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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.

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Different Types of Financial Instruments [Guide]

January 11, 2021 12:20 UTC

Any aspiring trader or investor will have come across the term “financial instrument” before. But do you understand what it is? In this article, we will define the meaning of this term before examining some of the different types of financial instruments in detail.

Types of Financial Instruments

What Is a Financial Instrument?

International Accounting Standards define a financial instrument as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". In other words, financial instruments normally involve obligations on one party (like a commitment to make specific payments), and benefits for the other party (like the right to receive specific payments, or evidence of ownership in a company).

Financial instruments can normally be traded among parties, making them less risky to hold (as you are able to sell them if you subsequently need the money) and creating the possibility of making gains and losses on such trades.

The Different Types of Financial Instruments

Financial instruments can be classified in many different ways. In this article we will put them into two different types of financial instruments: cash instruments and derivative instruments. In the following sections, we will examine the different classifications of financial instruments and look at some examples.

Cash Financial Instruments

Cash financial instruments are typically generated, or issued, by organisations (mostly governments and corporates) in order to raise capital. In this context, those organisations are often referred to as issuers.

The prices for cash instruments are, either, set by the issuer (after advice from financial professionals), or arrived at by negotiation between the issuer and investors, who typically buy financial instruments on the expectation of making a profit.

Once issued and sold, the holders (traders and investors) can trade them openly in the financial markets, at a price set by supply and demand.

Below, we describe the main cash types of financial instruments.

Stocks and Shares

As the name implies, a share represents a share of ownership in a company. If a company issues 100 shares and you buy 1 of them, you own 1/100th, or 1%, of the company. From that point on, until you sell the share, you will be entitled to 1% of any dividends paid by that company, 1% of the votes at shareholder meetings, etc.

This last point is a simplification, as companies sometimes have multiple share classes, with each class having different rights assigned to them.

“Stock” is simply another word for “share”.

Bonds

A bond is like an IOU, a certificate that the issuer (or borrower) gives an investor in return for some cash. In the case of a bond, the document will specify the terms and conditions, including the size and frequency of the coupon (or interest) payments and the date when the bond has to be repaid; called the maturity date.

Failing to pay coupons on time, or to repay the bonds on maturity, exposes the issuer to a risk of being put into default by the bond holders.

As governments do not issue shares, bonds are the “go to” financial instrument that governments rely on to raise money from investors. At any one time there will be trillions of dollars of government bonds in circulation.

Loans

Loans are made by banks and other credit institutions to organisations such as companies, sovereign governments, or government agencies. From the borrowers’ point of view, loans look fairly similar to bonds but because there are fewer parties involved (normally only one bank, sometimes a handful) they are much easier and quicker to negotiate and document than bonds, which could have thousands of investors involved.

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Convertible Bonds

A convertible bond, or just convertible, is a bond which will either be repaid or converted into shares at a date in the future. Convertible bonds, therefore, look like a bond for the first part of their life, then they are either repaid or converted into shares for the second part of their life.

The terms for convertible bonds will define the size and frequency of coupon payments (if any); and the terms and the date for repayment or conversion.

Instead of a specific date, convertible bonds often convert to equity on a “trigger” event, the most common one being the issue and sale of new shares by the company.

Convertible Loans

A convertible loan is a loan which will either be repaid or convert into equity at a date in the future. The terms for convertible loans will determine the size and frequency of interest payments (if any); and the terms and the date for repayment or conversion.

As with convertible bonds, instead of a specific date, the loan often converts to equity when a “trigger” event takes place.

Summary

The table below summarises the cash financial instruments which we discussed in the preceding sections: 

Financial Instrument

Typical Issuer

Typical Buyer

Benefits for Buyer / Holder

Obligations for Seller / Issuer

Shares / Stock

Companies

Traders and investors

Literally, a share in the ownership of a company and the rights to receive all relevant benefits, e.g., voting rights, pre-emption, dividends, information, etc.

Equal treatment for each owner of each share of the same class.

Distribution of dividends, administration of all shareholder rights.

Bonds

Companies, governments and other large organisations.

