LN2 Asset Classes and Financial Instruments

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Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Risk Management
Prof. Jorge Miguel Bravo, PhD
Sara Dantas, MSc
#2: Asset Classes and Financial Instruments
Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Major Classes of Financial Assets or Securities
Major Classes of Financial Assets or Securities
– Money market
– Bond market
– Equity Securities
– Indexes
– Derivative markets
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The Money Market
Main Money Market Financial Assets or Securities
– Treasury Bills
– Certificates of Deposits 
– Commercial Paper
– Eurodollars
– Repurchase Agreements (RPs) and Reverse RPs
– The LIBOR & EURIBOR Markets
– Others: Bankers Acceptances, Brokers’ Calls, Federal Funds
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Major Components of the Money Market
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Treasury Bills
• Treasury bills (T-bills) represent a form of government borrowing from the public
• Investors buy the bills at a discount from the stated maturity value
• At the bill’s maturity, the holder receives from the government a payment equal to 
the face value of the bill; The difference between the purchase price and ultimate 
maturity value constitutes the investor’s earnings
• T-bills are issued with maturities of up to (normally) 52 weeks
• Rather than providing prices of each T-bill, market quotations report yields based 
on those prices; You will see yields corresponding to both bid and asked prices
• Asked price: price you would have to pay to buy a T-bill from a securities dealer
• Bid price: (slightly lower) price you would receive if you wanted to sell a bill to a 
dealer.
• bid–asked spread: dealer’s source of profit
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Treasury Bill Yields
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=billrates
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=billrates
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Treasury Bill Yields
• The yields in the previous figure are reported using the bank-discount 
method, that assumes that the year has only 360 days and computes the 
yield as a fraction of par value
• This means that the bill’s discount from its maturity or face value is 
“annualized” based on a 360-day year, and then reported as a percentage of 
face value
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Treasury Bill Yields
• Example: for the T-bill maturing on October 27, days to maturity are 171 and 
the yield under the column labeled “Asked” is given as 0,34%. This means 
that a dealer was willing to sell the bill at a discount from par value of 0,34% 
x (171/360) = 0,1615%
• A bill with $10,000 par value could be purchased for
• Similarly, on the basis of the bid yield of 0,35%, a dealer would be willing to 
purchase the bill for
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Treasury Bill Yields
• An investor who buys the bill for the asked price and holds it until maturity will see 
her investment grow over 171 days by a multiple of
• Annualizing this return using a 365-day year results in a yield of
which is the value reported in the last column under “Asked Yield”
• This last value is called the Treasury-bill’s bond-equivalent yield
• The Bond Equivalent, also called Coupon Equivalent, or the Investment Yield, is the 
bill's yield based on the purchase price, discount, and a 365- or 366-day year
• The Bond Equivalent can be used to compare the yield on a discount bill to the yield 
on a nominal coupon bond that pays semiannual interest
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Certificates of Deposit
• A certificate of deposit, or CD, is a time deposit with a bank
• Time deposits may not be withdrawn on demand. The bank pays interest 
and principal to the depositor only at the end of the fixed term of the CD
• CDs issued in denominations greater than $100,000 are usually negotiable, 
however; that is, they can be sold to another investor if the owner needs to 
cash in the certificate before its maturity date
• Short-term CDs are highly marketable, although the market significantly 
thins out for maturities of 3 months or more
• CDs are treated as bank deposits by Deposit Insurance Mechanisms, so they 
are currently insured for up to some amount (e.g., $250,000 in the US) in 
the event of a bank insolvency
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Commercial Paper
• Large, well-known companies often issue their own short-term unsecured debt notes 
rather than borrow directly from banks. These notes are called commercial paper
• Very often, commercial paper is backed by a bank line of credit, which gives the 
borrower access to cash that can be used (if needed) to pay off the paper at maturity
• Small investors can invest in commercial paper (normally) only indirectly, via money 
market mutual funds
• Most commercial paper is issued by nonfinancial firms. However, in recent years there 
was a sharp increase in asset-backed commercial paper issued by financial firms
• This was short-term commercial paper typically used to raise funds for the institution to 
invest in other assets. These assets were in turn used as collateral for the commercial 
paper—hence the label “asset backed”
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Eurodollars
• Eurodollars are dollar-denominated deposits at foreign banks or foreign branches 
of American banks
• Most Eurodollar deposits are for large sums, and most are time deposits of less 
than 6 months’ maturity
• A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A 
Eurodollar CD resembles a domestic bank CD except that it is the liability of a non-
U.S. branch of a bank, typically a London branch
• The advantage of Eurodollar CDs over Eurodollar time deposits is that the holder 
can sell the asset to realize its cash value before maturity
• Firms also issue Eurodollar bonds, which are dollar-denominated bonds outside the 
U.S., although bonds are not a money market investment because of their long 
maturities
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Universidade Nova de Lisboa 
Repos and Reverse Repos
• Dealers in government securities use repurchase agreements, also called “repos” or 
“RPs,” as a form of short-term, usually overnight, borrowing
• The dealer sells government securities to an investor on an overnight basis, with an 
agreement to buy back those securities the next day at a slightly higher price. The 
increase in the price is the overnight interest
• The dealer thus takes out a 1-day loan from the investor, and the securities serve as 
collateral.
