All about financial instruments

Is share market investing on your radar? Before you jump in and start investing, make sure you
have the basics down. For instance, do you know about the different financial instruments that
are available on the share market? A clear knowledge of how each instrument works will help
you make better decisions regarding your portfolio.
Basics of financial instruments
Financial instruments enable the flow of capital through financial markets around the world.
When you transact in the share market, the item you buy or sell is called a financial instrument. It
is essentially a legal agreement that documents a monetary value. It could be a physical
document or a digital one. A financial instrument could be cash, a contract to pay or receive cash
or some other instrument, or proof of one’s ownership of an asset.
Types of financial instruments
Financial instruments can be categorised according to the market segments that they belong
to—whether cash or derivatives.

  1. Cash instruments
    The value of cash instruments depends on how they are traded on the markets. Their demand and
    supply affect their market value. Cash instruments are generally liquid, which makes them easy
    to transfer. Shares and bonds are cash instruments in the share market. Cheques in the banking
    sector are also cash instruments.
  2. Derivative instruments
    A derivative instrument is a contract between two parties for an underlying asset. The value of
    the instrument takes its value from that of the underlying assets, which may be shares, stock
    market indices, or interest rates, for example. Futures and options contracts are examples of
    derivative instruments. They can be traded on the stock exchange or over the counter (OTC).
    Asset classes of financial instruments
    Financial instruments can also be classified based on their asset classes. Thus, you have debt-
    based, equity-based, and foreign exchange (forex) instruments.
  3. Debt-based instruments

Debt-based instruments represent a loan provided by the investor to the asset holder. Such
instruments can be subdivided into long-term and short-term instruments. Securities like bonds,
exchange-traded derivatives like bond futures and options, and OTC derivates like interest rate
swaps are examples of long-term debt-based financial instruments. Examples of short-term
instruments include securities like treasury bills, exchange-traded derivatives like short-term
futures, and OTC derivatives like forward-rate agreements.

  1. Equity-based instruments
    Equity-based financial instruments reflect ownership of the issuing entity. In other words, the
    holder of such an instrument gains ownership of an asset. Securities like stocks, along with
    exchange-traded and OTC derivatives like stock options and futures, are examples of equity-
    based instruments.
  2. Forex instruments
    Forex currencies represent a third category of financial instruments. Spot forex is an example of
    instruments traded in the cash segment. In the derivatives segment, currency futures can be
    traded on the exchange and foreign exchange forwards and swaps in the OTC market.
    Final word
    The different financial instruments are designed to meet different financial needs. For instance,
    investors who are risk-averse prefer to invest in bonds which bring steady but low returns.
    Equities fetch higher returns but are also riskier. And while currency investments serve as a
    hedge against risk, they are less suitable than stocks and bonds if you are saving up for
    retirement.
    If you are just starting out, open an account with a full-service broker like Kotak Securities. This
    will enable you to invest in a wider range of financial instruments across different segments and
    asset classes.

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