Financial products are investments and securities that are created to provide buyers and sellers with a long term or short term financial gain. Financial products enable risks to be spread, and liquidity to circulate around an economy.
Derivatives and options
Many financial products are derived from an existing asset or other financial product, and such products are called derivatives. Derivatives can be placed into one of two categories:
Forwards, which are contracts to deliver something, usually a financial benefit, at some point in the future.
Options, which are contracts that give one or both parties to a financial contract the right to gain a certain benefit in the future.
Derivatives date back thousands of years, and until fairly recently were sold exclusively to private individuals. During the last 35 years, complex markets have developed involving individuals and institutional investors. Trading has become increasingly sophisticated, with a greater reliance on technology. Option trading took off following the publication of the Black-Scholes pricing model in 1973. Until that point, it was difficult for buyers and sellers to value options effectively, but the Black-Scholes model, using sophisticated mathematical modelling, enabled even inexperienced traders to put a reasonably accurate value on the asset upon which the option was based. Some observers have argued that over-reliance on such pricing models partly contributed to the recent financial crisis.
Futures are contracts to buy or sell a real or financial commodity at some point in the future, but at a price agreed at the time of exchanging the contract. For example, a trader in coffee may purchase a contract for 30,000 lbs of Columbian coffee at $1.20 for delivery in 3 months. This contract could be sold to another trader at any point over the next 3 months. If, after 1 month, the market price rises to $1.40 the owner of the contract could sell it and make a profit of 20c per pound, and a total profit of $6,000.
There are four main commodity futures; agricultural products, metals, transport and energy.
There are also futures markets for interest rates, currencies, and share prices.
Corporate bonds are financial securities that are sold by private firms to raise large sums of money. Government bonds, referred to as gilts, are issued by central and local government, also to raise large sums. Most bonds are issued with a fixed rate, giving the holder a fixed return over the life of the bond, which may be up to 30-years. However, some bonds are issued with a floating rate.
Corporate bonds are more risky that government bonds because private firms can go bankrupt, whereas governments can raise funds by taxation, or by issuing new bonds, so holders of government bonds are guaranteed a return.
The issue of government bonds in the UK is managed by the Treasury's Debt Management Office (DMO).
Swaps are derivatives that allow the user to exchange one type of bond for another, commonly a fixed-rate bond for a floating-rate bond.
Hedge funds are investment funds for wealthy depositors looking to make a secure return by exploiting the skills and expertise of the professional fund manager. Hedge funds, which deal largely in derivatives, have become an important investment option for individuals and investing-organisations, including pension funds and insurance companies.
(Sources: Levinson, M, 1999: Guide to The Financial Markets, The Economist; and www.coffee-futures-trading.com)