Investing

Types of Financial Products & Definitions (Explained Simply)

Financial products are, in a nutshell, contracts that are bought and sold on a marketplace. This is a very general definition as financial products, also called financial vehicles, are diverse and come in several different forms.

The central concept behind a financial product is that it lets you convert your fiat currency into something that can be bought and sold with others on a market. When it comes to financial products, there are several possible ways to classify them.

In this article, we will divide financial products into categories based on the technical features that each product demonstrates. Keep in mind though that there may be other ways to divide and classify financial products, depending on which features of those products are relevant for your current interests. 

Under our analysis, there are 4 major types of financial products bought and sold on markets:

  1. Securities,
  2. Derivatives,
  3. Commodities
  4. Currencies.

This is by no means an exhaustive list. Some financial products might not fit neatly into these categories, but this article serves as a general overview of the main ones you’ll come across. 

Securities

A security is a type of instrument that is used to directly finance companies, banks, public entities, or governments. Essentially, securities represent an entitlement to something, like an asset or a contract.

In that sense, you can kind of think of securities as a type of promise: the holder of a security is promised something proportional to the number of securities that they hold. Securities can be short-term or long-term, and the money used to purchase securities are used to directly finance various entities.

Stocks 

Stocks are probably the most common kind of security and represent a portion of ownership in a company. When you buy a stock, you are buying a piece of ownership in a company.

Generally, stock ownership also comes with company voting rights about certain issues. Since stocks represent ownership, they entitle you to a portion of the value of the entire company. Companies sell stock to individual investors to finance their operations.

Stocks can appreciate or depreciate in value, depending on market conditions. Investors primarily make money by buying stocks, waiting for them to increase in value, then selling them for profit. 

Bonds

Bonds are basically loans that an individual gives to some company, public entity, or government. Like stocks, companies sell bonds to finance operations.

However, unlike stocks, bonds do not represent a claim of ownership. Instead, bonds represent an obligation on the behalf of the issuer to pay back the loan plus interest by a specific maturation date.

Bonds are considered long-term investments and usually have long maturation dates; on the order of 20-35 years. Bond markets have less risk than stocks, but they have a consequently lower return as you mainly earn money on bonds through interest, not capital appreciation. 

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Mutual Funds

Mutual funds are a special kind of financial vehicle that is made up of several people pooling their money to purchase securities.

The benefit of mutual funds is that it lets investors combine their money to buy more than they would be able to by themselves. Individuals are entitled to a portion of the fund proportional to how much they invest. 

Two popular types of mutual funds are index funds and exchange-traded funds. Index funds are bundles of securities that track a specific index (e.g. S&P 500).

ETFs are like index funds, except shares of ETFs can be bought and sold on the market, like stock. Index funds are sometimes called secondary securities as a portion of an index fund represents ownership in several securities.

Mutual funds are a bit hard to classify as they may include several different types of financial products, such as cash instruments, insurance companies’ debt, foreign exchange, shares, derivatives, and more.

Derivatives

A derivative is a type of security whose value is derived from an individual or group of individual securities.  Derivatives represent a contract between the buyer and seller, and the price of derivatives changes depending on price movements of the underlying asset (known as the benchmark).

Derivatives are commonly used to speculate on market movements or leverage their holdings. Another way to think of a derivative is that they give an investor the right to buy or sell some security at a specific price or a specific time. derivatives are usually considered to have high risk in capital markets.

Futures

A future is a type of derivative that represents an agreement between two parties to buy and sell an asset at a fixed price at a fixed date. For example, individual A can buy a future that obligates company B to sell the shares at $30 per share by date X.

If the price of the shares goes above $30 by date X, then A can sell the futures contract for a profit. Individual A is hedging their risk by ensuring they can buy shares at a specific price even if the share price rises. 

Options

Options are very similar to futures except that the holder of an option does not have an obligation to exercise that agreement.

Futures give an obligation to buy/sell but options give a right, but not the obligation to buy/sell. Options are used to hedge risk or speculate on the price movement of underlying assets, just like futures, except they are a bit more flexible.

Swaps 

A swap is another kind of derivative that is used to turn one kind of cash flow into another. For example, a commodity swap allows two people to trade cash flows based on the price of the underlying commodity.

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An interest swap lets the trader convert from a fixed interest rate on a loan to a variable interest rate or the other way around. There are many different types of swaps, depending on the underlying asset class, including currency swaps and credit default swaps. 

Commodities

A commodity is a type of financial product that represents ownership or a share of some physical good or raw material.

In general, commodities trading involves things like precious metals (gold, silver, platinum) or natural resources (coal, oil, natural gas, etc) but can also include so-called ‘soft’ commodities which include agricultural products or livestock.

For example, if an investor believes that the price of gold will rise, they can invest their money in gold and potentially profit if the price of gold rises. The logic is the same behind any other kind of commodity. Oil commodities are bought and sold based on the changing price of oil and so on.

Commodities are usually included in portfolios as a hedge against inflation. Since the exact quantity of a given commodity is (generally) fixed, there is less risk of inflation, unlike with fiat currency which is in principle unlimited.

Generally, commodities trading tends to get more popular if stocks and other securities take a nosedive.

Generally speaking, it is much more difficult to directly trade commodities than it is to trade securities. However, one can indirectly invest in commodities by investing in securities of companies that process or manufacture those commodities, such as a mining company or agricultural company.

Aside from directly trading commodities, there is also a large derivative market surrounding commodities that include futures, contracts, etc. 

Currencies

Currencies are generally not considered a distinct asset class or financial product, but we are including them here, simply because currencies can be traded on a market.

Currencies are traded on foreign exchanges (or crypto exchanges), and let people convert one type of currency into another. 

Currency trading is practically a necessity as different countries and entities from different nations need to trade with one another.

An interesting feature of currency trading is that there is no centralised marketplace for trading, as there is for securities. That means that the majority of foreign currency transactions occur between individual investors.

Investors can make money on forex markets by trading currencies as the relative price changes.

Before the advent of the internet, currency trading was very difficult and mostly done by large banks, multinational corporations, or wealthy individuals. However, forex trading is much more accessible with the rise of online foreign exchanges.

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Final Thoughts

A financial instrument is a useful concept to have a grasp over. Virtually every aspect of the economy depends on the assets and contracts that financial products carry.

All financial products hold risks, so it is up to the individual investor to determine the kinds of financial and cash instruments and products. In the trading industry, it is important to understand these instruments for navigation in the stock market.

When investing and trading your money in the economy, there is always an incentive to have several sources of income through multiple investments.

Investments differ based on the kind of financial instrument they are and you need to know the relevant information about them.

Tom
About author

Fully qualified CISI Investment adviser for 5 year. Managed UK private client portfolios.
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