Financial Products: Back-To-School

downloadMeaning: Financial products refer to instruments that help you save, invest, get insurance or get a mortgage. These are issued by various banks, financial institutions, stock brokerages, insurance providers, credit card agencies and government sponsored entities.

Definition: A financial product is a contract between two agents stipulating movements of cash now and in the future. A financial product has value, but it is not tangible.

Finance being about promises, it requires powers capable of enforcing them. This is why modern finance and modern money developed in parallel with the emergence, in western Europe, of powerful monarchies, which replaced feudality between 1000 and 1700. Then absolute monarchies were replaced by various “republican” systems, which retained however (and even reinforced) the centralized authority of monarchies. At the beginning of the 21st century, we are witnessing the slow demise of nation-states. This is due to the combination of several factors, among them these two:

1) Advent of new communication systems which prevent states from controlling the free diffusion of information in their populations:

  • This is one of the reasons of the ex-Ottoman empire post-colonial state revolutions in Northern Africa.
  • But this erosion of credibility can also be observed in France.

2) Some new international firms have the capacity to maintain systems of signs (moneys) that are better and more reliable than international State currencies.

Types of financial products: Financial products are categorized in terms of their type or underlying asset class, volatility, risk and return.

1) Shares: These represent ownership of a company. While shares are initially issued by corporations to finance their business needs, they are subsequently bought and sold by individuals in the share market. They are associated with high risk and high returns.

2) Bonds: These are issued by companies to finance their business operations and by governments to fund budget expenses like infrastructure and social programs. Bonds have a fixed interest rate, making the risk associated with them lower than that with shares.

3) Treasury Bills: These are instruments issued by the government for financing its short term needs. They are issued at a discount to the face value.

4) Options: Options are rights to buy and sell shares. An option holder does not actually purchase shares. Instead, he purchases the rights on the shares.

5) Mutual Funds: These are professionally managed financial instruments that involve the diversification of investment into a number of financial products, such as shares, bonds and government securities. This helps to reduce an investor’s risk exposure, while increasing the profit potential.

6) Certificate of Deposit: Certificates of deposit (or CDs) are issued by banks, thrift institutions and credit unions.They usually have a fixed term and fixed interest rate.

7) Annuities: These are contracts between individual investors and insurance companies, where investors agree to pay an allocated amount of premium and at the end of a pre-determined fixed term, the insurer will guarantee a series of payments to the insured party.

Complex Financial Products: There are certain financial products that are highly complex in nature. Among these are:

1) Credit Default Swaps (CDS): Credit default swaps are highly leveraged contracts that are privately negotiated between two parties. These swaps insure against losses on securities in case of a default.

2)  Collateralized Debt Obligations (CDO): These are securities that are created by collateralizing various similar debt obligations such as bonds and loans. CDOs can be bought and sold. The buyer gains the right to a part of the debt pool’s principal and interest income.

Conclusion: One of the most significant factors to consider when choosing financial products is your risk appetite. Risky investments are usually associated with higher returns than safer investments. According to empirical data, shares usually outperform all other investments over the long term. However, in the short term, shares can be extremely risky due to their random and volatile nature.

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