Market Risk Analysis Volume III: Pricing, Hedging and Trading Financial Instruments

Preface to Volume III

A financial instrument is a legal contract between two or more parties that defines conditions under which the various parties incur costs and receive benefits. A cost or benefit need not be a monetary amount; it could be a commodity, for instance. The simplest type of financial instrument is a financial asset, which is a legal claim on a real asset such as a company, a commodity, cash, gold or a building. A financial security is a standardized form of financial asset that is traded in an organized market. For instance, equity securities (shares on a company's stock) are traded on exchanges and debt securities such as bonds and money market instruments (including bills, notes and repurchase agreements) are traded in brokers' markets.

A derivative contract, usually called a ‘derivative’ for short, is another type of financial instrument which is a contract on one or more underlying financial instruments. The under-lying of a derivative does not have to be a traded asset or an interest rate. For instance, futures on carbon emissions or temperature have started trading on exchanges during the last few years. Derivatives are the fastest-growing class of financial instruments and the notional amount outstanding now far exceeds the size of ordinary securities markets. For instance, in 2007 the Bank for International Settlements estimated the total size of the debt securities market (including all corporate, government and municipal bonds and money market instruments) ...