What Does Financial Instrument Mean?

A financial instrument is an asset, but refers specifically to contracts or similar tokens of trust which can be traded, transferred, or exchanged.

Here’s a simple example. If you give someone an IOU for $10 and that person transfers that IOU to a 3rd party, who could then come to you to claim the $10, that piece of paper saying “I owe you $10” is a simple financial instrument.

Financial instruments involve one party owing another party something: cash, part ownership of a company, interest, or future delivery of another asset. They include equities (stock shares), loans, bonds, currency, futures contracts, options, binary options, Nadex spread contracts, and US Treasury bills and notes.

Financial instruments are type of asset

However, there are other kinds of assets besides instruments. An asset can be anything of value which has a price. All of these are assets:

  • Dollar bills, yen notes, rupee coins
  • Bushels of corn
  • Gold bars and coins
  • Shares of company stock
  • Bitcoins
  • Barrels of oil
  • Stock index futures contracts

Of the above, the corn, gold, and oil are not financial instruments. However, a contract for immediate or future delivery of corn, gold, or oil is a financial instrument.

Two types of financial instruments: cash and derivative

  • Cash instruments have value based on what the market says they are worth. Buyers and sellers agree on a price. Or in the case of debt instruments, borrowers and lenders agree on the amount to be transferred or loaned as well as the interest rate and terms of repayment.
  • Derivative instruments, as the name implies, derive their value from the value of something else: an asset, a measurement, an interest rate or other variable, or even another derivative. Some of the riskiest instruments involved in the 2008 financial crisis were basically derivatives on other derivatives.

Even a number like the Federal Reserve's interest rate can serve as the underlying asset of a derivative. On Nadex, you can trade the Fed Funds rate and whether it will go up, down, or stay the same using a weekly binary option on the Fed Funds rate. A binary option is a derivative financial instrument.

The binary option or spread's price reflects the underlying asset price

The price movement of the underlying market impacts the derivative. For example, if the price of a barrel of oil goes from $50 to $55, the value of a binary option based on that underlying asset would also tend to go up. The underlying asset in this case is the crude oil futures contract for the current front-month. 

The exact increase in the price of the derivative, the binary option, isn't predetermined by a fixed formula or decided by Nadex. The price of the binary is decided by the buyers and sellers themselves.

Because a barrel of crude oil is now worth $5 more, it makes sense that the binary option based on that asset would also be more valuable. Sellers will demand a higher price for it and buyers will be willing to pay more. 

It's important for traders to have accurate price data so they can be sure they are seeing the true price of the underlying asset. Because Nadex is CFTC-regulated, price data comes from trusted sources. 

Nadex offers trading on 29 assets in five asset classes

  • Stock indices: Dow®, S&P 500®, Nasdaq 100®, Russell 2000®, China A50®, FTSE 100®, DAX®, Nikkei 225®
  • Forex: EUR/USD, AUD/USD, EUR/GBP, GBP/USD, USD/CAD, AUD/JPY, USD/JPY, GBP/JPY, EUR/JPY, USD/CHF
  • Commodities: gold, silver, copper, crude oil, natural gas, corn, soybeans
  • Economic Events: weekly jobless claims, nonfarm payroll, Fed Funds rate
  • Cryptocurrencies: Bitcoin

 

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