What Are Financial Instruments? Types and Asset Classes

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A financial instrument is a contract that gives one party a financial asset and another party a matching financial liability or ownership stake. Stocks, bonds, loans, bank deposits, checks, certificates of deposit (CDs), fund shares and derivatives such as options, futures and swaps are all financial instruments. Each one confers a right or an obligation that has monetary value and can usually be traded, transferred or settled.

Financial instruments are typically grouped in two ways: by type (cash instruments vs. derivative instruments) and by asset class (debt-based, equity-based and foreign exchange). The two groupings overlap, so a single instrument has both a type and a class. A Treasury bill is a debt-based cash instrument. A stock option is an equity-based derivative.

What makes something a financial instrument

The test is whether a contract creates a claim. International Accounting Standard 32 (IAS 32) defines a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A bond is an asset for the investor and a liability for the issuer. A share is an asset for the shareholder and an equity instrument of the company.

In practice, a financial instrument takes one of three forms:

1. Cash itself, or a document that moves cash, such as a check.
2. A contractual right to receive or deliver cash or another financial instrument, such as a loan, bond or derivative.
3. Evidence of ownership in an entity, such as common or preferred stock.

The “document” can be paper or purely electronic. Most shares and bonds today exist only as entries in brokerage and depository records, with the same legal claim as a paper certificate.

Instruments are what allow capital to move between savers, investors, businesses and governments. A company raises money by issuing shares or bonds; a bank funds loans partly through deposits; an exporter hedges future currency receipts with a forward contract. In each case the instrument defines who pays whom, how much and under what conditions.

Cash instruments vs. derivative instruments

Cash instruments

The value of a cash instrument is set directly by the market or by the agreement between the parties. There is no separate underlying asset driving the price.

• Securities such as stocks and bonds are cash instruments that can be readily bought and sold. They are sometimes called primary instruments.
• Deposits and loans are cash instruments agreed between borrowers and lenders. Their value comes from the contract terms (principal, interest and repayment schedule), not from a market quote.
• Checks are cash instruments because they transfer payment from one bank account to another.

Derivative instruments

A derivative’s value depends on something else: a stock, bond, commodity, currency, interest rate or index. The main forms are:

• Options, which give the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a set price by a set date.
• Futures, standardized exchange-traded contracts to buy or sell an underlying at a set price on a future date.
• Forwards, customized versions of the same idea agreed privately between two parties.
• Swaps, agreements to exchange cash flows, such as fixed interest payments for floating ones.

A hypothetical call option shows how the dependence works. Suppose a stock trades at $48 and you buy a call with a $50 strike price for a $3 premium per share. A standard U.S. equity option covers 100 shares, so the premium costs $300. If the stock is at $60 at expiration, the option is worth $10 per share ($60 minus $50), or $1,000, for a gain of $700 before commissions. If the stock finishes at or below $50, the option expires worthless and you lose the $300. Before expiration, the option’s price rises and falls with the stock, though not by the same percentage.

Derivatives trade in two venues. Exchange-traded derivatives have standardized terms and are cleared through a central clearinghouse. Over-the-counter (OTC) derivatives are negotiated directly between parties, which allows custom terms but exposes each side to the other’s ability to pay.

Asset classes of financial instruments

Debt-based instruments

A debt instrument is a loan from the investor to the issuer, repaid with interest. Debt instruments are split by maturity.

Short-term debt (one year or less):

• Cash instruments: Treasury bills, commercial paper, bank deposits and CDs. Deposits and CDs count as debt instruments because the bank owes the depositor principal plus interest.
• Exchange-traded derivatives: short-dated interest rate futures.
• OTC derivatives: forward rate agreements, which lock in an interest rate for a future borrowing period.

Long-term debt (more than one year):

• Cash instruments: bonds, mortgage-backed securities and long-term loans.
• Exchange-traded derivatives: fixed-income futures and options, such as Treasury bond futures.
• OTC derivatives: interest rate swaps, interest rate caps and floors, and long-dated interest rate options.

Fixed-rate debt instruments carry interest rate risk: when market rates rise, existing bonds with lower coupons lose value.

Equity-based instruments

Equity instruments represent ownership. The main cash instruments are common stock, which usually carries voting rights and a residual claim on profits, and preferred stock, which typically pays a set dividend and ranks ahead of common stock but often has limited or no voting rights. Some companies issue several classes of common stock with different voting rights; Alphabet’s GOOG and GOOGL shares are a well-known case.

Pooled vehicles that hold stocks, such as equity ETFs and stock mutual funds, are also equity-based instruments, as are shares of real estate investment trusts (REITs). Exchange-traded derivatives in this class include stock options, index options and equity futures.

Foreign exchange instruments

Foreign exchange (forex) instruments are often treated as a third, distinct class because a currency trade is neither a loan nor an ownership stake. It is an exchange of one currency for another.

• Spot transactions convert one currency into another for immediate settlement (conventionally two business days for most pairs).
• Forwards and futures fix an exchange rate for a future date.
• Currency options give the right to exchange at a set rate.
• Currency swaps exchange principal and interest in one currency for the same in another.
• Contracts for difference (CFDs) settle the price change of a currency pair in cash without delivery. CFDs are not available to retail traders in the United States, though they are widely offered elsewhere.

Financial instruments vs. securities

A security is a tradable financial instrument, typically one that can be bought and sold on a market and is regulated as such. In the United States, securities fall under laws such as the Securities Act of 1933 and the Securities Exchange Act of 1934. Stocks, bonds, ETF shares and mutual fund shares are securities.

The broader category of financial instruments also includes contracts that are not securities: personal and business loans, bank deposits, checks and many OTC derivatives. The difference matters for investors because securities come with disclosure rules and trading protections that a private loan agreement or bank deposit does not carry (deposits have their own protections, such as deposit insurance).

Financial instruments vs. financial intermediaries

Instruments are the contracts. Financial intermediaries are the institutions that create, hold or match them: banks, brokers, insurance companies, pension funds and mutual fund companies. A bank is an intermediary; the deposit and the mortgage it handles are instruments. A fund company is an intermediary; the fund share you buy is the instrument.

Are commodities financial instruments?

Physical commodities such as gold, crude oil, wheat or copper are traded on global markets, but they are not financial instruments. A bar of gold or a barrel of oil is a physical good; it does not give anyone a claim against a counterparty.

Contracts based on commodities are a different matter. Commodity futures, forwards, options and swaps are financial instruments because they create rights and obligations between the parties. Commodity ETFs that hold futures contracts, and shares of mining or energy companies, are also financial instruments. The contract or share is the instrument; the commodity is its underlying.

Is an insurance policy a financial instrument?

Insurance policies are not securities, but they can be viewed as an alternative type of financial instrument. A policy is a legally binding contract under which the insurer must pay a monetary benefit when specified conditions are met, such as the insured person’s death under a life policy. That creates a claim for the policyholder and an obligation for the insurer.

Some policies carry additional financial value. Permanent life insurance builds a cash value the owner can borrow against or surrender, alongside the death benefit. Policies issued by a mutual insurer may give the policyholder an ownership interest and a claim to dividends.

Examples of financial instruments

The Bottom Line

Investors comparing stocks, bonds, deposits, funds and derivatives can use these groupings to see what each one actually promises. Classifying an instrument by type and asset class shows where its value comes from and what risks it carries. Checking whether it is also a security matters, because securities carry disclosure rules and trading protections that private loans and many OTC contracts do not.