HFM information and reviews
HFM
96%
FXCC information and reviews
FXCC
92%
FxPro information and reviews
FxPro
89%
FBS information and reviews
FBS
88%
Vantage information and reviews
Vantage
85%
MultiBank Group information and reviews
MultiBank Group
84%

Financial Instruments Explained: Types And Asset Classes


Every beginning investor, having defined his investment objectives and risk profile, thinks about how to structure his portfolio so that it meets his needs. There are a large number of financial instruments on the market and the question of proper portfolio structuring is more relevant than ever. A financial instrument is any contract by means of which there is a simultaneous increase in financial assets of one enterprise and financial liabilities (of debt or equity nature) of another. A distinction is made between primary financial instruments, represented by cash, types of securities, accounts payable and receivable on current transactions, and secondary, or derivative.

There are four types of markets: currency market, futures market, money market, and stock market. Each of them uses different financial instruments, i.e. documents that can be sold or transferred to get money. Securities are traded on the stock market, and they are its main instrument. In essence, they are certain types of liabilities, with the help of which one invests money - investing.

The Different Types Of Financial Instruments

Let's start at the beginning. All securities are traded on the stock exchange, where all assets represented on it are traded in an organized manner. The instruments themselves are divided into two types: basic (cash) and derivatives. The first refers to usual securities and goods: shares, bonds, stock indices, interest rates, currencies, raw materials, energy, and others.

A derivative financial instrument is an agreement (contract) between two parties for the execution of a predetermined transaction with an underlying asset. As a rule, this is the purchase, sale, delivery, or transfer of securities and assets at a predetermined price at a specified time. Derivative financial instruments are also called secondary instruments.

Cash Financial Instruments

Cash instruments are defined as instruments that can be transferred and valued readily in the market. Some of the most common examples of cash instruments are deposits and loans which the lenders and borrowers are required to be agreed upon.

Stocks And Shares

The most popular type of financial instrument is a share - a security that secures the rights of its owner to receive part of the profits of a joint stock company in the form of dividends, to participate in the management of the company, and the property that remains after its liquidation. Shares can be ordinary and preferred. The rights of holders of ordinary and preferred shares differ: preferred shares do not give the right to vote, but, as a rule, the amount of the dividend is known in advance, and payments are made in the first place. By contrast, common shares give the right to vote, but the dividend amount is not known in advance.

For both common and preferred shares, dividends are not guaranteed. As a rule, dividends are not paid if the company makes a loss for the year. The owner of the stock receives income through dividends and/or share price appreciation.

Bonds

A bond is a security under which the bond issuer is obliged to return the face value of the bond and the interest on the date of expiry (the investor borrows money from the bond issuer). There are fixed-rate bonds (the most common group), variable-rate bonds (the interest payable is linked to EURIBOR or LIBOR), and zero-coupon bonds (no coupon payments - the profit is generated from the difference between the issue or purchase price of the bond and the face value paid when the bond is redeemed).

Bonds can have varying levels of risk. Ratings assigned by credit rating agencies guide risk levels. If a bond has an investment-grade rating (BBB- to AAA), the risk level is lower. In turn, the risk of speculative-grade bonds (rated BB+ and below) is higher. Rating agencies update their risk scores and ratings with some regularity. Depending on changes in the economic and operating environment, and company and country development, the rating can be either more positive or more negative, and this can also affect the price of the bond.

There are two types of investment returns on a bond: interest payments, which are calculated based on the face value of the bond; trading gains or losses on the bond, which depend on the purchase and sale price of the bond, which in turn depends on changes in market interest rates.

For fixed-rate bonds, prices change contrary to interest rates, i.e., if interest rates increase, bond prices decrease (and vice versa). The longer the remaining maturity of a bond, the greater the change in price per unit of an interest rate change. For example, if the market interest rate increases by 1%, or 2% for a bond with a remaining maturity of 1 year, the price will decrease by about 2%, and the price of a bond with a remaining maturity of 6 years will decrease by about 7%. If interest rates decrease, the price of the bond increases by the same amount. Thus, long-term bonds have higher interest rate risk than short-term bonds.

The main risks associated with bond investments are interest rate risk; credit risk; issuer risk.

Loans

Loans are made by banks and other lending institutions to entities such as companies, sovereign governments, or government agencies. From the perspective of borrowers, loans are quite similar to bonds, but because there are fewer parties involved (usually only one bank, sometimes several), they are much easier and faster to negotiate and document than bonds, which can have thousands of investors involved.   

Derivative Financial Instruments

Financial derivatives are necessary to reduce the market risks that arise when you trade cash assets. In the securities market, this is called hedging. Risk insurance occurs as a result of the pre-designation of transaction terms. The derivatives market has other advantages which are peculiar to it. They are mostly suitable for traders and speculative strategies. For example, there is no need to pay the whole sum of the contract to make a derivative transaction.

