The Financial Instruments
Differentiating Between the Types of Financial Instruments Used in Capital Transactions
Financial instruments are formal, legal documents that set out the rights and obligations of buyers (capital suppliers) and sellers (capital users) of the securities. These instruments offer numerous advantages as a means of distributing capital in an advanced economy. Typically, they have standard features, which facilitate their trading. Both suppliers and users of capital can choose from a variety of securities to meet their particular needs.
In Table 2.3, we’ll explore the different types of financial instruments and provide examples for each type. Even if you are already familiar with some of these products, they will all be covered in detail in later chapters of the course.
Types of Financial Instruments
| Financial Instrument |
Definition |
Examples |
| Fixed-income securities |
These securities (also called debt securities) formalize a relationship where the issuer promises to repay the loan at maturity and makes interim interest payments. |
• Treasury bills |
|
The term of the loan varies depending on the type of the instrument. |
• Bonds |
| Equity securities |
Equity securities (commonly called stocks, equities, or shares) represent an ownership stake in the issuing company. |
• Common stock (also called common shares) |
|
For example, if the value of a company increases, the owner of stock may realize a capital gain upon selling it. |
• Preferred shares |
| Derivatives |
A derivative derives its value from an underlying asset, such as a stock or an index. These are typically more suited to sophisticated investors. |
• Options |
|
|
• Forwards |
| Managed products |
Managed products (also called investment funds) are pools of capital gathered from investors to buy securities according to a specific investment mandate. |
• Mutual funds |
|
|
• Exchange-traded funds |
|
|
• Private equity funds |
| Structured products |
Structured products are financially engineered products with characteristics of debt, equity, and an investment fund. |
• Principal-protected notes |
|
|
• Index-linked guaranteed investment certificates |
Key Takeaways
- Fixed-income securities: Are designed to provide regular income through interest payments and the return of principal at maturity. Examples include Treasury bills and bonds.
- Equity securities: Represent ownership in a company, commonly known as stocks. They offer potential for capital gains. Examples are common stock and preferred shares.
- Derivatives: Financial products that derive value from underlying assets. They are often used for hedging or speculative purposes. Examples are options and forwards.
- Managed products: These are collective investment schemes pooling capital to purchase securities based on an investment mandate. Examples include mutual funds and exchange-traded funds.
- Structured products: Engineered to have features of both debt and equity, these often serve specific financial needs. Examples include principal-protected notes and index-linked guaranteed investment certificates.
Frequently Asked Questions (FAQs)
What are the main advantages of financial instruments in capital transactions?
- Financial instruments provide standardized features, making trading easier. They offer a variety of options to meet the specific needs of capital suppliers and users.
How do fixed-income securities differ from equity securities?
- Fixed-income securities involve a promise of repayment of the principal with periodic interest payments, while equity securities represent ownership in a company, with returns potentially coming from capital gains.
Who are typical users of derivatives?
- Derivatives are more suited to sophisticated investors seeking to hedge risks or engage in speculative activities.
What is the primary purpose behind managed products?
- Managed products aim to pool capital from multiple investors to purchase securities aligned with a specific investment mandate, providing diversification and professional management.
Glossary
- Capital Suppliers: Entities or individuals who provide financial resources in return for securities.
- Capital Users: Entities or individuals who utilize the financial resources for growth and operations.
- Maturity: The date at which a debt security is due for repayment of the principal.
- Capital Gain: The profit realized when an asset is sold for more than its purchase price.
Diagrams and Charts
Here is a simple example diagram using Mermaid to differentiate these categories visually:
mindmap
root((Financial Instruments))
Fixed-income
Treasury Bills
Bonds
Equity
Common Stock
Preferred Shares
Derivatives
Options
Forwards
Managed Products
Mutual Funds
Exchange-traded Funds
Structured Products
Principal-protected Notes
Index-linked Investment Certificates
📚✨ Quiz Time! ✨📚
## What are fixed-income securities?
- [ ] They represent ownership stakes in a company.
- [ ] They are products whose value is derived from an underlying instrument.
- [ ] They are typically pools of capital gathered from investors.
- [x] They involve the issuer promising to repay the loan at maturity and making interest payments to the investor.
> **Explanation:** Fixed-income securities, also known as debt securities, formalize a relationship where the issuer promises to repay the loan at maturity and make interim interest payments.
## Which of the following is an example of an equity security?
- [ ] Bonds
- [ ] Treasury bills
- [ ] Options
- [x] Common shares
> **Explanation:** Equity securities, also known as stocks, equities, or shares, represent ownership stakes in a company. Common shares are a type of equity security.
## What type of financial instrument is best suited to sophisticated investors due to its value derivation from an underlying instrument?
- [ ] Fixed-income securities
- [ ] Equity securities
- [ ] Managed products
- [x] Derivatives
> **Explanation:** Derivatives are financial products whose value is derived from the value of an underlying instrument, such as a stock or an index, making them more suitable for sophisticated investors.
## What are mutual funds?
- [ ] Fixed-income securities that pay regular interest.
- [ ] Equity shares in a company.
- [x] Pools of capital gathered from investors to buy securities according to a specific investment mandate.
- [ ] Financially engineered products with characteristics of debt, equity, and an investment fund.
> **Explanation:** Mutual funds are managed products, or investment funds, that pool capital from investors to purchase securities according to a specific investment mandate.
## Which of the following best describes structured products?
- [x] Financially engineered products with characteristics of debt, equity, and investment funds.
- [ ] Pools of capital gathered from investors according to a specific mandate.
- [ ] Investment products whose value is derived from underlying instruments.
- [ ] Equity shares providing ownership in a company.
> **Explanation:** Structured products are financially engineered products that possess characteristics of debt, equity, and investment funds.
## Which of these financial instruments includes products like principal-protected notes and index-linked guaranteed investment certificates?
- [ ] Derivatives
- [ ] Equity securities
- [ ] Fixed-income securities
- [x] Structured products
> **Explanation:** Structured products include financial instruments such as principal-protected notes and index-linked guaranteed investment certificates.
## What is the primary characteristic of fixed-income securities?
- [ ] They represent ownership in a company.
- [ ] They are best suited for sophisticated investors.
- [ ] They are pools of capital for specific investment mandates.
- [x] They involve regular interest payments and repayment of the loan at maturity.
> **Explanation:** The primary characteristic of fixed-income securities is that they involve regular interest payments to the investor and the repayment of the loan at maturity.
## Which type of financial instrument includes common shares and preferred shares?
- [ ] Fixed-income securities
- [x] Equity securities
- [ ] Derivatives
- [ ] Managed products
> **Explanation:** Common shares and preferred shares fall under the category of equity securities, which represent ownership stakes in a company.
## Which of the following types of financial instruments facilitates the distribution of capital in a sophisticated economy and has standard features?
- [x] Securities
- [ ] Derivatives
- [ ] Private equity funds
- [ ] Exchange-traded funds
> **Explanation:** Securities, both fixed-income and equity securities, facilitate the distribution of capital in a sophisticated economy and tend to have standard features.
## Which of the following is a derivative?
- [ ] Bonds
- [ ] Mutual funds
- [ ] Preferred shares
- [x] Forwards
> **Explanation:** Forwards are a type of derivative, which are financial products whose value is derived from an underlying instrument such as a stock or index.