A “financial instrument” is a monetary contract between parties originated by a financial institution in order to better match the other party’s (client) needs. Parties in these contracts can trade, modify or settle them between each-other. As a contract, the financial instrument may be evidence of ownership on specific assets (as in stocks and shares). Likewise, financial instruments may regulate the lending relationship between the lender and the borrower. In other words, debt instruments such as bonds or other short term debt securities (T-Bills, commercial papers etc.), are financial debt instruments which holds contractual rights to receive cash (the borrower of the ash and issuer of the financial instruments) at the same time as well as the right to have that cash back (the lender of cash and investor of the financial instrument) at the same time together with the profit as a reward of the engagement and risk taking.
The Association of Chartered Certified Accountants (ACCA) has the following definition for a financial instrument:
“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. These definitions are wide and include cash, deposits in other entities, trade receivables, loans to other entities, investments in debt instruments, investments in shares and other equity instruments.”
However, it is important to know that there is a different definition of financial instruments in accounting and financial market supervision.
There is a difference between a security and a financial instrument. Not all financial instruments are securities, but all securities are financial instruments. Generally speaking if these financial instruments give the holders the right to be freely transferable and tradable which no restrictions attached, they are called “Securities”. To put it simply; a security is a financial instrument which represents an asset or package of capital that we can trade. Primarily, the securities (instruments) are designed to be traded on the secondary markets (also known as the Securities Exchange).
Historically, securities existed prior to the term financial instruments being introduced. Securities were the legal institution that allowed transfer of cash in return for rights and future payments or residual assets. The difference between securities and ordinary debt or liability was the possibility to create a secondary market with securities and make them liquid. However, from a technical point of view, each security, in order to be created, had firstly to be designed as a legal instrument, thus the risk profile was given to the public, who could invest looking for higher rates of return.
In essence, financial instruments are grouped into three exclusive categories on the basis of the market organization and risk profile: fixed income instruments, equity income instruments, and derivative instruments.
The following table mentions the classification of financial instruments (financial assets or liabilities) on the basis of various parameters:
There are the different types of financial instruments:
- Transferable Securities;
- Money Market Instruments;
- Units in Collective Investment Undertakings;
- 4-a. Options, futures, swaps, forward rate agreements, and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivative instruments, financial indices or financial measures which may be settled physically or in cash;
- 4-b. Options, futures, swaps, forward rate agreements, and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of a default or other termination event);
- 4-c. Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF (multilateral trading facility);
- 4-d. Options, futures, swaps, forwards, and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in previous point and not being for commercial purposes that have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognized clearing houses, or are subject to regular margin calls;
- 4-e. Derivative instruments for the transfer of credit risk;
- 4-f. Financial contracts for differences;
- 4-g. Options, futures, swaps, forward rate agreements, and any other derivative contracts relating to climatic variables, freight rates, emissions allowances, inflation rates, or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of a default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices, and measures not otherwise mentioned that have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market or an MTF, are cleared and settled through recognized clearing houses, or are subject to regular margin calls
- The mentioned types are used as the definition of financial instruments used for the market supervisory rules in Europe (such as EU directives MIFiD I and II).