Options

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell a specified asset at or before a specified price. Like stocks or bonds, an option is a security. In addition, it is a legally binding contract between the parties with strictly defined terms and properties. The idea of an option is easy to explain with an example. Let's say you want to buy a house, and you find an interesting option. Unfortunately, you do not have enough money, and the missing amount will not appear until three months later. In this case, you can negotiate the following deal with the owner: you can buy the house for $200,000 within three months and pay the owner $3,000 for this opportunity.

Now let's look at two situations that can arise after making such an agreement. It turns out that Elvis Presley grew up in this house! As a result, the market value of the house soars to a million dollars. Since the owner sold you the option, he is obligated to surrender the house for the promised $200,000. In this case, you can make a profit of $797,000 ($1,000,000 - $200,000 - $3,000). You come to take a closer look at the house and discover that the walls are full of asbestos, the master bedroom is regularly haunted by ghosts, and a rat family is barricaded in the basement. And if you thought it was a dream home before, now you don't want to think about it. But you didn't buy the house, you bought an option, so you don't have to buy it. True, you lost the value of the option ($3,000).

This example makes two important points. First, when you buy an option, you get a right, but not an obligation. You can always just wait until the option expires and then throw it away. When that happens, you will lose 100% of the money you spent to buy it. Second, an option is a contract on the underlying asset. In our example, the underlying asset is a house, but usually, it is a stock or a stock index.

There are two basic types of options: Call and Put

A call gives the buyer the right to buy an asset at a certain price for a certain period. This is similar to a long position in stock: the buyer of a call hopes that the value of the stock will increase markedly before the option expires. A put gives the holder the right to sell an asset at a specific price over a certain period. A put is similar to a short position: in this case, the buyer hopes that the stock price will fall before the option expires.

Futures

In simple words, a futures is a contract for the delivery of a primary asset at a certain time in the future, but at a predetermined price. Sometimes you may hear a phrase like "sale of long-term contracts for the delivery of oil" instead of the term. In this case, it is the same exchange-traded instrument.

The execution date of such a futures contract is called the expiration date. On this day, the buyer remits the money to the seller and receives from him the material value or asset.

A newcomer to trading may hear other unusual terms in the context of this topic:

Similarly, these terms are used when evaluating changes in value over time. Thus, if the price of an exchange-traded instrument goes up, it is a contango, and vice versa.

CFDs

Contracts for Difference (CFDs) are popular financial instruments. They allow you to join the price movements of stocks, indices, futures, metals, currencies, and energy resources. Thanks to them, one can freely open and close transactions without actually purchasing an asset. The trader, for example, by opening a position to buy a CFD on a stock, does not become a co-owner of the company. However, the floating balance of his position changes following the real value of securities. The financial result of the transaction is determined by the difference between the opening and closing price.

The broker also adjusts for dividends (commensurate with the volume of the transaction). On the day of their official payment according to the Calendar, when a trader has an open Buy position, the dividends are credited to the account. When the Sell position is open, the dividends are deducted.

Warrants

A warrant is a security that gives the recipient the right to buy the stock at a fixed price for a set period. Warrants are sometimes called "sweeteners" or "attractants to a stock transaction" because they are often issued in conjunction with bonds. Granting warrants of some kind as a way to make a deal more attractive to a lender is a long-established practice.

In many cases, warrants are bonded at the time of issuance. The loan agreement will specify whether the warrant can be separated from the bond. Generally, the recipient of a warrant can separate it immediately and sell it as a separate security.

Warrants have been listed and freely traded on the New York Stock Exchange (NYSE) since April 13, 1970. At the beginning of 2017, however, only 20 warrants were listed on that exchange. Warrants are still popular in Europe. At the same time – in early 2017 – there were about 57,000 warrants listed on the European stock exchange Euronext.

Forwards

Forwards are practically the same as futures, but they are more of an over-the-counter instrument. They are often used by banking organizations. The difference is that forwards are more often concluded for the delivery of an asset.

Swaps

Swaps are less known among newcomers than the financial instruments listed above. In the securities market, a swap is a bilateral exchange of payments that benefits both parties to the transaction. As a rule, one hedges against losses in quotations; the other hedges against their rise. All foreign exchange derivatives are used in a similar way.

There are also interest swaps. This kind of derivative financial instrument allows for deriving profit when interest credit rates change. The first side of the swap benefits from a fixed rate, while the second side benefits from a floating rate. Interest rate derivatives are used as a way to protect against stock market risks and for speculation.

For example, company A wants to save money; it would be more profitable to pay 9% on the loan. Firm B, on the other hand, does not like the fact that the floating rate can rise at any time. This state of affairs does not allow them to budget over the long term. The swap allows the organizations to swap interest rates. Now "A" pays 9% instead of 10%, and "B" gets a stable fixed 10%.

#source


RELATED

What Is Stop Loss and Take Profit?

