Anybody involved in business or personal finance should understand the meaning and kinds of financial contracts that exist. Financial contracts are contracts between two people which specify terms of a monetary transaction. They are available in several forms and supply various benefits and purposes. In this blog, we will explain the kinds of financial contracts.
What Are Financial Contracts?
Financial contracts are agreements describing how monetary transactions between two or more people will happen. They might entail borrowing money, investing, purchasing or even selling assets, or controlling risk. These contracts are meant to provide a legal framework which protects all parties.
Common Types of Financial Contracts
These are the basic types of financial contracts:
- Debt Agreements
- Equity Agreements
- Derivative Contracts
- Lease Agreements
- Insurance Contracts
Let us examine each type to see their operation and purpose.
Debt Agreements
Debt agreements are agreements under which a single party borrows money from another and agrees to repay that money in due course with interest. They’re the most common form of financial contracts and include:
- Loans: A loan is a contract in which a bank offers cash to a borrower that agrees to pay back the sum with interest for a time period. Loans might be secured (backed by collateral like a home or automobile) and unsecure (not backed by collateral).
- Bonds: Bonds are equity securities sold by governments or corporations. Whenever you buy a bond, you loan money to the issuer in exchange for regular interest payments and also the return of the bond’s face value at maturity.
Equity Agreements
Equity agreements give somebody ownership of a business. The most popular types include:
- Stocks: Stocks represent ownership of a business. If you purchase stocks, you own a part of the company. This ownership provides you with a cut of the company’s earnings and, in a number of instances voting rights in business decisions.
- Convertible Bonds: They are bonds convertible into a set number of the seller’s equity shares. This particular option enables the bondholder to profit from the company’s growth.
Derivative Contracts
Derivatives are financial contracts whose value comes from an underpinning asset like stocks, bonds, currencies or commodities. They’re used to hedge risk or even speculate on price movements. Common derivative contract kinds include :
- Options: An option grants the owner the right but not the obligation to purchase and sell an item at a particular cost over a specified time period. There are two kinds: calls (right to buy) and puts (right to sell).
- Futures: A futures contract requires the purchaser to purchase and the seller to sell an item at a future date for a fixed value. They’re standardised contracts that are traded on exchanges.
- Swaps: A swap is an agreement between two parties to exchange money flows or any other financial instruments during a certain period of time. The most popular kinds include interest rate swaps and currency swaps.
Let us understand about these in detail.
Options
Options are used to hedge risk or even speculate about price changes. They work this way:
- Call Option: Provides the holder the right to purchase an asset at a particular cost for a particular time. For instance, in case you own a call option on a stock with a strike price of Rs 50, you can purchase the stock for Rs 50 if its market price increases to Rs 70.
- Put Option: Provides the owner the right to sell an asset at a specified price within a particular time. For instance, in case you have a put option on a stock having a price of Rs 50, you could sell the stock for Rs 50 if its market price drops to Rs 30.
Futures
Futures contracts are standard arrangements to purchase or sell an asset at a future cost on a specific date. They’re used on commodities markets for oil, gold and agricultural items. They work this way:
- Hedging: Imagine you’re a wheat farmer and worry wheat prices are going to fall. You can buy your wheat at harvest and lock in revenue through a futures contract.
- Speculation: Futures also can bet on price movements for investors. In case you think oil prices will rise, you can purchase futures contracts and then anticipate to sell them at a higher cost later.
Swaps
Swaps are exchanges of cash flows or other financial instrument. Among the most common kinds include:
- Interest Rate Swaps: Parties swap fixed interest payments for variable payments to manage interest rate exposure. For instance, a company with a variable rate loan may well alter its payments to fixed rate payments to stabilise its debts.
- Currency Swaps: Parties exchange cash flow in several currencies. This helps multinationals with currency risk. For example, a Euro – earning Indian company might swap its euro cash flows for rupees to cover its expenses.
Lease Agreements
Lease agreements are contracts under which the lender pays the lessor to use an asset for a particular time. Common lease agreements consist of:
- Operating Leases: They’re short term leases where the lessee utilises the property for less than its useful life. The lessor owns and will be responsible for maintenance.
- Finance Leases: They’re long-term leases where the lessee utilises the asset for the vast majority of its useful life. The lessee pays for maintenance and could buy the asset at the conclusion of the lease period.
Insurance Contracts
Insurance contracts are agreements in which a single party (the insurer) agrees to pay another party (the buyer) for particular damages or losses in return for regular premium payments. Common types of insurance contracts include:
- Life Insurance: This particular contract pays a death benefit to specified beneficiaries upon the insured person’s death. It offers financial security to the insured or his dependents.
- Health Insurance: This particular contract covers medical costs incurred by the insured. It might include hospital stays and doctor visits, prescription medications along with other healthcare services.
- Property & Casualty Insurance: This particular insurance covers loss of property (such as house, automobile) and responsibility for injuries to other individuals.
How to Select the Right Financial Contract
The right financial contract is customised for your objectives, risk tolerance and economic situation. Tips on making a well-educated decision are:
- Evaluate Your Goals: Set your goals for the contract. Are you borrowing money, hedging risk, investing, or guarding against losses?
- Understand the Risks: Each kind of contract carries different risk levels. Know the downsides and also the way they compare with your risk tolerance.
- Consider the Costs: Some contracts have costs, interest, or premiums attached. Look at these costs and decide in case they’re inside your budget.
- Seek Professional Advice: In case you have concerns about which contract to select, speak with a financial adviser or expert like StartupFino for individualised advice.
Conclusion
Financial contracts are tools in finance that provide methods to manage cash, spend or protect against risks. Knowing the kinds of financial contracts will help you to make the very best economic decision based on your monetary objectives and risk tolerance. Regardless of whether you’re a business proprietor, investor, or simply someone wanting to understand your finances better, this guide can help you understand financial contracts.
FAQs
What is a contract in finance?
A contract in finance is a contract among two or more parties describing the terms and conditions of a financial transaction (responsibilities, responsibilities, compensation). They’re legally binding contracts that are used to handle, hedge or even speculate on financial assets.
What kind of contracts exist in global finance?
For international finance, typical kinds of contracts are international exchange contracts, overseas loan agreements, trade finance agreements and derivatives including futures, swaps and options. These contracts manage risks of change in currency, interest rates, along with global trade.
What are the four types of contracts?
The four kinds include express contracts (plainly stated terms), implied contracts (inferred from actions), quasi contracts (created by law to stop unjust enrichment) and e-contracts (agreements made electronically). Each has a unique legal and practical function in various circumstances.
What are contracts on the basis of formation.?
Contracts based on formation include:
- Express Contract: The parties specify terms explicitly.
- Implied Contract: Terms are inferred from action or circumstance.
- Quasi Contract: Imposed by law to stop unjust enrichment.
- E-Contract: Electronic agreements generally are made over the internet.
How many kinds of contracts does business have?
Typical kinds of contracts in business are : bill of sale, employment agreement, license agreement, promissory note and nondisclosure agreement. These contracts define sale terms, employment circumstances, intellectual property rights, confidentiality, and debts.
What is a financial deal?
A financial deal is a transaction or agreement where individuals exchange cash, goods or services. This might involve purchasing or even selling stocks, getting a loan, acquisitions and mergers or even carrying out derivative contracts to hedge monetary risks.
