Different Types of Financial Instruments Explained
For most traders who are just starting to venture into trading, forex crops up as the first trading instrument or product. This has to do with the fact that retail forex trading is relatively straightforward. Being a highly leveraged product and the existence of a decentralized exchange, makes it easy for the average Joe to transfer funds to a forex broker and start trading. So aside from Forex, what are the different types of financial instruments?
However, when it comes to the financial markets, there are many types of products that you can trade. Most commonly, traders might have heard about stocks, ETF’s, mutual funds, bonds, futures, spot forex, options trading to name a few. Dig a bit deeper and you will recognize a plethora of financial products to trade.
Curious to know? Well, some of the ‘not so common to the retail trading arena’ include; Non-deliverable forwards, Credit default swaps, Credit link notes and many more.
For the most part, regardless of how fancy a name may be, the financial products are classified into two main types.
- Cash instruments
- Derivative instruments
A cash instrument is classification of a financial product whose value is determined by the markets. These could be securities and most importantly, the ones that can be easily transferable. They are also more liquid.
A derivative instrument is one whose value is derived from the underlying asset such as index or interest rate of even currency rates. The term asset is commonly used, but there can only be two types of assets.
- Equity based asset
- Debt based asset
The exception to the case is of course foreign exchange, which falls into none of the above categories.
Both of the above types of financial instruments are then sub-classified into exchange traded or over-the-counter (OTC) traded products.
Thus, combining the above, the financial instruments are as follows:
Debt based instruments (long term)
- Bonds (cash or securities instrument)
- Bond futures, options (exchange traded derivatives)
- Interest rate swaps, IR options, IR caps and floors (OTC derivatives)
Debt based instruments (short term)
- T-bills (cash or securities instrument)
- Interest rate futures (exchange traded instrument)
- Forward rate agreements (OTC derivatives)
Equity based instruments
- Stocks (cash or securities instruments)
- Stop options or futures or funds (exchange traded instrument)
- Spot Foreign Exchange (Other)
- FX futures (exchange traded instruments)
- FX options, currency swaps (OTC derivatives)
Why so many different instruments?
The fact there are so many different types of financial instruments comes back to the main point of what an investor or a speculator wants. For example, some investors prefer to park their money into safe haven assets such as bonds.
The bond markets tend to give a yield that is typically lower than the returns one can expect from the equity markets. However, the advantage here is that bonds are less risky and safer. In most cases, bonds are often backed by government pledges.
A stock market investment might seem more ideal for an investor who prefers to take on more risk. For taking up this risk, the investor is of course compensated with higher returns. However, there is no guarantee.
The choice of investing in debt or equity markets also goes into a lot of detail and investors mix their portfolios for various reasons.
When it comes to the currency markets, again at the end of the day it is the investor or the speculator’s choice and ultimate goals. For an export business, investing in currencies is more ideal as it allows them to hedge their currency risks. For such a business, stocks might not be that important.
Likewise, for a person looking to park some funds towards their retirement, bonds (and stocks) might seem more ideal than currencies.
So far we have touched upon the different types of financial instruments available. In the next article we will get into more details about the various types of financial instruments.