Financial Instrument Meaning Types And Importance

Financial Instrument: Meaning Types And Importance

Financial instruments play a crucial role in the financial markets by providing mechanisms for raising capital, investing funds, and managing risk. 

2025-02-09

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Key Takeaways:

  • A financial instrument is an asset that you can put in for trading or investing to extract returns.
  • In India, people use all types of financial instruments, including life insurance policies, fixed deposits, savings schemes, mutual funds, bonds, and equity stocks.
  • They are essential for capital formation, investment, and risk management, in turn facilitating economic stability in the financial markets of the country.
  • The tax benefits of financial instruments make them more attractive. However, they are applicable to selected ones only.
  • Assets have classes and can be classified into equity-based, debt-based, and hybrid financial instruments.

What are Financial Instruments?

A financial instrument is an agreement between two parties with monetary value. In other words, any asset that holds capital and which can be traded is a financial instrument. It is noteworthy that financial instruments can be palpable or virtual documents representing a legal agreement of any monetary value.

Some examples of financial instruments include life insurance plans, shares, bonds, stocks, SIPs, etc. Now, let us understand more about the different types of financial instruments that are popular in India.

Financial Instruments Available in India

Understanding what are financial instruments becomes easy by knowing about the array of financial instruments that are available in India. They serve as a medium of wealth creation. People prefer to invest in financial instruments instead of keeping their money in a savings account, as the former has an appreciative trend.

Recommended Reading: Wealth Management

Life Insurance Policies:

These are financial instruments offering you protection against different types of financial risks, such as – sudden death and old age. As the untimely demise of a breadwinner places the family members in economic instability, life insurance plans become critical.

Secondly, they are also helpful during retirement, as individuals' income-generating ability recedes. A few popular life insurance plans include:

  • Term Life Insurance: Acts as long-term financial protection for family
  • Savings Plans: Safe long-term investments with guaranteed returns.
  • Pension Plans or Annuities: Helps you turn your retirement corpus into a reliable and lifetime income.
  • ULIPs (Unit-linked Investment Plans): ULIPs are insurance instruments with investment benefits. In other words, ULIPs allow you to build wealth over time and protect your loved ones and yourself.

Small Savings Schemes:

Small Savings Schemes aim to encourage citizens to save regularly as they are generally government-backed. They are popular as they come with a sovereign guarantee of returns and tax benefits. A few saving schemes that you can consider are listed below:

  • Post office recurring deposits
  • Public Provident Fund (PPF)
  • Kisan Vikas Patra
  • National Savings Certificate (NSC)

Fixed Deposits (FDs)

They entail cash investments in banks or post-office and are highly popular. FDs come with a zero risk factor, and you are guaranteed returns. However, the annual returns on FDs can range from 6 to 9 per cent.

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Certificate of Deposits (CDs): 

A certificate of deposits is a negotiable money market instrument issued in dematerialised form and used as a promissory note for funds deposited at a bank for a stipulated period.

  • Financial institutions to raise large sums of money issue CDs.
  • They are available in denominations of INR 1 lakh and multiples.

Equity Stocks: 

It is a type of security that represents the ownership of a company and is traded in stock markets.

  • It represents the money you can return to shareholders of a company if all the assets are liquidated and the entire company debt is paid off.
  • Equity is one of the most typical financial indicators investors use to determine a company's health.

Bonds

They are fixed-income instruments you can issue to raise working capital.

  • Private entities and government ventures, including the central and state governments, issue bonds to raise funds
  • Bonds that the government issues have a lower risk rate but ensure returns; on the other hand, bonds raised by private entities have high risks.

Must Read: What are Financial Assets?

Derivatives 

These instruments act in favour of risk management, speculating price movements, and enhancing portfolio returns. Derivatives are like the chess pieces of the financial world. Assets such as stocks, commodities, or currencies are where the value of derivatives is extracted from. Investors use it to predict price fluctuations and reduce risk and eventually create a diverse portfolio that generates better returns.

Mutual Funds

Advertisements are always on the television that mutual fund investments are beneficial but subject to market risks. The truth is that it is a financial instrument with a systematic approach where investors pool their money. Later, the process of investing money in a variety of stocks falls on the shoulders of a professional fund manager. Their task is to create a balanced and diversified investment to minimise risk that offers potentially higher returns.

Foreign Exchange Market Instruments 

In the global market, the foreign exchange market, aka Forex, holds power, where investors exchange currencies based on the predictions of tools like futures, forwards, swaps, etc. It helps them protect their funds from currency fluctuations and is also the most liquid financial market not only in India but in the world. 

Importance of Financial Instruments

Financial instruments in India have a specific role to play in streamlining the flow of the global economy. Instruments like life insurance policies, fixed deposits, and small savings schemes have less risk but with fixed returns at a certain rate. It helps in ensuring the economy's stability. Meanwhile, equity stocks and mutual funds can gain instant wealth if you plan to grow and are not looking for security. They allow businesses as well as the government to generate capital for development and expansion purposes, which is essential for the growth of the economy.

