A financial instrument is a monetary contract between savers and users. We can create, trade, or modify financial instruments.
A financial instrument may be evidence of ownership of part of something, as in stocks and shares. Bonds, which are contractual rights to receive cash, are financial instruments.
Checks (UK: cheques), futures, options contracts, and bills of exchange are also financial instruments.
Securities, i.e., contracts that we give a value to and then trade, are financial instruments.
Put simply; a financial instrument is an asset or package of capital that we can trade.
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
The definition is wide and includes cash, deposits in other entities, trade receivables, loans to other entities. Investments in debt instruments, investments in shares and other equity instruments.
Financial instrument – cash or derivative
There are two main types of financial instruments, derivative or cash instruments.
Cash instruments are instruments that the markets value directly.
Securities, which are readily transferable, for example, are cash instruments.
Deposits and loans, where both lender and borrower must agree on a transfer, are also cash instruments.
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks
Financial instrument by asset class
We can also categorize financial instruments by asset class, depending on whether they are debt or equity based.
Debt-based financial instruments reflect a loan the investor made to the issuing entity.
Equity-based financial instruments, on the other hand, reflect ownership of the issuing entity.
Regarding these types of financial instruments, Wikipedia writes:
“If the instrument is debt, it can be further categorized into short-term (less than one year) or long-term.”
“Foreign exchange instruments and transactions are neither debt- nor equity-based and belong in their own category.”
This is an important component of the financial system. The products which are traded in a financial market are financial assets, securities or other types of financial instruments. There is a wide range of securities in the markets since the needs of investors and credit seekers are different.
They indicate a claim on the settlement of principal down the road or payment of a regular amount by means of interest or dividend. Equity shares, debentures, bonds, etc are some examples.