What economic function do financial instruments fulfill?
What are the characteristics of different types of financial
instruments?
Financial instruments, sometimes called
financial securities, are legal contracts that
detail the obligations of their makers, the
individuals, governments, or businesses that issue (initially sell)
them and promise to make payment, and the rights of their
holders, the individuals, governments, or
businesses that currently own them and expect to receive
payment. Their major function is to specify who owes what
to whom, when or under what conditions payment is due, and how and
where payment should be made.
Financial instruments come in three major
varieties—debt, equity, and
hybrid. Debt instruments, such as bonds, indicate
a lender–borrower relationship in which the borrower promises to
pay a fixed sum and interest to the lender at a specific date or
over some period of time. Equity instruments, such as stocks,
represent an ownership stake in which the holder of the instrument
receives some portion of the issuer’s profits.
Hybrid instruments, such as preferred stock, have some of the
characteristics of both debt and equity instruments. Like a bond,
preferred stock instruments promise fixed payments on specific
dates but, like a common stock, only if the issuer’s profits
warrant. Convertible bonds, by contrast, are hybrid instruments
because they provide holders with the option of converting debt
instruments into equities.
Today, many financial instruments are merely electronic
accounting entries—numbers in a spreadsheet linked to a
contract. In the past, however, they took corporeal form as in
the case of stock certificates, like that pictured in Figure
2.2 "Allied Paper stock certificate, 1964".
How would you characterize financial instruments in the
following forms?
I, Joe Schmo, promise to pay to Jane Doe at her home on
Mockingbird Lane $100 at the end of the fiscal quarter.
I, Joe Schmo, promise to pay to Jane Doe at her home on
Mockingbird Lane 10 percent of all profits arising from my taco
stand at the end of each fiscal quarter.
I, Joe Schmo, promise to pay to Jane Doe at her home on
Mockingbird Lane $100 at the end of each fiscal quarter if my taco
stand earns at least that much profit.
The first instrument is a debt because Joe promises to pay Jane
a fixed sum on a certain date. Joe is a simple borrower and Jane,
his creditor/lender. The second instrument is an equity because Joe
promises to pay Jane a percentage of profit, making Jane a part
owner of the business. The third instrument is a hybrid because Joe
promises to pay Jane a fixed sum but only if his taco stand is
profitable. Parallel to the first instrument, Jane will receive a
fixed sum on a fixed date (as in a loan), but like the second
instrument, payment of the sum is contingent on the taco stand’s
profits (as in an ownership stake).
KEY TAKEAWAYS
Financial instruments, or securities, are contracts that
specify who pays whom as well as how, if, when, and where payment
is due.
Debt instruments are for fixed sums on fixed dates and need to
be paid in all events.
Equities are ownership stakes that entitle owners to a portion
of profits.
Hybrid instruments are part debt and part equity or are
convertible from one into the other.