3 min
19-August-2024
Financial instruments are tools that help individuals and businesses manage money, invest for the future, and protect against risks. In India, there are several types of financial instruments that cater to different needs, whether you want to save, invest, or secure your financial future. This guide will explain the different types of financial instruments available in India and how they can be used effectively.
What are financial instruments?
A financial instrument is any asset that holds capital and can be traded in the market. It can be purchased, created, traded, settled, or modified as per the requirements of the involved parties. It acts as a financial asset to one party and a liability to another. For instance, a mortgage loan would be considered an asset for the bank since it would receive interest alongside the lent capital. On the other hand, the mortgage would be a liability for the homebuyer, as they would be obliged to pay back the loan with interest.
Types of Financial Instruments
Financial instruments in India can be broadly categorised into primary and secondary instruments.
A. Primary Financial Instruments
Primary financial instruments are straightforward and include things like bank deposits, stocks, and bonds. These instruments are usually the first choice for people who want to save or invest their money.
1. Bank deposits
Bank deposits are the most common financial instruments in India. They include savings accounts, fixed deposits (FDs), and recurring deposits (RDs). When you deposit money in a bank, you earn interest over time. Fixed deposits are particularly popular because they offer higher interest rates compared to savings accounts. They are a safe and reliable way to grow your savings, especially for conservative investors.
2. Stocks (Equities)
Stocks, or equities, represent ownership in a company. When you buy shares of a company, you become a shareholder, which means you own a part of that company. Stocks can provide high returns, but they also come with risks because their value can fluctuate based on the company’s performance and market conditions. Investing in stocks is suitable for people who are willing to take on more risk for the possibility of higher returns.
3. Bonds
Bonds are debt instruments where you lend money to a company or government, and in return, you receive interest payments. In India, bonds are issued by companies, municipalities, and the government. Bonds are generally safer than stocks and are a good option for those looking for steady income with lower risk.
B. Secondary financial instruments
Secondary financial instruments, also known as derivatives, are more complex and derive their value from an underlying asset, such as stocks, bonds, or commodities. These are mainly used for managing risk or speculation.
1. Futures contracts
A futures contract is an agreement to buy or sell an asset at a future date for a predetermined price. These contracts are commonly used in India for trading commodities like gold, silver, and agricultural products. Futures contracts can help investors protect themselves from price fluctuations.
2. Options contracts
Options are contracts that give you the right, but not the obligation, to buy or sell an asset at a set price within a specific time frame. In India, options are widely used in the stock market. They can be used to hedge against risks or to speculate on future price movements.
3. Forward contracts
Forward contracts are customised agreements between two parties to buy or sell an asset at a specific price on a future date. Unlike futures contracts, forward contracts are not standardised and are typically used by businesses in India to hedge against currency or commodity price risks.
How to use financial instruments in India
Using financial instruments effectively depends on your financial goals, risk tolerance, and time horizon. Here’s how you can use different financial instruments to achieve your financial objectives.
1. Saving for the future
If your goal is to save money for future needs, such as education, marriage, or retirement, you can use bank deposits like fixed deposits or recurring deposits. These instruments are safe, offer guaranteed returns, and are easy to understand.
2. Investing for growth
For those looking to grow their wealth over time, investing in stocks and mutual funds can be a good option. Stocks offer the potential for higher returns, but they also come with higher risks. It’s important to do your research or consult with a financial advisor before investing in the stock market.
3. Managing risks
If you have investments that are exposed to risks, such as currency fluctuations or changes in commodity prices, you can use derivatives like futures and options to protect your investments. For example, businesses in India often use forward contracts to lock in exchange rates, protecting themselves from currency risk.
Risks associated with financial instruments
While financial instruments can help you achieve your financial goals, they also come with risks. Here are some common risks associated with different financial instruments:
1. Market risk
Market risk refers to the possibility of losing money due to changes in the value of financial instruments. For example, the value of stocks can go down due to poor market conditions, affecting your investment.
2. Credit risk
Credit risk is the risk that the issuer of a bond or a loan will default on their payments. This risk is particularly relevant for corporate bonds, where the company’s ability to repay its debt is a key factor.
3. Liquidity risk
Liquidity risk arises when it is difficult to sell a financial instrument without a significant loss in value. Some stocks or bonds may not be easily sold, especially in a declining market.
4. Interest rate risk
Interest rate risk affects bonds and other fixed-income securities. If interest rates rise, the value of existing bonds may decrease, as new bonds may be issued at higher rates.
5. Currency risk
Currency risk occurs when the value of investments or transactions is affected by changes in exchange rates. This is particularly relevant for businesses that deal with foreign currencies.
If you are looking for safe investment option, then you can consider investing Bajaj Finance Fixed Deposit. With a top-tier AAA rating from financial agencies like CRISIL and ICRA, they offer one of the highest returns, up to 8.85% p.a.
Advantages of financial instruments
Financial instruments are provided under more relaxed terms compared to other financial products on the free market.
Along with public funds, they also mobilise private financing, increasing the monetary support available to the final recipients.
Liquid assets such as cash in hand and cash equivalents are favourable for companies since they can easily be used for making quick payments or dealing with financial contingencies.
Also Read: Financial asset
What are financial instruments?
A financial instrument is any asset that holds capital and can be traded in the market. It can be purchased, created, traded, settled, or modified as per the requirements of the involved parties. It acts as a financial asset to one party and a liability to another. For instance, a mortgage loan would be considered an asset for the bank since it would receive interest alongside the lent capital. On the other hand, the mortgage would be a liability for the homebuyer, as they would be obliged to pay back the loan with interest.
