Financial Instrument

What are Financial Instruments?

Financial instruments are certain contracts or any document that acts as

financial assets such as debentures and bonds, receivables, cash deposits,

bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA

or forward rate agreement, etc to one organization and as a liability to

another organization and these solely taken into use for trading purposes.

Types of the Financial Instrument

The three types of financial instruments are mentioned below:
 1. Money Market Instruments: Money market instruments include call

or notice money, caps and collars, letters of credit, forwards and

futures, financial options, financial guarantees, swaps, treasury

bills, certificates of deposits, term money, and commercial papers.

2. Capital Market Instruments: It includes instruments like equity

instruments, receivables, and payables, cash deposits, debentures,

bonds, loans, borrowings, preference shares, bank balances, etc.

3. Hybrid Instruments: It includes instruments like warrants, dual

currency bonds, exchangeable debt, equity-linked notes, and

convertible debentures, etc.

Example of Financial Instrument

XYZ Limited is a banking company that issues financial instruments such as

loans, bonds, home mortgages, stocks and asset-based securities to its

customers. These may act as a financial asset for the aforesaid banking

company but for customers, these are nothing but financial liabilities that

must be duly paid on time by them. On the other hand, the amount that is

deposited by the customers in the bank acts as a financial asset for the

customers depositing the same whereas a financial liability for a banking

company.

Advantages
There are several different advantages of the Financial Instrument are as

follows:

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 Liquid assets like cash in hand and cash equivalents are of great use

for companies since these can be easily used for quick payments or

for dealing with financial contingencies.

  Stakeholders often feel more secure in an organization that has

employed more capital in their liquid assets.

 Financial instruments provide major support in funding tangible

assets. This is possible through fund transfer from tangible assets that

are running in surplus values to those tangible assets that are lying in

deficit.

 Financial instruments allocate the risk with respect to the risk-bearing

capacities of the counterparties that have participated in making an

investment intangible assets.

 Companies who choose to make an investment in real assets yield

higher revenues since they get a diversified portfolio, hedged

inflation, and they can also hedge against uncertainties caused as a

result of political reasons.

 Financial instruments like equity act as a permanent source of funds

for an organization. With equity shares, payment of dividends to

equity holders is purely optional. Equity shares also allow an

organization to have an open chance of borrowing and

enjoy retained earnings.

Disadvantages
The different limitations and drawbacks of the Financial Instrument include

the following:

 Liquid assets such as savings accounts balances and other bank

deposits are limited when it comes to ROI or return of investment.

This is high because of the fact that there are zero restrictions for the

withdrawal of deposits in savings accounts and other bank balances.

 Liquid assets like cash deposits, money market accounts, etc might

disallow organizations from making a withdrawal for months or

sometimes years too or whatever is specified in the agreement.

 If an organization wishes to withdraw the money before the

completion of the tenure mentioned in the agreement, then the same

might get penalized or receive lower returns.

 High transactional costs are also a matter of concern for

organizations that are dealing with or wish to deal with financial

instruments.

 An organization must not over-rely on debts like principal and

interest since these are supposed to be paid on a consequent basis.

 Financial instruments like bonds payout return much lesser than

stocks. Companies can even default on bonds.

  Some of the financial instruments like equity capital are Life-long

burden for the company. Equity capital acts as a permanent burden in

an organization. Equity capital cannot be refunded even if the

organization has a sufficient amount of funds. However, as per the

latest amendments, companies can opt for buying-back its own

shares for the purpose of cancellation but the same is subjected to

certain terms and conditions.

Important Points
 Derivatives like forwards and futures can bring huge benefits for

small-sized companies but if only these are taken properly into use. If

these are inappropriately used, then these might cause an

organization to suffer from huge losses and bankruptcy.

 Organizations must be very careful while dealing with swaps since it

carries a higher level of risk.

 Proper management of financial instruments can help firms in cutting

down their material costs and maximize sales and profit figures.

 They are generally used by people who are unable to afford or do not

have access to credit facilities and systematic savings.

  Informal financial instruments offer highly flexible services as per the

needs of an individual. It can be initiated and completed within a few

minutes of applying as it merely needs a simple cash receipt or an

oral agreement.

Conclusion
To conclude, it can be said that the financial instruments are nothing but a

piece of document that acts as financial assets to one organization and as a

liability for another organization. These can either be in the form of

debentures, bonds, cash and cash equivalents, bank deposits, equity shares,

preference shares, swaps, forwards and futures, call or notice money, letters

of credit, caps and collars, financial guarantees, receivables and payables,

loans and borrowings, etc. Each type of financial instrument has its own

advantages and disadvantages.

Financial instruments must be appropriately taken into use for deriving

most benefits out of them. These can be of huge significance for companies

that are looking for minimizing their costs and maximizing their

revenue model. Thus, organizations must make sure that they are properly

using financial instruments so that they can reap greater benefits out of it

and eliminate the chances of them getting backfired.

 Recommended Articles
This has been a guide to what are Financial Instruments. Here we discuss

types and examples of Financial instruments along with advantages and

disadvantages. You can learn more about financing from the following

articles –

 Financial Structure

 Types – Debt Instruments

 Financial Distress

 What is Negotiable Instruments?

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