Last editedMay 20213 min read
From mutual funds to precious metals, there are many different types of financial instruments. Some are riskier than others, so how can you incorporate them into your investment plan? Here’s what you need to know about this type of asset, starting with the financial instrument definition.
Financial instrument definition: what are financial instruments?
A financial instrument refers to any type of asset that can be traded by investors, whether it’s a tangible entity like property or a debt contract. Financial instruments can also involve packages of capital used in investment, rather than a single asset. What types of assets qualify as financial instruments? These could be anything from cash to shares.
Financial instruments can be real-life documents or virtual agreements, representing ownership over something of monetary value. There are a few different categories to consider.
Equity-based financial instruments: the agreement represents actual ownership of the asset
Debt-based financial instruments: the agreement represents a loan made by the investor to the asset’s owner
Foreign exchange financial instruments: the agreement pertains to Forex currency exchange rates
Types of financial instruments
There are several ways to break up financial instruments into categories, including the equity-based and debt-based that we’ve mentioned above. Another way to look at them is through the lens of cash vs derivative.
Cash financial instruments
Cash instruments include things like deposits and loans, as well as easily transferable securities. This type of instrument is directly influenced by the market, so any market fluctuations will be directly reflected in the cash asset’s value.
Derivative financial instruments
By contrast, derivative financial instruments are based on underlying components like interest rates and markets. Examples include assets like equity options contracts, which derive value from underlying stock. When you purchase an option, you aren’t obligated to buy or sell the stock at any specified price although the option’s value rises and falls according to stock value.
Financial instruments examples: complex vs non-complex
In addition to looking at the different types of financial instruments mentioned above, you can also split them into the categories of complex and non-complex.
Complex financial instruments examples
Examples of complex financial instruments include most derivatives, because they require an advanced understanding of trading. Each offers its own benefits; while one type of derivative is tax-exempt, another might be perfect for hedging.
Call and put options
Non-complex financial instruments examples
By contrast, non-complex instruments are easier to understand and can be traded without specialist, in-depth knowledge. They might simply require a starting investment and are often managed by a separate entity like a hedge fund manager.
Mutual investment funds
Exchange traded funds (ETF)
How to choose the right financial instruments
As you can see, there are many different types and examples of financial instruments. How can you choose the best fit for your investing needs? Here are a few tips to keep in mind.
1. Set realistic financial goals.
Financial instruments can set you on the right path to achieving your investment goals, but you first must define them. These might include short-term goals like raising capital to fund a new business venture, or a long-term goal like funding an early retirement. Some instruments are more geared to the short-term, while others are long-term investment funds.
2. Analyse your risk profile.
We all have different risk profiles, blending psychological factors like risk tolerance with need-based risk requirements. If you have a high appetite for risk, financial instruments involving the stock market might be a better choice than low-risk government bonds with a lower pay-out. Naturally, your capacity to take a risk should also be considered. Small business owners might have limited resources to lose, in which case a long-term managed mutual fund might be the best option.
3. Understand the advantages of each financial instrument
There are pros and cons to all types of financial instruments. You should compare factors like objective, level of risk, management, and time limitation before making any decision. Naturally, your starting level of investment should weigh into the equation; never invest what you can’t afford to lose. It’s important to understand how the instrument works, so do your research into mutual funds or Forex trading before you invest. Those who are new to investing might want to stick with non-complex financial instruments like mutual funds.
Finally, enlist the help of expert financial managers when in doubt. Ideally, you should have a diverse portfolio containing several types of financial instruments for hedging purposes. An expert will be well-positioned to assist with this.
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