• A term repo is essentially an identical transaction, except that the term of the 
implicit loan can be 30 days or more. Repos are considered very safe in terms of 
credit risk because the loans are backed by the government securities
• A reverse repo is the mirror image of a repo. Here, the dealer finds an investor 
holding government securities and buys them, agreeing to sell them back at a 
specified higher price on a future date
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Universidade Nova de Lisboa 
The LIBOR & EURIBOR Markets
• The London Interbank Offered Rate (LIBOR) is the rate at which large banks in 
London are willing to lend money among themselves
• This rate, which is quoted on dollar- denominatedloans, has become the premier 
short-term interest rate quoted in the European money market, and it serves as a 
reference rate for a wide range of transactions
• For example, a corporation might borrow at a floating rate equal to LIBOR plus 2%.
• LIBOR interest rates may be tied to currencies other than the U.S. dollar. For 
example, LIBOR rates are widely quoted for transactions denominated in British 
pounds, yen, euros, and so on
• There is also a similar rate called EURIBOR (European Interbank Offered Rate) at 
which banks in the euro zone are willing to lend Euros among themselves
• Official data: https://www.emmi-benchmarks.eu/
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https://www.emmi-benchmarks.eu/
Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Equity Securities
• By purchasing equity, you become part owner of the company
• If an individual owns more than 50% of the equity or shares of the company, the 
individual is called a controlling shareholder of that company
• Investing in equities
– listed equities: traded on an exchange
– unlisted equities: called private equity
• Types:
– Common stock: Residual claim, Limited liability
– Preferred stock: participation in the earnings of a company, right to a regular dividend 
payment based on the shares' face (par) value, Priority over common stocks, 
– Convertible notes
– Depository receipts: negotiable financial instrument issued by a bank to represent a 
foreign company's publicly traded securities (e.g., ADRs)
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Universidade Nova de Lisboa 
Equity
• Rationale for Use: The main reason for buying equity is to become part owner of 
the respective company
• This ownership gives two potential revenue streams:
– dividends (i.e., part of the profit)
– share‐price appreciation
• As an asset class, equities tend to outperform inflation over time
• Specific Risks
– Share prices (i.e., the price of equity) have a tendency to fluctuate quite a bit.
– This price uncertainty is a result of (a combination of) many risks: market risk, 
business risk, currency risk if it concerns a foreign equity, country risk, etc.
