A financial instrument is an asset, but refers specifically to contracts that can be traded, transferred, or exchanged.

Introduction

A financial instrument is defined as a contract between individuals/parties that holds a monetary value. They can either be created, traded, settled, or modified as per the involved parties' requirement. In simple words, an asset that holds capital and can be traded in the market is a financial instrument.

Examples of financial instruments are cheques, shares, stocks, bonds, futures, and options contracts.

Understanding Financial Instruments

Financial instruments can be primarily classified into two types - derivative instruments and cash instruments.

Derivative instruments are instruments whose characteristics and value can be derived from their underlying entities, such as interest rates, indices, or assets, among others. The value of such instruments can be obtained from the performance of the underlying component. Also, they can be linked to other securities such as bonds and shares/stocks.

On the other hand, they 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, where the lenders and borrowers must be agreed upon.

Other Classifications

Financial instruments can also be classified based on the asset class, i.e., equity-based and debt-based financial instruments.

Equity-based financial instruments include securities, such as stocks/shares. Also, exchange-traded derivatives, such as equity futures and stock options, fall under the same category.

On the other hand, debt-based financial instruments consist of short-term securities, such as commercial paper (CP) and treasury bills (T-bills), which have a maturity period of one year or less.

Cash instruments such as certificates of deposits (CDs) also fall under this category. Similarly, exchange-traded derivatives, such as short-term interest rate futures, fall under this category.

Since the maturity period on long-term debt-based financial instruments exceeds a year, securities such as bonds fall under the category. Exchange-traded derivates include bond futures, and options are the other examples.