An Insight into Understanding Types of Financial Instruments

in Business

If you are not a broker or a seasoned investor, listening to talk about trade can sound a bit like a foreign language. Professionals have devoted years of formal and informal study to acquire their knowledge of markets. Still, you can obtain a working knowledge with a solid overview and some helpful tips.

Let’s start with some insight into financial instruments, which can be defined as tradable assets or capital packages. The major categories of financial instruments include stock indices, government treasuries, commodities, derivatives, and forex.

Stock Indices

Stock can be termed as a share of ownership in a firm. Stock indices list company stock from specific sectors or based on market caps and represent the broader stock market’s performance or portion of it. To enable investors to easily compare investment returns, select stock prices are typically weighted when they are listed on an index. The S&P 500 is one among the best known financial instruments, listing stocks of up to five hundred companies; the movement of this index is an important indicator of the performance of the United States stock exchange.

Similarly, the Australia 200 is made up of the two hundred largest ASX stocks and serves as the primary index for the country’s equity performance. Indices themselves are effectively just numbers, so to trade on their value requires a product that reflects their performance, including index funds, exchange-traded funds, and derivatives.

Government Treasuries

Also known as bonds, government treasuries are some of the safest financial instruments due to the guarantee on returns that goes along with their purchase. When you purchase a bond, you are entering a contract to hold the bond for a specified period; when that time has passed, the bond has matured, and the issuer will repay you the principal value plus a specified interest rate.

Corporations and governments frequently seek bonds instead of bank loans because they function the same but generally have lower interest rates and are unconditional. Bonds provide a predictable and reliable stream of income and can be used to effectively hedge risk.

Commodities

Commodities are physical goods that enable further portfolio diversification. These financial instruments include energy, where crude oil is the most traded, followed by natural gas. Metals, both industrial and precious, are heavily traded, with gold, silver and platinum topping the list.

Because of the reliability and enduring value, many investors look to precious metals as an instrument to hedge against inflation or to offset the devaluation of the currency. Agricultural products are also a frequently traded commodity, including live cattle, lean hogs, pork bellies, soybeans, corn, wheat, coffee and cocoa.

Derivatives

A derivative can be termed as a financial instrument whose value is derived from its underlying asset. These include swaps, options, and futures. Derivatives are frequently used for risk management as an instrument for hedging. They are also popular for speculation and exploiting price differences between multiple markets. In addition, the transaction costs for derivatives are generally less than other financial instruments. ASX SPI futures are the benchmark derivative instrument for hedging and trading in the Australian equity index market.

Forex

Forex is the converting one currency to another, facilitating international investment and trade by enabling businesses that earn in one type of currency to pay in another. Forex is traded in pairs by purchasing one currency and simultaneously selling another. Investors in this instrument include individuals seeking minor profits from value fluctuations, central banks attempting to limit the circulation of currency and major international banks that control over 50% of the global forex market. Forex is one of the financial instruments traded over-the-counter instead of through a brokerage or exchange.

Financial instruments may be real or virtual, cash or derivative, representing a legal agreement involving monetary value. The important takeaway is that they don’t have to feel overwhelming. There are many different financial instruments available with varying levels of risk and commitment to round out even the beginner’s investment portfolio.


Image Credits: Burak K

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