1.2.1. Derivatives and Securities
Many businesses finance their operations by issuing stocks and bonds. A stock is an instrument that represents an ownership share in a corporation. The holder of these shares may keep them indefinitely or sell them to another investor. Bonds are instruments that represent a claim on money lent to a business or government entity. For instance, a company issues bonds as a way to borrow money. Investors lend the money by purchasing the bonds. The corporation in turn promises to pay back the loan plus interest at some time in the future. The lender may keep the bonds or sell them to other investors.
Collectively, stocks and bonds are known as securities. A security is a financial instrument representing a claim on a group of assets. An asset is any item of ownership having positive monetary value. An asset can be a financial asset, such as stocks and bonds, or a real asset, such as agricultural commodities, currencies, or oil.
Recall that derivatives are a financial instrument whose returns are based on (derived from) the performance of real or financial assets. Whereas securities represent claims on an asset and must always have a positive value, derivatives represent claims on the price of an asset and may have either a positive or a negative value.*
* For regulatory purposes, these definitions were muddied in 2000 with the passage of the Commodity Futures Modernization Act. By giving the SEC joint jurisdiction with the CFTC over single stock futures, the Act created a new term called a “security future” and redefined “security.” A securities future is defined as a single stock or narrow-based securities index futures contract. Security is redefined to encompass securities futures, securities puts, securities calls, securities straddles, and securities options. These are all considered securities for purposes of regulatory jurisdiction but remain derivatives in the stricter sense of the word.
Futures, as we