Asset classes are the different kinds of actual vehicles that are available for trading at different exchanges. For example, cash interest rate bonds, cash foreign exchange, and cash stock shares are what we described in the previous section, but we can have financial instruments that are derivatives of these underlying products. Derivatives are instruments that are built on top of other instruments and have some additional constraints, which we will explore in this section. The two most popular derivatives are futures and options, and are heavily traded across all derivatives electronic exchanges.
We can have future contracts pertaining to underlying commodities, energy, equities, interest rate bonds, and foreign exchanges that are tied to the prices of the underlying instruments, but have different characteristics and rules. A simple way to think of a future contract is that it is a contract between a buyer and a seller in which the seller promises to sell a certain amount of the underlying product at a certain date in the future (also known as the expiry date), and where the buyer agrees to accept the agreed-upon amount at the specific date at the specific price.
For example, a producer of butter might want to protect themselves from a potential future spike in the price of milk, on which the production costs of butter directly depend, in which case, the butter producer can enter into an agreement with a milk producer to provide them with enough milk in the future at a certain price. Conversely, a milk producer may worry about possible buyers of milk in the future and may want to reduce the risk by making an agreement with butter producers to buy at least a certain amount of milk in the future at a certain price, since milk is perishable and a lack of supply would mean a total loss for a milk producer. This is a very simple example of a future contract trade; modern future contracts are much more complex than this.
Similar to future contracts, we can have options contracts for underlying commodities, energy, equities, interest rate bonds, and foreign exchanges that are tied to the prices of the underlying instruments, but have different characteristics and rules. The difference in an options contract compared to a futures contract is that the buyer and seller of an options contract have the option of refusing to buy or sell at the specific amount, at the specific date, and at the specific price. To safeguard both counterparties involved in an options trade, we have the concept of a premium, which is the minimum amount of money that has been paid upfront to buy/sell an options contract.
A call option, or the right to buy, but not an obligation to buy at expiration, makes money if the price of the underlying product increases prior to expiration because now, such a party can exercise their option at expiration and buy the underlying product at a price lower than the current market price. Conversely, if the price of the underlying product goes down prior to expiration, such a party now has the option of backing out of exercising their option and thus, only losing the premium that they paid for. Put options are analogous, but they give the holder of a put contract the right to sell, but not an obligation to sell, at expiration.
We will not delve too deeply into different financial products and derivatives since that is not the focus of this book, but this brief introduction was meant to introduce the idea that there are a lot of different tradeable financial products out there and that they vary significantly in terms of their rules and complexity.