The most common financial instruments explained
There are numerous financial instruments that can be divided into different categories. In this article we give you an overview of the most important classes and show you where which instruments are used.
Financial instruments are contracts for assets that have a monetary value. These contracts can be concluded with different providers, for example with banks or with a broker - depending on the assets in question.
The various financial instruments are used by companies when they want to increase their capital, for example. In this case, they can issue shares so that they receive money from investors and thus capital in return.
Financial instruments are also used to hedge capital, for example when a company wants to secure a certain exchange rate for foreign currency transactions.
Financial instruments can be divided into three different classes:
- Cash instruments
- Derivative instruments
- Foreign exchange (Forex) instruments
Financial instruments belonging to the cash class are directly influenced by current market conditions. Cash instruments include securities and loans.
Securities are traded on the stock exchange. The person who buys a security receives in return a share in a company that issues these securities.The best-known examples of securities are shares.
Loans are also cash instruments where there is a contract between lender and borrower. This contract specifies, for example, how high the monthly interest instalments and the interest rate will be when the loan is repaid.
In derivative instruments, the value is derived indirectly from the underlying asset of the derivative. There are many different assets, for example:
- Raw materials
The best-known derivative instruments are:
In the case of futures, a transaction is contractually fixed in which derivatives are exchanged for money at a specified future date at a fixed price.
In the case of a warrant, the seller of the option grants the buyer the right to purchase further derivatives at a predetermined price within a certain period of time.
Foreign exchange instruments are transactions that are concluded on the currency market. These include, for example:
- Spot transactions
- Outright Forwards
- Currency swaps
A spot transaction is a currency exchange where the exchange takes place no later than the second business day after the transaction is concluded - i.e. "on the spot".
With outright forwards (also called currency forwards), currencies are exchanged at a predetermined exchange rate and a point in time after the spot date. Investors are thus protected from high exchange rate fluctuations.
In swap transactions, money is simultaneously lent in one currency and money of the same value is lent in another currency - i.e. two parties exchange the same monetary value with each other in different currencies.
The money is then swapped back at a predetermined maturity date and exchange rate: the two swapping parties receive their original amount back in the original currency.
Financial instruments can also be classified according to asset class. A distinction is then made between debt-based financial instruments and equity-based financial instruments.
Debt-based financial instruments can be divided into short-term and long-term instruments. The former have a maturity of one year or less; the latter have a maturity of more than one year.
Short-term debt-based financial instruments include, for example, treasury bills, while bonds are long-term debt-based financial instruments. Both types can be traded in different ways, e.g. as futures or options.
Equity-based financial instruments are characterised by the fact that the buyer becomes the owner. The best-known example is company shares, where the investor receives shares in the company in exchange for money. These financial instruments are used by companies to increase their capital in the long term. There is no obligation to repay, but investors participate in profits through dividend payments.