Markets products

Markets interviews often start broad: "what does a rates desk trade?" or "how would a company hedge its currency risk?" You need a clear picture of the main products, who uses them and how they pay out. This lesson covers the essentials, with simple numbers you can reproduce on a whiteboard.

Cash products

Cash products are the underlying instruments themselves. Equities are shares in companies, traded on exchanges such as the London Stock Exchange. Bonds are loans in tradable form: gilts from the UK government, and corporate bonds from companies, which pay a higher yield to compensate for credit risk. Spot FX is the exchange of one currency for another, normally settling two business days later.

Derivatives are contracts whose value depends on something else, such as a share price, an index, an interest rate or an exchange rate. They let clients hedge risk or take a view without buying the underlying asset outright.

Forwards and futures

A forward is a private agreement to buy or sell something at a fixed price on a future date. Companies use FX forwards constantly: a UK exporter expecting dollars in six months can fix today how many pounds it will receive.

A future does the same job but is standardised and traded on an exchange. Gains and losses are settled every day through margin, which reduces the risk that the other side fails to pay. FTSE 100 index futures, for example, are worth £10 per index point.

Forward FX rates come from interest rates. With GBP/USD spot at 1.2700, a one-year sterling rate of 4% and a dollar rate of 5%, the one-year forward is 1.2700 × 1.05 ÷ 1.04, about 1.2822. Sterling has the lower interest rate here, so it buys more dollars forward than spot.

Swaps

An interest rate swap exchanges fixed interest payments for floating ones on a notional amount, which is never itself exchanged. In sterling, the floating leg is usually compounded SONIA. A company with a SONIA-linked loan can pay fixed on a swap to lock in its borrowing cost. UK pension schemes often receive fixed on long-dated swaps to match their long-term liabilities. Payments are netted, so only the difference changes hands.

Options

An option gives the buyer a right but not an obligation. A call is the right to buy at the strike price; a put is the right to sell at the strike price. The buyer pays a premium up front, which is the most they can lose. The seller receives the premium and takes on the obligation.

Before expiry, an option's price has two parts: intrinsic value, what it would pay if exercised now, and time value, which reflects the chance of a better payoff before expiry. More volatility and more time both increase time value.

Credit default swaps

A credit default swap (CDS) works like insurance against a borrower defaulting. The buyer pays a regular premium, quoted as a spread in basis points a year on the notional amount, and receives a payment if a credit event, such as a failure to pay, occurs. A spread of 150bp on £10m costs £150,000 a year. Investors use CDS to hedge bonds they own, or to take a view on a company's creditworthiness without buying or selling its bonds. A widening spread means the market sees more risk.

Repo

A repo, or sale and repurchase agreement, is a short-term secured loan. One party sells securities, often gilts, and agrees to buy them back later at a slightly higher price. The difference is the interest. Banks, hedge funds and pension schemes use repo to fund positions cheaply, and the gilt repo market is central to how sterling markets function.

Who uses what

• Companies: FX forwards for trade flows, interest rate swaps for loans
• Pension schemes and insurers: gilts, index-linked gilts, swaps and repo to match long-term liabilities
• Asset managers: shares, bonds and index futures to adjust exposure quickly
• Hedge funds: all of the above, often with leverage and options