# Financial Instruments Explained: Types and Asset Classes

> **Definition**
>
> A financial instrument is a real or virtual legal agreement of monetary value which can be traded or exchanged, and may be an asset such as stocks, bonds, derivatives, and loans.

## What Is a Financial Instrument?

Financial instruments are assets that can be traded or exchanged. Some examples of financial instruments include stock shares, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), mutual funds, loans, and derivatives contracts.

Financial instruments provide an efficient flow and transfer of [capital](https://www.investopedia.com/terms/c/capital.asp) among the world’s investors. They may be [assets](https://www.investopedia.com/terms/a/asset.asp) in cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of ownership in some entity.

### Key Takeaways

*   A financial instrument is a real or virtual document representing a legal agreement that involves any kind of monetary value.
*   Financial instruments may be divided into two types: cash and derivatives.
*   They also are categorized by asset class, which depends on whether they are debt-based or equity-based.
*   Foreign exchange instruments comprise a third, unique type of financial instrument.

![Financial Instrument](https://www.investopedia.com/thmb/ZanbrkicY35fDIlTdTh3KJHHPG0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Terms-financial-instrument-4196427-final-0a2aca5199544ab3af1369fbb130ca34.jpg)

*— Madelyn Goodnight / Investopedia*

## Understanding Financial Instruments

Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt-based financial instruments represent a [loan](https://www.investopedia.com/terms/l/loan.asp) made by an investor to the owner of the asset.

[Foreign exchange](https://www.investopedia.com/terms/f/foreign-exchange.asp) instruments comprise a third, unique type of financial instrument. Different subcategories of each instrument type exist, such as [preferred share equity](https://www.investopedia.com/ask/answers/040915/what-are-advantages-and-disadvantages-preference-shares.asp) and common share equity.

> **Important**
>
> International Accounting Standards define financial instruments as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”

## Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and [derivative instruments](https://www.investopedia.com/articles/optioninvestor/10/derivatives-101.asp).

### Cash Instruments

*   The values of [cash](https://www.investopedia.com/terms/c/cash.asp) instruments are directly influenced and determined by the markets and can be readily brought and sold. Stocks and bonds are examples of such [primary instruments](https://www.investopedia.com/terms/p/primary-instrument.asp).
*   Cash instruments may also be deposits and loans agreed upon by borrowers and [lenders](https://www.investopedia.com/terms/l/lender.asp). Checks are an example of a cash instrument because they transmit payment from one bank account to another.

### Derivative Instruments

*   The value and characteristics of [derivative](https://www.investopedia.com/terms/d/derivative.asp) instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
*   An equity options contract—such as a [call option](https://www.investopedia.com/terms/c/calloption.asp) on a particular stock, for example—is a derivative because it derives its value from the underlying shares. The call option gives the right, but not the obligation, to buy shares of the stock at a specified price and by a certain date. As the price of the underlying stock rises and falls, so does the value of the option, although not necessarily by the same percentage.
*   There are over-the-counter ([OTC](https://www.investopedia.com/terms/o/otc.asp)) derivatives and exchange-traded derivatives. OTC is a market or process where securities not listed on formal exchanges are priced and traded.

## Types of Asset Classes of Financial Instruments

Financial instruments may also be divided according to an [asset class](https://www.investopedia.com/terms/a/assetclasses.asp), which depends on whether they are debt-based or equity-based.

### Debt-Based Financial Instruments

Debt-based instruments are essentially loans made by an investor to the issuer in return for a payment of interest.

Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of Treasury bills ([T-bills](https://www.investopedia.com/terms/t/treasurybill.asp)) and [commercial paper](https://www.investopedia.com/terms/c/commercialpaper.asp). Bank deposits and certificates of deposit (CDs) are technically debt-based instruments because they earn interest payments.

[Exchange-traded derivatives](https://www.investopedia.com/terms/e/exchange-traded-derivative.asp) are traded for short-term, debt-based financial instruments such as short-dated interest rate futures. There also are [OTC derivatives](https://www.investopedia.com/ask/answers/052815/what-overthecounter-derivative.asp) such as [forward rate agreements](https://www.investopedia.com/terms/f/fra.asp).