Types of Financial Instruments
Financial instruments in India can be broadly categorised into primary and secondary instruments.
A. Primary Financial Instruments
Primary financial instruments are straightforward and include things like bank deposits, stocks, and bonds. These instruments are usually the first choice for people who want to save or invest their money.
1. Bank deposits
Bank deposits are the most common financial instruments in India. They include savings accounts, fixed deposits (FDs), and recurring deposits (RDs). When you deposit money in a bank, you earn interest over time. Fixed deposits are particularly popular because they offer higher interest rates compared to savings accounts. They are a safe and reliable way to grow your savings, especially for conservative investors.
2. Stocks (Equities)
Stocks, or equities, represent ownership in a company. When you buy shares of a company, you become a shareholder, which means you own a part of that company. Stocks can provide high returns, but they also come with risks because their value can fluctuate based on the company’s performance and market conditions. Investing in stocks is suitable for people who are willing to take on more risk for the possibility of higher returns.
3. Bonds
Bonds are debt instruments where you lend money to a company or government, and in return, you receive interest payments. In India, bonds are issued by companies, municipalities, and the government. Bonds are generally safer than stocks and are a good option for those looking for steady income with lower risk.
B. Secondary financial instruments
Secondary financial instruments, also known as derivatives, are more complex and derive their value from an underlying asset, such as stocks, bonds, or commodities. These are mainly used for managing risk or speculation.
1. Futures contracts
A futures contract is an agreement to buy or sell an asset at a future date for a predetermined price. These contracts are commonly used in India for trading commodities like gold, silver, and agricultural products. Futures contracts can help investors protect themselves from price fluctuations.
2. Options contracts
Options are contracts that give you the right, but not the obligation, to buy or sell an asset at a set price within a specific time frame. In India, options are widely used in the stock market. They can be used to hedge against risks or to speculate on future price movements.
3. Forward contracts
Forward contracts are customised agreements between two parties to buy or sell an asset at a specific price on a future date. Unlike futures contracts, forward contracts are not standardised and are typically used by businesses in India to hedge against currency or commodity price risks.
How to use financial instruments in India
Using financial instruments effectively depends on your financial goals, risk tolerance, and time horizon. Here’s how you can use different financial instruments to achieve your financial objectives.
1. Saving for the future
If your goal is to save money for future needs, such as education, marriage, or retirement, you can use bank deposits like fixed deposits or recurring deposits. These instruments are safe, offer guaranteed returns, and are easy to understand.
2. Investing for growth
For those looking to grow their wealth over time, investing in stocks and mutual funds can be a good option. Stocks offer the potential for higher returns, but they also come with higher risks. It’s important to do your research or consult with a financial advisor before investing in the stock market.
3. Managing risks
If you have investments that are exposed to risks, such as currency fluctuations or changes in commodity prices, you can use derivatives like futures and options to protect your investments. For example, businesses in India often use forward contracts to lock in exchange rates, protecting themselves from currency risk.
Risks associated with financial instruments
While financial instruments can help you achieve your financial goals, they also come with risks. Here are some common risks associated with different financial instruments:
1. Market risk
Market risk refers to the possibility of losing money due to changes in the value of financial instruments. For example, the value of stocks can go down due to poor market conditions, affecting your investment.
2. Credit risk
Credit risk is the risk that the issuer of a bond or a loan will default on their payments. This risk is particularly relevant for corporate bonds, where the company’s ability to repay its debt is a key factor.
3. Liquidity risk
Liquidity risk arises when it is difficult to sell a financial instrument without a significant loss in value. Some stocks or bonds may not be easily sold, especially in a declining market.
4. Interest rate risk
Interest rate risk affects bonds and other fixed-income securities. If interest rates rise, the value of existing bonds may decrease, as new bonds may be issued at higher rates.
5. Currency risk
Currency risk occurs when the value of investments or transactions is affected by changes in exchange rates. This is particularly relevant for businesses that deal with foreign currencies.
If you are looking for safe investment option, then you can consider investing Bajaj Finance Fixed Deposit. With a top-tier AAA rating from financial agencies like CRISIL and ICRA, they offer one of the highest returns, up to 8.85% p.a.
Advantages of financial instruments
Financial instruments are provided under more relaxed terms compared to other financial products on the free market.
Along with public funds, they also mobilise private financing, increasing the monetary support available to the final recipients.
Liquid assets such as cash in hand and cash equivalents are favourable for companies since they can easily be used for making quick payments or dealing with financial contingencies.
Are commodities a financial instrument
While commodities such as precious metals, raw materials, energy products, and agricultural products are traded in global markets, they fail to meet the definition of a financial instrument. This is because they do not confer an obligation or claim over something else. Meanwhile, commodity derivatives fall under the financial instrument category; they include forwards and futures and options contracts that use a commodity as the underlying asset.Are insurance policies a financial instrument
While insurance policies are not viewed as securities, they can be considered an alternative type of financial instrument since they confer obligations to the insurer and a claim and certain rights to the policyholder. For instance, an insurance policy offers monetary benefits if certain pre-defined conditions are met. If the insurer is a mutual company, the policy may also grant ownership and a claim to dividends. Moreover, they hold a specified value (such as cash value) in terms of both the death benefit and living benefits for permanent policies.Also Read: Financial asset
