Financial Instrument: Written legal obligation of a transfer of something of value from one party to another party at some future time under certain conditions.
Let’s break this definition down into four parts:
- Legal Obligation: Financial Instruments are backed by government rules and regulations. If you violate the agreement set forth in an instrument, you are subject to legal penalties.
- Transfer something of value from one party to another: Typically a financial instrument will dictate the payments of money from one person/firm to the other.
- At some future date: So instruments will have a time dimension tied to them. Many loans require a monthly payment for the next years. The instrument will be specific on when money changes hands.
- Under specific conditions: Some instruments will have rules on when money is to be transferred. The simplest example is that of insurance. The insurance company will pay a claim only under certain conditions.
Uses of Financial Instruments
Financial Instruments are typically used for three uses:
- Means of Payment: purchases of goods and services, eg. stock options as part of employment.
- Store of Value: Transfer of buying power into the future, eg Retirement Accounts, Stocks, and Bonds etc.
- Transfer of Risk: Typically transfers risk from a person to a company, eg Insurance.
The last two are the most common. Not too many financial instruments are used directly for purchasing goods and services. That’s what money is for. The typically behavior is to take a financial instrument, turn it into money, and then make a purchase.
Characteristics of Financial Instruments: Standardization and Information
Given the definition and multiple uses of financial instruments, it is not surprising that these instruments can have very complex contracts. These complications make financial agreements costly to maintain and monitor. Thus we find a substantial amount of standardization of instruments. This is simply the practice having several instruments with the same basic rules and payouts. Even though hundreds of companies offer auto insurance, each policy has several of the same features. Without standardization the buying and selling of financial instruments would become extremely costly.
A second feature of instruments is that they communicate information. Collecting and communicating information can be very costly. Thus, instruments are typically designed to gather information. On one side, the borrower will typically provide information to the financial firm. The firm typically has specialists which can use this information to design the appropriate financial instrument.
Underlying versus Derivative Instruments
There are two general classifications of instruments: underlying and derivative.
- Underlying Instruments: These instruments are used by savers or lenders to transfer resources directly to investors or borrowers. The standard example of these is stocks and bonds.
- Derivative Instruments: The value and payoff of the instruments are derived from behavior. Examples of derivatives include futures and options. The derivative specifies a payment between the buyer and seller. The payment is contingent on the price of the instrument.
A Primer for Valuing Financial Instruments
Here’s are first look as to why different instruments have different values. There are four basic properties which alter the value of a financial instrument:
- Size: The larger the payment, the higher the value.
- Timing: Economic Agents are impatient. The sooner the payments; the higher the value.
- Likelihood: The more likely it is that payments will be made; the higher is the value of the associated instrument.
- Circumstances: Payments that are made when most needed are most valuable.eg we only buy insurance against bad events.
Examples of Financial Instruments
Financial Instruments Used Primarily as Stores of Value
- Bank Loans: The borrower obtains resources from the bank immediately in exchange for a set of future payments.
- Bonds: Similar to bank loans except that the borrower is typically and from or government. The borrower issues a bond which is purchased by another party, the lender, for some price. The borrower uses cash to make purchases. The lender holds the bond which guarantees some future lump sum payment or a stream of future interest payments.
- Mortgages: Simply a loan to purchase real estate. In most mortgages the house serves as collateral. This means that if the borrower defaults, the lender gains ownership of the house. The use of collateral simply transfers risk from the lender to the borrower. Set up properly, the lender faces minimal risk.
- Stocks: The holder of a share owns a small piece of the firm and is entitled to a portion of the profits. Firms typically issue stock to raise funds.
Financial Instruments Used Primarily to Transfer Risk
- Insurance Contracts: The buyer of the contract makes premium payments to the other party under the condition that the other party must make payments under certain conditions.
- Futures Contracts: An agreement to trade an asset at some future date at some fixed price.
- Options: The holder receives the right to buy or sell a fixed amount of an asset at a predetermined price at specific date or during a specific period. It is important to realize that it is a choice to buy or sell not a requirement.
Financial Institutions are the firms which provide access to financial markets. These institutions serve as a middle man between savers and borrowers and are thus sometimes called financial intermediaries. The main purpose of a financial institution is to reduce transactions costs by specialization in some particular financial instrument. These firms also reduce information costs by having efficient methods of monitoring and screening potential borrowers. Financial institutions streamline many things which individual would find costly or impossible to do. Think about investing in the stock market without a brokerage firm…
The Structure of the Financial Industry
The structure of financial industry is summarized by breaking firms into two categories: depository and non-depository institutions. A depository institution takes in deposits and makes loans. These are more typically called banks. Non-depository institutions trade other financial instruments. These include insurance companies, securities firms, pension funds, and others. We can generally classify financial firms into six categories:
- Depository Institutions: These firms take in deposits and make loans. These include commercial banks, savings and credit unions among others.
- Insurance Companies: These firms accept premiums which are typically invested. In return, they promise to pay compensation to policyholders should a certain event occur. You name an event and you can probably buy insurance for it.
- Pension Funds: These firms invest individual or group contributions into the financial market in order to provide retirement payments. These firms include companies like NSSF.
- Securities Firms: These firms include brokers, investment banks, and mutual fund companies. These firms act like middle men. They give individuals access to financial markets. The individual faces the risk of the investment.
- Finance Companies: Use a pool of assets to make loans to customers. Unlike banks, these firms use financial debts to make loans not deposits.
- Government-Sponsored Enterprises: Government agencies which provide loans directly to farmers and sometimes home mortgagors. These firms include AFC. This segment of the market also covers Social Security and Medicare.