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Universidade Nova de Lisboa 
Companies in the Dow Jones Industrial Average
http://money.cnn.com/data/dow30/
Company Price Change % Change Volume YTD change
MMM 3M 189.09 +0.19 +0.10% 1,662,286 +5.89%
AXP American Express 79.58 +0.08 +0.10% 4,434,208 +7.42%
AAPL Apple 139.52 +0.18 +0.13% 17,446,297 +20.46%
BA Boeing 182.02 +1.09 +0.60% 2,451,990 +16.92%
CAT Caterpillar 95.93 +0.27 +0.28% 4,683,089 +3.44%
CVX Chevron 111.81 -1.36 -1.20% 6,660,335 -5.00%
CSCO Cisco 34.20 +0.01 +0.03% 21,033,740 +13.17%
KO Coca-Cola 41.99 -0.19 -0.45% 11,273,704 +1.28%
DIS Disney 110.86 +0.19 +0.17% 5,114,421 +6.37%
DD E I du Pont de Nemours and Co 79.39 -0.42 -0.53% 4,562,937 +8.16%
XOM Exxon Mobil 82.52 -0.31 -0.37% 12,711,508 -8.58%
GE General Electric 29.86 -0.14 -0.47% 29,982,940 -5.51%
GS Goldman Sachs 250.90 -1.11 -0.44% 2,497,340 +4.78%
HD Home Depot 146.02 -1.11 -0.75% 3,996,289 +8.91%
IBM IBM 180.38 -0.09 -0.05% 2,980,516 +8.67%
INTC Intel 35.80 +0.23 +0.65% 23,434,893 -1.30%
JNJ Johnson & Johnson 123.83 +0.12 +0.10% 6,643,988 +7.48%
JPM JPMorgan Chase 91.41 -0.51 -0.55% 11,156,845 +5.93%
MCD McDonald's 128.07 +0.04 +0.03% 3,332,350 +5.22%
MRK Merck 65.96 -0.51 -0.77% 8,328,744 +12.04%
MSFT Microsoft 64.40 +0.13 +0.20% 18,520,987 +3.64%
NKE Nike 56.55 -0.22 -0.39% 7,124,445 +11.25%
PFE Pfizer 33.99 -0.36 -1.05% 29,206,226 +4.65%
PG Procter & Gamble 90.29 -0.08 -0.09% 5,362,951 +7.39%
TRV Travelers Companies Inc 121.47 -0.18 -0.15% 1,773,937 -0.78%
UTX United Technologies 112.28 +0.62 +0.56% 2,457,237 +2.43%
UNH UnitedHealth 167.68 -0.40 -0.24% 2,702,294 +4.77%
VZ Verizon 49.44 -0.59 -1.18% 12,896,873 -7.38%
V Visa 89.06 +0.12 +0.13% 5,688,364 +14.15%
WMT Wal-Mart 69.36 -0.01 -0.01% 7,282,861 +0.35%
http://money.cnn.com/quote/quote.html?symb=MMM
http://money.cnn.com/quote/quote.html?symb=AXP
http://money.cnn.com/quote/quote.html?symb=AAPL
http://money.cnn.com/quote/quote.html?symb=BA
http://money.cnn.com/quote/quote.html?symb=CAT
http://money.cnn.com/quote/quote.html?symb=CVX
http://money.cnn.com/quote/quote.html?symb=CSCO
http://money.cnn.com/quote/quote.html?symb=KO
http://money.cnn.com/quote/quote.html?symb=DIS
http://money.cnn.com/quote/quote.html?symb=DD
http://money.cnn.com/quote/quote.html?symb=XOM
http://money.cnn.com/quote/quote.html?symb=GE
http://money.cnn.com/quote/quote.html?symb=GS
http://money.cnn.com/quote/quote.html?symb=HD
http://money.cnn.com/quote/quote.html?symb=IBM
http://money.cnn.com/quote/quote.html?symb=INTC
http://money.cnn.com/quote/quote.html?symb=JNJ
http://money.cnn.com/quote/quote.html?symb=JPM
http://money.cnn.com/quote/quote.html?symb=MCD
http://money.cnn.com/quote/quote.html?symb=MRK
http://money.cnn.com/quote/quote.html?symb=MSFT
http://money.cnn.com/quote/quote.html?symb=NKE
http://money.cnn.com/quote/quote.html?symb=PFE
http://money.cnn.com/quote/quote.html?symb=PG
http://money.cnn.com/quote/quote.html?symb=TRV
http://money.cnn.com/quote/quote.html?symb=UTX
http://money.cnn.com/quote/quote.html?symb=UNH
http://money.cnn.com/quote/quote.html?symb=VZ
http://money.cnn.com/quote/quote.html?symb=V
http://money.cnn.com/quote/quote.html?symb=WMT
Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Stock Market Indexes
• Dow Jones Industrial Average (US)
• NASDAQ (US)
• Euro Stoxx 50 (EU)
• Nikkei (Japan)
• FTSE (Financial Times of London)
• Dax (Germany)
• MSCI (Morgan Stanley Capital International)
• Hang Seng (Hong Kong)
• TSX (Canada)
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Private Equity
• Refers to equity (i.e., ownership) that is not quoted on a stock exchange
• Private equity consists of investors and funds that make investments directly into 
privately owned companies
• Common in case of buyouts of public companies that result in a delisting of public 
equity
• Capital for private equity is raised from retail and institutional investors, and can be 
used to fund new technologies, expand working capital within a privately owned 
company, make acquisitions, or strengthen a balance sheet
• Private equity investments often demand long holding periods (e.g., to allow for a 
turnaround of a distressed company or a liquidity event such as an IPO or sale to a 
public company)
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Universidade Nova de Lisboa 
Private Equity
• Two of the more common private equity investment strategies are:
1. Venture capital. This refers to taking an equity stake in a firm in a less mature 
industry
2. Leveraged buyouts . a target firm is acquired by a private equity investor, 
whereby the purchase is financed through debt with the target company’s 
operations and assets as collateral.
