What is a financial instrument?

A financial instrument is defined as a contract that creates a financial asset for one entity and a financial liability or equity instrument for another. This definition encompasses a broad range of instruments such as stocks, bonds, derivatives, and loans. In essence, financial instruments can be categorized as either assets or liabilities depending on the perspective of the parties involved in the contract. For instance, when one party issues a bond, it becomes a liability for the issuer while simultaneously creating a financial asset for the bondholder. This dual nature is crucial for understanding how different financial instruments function within the context of financial markets and accounting practices.

The other options provided do not accurately capture the comprehensive definition of a financial instrument. A physical asset traded in the market refers more to tangible goods, such as real estate or commodities, rather than the contractual nature of financial instruments. A liability arising from past transactions, while it may relate closely to financial instruments, does not cover the concept of financial assets or equity that can be created through contracts. Lastly, an investment generating passive income may result from financial instruments but does not define what a financial instrument is. Thus, the first option is the most comprehensive and accurate representation of a financial instrument.