10.3.2 Financial Assets

Overview of Financial Assets

In recent decades, financial derivatives have experienced explosive growth, driven primarily by several key factors:

• Increasing volatility in interest rates, exchange rates, and equity prices
• Financial deregulation coupled with intensified competition amongst financial institutions
• Globalization of trade and tremendous advances in information technology
• Significant theoretical breakthroughs in financial engineering

Equity Derivatives

Equity derivatives are a large category of financial derivatives with equity as the underlying asset. The most predominant products in this category are equity options on individual stocks. These derivatives are predominantly traded on organized exchanges, such as:

• Montréal Exchange
• Chicago Board Options Exchange
• International Securities Exchange
• Boston Options Exchange
• NYSE AMEX Options
• NYSE ARCA Options markets

Interest Rate Derivatives

Interest rate derivatives traded on exchanges are generally based on securities that are sensitive to interest rate changes rather than the interest rates directly. In Canada, the underlying assets for these derivatives include banker’s acceptances and Government of Canada bonds. All Canadian futures trading related to interest rates occurs at the Montréal Exchange.

In Over-The-Counter (OTC) markets, interest rate derivatives typically are connected to well-defined and recognized floating interest rates, such as:

• Treasury bill yields
• Treasury bond yields
• London Interbank Offer Rate (LIBOR)

Unlike market-traded derivatives that settle based on securities, OTC interest rate derivatives usually settle in cash, due to their basis on interest rates.

Currency Derivatives

Currency derivatives trades commonly involve major currencies like the U.S. dollar, British pound, Japanese yen, Swiss franc, and the Euro. Contracts in this area include:

• Currency futures and options, traded on organized exchanges
• Currency forwards and swaps, which are typically found in the OTC market

Did You Know?

A swap is a private contractual agreement between two parties. It allows them to exchange (swap) periodic payments in the future based on a predetermined formula. Essentially, swaps resemble a series of forward contracts packaged together. More details regarding swaps can be found in the Derivatives Fundamentals Course (DFC).

Key Takeaways

• Equities: Equity derivatives mostly involve equity options on individual stocks and are traded on recognized exchanges.
• Interest Rates: Interest rate derivatives in Canada are traded on the Montréal Exchange with the underlying assets being sensitive securities, such as banker’s acceptances and government bonds.
• Currencies: Currency derivatives on exchanges include futures and options, while forwards and swaps are usually encountered in the OTC markets.

Frequently Asked Questions (FAQs)

Q1: What are the key drivers of the growth in financial derivatives?

• A: Volatile interest and exchange rates, financial deregulation, enhanced competition among financial institutions, trade globalization, and significant strides in information technology.

Q2: What are the main venues for trading equity derivatives?

• A: Equity derivatives are mainly traded on exchanges like the Montréal Exchange, Chicago Board Options Exchange, International Securities Exchange, among others.

Q3: How are interest rate derivatives typically settled?

• A: OTC interest rate derivatives are generally settled in cash due to their foundation on interest rates rather than actual securities.

Q4: What is a currency swap?

• A: A currency swap is a private agreement to exchange future periodic payments based on an agreed formula, acting similarly to a series of forward contracts.

Glossary

• Equity Derivative: A financial instrument whose value is based on an underlying equity asset, most often an individual stock.
• OTC (Over-The-Counter) Market: A decentralized market where participants trade securities directly between two parties without a central exchange or broker.
• LIBOR (London Interbank Offer Rate): The interest rate at which banks offer to lend funds to one another in the international interbank market for short-term loans.
• Swap: A financial agreement in which two parties exchange cash flows or liabilities from two different financial instruments.

    pie
	    title Composition of Currency Derivatives
	    "USD": 35
	    "GBP": 25
	    "JPY": 15
	    "CHF": 10
	    "Euro": 15

This diagram provides a typical distribution of currency derivatives by major currencies.

Continue to explore further sections for a greater understanding of financial assets and their integral role in modern finance.