At a very high level, a financial instrument is simply a monetary contract between parties.  The International Accounting Standards define a financial instrument as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”

The key word to focus on here, in my opinion, is ‘contract.’  The contract portion of this really determines whether it is a financial instrument or not.  While the timing and asset classes can classify these financial instruments into different categories, the contract is what makes it fall into the much larger ‘bucket’ of financial instruments.

There are mainly two different types of financial instruments, cash instruments and derivative instruments.

Cash instruments are instruments that are very liquid and can be easily traded.  One very common example of a cash financial instrument is a stock.

The stock is consistently traded throughout the day and the values will fluctuate based off the performance of the company as well the market demand for the shares of that company, likely fluctuating throughout the day.  At any point, you can sell your shares of that company (or buy shares) and it is a very fast, liquid transaction.  It is considered a cash financial instrument because I now hold an equity share of the company whose stock I just purchased, or the shares that I sold are now owned by someone that has an equity share of the company.

On the other hand, we have derivative instruments.  Derivative investments are those whose value comes from the value of the asset they replace.  In a simpler term, it’s a security that is linked to another security.  I think the easiest way to think of a derivative instrument is to think of an interest rate. 

The interest rate is a derivative financial instrument, but it is linked to the amount that is outstanding on the loan.  In other words, a 5% interest rate is only one piece of the puzzle as it must be tied to a dollar amount to have any sort of true meaning or monetary value.

So, what are some other examples of both cash and derivative financial instruments?

Cash Financial Instruments –

• Bonds – Bonds provide a fixed income for an investor and are paid regularly based off specific maturity dates. 
• Cash Loans and Deposits – These are cash financial instruments if both the borrower and the lender agree on the timing of the transfer and the other details imperative to the deal.  Since they are backed by the financial asset of the entity where the money was deposited, this is a contractual obligation.

Derivative Instruments –

• Futures/Options – Futures and Options are tied to the future performance of a stock price so they would be classified as a derivative instrument, as the actual transaction will not take place until a certain time in the future but there is a contractual obligation in place before then.

There are many more types of financial instruments, such as payables and receivables, investments in debt, finance leases, and many others.

Oftentimes you’ll see financial instruments in a company’s balance sheet, and it’s helpful to know that there are many ways they can be categorized and defined.

As I mentioned in the beginning, financial instruments can also be categorized by their asset class depending on if the financial instrument is asset-based or debt-based.  When basing these financial instruments on whether they’re either a debt or asset-based, it’s interesting that you’ll start to see some of the examples from the cash and derivative-based instruments be blended together in these different classifications.

Some examples of these different asset-based instruments are below:

Asset-Based Financial Instruments –

• Stock – someone owns a portion of the company so they’re holding onto that asset
• Futures/Options – like stock, someone owns a portion of the company.  While their intentions are different than someone that simply owns the stock and is likely looking to buy and hold, their ownership of the company is the same.

Debt-Based Financial Instruments –

• Bonds – You are buying bonds to generate a sense of income, so the government is paying you money in a ratable time period as a mean for compensation for you allowing them to borrow money from you.  They are indebted to you, so they’re paying you ‘interest’ since you’re letting them borrow your money.
• Cash Loans and Deposits – this is very similar to the bonds comment previously but it is much straighter forward.  When you deposit your money into a bank, you’re allowing the bank to use your money however they want, and in return they’re going to be paying you interest on that money.  Hopefully, you’re earning more than I earned in my Fifth Third savings account (.01%) and if not, then hopefully you’re going to switch over to a high-yield savings account like I did when I moved all of my emergency fund over to Ally, but alas I digress.

The big takeaway that I have from this discussion is that some of these day-to-day activities might not seem like you’re doing anything worth writing home about, but maybe you need to think a little more about your activities and learn from how companies are allocating capital today. 

When you setup that bank account, you’re not just finding a dumping ground for any extra money you have at the end of the month – you’re entering into a contractual obligation with that company for them to use your money however they want and they’ll pay you interest based off where your money goes, such as in a checking account, savings account, CD, etc.

Simply by thinking of some of these decision as ‘contracts’ will likely make you think a little bit more about them, and you should!  I challenge you to post-audit the way that you’re managing your money and to find if there are any sort of inefficiencies with your various financial instruments – I’d be willing to bet that there are, and that’s a good thing!

Finding ways to make your life more efficient is good!  Closing your eyes and wandering through life blindly…not so good.  To quote one of my early hockey coaches…

It’s no way to go through life with your head up your ass because it stinks, and you can’t see where you’re going!”