Indices

A derivative trade is a contractual agreement to exchange cashflows or other securities in the future, based on observed events in the market. To begin understanding the common features of such trades, we imagine ourselves in the far future, working out the payments to which each party is contractually bound.Through this thought experiment, we see a clear distinction between the market events – which enter the public record as historical fixings – and the terms of the trade, which describe the computation of a payout based on these fixings. Such historical fixings are not one-time events, but periodic (usually daily) snapshots of some ongoing process, which we call an index.Indices, defined in this way, have two crucial properties. First, they stand at the interface – to a large extent, they define the interface – between trades and models. Once a model can simulate the dynamics of indices and of discounting, it need give no further consideration to trades.Second, indices are a bridge uniting past and future. The computation of a payout from a set of index fixings is defined by the termsheet of a trade, and we will perform the same steps whether we are testing a scenario of the future, performing a postmortem on the past, or pricing and administering a live trade.