A financial instrument, or a security, is an asset (an item of value) that can be bought and sold freely on the market.
To make sure investors choose the right instruments for their needs, those instruments are classified into different asset classes based on their characteristics, behavior, or the regulations that affect them.
This article covers the numerous financial instruments that are available for investments and how they are divided into asset classes to offer a clarification for investors.
An asset class groups together financial securities (tradable financial assets that are monitored by a regulatory authority) with similar features based on factors such as:
- The maturity time (the time remaining for a financial security to expire. For a 10-year Government Treasury Bond, the maturity time is 10 years from the date when the bond was issued)
- The issuing authority
- The rate of return for certain assets and the underlying investment process and risk.
The main asset classes are covered below:
As the name suggests these securities or debt instruments pay regular income at fixed intervals and the principal (the actual amount) at the time of maturity. Both government and companies can issue bonds, in order to raise funds from investors and help them earn a steady source of income.
A bond is one of the most commonly used debt instruments. It helps an investor earn fixed regular payments on the actual amount being invested to buy the bonds. The regular payments are calculated based on an interest rate, commonly known as a coupon. The principal amount of the bond is paid in full at the end of maturity period.
Bonds can come under different names. For example, bonds from the US Treasury are called T-bills (short-term), or notes (medium term), or other names.
Let’s take an example: say a 10-year US Government bond is currently trading at a coupon of 2.25%. If you decide to buy bonds worth $1000 you will be entitled to get$22.5 every year for the next 10 years and $1000 on the date of expiry. Government bonds are issued in the bond market to help fund important projects or the budget deficit and carry little or no-risk since they are backed by highest authority — the government.
This asset class has a shorter maturity period (less than a year), thus exhibiting very high liquidity. T-bills, CDs, Commercial Papers (CPs), are common examples of money market instruments.
Equity is a major source of fundraising. Companies list their shares (stocks) on regulated stock exchanges so that investors can purchase them — each stock represents a tiny ownership stake in the company. In exchange, the company will be able to raise funds to run and expand the business.
Since the amount of funds that can be raised is much higher, investors can enjoy huge returns with a comparable increase in risk.
Usually, the higher the risk involved in an equity the better chances it holds for an investor to make profits. But, those profits are linked with the company’s performance and its financial robustness. Shares of a company are offered through an Initial Public Offering (IPO) in the Primary Market and once the shares are listed, they are traded in the Secondary Market. An investor can buy or sell shares depending on his preference, and can consider factors like the company’s performance and the potential risk.
For instance, Amazon’s stock (NASDAQ: AMZN) is currently trading at a stock price of $1162. If you as an investor bought the stock at$900 because you believed that Amazon will continue to perform well in the e-commerce space, you would have reaped a profit by selling your shares today. In contrast, many investors refrain from equity investments since they are subject to market risk and it is sometimes difficult to track stock performance without proper guidance.
Commodities fall into another group of assets that can be traded. Both virtual and physical marketplace for commodities exist and traders can buy or sell through various commodity exchanges. Many different types of commodities are traded almost daily ranging from crude oil, gold, silver, corn, coffee, sugar to milk, cattle, pork, etc.
Popular commodity exchanges are the New York Mercantile Exchange (NYMEX) and Chicago Board of Trade (CBOT), which are closely monitored by the regulatory authorities like the Commodities Futures Trading Commission (CFTC) in the United States.
Commodities are covered in greater detail later in this guide.
Unlike all other exchanges where one of the equivalents is cash or currency, the Foreign Exchange Markets oversee the trading of two or more currencies. The exchange market determines the foreign exchange rate between two currencies based on the supply and demand of currencies. The markets indulge in trading massive volumes and functions primarily as an over-the-counter (OTC) market. When two parties enter into a physical contract without an exchange the transaction is said to be an OTC. Exchange rates are determined by financial institutions by using an ‘interbank market’ rate.
Let’s look at an example. The exchange rate between the dollar and the euro is 1.18 $/€. For obtaining one Euro, you will need 1.18 dollars. On the contrary, if you are at the United States Airport Exchange counter and going to the Europe with close to$1000, you will receive €847.13.
FOREX is covered in greater detail later in this guide.
A derivative instrument derives its value from an underlying commodity or asset such as stock, stock market indices, commodities (gold, silver, sugar, corn etc.) or bonds (raised by government or corporates). They are either traded through an exchange or directly done over-the-counter where an exchange is not involved and the transactions take place directly between the two parties.
The three major types of derivatives are futures, forward and options where the maturity of contracts, expiry date, and mode of trading differs.
Since a derivative, as the name suggests, functions on the underlying commodity, its price is determined based on the price of the commodity. Any fluctuation in the price or performance of the commodity will directly impact the derivative’s value.
