A Financial Instrument is a legal document identified by cheques, drafts, bonds, shares, bills of exchange, futures or options contracts etc., which has a monetary value. The agreement is signed between two parties regarding payment of money with specified conditions.
Categories of Financial Instruments:
The financial instruments can be broadly classified under 3 categories:
- Equity based: characterized by ownership of assets.
- Debt based: loans from an investor to the owner of assets.
- Foreign exchange instruments: unique instrument dealing with international currencies
Types of Financial Instruments: There are various kinds of financial instruments based on the nature of the asset and transaction.
- EQUITIES: They are the securities that signify an individual/company’s ownership in another company. The equities can be bought or sold in stock market, which is an indirect mode of trade, where the stock market intermediates. Otherwise, equities can be directly purchased or sold via Initial Public Offering (IPO) mechanism. It is often deemed as a good investment option due to its long-term nature which yields higher returns. However, a drawback is the associated risks involved in such long term investment spending.
- MUTUAL FUNDS: It is an investment scheme in which a group of people collectively invests funds with a predetermined objective. The pooled money is again invested in stocks, bonds, short term money market instruments and other securities by the mutual fund complexes. The major advantage in such an investment plan lies in its cost effectiveness, risk diversification, professional management and sound regulation.
- BONDS: Bonds are debt based financial instruments, bearing interest on maturity. The organizations or companies generate funds by issuing bonds with fixed interest rate for a definite period of time (maturity period). Bonds have a maturity period of one year which distinguishes them from other debt securities like commercial papers, treasury bills and money market instruments. Bonds are issued by both private companies and government organizations. Usually, government bonds are a safe area for investment due to their lower risk level and fair returns.
- CASH EQUIVALENTS: The name itself suggests that this is the most liquid investment option. These are the assets that can be readily converted into cash. Money market holdings, short-term government bonds or treasury bills, commercial papers, etc. are few examples of cash equivalents.
- DEPOSITS: These are investment avenues where surplus funds are invested in banks or post-offices. The risks associated are the lowest in this case but so are the returns on such deposits.