into equity but not at a time that is convenient for the investor.
Preference
Shares are another type of equity instrument. Preferential shares are the type of shares that grant a class of shareholders, the right to a fixed rate of dividend that is paid first to the preference shareholders and then to other classes of shareholders (ordinary shareholders).
Even though, the issuer has no recourse if the preferred dividend is unpaid; certain preference shares may grant a cumulative entitlement to dividends, allow- ing the preference shareholders to receive dividends that were not paid earlier. Preference shareholders do not have normal voting rights.
On the basis of timing of delivery, the financial instruments are classified as either cash market instruments or futures market instruments.
Let us discuss these.
- Cash market: In the cash market, the transactions are settled in real-time and the investors pay the entire amount of investment either in cash or through borrowed capital.
- Futures market/Derivatives: In the derivatives market, a settlement that involves delivery of security or commodity, occurs later. It means that the transactions in derivatives markets are generally cash-settled (instead of delivery of commodity).
In futures markets, investors and traders can trade easily as it does not require payment of the total amount of assets. Rather, only a certain percentage of the total asset amount known as margin is sufficient.