To understand the derivative market, let’s analyze a simple contract between a farmer and a consumer. If both the parties enter into a future contract (whose expiry is maybe 6 months down the line) where the farmer promises to deliver 1000 quintals of wheat to the consumer at $15 per quintal, there are three possible outcomes:
- The price rises to above $15 per quintal, say$20. In this case, the consumer is still assured of the delivery and got a great deal (profited $5 / quintal). On the other hand, the farmer cannot book a higher profit and lost some money.
- The price drops below $15/quintal, say$10. The consumer paid a higher price ($15 / quintal) even when he could have got the same quantity at a cheaper rate now ($10 / quintal). The farmer profited and was able to successfully protect himself against the price drop.
- The price remains the same in which case, no money is owned by the farmer or the consumer.
As you can see from the above example, both sides have something at stake and the one who secures a better position in the contract books exits with a profit. A derivative contract makes sure that a physical delivery is made for commodity and the items or a contract is in place such that a situation of default is negated. Both physical and virtual contracts exist in the derivatives market.
Futures are covered in greater detail later in this guide.
A forward contract is similar to a futures contract, though it differs in the following ways:
- A forward contract is much more customizable — it can include any commodity, amount or delivery date.
- There is no centralized trading exchange for forwards contract unlike the futures market. Hence, they are considered over-the-counter (OTC) instruments — while this makes it easier to customize, it also tends to have much higher default risk.
Forward contracts are covered in greater detail later in this guide.
An example of an Options Contract could be understood by taking the case of a home dealer who has an attractive property priced at $90,000. Kevin is interested in the property but is short of cash. He can spare only$10,000 as a down-payment from his savings and would likely have to opt for a home loan. The dealer provides Kevin with a buffer time of 2 weeks and takes $2000 from Kevin as a security fee. At the time when these verbal assurances are been made, a contract is drafted by the dealer — now there are two scenarios that might arise:
- Kevin is successful in raising a home loan for the remaining $80,000 and he signs up a contract with the dealer. The dealer in this case have to hand over the property to Kevin. In other words, Kevin exercised his option to buy the house.
- In the second case, Kevin is unable to raise funds through a home loan. As part of the contract, the dealer keeps the $2000 security fee that Kevin had initially paid.
Options are covered in greater detail later in this guide.
As the term indicates, a swap contract enables two parties to exchange two different financial instruments or assets, much like barter trading of financial instruments. Due to their nature, swap contracts are not exchange-traded.
The simplest form of swap contracts is a swap contract where the first party pays a regular fixed interest rate to the second party (much like if the second party owns a bond), and the second party agrees to pay to the first party a variable interest payment (depending on any factor such as the actual interest rate or other factors) at regular time intervals. With this process, the risk is effectively transferred to the second party (who pays the variable interest payment).
The interest payments (both the fixed and the variable) are paid on a notional amount , and not an actual amount. The notional amount is used only for calculation of the interest payment and is not actually paid.
The notional amount is a hypothetical amount that is not actually paid or exchanged between the two parties. It is only used to calculate the interest payment.
For example, company A and company B agree on a swap where company A pays company B a fixed interest payment of 4% every year on a notional amount of $10 million. Company B agrees to pay company A a variable interest payment of 2% plus the fed’s rate per year.
The interest rate swap enables the two parties to exchange a fixed interest for a floating interest rate, which gives investors the ability to hedge their investments and manage risk. This is done as the investor who pays a fixed interest knows in advance the costs she is going to pay as they are fixed. In other words, the maximum risk exposure is known in advance.
The other type of swap is the foreign currency swap, where two parties agree to exchange principal amount and interest payment in different currencies. Assuming the first company is Norwegian and the other is American. The principal amount is 8 million krone, at an exchange rate of 8 NOK = 1 USD. The Norwegian company pays 8 million and the American company pays 1 million to each other. Then, the Norwegian company has borrowed dollars and the American companies has borrowed Norwegian krone, therefore an interest payment is due to be paid by each at the end of every year. This type of contracts helps companies in different countries get funding they need in foreign currencies, improving their competitiveness, and reducing currency risk.
To settle interest payments, the companies will calculate the interest payment due based on the current market exchange rate.
At the end of the period, the two companies retrieve the principal amounts they had paid initially.
The above examples represent rather simple forms of derivative contracts. Other more complex forms of derivatives exist, such as mortgage backed securities, and collateralized debt obligations, among others. The complexity of those products makes them inherently risky, given that the risk is difficult to assess. Such derivatives have been the subject to blame for the collapse of 2008, where the derivatives market had ballooned. Those derivatives were mostly related to the housing market and they were one of the factors behind the collapse.
There are a variety of alternative investments available including Hedge Funds, Private Equity, Venture Capital, Real Estate, and Crowdfunding, amongst others. These are all covered in greater detail later on in the guide.