• In all strategies, the private equity investors know prior to investing how and when 
they intend to exit the investment (e.g., through IPO or onward sale), thus realizing 
the profit on the investment in the firm
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Universidade Nova de Lisboa 
Private Equity: Rationale for Use
• Given the effort and time involved in private equity (e.g., select company, due 
diligence, acquisition, manage, sell, etc.), the anticipated return on these 
investments is significantly higher than with conventional assets
• Private equity investors are legal insiders having much broader access to 
information and management as compared to conventional assets (where insider 
trading is a crime)
• Private equity firms invest in a company to make it more valuable, over a number of 
years, before selling it to a buyer who appreciates that lasting value has been 
created
• Private equity firms are extremely selective and spend significant resourcesassessing the potential of companies to understand the risks and how to mitigate 
them
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Private Equity: Specific Risks
• Illiquidity. Private companies are illiquid by nature. Private equity firms expect to 
commit to each investment for several years
• Costly . specialist resources, infrastructure, and expertise are required
• Restricted access . It is not easy to obtain access to good private equity 
opportunities, as they are usually not openly offered to the public.
• High barriers to entry. To enter the private equity world you will require specialist 
knowledge, a network, and capital
• Complexity. at many stages specialist knowledge is required (e.g., company 
valuation, company due diligence, management, etc.)
• Dilution . The attractiveness of private‐equity investing could become harder to 
locate good investment opportunities.
• Business uncertainty
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Bond (or fixed income)
• Definition: A debt security (or a bond) is a financial claim by which
o The issuer (or the borrower) is committed ….
o … to paying back to the bondholder (or the lender) …
o … the cash amount borrowed (called the principal or face value)
o … plus periodic interests (called the coupons) calculated on this amount during a 
given period of time
o … on specified pre-determined dates
• A bond is a loan for a defined period of time and a fixed (or floating) interest rate
• Contrary to equities, a bond does not represent ownership
• Bonds are used by companies, municipalities, and governments to finance a variety of 
projects and activities
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Bond Characteristics
• Bond Characteristics
 Coupon rate
 # payments per year
 Maturity
 Time to maturity 
 Face Value
 Other features (options, reimbursement options,…)
• Example
 A US Treasury bond with coupon 3.5%, maturity date 11/15/2006 and a nominal 
issued amount of $18.8 billion …
 … pays a semi-annual interest of $329 million ($18.8 billion times 3.5%/2) 
 … every six months until 11/15/2006 included, as well as $18.8 billion on the 
maturity date
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yieldprice coupon rate maturity date
Bond Markets: 
A US Treasury-Bond Description on Bloomberg
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Universidade Nova de Lisboa 
Listing of Treasury Issues
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Universidade Nova de Lisboa 
Bond (or Fixed Income)
• The interest on the bond typically depends on the
• rating of the issuer (the lower the rating, the higher the cost to borrow money and 
therefore the higher the coupon) 
• the duration of the bond (the longer the duration, the higher the coupon)
• Rating agencies (e.g., Fitch, Standard & Poor’s, and Moody’s) rate the bond issuer’s ability to 
repay the loan at maturity
• AAA‐rated (or Aaa or high‐grade) bonds are the safest, while the lowest D‐rated bonds 
are the ones that are in default
• Bonds are either considered investment grade (BBB or Baa and above) or junk (BB or Ba
and below)
• In the case of junk bonds, the chance that the respective company defaults is more 
likely, which makes the investment more speculative and subject to price fluctuations.