Financial instruments contribute to market liquidity by facilitating the transfer of funds between savers and borrowers. It enables investors to diversify their portfolio, manage risk, and ensure the assets are bought and sold with minimum price fluctuations. At the same time, the global market is rising with investors trying their hands on Forex, where currencies play a major role. Overall, financial instruments play a critical role in wealth creation, economic stability, and the effective allocation of resources.

Tax Benefits of Financial Instruments

Many financial instruments offer tax benefits, making them attractive investment options. Here are some common examples:   

  1. Tax-Deductible Investments:
    • Equity Linked Savings Schemes (ELSS): Investments in ELSS can be claimed as a deduction under Section 80C of the Income Tax Act up to a maximum of ₹1.5 lakh.   
    • Public Provident Fund (PPF): Contributions to a PPF account are eligible for a deduction under Section 80C.   
    • National Savings Certificates (NSC): NSCs are another option for tax deductions under Section 80C.   
    • Sukanya Samriddhi Yojana (SSY): This scheme, designed for girls, offers tax benefits under Section 80C.   
  2. Tax-Free Interest: 
    • National Savings Certificates (NSC): Interest earned on NSCs is generally exempt from income tax.
    • Senior Citizens' Savings Scheme (SCSS): SCSS offers tax-free interest to senior citizens.
  3. Tax-Free Gains:
    • Capital Gains from Listed Securities: Long-term capital gains from listed securities held for more than one year are generally exempt from tax, subject to certain conditions.
  4.  Additional Tax Benefits:
    • Home Loans: Interest paid on a home loan is eligible for a deduction under Section 24 of the Income Tax Act.   
    • Medical Insurance Premiums: Premiums paid for health insurance can be claimed as a deduction under Section 80D.

 

Asset Classification of Financial Instruments

Financial instrument assets have classes, namely equity, where it is ownership-based, such as in stocks; then there is debt, where assets are considered borrowed capital like those in bonds; and lastly, hybrid instruments, which are a mix of both, for example, convertible debentures. To understand them in depth, read on.

  1. Equity-Based Financial Instruments:- Take stocks, for example: When investors purchase these equity instruments of a particular project or a company, they become its shareholders. They earn returns through dividends and capital appreciation, but it is again subject to a high market risk.
  2. Debt-Based Financial Instruments:- Borrowed capital instruments like bonds and fixed deposits or certifications of deposits refer to debt-based financial instruments. Here, you lend money to the government or corporations in exchange for a fixed interest rate for a specific period of time. These have lower-risk equities compared to the other two classes.
  3. Hybrid Financial Instruments:- Basically, a combination of equity and debt is what you can call a hybrid financial instrument. Convertible debentures are the best examples of this category of asset, where you receive fixed returns but with an option to convert them into equity if needed and on meeting certain conditions. 

Did You Know?

The concept of life insurance dates back to ancient Rome. Romans formed burial clubs called "collegia" to cover funeral expenses and provide for surviving family members

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Wrapping Up

Financial instruments are crucial in driving economic growth and stability by facilitating capital formation, investment opportunities, and risk management. From life insurance policies to equity stocks and bonds, each instrument serves unique purposes, enabling individuals and institutions to achieve financial goals and manage economic uncertainties effectively. In India, the variety of available financial instruments, such as small savings schemes and fixed deposits, offers diverse options for wealth creation and financial security.

Additionally, understanding the tax implications of these instruments is crucial for maximising returns. By leveraging the benefits of financial instruments, investors can ensure financial stability and contribute to broader economic development.

Glossary:

  • Market Liquidity: The ease with which an asset can be bought or sold in the market without affecting its price.
  • Life Insurance Policies: Financial instruments providing protection against financial risks like sudden death and old age.
  • Small Savings Schemes: Government-backed savings schemes aimed at encouraging citizens to save regularly.
  • Derivatives: Financial contracts whose value is derived from the performance of an underlying asset.
  • Fixed Deposits (FDs): Cash investments in banks or post offices with guaranteed returns and a zero risk factor.
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Uncertain About Insurance

Disclaimer - This article is issued in the general public interest and meant for general information purposes only. The views expressed in this blog are solely those of the writer and do not necessarily reflect the official policy or position of Canara HSBC Life Insurance Company Limited or any affiliated entity. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability with respect to the blog or the information, products, services, or related graphics contained in the blog for any purpose. Any reliance you place on such information is therefore strictly at your own risk. You should consult with a qualified professional regarding your specific circumstances before taking any action based on the content provided herein.

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FAQs Related to Financial Instruments

Financial instruments are contracts or documents that represent a financial asset to one party and a financial liability or equity instrument to another. Examples include stocks, bonds, derivatives (like futures and options), insurance policies, and savings schemes. They are essential for trading, investment, financing, and risk management purposes in the financial markets.

The types of financial instruments traded include stocks (equities), bonds, derivatives (futures, options, swaps), foreign exchange (forex), commodities, ETFs (Exchange-Traded Funds), and mutual funds.

The function of financial instruments is to facilitate investment, financing, trading, risk management, and liquidity provision in financial markets.

The various features of financial instruments are transferability, liquidity, value representation, risk-return profiles, legal frameworks, marketability, and maturity terms.