Types of financial instruments
Types of financial instruments
There are three main types of financial instruments:
Equities (Stocks)
Fixed income (Bonds)
Derivatives
Equities
Equities represent ownership interest in a company, typically in the form of stocks. When an investor purchases equity shares, they are buying a fraction of the company and are entitled to a portion of its profits, usually distributed as dividends.
Equities can be categorised into two main types: common stock and preferred stock. Common stock provides voting rights and potential dividends, but holders face greater risks, including the possibility of losing their entire investment. Preferred stock, on the other hand, generally does not offer voting rights but grants fixed dividends and has priority over common stock in asset distribution if the company liquidates.
Investing in equities is often considered a key component of building wealth over the long term. Historically, equities have outperformed other asset classes, such as bonds or cash equivalents, due to the potential for capital appreciation and income generation. However, they also come with higher volatility and risk, as stock prices can fluctuate based on company performance, market conditions, and economic factors.
Investors typically purchase equities through stock exchanges, where shares are bought and sold. The value of equities can change rapidly, influenced by various factors including company earnings, economic indicators, industry trends, and broader market movements. Diversification across different sectors and regions can help mitigate risks associated with equity investments.
Fixed income
Fixed income, commonly associated with bonds, refers to investment vehicles that provide returns in the form of regular, fixed interest payments and the return of principal at maturity. Bonds are essentially loans made by investors to borrowers, typically governments, municipalities, or corporations.
When an entity issues a bond, it promises to pay a specified amount of interest (the coupon) at regular intervals over the life of the bond, as well as to repay the principal (the face value) at maturity. The interest rate, or yield, is often determined at the time of issuance and can vary based on factors such as the creditworthiness of the issuer, prevailing interest rates, and overall economic conditions.
Bonds are generally classified into several categories:
Government Bonds: Issued by national governments and often considered low-risk, as they are backed by the government's ability to raise taxes or print currency. Examples include U.S. Treasury bonds.
Corporate Bonds: Issued by corporations to raise capital, these typically carry higher risk compared to government bonds, resulting in potentially higher yields.
Municipal Bonds: Issued by states, cities, or other local government entities, these bonds often offer tax-exempt interest income to investors.
Foreign Bonds: Issued by foreign governments or corporations, these can provide diversification but carry additional risks, including currency and political risks.
Investors choose fixed income securities like bonds for several reasons, including income generation, portfolio diversification, and risk management. While generally less volatile than stocks, bond prices can fluctuate based on changes in interest rates, credit ratings, and market conditions. In an environment of rising interest rates, bond prices typically fall, and vice versa.
Overall, fixed income investments serve as a fundamental component of a balanced investment portfolio, particularly for those seeking stable income and lower volatility.
Derivatives
Derivatives are financial instruments whose value is derived from the performance of an underlying asset, index, or rate. They can be based on a variety of assets, including stocks, bonds, currencies, interest rates, and commodities. Derivatives are primarily used for risk management, speculation, and arbitrage.
There are several types of derivatives, the most common being:
Futures Contracts: These are agreements to buy or sell an asset at a predetermined price at a specified time in the future. Futures are standardised and traded on exchanges.
Options Contracts: These provide the holder the right, but not the obligation, to buy or sell an asset at a set price before a specific expiration date. Call options give the right to buy, while put options give the right to sell.
Swaps: These are agreements between two parties to exchange cash flows or financial instruments. Common types include interest rate swaps and currency swaps.
Forwards: Similar to futures, forwards are customised contracts that obligate the buyer to purchase, or the seller to sell, an asset at a specified future date and price. Unlike futures, forwards are traded over-the-counter (OTC) and are not standardised.
Derivatives can be used effectively to hedge against risks. For instance, a farmer might use futures contracts to lock in the price of crops, ensuring predictable revenue despite fluctuating market prices. Conversely, they can also be used for speculative purposes, allowing traders to bet on the future direction of an asset’s price.
While derivatives can offer significant benefits, such as increased liquidity and leverage, they also carry inherent risks, including the potential for substantial losses. Thus, their use necessitates a thorough understanding of the underlying assets and market dynamics.