five colors of financial instruments

S. Mark BarnesSeptember 2009

• Just like an artist can create all colors from three primary colors, a financial artist can create all financial instruments from five basic concepts.

The Five Colors• Equity Shares• Bonds• Forward/Futures• Options• Notional Principal Contracts

Equity Shares• Ownership• Right to the residual cash flows (the money

left after all expenses are paid).

Bonds• Debt• Created by Contract (voluntary loan)• Right to Interest Payments• Priority Over Equity Holders

Derivatives• The word derivative means that its value is

derived (comes from) the value of an underlying asset.

• Three Derivative Colors– Forwards/Futures– Options– Notional Principal Contract

Forwards/Futures• Forwards are traded OTC• Futures are traded on an exchange• Contract that obligates the seller to sell and

the buyer to buy:– Specified Asset– Specified Price– Specified Time

Options• Traded OTC and on exchanges• Created by contract • Requires payment of a premium• Right to buy/sell (but not obligated)

underlying asset:– Underlying Asset– Strike Price – Expiration Date

Call Option• Right to buy

Put Option• Right to sell

American vs. European• American Option: Option can be exercised

at any point in time up until the expiration date.

• European Option: Option can only be exercised on the expiration date.

Digital or Binary Options• Cash Settled• Specified payment amount, if option is in

the money. • Example: If option expires in the money,

option purchaser receives $1 million (no matter how far the underlying asset exceeds the strike price.)

Notional Principal Contract• Traded OTC• Parties agree to make net periodic

payments during the term of the contract based on price movements of the specified asset/index.

• Notional Amount: Base amount used to compute payments.

Example of Notional Principal Contract(Currency Swap)

• Purpose: Put the parties in the position they would have been in had ¥/$ exchange rate stayed at ¥100 per $1.00 for five years.

• Notional Principal amount: $1 billion• Periodic payments made at the end of each year for five

years.• At the end of each year, the parties calculate a net

payment to be made by one party to the other based on current exchange rate. The payment will put both parties in the economic position they would have been in if the rate was ¥100 per $1.00.

Payment Calculation Example• At end of year one, exchange rate is

¥95/$1.00.• The $ party is now in a worse position and

must be compensated under the contract. • The ¥ party must pay a net payment of

$52,631,579 to the $ party. • At the end of year two, another payment

would be calculated based on the exchange rate at that time.

Payment Calculation• (At ¥100/$1.00) $1 billion = ¥100 billion• (At ¥95/$1.00) $1 billion = ¥95 billion• Thus, $ party is short ¥5 billion• (At ¥95/$1.00) ¥5 billion = $52,631,579

(payment)• If rate is higher than ¥100/$1.00, $ party

must make net payment to ¥ party.