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Universidade Nova de Lisboa 
Bond (or Fixed Income)
• Bonds can be
• Secured: the bond issuer has pledged specific assets to the bondholders in case the 
issuer cannot repay the loan
• Unsecured (also called debentures): have their interest payments and return of the 
principal amount only guaranteed by the credit of the issuing company. If the company 
fails, you may get little or nothing of your investment back
• Rationale for Use
• Bonds are generally considered a safe and conservative investment. Over time stocks 
tend to outperform bonds
• Bonds provide a higher level of return predictability
• the coupon is usually higher than the interest offered by banks
• investing in debt is in general safer than investing in equity; if a company goes bankrupt, 
debt‐holders are ahead of shareholders in the line to be paid
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Universidade Nova de Lisboa 
Bond (or Fixed Income): Specific Risks
1. Market risk: The price of a bond fluctuates
2. Credit/default risk: This means that the bond issuer is no longer able to meet its obligation 
under the bond agreement
3. Interest rate risk: If interest rates rise (decline), the bond becomes less (more) attractive 
and therefore cheaper (more expensive, prepayment risk)
4. Inflation risk: The return on the bond must at least match the inflation rate
5. Liquidity risk: Not all bonds have the same marketability. The less liquid are the bonds the 
higher coupon rate is expected to be
6. Currency risk: for bonds denominated in a foreign currency, you run the risk that 
weakening of the bond currency affects the value of your investments.
7. Prepayment risk: This is the risk that a bond issuer prepays the loan before the maturity 
date, e.g., when interest rates in the market has fallen way below the coupon rate
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Universidade Nova de Lisboa 
Convertible Bond
• A convertible bond is a hybrid asset class that grants its holder an option to exchange the 
bond into a specified number of common shares at a specified price
• Is often described as a straight bond plus a call option on the company’s stock
• The call component
 allows the holder a mechanism by which he can benefit from future capital appreciation 
in the company’s equity while the fixed‐income component provides a return floor
 protects the holder from dramatic increases in interest rates, as in that case the holder 
has the opportunity to convert the bond into shares of common stock
• Companies issue convertible bonds to
 Reduce interest expense: lower coupon rate than on a straight bond
 Enhance issue marketability
 Sell equity at a premium over the current market price
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Convertible Bond: rationale for use & risks
• Convertible bonds are attractive when investing in firms whose future risk is difficult to 
assess. Because convertible holders have the right, not the obligation, to convert to equity, 
they are protected against stock price declines while benefiting from price increases
• the conversion feature is a sweetener
• Sometimes investment managers invest in convertible bonds because they are restricted 
regarding the percentage of their portfolio that can be invested in equities
• On the quantitative side, convertibles over the long run can be expected to have return and 
risk between that of stock and nonconvertible corporate bonds
• Specific Risks
 Like bonds, convertibles have default risk and thus must have higher yields
 delayed method of equity financing, i.e., delayed dilution of common stock and EPS
 The indenture provisions (restrictive covenants) on a convertible bond are generally 
much more stringent than they are in common or preferred stock
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Universidade Nova de Lisboa 
Mutual Fund
• Investment vehicle that is made up of a pool of funds collected from many investors
• The manager of this pool invests in securities such as stocks, bonds, and so on, to produce 
capital gains and income for the fund’s investors; Mutual funds come with an official 
prospectus that describes the objectives, style, instruments, and so on of the fund
• Mutual funds issue shares. The value of the share—net asset value (NAV)—is the total value 
of theoverall investment pool divided by the number of outstanding shares
• There are different kinds of mutual funds:
1. Money market funds
2. Bond Income funds
3. Balanced funds
4. Equity funds
5. Global international funds
6. Index funds (replicate the performance of a broad market index, e.g., DJIA)
7. Specialty funds (sector funds, regional funds, socially responsible funds,…)
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Universidade Nova de Lisboa 
Mutual Funds
• Rationale for use
• They give (relatively) small investors access to professionally managed, 
diversified portfolios. Each shareholder participates proportionally in the gain 
or loss of the fund.
• Diversification: by having more stocks, you will be less hurt when one of your 
stocks goes down
• Economies of scale: thanks to the size of the fund, the transaction costs will be 
lower
• Liquidity: it is easier to sell one fund than to sell an entire portfolio
• Simplicity: it is easy to buy and sell
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Universidade Nova de Lisboa 
Mutual Funds: specific risks
• Difficult to select the right fund(s) from thousands of options
• Manager risk: Managers can make mistakes
• Rigid guidelines: Most mutual funds have clearly stipulated in the prospectus how 
they have to be invested. Even if you managed to find the best telecom fund in the 
world, once the entire telecom sector collapses your telecom fund will also go 
down
• Costs: There are lots of parties involved in the establishment, management, 
administration, and distribution of mutual funds
• Dilution: The more diversified you are, the more likely that you will just follow the 
benchmark, which you most likely could have achieved with a cheaper, passively 
managed index fund
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Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Electronically Traded Funds (ETF)
• An ETF is a security that tracks an index, a commodity, or a basket of assets like an index 
fund, but trades like a stock on an exchange
• In other words, if you buy a commodity ETF (e.g., coffee) and the respective commodity 
prices go up, then the value of your ETF will increase accordingly.
