Derivative and Hybrid Instruments
Derivatives and hybrids constitute a large and growing portion of the financial markets today. Derivatives are instruments that are derived from other underlying instruments. For example, a stock option is an instrument that is derived from and depends on the existence of the underlying stock. Currency futures are derived from and depend on the existence of the underlying currency. Hybrids are instruments that combine the features of different types of instruments. For example, convertible bonds combine the features of bonds and stocks. The derivative instruments discussed in this chapter are futures, options, warrants, and swaps. The hybrid instruments discussed in this chapter are preferred stock, convertible bonds, convertible preferred stock, and junk bonds. Special features of investment instruments such as indexed terms, resets, caps, and put features are also discussed.
Futures contracts evolved from forward contracting, which has existed for centuries. Forward contracts are agreements to exchange an asset at some specified time in the future for a specified price. The price and conditions of the exchange are arranged in the forward contract and the transaction takes place at a specified later date. The forward market does not stand in any particular location. Market makers are large banks around the world, with London, New York, and Tokyo as the centers. The forward