Rahul has just completed his graduation and has started working in an organization where he has completed nine months. After paying off his remaining education loan he has now saved a corpus which he wants to invest but he is not aware of the possible options. So, he asks his friend Sameer for help. Sameer is a financial planner by profession. Rahul asks Sameer to help him in investing in Financial Instruments and also explain the types so that he can select the ones most suitable to him.
Sameer begins by explaining him about Financial Instruments –
A financial instrument is a monetary contract between two parties which can be created, traded, modified and settled. It can be evidence of ownership of an asset.
“A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”
– The Association of Chartered Certified Accountants (ACCA)
These instruments can be divided into two types cash instruments and derivative instruments or can be divided based on asset class like debt instrument or equity instrument. The third unique category is of foreign exchange instruments.
Below table summarizes all the financial instruments based on types and asset classes –
Debt vs Equity Instruments
Debt and Equity instruments differentiated based on them based on the type of claim that the holder has on it. When the claim os for a fixed dollar amount it is a debt instrument. For example a car loan, Infrastructure bonds issued by the Government of India, Bonds issued by private companies. Debt instruments can be either short term less than one year or long term with tenure greater than one year.
In comparison to this equity, instruments obligate the issuer of the financial instrument to pay the holder an amount only if profits have been earned and after the debt payments are made. Common examples of equity instruments are common stock or a partnership share in the business. However, some securities fall in both these categories and have attributes of both. One such example is preferred shares, convertible bonds.
Foreign exchange does not fall into any of the above buckets and has its category. Foreign exchange instruments in the form of cash are spot foreign exchange and in the form of exchange-traded derivatives are currency futures and in the over the counter derivatives are foreign exchange options and outright forwards.
Instruments based on Types –
Cash vs Derivatives
Cash instruments can be defined as the instruments whose value can be determined directly in the markets and securities which are readily transferrable. Derivative instruments derive their value and characteristics from an underlying asset, index, common stock. They can either be exchange-traded or over the counter derivatives.
Rahul: Sameer I have understood the high types but how do I know which instruments to invest in?
Sameer: Yes, I will give you a brief of the individual instrument –
- Bonds – Bond is a type of long term debt instrument in which the issuer owes the holder debt and is obligated to pay interest (coupon payments) for the specified amount of period (maturity date) at a later date.
- Loans – Loan is basically lending money from individuals, organizations, banks, trust etc. Till the time the entire amount is given back the recipient has to pay interest.
- Bond Futures – Futures contract is a predetermined contract where the buyer or the seller agrees to buy or sell something at a predetermined time and a predetermined price in the future. The asset is usually a commodity or a financial instrument. In the case of bond futures, it is a bond.
- Options on Bonds – Options gibe the buyer the right but not the obligation to buy or sell the underlying asset on the option at a specified date and a specified price depending on the type of option. In case of options on bonds, the underlying asset bonds.
- Interest rate swap – It is a type of interest rate derivate which involves exchanging interest rates between two parties.
- Interest rate cap and floor – This again is a type of interest rate derivative where the underlying is the interest rate and in case of interest rate cap the buyer receives payment if the interest rate exceeds the agreed strike price. Similarly, for the interest rate floor, the buyer receives payments if the interest rate is lower than the specified strike price.
- Exotic derivatives – These are customized derivative products and are complex to the generally traded vanilla options.
- T bills, Deposits, Certificate of Deposits – Treasury bills popularly known as T bills are issued by the government and are available for 30,60,90,120,360 days. They are considered to be very liquid. Deposits can be a savings bank account, current account. Certificate of deposits are again issued by the government and are very liquid.
- Foreign exchange instruments – These include currency swaps, foreign exchange options, foreign exchange swaps and are mainly related to currencies.
Rahul: Thanks Sameer this was very helpful. Now that you have given me an overall picture I will be able to understand which ones are suitable for me. I will think about it and get back to you.
Sameer: You are welcome!!
There are a lot of financial instruments, but each financial instrument serves the purpose and needs of an investor. For a risk-averse investor investing in the bond market would be a better option than investing inequities. Likewise investing in the currency market depends on the choice and objective of the investor. For some businesses dealing with imports and exports investing in currencies would be the right option!