Instruments are a means to an end. You want to create music, you need a musical instrument. You want to see videos, you need an audio-visual instrument/equipment. Similarly, you want to make some money, you need to own a financial instrument. Financial instruments are financial contracts between interested parties. They can be created, traded, modified and settled. There are different types of financial instruments, viz, currency, share and bond.
Types of Financial Instruments
Financial instruments can be either cash instruments or derivative instruments:
Cash instruments
Cash instruments are those whose value is determined directly by the markets. They can be securities, which are readily transferable and loans and deposits, where both borrower and lender have to agree on a transfer.
Derivative instruments
Derivative instruments are those which derive their value from the value and characteristics of one or more underlying entities such as an asset, index, or interest rate. They can be exchange-traded derivatives and over-the-counter (OTC) derivatives.
Furthermore, the financial instruments can be classified based on the ‘asset class’ into ‘equity-based’ or ‘debt based’. If the instrument is debt, then they can be further categorized as ‘short-term debt’ and ‘long-term debt’. Foreign exchange instruments and transactions are neither debt- nor equity-based and belong in their own category.
To summarize:
Asset class | Instrument type | |||
Securities | Other cash | Exchange-traded derivatives | OTC derivatives | |
Debt (long term) > 1 year | Bonds | Loans | Bond futures Options on bond futures | Interest rate swaps Interest rate caps and floors Interest rate options Exotic derivatives |
Debt (short term) ≤ 1 year | Bills, e.g. T-bills Commercial paper | Deposits Certificates of deposit | Short-term interest rate futures | Forward rate agreements |
Equity | Stock | N/A | Stock options Equity futures | Stock options Exotic derivatives |
Foreign exchange | N/A | Spot foreign exchange | Currency futures | Foreign exchange options Outright forwards Foreign exchange swaps Currency swaps |
Long term Debts (More than one year)
- Bonds: The bond is a debt security, under which the issuer owes the holders a debt and (depending on the terms of the bond) is obliged to pay them interest (the coupon) or to repay the principal at a later date, termed the maturity date.
- Loans: In finance, a loan is the lending of money by one or more individuals, organizations, and/or other entities to other individuals, organizations etc. The recipient incurs a debt, and is usually liable to pay interest on that debt until it is repaid, and also to repay the principal amount borrowed.
- Bond Futures: A futures contract (more colloquially, futures) is a standardized forward contract, a legal agreement to buy or sell something at a predetermined price at a specified time in the future. The asset transacted is usually a commodity or financial instrument. In a bond futures, the asset is a bond.
- Options on bond futures: An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on a specified date, depending on the form of the option. Here the asset is a bond futures.
- Interest rate swaps: An interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a linear IRD and one of the most liquid, benchmark products.
- Interest rate caps and floors: An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
- Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price. Caps and floors can be used to hedge against interest rate fluctuations.
- Interest rate options: An Interest rate option is a specific financial derivative contract whose value is based on interest rates. Its value is tied to an underlying interest rate, such as the yield on 10-year treasury notes.
- Exotic derivatives: An exotic derivative, in finance, is a derivative which is more complex than commonly traded “vanilla” products.
Short Term Debts (Less than one year)
- Bills: A United States Treasury security is an IOU from the US Government. It is a government debt instrument issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Treasury securities are often referred to simply as Treasuries.
- Deposits: A deposit account is a savings account, current account or any other type of bank account that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank’s books, and the resulting balance is recorded as a liability for the bank and represents the amount owed by the bank to the customer. Some banks may charge a fee for this service, while others may pay the customer interest on the funds deposited.
- Certificates of Deposit: A certificate of deposit (CD) is a time deposit, a financial product commonly sold in the United States and elsewhere by banks, thrift institutions, and credit unions.
- Short-term interest rate futures: An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset.
- Forward Rate Agreement: A forward rate agreement (FRA)is an interest rate derivative (IRD). In particular, it is a linear IRD with strong associations with interest rate swaps (IRS)..
Equity
- Stock: The stock of a corporation is constituted of the equity stock of its owners. A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares.
- Stock Options: In stock options, the underlying asset is a stock.
- Equity Futures: In equity futures, the asset transacted is an equity/share.
- Exotic Derivatives: An exotic derivative, in finance, is a derivative which is more complex than commonly traded “vanilla” products. This complexity usually relates to determination of payoff.
Foreign Exchange
Foreign exchange instruments in the form of cash/currency are Spot foreign exchange and those in form of exchange traded derivatives are currency futures and over the counter derivatives are foreign exchange options, outright forwards, foreign exchange swaps and currency swaps.
Jobs related to Financial Instruments
Some of the jobs related to financial instruments are as follows:
1. Derivative Strategist
A derivatives strategist works with products like swaps, futures, options, variance swaps, dispersion, exotic and hybrid options. The main focus is on clients such as institutional investors like hedge funds, asset managers, pensions, endowments and insurance. A derivative strategist is responsible for generating trade ideas on bespoke client requests such as volatility, macro cross-asset, hedging, etc. He participates in the sales pitch and strategy presentations for various products/strategies. He assists in writing strategy papers along with corresponding backtesting.
2. Treasury Analyst
A treasury analyst is in charge of an organization’s financial activity, managing cash flow, credit, income, asset levels, and liability obligations. Their exact job duties may vary depending on their employer (for example, whether they work at businesses, non-profit organizations, or government agencies). Generally, though, these professionals coordinate with all internal finance, accounting, and accounts departments to ensure correct money management. Treasury analysts may also be tasked with analyzing financial patterns and making projections for income and expenses, as well as assisting in the development of investment strategies.
3. Market Risk Analyst
Market risk analysts provide a company or investor with information on market trends. Risk analysts must have an overall grasp of the industry in which they are conducting research in order to be able to provide a comprehensive market assessment. Information provided by analysts may be used by a company to inform decisions about possible investments and proposed ventures. Market risk analysts perform research to determine the probability of asset loss or reward from investments in their particular industry. Tasks may include
- Conducting statistical analyses
- Developing risk management systems
- Consulting with securities traders
- Reporting and presenting research results
4. Equity Research Associate
Equity research associates play a significant role in putting together the research reports and other information that investors receive on stocks, bonds and mutual funds. Their work involves extensive research and number-crunching to building expertise on particular companies or a specific industry. An equity research associate is a cross between a corporate finance analyst and a statistician. Associates are responsible for researching companies, projecting earnings, following overall market trends and producing research reports on the companies they follow.
5. Equity Analyst
The role of an equity analyst is to analyze financial data and public records of companies, and use this analysis to determine the value of the company’s stock and to predict the company’s future financial picture. This job is focused heavily on research and analysis.
There are many other jobs related to financial instruments. In fact, it would not be wrong to say that most of the jobs in the financial industry can be traced to the financial instruments. Hope you find this article interesting. Do keep visiting us on “edupristine blogs” for blogs related to myriad other topics that you may find interesting.
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