scorecardresearchFinancial Instruments: What are the different categories?

Financial Instruments: What are the different categories?

Updated: 31 Jul 2022, 07:53 AM IST

A financial instrument is a legal agreement between two parties with monetary value. The three main categories of financial instruments are cash, derivatives, and foreign exchange. To know more about these in detail, go through the article.

Know about the types of financial instruments.

Know about the types of financial instruments.

A contract between parties that has a monetary value is referred to as a financial instrument. According on the needs of the parties involved, they can either be formed, exchanged, resolved, or amended. Simply put, it is an item that can hold value and be exchanged on the open market.

Financial instruments, which signify ownership over anything of monetary worth, might be physical documents or digital agreements. One side must provide a financial instrument, if another were to pay cash for a bond, in order for the transaction to be completed. The bond must be provided by one entity, and payment must be made in cash by the other.

Financial instruments are divided into three basic types: Cash, derivatives and foreign exchange. Let us discuss each one of them in detail.

Cash Instruments

Cash instruments are financial products whose values are primarily affected by market conditions. Securities, loans and deposits are few types of cash instruments. Securities indicates ownership of a share of a publicly listed corporation on the stock exchange when it is bought or sold. On the other hand, as they represent financial assets with some form of contractual agreement between parties, deposits and loans are also regarded as cash instruments.

Derivative Instruments

Instruments that may derive their features and value from their underlying entities, like as interest rates, indices, or assets, are known as derivative instruments. Depending on how well the underlying component performs, one may determine the worth of such instruments. They may also be connected to other types of assets, like bonds and stocks and shares. Options, futures, and forward contracts are a few types of derivative instruments.

Foreign Exchange Instruments

Foreign exchange instruments are connected to the foreign exchange market and generally deal with currency agreements, which are further divided into three categories - spot, outright forward, and currency swap. In spot, the currency exchange happens no later than the second working day after the agreement's date. The exchange of currencies occurs before to the agreed-upon date in the outright forward. A currency swap entails the concurrent buying and selling of currencies having various value dates.

Purchasing these financial instruments has its own set of advantages. However, it is crucial to understand that these often comes with several pitfalls. Therefore, it is wise to consider the risks before purchasing these instruments.

We explain hedging through derivatives here. 
First Published: 31 Jul 2022, 07:53 AM IST