Financial Instruments 101: A Beginner’s Guide to the Different Types of Financial Instruments

“Before you can become a millionaire, you must learn to think like one. You must learn how to motivate yourself to counter fear with courage. Making critical decisions about your career, business, investments and other resources conjures up fear, fear that is part of the process of becoming a financial success.” – Thomas J. Stanley

This quotation mentioned above by Thomas Stanley speaks of the need to counter fear with courage. One of the best ways to combat anxiety with courage is knowledge. Simply stated, the more you know about a specific topic, the more confident you will be and the less likely you will be to make mistakes.

Furthermore, this valuable point can be translated into the online financial market trading industry and the use of the different financial instruments.

What are financial instruments?

Before we take a look at the different types of financial instruments which are available to invest in (or trade on), let’s look at a concise definition of a financial instrument:

According to Investopedia, a financial instrument is an asset (or “packages of capital”) that can be traded on one or more of the global financial markets. Furthermore, they aim to “provide an efficient flow and transfer of capital all throughout the world’s investors.”

Types of financial instruments

It goes without saying that there are a number of assets or financial instruments that are available for you to trade on (or invest in). It is also important to note that financial instruments are either derivative or cash instruments.

Here are one of each type of instrument to help you understand the concept of financial instruments:

Contracts for Difference (CFD)

A CFD is a derivative financial trading instrument. In other words, you can use a CFD to speculate on the price movements of an underlying asset. A Contract for Difference is essentially a legal agreement between investor and investment house. This contract has a start date and an end date. And the difference between the asset’s price at the start of the contract and its price at the end of the contract is paid either to the investor or by the investor.

For example, should you believe that the price of a certain asset is going to rise rapidly, and you do not wish to buy a large number of the underlying asset, you can take out a CFD where you will pay the difference between the opening price and closing price should the price drop. On the other hand, should the price rise the broker owes you the difference between the two prices.

Securities

Securities are examples of cash financial instruments. In other words, their value is “directly determined by the markets.” Examples of securities are bank notes, bonds, and stocks. You buy and sell them at market-determined prices. For example, let’s assume that you wish to purchase 100 US Dollars (USD) in bank notes, and you have British Pounds (GBP) in bank notes, you approach a foreign exchange agency who will quote you a price in GBP for the USD. This rate is primarily market driven. Should the USD be strong against the GBP, it will cost you more for the 100 USD, and vice versa.