Stop-Loss is a pending order used by traders to minimize risks. When analyzing the market, traders may misinterpret the asset price movement and incur losses...

Why every trader needs a trading strategy

A trader without a trading strategy (TS) is like a driver with no map. Whatever your strategy is, it will help you deal with the chaos happening in the markets. This article...

What Is A Demo Account And Why Is It So Important?

A trader gradually learns the essence of exchange trading. In this case, he can choose two ways - to use a demo account or trade immediately for real money...

A Comprehensive Guide On How To Trade USD/CAD Currency Pair

The USD/CAD currency pair represents the relationship between the US dollar and the Canadian dollar and is a favored choice among currency traders due to its active trading hours...

Guide To Choosing A Broker In 2023

Choosing a reliable broker is an important step in the career of a successful trader. It is the broker, being the intermediary between you and the market...

The Criticality of Stop Orders in Trading: An In-Depth Guide

The vast universe of financial markets demands a keen understanding of its intricacies. For traders and investors alike, navigating this complex ecosystem is pivotal...

Demystifying the 60/40 Rule in Forex Trading: A Comprehensive Guide to Tax Implications

Forex trading, also known as foreign exchange trading, is a dynamic market where currencies are bought and sold globally. The primary aim of forex traders is to make profitable trades...

Crypto rading for Beginners: Best Strategies and Patterns

Today, there are more than 19,000 cryptocurrencies in existence and counting. On the one hand, crypto trading opens up huge opportunities. On the other hand, such a wide variety can...

What are derivatives in finance?

When referring to derivatives, it is about financial agreement that establishes a value through the value of an underlying asset. This means that they have no value...

What is forex scalping? Understanding the ins and outs

In the forex industry and investment world, scalping refers to trading currencies based on a set of real-time analysis. The idea and purpose behind this, is to make profit through buying...

What is earnings season and why is it important for traders?

Every earnings season is a new opportunity to grow as an investor. An Earning Season is an important financial event and a new opportunity to grow as an investor...

What is a moving average and how do I use it?

Moving averages are one of the easiest types of technical indicator to understand and use. They provide a simplified view of the price action of an asset, with most...

The gamification of trading and the case for financial literacy

Trading apps are attracting younger audiences with new investment approaches and appetites, sparking knee-jerk reactions from regulators and media...

Negative Balance Protection: What Is It And How Does It Work

Contract for Difference (CFD) trading is a popular form of investment, but as with any investment, it involves a degree of risk. Managing risk in trading is critical to protect your capital...

Basic Concepts Of The Stock Market And Their Applications

A stock market is a trading floor where stocks listed by companies are traded through direct exchanges between multiple parties (OTC). This kind of interaction...

What Is the OTC Market?

Over-The-Counter markets are popular among investors and traders. This term is mostly associated with the trading of company shares. Yet, it's possible...

Strongest and Most Valuable Currencies in the Global Landscape

In the realm of international economics and trade, the strength and value of a currency play a vital role. A strong currency reflects the health of its nation's economy and its global economic stature...

How Are Commodities Traded In Simple Terms

The lookout for how are commodities Traded is as old as the financial market itself. Perhaps commodities trading is even older than the financial market...

Understanding Cross Trading: An In-Depth Analysis

In the labyrinthine world of finance, cross trading stands out as a debated and intricate transactional practice. While it offers certain efficiencies, it’s also encased in a thick layer of regulatory...

Stop Loss: the lifeline of every trader

Stop Loss (SL) is one of the most important concepts in the FX market. Every trader has the opportunity to benefit from this trading tool.

XM information and reviews
XM
82%
FP Markets information and reviews
FP Markets
81%
FXTM information and reviews
FXTM
80%
AMarkets information and reviews
AMarkets
79%
Octa information and reviews
Octa
79%
BlackBull information and reviews
BlackBull
78%

© 2006-2024 Forex-Ratings.com

The usage of this website constitutes acceptance of the following legal information.
Any contracts of financial instruments offered to conclude bear high risks and may result in the full loss of the deposited funds. Prior to making transactions one should get acquainted with the risks to which they relate. All the information featured on the website (reviews, brokers' news, comments, analysis, quotes, forecasts or other information materials provided by Forex Ratings, as well as information provided by the partners), including graphical information about the forex companies, brokers and dealing desks, is intended solely for informational purposes, is not a means of advertising them, and doesn't imply direct instructions for investing. Forex Ratings shall not be liable for any loss, including unlimited loss of funds, which may arise directly or indirectly from the usage of this information. The editorial staff of the website does not bear any responsibility whatsoever for the content of the comments or reviews made by the site users about the forex companies. The entire responsibility for the contents rests with the commentators. Reprint of the materials is available only with the permission of the editorial staff.
We use cookies to improve your experience and to make your stay with us more comfortable. By using Forex-Ratings.com website you agree to the cookies policy.