A financial instrument is an asset, but refers specifically to contracts that can be traded, transferred, or exchanged.
For example, if you give someone an IOU for $100 and that person transfers that IOU to a third-party, who could then comes to you to claim the $010, that piece of paper saying “I owe you $100” is a simple financial instrument.
Financial instruments involve one party owing another party something: cash, part ownership of a company, interest, or future delivery of another asset.
They include equities (shares), loans, bonds, currency, futures contracts, options, and U.S. Treasury bills and notes.
There are other kinds of assets besides instruments. An asset can be anything of value that has a price. All of these are assets:
- Barrels of oil
- Bushels of corn
- Gold bars
- Shares of company stock
- Rare painting
- Stock index futures contracts
While corn, gold, and oil are not financial instruments., a contract for immediate or future delivery of corn, gold, or oil is a financial instrument.
Two Types of Financial Instruments
There are two types of financial instruments:
Cash instruments have value based on what the market says they are worth. Buyers and sellers agree on a price.
Or in the case of debt instruments, borrowers and lenders agree on the amount to be transferred or loaned as well as the interest rate and terms of repayment.
Derivative instruments, as the name implies, derive their value from the value of something else: an asset, a measurement, an interest rate or other variable, or even another derivative.
The price movement of the underlying asset impacts the derivative.
For example, if the price of Netflix shares goes from $500 to $600, the value of an options contract based on that underlying asset would also tend to go up. The underlying asset, in this case, is Netflix stock.
The exact increase in the price of the derivative isn’t predetermined by a fixed formula. The price is decided by the buyers and sellers themselves.
Because a share of Netflix s now worth $100 more, it makes sense that the derivative based on that asset would also be more valuable. Sellers will demand a higher price for it and buyers will be willing to pay more.
It’s important for traders to have accurate price data so they can be sure they are seeing the true price of the underlying asset.