Understanding the Fundamentals of Financial Instruments

Financial instruments are assets that can be traded on the financial markets. They take several forms and serve a variety of functions, including raising funds, hedging risks, and investing. The following are the primary categories of financial instruments:

1. Equity Instruments:

Stocks represent ownership in a corporation. Common equities grant voting rights and possible dividends, whereas preferred stocks provide set income but no voting rights.

Warrants: Grant the right to purchase a company’s stock at a specified price before it expires.

2. Debt Instruments

– Bonds: Long-term debt securities issued by firms and governments. Investors receive periodic interest payments and the principal at maturity.

– Debentures are unsecured bonds that rely on the issuer’s creditworthiness rather than collateral.

– Commercial Paper: Short-term, unsecured promissory notes issued by firms to cover short-term liabilities.

3. Derivative Instruments

– Futures: Contracts requiring buyers to purchase and sellers to sell a specific asset at a predetermined future date and price.

– Options: Offer the right, but not the responsibility, to buy (call option) or sell (put option) an asset at a certain price before it expires.

– Swaps: Parties agree to exchange cash flows or other financial instruments, which are frequently used to control interest rate or currency risks.

4. Hybrid Instruments

– Convertible Bonds: Debt securities that can be converted into a specific number of the

issuer’s shares.

– Preference Shares: Equity shares that pay fixed dividends and have priority over common shares in asset liquidation, but lack voting rights.

5. Cash Instruments

– Cash and Cash Equivalents: Currency, bank deposits, and liquid assets can be easily converted into cash.

– Certificates of Deposit (CDs): Bank time deposits that provide higher interest rates than savings accounts in exchange for locking money away for a set period of time.