FINANCIAL INSTRUMENTS EXPLAINED: TYPES AND ASSET CLASSES

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, and
loans.

Financial instruments provide efficient flow and transfer of capital among the world’s investors. They are assets
that may be in the form of cash, a contractual right to deliver or receive cash or another type of financial
instrument, or evidence of ownership in some entity.

Stock shares - The term stock is used to express equity ownership in a business. A stock represents a piece of
ownership in a corporation. On the other hand, a share of stock is a unit of ownership in the business. The
number of shares determines how big of a piece of ownership in a business you have.

ETF - An exchange-traded fund (ETF) is a basket of investments, like stocks or bonds, that allows you to
invest in a diversified portfolio of securities with a single purchase. ETFs typically have lower fees than other
investment funds and are traded more easily, offering greater liquidity.

Bond - A bond (aka fixed income) is an instrument used by governments and companies to raise money by
borrowing from investors. Think of them like loans. They are typically issued by the government and
companies to fund specific projects, rather than issuing actual shares in a company. Many of these bonds
receive ratings that determine how sound of an investment they may be.
TYPES OF BONDS
Corporate Bonds:
 These are issued by a company to fund expansion projects, research, and development. The
returns from corporate bonds are taxable, but they typically yield higher returns than
government bonds, which offsets the taxes.
Municipal Bonds:
 This type of bond is issued by a city or state to fund projects like schools, roads, and hospitals.
These types of bonds have untaxed returns. There are two types of municipal bonds:
o General Obligation: these bonds fund projects that don’t produce income, but rather
add value to a community, such as a playground or park. The payments are guaranteed
on these bonds in good faith and are often paid through an increase in taxes.
o Revenue Bonds: these bonds are expected to create income, and they pay back
investors with the income that they do create. An example of a revenue bond is a new
highway. The revenue from the tolls on the new highway would become returns for
the investors. The yield on a revenue bond is typically higher than on a general
obligation bond.
Treasury Bonds:
 These are bonds issued by the Government. They are considered risk-free. Because of the low-
risk, they do not yield high returns and any income is taxed by the Federal government.
Junk Bonds:
 These are simply low-rated corporate bonds. They may offer higher returns, but that higher
return comes with higher risk.
Bond funds:
 These are essentially mutual funds of bonds. This is a group of bonds that is held under one
fund. This way you are investing into a portfolio of bonds, rather than selecting just one
specific bond. Bond funds can also contain multiple types of bonds (corporate, municipal, and
Treasury). The benefit of a bond fund is that it minimizes risk. By investing in multiple bonds,
there is a higher chance of greater return. On the flipside, these bonds are professionally
managed, so you likely will have to pay a management fee.
CD - A Certificate of Deposit (CD) is a type of savings account that pays a fixed interest rate on money held for
a specific period, offering potentially higher returns than traditional savings accounts, but with less flexibility
for withdrawals.

Loan - The term loan refers to a type of credit vehicle in which a sum of money is lent to another party in
exchange for future repayment of the value or principal amount. In many cases, the lender also adds interest
or finance charges to the principal value, which the borrower must repay in addition to the principal balance.
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 made by an investor to the owner of the asset.

TYPES OF ASSET CLASSES OF FINANCIAL INSTRUMENTS

Financial instruments may also be divided according to an asset class, 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) and commercial paper. Bank deposits and certificates of deposit (CDs) are technically
debt-based instruments because they earn depositors interest payments.

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 (MBS).

Mortgage - A mortgage is a loan used to purchase or maintain a home, plot of land, or other real estate. The
borrower agrees to pay the lender over time, typically in a series of regular payments divided into principal and
interest. The property then serves as collateral to secure the loan.

In the Philippines, real estate mortgages and other interests in registered land are registered with the Register of
Deeds (ROD), which is under the supervision of the Land Registration Authority (LRA). Mortgage should be
registered in the said registry to be valid against third parties.

Equity-Based Financial Instruments

Equity-based financial instruments represent ownership or a claim on the residual value of an entity, such as a
company, and include common stock, preferred stock, and equity-linked instruments like warrants and options.

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

ACTIVITY: IN A SHORT BOND PAPER, DRAW AN EXAMPLE OF FINANCIAL INSTRUMENTS SUCH AS:

1. Bond Certificate
2. Stock Certificate
3. Certificate of Deposit
4. Loan certificate