Financial Instruments in Finance

 Financial Instruments in Finance

Stocks: Owning a piece of the cake

Imagine you love a shoe and wanted to own a part of the brand that created it. That's what stocks were created to do. When you purchase a stock, you become a shareholder and part owner of the company you bought it from. You can have a say in some decisions and if the company does well then the value of the stock that you own goes up! Meaning you are profiting money from your original investment into the company. But if the company does poorly, then the value of your share goes down translating to you losing money from your original investment.

Types of Stocks

Common stocks: These are the stocks most people think of. If you buy them, you own a piece of the company's assets and earning and have a say in some decisions. The value of your stocks rises and falls with the company's performance. If the company does well, your stock might increase in value and you might receive dividends, a portion of the company's profits. However, as you might have guessed, if the company does poorly, then the stocks value could go down.

Preferred Stocks: With these types of stocks you still have a share and part ownership in the company but typically without any voting rights or say in the company. However, you have a higher claim on the earning and assets of the company. Meaning if the company pays dividends to its stockholders, the preferred stockholders get paid first before the common stock holders. Proffered stock dividends can be fixed or set as a percentage of the par value, making them a more predictable income source.

Blue-Chip Stocks: These stocks are shares in large, well-known companies with a history of growth and reliable performance in the stock market. Think of companies like Apple or Microsoft. They're called blue-chip after the highest valued chips in poker.Stock Market Exchanges 

Bonds: Lending Money and Earning Interest

Think of bonds like lending money to a friend but better. When you purchase a bond, you are lending money to a company or government and are promised to get paid back with interest overtime. If you don't feel like being as risky in buying stocks, you buy bonds. Bonds are considered safer than stocks. They're like a loan that you give to the company, so you are know the bank for the company. When a company needs to raise funds and you purchase their bonds, you are essentially lending them money and they promise to pay you back with interest.

Types of Bonds

Government Bonds: These are issued by national governments. Here in the US, there are treasury bonds, notes, and bills. They are backed by the full faith and credit of the US Government, making them super secure, but they have lower returns

Municipal Bonds: Issued by cities, states, or local entities, these bonds are used to finance public projects, like building schools, or highways. The fantastic thing about these is that the interest earned is usually tax-free.

Corporate Bonds: Companies issue these bonds. They tend to have high interest rates compared to the government and municipal bonds. The benefit of having higher interest rates is because how it is a higher risk that a company can go bankrupt compared to the other types of bonds.

Derivatives: High Risk, High Reward

These unique financial instruments called derivatives, 'derive' their value from an underlying asset, like commodities, bonds, stocks, or currencies. A derivative is like a bet on future price movements of assets. The primary types of derivatives you'll encounter include futures, options, and swaps. Their value changes as the price of the underlying asset changes. 

Futures: These are contracts to buy or sell a specific asset at a predetermined price on a set future date. These are typically traded on an exchange.

Options: For options, the buyer has the right, but not the obligation, to buy or sell an asset at a set price before a certain date.

Swaps: This is an agreement between two parties to exchange financial instruments or cash flows. A common type of swap is an interest rate swap.

Even though derivatives might sound like risky business, they carry some key benefits. They can allow investors to hedge against price changes, giving a form of price protection. It also offers leverage, meaning investors can control large amounts of assets with small amounts of money.