Types of Financial Instruments in the Stock Market
The history of financial instruments is as old as the history of financial transactions. Barter could be called the precursor to all financial instruments; many would argue its history as old as the history of homo sapiens as a species itself. But moving on, the first paper money is generally attributed to have come from the Tang Dynasty (617–907 BCE) of China, and the first coins can be traced back to the Lydian civilisation in 700 BC. Currency, thus, forms the first financial instrument. Currency was closely followed by derivatives, which were used as far back as 2 BCE in Mesopotamia and for harvest speculations in ancient Greece. However, derivatives only grew in popularity in the late 20th century, beginning in the 1970s. While the exchange of coinage has occurred since ancient times, foreign exchange as financial instruments only started forming with modern standards.
Types of financial instruments
The types of financial instruments can be classified into three different categories. Namely, they are cash, derivatives and foreign exchange.
- Cash instruments refer to a class of financial instruments whose values are directly shaped by market conditions. Cash instruments are of two types: one, securities and two, debts and loans.
- Securities refer to financial instruments which have monetary value and are traded on the stock markets.
- Debts and loans refer to financial instruments that represent monetary assets in contracts or agreements between parties.
- Derivatives refer to financial instruments which derive their value from underlying assets. The primary forms of derivative instruments include futures, forwards, swaps, options, and synthetic agreements.
- Futures are standardised contracts for the exchange of underlying assets traded on regulated exchanges and settled via a central counterparty (CCP).
- Forwards are customisable contracts for exchanging underlying assets with lax regulations and traded on the Over Counter (OTC) markets.
- Options provide the buyer a right to buy or sell underlying assets for a fixed price at a specific time in the future but do not impose the legal obligation to do so.
- Swaps refer to bilateral agreements in which the two parties agree to exchange revenue streams from two different sources for a fixed time at the end of the contract duration.
- Synthetic agreements are agreements that guarantee a fixed exchange rate which is specified at the time of the agreement for a fixed time.
- Foreign exchange refers to a unique category of financial instruments that involve trade in the world's different currencies.
Financial instruments can also be categorised based on their asset class. The two types of financial instruments based on asset class are:
- Debt-based financial instruments refer to financial mechanisms used by an economic entity to increase capital in the business.
- Equity-based financial instruments refer to financial mechanisms that form the basis for legal ownership of an asset.
Different types of financial instruments in India, such as stock trade, mutual funds, and F&O. All fall under the above classification.
Financial instruments form the base of all financial transactions. Different financial instruments provide additional values to financial markets. They evolve as the world of finance evolves and grows, creating ever-changing trends. Investors and traders in the pursuit of greater profits or financial stability follow those trends. The rise in electronic trading systems led to digital cryptocurrencies such as Bitcoin and the growth of digital paperless transactions. Financial instruments can evolve, which makes them an irreplaceable part of finance.
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