What Is a Primary Instrument?
A primary instrument is a financial investment whose price is based directly on its market value. It can be any type of financial investment that is priced based on its own value.
Key Takeaways
- A primary instrument is a financial investment whose price is based directly on its market value.
- Primary instruments include cash-traded products like stocks, bonds, currencies, and spot commodities.
- Understanding primary instruments provides the base knowledge for derivatives, whose prices are derived from the primary (underlying) asset.
Understanding Primary Instruments
Primary instruments are standard financial investments. They often trade on mainstream exchanges with high levels of liquidity. Their market value is determined based on assumptions about their individual characteristics.
Examples of primary instruments include stocks, bonds, and currency, among others. Any spot market that trades the 'cash' asset involves a primary instrument. By contrast, the price of derivative instruments, such as options and futures, is often based on the value of a primary instrument.
Primary investments like stocks are what most beginning investors think of when they think about investing. This is because investing in primary instruments often requires only a general knowledge of markets and investment principles.
Understanding primary instruments provides the base knowledge for derivatives. Derivatives were created to hedge against some of the risks of primary instruments. Derivatives also provide products for alternative investment strategies that are based on the speculation of values of underlying primary instruments.
Derivative Instruments
Derivatives create an alternative product for investors seeking to benefit from changes in the market value of primary instruments. They are known as non-primary instruments. Call and put options, and futures are some of the derivatives that can be used to profit from primary instruments. Derivatives get their name because they are derived from the primary (underlying) asset.
Derivatives are generally more complex than primary instruments because of the pricing methodologies. Derivative products have values that are generated from the primary instrument. Options on stocks are some of the most common derivative products used by alternative investors.
Black Scholes is the main methodology for calculating the price of derivative options on stocks. It determines the price of a derivative product by considering five input variables:
- The strike price of the option
- The current stock price
- Time to expiration of the option
- Risk-free rate
- Volatility
Black Scholes is used to calculating prices for call and put options. Call options offer an investment product for investors seeking to benefit from a rising stock price. Buying a call option gives an investor the right to buy a stock at a specified strike price. Buying a put option gives an investor the right to sell a stock when they estimate a price is falling.
Call and put options are two of the most common types of non-primary instruments traded in the market. Futures products are also non-primary instruments that allow investors to hedge against market movements of primary instruments. Futures contracts are typically priced from a cost of carry or expectancy model. They allow an investor to take a future bet on a primary instrument by buying a futures contract. Futures contracts can be bought for a variety of primary instrument investments. Currency futures that bet on future prices of currency values are some of the most common types of futures traded by investors.