• Like any listed stock, ETFs experience price fluctuations throughout the day as they are 
bought and sold. In that sense an ETF is in fact a hybrid between a mutual fund and a stock
• The main differences from normal mutual funds are:
• ETFs can be bought and sold at any point of time during the day
• For ETFs you don’t pay redemption fees, but just transaction fees (like what we are used 
to when buying and selling stocks)
• Most of the time ETFs are passive investment instruments, designed to mimic a 
benchmark index
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Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
ETF: Rationale for Use
• Cost‐effective: the management fees can be low (sometimes only a few basis points) where 
mutual funds charge up to 1.5 to 2%. The main costs involved in ETFs are the transaction fees
• Simple: They can be bought and sold throughout the day, with no lengthy 
subscription/redemption process; They provide an opportunity (taking into account the 
costs) for more speculative investors to bet on a short‐term direction of the market
• Transparent: the full set of portfolio holdings is shown on the ETF provider’s website
• Liquid: they can be bought and sold at any time during the trading day
• Great diversification tool: Through ETFs it is easy and cheap to obtain access to commodities, 
regions, industries, leverage strategies, and so on
• Highly flexible: Thanks to the impressive number of available ETFs, it has become possible to 
trade the entire market or various investment strategies as if it were one single stock
• Transferability: ETFs are considered a portable investment. Whenever an investor wants to 
change banks, it is often quite a challenge to transfer mutual funds holdings from one bank 
to another
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Universidade Nova de Lisboa 
ETF: Specific risks
• Market Risk
• Exotic-Exposure Risk
• Counterparty Risk
• Shutdown Risk: The fund is liquidated and shareholders are paid in cash
• ETF-Trading Risk: you can't buy an ETF with zero transaction costs. Like any stock, 
an ETF has a bid-ask spread, which can vary from one penny to many euros
• Tracking error: Most ETFs are mimicking a specific benchmark index. However, in 
most cases there will be a (slight) tracking error (i.e., a deviation either higher or 
lower) of an ETF portfolio’s return from its benchmark index
37
Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Derivatives
• A derivative is a contract between two or more parties whose value is based on an 
agreed-upon underlying financial asset, index or security
• The price of the derivative is dependent on or derived from one or more (agreed) 
underlying assets as well as on the duration of the contract
• Common underlying instruments include: bonds, commodities, currencies, interest 
rates, market indexes and stocks
• There are many different types of derivative instruments, but the most commonly 
known types are: Futures contracts, forward contracts, options, swaps and warrants
• Derivatives are used for
 Speculating: seek to profit from changing prices in the underlying asset, index or 
security
 Hedging: derivatives used as a hedge allow the risks associated with the underlying 
asset's price to be transferred between the parties involved in the contract
38
Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Futures and forward contracts 
• A forward commitment is a contract between two (or more) parties who agree to 
engage in a transaction at a later date and at a specific price agreed on at the trade date
• Example: two parties agree today to exchange 500,000 barrels of crude oil for $42.08 a 
barrel three months from today. Entering a forward contract typically does not require 
the payment of a fee
• There are two major types of forward commitments:
• Forward contracts, or forwards, are OTC-traded derivatives with customized terms 
and features
• Futures contract, or futures, are exchange-traded derivatives with standardized 
terms
• The difference between the actual price at the time of delivery of the asset on the pre-
agreed date and the forward or future price is the profit or loss by the purchaser
39
Instituto Superior de Estatística e Gestão de Informação
Universidade Nova de Lisboa 
Derivatives Markets
Options
• Basic Positions
• Call (Buy)
• Put (Sell)
• Terms
• Exercise Price
• Expiration Date
• Assets
Futures 
• Basic Positions
• Long (Buy)
• Short (Sell)
• Terms
• Delivery Date
• Assets