What is a financial product?
A financial product is a contract between two agents stipulating movements of cash now and in the future
We didn't represent an arrow from A to B, because actually there may be no movement of cash today. But there must be movements in the future. They depend on various conditions, stated in the contract.
So, once again, time plays a fundamental role.
From A's viewpoint, the movements of cash are these
Modern money also derives from simple financial products. The banknotes we have in our pocket, at first were receipts given by a bank (selected to be a central bank) to a State in exchange for a loan. Let's clarify this sentence which involves several ideas. The operation between the bank and the State goes like this
After the operation the balance sheet of the bank is as follows (suppose it was the first operation of the bank):
The banknotes, initially given to the State Treasury, will be used for the State's expenditures (paying civil servants, various purchases, financing wars...), and will eventually ooze into the population. Without going into details here, the creation of the money we keep in commercial bank accounts follows similar lines.
Many countries selected their central bank in the XIXth century. The Bank of England, created in 1694, became the central bank of England in 1844. The United States are an exception: due to the fierce taste of Americans for independence, they created their own central bank (the Federal Reserve System) only in 1913.
Money will be the topic of our third course in the trilogy: accounting, finance, money
A financial product has value, but it is not tangible. To build our understanding of the various types of values, let's consider several examples.
This is consumable tangible value. A hammer is also tangible value, but you don't eat it; it is a tool to produce consumable value (for instance, a house in which we will live).
Or, put another way, gold has always been desirable. Because it is rare and pretty, it is suited for display of power and wealth, and furthermore it doesn't alter. So, ever since men are on Earth they have been willing to pay a high value for gold (relative to what wealth produces an hour of work). And this is still the case today.
When President Ben Ali fled Tunisia, after the January 2011 uprisings, he took with him 1.5 tonnes of gold.
This "receipt" has legal tender status in the United States of America, and various other countries in the world.
We shall study, in our course in money, how come pieces of paper like that can play such an important role in the functionings of a community.
Finance being about promises, it requires powers capable of enforcing them. This is why modern finance and modern money developed in parallel with the emergence, in western Europe, of powerful monarchies, which replaced feudality (having itself come after the collapse of the western Roman empire and the subsequent "barbarian" kingdoms) between 1000 and 1700.
Then absolute monarchies were replaced by various "republican" systems, which retained however (and even reinforced) the centralised authority of monarchies.
Let's leave, for the time being, these momentous topics and return to the description of selected financial products.
For instance, when the price of oil reached $140 in 2008, Air France found "futures" investors willing to sell it kerozen at some future dates at $200 per barrel. Air France entered into large such contracts. They were intended to cover the company against possibly even higher prices in the future. Unfortunately, prices subsequently plummeted, and for a while Air France paid its kerozen very dearly.
Today (February 15th, 2011) Google stocks trade for $628.
Here is an example of option:
Such an option is called a "call option".
Then, on June 11th, if the price of Google stocks is higher than $600 A, will "exercise" its option, and buy one stock from B (and usually resell it right away, pocketing the difference between the market price and his exercise price). If on June 11th, on the other hand, the price of Google stocks is lower than $600, A won't exercise its right and simply discard his option.
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