Financial instruments are assets that can be traded. They can also be seen as packages of capital that may be traded. Most types of financial instruments provide an efficient flow and transfer of capital all throughout the world’s investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.
Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt-based financial instruments represent a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of financial instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity.
International Accounting Standards defines financial instruments as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Financial instruments may be divided into two types: cash instruments and derivative instruments.
The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.
The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates or indices. These can be over-the-counter (OTC) derivatives or exchange-traded derivatives.
Bank guarantees (BG) are guarantees from a lending institution ensuring the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank covers it. A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down loans, and thereby expand business activity.
A standby letter of credit (SBLC) is a guarantee of payment issued by a bank on behalf of a client that is used as payment of last resort should the client fail to fulfill a contractual commitment with a third party. Standby letters of credit are created as a sign of good faith in business transactions and are proof of a buyer’s credit quality and repayment abilities. The bank issuing the standby letter of credit performs brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then sends notification to the bank of the party requesting the letter of credit (typically a seller or creditor).
The online sale and lease of bank guarantees and standby letters of credit is indicative of financial crime.
Financial instruments may also be divided according to asset class, which depends on whether they are debt-based or equity-based.
Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs). Exchange-traded derivatives under short-term debt-based financial instruments can be short-term interest rate futures. OTC derivatives are forward rate agreements.
Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives.
Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives.
There are no securities under foreign exchange. Cash equivalents come in spot foreign exchange. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options, outright forwards and foreign exchange swaps.
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