Afinancial instrumentis a legal contract between two or more parties that defines conditions
under which the various parties incur costs and receive benefits. A cost or benefit need not
be a monetary amount; it could be a commodity, for instance. The simplest type of financial
instrument is a financial asset, which is a legal claim on a real asset such as a company, a
commodity, cash, gold or a building. Afinancial securityis a standardized form of financial
asset that is traded in an organized market. For instance, equity securities (shares on a
company’s stock) are traded on exchanges and debt securities such as bonds and money
market instruments (including bills, notes and repurchase agreements) are traded in brokers’
markets.
Aderivative contract, usually called a ‘derivative’ for short, is another type of financial
instrument which is a contract on one or more underlyingfinancial instruments. The underlying of a derivative does not have to be a traded asset or an interest rate. For instance,
futures on carbon emissions or temperature have started trading on exchanges during the last
few years. Derivatives are the fastest-growing class of financial instruments and the notional
amount outstanding now far exceeds the size of ordinary securities markets. For instance,
in 2007 the Bank for International Settlements estimated the total size of the debt securities
market (including all corporate, government and municipal bonds and money market instruments) to be approximately US$70 trillion. However, the amount outstanding on all interest
rate derivatives was nearly $300 trillion.