Financial Instrument
Tue, Apr 15A financial instrument is a type of asset, specifically referring to contracts that can be traded, transferred, or exchanged. For instance, if you issue an IOU for $100 to someone, and that individual then passes the IOU to a third party who can come to you to claim the $100, that document stating “I owe you $100” serves as a basic financial instrument.
Financial instruments involve a situation where one party owes another something, which could be cash, partial ownership in a company, interest, or the future delivery of another asset. They encompass equities (shares), loans, bonds, currencies, futures contracts, options, and U.S. Treasury bills and notes.
However, there are other types of assets beyond financial instruments. An asset can be anything of value that has a price. Examples of assets include:
- Barrels of oil
- Bushels of corn
- Gold bars
- Shares of company stock
- Bitcoin
- Rare paintings
- Stock index futures contracts
While corn, gold, and oil themselves are not financial instruments, a contract for the immediate or future delivery of these commodities qualifies as a financial instrument.
There are two main categories of financial instruments: cash instruments and derivative instruments.
Cash instruments derive their value from the market's perception of their worth. Buyers and sellers agree on a price. In the case of debt instruments, borrowers and lenders negotiate the amount to be transferred or loaned, along with the interest rate and repayment terms.
On the other hand, derivative instruments, as the name suggests, obtain their value from another asset, measurement, interest rate, or variable, or even from another derivative. The price fluctuations of the underlying asset influence the derivative's value.
For example, if the price of Netflix shares rises from $500 to $600, the value of an options contract based on that stock would likely increase as well. Here, the underlying asset is Netflix stock.
The exact increase in the derivative's price is not determined by a fixed formula; instead, it is established by the interactions of buyers and sellers. As the value of a Netflix share increases by $100, it follows that the derivative linked to that asset would also gain in value. Sellers will seek a higher price, while buyers will be inclined to pay more.
For traders, having accurate price data is crucial to ensure they are aware of the true value of the underlying asset.
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