Financial “products” or “instruments” are contracts that can be negotiated on capital markets. There are several ways to classify such products. The approach taken in this website is to focus on the technical characteristics of such instruments. However, we also present an alternative classification based on market segment which more closely reflects economic realities.
Technical viewpoint: Securities / balance sheet transactions / derivatives
Securities cover all direct financing instruments of companies, banks, states or public entities. A security represents a share of a medium or short-term (Medium term note, commercial paper) claim or long term claim (bonds), or a share in the capital of a company (equities or shares). For the issuer of the security, it is a financing instrument and for the buyer an investment instrument. Securities can be traded over the counter or through organised markets (such as the NYSE or Euronext) in variable amounts, either whole numbers (shares), decimals (certain shares in UCITS) or nominal amounts for bonds. Securities are negotiable instruments, in other words they can change hand after they have been issued on what is called the secondary market, provided of course that a counterparty exists for the exchange. In this section we will deal with related subjects such as securitisation and corporate actions.
Balance sheet transactions
Balance sheet transactions include all transactions involving an immediate or deferred recognition in the balance sheet of operators (purchase/sale transactions or issuance of securities, but we have chosen to isolate the “securities” section given the extent of the subject…). Loans/cash borrowings, uncovered or guaranteed by collateral (repos) represent the simplest element as basically simply cash loans or borrowings. Currency transactions concern currency markets and cover purchase/sale transactions in currencies, either spot or futures. These products are only traded over the counter.
Derivative products include all transactions generally referred to as “off-balance sheet” as not recorded in the balance sheet of the financial institution. They are referred to as “derivative” because they have been developed from or in some way “out of” basic financial instruments. As the imagination of markets is limitless, the number and variety of such products is practically infinite and it is therefore difficult to make an exhaustive presentation. In addition, derivative products usually mix various types of basic asset: equities and bonds, currencies and interest rates. Derivative products are traded on organised markets (options markets and futures markets) or over the counter: interest rate swaps, credit derivatives, FRAs.
Risk approach: classification by economic characteristic
A presentation that is closer to economic reality consists in classifying products by market or by the type of risk traded.
Interest-rate products include all those whose income and valuation depends on an interest-rate and which therefore fluctuate according to market rates. The associated risk is an interest-rate risk. In this category can be found securities representative of claims such as bonds and MTNs, cash loans and borrowings, repos and derivative products whose underlying asset is interest-rate sensitive: interest-rate swaps, FRAs, interest-rate futures, interest-rate options and caps and floors etc.
The equity and equity derivatives markets are based on securities (shares, investment securities and hybrid securities) which represent a share in the capital of a company or which provide access in the case of hybrids (convertible bonds, bonds with equity warrants). Equities can change hand through purchase and sale transactions but also temporarily through the lending/borrowing of securities. Equity derivatives (futures, options and warrants) facilitate hedging transactions or enable investors to take a position on market fluctuations or associated equity risk.
The forex market (or foreign exchange market) is the place where spot or term trading of currencies occurs. In this market, prices, i.e. the currency exchange rate, can fluctuate very rapidly. FX options and futures enable operators to hedge against currency fluctuations, in other words to hedge FX risk. Traders specialised in currency transactions are called forex brokers.
Credit derivatives enable operators to take a position (speculation or hedging) vis-a-vis the credit risk of a company, country or market sector.
Commodities are raw materials traded spot or more frequently derivative products (futures) traded on international markets.
Shares in funds, asset-backed securities (ABS) and other structured products are composite products that are difficult to classify in a particular category. In the case of an ABS or CDO, for example, the main risk is related to securitised assets and can take many forms. Furthermore, if the structure includes a CDS or a guarantee provided by a monoline insurance company, the quality of the security also depends on the CDS underlying risk or the guarantor. Such instruments, by their nature composite, cannot like the others be assimilated to a specific economic risk.