Monday Oct 23 2023 13:46
3 min
At their most basic level, financial instruments are assets that can be traded on the financial markets.
Shares are a type of financial instrument. So are commodities, and bonds. Even cash is a type of financial instrument. The most traded instruments in terms of market size are currencies, with the forex market being the world’s largest trading market.
The most well-known asset that isn’t technically classed as an instrument are commodities. (Interestingly, derivatives on commodities are considered instruments.)
Financial instruments can be either physical or virtual, or – as is most common these days – a combination of both.
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For example, both bonds and shares were once bought and sold as physical certificates. These days, though, they’re mostly traded virtually. Crypto currencies are an example of an entirely virtual asset, with no physical backing at all.
Even physical gold can technically be traded virtually, through funds that represent the physical asset.
Financial instruments are typically considered either cash instruments or derivative instruments.
This is the term for instruments whose cash value is directly influenced by the markets. Traders buy and sell at the current cash value. These instruments tend to be easy to transfer between owners. Bonds are a good example of a cash instrument.
Unlike cash instruments, the price of derivative instruments are only based on the cash value of an asset. When you trade derivatives, you don’t actually own the asset; you just speculate on the price movement. CFDs and spread-betting are two examples of ‘derivatives’.
Financial assets are normally classed into three types:
1. Debt-based. These are usually instruments where the bearer agrees to borrow from the lender for a set term, usually with the promise of paying interest on the debt when the term expires. Government bonds are a good example of this. The buyer lends money to the government, in return for repayment with interest when the bond expires.
2. Equity-based. This means that the buyer provides the lender with capital. Stocks are the most common equity-based instruments. ETFs and mutual funds are also equity-based.
3. Foreign exchange. Currencies are the most frequently traded financial instrument. Any trade in the forex market is considered foreign exchange.
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