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. 

Written by : Anamika Arora

Reviewed by : Jasmeet Bedi

Jasmeet Bedi

2024-08-09

1644 Views

6 minutes read

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Table Of Content:

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 policies, 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

1.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

  • 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.

2.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:

  • Public Provident Fund (PPF)

  • Kisan Vikas Patra

  • National Savings Certificate (NSC)

3. 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.

4.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.

5.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.

6. 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?

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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Importance of Financial Instruments

Financial instruments in India are fundamental to the efficient functioning of the global economy. They enable businesses and governments to raise capital for expansion and development projects, thereby stimulating economic growth. These instruments also provide investors with various options to diversify their portfolios, manage risks, and enhance returns.

Furthermore, financial instruments contribute to market liquidity, ensuring that assets can be bought and sold quickly and with minimal price fluctuations. By facilitating the transfer of funds between savers and borrowers, financial instruments support financial stability and enable the implementation of monetary policies. Overall, they 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:   

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.   

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.

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.

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.

 

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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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.