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What are financial instruments? Definitions and differences

November 4, 2022

10 min

What are financial instruments? Definitions and differences

Let’s find out what financial instruments are and which are the main products you can invest in, divided into asset classes. The different economic characteristics can be summarised in 7 categories, from shares to cryptocurrencies: let’s go through them to find out which financial instrument is best for you.

What are financial instruments?

Financial instruments are all assets in which you can invest. So, you must first understand what investing means. However, the definition of investment is extremely personal: everyone has their own objectives and a different appetite for risk. Based on these criteria, people will choose the solution that best suits them. Let us therefore delve into what solutions the financial market offers us.

By definition, financial instruments are any form of investment or product of a financial nature. Italian law recognises the following products as financial instruments:

  1. Shares and other securities relating to risk capital
  2. Bonds, government bonds and other debt securities
  3. Units in mutual funds
  4. Derivative contracts, such as futures, swaps, options and forwards
  5. Any other security that permits the acquisition of the listed instruments and their indices, as well as the combination thereof (ETFs).

Each of these securities or products is traded in a specific financial market, such as stocks or bonds which together constitute the general securities market.

In addition, financial instruments can also be divided into ‘asset classes‘: categories based on similar economic characteristics and similar market behaviour, as well as by reference to shared regulations. There are five main asset classes, a term used globally to refer to categories of financial instruments:

  1. Equities (equity/stock/shares)
  2. Debts/bonds
  3. Commodities
  4. Real estate
  5. Liquidity (cash)

Actually, means of payment such as cash, cheques, credit cards and even current accounts, cannot be considered financial instruments by law. Unencumbered money (liquidity) is nevertheless an important component of investment and is therefore recognised as a key asset class.

In order to understand what financial instruments are, we will proceed by explaining each asset class ; then by adding up instruments that are cross-categorised, such as investment funds, ETFs and derivative contracts. Finally, we will mention ‘alternative’ instruments, such as investments in start-ups or the new cryptocurrency market, which can be subdivided into DeFi, NFT and Metaverse.

1. Stocks, bonds and government securities

Stocks and bonds (corporate bonds and government securities) constitute two different asset classes, but are often placed side by side because they both represent primary financial instruments. In short, their value is not dependent on other underlying financial products, as is the case with derivatives and various types of funds. Investing in shares and bonds directly exposes you to an economic activity, thus to its gains and losses.

First of all, what is a share? In short, the ownership of a company is divided into fractions and distributed as shares. The meaning of a share lies precisely in the way the company raises finance: by becoming public, thus relinquishing complete control of the business. In contrast, the meaning of a bond corresponds to a different mechanism: essentially, companies (or states) issue debt securities to obtain capital. To understand what a bond is,you can consider it a ‘loan‘ that the investor makes to the economic entity that issues it.

This article on stocks and bonds delves into the differences and explains everything you need to know about these financial instruments, which make up the largest slice of the traditional market.

2. Raw materials or commodities

A raw material by definition is a raw product obtained from the exploitation of natural resources. Raw materials (or commodities) are physical and fungible goods, i.e. divisible into interchangeable units: a kilo of wheat is the same as any other kilo of wheat! On the market, they are financial instruments traded independently of the producer.

To understand what raw materials are, we could then distinguish between agricultural and mining commodities, or into food and industrial categories. Ultimately, though, what are raw materials?

  • Precious metals: gold, platinum, silver, palladium;
  • Non-precious metals: aluminium, copper, steel, etc;
  • Energy: e.g. petrol, natural gas, oil;
  • Agricultural goods and meat

Commodities differ in durability and storage: unlike most financial instruments, being physical assets they are subject to perishability and require space for storage.

The literal meaning of commodity, however, indicates another characteristic. The term derives from the French commodité, meaning ‘easily obtainable’. As raw materials, processing is minimal (extraction or cultivation/breeding is sufficient), which is why their production is traditionally considered ‘easy’. Furthermore, among raw materials, we can recognise two groups: renewable or non-renewable. This depends on the degree of availability. Oil, for example, is non-renewable because it is exhaustible. Secondary‘ raw materials, on the other hand, are those that are recyclable or from the processing of which waste can be recovered.