**Long-Term Debt Instruments**

Long-term debt-based financial instruments last for more than a year.

Long-term debt securities are typically issued as bonds or [mortgage-backed securities](https://www.investopedia.com/terms/m/mbs.asp). Exchange-traded derivatives on these instruments are traded as fixed-income futures and options.

OTC derivatives on long-term debts include [interest rate swaps](https://www.investopedia.com/terms/i/interestrateswap.asp), interest rate caps and floors, and long-dated interest rate options.

### Equity-Based Financial Instruments

Equity-based instruments represent ownership of an asset.

Stocks are equity-based instruments, as are ETFs and mutual funds that are invested in stocks.

Exchange-traded derivatives in this category include [stock options](https://www.investopedia.com/terms/s/stockoption.asp) and equity futures.

### Foreign Exchange Instruments

[Foreign exchange](https://www.investopedia.com/articles/forex/11/why-trade-forex.asp) instruments include derivatives such as forwards, futures, options on currency pairs, and contracts for difference.

Currency [swaps](https://www.investopedia.com/terms/s/swap.asp) are another common form of forex instrument.

In addition, forex traders may engage in spot transactions for the immediate conversion of one currency into another.

## What Are Some Examples of Financial Instruments?

A financial instrument is any document, real or virtual, that confers a [financial obligation or right to the holder](https://www.investopedia.com/ask/answers/083115/are-stocks-real-assets.asp).

Examples of financial instruments include stocks, ETFs, mutual funds, [real estate investment trusts](https://www.investopedia.com/terms/r/reit.asp), bonds, derivatives contracts (such as options, futures, and swaps), checks, certificates of deposit (CDs), bank deposits, and loans.

## Are Commodities Financial Instruments?

[Commodities](https://www.investopedia.com/terms/c/commodity.asp) such as precious metals, energy products, raw materials, and agricultural products are traded on global markets, but they do not typically meet the definition of a financial instrument. That’s because they do not confer a claim or obligation.

However, commodity derivatives are financial instruments. They include futures, forwards, and options contracts that use a commodity as the underlying asset.

## Is an Insurance Policy a Financial Instrument?

Insurance policies are not considered securities, but they could be viewed as an alternative type of financial instrument because they confer a claim and certain rights to the policyholder and obligations to the insurer.

An insurance policy is a legally binding contract established with the insurance company and policy owner that provides monetary benefits if certain conditions are met (such as death in the case of life insurance).

If the insurer is a mutual company, the policy may also confer ownership and a claim to dividends. Insurance policies also have a specified value in terms of both the [death benefit](https://www.investopedia.com/terms/d/deathbenefit.asp) and [living benefits](https://www.investopedia.com/articles/insurance/10/living-and-death-benefit-riders.asp) (e.g., cash value) for permanent policies.

## The Bottom Line

A financial instrument is effectively a monetary contract (real or virtual) that confers a right or claim against some counterparty in the form of a payment ([checks](https://www.investopedia.com/terms/c/check.asp), [bearer instruments](https://www.investopedia.com/terms/b/bearer-instrument.asp)), equity ownership or dividends (stocks), debt (bonds, loans, deposit accounts), currency (forex), or derivatives (futures, forwards, options, and swaps).

Financial instruments can be categorized by asset class and as cash-based, securities, or derivatives. Depending on their type, financial instruments may be exchangeable on listed or over-the-counter markets.

> **Article Sources**
>
> 1.  Emanuel Camilleri and Roxanne Camilleri, via Google Books. “[Accounting for Financial Instruments: A Guide to Valuation and Risk Management](https://books.google.com/books?id=tCElDwAAQBAJ&pg=PA62),” Page 62. Taylor & Francis, 2017.
>     
> 2.  Financial Edge. “[Derivative Financial Instruments](https://www.fe.training/free-resources/credit/derivative-financial-instruments/).”