Financial Instruments
Overview
Financial instruments are contracts between parties that give rise to a financial asset of one entity and a financial liability or equity instrument of another entity. They can be created, traded, modified, and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive, or deliver, cash or another financial instrument.
Classification
Financial instruments can be either cash instruments or derivative instruments:
- Cash Instruments: Cash instruments are financial instruments whose value is determined directly by the markets. They can be securities, which are readily transferable, and instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.
- Derivative Instruments: Derivative instruments are financial instruments which derive their value from the price and other characteristics of one or more underlying entities such as an asset, index, or interest rate. They can be exchange-traded derivatives and over-the-counter (OTC) derivatives.
Cash Instruments
Cash instruments can be further classified into debt-based financial instruments and equity-based financial instruments:
- Debt-Based Financial Instruments: These are loans with an agreement to pay back with interest. The lender considers them as assets while the borrower considers them as liabilities.
- Equity-Based Financial Instruments: These are shares that are owned by shareholders in a corporation or other entity and represent an ownership interest.
Derivative Instruments
Derivative instruments can be classified into credit derivatives, equity derivatives, foreign exchange derivatives, and interest rate derivatives:
- Credit Derivatives: These are contracts that transfer credit risk from one party to another.
- Equity Derivatives: These are derivatives where the underlying asset is based on equity securities.
- Foreign Exchange Derivatives: These are contracts that have foreign exchange rates as their underlying asset.
- Interest Rate Derivatives: These are financial instruments with an underlying asset that is the right to pay or receive a notional amount of money at a given interest rate.
Valuation
The value of a financial instrument is generally determined by the market or by valuation techniques including present value, discounted cash flow models, and option pricing models. The inputs to these models are taken from observable markets where possible, but where this is not feasible, a degree of judgment is required in establishing fair values.
Risk and Regulation
Financial instruments carry various types of risks such as credit risk, market risk, operational risk, and liquidity risk. They are subject to various regulations and standards in order to protect investors and ensure the integrity of the market.