Q. What is an Instrument?
An instrument is a means by which something of value is transferred, held, or accomplished. In the field of finance, an instrument is a tradable asset, or a negotiable item, such as a security, commodity, derivative, or index, or any item that underlies a derivative.
In separate contexts, an instrument can alternatively refer to an economic variable that can be controlled or altered by government policymakers to effect a change in other economic indicators. It can also refer to a legal document such as a contract, will, or deed.
KEY TAKEAWAYS
An instrument is an implement with which to store or transfer value or financial obligations.
A financial instrument: is a tradable or negotiable asset, security, or contract.
Legal instruments: may contain binding terms, rights, and/or obligations.
Understanding Instruments
International Accounting Standards (IAS) defines 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.”
Basically, any asset purchased by an investor can be considered a financial instrument. Antique furniture, wheat, and corporate bonds are all equally considered investing instruments in that they can all be bought and sold as things that hold and produce value.
The values of cash instruments (financial securities that are exchanged for cash like a share of stock) are directly influenced and determined by markets. These can be securities that are easily transferable. The value and characteristics of derivative instruments are derived from their components, such as an underlying asset, interest rate, or index.
Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.
Economic Instruments
In terms of instruments as economic variables, policymakers and central banks commonly adjust economic instruments, such as interest rates, to achieve and maintain desired levels of other economic indicators, such as inflation or unemployment rates. Economic instruments may also include such assets as performance bonds or pollution taxes, all designed to bring about some change that is sought as a part of a policy.
For instance, an economic instrument like a tax might be instituted to help reflect some form of cost, which might not be monetary, that is incurred in the procurement or production of some goods or services. Accessing and using natural resources can have broader effects on the environment and lead to the depletion of that resource. Fees on the production of such resources might be instituted to reflect the impact of exploiting these resources.
Legal Instruments
From a legal perspective, some examples of legal instruments include insurance contracts, debt covenants, purchase agreements, or mortgages. These documents lay out the parties involved, triggering events, and terms of the contract, communicating the intended purpose and scope.
With legal instruments, there will be a statement of any contractual relationship that is established between the parties involved, such as the terms of a mortgage. These may include rights given to certain parties that are secured by law. A legal instrument presents in a formal fashion that there is an obligation, act, or other duty that is enforceable.
Conclusions:
- A financial asset is a liquid asset that represents—and derives value from—a claim of ownership of an entity or contractual rights to future payments from an entity.
- A financial asset’s worth may be based on an underlying tangible or real asset, but market supply and demand influence its value as well.
- Stocks, bonds, cash, CDs, and bank deposits are examples of financial assets.
Intangible assets are the valuable property that is not physical in nature. They include patents, trademarks, and intellectual property.
Financial assets are in-between the other two assets. Financial assets may seem intangible—non-physical—with only the stated value on a piece of paper such as a dollar bill or a listing on a computer screen. What that paper or listing represents, though, is a claim of ownership of an entity, like a public company, or contractual rights to payments—say, the interest income from a bond. Financial assets derive their value from a contractual claim on an underlying asset.
This underlying asset may be either real or intangible. Commodities, for example, are the real, underlying assets that are pinned to such financial assets as commodity futures, contracts, or some exchange-traded funds (ETFs). Likewise, real estate is the real asset associated with shares of real estate investment trusts (REITs). REITs are financial assets and are publicly traded entities that own a portfolio of properties.