Financial instruments are contracts or documents that act as a financial asset to one organisation and a liability to another. The types of financial instruments are debentures and bonds, receivables, cash deposits, bank balances, swaps, caps, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, and more.
Importance of Financial Instruments
Let us examine the significance of financial instrument categories here-
- Forwards and futures contracts, for example, can provide significant benefits to small businesses if used correctly. However, if these are employed incorrectly, they can lead to massive losses and collapse for a company.
- Organizations must use extreme caution when dealing with swaps due to the increased risk.
- Proper financial instrument management can assist businesses in reducing material costs while increasing sales and profits.
- People who cannot afford or do not have access to credit and systematic savings typically use them.
Types of Financial Instruments in India
The major financial instruments in India are:
The underlying asset, such as resources, currency, bonds, stocks, indexes, and so on, determines the value of derivative instruments. The underlying assets determine the performance of derivatives instruments.
The most popular types of derivative instruments are as follows:
- Forward Contract - It is a personalized arrangement. It involves the exchange of an underlying asset between two parties at a certain exchange during a specific time period.
- Future - A derivative contract involving the exchange of derivatives at a predetermined exchange rate on a future date.
- An option is a kind of derivative contract between two parties. The buyer obtains the right to buy or sell the underlying asset at a set price for a set length of time. However, there is no need to use the right.
- SAFE (Synthetic Agreement for Foreign Exchange): This arrangement takes place in the over-the-counter (OTC) market. It ensures a specific exchange rate for a set length of time.
- Interest Rate Swap: This is a two-party derivative arrangement. It entails the exchange of interest rates in which one party promises to pay the interest rate on the other party's loans in various currencies.
b) Cash Instruments
Cash instruments are easily transferable and marketable. Furthermore, market conditions have a direct impact on the value of these financial instruments. There are two kinds of cash instruments:
- Securities are monetary financial instruments that trade on the stock market. When you buy a security (share), you are buying a piece of a publicly traded corporation on the stock exchange.
- Deposits and loans are both cash instruments because they reflect monetary assets and bind both parties to a contract.
c) Foreign Exchange Financial Market Instruments
Overseas exchange instruments, which include currency agreements and derivatives, are traded in overseas markets. These are the world's most liquid and major trading volume markets. The trade volume ranges from billions to trillions of dollars.
Since the forex market is open 24 hours a day, seven days a week, many financial institutions, brokers, and banks deal with these instruments.
d) Mutual Funds
A mutual fund is a fund that is created via the contributions of several investors. The funds are subsequently invested in marketable securities such as shares, bonds, money market instruments, and other securities.
It provides investors with the chance to participate in diversified and professionally managed assets at a cheap cost. You have the option of having these funds handled by qualified and professional portfolio managers who will conduct extensive studies before investing your money.
Asset Classification of Financial Instruments
In addition to the previously mentioned classifications, financial instruments can be divided into two asset classes: equity instruments and debt instruments. Let's look at how these two groups are recorded in financial statements.
- Equity instruments are valued at fair value, less any issuing costs. In many circumstances, equity shares are recorded at face value, with any additional consideration recorded as a share premium. The share premium is reduced by any issuing costs.
- Debt instruments are reported at the cost of acquisition, with any premium or discount above the par value amortized during the asset's life. The expenses of transactions are capitalized.
They are further classified into three types:
- Spot: The actual exchange of currency in this currency arrangement occurs no later than the second working day following the original date of the agreement. The currency exchange is referred to as a spot since it occurs on the spot (within a limited window).
- Outright Forwards: In this currency transaction, the actual exchange of currency occurs 'forwardly' and before the agreed-upon date. This is advantageous in the event of fluctuating currency rates.
- Currency Swap: The simultaneous purchase and sale of currencies with different set value dates.