income and foreign exchange (FX)). The processes for dealing with each of these trades will normally depend on the asset class rather than the product itself.
As we have seen, some products exist in more than one asset class. Every asset class has a suite of possible products. A financial institution organises its traders, sales staff, middle office and controllers around each asset class rather than around each product.
A trade is an actual instance of a product. There are two parties to any trade, often referred to as counterparties or counterparts. Many products make reference to other parties or events. For example, UBS might buy Ford Motor Company shares from BNP Paribas. The two parties to the trade are UBS and BNP Paribas. Once purchased, UBS will have to claim dividends from Ford and not from BNP Paribas, so UBS will have to make Ford aware of its acquisition.
Some products make reference to events or entities. A swap trade (described below) needs at least one reference entity for its float leg (or two for a float-float swap). The reference will state the date, time and nature of the entity to be taken into consideration. An analogy might be to betting on a horse. The customer purchases the bet from the seller (the bookkeeper) but any winnings are dependent on the reference entity in the bet (the horse and the race). The horse itself knows nothing of the trade.
As mentioned, financial products are contracts. We can analyse the product by looking at the terms and conditions of the contract, but it is often easier to examine the cash or asset flows. The product is uniquely defined by the following:
■ date
■ value
■ direction
■ type of cashflow (cash or physical).
The cashflows are the mechanics of how the trade works from start to finish. The value of the trade is something different. Value is a function of the expected worth of future cashflows. Note the keywords expected and future – these involve a view of how the underlying market forces will change over time. So do not confuse cashflows, which are determined at the start of the trade by the type of product being traded, with value which varies over the lifetime of the trade.
For a consistent approach, let us consider each product from our point of view as a trader who is buying something. We shall use the following graphical notation:
■ A down arrow indicates something we are contractually obliged to part with.
■ An up arrow indicates something we are contractually expecting to receive.
■ A grey arrow indicates money (cash) in our own currency.
■ A black arrow indicates something other than money or cash in a foreign currency.
■ A straight line indicates a fixed amount.
■ A dotted line indicates an unknown amount.
3.1 Spot trades
A spot trade is the purchase of an asset for cash. It is the simplest financial product and is often referred to as an outright because, once the cash and assets are exchanged, there is no residual obligation on either party – the trade is settled outright.
In Figure 3.1, we are buying a fixed quantity of something in exchange for cash.
Figure 3.1 Cashflows on spot trade
Notice that the actual exchange does not necessarily take place when the trade is agreed. There is a gap known as the settlement period, which could be anything from a few hours to three days after transaction. However, everything is committed at the time of transaction and the size of payment and assets is fully determined and cannot be changed.
Examples of spot trades in various asset classes are:
■ Commodity: We buy 1m troy ounces of Gold from Commerzbank at USD 1000 per troy ounce.
■ Equity: We buy 10,000 Ford Motor Company shares from BNP Paribas at USD 17.32 per share.
■ FX: We buy 10m Swiss Francs from RBS at exchange rate of 1.118142 francs per US dollar.
■ Fixed income: We buy 5m IBM Bonds from Chase Manhattan at 92.88 cents per bond.
Note that when purchasing an equity or a bond, we have settled outright with the counterparty (BNP Paribas or Chase Manhattan in the examples above) so they have no further financial responsibility or liability, but we now own an active financial instrument and will need to manage it in order to draw dividends or coupons in the future from the issuer (Ford Motor Company or IBM respectively). An analogy is to purchasing home insurance from an insurance broker. Once the broker has sold the insurance he is finished with the deal; in the event of a claim you would have to go straight to the insurer.
3.2 Future (forward)
The definition of a forward or future is very similar and the resulting cashflows are identical. There are some technical differences explained in section 5.1 but for now we shall consider them as one.
As the name implies, a future is a product that will result in an exchange of assets sometime in the future, although the price and amount is agreed now. Also, the trade is legally binding as from now. It is very similar to a spot trade with a very long settlement period. Since the agreed price now and the prevailing market price at time of exchange may be different, both parties will have to come to an agreement for the fair price of the product, taking into account expected future prices.
Futures can be physical or cash settled as shown in Figures 3.2 and 3.3 respectively. Physical settlement means an actual exchange of cash for asset at the future time. Cash settlement means that at settlement, we take the difference between the prevailing market price and the price at which the trade was agreed and one party pays that cash difference to the other.
Figure 3.2 Cashflows on physical future trade
Figure 3.2 shows a physical futures exchange. We agree now that at a future time (known as the future settlement date), we will pay cash and receive a fixed amount of a commodity. All the exchanges are therefore known from now.
Figure 3.3 Cashflows on cash future trade
However a cash settlement future works differently. Suppose we agree now to buy 1m troy ounces of gold from Commerzbank at USD 1000 per troy ounce for cash settlement in six months from today. If, in six months' time, gold was trading at USD 1010 per troy ounce, Commerzbank would owe us:
They would pay USD 10m in cash and no gold would change hands.
If, on the other hand, the price in six months fell to USD 994, we would have to pay:
3.3 Loan
Loans are common in everyday life. If we are the borrower (the purchaser of the loan) then we receive money now and