Traders and investors

Receipt of coupons (i.e. payments) made at regular intervals (.e.g., quarterly) or at the bond’s maturity. Repayment of principal on the bond’s maturity.

Timely payment of coupons and principal as defined in the bond’s terms.

Loans

Companies, governments and other large organisations.

Banks and other credit providers.

Receipt of interest payments and of principal as defined in the loan’s terms.

Timely payment of interest and principal as defined in the loan’s terms.

Convertible bonds

Companies

Traders and Investors

Before conversion: receipt of coupons at regular intervals (e.g., quarterly) or at maturity. After conversion: as with shares.

Before conversion: payment of coupons at regular intervals (e.g., quarterly) or at maturity. After conversion: as with shares.

Convertible loans

Companies

Traders and Investors

Before conversion: receipt of interest payments at regular intervals or at maturity. After conversion: as with shares.

Before conversion: interest payments at regular intervals or at maturity. After conversion: as with shares.

Derivative Financial Instruments

As the name suggests, derivative financial instruments, or simply derivatives, derive their value from something else. That something else is referred to as the underlying asset, or simply the underlying.

The most common underlying assets are shares, bonds, indices (like the S&P 500), interest rates, commodities (like coffee or oil) and currency pairs.

Different types of derivative financial instruments have different characteristics, but they have two things in common that make them popular with traders and investors.

Firstly, a small fee often allows the derivative holder to take a large position in the markets. In other words, they offer the opportunity for traders to leverage their trades, magnifying the potential gains or losses.

Secondly, derivatives make it easy not only to go long, or buy, an underlying asset when you think the price will go up; but also  to go short, or sell, an underlying asset when you think the price is likely to fall.

Below, we take a look at the most common derivative derivative types of financial instruments.

Options

Owning an option, gives you the option, but not the obligation, to buy (or to sell) the underlying asset at a specific price, known as the strike price.

Options that give you the right to buy the underlying asset are sometimes referred to as “calls” and those that give you the right to sell as “puts”.

When an option holder decides to go ahead and buy (or sell) the underlying, they are said to exercise the option.

Every option has an expiration date. If the holder does not exercise the option before that date then the option ceases to exist and the holder loses the fee paid to acquire it. This is quite common as options are only exercised when they are likely to make a profit for the option holder.

Futures

Futures work in the same way as options, except that they don’t give you an option but an obligation. In other words, the holder does not have a choice and the future has to be exercised on or before the maturity date; whether or not the transaction will work in favour of the holder of the future.

CFDs

Contracts For Difference (CFDs) are an agreement, or contract, made between two parties to exchange the difference in the price of an asset from when the contract starts to when it ends. 

Like other derivatives, CFDs can be used to speculate on rising and falling prices. However, unlike the other derivative products listed above, CFDs are purely speculative, the underlying asset will never change hands at the end of the contract.

Warrants

Warrants tend to work in exactly the same way as share options, the main difference being that they are issued by companies themselves and sold by them in order to raise capital.

Summary

The table below summarises the types of financial instruments discussed in the previous sections:

Financial Instrument

Typical Issuer

Typical Buyer

Benefits for Buyer / Holder

Obligations for Seller / Issuer

Options

Banks and other financial institutions.

Traders, investors, corporates

The option to buy (or sell) the underlying asset at a predetermined price.

To sell (or buy) the underlying asset at a predetermined price if the holder wishes to exercise their option.

Futures

Banks and other financial institutions.

Traders, investors, corporates

The obligation to buy (or sell) the underlying asset at a predetermined price.

To sell (or buy) the underlying asset at a predetermined price.

CFDs

Banks, brokers and other financial institutions.

Traders and investors

The obligation to exchange, with the counterparty, the difference in price of the underlying asset between the date when the contract starts and its end. 

The obligation to exchange, with the counterparty, the difference in price of the underlying asset between the date when the contract starts and its end. 

Warrants

Companies

Traders and Investors

The option to buy company shares at a predetermined price.

To sell company shares at a predetermined price, if the holder wants to exercise.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.