Financial products refer to those 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. Financial products are categorised in terms of their type or underlying asset class, volatility,
risk and return.
Financial Products: Types
The major types of financial products are:
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. Returns on shares can be in the form of dividend payouts by the company or profits on the sale of shares in the stock
market. Shares, stocks, equities and securities are words that are generally used interchangeably.
Bonds: These are issued by companies to finance their business operations and by governments to fund expenses like
infrastructure and social programs. Bonds have a fixed interest rate, making the risk associated with them lower than that
with shares. The principal or face value of bonds is recovered at the time of maturity.
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. The profit earned by the investor is the difference between the face or maturity value and the
price at which the Treasury Bill was issued.
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.
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.
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.
Annuities: These are contracts between investors and insurance companies, wherein the latter makes periodic payments in
exchange for financial protection in the event of an unfortunate incident.
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. Since the government does not regulate CDS
related activities, there is no specific central reporting mechanism that determines the value of these contracts.
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.
CDS and CDO products have played a major role in the Financial Crisis of 2008 onwards. During these troubled times,
CDO ratings reflected incorrect information on the credit worthiness of borrowers, concealing the underlying risk in mortgage
investments. Meanwhile, the size of the CDS market far exceeded that of the mortgage market in mid-2007. Thus, when the defaults
began to unfold during the Financial Crisis, the banks were not in a position to bear the losses.
One of the most significant factors to consider while choosing financial products is your risk appetite. Risky investments are
usually associated with higher returns than are safe ones. According to empirical data, shares usually outperform all other
investments over the long term. However, in the short term, stocks can be extremely risky.