Types of Financial Instruments: 4 Main Types, Advantages, and Disadvantages

A financial instrument is a financial contract between two parties. It is a document that represents an asset to one party and liability to another. It carries financial value and represents a binding agreement between two or more parties.

It is used by investors to predict future value. Examples of financial instruments are bills of exchange, bond, share, stocks, futures, cheque, currency, swaps, options, etc. Different types of financial instruments are described below:

1) Cash Instruments

Cash instruments have directly available market value and market forces directly determine their value. Cheques, shares, bonds are some examples of cash instruments. If lender and borrower agree over the transferability, deposits, and loans are also cash instruments.

Debt-based financial instruments are two types – long-term and short-term. Long-term debt instruments are interest rate swaps, bonds, futures, and options. Short-term debt instruments are interest rate futures and forward rate agreements.

2) Equity-based Instruments

Equity instruments are a way to fund operations and provide evidence of ownership. The common types of equity instruments are common stock, preferred stock, dividend, etc.

  • Common stock works as an equity instrument when a public company needs to raise funds. Common stocks don’t guarantee dividends. When a company faces a financial struggle that leads to liquidation, common stock is paid to stockholders as a last option. The board of directors is elected by common stockholders and this form of equity yields higher rates of return.
  • Preferred stock is similar to common stock. When a company goes into liquidation, preferred stockholders are in the second position to be paid after bondholders. When a company is in a profitable position, preferred stockholders receive an increased dividend. Preferred stock is flexible, and some preferred stocks are convertible.
  • Dividends are paid by publicly listed companies as a reward for investors. Dividends should be approved by shareholders by their voting rights. Dividends can be paid anytime but it is most commonly paid quarterly or annually.
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3) Debt-based Instrument

Debt instrument is a documented binding obligation used to raise capital. Examples of debt instruments are loans, bonds, credit cards etc.

When an entity needs capital debt instrument can be a useful tool which provides capital to that entity in the promise of repaying that capital over time.

The International Financial Reporting Standards have some requirements for the reporting of debt instruments on an entity’s financial statement.

The common and flexible type of debt instrument is credit card that an entity uses to obtain capital.

Another complex type of debt instrument is debt security which is used by entities when entities choose to structure debt in order to obtain capital.

Some common debt security instruments are treasuries, municipal bonds, corporate bonds etc.

4) Foreign Exchange

Foreign exchange is a unique type of financial instrument where the trading of one currency to another take place. In the foreign exchange market, foreign exchange transactions take place.

Forex market is considered most liquid market in the world. Foreign exchange is a simple method of changing one currency for another.

Recording Financial Instruments

The recording of financial instruments depends on whether an organization is buying or issuing financial instruments. Financial instruments are considered as financial assets when instruments are bonds, stocks, and sales on credit.

Financial instruments are considered as liabilities when instruments are accounts payable or long-term loan.

Reason for so Many Financial Instruments

The fact that each financial instrument serves a different purpose and meet different needs of investors, so it is the necessity of investors which is the reason of different financial instruments.

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Investors mix their portfolios for many reasons, so they choose to invest in debt or equity market.

For example, for saving purposes after retirement bonds and stocks are better options than other instruments. On the other hand, from a business perspective, it is a better option to invest in currencies.

Advantages of Financial Instruments

According to the risk-bearing capacity of counterparties, financial instruments allocate risks. Companies can use financial instruments to hedge currencies for future uncertainties.

Equity-based instruments are a permanent source of funds for businesses because equity shares allow businesses to have a good option of borrowing and enjoy retained earnings.

Disadvantages of Financial Instruments

Liquid assets like cash deposits and money market accounts will not allow to withdraw funds for a specified time mentioned in the agreement.

If a company wants to withdraw before maturity period, they may get lower returns. Swaps is a financial instrument which carries higher level of risks.

It can be stated at the end that proper management of financial instruments can help organizations in cutting down costs and maximizing their revenue model.