Understanding financial instruments
Basically, any asset purchased by an investor can be considered financial instruments. Antique furniture, wheat, and corporate bonds are all equally considered investing instruments in that they can all be bought and sold as things that hold and produce value. Instruments can be debt or equity, representing a share of liability (a future repayment of debt) or ownership. An instrument, in essence, is a type of contract or medium that serves as a vehicle for an exchange of some value between parties.
The values of cash instruments (financial securities that are exchanged for cash like a share of stock) are directly influenced and determined by markets. These can be securities that are easily transferable. The value and characteristics of derivative instruments are derived from their components, such as an underlying asset, interest rate, or index.
A standby letter of credit is issued by a bank to secure the contract, but can also be advantageous after payment of the transaction. It is generally used for the purchase of goods and services such as a car, a house or a vehicle, as well as for other purposes.
Standby letters of credit are common, but many people do not know what they are and what they are for. A standby letter of credit is a letter issued by a bank promising to pay the beneficiary if the originator does not do so. It is often in the form of a contract or, in some cases, a loan, whereby the bank guarantees the payment.
A bank guarantee provides the contracting party with the assurance that it is a third financial institution which ensures that the applicant complies with the terms of the contract in order not to fall into default. In essence, the bank will do everything necessary to fulfill a contractual obligation, be it a loan, a deposit or even an interest payment. The bank wants to be sure that every customer can fulfill their contractual obligations so that they do not lose money.
Technically, a financial instrument is a form of capital that can be printed, packaged, traded and stored, but it is considered a contract between the two parties involved. Standardized financial instruments are stored in a variety of forms such as bank accounts, bonds, certificates of deposit, money market funds, etc. Increasingly, the parties are also covered, and these can also be regarded as financial instruments. These can be either physical assets (e.g. gold, silver, gold bars or gold coins) or financial assets.
Types of Financial Instruments
Financial instruments may be divided into two types: cash instruments and derivative instruments.
Cash Instruments
- The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable.
- Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.
Derivative Instruments
- The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
- An equity options contract, for example, is a derivative because it derives its value from the underlying stock. The option gives the right, but not the obligation, to buy or sell the stock at a specified price and by a certain date. As the price of the stock rises and falls, so too does the value of the option although not necessarily by the same percentage.
- There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a market or process whereby securities–that are not listed on formal exchanges–are priced and traded.
From a legal perspective, some examples of legal instruments include insurance contracts, debt covenants, purchase agreements, or mortgages. These documents lay out the parties involved, triggering events, and terms of the contract, communicating the intended purpose and scope.
With legal instruments, there will be a statement of any contractual relationship that is established between the parties involved, such as the terms of a mortgage. These may include rights given to certain parties that are secured by law. A legal instrument presents in a formal fashion that there is an obligation, act, or other duty that is enforceable.
Activation of loan with financial instruments
The term loan refers to a type of line of credit in which a sum of money is lent to another party in exchange for future repayment of the value or principal amount. In many cases, the lender also adds interest and/or finance charges to the principal value which the borrower must repay in addition to the principal balance. Loans may be for a specific, one-time amount, or they may be available as an open-ended line of credit up to a specified limit. Loans come in many different forms including secured, unsecured, commercial, and personal loans.
A LOC is an arrangement between a financial institution—usually a sblc provider—and a client that establishes the maximum loan amount the customer can borrow. The borrower can access funds from the line of credit at any time as long as they do not exceed the maximum amount (or credit limit) set in the agreement.
A line of credit has built-in flexibility, which is its main advantage. Borrowers can request a certain amount, but they do not have to use it all. Rather, they can tailor their spending from the LOC to their needs and owe interest only on the amount they draw, not on the entire credit line. In addition, borrowers can adjust their repayment amounts as needed, based on their budget or cash flow. They can repay, for example, the entire outstanding balance all at once or just make the minimum monthly payments.
Finance Charges and Interest Rates
Finance charges for commoditized credit services, such as car loans, mortgages, and credit cards, have known ranges and depend on the creditworthiness of the person looking to borrow. Regulations exist in many countries that limit the maximum finance charge assessed on a given type of credit, but many of the limits still allow for predatory lending practices, where finance charges can amount to 25% or more annually.
Finance charges are a form of compensation to the lender for providing the funds, or extending credit, to a borrower. These charges can include one-time fees, such as an origination fee on a loan, or interest payments, which can amortize on a monthly or daily basis. Finance charges can vary from product to product or lender to lender.
There is no single formula for the determination of what interest rate to charge. A customer may qualify for two similar products from two different lenders that come with two different sets of finance charges.
Understanding Finance Charges
One of the more common finance charges is the interest rate. This allows the lender to make a profit, expressed as a percentage, based on the current amount that has been provided to the borrower. Interest rates can vary depending on the type of financing acquired and the borrower’s creditworthiness. Secured financing, which is most often backed by an asset such as a home or vehicle, often carries lower interest rates than unsecured financings, such as a credit card. This is most often due to the lower risk associated with a loan backed by an asset.
Finance charges allow lenders to make a profit on the use of their money. Finance charges for commoditized credit services, such as car loans, mortgages, and credit cards, have known ranges and depend on the creditworthiness of the person looking to borrow. Regulations exist in many countries that limit the maximum finance charge assessed on a given type of credit, but many of the limits still allow for predatory lending practices, where finance charges can amount to 25% or more annually.
Finance charges are a form of compensation to the lender for providing the funds, or extending credit, to a borrower. These charges can include one-time fees, such as an origination fee on a loan, or interest payments, which can amortize on a monthly or daily basis. Finance charges can vary from product to product or lender to lender.
There is no single formula for the determination of what interest rate to charge. A customer may qualify for two similar products from two different lenders that come with two different sets of finance charges.
One of the more common finance charges is the interest rate. This allows the lender to make a profit, expressed as a percentage, based on the current amount that has been provided to the borrower. Interest rates can vary depending on the type of financing acquired and the borrower’s creditworthiness. Secured financing, which is most often backed by an asset such as a home or vehicle, often carries lower interest rates than unsecured financings, such as a credit card. This is most often due to the lower risk associated with a loan backed by an asset.
KEY TAKEAWAYS
- A line of credit (LOC) is a preset borrowing limit that a borrower can draw on at any time.
- Types of credit lines include personal, business, and home equity, among others.
- A LOC has built-in flexibility, which is its main advantage.
- Potential downsides include high interest rates, severe penalties for late payments, and the potential to overspend.
- A loan is when money is given to another party in exchange for repayment of the loan principal amount plus interest.
- Loan terms are agreed to by each party before any money is advanced.
- A loan may be secured by collateral such as a mortgage or it may be unsecured such as a credit card.
- Revolving loans or lines can be spent, repaid, and spent again, while term loans are fixed-rate, fixed-payment loans.
- An instrument is an implement with which to store or transfer value or financial obligations.
- A financial instrument is a tradable or negotiable asset, security, or contract.
- Legal instruments may contain binding terms, rights, and/or obligations.
- A finance charge, such as an interest rate, is assessed for the use of credit or the extension of existing credit.
- Finance charges compensate the lender for providing the funds or extending credit.
- The Truth in Lending Act requires lenders to disclose all interest rates, standard fees, and penalty fees to consumers.
- An origination fee is typically 0.5% to 1% of the loan amount and is charged by a lender as compensation for processing a loan application.
- Origination fees are sometimes negotiable, but reducing them or avoiding them usually means paying a higher interest rate over the life of the loan.
- These fees are typically set in advance of the loan execution, and they should not come as a surprise at the time of closing.
