Equity, Fixed Income, FX, and Commodities

An asset class is a group of investments and risks with a common economic exposure. A share represents ownership. A bond represents lending. A currency creates an exchange-rate exposure, while a barrel of oil creates a commodity-price exposure.

An asset class is different from an instrument. An instrument is the contract or security used to hold or trade an exposure. A share is an equity instrument, and a government bond is a fixed-income instrument. A futures contractIn finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.Read on Wikipedia → is a derivative instrumentIn finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:an item that can or must be bought or sold, a future act which must occur, a price at which the future transaction must take place, and a future date by which the act must take place.Read on Wikipedia →: a standardised agreement to buy or sell its underlying later. A currency future, for example, is a derivative whose underlying exposure is foreign exchange.

In a basic markets or derivatives discussion, four groups are useful: equity, fixed income, foreign exchange (FX)The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. By trading volume, it is by far the largest market in the world, followed by the credit market.Read on Wikipedia →, and commodities. In some trading and risk systems, rates and credit are split into separate groups instead of being kept together under fixed income. Cash, real estate, and private markets may also be treated as separate asset classes.

Equity: ownership in a business

EquityIn finance, equity is an ownership interest in property that may be subject to debts or other liabilities. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets owned. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.Read on Wikipedia → represents an ownership claim on a company. The common shareholders are entitled to the value that remains after the company has paid its creditors and other obligations.

A shareholder may receive dividends, but dividends are not guaranteed. The share price can also change as the market changes its view of the company’s future profits, cash flows, and risks. A share normally has no maturity date: the investor can sell it, but the company does not normally have to repay the share at a fixed date.

The main exposure is therefore to the value of the business. Important risks include:

• the company earns less than expected;
• the value of the whole stock market falls;
• interest rates change the value investors place on future profits;
• the share becomes difficult to sell.

A portfolio manager can hold shares directly or use an index fund. A trader can also use an equity derivative, such as a stock future or an optionIn finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.Read on Wikipedia →. The instrument changes, but the central risk is still linked to the share price or to a stock index.

For example, an investor who owns shares may buy a put optionIn finance, a put or put option is a derivative instrument in financial markets that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.Read on Wikipedia →, which gives the buyer the right to sell at an agreed price, to limit the loss from a fall in the share price. The option has its own premium and contract terms, but its purpose is to limit the loss on the shares.

Fixed income: lending money

Fixed incomeFixed income is a type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not: in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.Read on Wikipedia → covers debt investments. The investor lends money to a government, company, or another borrower. In return, the borrower promises payments such as interest and repayment of the principal, the amount originally lent.

The payments are contractual, but the word “fixed” does not mean that every payment is constant. A floating-rate note can pay interest based on a reference rate. An inflation-linked bond can change its payments or principal with an inflation index.

A yield is a market-implied rate that relates a bond’s price to its promised cash flows under a specified convention. For example, yield to maturity treats the bond’s price, coupons, repayment, maturity, and reinvestment assumptions as one calculation. It is not necessarily the investor’s realised annual return: a default, a sale before maturity, or different coupon reinvestment can change that result.

Three risk drivers matter for a bond’s price:

Risk driver	Main exposure	Typical effect
Rates	Interest rates used to value future cash flows	Bond prices usually fall when comparable yields rise
Inflation	The purchasing power of future payments	When inflation rises, fixed payments buy less in real terms
Credit	The borrower’s ability to pay	The bond can lose value if default risk increases

A bond’s price depends on its promised cash flows, the time until they arrive, and the yield the market requires. A longer-maturity bond usually reacts more to a change in rates than a shorter-maturity bond with similar credit quality and coupon, the periodic interest payment.

A bank or fund can manage this exposure with bonds, interest-rate futures, or an interest-rate swapIn finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).Read on Wikipedia →. In an interest-rate swap, the parties exchange interest payments calculated in different ways, often a fixed rate for a floating rate. The trade changes the rate exposure without requiring the institution to replace every bond in its portfolio.

Credit derivatives add another layer. A credit default swapA credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.Read on Wikipedia → can transfer credit risk from one party to another. It pays the protection buyer if a defined credit event happens, such as the borrower’s default or bankruptcy. The buyer still depends on the protection seller being able to pay; this is counterparty riskCredit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal payment, leading to disrupted cash flows and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.Read on Wikipedia →.

Foreign exchange: one currency against another

Foreign exchange, usually called FX, is the market for exchanging one currency for another. An FX quote is always relative. EUR/USD tells us how many US dollars are needed for one euro.

