To the perennial question “Which comes first; the music or the words”? Ira Gershwin responded, “What usually comes first is the contract”.
And so it is with financial instruments like derivatives, which after all are contracts – whether standardized or bespoke.
The structure of the contract – unsurprisingly – influences its behavior.
Structure would be the terms of the contract (as found in the confirm or term sheet). This would detail: the commitments required and resources committed under the contract (e.g. the payouts or payments to be made, the instruments to be referenced or delivered, the notices or services required etc.); the parties involved in these commitments (e.g. the counterparties to the trade, payment or calculation agents etc.); and the events that both govern and unfold from the realization of these commitments (e.g. time, an embedded choice, a default or downgrade etc.). The sharp-eyed will notice the (deliberate) borrowing of terminology from the REA accounting model – more of which to come.
Behavior can be thought of both as the remaining state space of possibilities that the contract embodies and the actual realization of paths through that state space. The state space is bounded (and so influenced) by the contract terms – e.g.
- The specified parties bound actors that can be involved in the execution of the contract,
- The contract’s maturity time-bounds its existence,
- A knock-out barrier in a barrier option state-bounds the contract’s existence.
Behavior in turn influences (future) structure in that the realization of certain states within the state space can alter the (future) state space of possibilities
– think how an option exercise constrains the state space of the un-exercised option, or how the default of a reference entity within the index constrains the state space of an index default swap, or the touching of a knock-in barrier expands the state space of a barrier option, or just the passage of time on the state space of an option (all else being equal).
Much of the management of a financial derivative contract (or indeed any financial contract) involves an ongoing analysis of that bounded state space of possibilities
- whether in forming an expectation/probabilistic view and thus valuation of some or all of the states (in MTM, risk or collateral calculations say), or in determining the set of events embodied in one or more states (e.g. in determining payments for settlement or funding requirements).
We will use this structure and behavior axes often in our thinking about derivative contracts, their management processes and systems as it offers a very useful and intuitive way of thinking of similar sets of derivatives and financial instruments in general and also in thinking of how to dimension the complexity of products and their associated processes.