Financial instruments are securities that both large and small investors can use to gain exposure to the financial markets. Some of these securities are common, such as equity or stock investments, as well as bonds or debt securities. Small investors and institutional investors, including mutual funds, frequently buy and sell stocks and bonds. More complex financial instruments, including derivative contracts, such as futures and options, are often used by professional money managers, including hedge funds.
Stocks and bonds are the most traditional types of financial instruments, although there are sophisticated ways to invest in these securities. When an investor purchases stock, he or she is obtaining an equity stake in that corporate entity that entitles him or her to share in profits and vote on some key events. Buying equity also exposes an investor to risk in that there is little recourse if a stock loses value.
Bonds are a type of debt, and this category represents another type of financial instrument. Companies, local governments, and federal governments might issue bonds as a means to raise money in the capital markets. Investors who buy bonds are lending the issuer money in exchange for receiving ongoing interest payments in addition to a final payment worth the principal amount of the original investment when the bond reaches maturity. Bonds are often considered a safe haven for investing because traditional bonds are relatively secure. There are more risky bonds, known as high yield investments, that pay a higher interest rate but that have a greater risk of default versus a more conservative debt instrument, such as an investment-grade bond.
Futures and options are among the most sophisticated and potentially risky financial instruments, and they are often used by professional money managers. A futures contract is an agreement to purchase or sell, also known as trade, some underlying product such as gold, crude oil, or agricultural items at a future date and at a preset price. Options are contracts that give traders an option to buy other financial instruments, including stocks, at a predetermined price within a given time frame.
Alone, derivatives hold no value. The value of these financial instruments is determined by the underlying security or asset, such as a stock or natural resource. Hedge funds, which are lightly regulated investment funds run by professionals and designed to generate returns that exceed the broader markets, often use derivatives trading to speculate on an anticipated price movement or to hedge, or protect, another trading position.