What are derivative instruments?

It may sound like a house of cards, but many financial instruments in the global economy are based on nothing more than the value of other financial instruments. Today it would be impossible to responsibly manage any significant international investment without an understanding of financial derivatives like options, financial futures, and interest rate swaps. A stock option, which allows an investor to purchase or sell a given stock at a fixed price sometime in the future, is called a derivative because its value is determined by the value of an underlying stock.

A financial future is an agreement to buy a financial instrument— such as a stock or bond—sometime in the future at a fixed price. A stock index future, for example, allows investors to benefit from the rise in a stock index by buying, in a sense, all the shares in the index. Just as a gold future goes up in value when gold's price rises, a future on the Standard & Poor's 500 will increase in value when the stock index rises.

The basic idea of a swap is to trade something you have for something you want. A swap is a trade agreement between two or more counterparties, usually banks, to exchange different assets or liabilities such as interest payments. Essentially, it allows both parties to obtain the right assets and cash flows for their own particular needs. In the case of banks, this most often means trading two loans with different interest rates or different foreign currencies. For example, a bank lending money to consumers at a fixed interest rate may be borrowing money at floating or periodically changing interest rates. In order to eliminate the risk of having borrowed and lent money at two different interest rates, the bank enters into an interest rate swap agreement with another institution to exchange one flow of interest rates for another.

Questions:

1. What is ‘a financial instrument’?

2. What does a stock option allow?

3. What is ‘a financial future’?

4. What is the basic idea of a swap?

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