The terminology crash course
Think about a bottle of ice cold spring water in New York, in the Gobi Desert and in the Swiss Alps where the water was bottled.
You can assume that the bottle can be safely and cheaply beamed (as in ‘Beam me up Scottie’) from the Alps to New York as well as to the Gobi Desert. Would the price of the bottle be different at the three locations? Why?
The value of the bottle at each location is dependent not on itself but on an external factor. The environment! Reflected by paying capacity in New York, abundance in the Alps and heat and scarcity in the Gobi Desert.
A derivative instrument is very similar to bottled water in the Gobi Desert. Its value is determined completely by external variables. The external factor could be anything but in general is either a financial asset or an economic variable (such as interest rates). The external factor or variable is called the underlying.
A stock index is a derivative instrument. A stock index calculates its value by using the current prices of all the stocks included in that index.
An Asian index would include the prices of selected Asian stocks. A technology index would include the prices of selected technology stocks. An Internet index would include the prices of selected Internet stocks.
A stock index would rise as it underlying stocks rise and will fall as its underlying stocks fall. Without the underlying stocks, the index has no meaning or value.
What are the different types of derivative instruments?
The five types of derivative instruments that we will cover in this course are:
Forward contracts for example a forward contract that allows you to exchange the Euro for US dollars 3 months in the future.
Future contracts, for example a future contract that allows you to buy silver on New York Metal Exchange.
Options, for example a Put option on Google.
Swaps, for example an interest rate swap that allows you to pay a fixed interest rate and receive a floating interest rate on 10 million US dollars over the next three years.
Exotics, for example a contract that allows the buyer to link what he make to the average spread between West Texas Intermediate (WTI) Crude Oil, Brent and Arab Light prices in the month end 30th June 2010.
Let’s take a look at each of these contracts one by one.