Financial Instruments: A System of Derivatives and Underlyings

As mentioned in the introduction, trading can be defined as an agreement between two parties in which one of the two consciously accepts a financial risk in return for the receipt of a specified payment or at least the expectation of such a payment at same future time from the counterparty. Financial instruments, also called financial products, are instruments which make such a risk mitigation or risk transfer possible. The purpose of this section is to present a classification of such instruments in a system of underlyings and derivatives, specifically for interest rate instruments. Interest rate risk is by far the most complex market risk. Correspondingly, interest rate instruments, ie. instruments having interest rates as their underlying risk factors, are among the most complex financial instruments traded on the market. Instruments on other risk factors such as stocks or foreign exchange rates can be classified analogously and will be discussed in detail in later sections of the book.