What are financial products?
A financial product is the umbrella term for a wide range of assets that are created to serve as an investment for investors. Financial products can also be referred to as financial investments, financial instruments or investment products. They can usually be traded and usually consist of elements such as A Interest, profit, income or a return, financial products often also have a specific term and are denominated in one or more currencies. Depending on the product, financial products fulfill different functions such as securing liquidity, capital formation or risk hedging. Depending on the investment objective to be pursued, these factors are weighted more or less accordingly. For example, there are financial products that have the specific aim of hedging risk, such as hedging products against currency risks.
Most types of financial products enable an efficient flow and transfer of capital for all investors in the capital market. The underlying assets can be, for example, cash, a contractual right to the delivery or receipt of cash, or evidence of ownership of a company. A financial product is therefore a real or virtual document that represents a legal agreement for any monetary value. There are a wide variety of financial products in different areas of the financial sector, for example in banks with funds such as money market funds, real estate funds, hedge funds, but also swaps, options, structured products and many more. In the insurance sector, there are, among other things, mixed life insurance policies that combine cover for certain risks, such as the risk of death or disability, with funds.
Risks and factors for financial products
Financial products are generally subject to the following three main risks: Market risk, which is the risk of a change in the market value of a financial product, credit risk – also known as default risk, andliquidity risk, which is the risk that the financial product can no longer be traded. The fourth risk associated with certain financial products is counterparty risk – caution is required here, particularly with structured products. After the 2008 financial crisis and the bankruptcy of Lehman Brothers, counterparty risk led to total defaults for numerous investors: They had bought financial products from Lehman Brothers, which was no longer able to fulfill the agreed contractual obligations as a counterparty after its bankruptcy.
There is the so-called magic triangle of investment. The magic triangle consists of three factors:
- Security: The market risk and credit risk should be minimized.
- Return: The return should be maximized.
- Liquidity: An investment can be bought and sold at any time.
These are often investment objectives that cannot all be met at the same time, but some kind of compromise has to be made.
Another factor in financial products that is becoming increasingly important is sustainability: this is often measured using an ESG ranking. ESG stands for:
- Environmental– Responsibility towards the environment.
- Social– responsibility towards society, customers and our own employees.
- Governance– transparency and the way in which the company is managed.
It is important to know the risks and factors of financial products in detail, before you invest. Make sure you are well informed before you invest and get advice from an independent asset manager, for example. without conflicts of interest.
Types of financial products
Financial products can be divided into two types: Spot instruments and derivative instruments.
Cash instruments
The value of cash instruments is directly influenced and determined by the markets. These can be securities that are easily transferable. Cash instruments can also be deposits and loans agreed by borrowers and lenders. Other examples are shares, bonds, ETFs and money market instruments.
Derivative instruments
The value and characteristics of derivative instruments are based on the underlying components of the instrument, such as assets, interest rates or indices. For example, a stock option contract is a derivative because its value depends on the underlying stock. The option gives the right, but not the obligation, to buy or sell the share at a certain price and by a certain date. If the share price rises or falls, the value of the option also changes, although not necessarily by the same percentage. There are over-the-counter (OTC) and exchange-tradedderivatives. OTC – over-the-counter – is a market or process in which securities that are not listed on an official stock exchange are traded.
Types of asset classes of financial products
Financial products can also be divided into asset classes depending on whether they are debt or equity-based. Equity-based financial products represent ownership of an asset – this is the case with shares, for example. Debt-based financial products represent a loan granted by an investor to the owner of the asset. Foreign exchange instruments represent a third, separate type of financial product. There are various sub-categories of almost every type of instrument; in the case of shares, for example, there are preference shares, ordinary shares, registered shares and bearer shares.
Debt-based financial products
In the case of debt-based financial products, a distinction must again be made between short-term and long-term financial products: Short-term debt-based financial products have a term of one year or less. This type of security is offered in the form of treasury bills and commercial paper. Cash of this type can be deposits and certificates of deposit (CDs). Exchange-tradedderivatives among short-term, debt-based financial products can be, for example, short-term interest rate futures. OTC derivatives are, for example, forward rate agreements.
Long-term debt-based financial products have a term of more than one year. The securities are bonds. According to international accounting standards, loans are also referred to as cash equivalents. Exchange-tradedderivatives are, for example, bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options and exotic derivatives.
Equity-based financial products
Many financial products have shares as the underlying security. Classic equity funds, but also so-called exchange-traded funds such as ETFs, belong to this category. However, structured products such as barrier reverse convertibles (BRCs) are also based on one or more equity options. Exchange-traded derivatives in this category include equity options and equity futures. However, equity options are of course also traded over the counter (OTC).