Financial instruments are an essential part of the trading experience, but what are they and how do they work? Read on to find out more.
What are financial instruments?
Put simply, financial instruments are monetary contracts between parties- they are the things that are bought and sold in financial trading. People and companies often trade financial instruments because they need the assets for themselves or their business. However, most of the time financial traders do not need the assets at all. They are simply looking to make a profit from movements in the price, for example by buying low, then selling high.
Some of the main categories of financial instrument are:
- Shares
- Indices
- Forex
- Commodities
Shares
A share is a unit of ownership in a company. For example, if a particular company is worth £10,000 and has issued 2000 shares, each share would be worth £5 (10,000 ÷ 2000). As the share price fluctuates, so does the value of the company. Investors who buy shares in a company are hoping it will grow in value, enabling them to sell the shares at a higher price.
By allowing investors to buy part of the company, the management can raise capital to put back into the business. If the funds are used wisely and the company becomes more profitable as a result, the value of the share price – and therefore the business – should rise. This means the company and its shareholders are heavily reliant on each other. The company needs shareholders to raise funds, and the shareholders hope the company will use their investment to grow the business – so they can make a profit.
Share prices can stay fairly stable for months, or change rapidly. The amount a share fluctuates is known as its volatility, which you can find out more about at our blog post here. Whether a share price moves up or down is based fundamentally on the laws of supply and demand. Essentially, if more people want to buy a share than sell it, the price will rise because the share is more sought-after. Conversely, if supply is greater than demand then the price will fall.
Most major shares are traded on the stock market. This is a general term for a global network of specific exchanges where shares are bought and sold. For example, the majority of UK shares are traded on the London Stock Exchange (LSE), while most US shares can be found on the New York Stock Exchange (NYSE) or NASDAQ.
These exchanges are highly-regulated marketplaces where buyers and sellers come together to negotiate the transaction of shares. Only certain qualified individuals are allowed to trade physically on the exchange itself, so investors generally need a stockbroker to act as a middleman.
Indices
Indices, also known as indexes, are the value of a group of companies, represented as a single number. Stock market indexes allow investors to broadly track securities as easily as they could track a single stock. When the index drops, that means the stocks within the index are, on average, decreasing in price.
While an index may contain hundreds, even thousands of stocks, they are not all included in the index equally. Each stock in an index has a weighting assigned to it, which determines how the shares in a given index basket are allocated; stocks with higher weightings have more influence on the index’s movements than those with lower weightings.
Types of stock market index that weight stocks differently include:
- Price-weighted indexes, which give more weight to companies with higher stock prices
- Market-capitalisation-weighted indexes, which give more weight to companies with higher market capitalisations (market capitalisation is the market value of a publicly traded company’s outstanding shares)
- Equal-weight indexes, which as the name suggests give equal weight to every stock regardless of market capitalisation, stock prices or any other factors
You can find out more about stock market indices at our blog post here.
Forex
Forex, also known as foreign exchange, FX or the currency market, is the largest financial market in the world. On average over $5 trillion worth of transactions take place every day; that’s around 100 times more than the New York Stock Exchange (NYSE), the world’s biggest stock exchange. As well as being traded by individuals and businesses, forex is also important for financial institutions, central banks, and governments. It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.
There are a huge number of market participants looking to trade forex at any particular time, from individual speculators wanting to turn a quick profit, to central banks trying to control the amount of currency in circulation. However, by far the most significant players in the forex market are the major international banks. Between them, Citigroup, Deutsche Bank, Barclays, JPMorgan and UBS account for around 50% of global forex trade.
You can find out more about forex trading at our blog post here.
Commodities
Commodities are physical assets. Unlike shares, indices or currencies they are raw materials mined, farmed or extracted from the earth.
Commodities are often placed into two groups:
- Soft commodities– these are agricultural commodities, farmed rather than mined or extracted.
- Hard commodities– these are generally mined from the ground, or taken from other natural resources.
To be officially tradable, a commodity must be entirely interchangeable with another commodity of the same type, no matter where it was produced, mined or farmed. Economists call this being fungible, and it means large quantities of commodities can be traded relatively quickly and easily on an exchange. This is because every trader can be confident they are buying/selling equivalent assets without needing to inspect them, or find out where or how they were produced.
There are two main ways to trade commodities:
- The spot market, where financial assets are sold for cash and exchanged right there and then.
- The futures market, where buyers and sellers agree to exchange a specific quantity of an asset at a fixed date in the future, at a price agreed today.
While futures contracts are often used by individuals and companies looking to exchange physical commodities at a later date, they are predominantly used for speculation and hedging.
It’s also worth noting that the price of futures contracts tends to be different from buying or selling an identical amount of that same commodity on the spot market. That’s because the seller needs to take into account future risks and charges, such as the cost to hold the commodity and then transport it to the buyer.
Commodities are bought and sold on a number of exchanges specialising in a particular type of commodity. Commodity futures are traded in contracts. Each commodity market has a standard size, set by the futures exchange where it trades. As commodities are often bought and sold in large amounts, the contract size also tends to be large.