Financial instruments – what are they? Definition of
Financial instruments are agreements between two parties, based on which a right (for one party) and a financial obligation (for the other) are created simultaneously. This agreement does not have to take written form, but it must have an ascertainable financial value.
The above definition is based on International Financial Reporting Standard 9. While correct, it needs to be supplemented – so that it can be applied to everyday business practices.
Financial instruments are thus responsible for capital movements in the economy. Entities (companies, institutions) with financial surpluses move their capital to entities that need funds, and they do so through financial instruments precisely.
Finally, financial instruments function as a means to:
- capital accumulation,
- capital investment,
- hedging capital against risk,
- making money in financial markets.
Types of financial instruments
The way to divide financial instruments into types is not uniform – there are at least several different variants, among which the most popular is the division into:
- equity instruments,
- debt instruments,
- derivatives.
Capital instruments
This group includes stocks and mutual fund shares. These are vehicles through which investors receive the right to:
- profit sharing,
- share of losses,
- voting in shareholder meetings.
Here are some examples of equity instruments.
Ordinary shares
Holders of common shares acquire the right to share in the profits of the company in which they have invested. These profits can be paid out in the form of dividends. Shareholders also have voting rights at general meetings of the invested company. This is the most popular among equity instruments.
With common stocks, investors can expect sizable returns, but they also face significant investment risks.
Preference shares
This is a type of stock that gives its holders priority in the payment of dividends. Holders of these financial assets can also receive fixed dividends. An important feature of shares of this type is the lack of voting rights at the company’s general meetings.
Participation units
This is a financial instrument created by investment funds. Under this cooperative model, the fund acquires numerous investors who purchase units and thus become co-owners of the investment portfolio, controlled by the fund.
It is this approach to categorizing financial instruments that we will build on.
Debt instruments
This collection includes bonds, treasury bills and deposits, i.e. loans that investors make to issuers. Using debt instruments, their issuers are obliged to repay their debts with interest by a certain date. From the point of view of investors, debt instruments carry much less risk – but in return they offer a lower rate of return.
Here are some examples.
Bonds
Bonds are debt instruments issued by governments, local governments, but also companies and corporations. An entity that issues bonds on the market becomes a debtor to bondholders. It must return the funds it receives from them on a fixed date – and with interest, which represents the earnings of the individuals and entities investing.
Bonds can be issued publicly or privately. Among bonds, there is an internal division into government bonds, municipal bonds and corporate bonds.
Treasury bills
Issuers of Treasury bills are national governments. They are one of the money market instruments used for short-term investment – it usually takes less than 12 months from deposit to withdrawal. Treasury bills are used by governments to meet the financial needs of the managed state.
Certificates of deposit
This is an instrument used to invest capital. Funds are given to a selected bank for disposal for a specified period of time. At the agreed date, the bank is obliged to settle with the investor, i.e. pay out the transferred capital with interest.
Important!
Both treasury bills, certificates of deposit and international market deposits fall into a separate category of money market instruments. This group includes short-term debt instruments with a maturity of less than a year.
Derivatives
The group of derivatives includes complex tools that are used to manage risk, speculate and hedge the investments being made.
Learn about examples of derivatives.
Options
It is an instrument through which the investor retains the right to buy or sell the asset specified in the contract, keeping the agreed price. An important feature of options is that investors have no obligation to buy or sell the asset in question. Thus, if the market situation changes, options make it possible to abandon the intention to buy or sell. This makes options a useful tool used in speculation and capital hedging.
Futures contracts
Agreements under which an investor agrees to buy or sell an underlying asset at a certain point in the future for a price specified in the agreement.
The underlying assets can be various types of financial instruments, for example, stocks and bonds, but also trade goods or short-term receivables.
Swaps
Contracts under which the parties agree to exchange future payments or streams of payments on agreed dates.
A popular application for swaps is the interest rate swap (IRS – interest rate swap), in which the parties exchange flows that depend on a fixed and floating rate. However, this is just one example – IRS transactions themselves are divided into several types (ordinary swap, currency swap, basic swap), and in addition to these there are also commodity, credit or currency swaps(FX swap).
Forward contracts
Forward contracts are used to buy or sell an asset in the future (on a fixed date), with the price fixed at the time the agreement is created (concluded). This is an instrument that is almost twinned with futures contracts – it is distinguished from them by the lack of standardization and execution outside the stock exchange. This makes forward contracts generally more risky.
In the collection of forward contracts you will find those based on currency, percentages and prices.
Is factoring a financial instrument?
At this point it is also worth clearing up doubts about factoring. This service involves the sale of receivables by the factor to the factor. The company using the service receives the cash resulting from the sold receivable, while the factor becomes the owner of the receivable – thus a right and a liability are created.
Thus, factoring is certainly a financial instrument that, in its basic form, provides a source of financing for businesses and revenue enhancement for service providers.
What are securities?
In the context of financial instruments, it is impossible to ignore the issue of securities. This is a separate set of financial instruments, which include:
- Creditor securities – including bills of exchange, bonds and checks,
- Equity securities – including shares or investment certificate,
- Commodity securities – including bills of lading and proof of contribution.
Important!
Every security belongs to a set of financial instruments, but not every financial instrument is a security.
Securities are called documents that guarantee the possession of a property right. A characteristic feature of securities is their marketability. Although they function only in electronic form, any holder of securities can trade them on the Warsaw Stock Exchange.
Important!
Securities transactions are subject to strict regulation and supervision, which in Poland is carried out by the Financial Supervision Commission. Securities are traded on public markets, so transactions are thoroughly documented and transparent.
Why use financial instruments?
Financial instruments enable the efficient and effective movement of capital in markets. Thus, they are tools through which entities (not only companies, but also institutions, local governments and governments) can effectively move the funds they hold in order to maximize their value.
The wide range of solutions available for trading in financial instruments allows entities to match their chosen instruments to their preferred level of risk and expected returns.
While the use of financial instruments requires extensive knowledge and a willingness to take risks (even for tools with less risk in principle), it is at the same time a way to increase turnover and revenue – and from diverse sources.
Using these tools can bring investors returns from:
- interest,
- dividends,
- exchange rate differences,
- effective implementation of the instrument,
- effective capital preservation,
- successful speculation,
- effective risk management.
Financial instruments also play an extremely important role for issuers, for whom they are one of the most important ways to raise capital. It is through these tools that issuers finance their operations and investments, thus bypassing or supplementing financing through loans and equity.
Threats and risks
The degree of risk taken, the transparency of transactions involving financial instruments, the degree of complexity – all these things matter in terms of the future profits of a company. However, it should be borne in mind that even the choice of the safest way to invest is not completely risk-free. The market situation can change from day to day, as can currency exchange rates or commodity prices. The counterparty may turn out to be insolvent, and the risk underestimated or changing over time.
The use of financial instruments is therefore a complex and challenging undertaking. Even if nothing happens that affects the global or national economy (armed conflict, pandemic, political reshuffle), other risks may arise. One of them is the lack of buyers for the assets held at any given time or at the expected price. In such a situation, it may be necessary to wait for the right moment or sell at a lower price than expected.
To protect against known, potential, and unpredictable threats, you should:
- analyze available historical data in detail before making specific moves,
- develop detailed scenarios for dealing with unusual situations,
- match the investment portfolio to the company’s capabilities and preferences,
- set and optimize investment targets on an ongoing basis, and regularly review their execution,
- accept an acceptable level of risk and do not go beyond the established limits.