The spot marketThe spot market or cash market is a public financial market in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market, in which delivery is due at a later date. In a spot market, settlement normally happens in T+2 working days, i.e., delivery of cash and commodity must be done after two working days of the trade date. A spot market can be through an exchange or over-the-counter (OTC). Spot markets can operate wherever the infrastructure exists to conduct the transaction.Read on Wikipedia → is for an exchange settled in the near term. A currency pair can also be traded through a forwardIn finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.Read on Wikipedia →, a futures contract, an option, or a swap for a later exchange or a different pattern of cash flows. The contract type is the instrument; the currency pair describes the underlying exposure.

Suppose a US company must pay a supplier €100,000 in three months. It enters a forward to buy euros at $1.10 per euro, fixing the dollar cost at $110,000. If the spot rate is $1.20 when the payment is due, buying euros without a hedge would cost $120,000. If the spot rate is $1.00, the unhedged cost would be $100,000, while the forward would still cost $110,000. These figures ignore fees and funding costs.

The company owes euros, so in economic terms it is short euros: a rise in EUR/USD raises its dollar cost. The forward gives it a long-euro position that offsets this exposure. This is hedgingA hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.Read on Wikipedia →. The company gives up the benefit of a favourable exchange-rate move in return for a more predictable dollar cost.

FX is different from equity or a bond because two currencies are always involved. Buying one currency means selling another. A bank’s position is described by both the currency and the direction of the trade.

Commodities: physical goods and their prices

CommoditiesIn economics, a commodity is an economic good, usually a resource, that specifically has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.Read on Wikipedia → are physical goods traded to defined market grades, such as crude oil, natural gas, copper, wheat, or gold. A commodity contract needs to define more than a price. It may also specify the grade, quantity, delivery location, and delivery date.

Commodity prices depend on supply and demand, but supply cannot always change quickly. Weather can affect agricultural products. Production outages can affect energy and metals. Storage and transport costs can affect the relationship between a spot price and a future delivery price.

A producer may sell futures to protect the price it will receive for future production. An airline may buy fuel futures or other contracts to reduce the effect of higher fuel prices.

A futures contract does not always mean that the trader will take physical delivery. Many positions are closed before delivery, and some contracts are settled in cash. The contract’s rules determine how settlement works.

The hedge may still be imperfect. The commodity used in the contract may not have the same location, grade, or delivery date as the commodity used by the business. Basis riskBasis risk in finance is the risk associated with imperfect hedging due to the variables or characteristics that affect the difference between the futures contract and the underlying "cash" position. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge before expiration, namely b = S - F. Barring idiosyncratic influence by the other aspects to be enumerated just below, by the time of expiration this simple difference will be eliminated by arbitrage. The other aspects that give rise to basis risk include:Quality (grade) arising when the hedge in place has a different grade which is not perfectly correlated with the basis; Timing arising due to mismatch between the expiration date of the hedge asset and the actual selling date of the underlying asset; Location arising due to the difference in the location of the asset being hedged and the asset serving as the hedge, and which typically includes a premium to cover the risk these transportation costs may rise, causing a negative impact on the hedger.Read on Wikipedia → is the risk that the hedge instrument’s price and the price the business actually pays or receives do not move together.

One exposure can use several instruments

The same asset class can appear through several instruments:

Exposure	Possible instruments	Main risk drivers
Equity	Shares, index futures, or put options	Share or index prices
Fixed income	Bonds, swaps, or government-bond futures	Rates, inflation, and credit
FX	Cash balances, forwards, or options	Currency-pair prices
Commodities	Physical goods, futures, or options	Spot and future prices, plus basis

A risk system may need to store contract terms such as maturity and an option’s exercise price. It separately stores position and account state such as marginIn finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:Borrowed cash from the counterparty to buy financial instruments, Borrowed financial instruments to sell them short, Entered into a derivative contract.Read on Wikipedia →, which is money or assets held as security for a futures position. It also needs to identify the economic exposures that drive the portfolio’s value, such as equity prices, interest rates, currency rates, or commodity prices.

A single position can contain more than one risk. A foreign-currency corporate bond has interest-rate, credit, and FX risk. A foreign company share bought by a dollar-based investor has equity risk and FX risk.

The same derivative can appear in different portfolios for different reasons. A currency forward may hedge an invoice, support a speculative position, or offset the risk in another investment.