Finally, precious metals such as gold have taken on the role of safe-haven assets: investing in these commodities is considered inflation-proof because they tend to retain their value over time. However, the price of commodities is always influenced by the law of supply and demand and other market dynamics.

3. Real estate: the property market

Real estate includes the physical structures, financial assets and instruments that make up the real estate (or property) market. Investing directly in ‘bricks and mortar’, e.g. buying houses to rent out, or participating in funds that manage real estate assets are both forms of real estate assets.

However, the activities of buying and selling and development, in order to make a profit, are not the only opportunities for income. The real estate market also includes the design and construction phases, as well as maintenance and services needed by those who will use the facilities. Finally, to define what real estate is, we can recognise five different types of real estate:

  • Residential: houses and flats for residential purposes;
  • Commercial: buildings such as shops, restaurants, hotels and entire shopping centres;
  • Industrial: property used for the production, distribution and storage of goods;
  • Vacant or agricultural land;
  • Land for ‘special’, i.e. public use: schools, places of worship, government facilities, for example.

Investing in real estate means participating in a market that is by nature ‘illiquid‘: selling a house takes much more time and steps than exchanging shares, for example.

4. Liquidity

Liquid money makes up the final asset class, although fiat money itself is not a financial instrument, but a medium of exchange, a unit of account and a store of value. Though, these characteristics make liquidity useful for investment:

  • It can be readily invested in the market, without having to liquidate other positions you hold;
  • It is a source of diversification and rebalancing, as investing cash can change the composition of your portfolio;
  • The capital generated by the sale of the instruments takes this form, pending reinvestment.

Being unencumbered by financial instruments, cash should theoretically be as risk-free as returns. However, simple deposits are subject to the erosion of inflation. One way to preserve your purchasing power would be to save and invest your liquidities.

5. Mutual funds and ETFs

Some financial instruments can be included in more than one asset class, depending on the investment object. This is the case with funds: they raise capital from several parties to invest in shares, bonds, commodities, derivatives or the real estate market. These instruments are diversified by nature because they buy different securities of the same reference index (benchmark): by distributing assets among different economic instruments, they moderate risk.

Mutual funds and ETFs (listed index funds) are the best examples of a ‘horizontal’ financial instrument. The way the fund is accessed and the way the assets are managed are the main differences. ETFs are generally passive instruments: they simply reproduce the performance of an index, retaining the underlying financial instruments without trading them on the reference market.

6. Derivative Financial Instruments

To understand what derivatives are, we can start once again from the etymology of the word. They are called ‘derivatives’ because their behaviour depends on another financial instrument or economic asset, called the ‘underlying asset’. These can belong to any of the categories already listed (shares, bonds, commodities, real estate), or represent market dynamics such as interest rates or inflation.

Derivative financial instruments are contracts entered into between counterparties in two possible ways:

  • Symmetrical: on maturity, both buyer and seller undertake to perform the agreed transaction;
  • Asymmetrical: only the seller has the obligation to provide the promised performance, while the buyer has the right to choose whether to take advantage of the agreement or to waive the terms.

In practice, derivative contracts reserve the buying and selling of a certain financial instrument at a given price, but postpone it to a future date, when it is possible or required to happen. Derivative option contracts, for instance, provide the buyer with two alternatives, to satisfy or abstain from the trade, while futures contracts oblige both parties to complete the mutual transactions.

Derivatives are used in specific investment strategies, i.e. risk hedging, speculation or arbitrage

7. Alternative financial instruments: start-ups and cryptocurrencies

The last category of financial instruments is far removed from the traditional asset classes, so they are termed as ‘alternative‘. We are talking about investments in innovative economic sectors, such as start-ups: fledgling companies with the potential to revolutionise a particular sector. In order to raise capital, these projects issue so-called participatory financial instruments: securities that raise capital and professional resources without ceding shares in the company, i.e. governance rights.

Cryptocurrencies are another alternative economic ‘object’. It is difficult to define them in traditional terms. Having been created as means of payment, it would be wrong to refer to cryptos as financial instruments, but many consider participation in DeFi ecosystems, the purchase of LAND in the metaverse or NFTs in general as an investment.

This overview of what financial instruments are is a good starting point for an informed choice, but to take care of your personal finances, independent research (DYOR), constant monitoring and knowledge of behavioural finance is equally important.