Sunday, December 9, 2012

What are financial instruments?

Examples of financial Instruments
In a previous blog titled "what is an ETF", we had opened a discussion about one particular financial instrument.  In this post, we'll briefly explore some other, relatively common financial instruments.

Financial instruments are, generally speaking, divided into two categories. The value of cash instruments are determined by the market. 

This grey, amorphous mass referred to as the market, is governed by supply and demand, as people buy and sell (or trade) various financial instruments.  

Cash instruments can further be divided into securities and other securities, like loans and deposits.

Derivative instruments simply imply that that value of the instrument is derived from something else. Most commonly, the value of the derivative is derived from the value and characteristics of another entity, like an asset, interest rate or index.  Derivatives can further be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives, describing how they are traded.

The descriptions above may sound overly complicated, but are not really that complex.  However, trading in many of these different instruments are often very complex, especially for a novice investor!

If you don't fully understand what you may be wanting to trade or invest in, please be sure to contact a professional financial advisor!

Let's explore a few simple, and relatively common examples of the 4 financial instruments described above:
  1. Securities include bonds, stocks and T-Bills (or Treasury Bills). Securities can also include commercial paper, also called promissory notes. Bonds, much like T-Bills and commercial paper, are instrument of indebtedness by the bond issuer to the bond holders. These are therefore called debt securities.  Stock on an incorporated business, on the other hand, constitutes an equity stake.
  2. Other securities are generally limited to loans, deposits, certificates of deposit, and FX-spot (foreign exchange) rates. Although the latter may be a term people are least familiar with, the Triennial Central Bank reported (in 2011) that as of 2010, the average daily turnover of global FX spot transactions reached nearly US$1.5 trillion!
  3. Exchange-traded securities include bond, stock, equity and currency futures.  Futures simply imply that parties agree to buy or sell a specified asset for a price agreed upon today (the strike price) with delivery & payment occurring at a future date (the delivery date).
  4. OTC derivatives are similar to exchange-traded securities, but also include interest rate and currency swaps, caps & floors and options.
You may have heard of a call and put:  This is financial jargon for a buy or a sell.  A simple way to help you remember that call = buy and put = sale, is to think: "I will call my broker to buy something, but I will put something up for sale".

I will offer some more discussion on stock options (and similar/other exchange-traded securities as our readership grows, and based on reader requests for more information.  Some derivatives, like stock option and restricted stock awards, are commonly used as an integral part of executive compensation plans, and we'll discuss these instruments in later postings as well.