Financial instruments are legal agreements that require one party to pay money or something else of value or to promise to pay under stipulated conditions to a counterparty in exchange for the payment of interest, for the acquisition of rights, for premiums, or for indemnification against risk. In exchange for the payment of the money, the counterparty hopes to profit by receiving interest, capital gains, premiums, or indemnification for a loss event.
A financial instrument can be an actual document, such as a stock certificate or a loan contract, but, increasingly, financial instruments that have been standardized are stored in an electronic book-entry system as a record, and the parties to the contract are also recorded. For instance, United States Treasuries are stored electronically in a book-entry system maintained by the Federal Reserve.
Some common financial instruments include checks, which transfer money from the payer, the writer of the check, to the payee, the receiver of the check. Stocks are issued by companies to raise money from investors. The investors pay for the stock, thereby giving money to the company, in exchange for an ownership interest in the company. Bonds are financial instruments that allow investors to lend money to the bond issuer for a stipulated amount of interest over a specified period.
Financial instruments can also be used by traders to either speculate about future prices, index levels, or interest rates, or some other financial measure, or to hedge financial risk. The 2 parties to these kinds of instruments are speculators and hedgers. Speculators attempt to predict future prices or some other financial measure, then buying or selling the financial instruments that would yield a profit if their view of the future should be correct. In other words, speculators bet about future prices or some other financial measure. For instance, if a speculator thought that the price of XYZ stock would rise, then he could buy a call option for the stock, which would be profitable if the stock does rise. If the option expires worthless, then the loss to the speculator is less than the loss that would have been incurred from actually owning the stock. Hedgers attempt to mitigate financial risk by buying or selling the financial instruments whose value would vary inversely with the hedged risk. For instance, if the owner of XYZ stock feared that the price might go down, but didn't want to sell before a specific time for tax purposes, then she could buy a put on the stock that would increase in value as the stock declined in value. If the stock goes up, then the put expires worthless, but the loss of the put premium would probably be less than the loss incurred if the stock declined.
Types of Financial Instruments
There are many types of financial instruments. Many instruments are custom agreements that the parties tailor to their own needs. However, many financial instruments are based on standardized contracts with predetermined characteristics. Some of the most common examples of financial instruments include the following:
- Exchanges of money for future interest payments and repayment of principal.
- Loans and Bonds. A lender gives money to a borrower in exchange for regular payments of interest and principal.
- Asset-Backed Securities. Lenders pool their loans together and sell them to investors. The lenders receive an immediate lump-sum payment and the investors receive the payments of interest and principal from the underlying loan pool.
- Exchanges of money for possible capital gains or interest.
- Stocks. A company sells ownership interests in the form of stock to buyers of the stock.
- Funds. Includes mutual funds, exchange-traded funds, real estate investment trusts, hedge funds, and many other funds. The fund buys other securities earning interest and capital gains which increases the share price of the fund. Investors of the fund may also receive interest payments.
- Exchanges of money for possible capital gains or to offset risk.
- Options and Futures. Options and futures are bought and sold either for capital gains or to limit risk. For instance, the holder of XYZ stock may buy a put, which gives the holder of the put the right to sell XYZ stock for a specific price, called the strike price. Hence, the put increases in value as the underlying stock declines. The seller of the put receives money, called the premium, for the promise to buy XYZ stock at the strike price before the expiration date if the put buyer exercises her rights. The put seller, of course, hopes that the stock stays above the strike price so that the put expires worthless. In this case, the put seller gets to keep the premium as a capital gain.
- Currency. Currency trading, likewise, is done for capital gains or to offset risk. It can also be used to earn interest, as is done in the carry trade. For instance, if a trader believed that the Euro will decline with respect to the United States dollar, then he could buy dollars with Euros, which is the same thing as selling Euros for dollars. If the Euro does decline with the respect to the dollar, then the trader can close the position by buying more Euros with the dollars received in the opening trade.
- Swaps. Swaps are an exchange of interest rate payments calculated as a percentage of a notional principal that is paid at periodic intervals. One leg of the swap pays a fixed rate of interest and the other leg pays a floating rate of interest. However, only the net amount is exchanged. For instance, if the interest based on the floating rate is $1000 greater than the interest based on the fixed-rate on a payment date, then the party receiving the fixed rate would pay $1000 to the party receiving the floating rate. The receiver of the fixed rate of interest enters into the swap usually to offset risk while the receiver of the floating rate generally hopes to profit from changes in the market interest rate. Usually, the floating rate is calculated as a spread above LIBOR or some other benchmark, such as Treasuries with comparable terms. If both legs of the swap pay in the same currency, and the swap is known as an interest rate swap, since both the fixed-rate and the floating rate are paid in the same currency. By contrast, a currency swap is the exchange of interest rate payments paid in different currencies, so the net amount is calculated based on the exchange rate on the payment date.
- Exchanges of money for protection against risk.
- Insurance. Insurance contracts promise to pay for a loss event in exchange for a premium. For instance, a car owner buys car insurance so that he will be compensated for a financial loss that occurs as the result of an accident.
Primitive Securities and Financial Derivatives
A custom agreement can better suit the needs of the parties involved; however, such instruments are extremely illiquid precisely because they are tailored to specific parties. Furthermore, such instruments would take time for anyone to completely understand the details, which would be necessary to assess the profit potential and risk. The solution to this illiquidity is to create financial instruments based on standardized contracts with standard terms and conditions.
Such financial instruments are called securities, which can be easily traded in financial markets, such as organized exchanges and in the over-the-counter market. Furthermore, they are more easily stored in an electronic book-entry system, which saves the cost of storing and transporting the instruments for clearing and settlement. Examples of securities include stocks, bonds, options, and futures.
Securities are classified as to whether they are based on real assets or on other securities or some other benchmark. Primitive securities are based on real assets or on the promise or performance of the issuer. For example, bonds are based on the issuer's ability to pay interest and principal and stocks depend on the performance of the company that issued the stock. Financial derivatives are based on the underlying asset which consists of other financial instruments or some benchmark, such as stock indexes, interest rates, or credit events. For example, the value of stock options depends on the price of the underlying stock, and mortgage-backed securities depend on an underlying pool of mortgages.
Valuation of Financial Instruments
The value of any financial instrument depends on how much it is expected to pay, the likelihood of payment, and the present value of the payment.
Obviously, the greater the expected return of the instrument, the greater its value. This is why the stock of a fast-growing company is highly valued, for instance.
A financial instrument that has less risk will have a higher value than a similar instrument that has more risk — the greater the risk, the more it lowers the value of the security because risk requires compensation. This is why United States Treasuries which have virtually no credit default risk command higher prices (lower yields) than junk bonds with the same principal. So an investor would pay less money for a junk bond with a $1,000 principal than for a Treasury with the same $1,000 principal and coupon rate since there is a much greater risk that the junk bond may default. So, by paying less money for the junk bond, the junk bond pays a higher yield.
The present value of a payment is determined by when the payment will be made. The greater the amount of time until payment, the less the present value of the security, and, hence, the lower its value. So a zero coupon bond that pays its $1,000 principal 1 year from now will obviously have greater value than a zero that pays its principal in 10 years.